Chapter 4 Demand Section 3: Elasticity of Demand

1. Chapter 4 Demand Section 3: Elasticity of Demand

2. Lesson Objectives: By the end of this lesson you will be able to: *Explain how to calculate elasticity of demand *Identify factors that affect elasticity. *Explain how firms use elasticity and revenue to make decisions.

3. Defining Elasticity Economists describe the way that consumers respond to price changes as elasticity of demand. Elasticity of demand measures how drastically buyers will cut back or increase their demand for a good when the price rises or falls. If you buy the same amount of a good after a large price increase, your demand is inelastic or relatively unresponsive to price changes. If you buy much less of a good after a small price increase, your demand is elastic or very responsive to price changes.

4. Calculating Elasticity Calculating the elasticity of demand: percentage change in the quantity of the good demanded DIVIDED BY The percentage change in the price of the good EQUALS The elasticity of demand for the good. The law of demand implies that an increase in the price of a good will always decrease the quantity demanded, and a decrease in the price of a good will always increase the quantity demanded. Elasticity of Demand Video

5. Price Range The elasticity of demand for a good varies at every price level. Demand for a good can be highly elastic at one price and inelastic at a difference price. Example: A magazine that originally cost 40 Cents goes up in price to 80 cents (50% increase). Even though the price increased, the magazine is still cheap. Most people will not be effected by the ten cent increase (inelastic). At the same time a magazine that originally cost $4.00 goes up in price to $6.00 (50% increase). Many people will refuse to pay $6.00 for a magazine (elastic).

6. Values of Elasticity Inelastic Demand: If the elasticity of demand for r good at a certain price is less than 1. Elastic Demand: If the elasticity is greater than 1 Unitary Elastic: If elasticity is exactly equal to 1.

7. Factors Affecting Elasticity The factors that affect elasticity depend on your personal preferences. What is essential to me? What goods must I have, even if he price rises greatly? 1. Availability of Substitutes If there are few substitutes for a good, then even when its price rises greatly, you might still buy it. Example: Your favorite band is playing in Cleveland this summer. There is no substitute for this band, therefore your demand for that concert is inelastic. Examples: Apple Juice. People can choose from many brands, therefore your demand for apple juice is elastic.

8. 2. Relative Importance A second factor in determining a good’s elasticity of demand is how much of your budget you spend on the good. If you already spend a large share of your income on a good, a price increase will force you to make some tough choices. Example: If you already spend half your income on clothes, even a small increase in the cost of clothing will probably cause a large reduction in the quantity you purchase. Necessities Versus Luxuries A necessity is a good people will always buy even when the price Increases (milk). A necessity is usually inelastic. A luxury is a good that is not needed for survival. (steak). A luxury is usually elastic.

9. 4. Change over time When a price changes, consumers often need time to change their spending habits. Example: A person might purchase a large vehicle that requires a greater volume of gasoline per mile to run. This person might work at a job many miles away from home. Even if the price of gas rises, it might take some time for the person to cut down on their gas consumption by switching to a small car, organizing a carpool, using public transportation, or finding a job closer to home.

10. Elasticity and Revenue How does elasticity help businesses? 1. Elasticity helps to measure how consumers respond to price changes for different products 2. The elasticity of demand determines how a change in prices will affect a firm’s total revenue or income. Computing a Firm’s Total Revenue A company’s total revenue is defined as the amount of money the company receives by selling its goods. This is determined by two factors: *Price of the goods *Quantity sold Example: If a pizzeria sells 150 slices of pizza per day at $4.00 per slice, it’s total revenue would be $600 per day.

11. Total Revenue and Elastic Demand Elastic Demand comes from one or more of these factors: *The availability of substitute goods *A limited budget that does not allow for price changes *The perception of the good as a luxury item. If these conditions are present, then the demand for the good is elastic, and a firm may find that a price increase reduces its total revenue. Example: Raise the price, less people buy, you lost money. Total Revenue and Inelastic Demand When demand is inelastic, price and total revenue move in the same direction: An increase in price raises total revenue, and a decrease in price reduce total revenue. Example: If you lower the price of socks by 50%, you may sell only 20% more socks. The increase in the quantity sold does not compensate for the lost revenue.