1 / 36

Understanding Price Elasticity of Demand: Concepts and Formulas

Explore the responsiveness of demand to price changes, elasticity types, formulas, and effects on total revenue. Learn how to calculate and interpret income elasticity for normal and inferior goods.

laverneh
Download Presentation

Understanding Price Elasticity of Demand: Concepts and Formulas

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Elasticity and Demand Price, Income and Cross Elasticity of Demand

  2. Elasticity and Demand • What is elasticity?????

  3. Elasticity – the concept • The responsiveness of one variable to changes in another • When price rises, what happens to demand? • Demand falls • BUT! • How much does demand fall?

  4. Elasticity – the concept • If price rises by 10% - what happens to demand? • We know demand will fall • By more than 10%? • By less than 10%? • Elasticity measures the extent to which demand will change

  5. Elasticity • 4 basic types used: • Price elasticity of demand • Price elasticity of supply • Income elasticity of demand • Cross elasticity

  6. Elasticity and Demand • What is price elasticity of demand????

  7. Elasticity • Price Elasticity of Demand • The responsiveness of demand to changes in price • Where % change in demand is greater than % change in price –elastic • Where % change in demand is less than % change in price - inelastic

  8. Elasticity The Formula: % Change in Quantity Demanded ___________________________ Ped = % Change in Price If answer is between 0 and -1: the relationship is inelastic If the answer is between -1 and infinity: the relationship is elastic Note: PED has – sign in front of it; because as price rises demand falls and vice-versa (inverse relationship between price and demand)

  9. Elasticity and Demand • Predicting the % Change in Quantity Demanded • e.g if E = 5 %ΔP = 5% what is %ΔQ = ????

  10. Elasticity and Demand • Predicting the % Change in Price • e.g if E = 5 %ΔQ = 25% what is %ΔP = ????

  11. Elasticity Price (£) The demand curve can be a range of shapes each of which is associated with a different relationship between price and the quantity demanded. Quantity Demanded

  12. Elasticity and Demand • What is total revenue????? • What is the relationship between Price Elasticity and TR????

  13. Elasticity Price Total revenue is price x quantity sold. In this example, TR = £5 x 100,000 = £500,000. This value is represented by the grey shaded rectangle. The importance of elasticity is the information it provides on the effect on total revenue of changes in price. £5 Total Revenue D 100 Quantity Demanded (000s)

  14. Elasticity Price If the firm decides to decrease price to (say) £3, the degree of price elasticity of the demand curve would determine the extent of the increase in demand and the change therefore in total revenue. £5 £3 TotalRevenue D 100 140 Quantity Demanded (000s)

  15. Elasticity and Demand • What is price effect????? • What is quantity effect????

  16. Elasticity Price (£) Producer decides to lower price to attract sales 10 % Δ Price = -50% % Δ Quantity Demanded = +20% Ped = -0.4 (Inelastic) Total Revenue would fall 5 Not a good move! D 5 6 Quantity Demanded

  17. Elasticity Price (£) Producer decides to reduce price to increase sales % Δ in Price = - 30% % Δ in Demand = + 300% Ped = - 10 (Elastic) Total Revenue rises 10 Good Move! 7 D 20 5 Quantity Demanded

  18. If demand is price elastic: Increasing price would reduce TR (%Δ Qd > % Δ P) Reducing price would increase TR (%Δ Qd > % Δ P) If demand is price inelastic: Increasing price would increase TR (%Δ Qd < % Δ P) Reducing price would reduce TR (%Δ Qd < % Δ P) Elasticity

  19. Elasticity and Demand • What factors affect price elasticity of demand • Availability of substitutes • Percentage of consumer budget • Time period of Adjustment

  20. Elasticity and Demand • Calculating Price elasticity of demand • E = %ΔQ = ΔQ x 100 = ΔQ x P • %ΔP Q………ΔP Q ΔP x 100 P

  21. Elasticity and Demand • What is Marginal Revenue???? • MR = ΔTR ΔQ

  22. Elasticity and Demand

  23. Elasticity and Demand • What is the relationship between MR & Price Elasticity???? • MR = P ( 1 + 1/E)

  24. Elasticity and Demand • What is Income Elasticity???? • Em = % ΔQ • %ΔM

  25. Elasticity • Income Elasticity of Demand: • The responsiveness of demand to changes in incomes • Normal Good– demand rises as income rises and vice versa • Inferior Good– demand falls as income rises and vice versa

  26. Elasticity • Income Elasticity of Demand: • A positive sign denotes a normal good • A negative sign denotes an inferior good • Calc income elasticity of demand fig6.6 pg105

  27. Elasticity • For example: • Yed = - 0.6: Good is an inferior good but inelastic– a rise in income of 3% would lead to demand falling by 1.8% • Yed = + 0.4: Good is a normal good but inelastic–a rise in incomes of 3% would lead to demand rising by 1.2% • Yed = + 1.6: Good is a normal good and elastic–a rise in incomes of 3% would lead to demand rising by 4.8% • Yed = - 2.1: Good is an inferior good and elastic–a rise in incomes of 3% would lead to a fall in demand of 6.3%

  28. Elasticity and Demand • NB Income elasticity can be measured either over an interval or at a point on the general demand curve.

  29. Elasticity and Demand • When the change income is relatively small the point measure of income elasticity is calculated by multiplying. Slope of ΔQ • ΔM • For linear demand function • Q= a + bP + cM + dPr

  30. Elasticity and Demand • The point of measure of income elasticity is Em = cM Q

  31. Elasticity and Demand • What is Cross Price Elasticity????

  32. Elasticity • Cross Elasticity: • The responsiveness of demand of one good to changes in the price of a related good – either a substitute or a complement % Δ Qd of good t __________________ Xed = % Δ Price of good y

  33. Elasticity • Goods which are complements: • Cross Elasticity will have negative sign (inverse relationship between the two) • Goods which are substitutes: • Cross Elasticity will have a positive sign (positive relationship between the two)

  34. Elasticity • Price Elasticity of Supply: • The responsiveness of supply to changes in price • If Pes is inelastic - it will be difficult for suppliers to react swiftly to changes in price • If Pes is elastic– supply can react quickly to changes in price % Δ Quantity Supplied ____________________ Pes = % Δ Price

  35. Determinants of Elasticity • Time period– the longer the time under consideration the more elastic a good is likely to be • Number and closeness of substitutes–the greater the number of substitutes, the more elastic • The proportion of income taken up by the product– the smaller the proportion the more inelastic • Luxury or Necessity - for example, addictive drugs

  36. Importance of Elasticity • Relationship between changes in price and total revenue • Importance in determining what goods to tax (tax revenue) • Importance in analysing time lags in production • Influences the behaviour of a firm

More Related