Price Elasticity of Demand

Elasticity of Demand describes the percentage change in quantity demanded that follows a price change.

Elasticity of Demand

Demand is Elastic

Demand is Inelastic

Change in Price

Large Change in Qd

Change in Price

Small/No Change in Qd

Example: Dentist Visits

If the price increases, how much change will there be in the Quantity Demanded? Elastic or Inelastic?

Example: SailboatsElastic or Inelastic?

Key Factor - Preferences

Decides whether something is a necessity or a luxury.

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Make a list of goods and services and divide them up into the two categories of Elastic and Inelastic demand.

…Can you come up with any more broader categories…such as Necessities (vs) Luxuries?

Determinants of Elasticity

Necessities (vs) Luxuries Necessities tend to have inelastic demand and luxuries tend to have elastic

demand

Substitution possibilities Price elasticity of demand will be relatively high if it is easy to substitute

between products

Budget Share Items that take up a larger share of the budget tend to have higher price

elasticities of demand

Time Because substitution often takes time, price elasticity will usually be higher

in the long run than in the short run

Durability of Goods Computers, cars, washers, and dryers will be in greater demand if the price

drops.

Drugs Legal (heart medicine antibiotics) or illegal (heroin, cocaine)

Calculating Elasticity of

Demand Price elasticity of demand is defined as:

the percentage change in the quantity of a good demanded resulting from a one-percent change in its price = % change in quantity demanded / % change

in price = (ΔQ/Q)/(ΔP/P)

Price Elasticity = (P/Q)*(1/slope)

Principles of Microeconomics, 2nd Canadian Edition Slide 1-8 Copyright © 2005 McGraw-Hill Ryerson Limited

Equation for a Straight Line Demand Curve

P is for the price of the good Q is for the quantity demanded b is the vertical intercept m represents the slope

P b mQ

Principles of Microeconomics, 2nd Canadian Edition Slide 1-9 Copyright © 2005 McGraw-Hill Ryerson Limited

FIGURE 4.6

The Market Demand Curve for Canned Tuna

Principles of Microeconomics, 2nd Canadian Edition Slide 1-10 Copyright © 2005 McGraw-Hill Ryerson Limited

FIGURE 4.12

Graphical Interpretation of Price Elasticity of Demand

Price elasticity of demand at any point along a straight-line demand curve is the ratio of price to quantity at that point times the reciprocal of the slope of the demand curve.

Principles of Microeconomics, 2nd Canadian Edition Slide 1-11 Copyright © 2005 McGraw-Hill Ryerson Limited

FIGURE 4.11

Elastic and Inelastic Demand

Three Cases!

Examples.

1) Find slope given price, quantity and y-intercept. Then calculate price elasticity of demand. Determine unit elastic, elastic, inelastic?

2) Using a graph, be able to do the same thing.

Special Cases. Perfectly Elastic demand

Price elasticity of demand is infinite

(ΔQ/Q)/(ΔP/P) = ∞ Slightest change in

price leads consumers to find substitutes.

Horizontal demand curve

Ex: - Foreign currency market

Perfectly Inelastic demand Price elasticity of demand

is zero (ΔQ/Q)/(ΔP/P) = 0

Consumers do not switch to substitutes even when price increases dramatically

Vertical demand curve

Ex: - Diabetic (insulin)

- Addict (heroin)

Principles of Microeconomics, 2nd Canadian Edition Slide 1-14 Copyright © 2005 McGraw-Hill Ryerson Limited

FIGURE 4.14

Perfectly Elastic, Perfectly Inelastic, and Unit Elastic Demand Curves

Demand Curves The horizontal demand curve in panel (a) is perfectly elastic, or infinitely elastic, at every point. Even the slightest increase in price leads consumers to desert the product in favour of substitutes. The vertical demand curve in panel (b) is perfectly inelastic at every point. Consumers do not, or cannot, switch to substitutes even in the face of large increases in price. The demand curve in panel (c) represents a case of unit elastic demand. Regardless of the price selected, total expenditure is unchanged. In this example, total expenditure is $28 no matter what price is selected.

Elasticity of Supply

Can be elastic or inelastic depending on the product and circumstances.

“responsiveness of producers to price changes in their products”

Key Factors Time

Inelastic – short run, elastic – long run Perishability

Goods stored easily – More elastic

Ex: Raspberries (Perish very quickly)…no matter what the price, suppliers will not want to carry large amounts.

Practice!!!

1) Determining whether things will have an inelastic or elastic demand.

2) Calculating price elasticity of demand.

...assignment!

Expenditure & Revenue

Total Expenditure = Total Revenue (Consumers) (Producers)

Total Expenditure = (Number of Units bought) (Price) = TR

Principles of Microeconomics, 2nd Canadian Edition Slide 1-18 Copyright © 2005 McGraw-Hill Ryerson Limited

FIGURE 4.10

Total Expenditure as a Function of Price

For a good whose demand curve is a straight line, total expenditure reaches a maximum at the price corresponding to the midpoint of the demand curve.

Principles of Microeconomics, 2nd Canadian Edition Slide 1-19 Copyright © 2005 McGraw-Hill Ryerson Limited

FIGURE 4.7

The Demand Curve for Movie Tickets

An increase in price from $2 to $4 per ticket increases total expenditure on tickets.

0 1 2 3 4 5 6

2

4

6

8

10

12

D

Quantity (100s of tickets/day)

Pri

ce (

$/t

icket)

An increase in price from $2 to $4 per ticket increases total expenditure on tickets

Law of Demand & Total Expenditures

Many firms would like to know: “Will consumers spend more on my product

(will I get more revenue, in total) if I sell more units at a lower price or fewer units at a higher price?” Answer depends on the price elasticity of

demand

When price rises, total expenditure may Increase Decrease Or stay the same

Price Elasticity and Expenditures

For a product whose demand is “price elastic” Quantity demanded is highly responsive to price

changes Percentage change in quantity dominates An increase in price will reduce total expenditure A decrease in price will increase total expenditure

For a product whose demand is “price inelastic” Quantity demanded is not responsive to price

changes Percentage change in price dominates An increase in price will increase total expenditure A decrease in price will decrease total expenditure

ExampleTickets at a Blue Jays game.

P X Q = TR

Old Price $ 40 X 33,781 = $1,354,840

New Price $ 50 X 25,000 = $ 1,250,000

Demand is Elastic. Price results in TR

…The price resulted in a big change of attendance at the game. (Obviously, there could be other factors as well…different teams in town)

Principles of Microeconomics, 2nd Canadian Edition Slide 1-23 Copyright © 2005 McGraw-Hill Ryerson Limited

FIGURE 4.10

Total Expenditure as a Function of Price

For a good whose demand curve is a straight line, total expenditure reaches a maximum at the price corresponding to the midpoint of the demand curve.

Elastic side

Inelastic side

Elasticity of Demand –

Important for businesses to

consider… What happens if a florist increases the price of

roses 400 % in October ? Will sales go up or down ?

A. Probably, down

What happens if a florist increases the price of roses on February 14th? Will sales go down or up?

A. Probably up

- Why? Frantic husbands and boyfriends will pay exorbitant prices for a dozen roses on Valentine’s Day – if they know what’s good for them ! !

Practice!!!

1) Calculating Total Revenue/Total Expenditures using a graph.

2) Given a change in price, calculate the change in TR/TE, then determine whether the price elasticity of demand is Elastic, Inelastic, or Unit Elastic.