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Demand Elasticity
Chapter Four
Overview
The economic concept of elasticity The price elasticity of demand The cross-elasticity of demand Income elasticity Other elasticity measures Elasticity of supply
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Learning objectives
define and measure elasticity apply concepts of price elasticity, crosselasticity, and income elasticity understand determinants of elasticity show how elasticity affects business revenue
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Elasticity: the percentage change in one variable relative to a percentage change in another.
Chapter Four
Price elasticity of demand: the percentage change in quantity demanded caused by a 1 percent change in price
% Quantity Ep % Price
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Q2 Q1 P2 P 1 Ep (Q1 Q2 ) / 2 ( P 1P 2) / 2
Ep = coefficient of arc price elasticity Q1 = original quantity demanded Q2 = new quantity demanded P1 = original price P2 = new price
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Point elasticity: elasticity measured at a given point of a demand (or a supply) curve
dQ P 1 P = x dP Q1
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Q P1 p P Q1
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Some demand curves have constant elasticity such a curve has a nonlinear equation:
Q = aP-b
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Categories of elasticity Relative elasticity of demand: Ep > 1 Relative inelasticity of demand: 0 < Ep <1 Unitary elasticity of demand: Ep = 1 Perfect elasticity: Ep = Perfect inelasticity: Ep = 0
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Factors affecting demand elasticity ease of substitution proportion of total expenditures durability of product possibility of postponing purchase possibility of repair used product market length of time period
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Derived demand: the demand for products or factors that are not directly consumed, but go into the production of a another (final) product The demand for such a product or factor exists because there is demand for the final product
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The derived demand curve will be more inelastic: the more essential is the component the more inelastic is the demand curve for the final product the smaller is the fraction of total cost going to this component the more inelastic is the supply curve of cooperating factors
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Chapter Four
A long-run demand curve will generally be more elastic than a short-run curve
As the time period lengthens consumers find ways to adjust to the price change, via substitution or shifting consumption
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The relationship between price and revenue depends on elasticity Why? By itself, a price fall will reduce receipts BUT because the demand curve is downward sloping, the drop in price will also increase quantity demanded
As price decreases revenue rises when demand is elastic revenue falls when it is inelastic revenue reaches it peak if elasticity =1 the lower chart shows the effect of elasticity on total revenue
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Marginal revenue: the change in total revenue resulting from changing quantity by one unit
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at the point where marginal revenue crosses the X-axis, the demand curve is unitary elastic and total revenue reaches a maximum
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Examples: some real world elasticities coffee: short run -0.2, long run -0.33 kitchen and household appliances: -0.63 meals at restaurants: -2.27 airline travel in U.S.: -1.98 beer: -0.84, Wine: -0.55
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Examples: some real world elasticities white pan bread:-0.69 cigarettes: short run -0.4, long run -0.6 wine imports: -0.15 crude oil: -0.06 internet services: -0.6/-0.7
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Cross-elasticity of demand
Cross-elasticity of demand: the percentage change in quantity consumed of one product as a result of a 1 percent change in the price of a related product
% Q A Ex % PB
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Cross-elasticity of demand
Arc cross-elasticity
Q2 A Q1 A P2 B P 1B EX (Q1 A Q2 A ) / 2 ( P 1B P 2B ) / 2
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Cross-elasticity of demand
Point cross-elasticity
QA PB EX QA PB
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Cross-elasticity of demand
The sign of cross-elasticity for substitutes is positive The sign of cross-elasticity for complements is negative Two products are considered good substitutes or complements when the coefficient is larger than 0.5 (in ab. value)
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Income elasticity
Income elasticity of demand: the percentage change in quantity demanded caused by a 1 percent change in income
%Q EY %Y
Y is shorthand for income
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Income elasticity
Q2 Q1 Y2 Y1 EY (Q1 Q2 ) / 2 (Y1 Y2 ) / 2
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Income elasticity
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Examples: elasticity is encountered every time a change in some variable affects demand
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Elasticity of supply
Price elasticity of supply: the percentage change in quantity supplied as a result of a 1 percent change in price
Elasticity of supply
Q2 Q1 P2 P 1 Es (Q1 Q2 ) / 2 ( P 1P 2) / 2
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Elasticity of supply
When the supply curve is more elastic, the effect of a change in demand will be greater on quantity than on the price of the product When the supply curve is less elastic, a change in demand will have a greater effect on price than on quantity
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Global application
Example: price elasticities in Asia imports almost always price inelastic if exports price inelastic, export earnings will rise as prices rise if exports price elastic, export earnings will rise with world incomes
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