Chapter 20Chapter 20

Elasticity: Demand and Elasticity: Demand and SupplySupply

Price Elasticity of DemandPrice Elasticity of Demand

How sensitive is the quantity demanded to How sensitive is the quantity demanded to changes in price? How responsive are changes in price? How responsive are consumers to price changes?consumers to price changes?

Definitions of Definitions of Price Elasticity of DemandPrice Elasticity of Demand:: the percentage change in the quantity the percentage change in the quantity

demanded of a product divided by the demanded of a product divided by the percentage change in the price of the product.percentage change in the price of the product.

The percentage change in the quantity The percentage change in the quantity demanded caused by a one percent change in demanded caused by a one percent change in the price.the price.

Price Elasticity:Price Elasticity:Mathematical DefinitionMathematical Definition

The price elasticity of demand, The price elasticity of demand, eedd,, is:is:

ExampleExample: if the quantity of videotapes : if the quantity of videotapes rented falls by 3% when the price is rented falls by 3% when the price is raised by 1%, then the price elasticity raised by 1%, then the price elasticity of demand is 3/1 = 3.of demand is 3/1 = 3.

PQ

eD

d %%

Sign of Price ElasticitySign of Price Elasticity

According to the law of demand, According to the law of demand, whenever the price rises, the whenever the price rises, the quantity demanded falls. quantity demanded falls. Thus the Thus the price elasticity of demand is price elasticity of demand is always negative.always negative.

Because it is always negative, Because it is always negative, economists usually state the value economists usually state the value without the sign. without the sign.

Demand Curve Shapes Demand Curve Shapes and Elasticityand Elasticity

Perfectly Elastic Demand CurvePerfectly Elastic Demand Curve The demand curve is horizontal.The demand curve is horizontal. Even the smallest change in price will cause Even the smallest change in price will cause

consumers to change their consumption by consumers to change their consumption by a huge amount.a huge amount.

Perfectly Inelastic Demand CurvePerfectly Inelastic Demand Curve The demand curve is vertical. The demand curve is vertical. The quantity demanded is totally The quantity demanded is totally

unresponsive to the price. Changes in price unresponsive to the price. Changes in price have no effect on consumer demand.have no effect on consumer demand.

Demand Curve Shapes Demand Curve Shapes and Elasticityand Elasticity

Elastic and InelasticElastic and Inelastic

The terms elastic and inelastic The terms elastic and inelastic refer to a price range, not to the refer to a price range, not to the entire demand curve.entire demand curve.Elastic regionElastic region: where : where eedd > > 1.1.

Unit elastic pointUnit elastic point: where : where eedd = = 1.1.

Inelastic regionInelastic region: where 0 < : where 0 < eedd < 1. < 1.

Using the Price Elasticity of Using the Price Elasticity of DemandDemand

It tells a manager in a firm whether to It tells a manager in a firm whether to raise or lower prices.raise or lower prices.

Total RevenueTotal Revenue (TR)(TR) equals the price equals the price times the quantity sold: times the quantity sold: TR = P x Q.TR = P x Q.

The law of demand tells us that The law of demand tells us that QQ falls falls when when PP rises rises..

What is the optimal price to maximize What is the optimal price to maximize total revenue? total revenue? AnswerAnswer: the price at the : the price at the unit-elastic point. At any higher price, unit-elastic point. At any higher price, total revenue is decreased!total revenue is decreased!

Total Revenue Total Revenue and Price Elasticityand Price Elasticity

PricePrice QuantityQuantity RevenueRevenue

$1000$1000 200200 $200,000$200,000

$900$900 400400 $360,000$360,000

$800$800 600600 $480,000$480,000

$700$700 800800 $560,000$560,000

$600$600 10001000 $600,000$600,000

$500$500 12001200 $600,000$600,000

$400$400 14001400 $560,000$560,000

$300$300 16001600 $480,000$480,000

$200$200 18001800 $360,000$360,000

$100$100 20002000 $200,000$200,000

Determinants of Determinants of the Price Elasticity of Demandthe Price Elasticity of Demand

Existence of SubstitutesExistence of Substitutes The more substitutes there are for a product, the greater The more substitutes there are for a product, the greater

the price elasticity of demand.the price elasticity of demand. Why pay more when you can switch to the substitute?Why pay more when you can switch to the substitute?

