Chapter 4 Elasticities of demand supply David Begg

Chapter 4 Elasticities of demand supply David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 8 th Edition, Mc. Graw-Hill, 2005 Power. Point presentation by Alex Tackie and Damian Ward

The price elasticity of demand …measures the sensitivity of the quantity demanded of a good to a change in its price It is defined as: % change in quantity demanded % change in price 1

The price elasticity of demand Example: If the price of an ice cream cone increases from $2. 00 to $2. 20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as: e. DP = (Q 2 – Q 1)/Q 1 (P 2 – P 1)/P 1 2

The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change. • Example: If the price of an ice cream cone increases from $2. 00 to $2. 20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as: 3

Elastic demand • Demand is ELASTIC – when the price elasticity (ignoring the negative sign) is greater than -1 – i. e. when the % change in quantity demanded exceeds the change in price • e. g. if quantity demanded falls by 7% in response to a 5% increase in price • elasticity is -7 5 = -1. 4 4

Figure 1 The Price Elasticity of Demand (d) Elastic Demand: Elasticity Is Greater Than 1 Price $5 4 Demand 1. A 22% increase in price. . . 0 50 100 Quantity 2. . leads to a 67% decrease in quantity demanded.

Inelastic demand • Demand is INELASTIC – when the price elasticity lies between -1 and 0 – i. e. when the % change in quantity demanded is smaller than the change in price • e. g. if quantity demanded falls by 3. 5% in response to a 5% increase in price • elasticity is -3. 5 5 = - 0. 7 6

Figure 1 The Price Elasticity of Demand (b) Inelastic Demand: Elasticity Is Less Than 1 Price $5 4 1. A 22% increase in price. . . Demand 0 90 100 Quantity 2. . leads to an 11% decrease in quantity demanded.

Unit elastic demand • Demand is UNIT ELASTIC – when the price elasticity is exactly -1 – i. e. when the % change in quantity demanded is equal to the change in price • e. g. if quantity demanded falls by 5% in response to a 5% increase in price • elasticity is -5 5 = -1 8

Figure 1 The Price Elasticity of Demand (c) Unit Elastic Demand: Elasticity Equals 1 Price $5 4 Demand 1. A 22% increase in price. . . 0 80 100 Quantity 2. . leads to a 22% decrease in quantity demanded. Copyright© 2003 Southwestern/Thomson Learning

Figure 1 The Price Elasticity of Demand (a) Perfectly Inelastic Demand: Elasticity Equals 0 Price Demand $5 4 1. An increase in price. . . 0 100 Quantity 2. . leaves the quantity demanded unchanged. Copyright© 2003 Southwestern/Thomson Learning

Figure 1 The Price Elasticity of Demand (e) Perfectly Elastic Demand: Elasticity Equals Infinity Price 1. At any price above $4, quantity demanded is zero. $4 Demand 2. At exactly $4, consumers will buy any quantity. 0 3. At a price below $4, quantity demanded is infinite. Quantity

Price elasticity for a linear demand curve Price The price elasticity varies along the length of a straight-line demand curve. D Elastic Unit elasticity Inelastic D Quantity 12

Elasticity of a Linear Demand Curve

What determines the price elasticity? • The ease with which consumers can substitute another good. • EXAMPLE: – consumers can readily substitute one brand of detergent for another if the price rises – so we expect demand to be elastic – but if all detergent prices rise, the consumer cannot switch – so we expect demand to be inelastic 14

Elasticity is higher in the long run • In the short run, consumers may not be able (or ready) to adjust their pattern of expenditure. • If price changes persist, consumers are more likely to adjust. • Demand thus tends to be – more elastic in the long run – but relatively inelastic in the short run. 15

Elasticity and revenue When price is changed, the impact on a firm’s total revenue (TR) will depend upon the price elasticity of demand. Revenue of a firm = P*Q 16

Price Elasticity and price reductions D Elastic Total Revenue Unit elasticity Inelastic D Quantity (+)TR< (-)TR Quantity 17 For a price fall: if demand is elastic, revenue from new sales will exceed the fall in revenue from existing sales - total revenue will rise; if demand is inelastic, revenue from new sales will be less than the fall in revenue from existing sales - total revenue will fall

Elasticity and tube fares How should tube fares be changed to increase revenues? • Passengers can use buses, taxis, cars etc – so demand may be elastic (e. g. -1. 4) – and an increase in fares will reduce the number of journeys demanded and total spending • If passengers do not have travel options – demand may be inelastic (e. g. -0. 7) – so raising fares will have less effect on journeys demanded – and revenue will improve 18

The cross price elasticity of demand for good i with respect to the price of good j is : % change in quantity demanded of good i % change in the price of good j This may be positive or negative The cross price elasticity tends to be negative – if two goods are substitutes: e. g. tea and coffee The cross price elasticity tends to be positive – if two goods are complements e. g. tea and milk. 19

Price elasticities in the UK with respect to a 1% price change in: Percentage change in the quantity demanded of Food Clothing Transport – 0. 4 0 0. 1 Clothing and footwear 0. 1 – 0. 5 – 0. 1 Travel and communications 0. 3 – 0. 1 – 0. 5 Food 20

The income elasticity of demand measures the sensitivity of quantity demanded to a change in income: % change in quantity demanded of a good % change in consumer income The income elasticity may be positive or negative. 21

Normal and inferior goods • A NORMAL GOOD has a positive income elasticity of demand – an increase in income leads to an increase in the quantity demanded • e. g. dairy produce • An INFERIOR GOOD has a negative income elasticity of demand – an increase in income leads to a fall in quantity demanded • e. g. coal • A LUXURY GOOD has an income elasticity of demand greater than 1 • e. g. wine 22

Income and the demand curve For an increase in income: INFERIOR GOOD Price NORMAL GOOD D 0 D 1 Quantity Demand curve moves to the right D 1 D 0 Demand curve moves to the left Quantity 23