ECON 2020 Priniciple of Microeconomics: Chapter 6: Elasticity

ECON 2020
Priniciple of Microeconomics
Chapter 6: Elasticity
Hyeon Joon Shin

Assistant Professor of Economics
The Falls School of Business, Anderson University
Semester II, 2014-15
Shin (FSB, Anderson Univ.)
1 / 14
Price Elasticity of Demand

2 / 14

The law of demand says that, other things being equal, consumers buy
more (or less) of a product, when its price declines (or rises).
2 / 14

Problem
Consider two products, gasoline and diamond. The price of gasoline per
gallon is $2, and that of diamond per carat is $2,000. By the law of
demand, when the price of each product rises, its quantity demanded
declines. Suppose that both prices increase by the same rate of 10%.
Which products quantity demanded would decline further? Explain why.
2 / 14

Problem
A Products Price Elasticity of Demand (Ed ) A measure of how
much consumers buy more (or less) of it when its price
falls (or rises).
2 / 14

Problem
A Products Price Elasticity of Demand (Ed ) A measure of how
much consumers buy more (or less) of it when its price
falls (or rises).
A change in quantity demanded due to a price change varies product to
product and over dierent price ranges for the same product.
2 / 14

Coe cient of the Price Elasticity of Demand
3 / 14

0
00
Suppose that when the price of a good changes from P to P , its

0
00
quantity demanded changes from Qd to Qd
3 / 14

0
00

0
00
The price elasticity of demand can be measured as the coe cient Ed :
Ed
percentage change in quantity demanded

percentage change in price
00
Qd Qd
0
Qd
100
P 00 P 0
P0
100
4Qd
4P
4Q d
Qd
4P
P
100
100
P
Qd
3 / 14

0
00

0
00
Ed

00
4P = P
00
100
P 00 P 0
P0
100
4Qd
4P
Qd Qd
0
Qd
4Q d
Qd
4P
P
100
100
P
Qd
P : change in price
3 / 14

0
00

0
00
Ed

00
00
100
P 00 P 0
P0
100
4Qd
4P
Qd Qd
0
Qd
4Q d
Qd
4P
P
100
100
P
Qd
4P = P
P : change in price
00
0
4Qd = Qd Qd : change in quantity demanded
3 / 14

Coe cient of the Price Elasticity of Demand (contd)
4 / 14

Problem
Suppose that quantity demanded of X is 20 at the price of $4, and it is 10
at the price of $5. Calculate coe cient of the price elasticity of demand
for X in both cases when the price rises from $4 to $5 and the price falls
from $5 to $4.
4 / 14

Problem
from $5 to $4.
Co cients of the price elasticity of demand in both cases should be the
same. Unfortunately, however, they are NOT.
4 / 14

Problem
from $5 to $4.
Therefore, we use the midpoint formula for calculating elasticity.
4 / 14

Problem
from $5 to $4.
P = average of two prices
4 / 14

Problem
from $5 to $4.
Qd = average of two quantities demanded
4 / 14

Problem
from $5 to $4.
We ignore the minus sign and simply present the absolute value of the
coe cient Ed .
4 / 14

Problem
from $5 to $4.
We ignore the minus sign and simply present the absolute value of the
coe cient Ed .
Problem
Redo the above problem, using the midpoint formula.
4 / 14
Interpretation of Ed
5 / 14
Elastic vs. inelastic demand:
Ed
Ed
Ed
> 1 : elastic
< 1 : inelastic
= 1 : unit-elastic
5 / 14
Ed
Ed
Ed
> 1 : elastic
< 1 : inelastic
= 1 : unit-elastic
Demand is elastic when a specic percentage change in price results in

a larger percentage change in quantity demanded.
5 / 14
Ed
Ed
Ed
> 1 : elastic
< 1 : inelastic
= 1 : unit-elastic

Demand is inelastic when a specic percentage change in price results
in a smaller percentage change in quantity demanded.
5 / 14
Ed
Ed
Ed
> 1 : elastic
< 1 : inelastic
= 1 : unit-elastic

Demand is inelastic when a specic percentage change in price results
in a smaller percentage change in quantity demanded.
Demand is unit-elastic when a specic percentage change in price
results in the same percentage change in quantity demanded.
5 / 14

Interpretation of Ed (contd)
6 / 14

Perfectly elastic vs. perfectly inelastic demand:
Ed
Ed
= : perfectly elastic
= 0 : perfectly inelastic
6 / 14

Ed
Ed
Demand is perfectly elastic when a percentage change in price results

in zero quantity demanded.
6 / 14

Ed
Ed

Demand is perfectly inelastic when a percentage change in price
results in no change whatsoever in quantity demanded.
6 / 14

Ed
Ed

Demand is perfectly inelastic when a percentage change in price
results in no change whatsoever in quantity demanded.
Problem
Derive the demand curve representing each of perfectly elastic demand
and perfectly inelastic demand.
6 / 14

7 / 14

Perfectly elastic vs. perfectly inelastic demand (contd)
7 / 14
The Total-Revenue (TR) Test

The Importance of Ed for Firms
8 / 14

Total Revenue (TR) The total amount of earnings that a seller
receives from the sale of a product:
TR = P
8 / 14

TR = P
Total revenue is calculated by multiplying the product price (P) by the

quantity sold (Q).
8 / 14

TR = P

quantity sold (Q).
In the theory of the rm, Ed is related to the eect of price changes on
total revenue and thus on prot, other things being equal.
8 / 14

TR = P

quantity sold (Q).
In the theory of the rm, Ed is related to the eect of price changes on
total revenue and thus on prot, other things being equal.
"When a rm changes the price of a product, whether its total revenue
(and thus its prot) rises or falls relies on the price elasticity of demand
for the product."
8 / 14

