Elasticity of Demand How does a firm go about determining the price at which they should sell their...

Elasticity of Demand

• How does a firm go about determining the price at which they should sell their product in order to maximize total revenue?

• Total Revenue = Price Quantity

• You are a marketing manager for Intel

• A new computer chip has been developed

• Decision to Be Made

• Do you sell the new chip at a high price ($400)?

• Do you sell the new chip at a low price ($200)?

Demand and Total Revenue

Quantity (millions of chips per year)

Pri

ce (d

olla

rs p

er c

hip)

40 80 120

100

200

300

400

Da



Pri

ce (d

olla

rs p

er c

hip)

40 80 120

100

200

300

400

DaTotal revenuegain

Total revenueloss



Pri

ce (d

olla

rs p

er c

hip)

100

200

300

400

Db

40 60 80 120



Pri

ce (d

olla

rs p

er c

hip)

100

200

300

400

Db

40 60 80 120

Total revenuegain

Total revenueloss



Pric

e (d

olla

rs p

er c

hip)

Db

Pric

e (d

olla

rs p

er c

hip)

Da


Slope Depends on Units of Measurement

• In these two examples, we can compare the slopes of the demand curves

• We cannot do so if we are dealing with different goods and services.

• Elasticity is independent of the units of measurement.

• Price elasticity of demand

• A measure of the responsiveness of the quantity demanded of a good to a change in its price (ceteris paribus).

Elasticity: A Units-Free Measure

Price elasticity ofdemand =

Percentage change in quantity demanded

Percentage change in price

Calculating Elasticity

• The changes in price and quantity are expressed as percentages of the average price and average quantity.

• Avoids having two values for the price elasticity of demand

Calculating the Elasticity of Demand


Pri

ce (d

olla

rs p

er c

hip)

36 40 44

390

400

410

Da

Originalpoint


Pri

ce (d

olla

rs p

er c

hip)

36 40 44

390

400

410

Da

Originalpoint

Newpoint



Pri

ce (d

olla

rs p

er c

hip)

36 40 44

390

400

410

Da

= -$20P

= 8Q

Originalpoint

Newpoint



Pri

ce (d

olla

rs p

er c

hip)

36 40 44

390

400

410

Da

Originalpoint

Newpoint

Pave = $400

= -$20P

= 8Q


Pri

ce (d

olla

rs p

er c

hip)

36 40 44

390

400

410

Da

Originalpoint

Newpoint

Pave =$400

Qave = 40

= -$20P

= 8Q



P

Q

%

%

Price elasticity of demand =Percentage change in quantity demanded


ave

ave

PP

QQ

/

/


P

Q

%

%

Price elasticity of demand =Percentage change in quantity demanded


ave

ave

PP

QQ

/

/

400/2040/8

= - 4

Inelastic and Elastic Demand

• Three demand curves that cover the entire range of possible elasticities of demand:

• Perfectly inelastic

• Unit elastic

• Perfectly elastic


• Perfectly inelastic demand • Implies that quantity demanded remains

constant when price changes occur.

• Price elasticity of demand = 0

6

12

Pri

ce

Quantity

D1

Elasticity = 0

Perfectly Inelastic

Unit elastic demand Implies that the percentage change in quantity demanded equals the percentage change in price.

Price elasticity of demand = -1



6

12

Pri

ce

Quantity

D2

1 2 3

Elasticity = -1

Unit Elasticity


• Perfectly elastic demand

• Implies that if price increases by any percentage, quantity demanded will fall to 0 and if price decreases by any percentage, quatity will rise to infinity.

• Price elasticity of demand =


6

12

Pri

ce

Quantity

D3

Elasticity =

Perfectly Elastic

Inelastic and Elastic Demand• Inelastic demand

• Implies the percentage change in quantity demanded is less than the percentage change in price.

