Chapter - 3

1. Chapter - 3 Elasticity

2. Elasticity of Demand • Price Elasticity • Income elasticity • Cross-price elasticity 2

3. 1- Price Elasticity of Demand Price elasticity of demand measures the responsiveness of buyers’ purchasing habits to a price change. Ep = the percentage change in a product’s quantity demanded divided by the percentage change in its price. 3

4. Degrees of Elasticity of Demand: 1- Elastic Demand: If a product’s elasticity is greater than 1. Ed > 1 2- Inelastic Demand: If a product’s elasticity is less than 1. Ed < 1 3- Unit Elasticity of Demand: If a product’s elasticity is equal to 1. Ed = 1 4- Perfectly Elastic Demand: A demand is perfectly elastic when a small increase in the price of a good its quantity to zero. Ed = ∞ 5- Perfectly Inelastic Demand: When the quantity demanded of a good dose not change at all to whatever change in price. Ed = 0 4

5. Price Elasticity of Demand Formula: ∆ Qd × P1 ∆ P Qd1 Where: Qd = quantity demanded P = price. 5 Ep =

6. Price Elasticity of Demand Example 1 Let’s say that a grocery store observes that at $2.00 per gallon of milk, buyers purchase 800 gallons per day. The next week, the grocery store increases its price to $3.00 per gallon and buyers purchase 700 gallons per day. What is the price elasticity of demand for milk? 6

7. Price Elasticity of Demand Example 1 answer • Qd1= 800 • Qd2 = 700 • P1 = $2 • P2 = $3 700 – 800 × 2 = - 0.25 3 – 2 800 7 Ep =

8. Price Elasticity of Demand Example 1 answer Officially, the answer is - 0.25, because the quantity demanded decreased (change of -100). However, because price elasticity of demand is always negative, we ignore the negative sign. 8

9. A product with a price elasticity of demand equal to 0.25 is: • Elastic • Unit elastic • Inelastic • None of the above 9 10 0 of 30

10. A product with a price elasticity of demand equal to 0.25 is: • Elastic • Unit elastic • Inelastic • None of the above 10

11. Price Elasticity of Demand Example 2 A movie theatre sells 1,800 tickets when it charges a price of $11. After it lowers its price to $9, it sells 2,600 tickets. What is the price elasticity of demand for tickets for this movie theatre? 11

12. Price Elasticity of Demand Example 2 answer 2600-1800 × 11 9-11 1800 Because the value is greater than 1, movie tickets at this theatre are price elastic. 12 Ep = = - 2.44

13. Determinants of price elasticity of demand are: • The availability of close substitutes. The more substitutes, the greater the elasticity. • The product’s expense to the consumer relative to her/his income or wealth. The higher the expense, the greater the elasticity. • The period of time under consideration. The longer the time period, the greater the elasticity. 13

14. Price elasticity determinants of gasoline • The availability of close substitutes. Gasoline does not have many substitutes. This makes gasoline inelastic. • The product’s expense to the consumer relative to her/his income or wealth. For many people gasoline is a considerable expense. This makes gasoline elastic. • The period of time under consideration. Within a short period of time, people cannot change their driving behavior much. This makes gasoline inelastic when looking at a short-run demand curve. • Overall, especially in the short run, gasoline is probably inelastic. 14

15. Elasticity and Revenue Revenue = quantity demanded x price • If a product is elastic and price increases, then revenue decreases. • If a product is elastic and price decreases, then revenue increases. • If a product is inelastic and price increases, then revenue increases. • If a product is inelastic and price decreases, then revenue decreases. • If a product is unit elastic and price changes, then revenue stays the same. 15

16. If a product is elastic and its price decreases, then the supplier’s total revenue: • Decreases • Increases • Stays the same • None of the above 16

17. If a product is inelastic and its price decreases, then the supplier’s total revenue: • Decreases • Increases • Stays the same • None of the above 17

18. If a product is unit elastic and its price decreases, then the supplier’s total revenue: • Decreases • Increases • Stays the same • None of the above 18

19. Income Elasticity of Demand Income elasticity of measures the responsiveness of buyers’ purchasing habits in response to an income change. Ei = ∆Qd × I1 ∆I Qd1 Where : Qd = quantity demanded, and I = income. The value can be positive (normal good) or negative (inferior good). 19

20. Income Elasticity of Demand Example: If the income increase from $1200 to $1600 which leads to increase the quantity demanded of meat from 10 kgs to 12 kgs. 1- Calculate the Income Elasticity of Demand. 2- Determine the kind of the product. 20

21. Income Elasticity of Demand 1- Ei = 12 – 10 × 1200 1600 – 1200 10 Ei = 0.6 2- Normal good. 21

22. Cross Price Elasticity of Demand The price change of a substitute or complementary product affects the quantity demanded of the other substitute or complementary product. Ec = ∆Qd × P1 ∆P Qd1 Substitutes have a positive cross price elasticity of demand. Complements have a negative cross price elasticity of demand. 22

23. Cross Price Elasticity of Demand Example: Suppose the milk price decrease from s.r.12 to s.r.10 this leads to decrease the quantity demanded of butter from 100 kg to 50 kg. 1-What is the Cross Price Elasticity of Demand? 2-What is the kind of the product? 23

24. Cross Price Elasticity of Demand 1- Ec = 50 – 100 × 12 10 – 12 100 = 25 × 0.12 Ec = 3 2- Substitutes product. 24