Elasticity

1. Chapter 19 Elasticity

2. Part I. Price Elasticity Chapter 19

3. Price Elasticity • The response of consumers to a change in price is measured by the price elasticity of demand. Chapter 19

4. Price Elasticity • The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price. % change in sales % change in price Chapter 19

5. Percentage Change (New-Old) Old (new price – old price) old price Chapter 19

6. Example: • Last year’s sales: • This year’s sales : • Last year’s price: • This year’s price: Chapter 19

7. Elasticity: % change in sales: % change in price: • Elasticity: Chapter 19

8. Price Elasticity • Technically, for normal goods price elasticity of demand (E) is always negative. Chapter 19

9. Elastic vs. Inelastic Demand • If E is larger than 1, demand is elastic. • Consumer response is large relative to the change in price. • If E is less than 1, demand is called inelastic. • Consumers aren’t very responsive to price changes. • If E equals 1, demand is unit elastic. Chapter 19

10. Demand Elasticity inelastic Unit elastic Chapter 19

11. Elasticity Extremes • A horizontal demand curve means that demand is perfectly elastic. • Any price increase would cause demand to fall to zero. • A vertical demand curve means that demand is completely inelastic. • Quantity demanded will not change regardless of the price change. • Addiction? Too rich to care? Either way, price is not an issue. Chapter 19

12. Demand Elasticity inelastic Chapter 19

13. Determinants of Elasticity • The price elasticity of demand is influenced by all of the determinants of demand. Chapter 19

14. Determinants of Elasticity • Necessities & Luxuries • Availability of Substitutes • Relative Price • Time Chapter 19

15. Necessities vs. Luxuries • Demand for necessities is relatively inelastic • Necessities are goods that are critical to our everyday life • we need to have them, regardless of the price. • Demand for luxury goods is relatively elastic. Chapter 19

16. Availability of Substitutes • The greater the availability of substitutes, the higher the price elasticity of demand. Chapter 19

17. Relative Price • The higher the price in relation to a consumer’s income, the higher the elasticity of demand. • The price elasticity of demand declines as price moves down the demand curve. Chapter 19

18. Time • The long-run price elasticity of demand is higher than the short-run elasticity. • Consumers are better able to change their buying habits over the long-run that in the short-run. Chapter 19

19. Price Elasticity and Total Revenue • Higher prices don’t always mean higher total revenue. • Total revenue = The price of a product multiplied by the quantity sold in a given time period: p x q. • Total revenue = Price x Quantity sold Chapter 19

20. Price Elasticity and Total Revenue • A price hike increases total revenue only if demand in inelastic • (E < 1). • A price hike reduces total revenue if demand is elastic • (E > 1). • A price hike does not change total revenue if demand is unitary elastic • (E = 1). Chapter 19

21. Changing Value of E • Price elasticity changes along a demand curve. • The impact of a price change on total revenue depends on the (changing) price elasticity of demand. Chapter 19

22. Part II. Income Elasticity Chapter 19

23. Income Elasticity • An increase in consumer income will cause a rightward shift in demand. • Consumers will now purchase more at any price than they did prior to the increase in income. Chapter 19

24. Income elasticity of demand • The percentage change in quantity demanded divided by percentage change in income. % change in sales % change in income Chapter 19

25. Example: • Last year’s sales: • This year’s sales: • Last year’s income: • This year’s income: Chapter 19

26. Elasticity: % change in sales % change in income • Elasticity: Chapter 19

27. A Normal Good: • Has an income elasticity greater than zero (positive). • as we make more money, we buy more • Has a price elasticity less than 0 (negative). • As the price increases, we buy less Chapter 19

28. An Inferior Good: • Has an income elasticity less than zero. • as we make more money, we buy less Chapter 19

29. A Luxury Good: • Has an income elasticity that is very high. • It takes a large increase in our income before we buy Chapter 19

30. Part III. Cross-Price Elasticity Chapter 19

31. Cross-Price Elasticity • A change in the price of one good affects the demand for another. • The decision to buy a good depends on the prices of substitutes and complements of that good. • Substitute goods are goods that substitute for each other. • Complementary goods are goods frequently consumed in combination. Chapter 19

32. Cross-Price Elasticity • The percentage change in the quantity demanded of X divided by percentage change in price of Y. % change in sales of one good % change in price of another good Chapter 19

33. Example: • Last year’s Coke sales: • This year’s Coke sales: • Last year’s Price of Pepsi: • This Year’s Price of Pepsi: Chapter 19

34. Elasticity: new Coke sales – old Coke sales new Pepsi price – old Pepsi price • Elasticity: Chapter 19

35. Cross-Price Elasticity • When the cross-price elasticity of demand has a negative sign the two goods are complementary goods. • When the cross-price elasticity of demand has a positive sign the two goods are substitute goods. Chapter 19

36. Choosing Among Products • The purchase of any one single good means giving up the opportunity to buy more of other goods. • Opportunity Costs • The most desired goods or services that are forgone in order to obtain something else. • What you give up to do something else Chapter 19