Price Elasticity of Demand• Measurement of a good’s

responsiveness to a change in price• The price effect is greater for some

goods than for others• Examples:

Price Elasticity of Demand• Large Price Effect → Elastic

Ex:

• Small Price Effect → InelasticEx:

Other Examples?

Factors Affecting Elasticity of Demand• Wants = more elastic, needs = more inelastic

• Time:• Can purchase be delayed?• Time to adjust…• Longer price change persists = more elastic (long run)• Immediately after price change = more inelastic (short

run)• Availability, Suitability, Price of Substitutes

• More/better/cheaper substitutes = more elastic• Ex: Ibuprofen vs. Insulin

• Percentage of Budget• Larger % = more elastic• Ex: New Car for me vs. LeBron James

Testing for Elasticity of Demand

• Graphical Comparison

The flatter the curve, the more Elastic the good.The steeper the curve, the more Inelastic the good.***ONLY APPLICABLE WHEN COMPARING 2 CURVES

Inelastic

Elastic

Testing for Elasticity of Demand• Total Revenue Test --- TR = P x Q• Example:• If P and TR move in the same

direction, demand isinelastic

• If P and TR move in oppositedirections, demand iselastic

• Gas?• Grade upgrade certificates?

$3

2

1

0 10 20 30 40 Q

P

•Lower price and elastic demand• Blue gain exceeds gold loss

a

b

D1

The Total Revenue Test

6-7

$4

3

2

1

0 10 20 Q

P

•Lower price and inelastic demand• Gold loss exceeds blue gain

c

d

D2

The Total Revenue Test

6-8

$3

2

1

0 10 20 30 Q

P

•Lower price and unit-elastic demand• Blue gain equals yellow loss

e

fD3

The Total Revenue Test

6-9

• As long as Total Revenue is increasing with every decrease in price, Demand is elastic**Marginal Revenue is positive

• When Total Revenue begins to decrease with every decrease in price, Demand becomes inelastic**Marginal Revenue is negative

Price Elasticity of Demand•Price-elasticity coefficient and formula

Percentage Change in QuantityDemanded of Product X

Percentage Change in Priceof Product X

Ed =

6-11

Price Elasticity of Demand•Calculate percentage change•Restate formula

Change in Quantity Demanded of X

Original Price of X

Ed =

Change in Price of X

Original Quantity Demanded of X

÷

6-12

Price Elasticity of Demand• Calculation problem

• $4-$5 is 25% increase• $5-$4 is 20% decrease

• Starting point matters• Midpoint formula

Change in QuantityEd = Sum of Quantities/2

÷Change in Price

Sum of Prices/26-13

Elasticity and the TR Curve

0 1 2 3 4 5 6 7 8

0 1 2 3 4 5 6 7 8

Quantity Demanded

Quantity Demanded

Pri

ceT

ota

l Rev

enu

e(T

ho

usa

nd

s o

f D

olla

rs)

$201816141210

8642

$87654321

a

bc

de

fg

h

ElasticEd > 1

Unit ElasticEd = 1

InelasticEd < 1

D

TR

6-14

Price Elasticity of Demand• Why use percentages?

• Unit free measure• Dollars vs. pennies

• Compare responsiveness across products• JBCs vs. Porsches

• Elimination of the (-) sign• Extreme cases

• Perfectly inelastic demand• Perfectly elastic demand

6-15

Interpretations of Elasticity

Elastic Demand

Inelastic Demand

Unit Elasticity

Ed = .04.02 = 2

Ed = .01.02 = .5

Ed = .02.02 = 1

6-16

Extending Elasticity of Demand• How does elasticity of demand affect us?• What do these have in common?

• Government taxes inelastic goods… Why?• Why doesn’t govt. tend to tax elastic goods?

““Government's view of the economy could be summed up Government's view of the economy could be summed up in a few short phrases: If it moves, tax it. If it keeps moving, in a few short phrases: If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it.”regulate it. And if it stops moving, subsidize it.”

-Ronald Reagan-Ronald Reagan

Homework:

•Read pgs. 143-149 and complete Review question #6 and Problems #5 and 7

20

Copyright ACDC Leadership 2015

Elasticity of Supply• Elastic – easy/quick to produce – lower

marginal cost for each additional unit produced

• Inelastic – harder/slower to produce – higher marginal cost for each additional unit produced

• Elasticity of supply increases as producers have more time to adjust to a price change

• Ex: 1979 Today

Factors Affecting Elasticity of Supply

1. Ease of Productioneasier = more elastic

2. Responsiveness to price

changequicker adjustment =

more elastic

3. Timemore time to adjust =

more elastic

Price Elasticity of Supply

Percentage Change in QuantitySupplied of Product X

Percentage Change in Priceof Product X

Es =

Responsiveness to price changes by producers

6-23

Elasticity of Supply changes over time

• Market Period – immediately after a change in price• Perfectly inelastic supply

• Short Run – up to a few months after a change in price• Inelastic or somewhat elastic supply• Fixed plant size

• Long Run – many months/years after a price change• Perfectly Elastic supply• Adjustable plant size

P

Q

Price Elasticity of SupplyThe Market Period• Perfectly inelastic supply

D1 D2

Sm

Q0

Pm

P0

GreatestPrice

Impact

6-25

Price Elasticity of Supply

The Short Run• Inelastic supply

P

Q

D1 D2

Ss

Q0

Ps

P0

Qs

LowerPrice

Impact

6-26

Fixed land.Some fixed capital.More labor?More fertilizer?

Price Elasticity of Supply

The Long Run• Elastic supply

P

Q

D1 D2

Sl

Q0

Pl

P0

Ql

LeastPrice

Impact

6-27

Price Elasticity of Supply•Applications•Antiques and reproductions

• Limited, inelastic supply• Strong demand• Resulting high price

•Volatile gold prices• Inelastic supply• Shifting demand

•Kidneys 6-28

Cross Elasticity of Demand

•Responsiveness of sales to change in price of another good

Percentage Change in QuantityDemanded of Product X

Percentage Change in Priceof Product Y

Exy =

6-29

Cross Elasticity of Demand• Substitute goods

• Positive sign • Complementary goods

• Negative sign• Independent goods

• Zero or near zero• Coke and Sprite Example• Mergers

6-30

Practice Problem• Let’s look at 2 goods, Widgets and Wadgets. Given the

following information:1. Calculate the price elasticity of demand for widgets. Is

demand for widgets elastic, inelastic, or unit elastic?2. Calculate the cross elasticity of demand for wadgets as

they relate to widgets. Would wadgets be considered complements, substitutes, or independent of widgets?

P₁ P₂ Q₁ Q₂

Widgets $3 $5 47 21

Wadgets $2 $2 12 3

Income Elasticity of Demand

• Responsiveness of sales to change in income• Income increases 20%, and quantity decreases

15% then the good is a(n)…• INFERIOR GOOD

• Normal goods – positive sign• Inferior goods– negative sign • How can this help you profit from a recession?

Percentage Change in QuantityDemanded

Percentage Change in IncomeEi =

6-32

33

2010 Question 6

Copyright ACDC Leadership 2015

2008 Audit Question 34