Price Elasticity of Demand A measure of the

responsiveness or sensitivity of quantity demanded to changes in the Price of a product.

When QD is relatively unresponsive to a

price change, Demand is said to be inelastic

Conversely, Demand is said to be elastic when it

is relatively responsive to a price change

Qualities That Affect Elasticity of Demand

Proportion of Income spent on the product

Availablity of close SUBSTITUTES Importance of the good-Luxury or

necessity. Is it habit forming? ability to Delay the purchase or adjust

purchasing behavior-Time

ELASTICITY COEFFICIENTS

Percentage vs. absolute numbers The changes in QD and in P are

comparisons of consumer responsiveness to price changes of different products

Absolute value (because P and QD are inversely related)

Summarizing Price Elasticity of DemandElasticity coefficient

Term Description Impact on Total Revenue

Impact on Total Revenue

Price Increase

Price Decrease

Greater than 1Єd > 1

Elastic QD changes by a larger % than does price

TR decreases

TR increases

Equal to 1Єd = 1

Unit Elastic QD changes by the same % as does the price

TR is unchanged

TR is unchanged

Less than 1Єd < 1

Inelastic QD changes by a smaller % than does price

TR increases

TR Decreases

Supply and Demand

Elasticities and Government-Set Prices

Midpoint Formula

A midpoint formula calculates price elasticity across a price and quantity range to overcome the problem of selecting the reference points for price and quantity. In this formula, the average of the quantities and the average of the two prices are used as reference points

Note several points about the graph of the demand curve and price elasticity of demand

Not the same at all prices. Typically D is elastic at higher prices and inelastic at lower prices

Cannot be judged from the slope of the D curve

Total Revenue Test – How does TR change when price changes?

1. elastic-a decrease in price will increase TR and an increase in price will decrease TR

2. inelastic-a decrease in price will decrease TR and an increase in price will increase TR

3. unit elastic-an increase or decrease in price will not affect TR

PRICE ELASTICITY OF SUPPLY Measures the sensitivity of Quantity

Supplied (Qs) to changes in the price of a product

general and mid-point formula are similar to those for the price elasticity of D. (Qs replaces QD)

Depends primarily on the amount of times sellers have to adjust to a price change

Supply tends to be more price inelastic in the short run than the long run

short run-a period of time in which producers are able to change the quantities of some but not all of the resources they employ. Some fixed cost and some variable costs.

long run-a period of time long enough to allow producers to change the quantities of all the resources they employ. All costs are variable, none are fixed.

Price Elasticity of Supply

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The percentage change in the quantity demanded of one commodity resulting from a 1 percent change in price of another commodity

What is Cross What is Cross Elasticity of Elasticity of Demand?Demand?

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E c = % Quantity of X % Price of Y

Cross Elasticity of Cross Elasticity of DemandDemand

If E E cc negative -

complements (steak & steak sauce)

If E E cc positive - substitutes

(butter & margarine)

Unrelated goods should

have a E E cc close to zero

Applications

Businesses concerned with cannibalization of various products A low cross elasticity indicates 2 products

(Coke/Sprite)are weak substitutes. Lowering the price of Sprite, thus increasing sales won’t impact Coke sales.

Government uses the concept in analyzing the impact of a merger and consequently the impact on competition. A high cross elasticity would indicate strong substitute, thus possibly reducing competition

The ratio of the percentage change in quantity demanded to the percentage change in income

What is Income What is Income Elasticity of Elasticity of Demand?Demand?

E i = % QuantityD

% Income

• E i > 0 Normal goods

• E i < 0 Inferior goods

• E i > 1 Luxury goods

• 0 < E i < 1 Necessities

What is a Price Ceiling?

A maximum price set by government below the marketbelow the market generated equilibrium price

Price Ceilings

Messing with the markets by the man. PCs set by the government prevents

the guiding/rationing function of prices in a market system.

It creates a shortage at the government set price.

Another rationing method must be found, so government often steps in and establishes one, excluding others in the process.

Create illegal markets for those who want to buy/sell outside of the gov’t set price

examples: rent control, interest rate limits

What is a Price Floor?

A minimum price set by government above the marketabove the market equilibrium price

Creates a surplus at the fixed price Distorts the market, governments

then have to figure out how to deal with the surplus

Many agricultural products, minimum wage

government interference with markets is controversial and always entails tradeoffs.

Rationing schemes must be devised to handle the shortages or special programs to shift demand or supply must be implemented.

The intervention imposes costs on some groups and benefits other groups.

Many unintended consequences or side effects