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Ch. 6: Price Elasticity of Demand and its Applications

Ch. 6: Price Elasticity of Demand and its Applications. Econ 2420. Price Elasticity of demand a measure of the responsiveness of qt. demanded to a given percentage change in price. Ep. = [ % change in qt ]/ [ % change in price ].

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Ch. 6: Price Elasticity of Demand and its Applications

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  1. Ch. 6: Price Elasticity of Demand and its Applications Econ 2420

  2. Price Elasticity of demand • a measure of the responsiveness of qt. demanded to a given percentage change in price. Ep. = [ % change in qt ]/ [ % change in price ] Example: Subway reduced the price of its foot-long sandwich to $5 plus tax in January from a regular price of $6.50. How does this pricing strategy affect its sales and revenue?

  3. 2. Examples • As a result of a rise in the price of cigarette by 30%, sales of cigarette drops by only 15%. What is the Ep. ? Ep = %ΔQ/%ΔP= -.15/.30 = /-.5/< 1 => price inelastic demand Interpret what Ep = -.5 means => a 1% increase in price reduces sales by only 0.5%. How sensitive are cigarette sales to the price increase? Not very sensitive=> The demand for cigarettes is price Inelastic. How do we know?

  4. b. As a result of a 20% discount on Spring shirts, sales of Spring shirts increase by 40%. What is the Ep. ? Ep. = %ΔQ/%ΔP=.4/-.2 = -2 This means that 1% decrease in price resulted in an increase in sales by 2%. How sensitive are Spring shirt sales to the price discount ? Very sensitive=> or The demand for spring shirts price Elastic since Ep= /-2/ >1

  5. 3. Measures of Price Elasticity of Demand a. Point Price Elasticity : Ep = [% change in qt]/[% change in price] = [(change in qt/qt)]/(change in price/price) = [(change in qt /change price)] x (price/qt) Suppose the price of ice cream increases from $2.00 to $2.20 and the quantity demanded falls from 10 to 8. Find the point Ep ? Ep = [Δq/ Δp] x [(p/q)] Ep= [-2/.2]/[2/10]= -2 = 2, or -2.75 = 2.75

  6. b. Midpoint or Average price elasticity of demand : Ep = (%change in qt)/(%change in price) = [ΔQ/ ΔP ]x [(p1+p2)/ Q1+Q2)] = [2/.2] x [4.20/18]= 2.33 Note: The demand for ice cream is price elastic over this price range (same for price change) 4. Ranges of price elasticity of demand *Elastic demand Ep > 1 *Unit elastic demand Ep = 1 *Inelastic demand Ep < 1 *Perfectly elastic Ep =  *Perfectly inelastic Ep = 0

  7. 5. Relationship of Total Revenue and Price Elasticity: Should you raise or lower to increase total revenue?The demand schedule for sugar

  8. Generalizations Note: Price elasticity of demand is used for pricing strategy When the price elasticity of demand >1, a price increase reduces total revenue and a price decrease increases total revenue (Lower price). When the elasticity of demand with elasticity =1, a change in the price does not affect total revenue (Don’t change price). When the price elasticity of demand < 1, a price increase raises total revenue and a price decrease reduces total revenue (Raise price).

  9. 6. Determinants of price Elasticity of demand .Necessities (less elastic) vs luxuries (more elastic) e.g. >demand for physician service is price inelastic >the demand for vacation travel more elastic than for business travel .Availability of close substitutes =>more substitutes=> more elastic; (butter or margarine) few substitutes=> less elastic (Gasoline) .Definition of the market –narrow (ice cream) =>more elastic vs broad (food)=> less elastic) .Time horizon –short-run (less elastic) vs long-run (more elastic) Example: Gasoline

  10. 7a. Income Elasticity of demand • the responsiveness of qt. demanded to a given percentage change in income • EI =[ (%change in qt. demanded)]/(% change in income) Examples: As result of a 5% increase in consumers’ income, car sales increases by 7.5%. What is the EIfor cars ? EI= 0.075/.05 = 1.5 This means that the demand for cars is income elastic.

  11. As a result of an increase in income by 5%, the demand for food increase by 2.5%. What is the EI for food ? EI= 0.025/0.05 = 0.5 => Income Inelastic This means that the demand for food is income inelastic because EI isless than 1.

  12. Midpoint or Average Income Elasticity formula EI = [ΔQ/(Q1+ Q2)/2]/ Δ I/(I1+I2)/2 (See handout, question # 2) Notice that EI > 0 (positive) for normal goods and EI < 0 (negative) for inferior goods.

  13. b. Cross price elasticity of demand - the responsiveness of qt demanded of product X as a result of a given percentage change in the price of product Y. Exy = (%change in qt. of X)/(%change in Py) Example: As a result of an 8% increase in the price of Ford Taurus car(Y), the qt demanded(X) of Toyota Camry increases by 12%. What is the Exy for Camry? Exy = 0.12/0.08 = 1.2. This means that the demand Ford Taurus is cross-price elastic since Exy = 1.2 > 1.

  14. Midpoint or Average cross price elasticity of demand formula Exy=[(ΔQx)/(Qx1+Qx2)]/[(ΔPy)/ Py1+Py2] (See # 3 handout) Notice that Exy > 0 for substitute goods and Exy < 0 for complementary goods.

  15. 8. Price elasticity of supply is the responsiveness of qt supplied to a given percentage change in price. Es = (%qt supplied)/(%change in price) Example : As result of an increase in the price of wheat by 20%, wheat farmers increase the qt. of wheat supplied by 30%. What is Es = .3/.2=1.5 Is supply price elastic? Yes, because Es>1.

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