At the end of this lecture, students should be able to define elasticity, define price elasticity of demand/supply and its determinants, compute the price elasticity of demand/ supply, know the variety of demand/supply curves, to know the relationship between total revenue and the price elasticity of demand, define and compute income elasticity of demand, define and compute cross-price elasticity of demand.
HC Elasticity/sensitivity analysis © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair of 42 Learning Objectives At the end of this lecture, students should be able to • Define Elasticity • Define Price Elasticity of Demand/Supply and Its Determinants • Compute the Price Elasticity of Demand/ Supply • Know the Variety of Demand/supply Curves • To know the relationship between Total Revenue and the Price Elasticity of Demand • Define and compute Income Elasticity of Demand HC • Define and compute Cross-Price Elasticity of Demand © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair Elasticity • Elasticity is a general concept that can be used to quantify the response in one variable when another variable changes HC e la s tic ity o f A w ith r e s p e c t to B © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e % % A B Karl Case, Ray Fair of 42 The Elasticity of Demand • Price Elasticity of Demand • Price-Cross Elasticity of Demand HC Income Elasticity of Demand â 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair of 42 Price Elasticity of Demand • A popular measure of elasticity is price elasticity of demand measures how responsive consumers are to changes in the price of a product HC p r ic e e la s tic ity o f d e m a n d © 2004 Prentice Hall Business Publishing % c h a n g e in q u a n tity d e m a n d e d % c h a n g e in p r ic e Principles of Economics, 7/e Karl Case, Ray Fair of 42 Sign of Price Elasticity HC • According to the law of demand, whenever the price rises, the quantity demanded falls Thus the value of demand elasticity is always negative, but it is stated in absolute terms © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair of 42 What Information Price Elasticity Provides HC • Price elasticity of demand and supply gives the exact quantity response to a change in price © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair of 42 Slope and Elasticity HC slope = 2−3 =− 10 − 5 slope = 2−3 =− 160 − 80 80 • Changing the units of measure yields a very different value of the slope, yet the behavior of buyers in both diagrams is identical © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair of 42 Types of Elasticity Hypothetical Demand Elasticities for Four Products HC PRODUCT % CHANGE IN % CHANGE IN PRICE QUANTITY DEMANDED (% QD) (% P) ELASTICITY (% QD % P) Insulin +10% 0% 0.0 Basic telephone service +10% -1% -0.1 Inelastic Beef +10% -10% -1.0 Unitarily elastic Bananas +10% -30% -3.0 Elastic © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Perfectly inelastic Karl Case, Ray Fair of 42 HC Perfectly Elastic and Perfectly Inelastic Demand Curves • • When demand does not respond at all to a change in price, demand is perfectly inelastic E= zero © 2004 Prentice Hall Business Publishing Demand is perfectly elastic when quantity demanded drops to zero at the slightest increase in price E= infinity Principles of Economics, 7/e Karl Case, Ray Fair 10 of 42 Elasticity, Total Revenue, and Demand • If ED is elastic (ED > 1), a rise in price lowers total revenue HC • Price and total revenue move in opposite directions © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair Elasticity, Total Revenue, and Demand HC • If ED is unit elastic (ED = 1), a rise in price leaves total revenue unchanged © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair Elasticity, Total Revenue, and Demand • If ED is inelastic (ED < 1), a rise in price increases total revenue HC • Price and total revenue move in the same direction © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair Elasticity and Total Revenue Unit Elastic Demand E = 1 TR constant $10 Price F E HC Gained revenue C A 2 © 2004 Prentice Hall Business Publishing TRE= $4x6=$24 TRF= $6x4=$24 Lost revenue B Principles of Economics, 7/e Quantity Karl Case, Ray Fair Elasticity and Total Revenue Inelastic Demand E 1 K J C A B HC TRJ = $8 x 2 = $16 TRK = $9 x 1 = $9 Gained revenue Lost revenue TR falls if price increases © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Quantity Karl Case, Ray Fair Total Revenue Along a Demand Curve • With elastic demand – a rise in price lowers total revenue HC • With inelastic demand – a rise in price increases total revenue © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair Inelastic ED 1 Principles of Economics, 7/e Q0 Quantity Karl Case, Ray Fair Price Elasticity and Total Revenue TR P Q Value of Ed Change in quantity versus change in price Effect of an increase in price on total revenue Effect of a decrease in price on total revenue Elastic Greater than 1.0 Larger percentage change in quantity Total revenue decreases Total revenue increases Inelastic Less than 1.0 Smaller percentage change in quantity Total revenue increases Total revenue decreases Unitary elastic Equal to 1.0 Same percentage change in quantity and price Total revenue does not change Total revenue does not change Type of demand • When demand is inelastic, price and total revenues are directly related Price increases generate higher revenues • When demand is elastic, price and total revenues are HC indirectly related Price increases generate lower revenues © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 39 of 42 The Determinants of Demand Elasticity • Availability of substitutes demand is more elastic when there are more substitutes for the product • Importance of the item in the budget demand is more elastic when the item is a more significant portion of the consumer’s budget HC • Time dimension demand becomes more elastic over time • Proportion of income spent on a product –if small portion of your income, a product is said to be inelastic, if greater % of income, product is elastic © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 40 of 42 Cross-price elasticity of demand • A measure of the response of the quantity of one good demanded to a change in the price of another good HC c r o s s p r ic e e la s tic ity o f d e m a n d © 2004 Prentice Hall Business Publishing % c h a n g e in q u a n tity o f Y d e m a n d e d % c h a n g e in p r ic e o f X Principles of Economics, 7/e Karl Case, Ray Fair • If the • CED= positive, then the products are substitutes • CED= negative, then the products are complementary HC • CED= zero, products are unrelated © 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair Income elasticity of demand – • measures the responsiveness of demand to changes in income in c o m e e la s tic ity o f d e m a n d % c h a n g e in q u a n tity d e m a n d e d % c h a n g e in in c o m e • if the HC • IED>0, normal goods- income increases, dd increases • IED