Chapter 4: ElasticityChapter 4: Elasticity

It measures the responsiveness It measures the responsiveness of of quantity demandedquantity demanded ( (or or demanddemand) with respect to changes ) with respect to changes in its ownin its own priceprice ( (oror income or income or the price of some other the price of some other commodity)commodity)..

Elasticity of Demand:Elasticity of Demand:

Why is Elasticity Important?Why is Elasticity Important?

How does a firm go about determining the price at which they should sell their product in order to maximize total revenue?

Total Revenue = Price Quantity

You are a marketing manager for Intel

A new computer chip has been developed

Decision to Be Made Do you sell the new chip at a high price

($400)? Do you sell the new chip at a low price

($200)?

Demand and Total RevenueDemand and Total Revenue

Quantity (millions of chips per year)

Pri

ce (

doll

ars

per

chip

)

40 80 120

100

200

300

400

Da

Demand and Total RevenueDemand and Total Revenue

Quantity (millions of chips per year)

Pri

ce (

doll

ars

per

chip

)

100

200

300

400

Db

40 60 80 120

Demand and Total RevenueDemand and Total Revenue

Quantity (millions of chips per year)

Pri

ce (

dolla

rs p

er c

hip)

Db

Pri

ce (

dolla

rs p

er c

hip)

Da

Quantity (millions of chips per year)

Slope Depends on Slope Depends on Units of MeasurementUnits of Measurement

In these two examples, we can compare the slopes of the demand curves

We cannot do so if we are dealing with different goods and services.

Pri

ce

Quantity

0 1 2 3 4 5 6 7 8

9

1

2

34

5

6

7

8

Effect of a change of unit of measurement on SlopeEffect of a change of unit of measurement on Slope

10

9 10 11

Slope Depends on Slope Depends on Units of MeasurementUnits of Measurement

In these two examples, we can compare the slopes of the demand curves

We cannot do so if we are dealing with different goods and services.

Elasticity is independent of the units of measurement.

Price elasticity of demandPrice elasticity of demand

A measure of the responsiveness of the quantity demanded of a good to a change in its own price (ceteris paribus).

Elasticity: A Units-Free Elasticity: A Units-Free MeasureMeasure

Pricein Change Percentage

DemandedQuantity in Change Percentage ε d

avg

avg

d

P P

Q

Q

Price Elasticity of

Demand

PΔ%

QΔ% d

Calculating ElasticityCalculating Elasticity

The changes in price and quantity are expressed as percentages of the average price and average quantity.

This way we avoid having two values for the price elasticity of demand for the same range of the demand curve

Example: Suppose, quantity demanded changes Example: Suppose, quantity demanded changes from 150 to 100 when Price increases from 5 to from 150 to 100 when Price increases from 5 to 10 dollars. Find out the price elasticity of demand 10 dollars. Find out the price elasticity of demand for this specific range of the demand curve.for this specific range of the demand curve.

avg

avgd

P P

Q Q

ε

6.5

3

1

5.1

5

2

5.1152

7.55

12550

Calculating the Elasticity of DemandCalculating the Elasticity of Demand

Quantity (millions of chips per year)

Pri

ce (d

olla

rs p

er c

hip)

36 44

390

410

Da

Originalpoint

Quantity (millions of chips per year)

Pri

ce (d

olla

rs p

er c

hip)

36 44

390

410

Da

Originalpoint

Newpoint

Calculating the Elasticity of DemandCalculating the Elasticity of Demand

Quantity (millions of chips per year)

Pri

ce (d

olla

rs p

er c

hip)

36 44

390

410

Da

= -$20P

= 8Q

Originalpoint

Newpoint

Calculating the Elasticity of DemandCalculating the Elasticity of Demand

Quantity (millions of chips per year)

Pri

ce (d

olla

rs p

er c

hip)

36 44

390

400

410

Da

Originalpoint

Newpoint

Pave = $400

= -$20P

= 8Q

Quantity (millions of chips per year)

Pri

ce (d

olla

rs p

er c

hip)

36 40 44

390

400

410

Da

Originalpoint

Newpoint

Pave =$400

Qave = 40

= -$20P

= 8Q

Calculating the Elasticity of DemandCalculating the Elasticity of Demand

Calculating ElasticityCalculating Elasticity

PΔ%

QΔ% d

Pricein Change Percentage

DemandedQuantity in Change Percentage ε d

avg

avg

P P

Q

Q

400/20

40/8

= - 4

Inelastic and Elastic DemandInelastic and Elastic Demand

Three demand curves that cover the entire range of possible elasticities of demand:

Perfectly inelastic Unit elastic Perfectly elastic

Perfectly inelastic demand Implies that quantity demanded remains constant when price changes occur.

