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