• In absolute sense, price elasticity of demand > 0 and < 1

• Elastic demand • Implies the percentage change in quantity demanded

is greater than the percentage change in price. • In absolute sense, price elasticity of demand > 1

Elasticity Along a Straight-Line Demand Curve

0 40 80 100 120 160 200

250

100

200

300

400

500

Pri

ce (

dolla

rs p

er c

hip)


Elasticity Along a Straight-Line Demand CurveElasticity = -4

0 40 80 100 120 160 200

250

100

200

300

400

500 Lowering the pricefrom $500 to $300results in a price elasticity of demand of -4.

Elastic

Pri

ce (

dolla

rs p

er c

hip)



Elasticity = -1/4

0 40 80 100 120 160 200

250

100

200

300

400

500 Lowering the pricefrom $200 to $0results in a price elasticity of demand of -1/ 4.

Inelastic

Pri

ce (

dolla

rs p

er c

hip)


Elasticity, Total Revenueand Expenditure

• Elastic demand — a 1 percent decrease in price will result in a greater than 1 percent increase in quantity demanded.• Total revenue will increase

• Unit elastic demand — a 1 percent decrease in price will result in a 1 percent increase in quantity demanded• Total revenue will not change


• Inelastic demand — a 1 percent decrease in price will result in a less than 1 percent increase in quantity demanded.

• Total revenue will decrease


• Total Revenue Test

• Price elasticity of demand can be estimated by

observing the change in total revenue that

results from a price change (ceteris paribus).


• Total Revenue Test

• Price cut and total revenue increases — demand is elastic.

• Price cut and total revenue decreases — demand is inelastic

• Price cut and total revenue does not change — demand is unit elastic

0 100 200

250

100

200

300

400

500

Pri

ce (

doll

ars

per

chip

)

D

25

0 100 200

250

100

200

300

400

500

Pri

ce (

doll

ars

per

chip

)

0 100 200

5

10

15

20

Tot

al R

even

ue (

bill

ions

of

doll

ars)


D

TR

25

0 100 200

250

100

200

300

400

500

Pri

ce (

doll

ars

per

chip

)

0 100 200

5

10

15

20

Tot

al R

even

ue (

bill

ions

of

doll

ars)


Maximum total revenue

When demandis inelastic, price cut decreasestotal revenue

When demandis elastic, price cut increasestotal revenue

Inelastic demand

Unitelastic

Elasticdemand

More Elasticities of Demand

• Cross elasticity of demand

• Measures the responsiveness of the demand for a good to a change in the price of a substitute or complement good.

Cross elasticity of demand =

Percentage changein quantity demanded

Percentage change in price of a substitute or complement

Cross Elasticity of DemandP

rice

of

Wal

kman

s

Quantity of Walkmans

D0


rice

of

Wal

kman

s


D1

Price of a CD player, a substitute, rises.Positive cross elasticity

D0


rice

of

Wal

kman

s


Price of a tape, a complement, rises. Negativecross elasticity

D1

Price of a CD player, a substitute, rises.Positive cross elasticity

D0D2

Income Elasticity of Demand

• Income elasticity

• Measures the responsiveness of the demand to a change in income.

Income elasticity of demand =

Percentage changein quantity demanded

Percentage change in income


• Income elasticity (in absolute sense) can be:

1 ) Greater than 1 (normal good, income elastic)• luxury goods - ocean cruises, jewelry

2 ) Between zero and 1 (normal good, income inelastic)

• necessities - food, clothing

3 ) Less than zero (inferior good)• potatoes, rice


Income elastic

Income inelastic

Income Income Income

Qua

ntit

y de

man

ded

Qua

ntit

y de

man

ded

Income elastic

Income inelastic

Income Income Income

Qua

ntit

y de

man

ded

Qua

ntit

y de

man

ded

Qua

ntit

y de

man

ded

Positiveincome elasticity

Negativeincome elasticity

m

Elasticity of Demand How does a firm go about determining the price at which they should sell their...

Documents

Transcript of Elasticity of Demand How does a firm go about determining the price at which they should sell their...