Understanding Elasticity of Demand

1. Chapter 4: Elasticity Elasticity of Demand: It measures the responsiveness of quantity demanded (or demand) with respect to changes in its own price (or income or the price of some other commodity).

2. Why is Elasticity Important? How does a firm go about determining the price at which they should sell their product in order to maximize total revenue? Total Revenue = Price ´ Quantity

3. You are a marketing manager for Intel • A new computer chip has been developed • Decision to Be Made • Do you sell the new chip at a high price ($400)? • Do you sell the new chip at a low price ($200)?

4. Demand and Total Revenue 400 Price (dollars per chip) 300 200 Da 100 40 80 120 Quantity (millions of chips per year)

5. Demand and Total Revenue 400 Price (dollars per chip) 300 200 100 Db 40 60 80 120 Quantity (millions of chips per year)

6. Demand and Total Revenue Price (dollars per chip) Price (dollars per chip) Da Db Quantity (millions of chips per year) Quantity (millions of chips per year)

7. Slope Depends on Units of Measurement • In these two examples, we can compare the slopes of the demand curves • We cannot do so if we are dealing with different goods and services. Or whenever the unit of measurement has been changed.

8. Effect of a change of unit of measurement on Slope Price 10 9 8 7 6 5 4 3 2 1 0 9 10 11 12 1 2 3 4 5 6 7 8 Quantity

9. Slope Depends on Units of Measurement • In these two examples, we can compare the slopes of the demand curves • We cannot do so if we are dealing with different goods and services. Or, whenever the unit of measurement has been changed. • Elasticityis independent of the units of measurement.

10. Price elasticity of demand A measure of the responsiveness of the quantity demanded of a good to a change in its own price (ceteris paribus).

11. Elasticity: A Units-Free Measure Price Elasticity of Demand

12. Calculating Elasticity The changes in price and quantity are expressed as percentages of the average price and average quantity. This way we avoid having two values for the price elasticity of demand for the same range of the demand curve

13. Example: Suppose, quantity demanded changes from 150 to 100 when Price increases from 5 to 10 dollars. Find out the price elasticity of demand for this specific range of the demand curve.

14. Calculating the Elasticity of Demand Original point 410 Price (dollars per chip) 390 Da 36 44 Quantity (millions of chips per year)

15. Calculating the Elasticity of Demand Original point 410 Price (dollars per chip) New point 390 Da 36 44 Quantity (millions of chips per year)

16. = -$20 = 8 Calculating the Elasticity of Demand Original point 410 Price (dollars per chip) New point 390 Da 36 44 Quantity (millions of chips per year)

17. = -$20 = 8 Original point 410 Price (dollars per chip) 400 Pave = $400 New point 390 Da 36 44 Quantity (millions of chips per year)

18. = -$20 = 8 Calculating the Elasticity of Demand Original point 410 Price (dollars per chip) 400 Pave =$400 New point Qave = 40 390 Da 36 40 44 Quantity (millions of chips per year)

19. Calculating Elasticity = - 4

20. Inelastic and Elastic Demand Three demand curves that cover the entire range of possible elasticities of demand: • Perfectly inelastic • Unit elastic • Perfectly elastic

21. Perfectly inelastic demand • Implies that quantity demanded remains constant when price changes occur. • Price elasticity of demand = 0

22. D Price Elasticity = 0 12 Perfectly Inelastic 6 0 1 Quantity

23. Unit elastic demand • Implies that the percentage change in quantity demanded equals the percentage change in price. • Price elasticity of demand = -1

24. Unit Elastic Demand Price Elasticity = -1 12 Unit Elasticity 6 D Quantity 1 2 3

25. Perfectly elastic demand • Implies that if price increases by any percentage, quantity demanded will fall to 0 and if price decreases by any percentage, quantity will rise to infinity. • Price elasticity of demand =

26. Perfectly Elastic Demand Price Elasticity = 12 D3 6 Perfectly Elastic Quantity

27. Inelastic and Elastic Demand Inelastic demand • Implies the percentage change in quantity demanded is less than the percentage change in price. • In absolute sense, price elasticity of demand > 0 and < 1 Elastic demand • Implies the percentage change in quantity demanded is greater than the percentage change in price. • In absolute sense, price elasticity of demand > 1

28. Elasticity Along a Straight-Line Demand Curve 500 Price (dollars per chip) 400 300 250 200 100 0 40 80 100 120 160 200 Quantity (millions of chips per year)

29. Elasticity Along a Straight-Line Demand Curve Elasticity = -4 500 Lowering the price from $500 to $300 results in a price elasticity of demand of -4. Elastic Price (dollars per chip) 400 300 250 200 100 0 40 80 100 120 160 200 Quantity (millions of chips per year)

