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Understanding Elasticity: How Price Changes Affect Demand

Chapter 5 explores the concept of elasticity in economics, focusing on how quantity demanded (Qd) responds to changes in price. We delve into price elasticity of demand, defining elastic, inelastic, unit elastic, perfectly elastic, and perfectly inelastic demand. Key examples clarify these concepts, illustrating the implications for total revenue when prices fluctuate. The chapter also examines factors affecting elasticity, including the availability of substitutes, budget share, and time. This comprehensive analysis is crucial for understanding consumer behavior and pricing strategies in the market.

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Understanding Elasticity: How Price Changes Affect Demand

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  1. Chapter 5Elasticity You are responsible for reading Chapter 4!!!

  2. What have we done? • Chapter 3 gave us downward sloping demand curves • Law of demand • Now want to see how Qd changes when price changes

  3. Elasticity • Response of one variable to a change in another variable • Price elasticity of demand • Measure of the responsiveness of Qd of a product to a change in the price of that product

  4. or rewrite as

  5. So… • What if Ed = 3? • If price was increased from the prevailing point the % change in Qd would be 3 times the change in price • Shouldn’t it be negative? • So price increases and Qd decreases? • Yes!! • For ease we look at the absolute value, but know that the law of demand holds

  6. Point elasticity • Measures the change between two observed points.

  7. example • P1 = 10 • P2 = 12 • Q1 = 100 • Q2 = 50 • Elasticity?? • Which is Point A??? • Big Problem!!!

  8. Problem • Answers vary depending on where you start • Becomes more important the larger the change

  9. Arc Elasticity • To avoid the endpoint problem take elasticity at the midpoint (average) of the two points

  10. Differences • With arc elasticity it is clear which points are used • P1 is the first price • P2 is the second price • Qd1 and Qd2 are the first and second quantity demanded respectively

  11. Price elasticity of demand can yield 5 basic results • Numerator > Denominator • Numerator < Denominator • Numerator = Denominator • Numerator = 0 • Denominator = 0 • Each has a specific name and result

  12. Elastic Demand • Ed > 1 • % change in quantity demanded > % change in price • FLATTER CURVE • What are some examples of an elastic good???

  13. Inelastic Demand • Ed<1 • % change in the price > percent change in quantity demanded • STEEPER CURVE • What are some examples of an inelastic good?

  14. Price Elasticity of Demand

  15. Unit Elastic Demand • Ed=1 • % change in price = % change in quantity demanded • Change in price brings a proportionate change in quantity demanded • CURVE

  16. Price Elasticity of Demand

  17. Perfectly Elastic Demand • Ed = (denominator = 0) • % change in quantity demanded is A LOT in response to a change in price • Price increases and quantity demanded goes to 0 • Totally flat --- horizontal • Extreme • Examples???

  18. Perfectly inelastic demand • Ed = 0 • % change in quantity demanded DOESN’T CHANGE in response to a change in price • Totally steep --- vertical • Extreme • Examples???

  19. Price Elasticity of Demand

  20. Aren’t demand curve downward sloping? • Because the extremes (perfectly inelastic and perfectly elastic) are not. • Use as points of reference only

  21. How does a change in price affect Total Revenue of a Firm? • Revenue depends on elasticity • Michael Jordan and Nike shoes • No substitutes -- inelastic demand • What happens to Qd if price increases? • Substitutes – elastic demand • What happens to Qd if price increases?

  22. What is total revenue?? • Total revenue = price*quantity • Firm uses to decide if to produce more or less

  23. examples • Elastic demand • Price increase • Price decrease • Inelastic demand • Price increase • Price decrease • Unit elastic demand • Price increase • Price decrease

  24. Elasticities, Price Changes, and Total Revenue

  25. Important to look at because… • Elasticity of the demand determines if with a price increase… • Total revenue increases • Total revenue decreases • Total revenue remains the same

  26. Price elasticity of demand and a straight line • Demand is downward sloping • Along the line elasticity varies from highly elastic to highly inelastic • But…remember SLOPE is constant

  27. P A B C D E F G Q Find Total Revenue and Elasticity of Demand

  28. Price Elasticity of Demand along a Demand Curve

  29. Summary • Upper end of Demand Curve • Qd is low and price is high • Freak out more when price is high • Lower end of Demand Curve • Qd is high and price is low • Freak out less when price is low

  30. So… • As move down the demand curve from higher prices to lower the price elasticity of demand goes from elastic to inelastic

  31. Determinates of price elasticity of demand • Number of substitutes available • Increase substitutes increases elasticity • More narrowly defined goods have more substitutes (compared to broadly defined) • Example: Fords vs all cars

  32. More determinates • Percentage of one’s budget that is spent on the good • More expensive??? More elastic • More affected by price (even small changes)

  33. Final determinate • Amount of time that passed since price change • Increase time passed gives more opportunity to change behavior or react to price change • Overtime can look for substitutes • Increase time increases elasticity • More elastic in long term than short

  34. Cross Elasticity of Demand • Measures the responsiveness of quantity demanded to a change in price of ANOTHER good

  35. When would you use Cross Price Elasticity? • To determine if goods are substitutes or compliments • Ec>0 – substitutes • % change in quantity demanded and price move in same direction • Ec<0 – compliments • % change in quantity demanded and price move in opposite directions • Ec=0 – goods unrelated

  36. Income elasticity of demand • Measures the responsiveness of quantity demanded to the change in income

  37. Why use income elasticity of demand? • Use to determine if a good is normal or inferior • Ey>0 – normal good • As income increases Qd increases • Ey<0 – inferior good • As income increases Qd decreases

  38. Can also say… • If |Ey| > 1 • % change in Qd > % change in Y • Income elastic • If |Ey| < 1 • % change in Qd < % change in Y • Income inelastic • If |Ey| = 1 • % change in Qd = % change in Y • Income unit elastic

  39. Can we use income elasticity in the real world?? • If invest in the stock market do you want to invest in a normal or inferior good? • Normal • Why • Increase income would increase quantity bought and increase stock prices

  40. Price Elasticity of Supply • Measures the responsiveness of quantity supplied of a good to the change in the price of that good

  41. Classification is like demand • Es > 1 • Elastic • Es < 1 • Inelastic • Es = 1 • Unit elastic • Each of these will result in a “normal” upward sloped supply curve

  42. Any extreme elasticities??? • Yes!! • Es = • Perfectly elastic or horizontal • Es = 0 • Perfectly inelastic or vertical

  43. Price Elasticity of Supply

  44. Price Elasticity of Supply

  45. Price Elasticity of Supply

  46. Does time play a role in elasticity of supply? • Yes!! • Overtime producers are able to adjust their behavior and production patterns • Supply becomes more elastic as time passes

  47. Elasticity and taxes • If government levies a tax on a product who pays the tax?? • Producers?? Consumers?? Share?? • Depends on the elasticity of demand and supply

  48. How find?? • Find equilibrium price • Supply shifts left in the amount of the tax • Find new equilibrium • Find point of second equilibrium on ORGINAL supply curve • Shows the actual price realized by firm or equilibrium price – tax = point in question • Difference between points determines how much of tax you pay

  49. Who Pays the Tax?

  50. Who pays more of the tax?? • Perfectly inelastic demand • Perfectly elastic demand • Demand more elastic than supply • Supply more elastic than demand

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