The Relationship between Ed and TR
9 / 14

Example
Consider a rm that wants to increase the price of its product in order to
increase its total revenue (and thus its prot). Can the price increase raise
the rms total revenue?
9 / 14

Example
Case (1): elastic demand (Ed > 1)
9 / 14

Example
P " and Q ## =) TR = (P
Q) #
9 / 14

Example
P " and Q ## =) TR = (P Q ) #
The rm should not increase but decrease the price of the product.
9 / 14

Example
P " and Q ## =) TR = (P Q ) #
Case (2): inelastic demand (Ed < 1)
9 / 14

Example
P " and Q ## =) TR = (P Q ) #

P "" and Q # =) TR = (P
Q) "
9 / 14

Example
P " and Q ## =) TR = (P Q ) #

P "" and Q # =) TR = (P Q ) "
The rm should increase the price of the product.
9 / 14

Example
P " and Q ## =) TR = (P Q ) #

P "" and Q # =) TR = (P Q ) "
Case (3): unit-elastic demand (Ed = 1)
9 / 14

Example
P " and Q ## =) TR = (P Q ) #

P "" and Q # =) TR = (P Q ) "

P " and Q # =) TR = (P
Q)
9 / 14

Example
P " and Q ## =) TR = (P Q ) #

P "" and Q # =) TR = (P Q ) "

P " and Q # =) TR = (P Q )
No eect of the price increase on total revenue
9 / 14
Price Elasticity along a Linear Demand Curve

Price Elasticity along a Linear Demand Curve and the TR Test
10 / 14

We know that price elasticity of demand varies with product to product.
10 / 14

Also, price elasticity of demand varies over dierent price ranges of the
same linear demand curve.
10 / 14

Also, price elasticity of demand varies over dierent price ranges of the
same linear demand curve.
Example
Price Elasticity of Demand for Movie Tickets and the TR Test:
10 / 14

(contd)
11 / 14

(contd)
Example
Price Elasticity of Demand for Movie Tickets and the TR Test:
11 / 14
Determinants of Price Elasticity of Demand

12 / 14

1
Substitutability
12 / 14

1
Substitutability
The more (or the less) substitutable products, the greater (or the
smaller) price elasticity of demand.
12 / 14

1
Substitutability
Example
Demand for Snickers bar is highly elastic because it is very substitutable for others
(e.g. Twix and Milky Way)
12 / 14

1
Substitutability
Example
2
Luxuries vs. Necessities
12 / 14

1
Substitutability
Example
2

The demand for a luxury good is elastic, whereas the demand for a
necessary good is inelastic.
12 / 14

1
Substitutability
Example
2

The demand for a luxury good is elastic, whereas the demand for a
necessary good is inelastic.
Example
Electricity is regards as a necessity, so its demand is inelastic. Demand for Cruise
travel in the Atlantic Ocean is elastic.
12 / 14
Income Elasticity of Demand

13 / 14

Income Elasticity of Demand (EI ) A measure of how much
consumers buy more or less of a good when their
income changes:
EI
=
=

percentage change in income
4Qd
I
4I
Qd
13 / 14

income changes:
EI
=
=

4Qd
I
4I
Qd
Normal Goods vs. Inferior Goods
13 / 14

income changes:
EI
=
=

4Qd
I
4I
Qd

EI > 0 : Normal Good
13 / 14

income changes:
EI
=
=

4Qd
I
4I
Qd

EI > 0 : Normal Good
EI < 0 : Inferior Good
13 / 14

Cross (Price) Elasticity of Demand
14 / 14

Cross Elasticity of Demand (EXY ) A measure of how much
consumers buy more or less of good X when the price of
good Y changes:
EXY
=
=
percentage change in quantity demanded of X

percentage change in price of Y
4Qd ,X
PY
4PY
Qd ,X
14 / 14

good Y changes:
EXY
=
=

4Qd ,X
PY
4PY
Qd ,X
Substitutes vs. Complements vs. Independent Goods
14 / 14

good Y changes:
EXY
=
=

4Qd ,X
PY
4PY
Qd ,X

EXY > 0 : X and Y are substitutes
14 / 14

good Y changes:
EXY
=
=

4Qd ,X
PY
4PY
Qd ,X

EXY < 0 : X and Y are complements
14 / 14

good Y changes:
EXY
=
=

4Qd ,X
PY
4PY
Qd ,X

EXY < 0 : X and Y are complements
EXY = 0 : X and Y are independent of each other
14 / 14

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ECON 2020

Hyeon Joon Shin

Semester II, 2014-15

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Price Elasticity of Demand

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Price Elasticity of Demand

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Price Elasticity of Demand

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Price Elasticity of Demand

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Price Elasticity of Demand

Semester II, 2014-15

Price Elasticity of Demand

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Price Elasticity of Demand

Suppose that when the price of a good changes from P to P , its

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Price Elasticity of Demand

Suppose that when the price of a good changes from P to P , its

percentage change in quantity demanded

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Price Elasticity of Demand

Suppose that when the price of a good changes from P to P , its

percentage change in quantity demanded

Semester II, 2014-15

Price Elasticity of Demand

Suppose that when the price of a good changes from P to P , its

percentage change in quantity demanded

Semester II, 2014-15

Price Elasticity of Demand

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Price Elasticity of Demand

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Price Elasticity of Demand

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Price Elasticity of Demand

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Price Elasticity of Demand

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Price Elasticity of Demand

Shin (FSB, Anderson Univ.)

Semester II, 2014-15

Price Elasticity of Demand