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1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3 Supply Elas.End 1 1.0 Elasticity of Demand and Supply SESSION 3: CHAPTER 5 Prof. Harmon The table of contents in the left frame : has links to each slide. The slide with the LECTURE OUTLINE lists the main topic s. These topics begin with a whole number (e.g. 2.0 ). The bottom frame : has options to print each slide and to display closed captioning of the audio. The image of the house appears on every slide in the upper left and operates as a hyper link to the slide LECTURE OUTLINE Tips for Navigation in the Video Lecture: Real World Examples SOFTWARE UPGRADES Illustrates price elasticity of demand and its determinants CIGARETTE TAXATION Illustrates price inelastic demand and relation to revenue Chart Source WSJ Image Source WSJ

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1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3 Supply Elas.End Software Customers Reactions to Fees for upgrades and maintenance Since software doesn't wear out,software companies provide upgrades free, generating additional revenue by selling users on new add-ons or increasing maintenance fees. These fees have crept up to as much as 22% or even 25% of the original license fee, from about 15% a few years ago. Some software companies now get the majority of their profits from such recurring revenue, with original license fees serving as an introductory loss leader. Some customers are happy to upgrade. The recent versions of most business applications, for example, allow better Web access to company data than previously possible For some customers the pain of an upgrade is outweighed by the value of the innovation. Many companies say the a business case for the hassles of installing a new version or adding on the latest bells and whistles.. 2 1.1 Software Upgrades Adapted from : Software Customers Force Change WSJ 1/2/2004Software Customers Force Change Elastic Demand Inelastic Demand

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1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3 Supply Elas.End 3 1.2a One Public Policy Issue Is If cigarette smoking continues at current rates Chart Source WSJ

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1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3 Supply Elas.End 4 1.2b Cigarette Taxes Raise Revenue: Low Demand Elasticity A price rise of 10 percent on a pack of cigarettes would be expected to reduce demand for cigarettes in the short term: by about 4 percent in high-income countries by about 8 percent in low- and middle-income countries, where lower incomes tend to make people more responsive to price changes. In both cases sales revenue increases because the percent increase in price is larger than the percent decline in quantity. (Remember revenue = price x quantity.) Long-run price responsiveness is estimated to be twice as high. Source: http://www.imf.org/external/pubs/ft/fandd/1999/ 12/jha.htm Chart Source WSJ

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1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3 Supply Elas.End 5 1.3 LECTURE OUTLINE 1. First SlideFirst Slide 2.0 Price Elasticity of DemandPrice Elasticity of Demand 3.0 Supply ElasticitySupply Elasticity 4.1 Income ElasticityIncome Elasticity 5.1 Cross Price ElasticityCross Price Elasticity Substitutes, Complements 6.0 Econ Lab EndEcon Lab End

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1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3 Supply Elas.End 2.0 Price Elasticity of Demand 2.1 Price Elasticity FormulaPrice Elasticity Formula 2.2 Numerical ExampleNumerical Example 2.3 Three points about elasticity of demandThree points about elasticity of demand 2.4 Categories of ElasticityCategories of Elasticity 2.5 Demand Elasticity and Total RevenueDemand Elasticity and Total Revenue 2.6 Constant Elasticity CasesConstant Elasticity Cases 2.7 Determinants of ElasticityDeterminants of Elasticity 6

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1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3 Supply Elas.End 7 2.1a Price Elasticity Thus far we have talked about the impact of changes in prices, incomes, and costs, on demand and supply in rather general terms In fact, in the real world of policy implementation, more precision is used The Law of demand says that a higher price will reduce quantity demanded, BUT BY HOW MUCH that is, will the number sold decline by only a little or by a lot?

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1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3 Supply Elas.End 8 2.1.b Formula for Price Elasticity of Demand Price elasticity of demand measures in a standardized way how responsive consumers are to price change elasticity is another word for responsiveness In simplest terms, the price elasticity of demand measures the percent change in quantity demanded divided by the percent change in price

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1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3 Supply Elas.End 9 To illustrate this process, let us write out the algebraic formula and do an example calculation. 2.1.c Price Elasticity of Demand Formula: In Words

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1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3 Supply Elas.End 10 Generalize the price elasticity formula If the price drops from p to p, other things constant, the quantity demanded increases from q to q The change in price can be represented as p and the change in quantity as q 2.1.d Price Elasticity of Demand Formula: Algebraic Expression

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1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3 Supply Elas.End 11 2.2 Demand Curve for Cigarettes For the price elasticity to be a useful measure, we should come up with the same result between points a and b as we get between b and a. To do this we must take the average of the initial price and the new price and use that as the base in computing the percent change in price. The same process should be used for changes in quantity demanded the average quantity demanded is 100,000 and the change in quantity demanded is 10,000 10% change Price elasticity between point a and b is: = 10% / - 20% = - 0.5 0.90 0 b Thousands per day D $1.10 a 95105 Price per taco in our example the base used for price is the average of $1.10 and $0.90 = $1.00 the change in price is -$0.20 divided by $1.00 - 20%

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1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3 Supply Elas.End 12 2.3.1 Three Points about Price Elasticity of Demand: Point #1 Because the average quantity and average price are used as a base for computing percent change, the same elasticity results whether going from the higher price to the lower price or the other way around

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1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3 Supply Elas.End 13 2.3.2 Point #2 Elasticity expresses a relationship between two amounts The percent change in quantity demanded The percent change in price Because the law of demand states that price and quantity demanded are inversely related, the change in price and the change in quantity demanded have opposite signs the price elasticity of demand has a negative sign

