6 Elasticity McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc All rights reserved Price Elasticity of Demand • Measures buyers’ responsiveness to • price changes Formula for price elasticity of demand Percentage Change in Quantity Demanded of Product X Ed = Percentage Change in Price of Product X LO1 Price Elasticity of Demand Formula • Eliminate the minus sign • Easier to compare elasticities LO1 Price Elasticity of Demand • Elastic demand, Ed > • Sensitive to price changes • Large change in quantity for small price change • Inelastic demand, Ed < • Insensitive to price changes • Small change in quantity for large price change • Unit elastic demand, Ed = – Equal changes in quantity and price LO1 Extreme Cases P D1 Perfectly inelastic demand (Ed = 0) Perfectly inelastic demand LO1 Extreme Cases P D2 Perfectly elastic demand (Ed = ∞) Perfectly elastic demand LO1 Price Elasticity of Demand • Can not use slope to determine • LO2 elasticity Can use slope to determine relative elasticity Total Revenue Test • Total Revenue = Price X Quantity • Inelastic demand • P and TR move in the same direction • Elastic demand • LO2 • P and TR move in opposite directions Unit elastic demand • TR doesn’t change when P changes Total Revenue Test Table 6.1 Price Elasticity of Demand for Movie Tickets as Measured by the Elasticity Coefficient and the Total-Revenue Test (3) Elasticity Coefficient (Ed) (1) Total Quantity of Tickets Demanded per Week, Thousands (2) Price per Ticket $8 5.00 14,000 Elastic 2.60 18,000 Elastic 1.57 20,000 Elastic 1.00 20,000 Unit Elastic 0.64 18,000 Inelastic 0.38 14,000 Inelastic 0.20 8,000 Inelastic LO2 (4) Total Revenue (1) X (2) (5) Total Revenue Test $8,000 Summary of Price Elasticity of Demand Table 6.2 Price Elasticity of Demand: A Summary Absolute Value of Elasticity Coefficient Demand Is: Impact on Total Revenue of a: Description Price Increase Price Decrease Qd changes by a larger percentage than does price Total Revenue decreases Total Revenue increases Greater than (Ed > 1) Elastic or relatively elastic Equal to (Ed = 1) Unit or unitary Qd changes by elastic the same percentage as does price Total revenue is unchanged Total revenue is unchanged Less than (Ed < 1) Inelastic or relatively inelastic Total revenue increases Total revenue decreases LO2 Qd changes by a smaller percentage than does price Determinants of Elasticity of Demand • Substitutability • • More substitutes, demand is more elastic Proportion of Income • Higher proportion of income, demand is more elastic • Luxuries vs Necessities • LO1 • Luxury goods, demand is more elastic Time • More time available, demand is more elastic Price Elasticity of Demand Table 6.3 Selected Price Elasticities of Demand Product or Service Price Elasticity of Demand (Ed) Product or Service Price Elasticity of Demand (Ed) Newspapers 10 Milk 63 Electricity (household) 13 Household appliances 63 Bread 15 Liquor 70 MLB Tickets 23 Movies 87 Telephone Service 26 Beer 90 Cigarettes 25 Shoes 91 Sugar 30 Motor vehicles 1.14 Medical Care 31 Beef 1.27 Eggs 32 China, glassware 1.54 Legal Services 37 Residential land 1.60 Automobile repair 40 Restaurant meals 2.27 Clothing 49 Lamb and mutton 2.65 Gasoline 60 Fresh peas 2.83 LO1 Applications of Ed • Large Crop Yields • Inelastic demand, lower total revenue • Excise Taxes • Inelastic demand, more total revenue • Decriminalization of Illegal Drugs • Inelastic demand, more total revenue • Decrease street crime LO1 Price Elasticity of Supply • Measures sellers’ responsiveness to price changes • Elastic supply (Es > ), producers are responsive to price changes • Inelastic supply (Es < 1), producers are not responsive to price changes Es = LO3 Percentage Change in Quantity Supplied of Product X Percentage Change in Price of Product X Price Elasticity of Supply • Time is primary determinant of elasticity of • supply Time periods considered • Immediate Market period • Can’t adjust any resources • Short Run • Able to adjust some resources • Long Run • Able to adjust all resources LO3 Applications of Elasticity of Supply • Antiques • Inelastic supply • Reproductions • More elastic supply • Volatile gold prices • Inelastic supply LO3 Cross Elasticity of Demand • Measures responsiveness of sales to • • • change in the price of another good Substitutes – positive sign Complements – negative sign Independent goods - zero Percentage change in quantity demanded of product X Ex,y = Percentage change in price of product Y LO4 Income Elasticity of Demand • Measures responsiveness of buyers • • to changes in income Normal goods – positive sign Inferior goods – negative sign Percentage change in quantity demanded Ei = Percentage change in income LO4