Price elasticity of demand = 0

avg

avg

d

d

P P

Q Q

ε

6

12

Pri

ce

Quantity

D

Elasticity = 0

Perfectly Inelastic

10

Unit elastic demandUnit elastic demand Implies that the percentage change in quantity demanded equals the percentage change in price.

Price elasticity of demand = -1

avg

avg

d

d

P P

Q Q

ε

Unit Elastic DemandUnit Elastic Demand

6

12

Pri

ce

Quantity

D

1 2 3

Elasticity = -1

Unit Elasticity

Perfectly elastic demandPerfectly elastic demand Implies that if price increases by any

percentage, quantity demanded will fall to 0 and if price decreases by any percentage, quantity will rise to infinity.

Price elasticity of demand =

avg

avg

d

d

P P

Q Q

ε

6

12

Pri

ce

Quantity

D3

Elasticity =

Perfectly Elastic

Perfectly Elastic DemandPerfectly Elastic Demand

Inelastic and Elastic DemandInelastic and Elastic Demand

Inelastic demandInelastic demand Implies the percentage change in quantity demanded

is less than the percentage change in price. In absolute sense, price elasticity of demand > 0 and

< 1

Elastic demandElastic demand Implies the percentage change in quantity demanded

is greater than the percentage change in price. In absolute sense, price elasticity of demand > 1

avg

avg

d

d

P P

Q Q

ε

Elasticity Along a Straight-Line Elasticity Along a Straight-Line Demand CurveDemand Curve

0 40 80 100 120 160 200

250

100

200

300

400

500

Pri

ce (

dolla

rs p

er c

hip)

Quantity (millions of chips per year)

Elasticity Along a Straight-Line Elasticity Along a Straight-Line Demand CurveDemand Curve

Elasticity = -4

0 40 80 100 120 160 200

250

100

200

300

400

500 Lowering the pricefrom $500 to $300results in a price elasticity of demand of -4.

Elastic

Pri

ce (

dolla

rs p

er c

hip)

Quantity (millions of chips per year)

Elasticity Along a Straight-Line Elasticity Along a Straight-Line Demand CurveDemand Curve

Elasticity = -1/4

0 40 80 100 120 160 200

250

100

200

300

400

500 Lowering the pricefrom $200 to $0results in a price elasticity of demand of -1/ 4.

Inelastic

Pri

ce (

dolla

rs p

er c

hip)

Quantity (millions of chips per year)

Elasticity Along a Straight-Line Elasticity Along a Straight-Line Demand CurveDemand Curve

|Elasticity| = 1

0 40 80 100 120 160 200

250

100

200

300

400

500

Pri

ce (

dolla

rs p

er c

hip)

Quantity (millions of chips per year)

Lowering the pricefrom $500 to $0results in a price elasticity of demand of -1.

|Elasticity| < 1

|Elasticity| > 1

Elasticity, Total RevenueElasticity, Total Revenueand Expenditureand Expenditure

Elastic demandElastic demand — a 1 percent decrease in price will result in a greater than 1 percent increase in quantity demanded. Total revenue will increase

Unit elastic demandUnit elastic demand — a 1 percent decrease in price will result in a 1 percent increase in quantity demandedTotal revenue will not change

avg

avg

d

d

P P

Q Q

ε

TR = P x Q

Elasticity, Total RevenueElasticity, Total Revenueand Expenditureand Expenditure

Inelastic demandInelastic demand — a 1 percent decrease in price will result in a less than 1 percent increase in quantity demanded. Total revenue will decrease

avg

avg

d

d

P P

Q Q

ε

Elasticity, Total RevenueElasticity, Total Revenueand Expenditureand Expenditure

Total Revenue TestTotal Revenue Test

Price elasticity of demand can be

estimated by observing the change

in total revenue that results from a

price change (ceteris paribus).