Importance of the Product in the Consumer’s Total Importance of the Product in the Consumer’s Total BudgetBudget The greater the portion of the consumer’s budget a good The greater the portion of the consumer’s budget a good

constitutes, the more price elastic the demand for the constitutes, the more price elastic the demand for the good.good.

Too much of the consumer’s buying power is tied up in Too much of the consumer’s buying power is tied up in this purchase to ignore price.this purchase to ignore price.

The Time Period under ConsiderationThe Time Period under Consideration The longer the period under consideration, the more The longer the period under consideration, the more

elastic the demand.elastic the demand.

Price DiscriminationPrice Discrimination

Price discriminationPrice discrimination is charging different is charging different customers different prices for the same customers different prices for the same product.product.

Why would firms want to do this?Why would firms want to do this? If different groups of customers have If different groups of customers have

significantly different price elasticities of significantly different price elasticities of demand for the same product, total revenue can demand for the same product, total revenue can be increased by charging each of the groups a be increased by charging each of the groups a different price.different price.

The groups must be easily identifiable, and The groups must be easily identifiable, and there must be little possibility of people from there must be little possibility of people from different groups trading with each other.different groups trading with each other.

DumpingDumping

DumpingDumping: A form of price discrimination : A form of price discrimination wherein an identical good is sold to wherein an identical good is sold to foreign buyers for a lower price than to foreign buyers for a lower price than to domestic buyers.domestic buyers.

Predatory DumpingPredatory Dumping: dumping intended to : dumping intended to drive rival firms out of business.drive rival firms out of business. Usually the predator raises prices after driving Usually the predator raises prices after driving

competitors from the marketplace.competitors from the marketplace. Usually charges of “dumping” against Usually charges of “dumping” against

foreign firms really are charges of foreign firms really are charges of “predatory dumping”.“predatory dumping”.

Other Demand ElasticitiesOther Demand Elasticities

Demand may respond to changes in other Demand may respond to changes in other variables. The measures of such responses are variables. The measures of such responses are also elasticities.also elasticities. Cross-Price Elasticity of DemandCross-Price Elasticity of Demand: The percentage : The percentage

change in the quantity demand for one good, divided change in the quantity demand for one good, divided by the percentage change in price of another good.by the percentage change in price of another good.

Measures the degree to which goods are Measures the degree to which goods are substitutessubstitutes or or complementscomplements..

If the cross-price elasticity is positive, then the goods If the cross-price elasticity is positive, then the goods are substitutes.are substitutes.

If the cross price elasticity is negative, then the goods If the cross price elasticity is negative, then the goods are complements.are complements.

Other Demand ElasticitiesOther Demand Elasticities, , ContinuedContinued

Income Elasticity of DemandIncome Elasticity of Demand How responsive is the demand for the product to How responsive is the demand for the product to

income?income? DefinitionDefinition: The percentage change in the quantity : The percentage change in the quantity

demanded divided by the percentage change in demanded divided by the percentage change in income.income.

Normal goodsNormal goods: goods for which the income elasticity : goods for which the income elasticity of demand is positive. of demand is positive.

That is, goods that consumers demand more of when That is, goods that consumers demand more of when their incomes rise.their incomes rise.

Inferior goodsInferior goods: Goods for which the income elasticity : Goods for which the income elasticity of demand is negative. of demand is negative.

Consumers will substitute away from these goods if Consumers will substitute away from these goods if their income permits it. their income permits it.

Necessities and LuxuriesNecessities and Luxuries

Goods with lower income elasticities are Goods with lower income elasticities are often called often called necessitiesnecessities, since the , since the quantities demanded don’t vary much quantities demanded don’t vary much with income. (Gas, electricity, medical with income. (Gas, electricity, medical services, etc.) services, etc.) Typical income elasticities are 0.4 or 0.5.Typical income elasticities are 0.4 or 0.5.

Goods with higher income elasticities are Goods with higher income elasticities are often called often called luxuriesluxuries, since people give , since people give them up readily when their incomes fall. them up readily when their incomes fall. Typical elasticities are 1.5 to 2.0.Typical elasticities are 1.5 to 2.0.