PRICE, INCOME, AND CROSS ELASTICITY

WHAT IS ELASTICITY?

Measure of just how much the quality demanded will be affected by a change in price or change in price of related goods.

2 significant words:

1. Measure- refers to as numbers or coefficients2. responsiveness- refers to the reaction to change

4 basic types of elasticity:1.Price elasticity of demand

2. Price elasticity of supply

3.Income elasticity of demand

4.Cross elasticity

Types of Elasticity

- measures the responsiveness of quantity demanded of a good to a change in the price.

1. Price elasticity of demand

How price elasticity is measured

Note: The price elasticity of demand is not the same as the slope of a demand curve.

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Price IncomeDemand13.00 3000.00 68.7514.00 3000.00 63.7420.00 3000.00 44.2021.00 3000.00 42.03

Computing price elasticity (income constant)

13.00 4000.00 91.8314.00 4000.00 85.1720.00 4000.00 59.2021.00 4000.00 56.31

Price Income Demand20.00 4000.00 59.2021.00 4000.00 56.31

Price Elasticity of Demand (Income = 4000)

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Ex: 1. Assumes that when gas prices increase by 50%, gas purchased fall by 25%.

PED= = -0.50

Demand is elastic when the percentage change in quantity demanded is greater than the percentage change in price. Elastic if demand changes a lot when the price

changes. The price elasticity is greater than one in absolute

value. A decrease in price leads to an increase in total revenue. An increase in price leads to a decrease in total revenue.

THE PRICE ELASTICITY OF DEMAND AND ITS MEASUREMENT

1. Elastic Demand:

ELASTICITYPrice (P)

Quantity Demanded

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10

5 20

Producer decides to reduce price to increase sales

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% Δ in Price = - 30%% Δ in Demand = + 300%

Ped = - 10 (Elastic)Total Revenue rises

Good Move!

Demand is inelastic when the percentage change in quantity demanded is less than the percentage change in price. The price elasticity is less than one in absolute value. A decrease in price leads to a decrease in total revenue. An increase in price leads to an increase in total revenue.

THE PRICE ELASTICITY OF DEMAND AND ITS MEASUREMENT

2. Inelastic demand

ELASTICITYPrice (P)

Quantity Demanded

10

D5

5

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% Δ Price = -50%% Δ Quantity Demanded = +20%

Ped = -0.4 (Inelastic)Total Revenue would fall

Producer decides to lower price to attract sales

Not a good move!

-Demand is unit elastic when the percentage change in quantity demanded is equal to the percentage change in price.

The price elasticity is equal to one in absolute value.

THE PRICE ELASTICITY OF DEMAND AND ITS MEASUREMENT

3. Unit elastic demand

-the total amount of funds received by a seller of a good or service.Total revenue is found by multiplying price per unit by the number of units sold.

WHAT DETERMINES PRICE ELASTICITY OF DEMAND?

Total Revenue

ELASTICITYPrice

Quantity Demanded (000s)

D

The importance of elasticity is the information it provides on the effect on total revenue of changes in price.

P5

100

Total revenue is price x quantity sold. In this example, TR = P5 x 100,000 = P500,000.This value is represented by the grey shaded rectangle.

Total Revenue

ElasticityPrice

Quantity Demanded (000s)

D

If the firm decides to decrease price to (say) P3, the degree of price elasticity of the demand curve would determine the extent of the increase in demand and the change therefore in total revenue.

P5

100

P3

140

Total Revenue

The relationship between price elasticity and total revenue

Types of Elasticity

2. Cross elasticity

- measures the responsiveness of quantity demanded by changes in price of another good.

• CROSS PRICE ELASTICITY WILL BE POSITIVE WHEN THE TWO GOODS ARE SUBSTITUTES IN CONSUMPTION.

• CROSS PRICE ELASTICITY WILL BE NEGATIVE WHEN THE TWO GOODS ARE COMPLEMENTS IN CONSUMPTION.

Summary of cross-price elasticities of demand: Table 4.3

If the products are …

Then the cross-price elasticity of demand will be …

Example

substitutes positive Pepsi and coca-cola

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

The relationship between price elasticity and total revenue: Table 4.2

If demand is … Then … Because …elastic an increase in price

reduces revenuethe decrease in quantity demanded is proportionally greater than the increase in price

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

Summary of cross-price elasticities of demand: Table 4.3

If the products are …

Then the cross-price elasticity of demand will be …

Example

substitutes positive Pepsi and coca-cola

complements negative Car and gasoline

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

Summary of cross-price elasticities of demand: Table 4.3

If the products are …

Then the cross-price elasticity of demand will be …

Example

substitutes positive Pepsi and coca-cola

complements negative Car and gasoline

unrelated zero printers and peanut butter

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

CROSS PRICE ELASTICITIES

Would you expect the cross price elasticity between the following pairs of goods to be positive or negative? Explain your answers. a) Coke and Pepsi. b) DVD players and DVDs.c) Gucci sunglasses and vegemite

CROSS PRICE ELASTICITIES

Solving the problem: STEP 1: Review the material. The problem is about

cross price elasticities of demand, covered on 109 – 110 of the text.

STEP 2: Solving (a). Coke and Pepsi are the classic example of two goods which are substitutes in consumption. An increase in the price of Coke would, therefore, lead to an increase in demand for Pepsi, so the cross-price elasticity would be positive.

CROSS PRICE ELASTICITIES

Solving the problem: STEP 3: Solving (b). DVD players and DVDs are

complements in consumption. An increase in the price of DVD players would see a decrease in demand for DVD players, and hence a decrease in demand for the complement DVDs. The cross-price elasticity between the two goods would, therefore, be negative.

Cross price elasticities

Solving the problem:

STEP 4: Solving (c). Gucci sunglasses and vegemite are completely unrelated goods, therefore, we would expect the cross price elasticity to equal zero.

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