Elasticity, Total RevenueElasticity, Total Revenueand Expenditureand Expenditure

Total Revenue TestTotal Revenue Test Price cut and total revenue increases

demand is elastic. Price cut and total revenue decreases

demand is inelastic Price cut and total revenue does not change

demand is unit elastic

0 100 200

250

100

200

300

400

500

Pri

ce (

doll

ars

per

chip

)

D

TR = P x Q

25

0 100 200

250

100

200

300

400

500

Pri

ce (

doll

ars

per

chip

)

0 100 200

5

10

15

20

Tot

al R

even

ue (

bill

ions

of

doll

ars)

Quantity (millions of chips per year)

D

TR

25

0 100 200

250

100

200

300

400

500

Pri

ce (

doll

ars

per

chip

)

0 100 200

5

10

15

20

Tot

al R

even

ue (

bill

ions

of

doll

ars)

Quantity (millions of chips per year)

Maximum total revenue

When demandis inelastic, price cut decreasestotal revenue

When demandis elastic, price cut increasestotal revenue

Inelastic demand

Unitelastic

Elasticdemand

More Elasticities of DemandMore Elasticities of Demand

Cross elasticity of demandCross elasticity of demand Measures the responsiveness of the

demand for a good to a change in the price of a substitute or complement good.

Cross elasticity of demand

= Percentage change Demand

Percentage change in price of a substitute or complement

Cross Elasticity of DemandCross Elasticity of DemandP

rice

of

Wal

kman

s

Quantity of Walkmans

D0

Cross Elasticity of DemandCross Elasticity of DemandP

rice

of

Wal

kman

s

Quantity of Walkmans

D1

Price of a CD player, a substitute, rises.Positive cross elasticity

D0

Cross Elasticity of DemandCross Elasticity of DemandP

rice

of

Wal

kman

s

Quantity of Walkmans

D0

Cross Elasticity of DemandCross Elasticity of DemandP

rice

of

Wal

kman

s

Quantity of Walkmans

Price of a tape, a complement, rises. Negativecross elasticity

D0D2

Income Elasticity of DemandIncome Elasticity of Demand

Income elasticity Measures the responsiveness of the demand to a

change in income.

Income elasticity of demand =

Percentage changein quantity demanded

Percentage change in income

Income Elasticity of DemandIncome Elasticity of Demand

Income elasticity can be:1 ) Greater than 1 (normal good, income elastic)

luxury goods - ocean cruises, jewelry

2 ) Between zero and 1 (normal good, income inelastic)

necessities - food, clothing

3 ) Less than zero (inferior good)potatoes, rice

Pri

ce

Quantity

0 1 2 3 4 5 6 7 8

9

1

2

34

5

6

7

8

Unit Tax and Tax Burden:Unit Tax and Tax Burden:

10

9 10 11

S1

S2

$2

Pri

ce

Quantity

0 1 2 3 4 5 6 7 8

9

1

2

34

5

6

7

8

Unit Tax and Tax Burden:Unit Tax and Tax Burden:

10

9 10 11

S1

S2

$2

Consumers’ part

Suppliers’ part

Pri

ce

Quantity

0 1 2 3 4 5 6 7 8

9

1

2

34

5

6

7

8

Elasticity and Tax Burden: Perfectly Inelastic DemandElasticity and Tax Burden: Perfectly Inelastic Demand

10

9 10 11

S1

S2

$2

Consumers’ part

Pri

ce

Quantity

0 1 2 3 4 5 6 7 8

9

1

2

34

5

6

7

8

Elasticity and Tax Burden: Perfectly Elastic DemandElasticity and Tax Burden: Perfectly Elastic Demand

10

9 10 11

S1

S2

$2

Producers’ part

Pri

ce

Quantity

0 1 2 3 4 5 6 7 8

9

1

2

34

5

6

7

8

Elasticity and Tax Burden: Perfectly Elastic SupplyElasticity and Tax Burden: Perfectly Elastic Supply

10

9 10 11

S1

S2

$2

Consumers’ part

Pri

ce

Quantity

0 1 2 3 4 5 6 7 8

9

1

2

34

5

6

7

8

Elasticity and Tax Burden: Perfectly inelastic SupplyElasticity and Tax Burden: Perfectly inelastic Supply

10

9 10 11

S1

$2

Producers’ part