Lecture Managerial economics (Ninth edition): Chapter 6 – Thomas, Maurice

Chapter 6 - Elasticity and demand. In this chapter, you will learn to: Explain how price elasticity of demand (E) is used to measure the responsiveness or sensitivity of consumers to a change in the price of a good, explain the role that price elasticity plays in determining how a change in the price of a commodity affects the total revenue (TR = P × Q) received, list and explain several factors that affect the elasticity of demand,...

Managerial Economics ninth edition Thomas Maurice Chapter Elasticity and Demand McGraw­Hill/Irwin McGraw­Hill/Irwin Managerial Economics, 9e Managerial Economics, 9e Copyright © 2008 by the McGraw­Hill Companies, Inc. All rights reserved Managerial Economics Price Elasticity of Demand (E) • Measures responsiveness or sensitivity of consumers to changes in the price of a good • E % Q % P • P & Q are inversely related by the law of demand so E is always negative • The larger the absolute value of E, the more sensitive  buyers are to a change in price 6­2 Managerial Economics Price Elasticity of Demand (E) Table 6.1 Elasticity 6­3 E Responsiveness Elastic % Q % P E Unitary Elastic % Q % P E Inelastic % Q % P E Managerial Economics Price Elasticity of Demand (E) • Percentage change in quantity demanded can be predicted for a given percentage change in price as: • % Qd = % P x E • Percentage change in price required for a given change in quantity demanded can be predicted as: • % P = % Qd ÷ E 6­4 Managerial Economics Price Elasticity & Total Revenue Table 6.2 Elastic % Q % P Quantity-effect dominates Price  rises Price  falls 6­5 Unitary elastic % Q % P No dominant effect Inelastic % Q % P Price-effect dominates TR falls No change in TR  TR rises TR rises No change in TR  TR falls Managerial Economics Factors Affecting Price Elasticity of Demand • Availability of substitutes • The better & more numerous the substitutes for a good, the  more elastic is  demand • Percentage of consumer’s budget • The greater the percentage of the consumer’s budget spent  on the good, the more elastic is demand • Time period of adjustment • The longer the time period consumers have to adjust to price  changes, the more elastic is demand 6­6 Managerial Economics Calculating Price Elasticity of Demand • Price elasticity can be calculated by multiplying the slope of demand ( Q/ P) times the ratio of price to quantity (P/Q) E 6­7 % Q % P Q  100 Q P  100 P Q P P Q Managerial Economics Calculating Price Elasticity of Demand • Price elasticity can be measured at an interval (or arc) along demand, or at a specific point on the demand curve • If the price change is relatively small, a point  calculation is suitable • If the price change spans a sizable arc along the  demand curve, the interval calculation provides a better  measure 6­8 Managerial Economics Computation of Elasticity Over an Interval • When calculating price elasticity of demand over an interval of demand, use the interval or arc elasticity formula E 6­9 Q P Average P Average Q Managerial Economics Computation of Elasticity at a Point • When calculating price elasticity at a point on demand, multiply the slope of demand ( Q/ P), computed at the point of measure, times the ratio P/Q, using the values of P and Q at the point of measure • Method of measuring point elasticity depends on whether demand is linear or curvilinear 6­ Managerial Economics Point Elasticity When Demand is Linear • Compute elasticity using either of the two formulas below which give the same value for E E P b    or  E Q P P A W h e r e   P  and   Q   ar e  value s  o f  pr ic e  and  q uant it y  d e m and e d at  t h e  po int  o f  m e as ur e  alo ng  d e m and , an d   A  ( a'/ b ) is  t h e  pr ic e ­ int e r c e pt  o f  d e m and 6­ Managerial Economics Point Elasticity When Demand is Curvilinear • Compute elasticity using either of two equivalent formulas below E Q P P Q P P A W h e r e   Q P  is  t h e  s lo pe  o f  t h e  c ur ve d  d e m and  at t h e  po int  o f  m e as ur e ,  P  and   Q   ar e  value s  o f  pr ic e  and   q uant it y  d e m and e d  at  t h e  po int  o f  m e as ur e , and   A is   t h e  pr ic e ­ int e r c e pt  o f  t h e  t ang e nt  line   e x t e nd e d  t o   c r o s s  t h e  pr ic e ­ ax is 6­ Managerial Economics Elasticity (Generally) Varies Along a Demand Curve • For linear demand, price and E vary directly • The higher the price, the more elastic is demand • The lower the price, the less elastic is demand • For curvilinear demand, no general rule about the relation between price and quantity 6­ S pe c ial c as e  o f   Q aP b  wh ic h  h as  a c o ns t ant pr ic e  e las t ic it y  (e q ual t o   b)  f o r  all pr ic e s Managerial Economics Constant Elasticity of Demand (Figure 6.3) 6­ Managerial Economics Marginal Revenue • Marginal revenue (MR) is the change in total revenue per unit change in output • Since MR measures the rate of change in total revenue as quantity changes, MR is the slope of the total revenue (TR) curve MR 6­ TR Q Managerial Economics Demand & Marginal Revenue (Table 6.3) 6­ Unit sales (Q) Price TR = P   Q MR =  TR/ Q $4.50 $      0  ­­    4.00 $4.00  $4.00    3.50 $7.00  $3.00    3.10 $9.30  $2.30    2.80 $11.20  $1.90    2.40 $12.00  $0.80    2.00 $12.00    1.50 $10.50  $0  $­1.50  Managerial Economics Demand, MR, & TR Panel A 6­ (Figure 6.4) Panel B Managerial Economics Demand & Marginal Revenue • When inverse demand is linear, = A + BQ   (A > 0, B  0 TR increases as Q  increases    (P  Elastic      ( E > 1) Elastic       ( E > 1) decreases) MR = 0 MR