30. Elasticity Along a Straight-Line Demand Curve 500 Lowering the price from $200 to $0 results in a price elasticity of demand of -1/ 4. Price (dollars per chip) 400 Inelastic 300 250 200 Elasticity = -1/4 100 0 40 80 100 120 160 200 Quantity (millions of chips per year)

31. Elasticity Along a Straight-Line Demand Curve 500 Lowering the price from $500 to $0 results in a price elasticity of demand of -1. |Elasticity| > 1 Price (dollars per chip) 400 |Elasticity| = 1 300 250 200 |Elasticity| < 1 100 0 40 80 100 120 160 200 Quantity (millions of chips per year)

32. TR = P x Q Elasticity, Total Revenueand Expenditure Elastic demand— a 1 percent decrease in price will result in a greater than 1 percent increase in quantity demanded. • Total revenue will increase Unit elastic demand— a 1 percent decrease in price will result in a 1 percent increase in quantity demanded • Total revenue will not change

33. Elasticity, Total Revenueand Expenditure Inelastic demand— a 1 percent decrease in price will result in a less than 1 percent increase in quantity demanded. • Total revenue will decrease

34. Elasticity, Total Revenueand Expenditure Total Revenue Test • Price elasticity of demand can be estimated by observing the change in total revenue that results from a price change (ceteris paribus).

35. Elasticity, Total Revenue & Expenditure Total Revenue Test • Price cut and total revenue increases • demand is elastic. • Price cut and total revenuedecreases • demand is inelastic • Price cut and total revenue does not change • demand is unit elastic

36. 500 400 Price (dollars per chip) 300 250 200 D 100 0 100 200 TR = P x Q

37. 500 400 Price (dollars per chip) 300 250 200 D 100 0 100 200 25 20 Total Revenue (billions of dollars) 15 10 TR 5 0 100 200 Quantity (millions of chips per year)

38. Elastic demand 500 400 Price (dollars per chip) Unit elastic 300 250 200 Inelastic demand 100 0 100 200 Maximum total revenue 25 20 Total Revenue (billions of dollars) 15 When demand is inelastic, price cut decreases total revenue When demand is elastic, price cut increases total revenue 10 5 0 100 200 Quantity (millions of chips per year)

39. Percentage change in Demand Cross elasticity of demand = Percentage change in price of a substitute or complement More Elasticities of Demand Cross elasticity of demand • Measures the responsiveness of the demand for a good to a change in the price of a substitute or complement good.

40. Percentage change In Demand Income elasticity of demand = Percentage change in income Income Elasticity of Demand Income elasticity • Measures the responsiveness of the demand to a change in income.

41. Income Elasticity of Demand Income elasticity can be: 1) Greater than 1 (normal good, income elastic) luxury goods - ocean cruises, jewelry 2) Between zero and 1 (normal good, income inelastic) necessities- food, clothing 3) Less than zero (inferior good) potatoes, rice

42. Unit Tax and Tax Burden: Price 10 S2 9 S1 8 7 6 5 $2 4 3 2 1 0 9 10 11 1 2 3 4 5 6 7 8 Quantity

43. Unit Tax and Tax Burden: Price 10 S2 Consumers’ part 9 S1 8 7 6 $2 5 4 3 2 Suppliers’ part 1 0 9 10 11 1 2 3 4 5 6 7 8 Quantity

44. Elasticity and Tax Burden: Perfectly Inelastic Demand Price 10 S2 Consumers’ part 9 S1 8 7 6 $2 5 4 3 2 1 0 9 10 11 1 2 3 4 5 6 7 8 Quantity

45. Elasticity and Tax Burden: Perfectly Elastic Demand Price 10 S2 9 Producers’ part S1 8 7 6 5 4 $2 3 2 1 0 9 10 11 1 2 3 4 5 6 7 8 Quantity

46. Elasticity and Tax Burden: Perfectly Elastic Supply Price 10 Consumers’ part 9 8 7 S2 6 $2 5 S1 4 3 2 1 0 9 10 11 1 2 3 4 5 6 7 8 Quantity

47. Elasticity and Tax Burden: Perfectly inelastic Supply Price S1 10 9 Producers’ part 8 7 6 5 4 3 $2 2 1 0 9 10 11 1 2 3 4 5 6 7 8 Quantity

48. Chapter 5 Marginal Utility & Consumer Choice:

49. Utility: The satisfaction or enjoyment a person obtains from consuming a good. Util: A hypothetical unit used to measure how much utility a person obtains from consuming a good.

50. Marginal Utility: The change in total utility a person derives from consuming an additional unit of a good. Total Utility: The total number of utils a person derives from consuming a specific quantity of a good.