Download - Elasticity of Demand Concepts
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Elasticity of Demand
by
Balaji K
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Overview Elastic Vs Inelastic Demand Difference between elastic, inelastic, and unitary
elastic demand/supply Types of Elasticity of Demand Determinants of price elasticity of demand Income elasticity Cross price elasticity of demand
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Elasticity of Demand
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
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Elasticity - Concept
D
According to Marshall “The elasticity of demand in a market is great or small according as the amount demanded increases much or little for a given fall in the price and diminishes much or little for a given rise in Price”
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Elastic Demand
D
“A small change in price may lead to a great change in quantity demanded.In this case ,demand is elastic”
Price in Rs Quantity Demanded of milk
25 1 litre
24 2 litre
27 0.5 litre
Demand is elastic if the percentage change in quantity is greater than the percentage change in price.
E > 1
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InElastic Demand
D
“A big change in price followed by small change in quantity demanded.In this case ,demand is inelastic”
E < 1Price in Rs Quantity Demanded of
milk
25 1 litre
14 1.2 litre
20 1.5 litre
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Types of Elasticity
D
1.Price Elasticity
a)Perfectly Elastic
b)Perfectly Inelastic
c)Relatively Elastic
d)Relatively Inelastic
e)Unit Elasticity of Demand
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Types of Elasticity
D
2.Income Elasticity
a)Zero Income Elasticity
b)Negative Income Elasticity
c)Unit Income Elasticity
d)Income Elasticity greater than unity
e)Income Elasticity less than unity
3.Cross Elasticity of Demand
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Price Elasticity
D
The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price.
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Part 1: Price Elasticity of Demand - Calculation
Base value for percentage changes in price or quantity is always midway between initial value and new value
Denominator
- Define the percentage change in price from any value P0 to any other value P1 as
2
)(
)( Price in Change %
PPPP
01
01
• Numerator: When quantity demanded changes from Q0 to Q1,
percentage change is calculated as
2
)_( DemandedQuantity in Change %
01
01
QQQQ
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Figure 1: Calculating Price Elasticity of Demand-- laptop computer demand
Quantity of Laptops
C
Price per Laptop
100,000 200,000 300,000 400,000 500,000 600,000
$3,500
3,000
2,500
2,000
1,500
1,000
B
A
D
D
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Calculating Price Elasticity of Demand -- An Example
Now let’s calculate an elasticity of demand for laptop computers using data in Figure 1 from point A to point B
% 2.18or ,182.0000,550
000,100
2)000,600000,500()000,600000,500(
Q%
• Use percentage changes for price and quantity to calculate price elasticity of demand ( )
% 40.0or ,400.0250,1$
500$
2
)000,1$500,1($)000,1$500,1($
P %
46.0400.0
182.0D
D
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Calculating Price Elasticity of Demand -- by Total Outlay Method
Price in Rs Quantity Demanded
Total Outlay
4.50 4 18
4 4.5 18
3 6 18
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Price Elasticity of Demand -- Categorize Goods
Inelastic DemandPrice elasticity of demand between 0 and -1
1.0 P%
Q % Demand Inelastic
|% Change in Quantity Demanded| < |% Change in Price|
• Extreme Case: Perfectly Inelastic Demand– Price elasticity of demand equal to 0
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Categorizing Goods by Elasticity• Elastic Demand
– Price elasticity of demand with absolute value > 1
|% Change in Quantity Demanded| > |% Change in Price|
• Extreme Case: Perfectly (infinitely) Elastic Demand– Price elasticity of demand approaching minus infinity
• Another Special Case: Unitary Elastic Demand– Price elasticity of demand equal to -1
1 P %
Q % Demand Elastic
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Figure 2: Extreme Cases of Demand
D
Perfectly Inelastic Demand
(a)
Quantity
Price per
Unit
1
2
3
$4
20 40 60 80 100
(b)
D
Quantity20 40 60 80 100
1
2
3
$4
Price per
Unit
Perfectly Elastic Demand
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Perfectly Elastic Demand CurveThe demand curve is horizontal, any change in price can and will cause consumers to change their consumption.
