Elasticity of Demand Supply Topic 2 b

Elasticity of Demand & Supply Topic 2(b)

What is the difference between these 2 diagrams? P 1 Demand P 1 P 2 Demand Q 1 Q 2 What is the reason for this difference?

What is elasticity of demand? l The responsiveness of quantity demanded l to a change in one of its determining factors

Point & Arc elasticity l Point elasticity l l l is elasticity at a specific point changes measured are likely to be very small Arc elasticity l is the average elasticity between 2 points where X is the determinant of demand

Price Elasticity is. . . P As price increases from P 1 to P 2, quantity decreases from Q 1 to Q 2 P 1 D Q 2 Q 1 Q

Price Elasticity of Demand l The responsiveness of quantity demanded to a change in price of a product % change in quantity demanded (Q) Ed = % change in own price (P) Ed = ΔQ x P 2 + P 1 ΔP Q 2 + Q 1

Computing the price elasticity of demand Example 1: 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. Calculate your elasticity of demand. Example 2: If the price of an ice cream cone decreases from $2. 20 to $2. 00 and the amount you buy increases from 8 to 10 cones. Calculate your elasticity of demand.

The midpoint method l 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. Price elasticity of demand = ∆Q Ed = (P 2 + P 1) (Q 2 – Q 1)/[(Q 2 + Q 1)/2] (P 2 – P 1)/[(P 2 + P 1)/2] x ∆P (Q 2 + Q 1)

Price Elasticity of Demand l Use of percentages choice of units l product comparison l l The minus sign indicates the demand follows the Law of Demand. l The absolute value of the coefficient measures the price elasticity of demand.

Price Elasticity of Demand (cont. ) l Elastic l Demand a given percentage change in price results in a larger percentage change in quantity demanded l Ed >1

Price Elasticity of Demand (cont. ) l Inelastic l Demand a given percentage change in price results in a relatively smaller percentage change in quantity demanded l Ed <1

Price Elasticity of Demand (cont. ) l Unit l elasticity a given percentage change in price results in an equal percentage change in quantity demanded l Ed = 1

Perfectly Inelastic Demand P D 1 Perfectly inelastic demand Ed = 0 Q

Perfectly Elastic Demand P D 1 Perfectly inelastic demand D 2 Perfectly elastic demand Ed = ∞ Q

Review Question 6 ED = -1. 62 l What does this mean? l l the sign the size Possible values of ED l >1 <1 =1 =0 Relatively elastic Relatively inelastic Unitary elastic Perfectly inelastic l =∞ Perfectly elastic l l l

Elasticity & Total Revenue l Knowing the value of the elasticity can tell us about the effect of a price change on Total Revenue l TR = Price x Qd

Price (per unit) 5 4 Price Elasticity of Demand Revenue Ed > 1 3 2 1 Total Revenue 0 2 4 6 7 8 10 12 14 20 16 TR 12 8 4 0 2 4 6 7 8 10 12 14 Units of X (thousands per week) 17

Price (per unit) 5 6 7 8 10 12 14 Price Elasticity of Demand Revenue 2 4 6 7 8 10 12 14 18 4 Ed > 1 Ed = 1 3 2 1 Total Revenue 0 2 4 20 16 12 8 4 0 Units of X (thousands per week)

Price (per unit) 5 4 Ed > 1 Ed = 1 3 Ed < 1 2 1 Total Revenue 0 2 4 6 7 8 10 12 14 Price Elasticity of Demand Revenue 20 16 TR 12 8 4 0 2 4 6 7 8 10 12 14 Units of X (thousands per week) 19

Elasticity & Total Revenue

Elasticity & Total Revenue Summary: l If demand is elastic, a change in Price elastic will cause Total Revenue to change in the opposite direction l If demand is inelastic, a change in price inelastic will cause total revenue to change in the same direction.

Own Price elasticity – its determinants l Number and closeness of substitutes l Luxuries vs. Necessities l Proportion of income spent on the product l Time period l Non-functional factors l bandwagon effect etc.

Price Elasticity of Supply • The responsiveness of quantity supplied to a change in price of a product E s= % change in quantity supplied of product X % change in the price of product X

Price Elasticity of Supply (cont. ) P D 2 Sm Immediate market period D 1 Pm Po D 2 D 1 Qo Q

Price Elasticity of Supply (cont. ) P Ss Short run Ps Po D 2 D 1 Qo Qs Q

Price Elasticity of Supply (cont. ) P PL Po Long run SL S ′L D 2 D 1 Qo Qo QL Q′L Q

Cross price elasticity l What value of EXY would you expect for a Substitute good l Complementary good l RQ #5 l

Cross price elasticity l EXY < 0 : Complementary goods l EXY > 0 : Substitute goods l EXY = 0 or near zero : Independent goods l Size of EXY measures the degree of complementarity or substitutability

Income Elasticity l Possible values of Ey l >0 (positive) : Normal goods >1 : Relatively elastic l <1 : Relatively inelastic l l < 0 (negative) : Inferior goods

Discussion Questions 1) Demand for oil might be relatively elastic over the longer term, and yet it could still be observed that over time people consume more oil (or only very slightly less) despite rising oil prices. How can this apparent contradiction be explained?

Discussion Questions 2) Why may a restaurant charge very high prices for wine and bottled water and yet quite reasonable prices for food?

Discussion Questions 3) Why are clothes with designer labels so much more expensive than ‘own brand’ clothes from a chain store, even though they may cost a similar amount to produce?