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1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3 Supply Elas.End 14 2.3.3 Point #3 Since constantly referring to elasticity as a negative number gets cumbersome, we will discuss the price elasticity of demand as an absolute value positive number For example, absolute value of the elasticity for cigarettes computed earlier will be referred to as 0.5 rather than 0.5

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1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3 Supply Elas.End 15 2.4.1 Three Categories of Elasticity The price elasticity of demand can be divided into three general categories depending on how responsive quantity demanded is to a change in price If the percent change in quantity demanded is smaller than the percent change in price, the resulting price elasticity has an absolute value between 0 and 1.0 demand is inelastic quantity demanded is relatively unresponsive to a change in price If the percent change in quantity demanded just equals the percent change in price a price elasticity with an absolute value of 1.0 unit-elastic demand

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1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3 Supply Elas.End 16 2.4.2Numerical Ranges of the Categories If the percent change in quantity demanded exceeds the percent change in price, the resulting price elasticity has an absolute value exceeding 1.0 demand is said to be elastic quantity is responsive to changes in price Summary Elastic absolute value greater than 1.0 responsive Unit elastic absolute value equal to 1.0 Inelastic absolute value between 0 and 1.0 unresponsive

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1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3 Supply Elas.End 17 2.5.1 Elasticity and Total Revenue Knowledge of price elasticity is especially valuable because it indicates the effect of a price change on total revenue Total revenue (TR) is the price (p) multiplied by the quantity demanded (q) at that price TR = p x q What happens to total revenue when price decreases?

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1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3 Supply Elas.End 18 2.5.2 Elasticity and Total Revenue A lower price means producers get less for each unit sold which tends to decrease total revenue However, a lower price increases quantity demanded which tends to increase total revenue Thus, the overall impact of a lower price on total revenue depends on the net result of these opposite effects

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1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3 Supply Elas.End 19 2.5.3Elasticity and Total Revenue Specifically When demand is elastic, the percent increase in quantity demanded exceeds the percent decrease in price total revenue increases When demand is unit elastic, the two are equal total revenue remains unchanged When demand is inelastic, the percent increase in quantity demanded is more than offset by the percent decrease in price total revenue decreases The next slide presents these relationships in a diagram

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1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3 Supply Elas.End 20 (a) Demand and Price Elasticity 2.5.4 Diagram: Demand, Price Elasticity and Total Revenue Panel (a) shows the linear demand curve and panel (b) shows the total revenue generated by each price- quantity combination along the demand curve. Since the demand curve is linear, its slope is constant a given decrease in price always causes the same unit increase in quantity demanded. The price elasticity of demand is greater on the higher-price end of the demand curve than on the lower-price end. $100 90 80 70 60 50 40 30 20 10 D 0 Quality per period 1002005008009001,000 $25,000 T o t a l r e v e n u e 0 Total revenue (b) Total Revenue TR = p x q Price per unit Quantity per period1,000500 Inelastic E D < 1 Unit elastic E D = 1 Elastic E D > 1 (Hint: the same price change at a high price level translates into a smaller denominator Slope = rise/run

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1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3 Supply Elas.End 21 (a) Demand and Price Elasticity $100 90 80 70 60 50 40 30 20 10 e d c b a D 0 Quality per period 1002005008009001,000 $25,000 T o t a l r e v e n u e 0 Total revenue (b) Total Revenue TR = p x q Price per unit Quantity per period 1,000500 Consider a movement from point a to point b on the demand curve. Between points d and e on the lower end, the 100-unit quantity increase is a percent change of 100/850 = 12% and the $10 price decrease is a percent decline of 10/15 = 67% a price elasticity of 0.2 = (12%/67%) 2.5.5 Diagram: Demand, Price Elasticity and Total Revenue The 100-unit increase in quantity demanded is a percent change of 100/150 = 67% while the $10 drop in price is a percent change of 10/85 = 12% the price elasticity of demand here is 5.6 = ( 67%/12%) 67% 12% 67%

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1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3 Supply Elas.End 22 (a) Demand and Price Elasticity $100 90 80 70 60 50 40 30 20 10 e d c b a D Inelastic E D < 1 Unit elastic E D = 1 Elastic E D > 1 0 Quality per period 1002005008009001,000 $25,000 T o t a l r e v e n u e 0 Total revenue (b) Total Revenue TR = p x q Price per unit Quantity per period 1,000500 Demand becomes less elastic as we move down the curve. Halfway down, the elasticity equals 1.0. Since we have a linear demand curve, the slope is constant but the elasticity varies slope is not the same thing as elasticity. Where demand is elastic, a decrease in price will increase total revenue because the gain in revenue from selling more units exceeds the loss in revenue from selling at the lower price. Where demand is inelastic, a price decrease reduces total revenue because the gain in revenue from selling more units is less than the loss in revenue at the lower price. 2.5.6 Summary: Demand, Price Elasticity and Total Revenue Elastic E D > 1Inelastic E D < 1 Unit elastic E D = 1 When Elasticity is unitary Total Revenue is at its peak

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1 Begin2 Demand Elas.4 Income Elas. 5 Cross-Price Elas. 3 Supply Elas.End 23 2.5.7 Example of Pricing & Inelastic Demand When Elmo Live arrives in stores on Tuesday, it will cost $60 -- about a third more than last year's model, and above the $50 tag that once was the high-water mark for most toys. Elmo Live hits stores as economic uncertainty is gripping consumers and prompting retailers such as Wal-Mart Stores Inc. and KB Toys Inc. to pitch low-cost toys to lure customers. Source: Mattel Gambles on Pricey Elmo for Holidays (WSK 10/9/08)Wal-Mart StoresMattel Gambles on Pricey Elmo for Holidays (WSK 10/9/08) To be increasing prices, sellers of Elmo must be of the view that demand is inelastic and hence the price increases will increase revenue

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