Perfectly Inelastic Demand CurveThe demand curve is vertical, the quantity demanded is totally unresponsive to the price. Changes in price have no effect on consumer demand.
In between the two extreme shapes of demand curves are the demand curves for most products
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Figure 3: Relationship between demand slope and elasticity
Elasticity Elasticity = |(1/slope)*(P/Q)|= |(1/slope)*(P/Q)|
Quantity
PRICE
Perfectly elastic
Perfectly inelastic
Relatively Inelastic Demand
Relatively Elastic Demand
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Elasticity Along a Demand CurveP
rice
$10987654321
0 1 2 3 4 5 6 7 8 9 10 Quantity
Elasticity declines along demand curve as we move toward
the quantity axis
Ed = 1
Ed = 0
Ed < 1
Ed > 1
Ed = ∞
Relatively Inelastic
Perfectly Inelastic
Unit Elastic
Relatively Elastic
Perfectly Elastic
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Elasticity and Total Revenue
Total revenue (TR) of all firms is defined as TR = P x Q
Rule: when two numbers are both changing, percentage change in their product is (approximately) the sum of their individual percentage changes Applying this to total revenue
Example: assume demand is unitary elastic and Q rises by 10% % Change in TR = 10% + (-10%) = 0
PQTR %%%
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Figure 4(a): When does it pay to raise the price?
Price increases from P0 to P1 and quantity demanded decreases from Q0 to Q1
Quantity
PRICE
Demand
P1
P0
Q1 Q0
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Figure 4(b): When does it pay to raise the price? How about revenue change?
Quantity
PRICE
Demand
P1
P0
Q1 Q0
Change in total revenue =
P1Q1-P0Q0
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Figure 4(c): When does it pay to raise the price? How much is the change in total revenue?
Quantity
PRICE
Demand
P1
P0
Q1 Q0
Change in total revenue =
P1Q1-P0Q0
Loss = P0*(Q0 - Q1)
= P0 ΔQ
Gain = Q1(P1 – P0)
= Q1ΔP
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Figure 5 Effects of Price Changes on Expenditure
W here demand is: A price increase will: A price decrease will:
Ine lastic ( | | < 1) increase expenditure decrease expenditure unitary e lastic ( | | = 1) cause no change in
expenditure cause
no change in
expenditure
e lastic ( | | > 1) decrease expenditure increase expenditure
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Elasticity & Straight-Line Demand Curves
Look at percentage change in P Look at percentage change in Q As we move upward and leftward by equal distances,
percentage change in quantity rises Percentage change in price falls
Elasticity of demand varies along a straight-line demand curve Demand becomes more elastic as we move upward
and leftward
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0
2
4
6
8
10
0 10 20 30 40 50
PRICE
QUANTITY
1
(1/ ) 5
DPE slope Q
slope fixed
As P increases, Q falls, elasticity gets bigger
| ED | > 1
elastic
| ED | = 1
Unit elastic
| ED | < 1
inelastic
2525
55
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Small SummaryInelastic
Demand
Unitary Elastic Demand
Elastic Demand
Definition |ED| <1 |ED| =1 |ED| >1
Total Revenue Same direction as price change
Does not change with price
change
Opposite direction
from price
Straight Line Demand Curve
Lower segment
Middle point Upper segment
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What Affects Elasticity? -- 1. Availability of Substitutes
Demand is more elastic If close substitutes are easy to find and buyers
can cut back on purchases of the good in question
Demand is less elastic If close substitutes are difficult to find and
buyers can not cut back on purchases of the good in question
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What Affects Elasticity? -- 2. Narrowness of Market
More narrowly we define a good, easier it is to find substitutesMore elastic is demand for the good
More broadly we define a goodHarder it is to find substitutes and the less
elastic is demand for the good Different things are assumed constant
when we use a narrow definition compared with a broader definition
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What Affects Elasticity? -- 3.Necessities vs. Luxuries
The more “necessary” we regard an item, the harder it is to find a substituteExpect it to be less price elastic
The less “necessary” (luxurious) we regard an item, the easier it can be substitutedExpect it to be more price elastic
Example?
