PRICE SYSTEM

Prepared by:

Prof. Ali Fallahchay

Learning Outcomes

• Price Elasticity of Demand and Types of Elasticity

• Calculating Elasticities: Arc, Point, Cross-price, Income and Supply

• Elasticity and Total Revenue

• Determinants of Demand Elasticity

Price Elasticity• Elasticity – measures the degree of responsiveness in the

quantity per unit of time to a change in any one of the factors of demand or supply.

• Price Elasticity – measures the relative responsiveness in quantity demanded to a change in price.

= - Q2 – Q1 x P1

P2 – P1 Q1

Elastic Demand Diagram

>1

Inelastic of demand

<1

Unit-elastic or Unitary

Perfectly Elastic

𝑒𝑑=∞

Perfectly inelastic

𝑒𝑑=0

Question and Answer

Q1: At a price of Php11.00, quantity demanded is 90; and at a price of Php9.00, quantity demanded is 110. The price elasticity of demand is:a. 0.1b. -0.82c. -1.22d. -1e. 0

Interpretation of Elasticity of Demand

• Ed > 1 demand is elastic

• Ed = 1 demand is unit elastic

• Ed < 1 demand is inelastic

• Extreme cases• Perfectly inelastic• Perfectly elastic

LO1

Arc Elasticity

𝑒𝑝=¿

│(Q2 – Q1) x (P2 + P1)│ │(P2 - P1) (Q2 + Q1)│

Example 1:Point Px Qx

A 16 0

B 14 2000

C 12 4000

D 10 6000

F 8 8000

G 6 10000

H 4 12000

L 3 14000

M 0 16000

Question and Answer

Q2:Find the 𝑒𝑝 for a movement from point B to point C

Q3:Find the 𝑒𝑝 for a movement from point C to point D

Total Revenue Test

• Total Revenue = Price X Quantity• Inelastic demand

• P and TR move in the same direction• Elastic demand

• P and TR move in opposite directions

LO2

Price Elasticity of demand and Total RevenueP Q TR = P x Q

10 1 10

9 2 18

8 3 24

7 4 28

6 5 30

5 6 30

4 7 28

3 8 24

2 9 18

1 10 10

Example 2

Total Revenue Test

LO2

$3

2

1

0 10 20 30 40 Q

P

a

bD1

• Lower price and elastic demand• Blue gain exceeds orange loss

Total Revenue Test

LO2

$4

3

2

1

0 10 20 Q

P

c

d

D2

• Lower price and inelastic demand• Orange loss exceeds blue gain

Total Revenue Test

LO2

$3

2

1

0 10 20 30 Q

P

e

fD3

• Lower price and unit elastic demand• Blue gain equals orange loss

Price Elasticity and Total RevenueELASTICITY IMPLICATIONS

Elastic As price decreases, quantity demanded and total revenue increases.

Inelastic As price decreases, quantity demanded increases, but total revenue decreases

Unitary As price decreases, the increase in quantity demanded exactly offsets it, and total revenue is constant

Cross Elasticity of Demand

• Measures responsiveness of sales to change in the price of another good

• Substitutes – positive sign• Complements – negative sign• Independent goods - zero

LO4

Percentage change in quantity demanded of product X

Ex,y = Percentage change in price of product Y

Cross Elasticity of Demand

• Application

• Change the price?

• Allow a merger?

LO4

Cross Elasticity

x

Before After

Commodity P Q P QProduct Y 80 600 60 800

Product X 40 400 40 300

Product Z 100 20 120 18

Product X 40 400 40 360

CROSS ELASTICITY OF DEMAND

ELASTICITY Category of Goods

INTERPRETATION

Positive Substitute Goods are substitutes for one another

Negative Complements Goods are consumed together

Zero Independents Goods are not related in consumption

Income Elasticity of Demand• Measures responsiveness of buyers

to changes in income • Normal goods – positive sign• Inferior goods – negative sign

LO4

Percentage change in quantity demanded

Ey = Percentage change in income

Simplified formula

ey =

ey =

x

ELASTICITYODS CATEGORY OF GOODS

INTERPRETATION

Positive Superior Consumption of the good varies directly with income

Negative Inferior Consumption of the good varies inversely with income

Zero Independent Consumption of the good does not vary with income

Price Elasticity of Supply

• Measures sellers’ responsiveness to price changes• Elastic supply, producers are

responsive to price changes• Inelastic supply, producers are not

responsive to price changes

LO3

Price Elasticity of Supply

• Formula to compute elasticity• Es > 1 supply is elastic• Es < 1 supply is inelastic

LO3

Percentage Change in QuantitySupplied of Product X

Percentage Change in Priceof Product X

Es =

Price Elasticity of Supply

• Time is primary determinant of elasticity of supply

• Time periods considered• Market period• Short Run• Long Run

LO3

Elasticity of Supply: The Market Period

LO3

P

Q

• Perfectly inelastic supply

D1

D2

Sm

Q0

Pm

P0

Elasticity of Supply: The Short Run

LO3

• Supply is more elastic than in market period

P

QD1

D2

Ss

Q0

Ps

P0

Qs

Elasticity of Supply: The Long Run

LO3

• Supply is even more elastic than in the short run

P

QD1

D2

Sl

Q0

Pl

P0

Ql

Applications of Elasticity of Supply

• AntiquesInelastic supply

• ReproductionsMore elastic supply

• Volatile gold pricesInelastic supply

LO3