Demand Elasticities

Chapter 3
 Why Should Managers Study
Elasticity?

Own-price elasticity helps managers

understand the impact that price changes will
have on their revenue.
Income elasticity can help managers
understand what income groups to target their
product to.
Cross-price elasticity can help managers
understand who their closest competitors are.

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 Demand Elasticity

Demand elasticity is the responsiveness of

quantity demanded to changes in the factors
that influence demand, product price, income,
or prices of related products.

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 Own Price Elasticity of Demand

Measured as the
percentage change
in quantity
demanded of a given
good, relative to a ep = %Qx %Px
percentage change
in its price, all else
constant.

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 Own Price Elasticity of Demand
Graphical Representation

A
P1
%P
B
P2

%Q

Q1 Q2 Q
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 Examples of Own-Price Elasticity

Cereal: -0.55
Fish: -0.29
Neumans Own Pasta Sauce: -2.32
Orange juice: -1.39

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 Own Price Elasticity and Total
Revenue
Value of
price Elasticity Relationship Impact on revenue
elasticity definition among
coefficient variables
Price increase results in
Elastic lower total revenue.
demand Price decrease results in
|ep| > 1 %Qd >
higher total revenue.
%Px
Price increase results in
Inelastic higher total revenue.
demand Price decrease results in
|ep| < 1 %Qd <
lower total revenue.
%Px
7 UnitCopyright
or 2010 Pearson Education, Inc. Price increase or decrease
 Graphical Representation of Relationship
Between Price Elasticity and Total Revenue

If demand is elastic,a decrease

P in price results in an increase P If demand is inelastic,a decrease
in total revenue, and an increase In price results in a decrease in
in price results in a decrease in total revenue, and an increase
total revenue. in price results in a increase in
A total revenue.
P1
Y B
P2

A
P1
X Y B
P2
X
Q1 Q2 Q Q1 Q2 Q
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8 Publishing as Prentice Hall
 Determinants of Own Price
Elasticity

The number of Demand is generally more

inelastic:
substitute goods.
The fewer the number of
The percent of a substitutes or perceived
consumers income substitutes available.
The smaller the percent of
that is spent on the
the consumers income that
product. is spent on the product.
The time period The shorter the time period

under consideration. under consideration.

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 Perfectly Elastic and Inelastic
Demand

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 Income Elasticity of Demand

The percentage
change in the quantity
demanded of a given
good, X, relative to a
ei = %Qx %I
percentage change in
consumer income,
assuming all other
factors constant.

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 Normal Good

Good X is a normal Cream

good if the demand ei = 1.72
for good X moves in Apples
the same direction as ei = 1.32
a change in income.
Potatoes
ei = 0.15

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 Inferior Good

Good X is an inferior Chicken

good if the demand ei = -0.106
for good X moves in
the opposite direction
of a change in
income.

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 Cross-Price Elasticity of Demand

The percentage
change in the quantity
demanded of a given
good, X, relative to a
exy = %Qx %Py
percentage change in
the price of good Y,
assuming all other
factors constant.

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 Substitutes

Two goods with a Boiler chickens and

positive cross-price beef
elasticity of demand exy = 0.20
coefficient are said to Boiler chickens and
be substitute goods. pork
exy = 0.28

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 Complements

Iftwo goods have a Bread and eggs

negative cross-price exy = -0.03
elasticity of demand
coefficient, they are
called
complementary
goods.

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Demand Elasticities

Appendix 3A
 Consumer Tastes and Preferences

Preference orderings are complete.

More of the goods are preferred to less of the
goods.
Consumers are selfish.
The goods are continuously divisible so that
consumers can always purchase one more or
one less unit of the goods.

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 Indifference Curves

A consumers
indifference curve that
shows alternative
combinations of the Y1
two goods that
Y
provide the same Y2
level of satisfaction or U2
X U1
utility.
X1 X2

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 Marginal Rate of Substitution

The ratio Y/X, which shows the rate at which

the consumer is willing to trade off one good
for another and still maintain a constant utility
level, is called the marginal rate of substitution
(MRSxy).

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 The Budget Constraint
The consumers
budget constraint
shows all the
combinations of two
goods that can be
purchased with a given
income and given the
prevailing prices of the
two goods.

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 Shifts in the Budget Constraint

Y1
B2

B1

Increase in income Increase in price of good X

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 Consumer Choice
The consumer
maximizes utility by
choosing a
combination of good X
and Y, lying on the
budget constraint and
simultaneously lying on
the indifference curve
furthest from the origin.

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 Changes in Consumer Choice

Increase in income Increase in price

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