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What Affects Elasticity? -- 4. Time Horizon
Short-run elasticity Measured a short time after a price change
Long-run elasticity Measured a year or more after a price change
Usually easier to find substitutes for an item in the long run than in the short run Therefore, demand tends to be more elastic in the
long run than in the short run
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What Affects Elasticity? -- 5. Importance in the Buyer’s Budget
The more of their total budgets that households spend on an itemThe more elastic is demand for that item
The less of their total budgets that households spend on an itemThe less elastic is demand for that item
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Importance of Elasticity of Demand
Price Fixation Production Distribution International Trade Public Finance
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Figure 6 Some Short-Run Price Elasticities of Demand
Specific Brands Narrow Categories Broad Categories
T ide Detergent – 2.7 9 Transatlantic A ir Travel – 1.3 0 Recreation – 1.09 Tourism in Thailand – 1.2 0
Pepsi – 2.08 G round Beef – 1.02 C loth ing – 0.89 Coke – 1.7 1 Pork – 0.7 8 Food – 0.6 7
M ilk – 0.5 4 Im ports – 0.5 8 C igarettes – 0.45 Transportation – 0.5 6 E lectric ity – 0.40 to – 0.5 0 Beer – 0.2 6 Eggs – 0.2 6 G asoline – 0.2 0 O il – 0.1 5
inelastic
elastic
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Part 2: Income Elasticity of Demand Percentage change in quantity demanded
divided by the percentage change in income With all other influences on demand with the price of
the good kept constant
Y %
Q %
Incomein Change %
DemandedQuantity in change %Y
• Interpretation: percentage increase in quantity demanded for each 1% rise in income
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Income Elasticity of Demand vs. Price Elasticity of Demand
Price elasticity measures sensitivity of demand to price as we move along a demand curve from one point to another
Income elasticity tells us relative shift in demand curve—increase in quantity demanded at a given price
While a price elasticity is virtually always negative, income elasticity can be positive or negative Normal goods Inferior goods
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Income Elasticity of Demand Economic necessity
Good with an income elasticity of demand between 0 and 1 Economic luxury
Good with an income elasticity of demand greater than 1 An implication
As income rises, proportion of income spent on economic necessities will fall
While proportion of income spent on economic luxuries will rise
But, it is important to remember that economic necessities and luxuries are categorized by actual consumer behavior Not by our judgment of a good’s importance to human survival
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Income Elasticity of DemandZero Income Elasticity Quantity demanded remains the same, even though money income increases. E=0
Negative Income ElasticityWhen income increases,quantity demanded falls(E<0)
Unit ElasticityWhen an increase in income brings about a proportionate increase in quantity demanded
,then income elasticity of demand is equal to 1(E=1)
Income Elasticity Greater Than UnityIn this case,an increase in income brings about a more than Proportionate increase in
quantity demanded.(E>1)
Income Elasticity Less Than UnityWhen income increases quantity demanded also increases but less than
Proportionately(E <1)
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Figure 9 Some Income Elasticities
Income Elasticity
Income Elasticity Good or Service Good or Service
F resh F ru it 1 .99 Im ports 2.7 3 C om puters 1.7 1 Transatlantic A ir Travel 1 .40 Transportation 1.7 9 C ollege Education 0.5 5 C igarettes 0.5 0 R ecreation 1.0 7 C hicken 0.42 C loth ing 1.02 Pork 0.3 4 F ood 0.60 to 0 .85 Fresh Vegetables 0.2 6 Tooth Extraction – 0.1 3 to 0 .4 7 G round Beef – 0.2 0 B read – 0.42 Potatoes – 0.8 1 Luxury (>1), Necessity (0<EY <1),
Normal (>0) and Inferior (<0) Goods defined by Income elasticties
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Part 3: Cross-Price Elasticity of Demand Cross-price elasticity of demand
Percentage change in quantity demanded of one good (x) caused by a 1% change in price of another good (z)
While all other influences on demand remain unchanged
z
x
P
Q
%
%XZ
• % Change in Quantity of Prod X / %Change in Price of
Prod Y• Substitutes (+)• Complements (-)
• Its size tells us how closely the two goods are related– A large absolute value for suggests that the two goods
are close substitutes or complements
xz
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Thank You
Complements (-) vs Substitutes (+)
defined by sign of cross price elasticity