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Chapter 4
DemandElasticity
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OverviewThe economic concept of elasticityThe price elasticity
of demandThe cross-elasticity of demandIncome elasticityOther
elasticity measuresElasticity of supply
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Learning objectivesdefine and measure elasticity
apply concepts of price elasticity, cross-elasticity, and income
elasticity
understand determinants of elasticity
show how elasticity affects business revenue
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The economic concept of elasticity
Elasticity: the percentage change in one variable relative to a
percentage change in another.
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Hall.
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Price elasticity of demandPrice elasticity of demand: the
percentage change in quantity demanded caused by a 1 percent change
in price
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Price elasticity of demandArc elasticity: elasticity which is
measured over a discrete interval of a curve
Ep = coefficient of arc price elasticity Q1 = original quantity
demanded Q2 = new quantity demanded P1 = original price P2 = new
price
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Price elasticity of demandPoint elasticity: elasticity measured
at a given point of a demand (or a supply) curve
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Price elasticity of demandThe point elasticity of a linear
demand function can be expressed as:
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Price elasticity of demand
Elasticity varies along a linear demand curve
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Price elasticity of demandSome demand curves have constant
elasticity
such a curve has a nonlinear equation: Q = aP-b where b is the
elasticity coefficient
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Price elasticity of demandCategories of elasticity
Relative elasticity of demand: Ep > 1Relative inelasticity of
demand: 0 < Ep < 1Unitary elasticity of demand: Ep = 1Perfect
elasticity: Ep = Perfect inelasticity: Ep = 0
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Price elasticity of demandFactors affecting demand
elasticityease of substitutionproportion of total
expendituresdurability of productpossibility of postponing
purchasepossibility of repairused product marketlength of time
period
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Price elasticity of demandDerived demand: the demand for
products or factors that are not directly consumed, but go into the
production of a another (final) product
The demand for such a product or factor exists because there is
demand for the final product
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Price elasticity of demandThe derived demand curve will be more
inelastic:the more essential is the componentthe more inelastic is
the demand curve for the final productthe smaller is the fraction
of total cost going to this componentthe more inelastic is the
supply curve of cooperating factors
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Price elasticity of demandA long-run demand curve will generally
be more elastic than a short-run curve As the time period lengthens
consumers find ways to adjust to the price change, via substitution
or shifting consumption
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Price elasticity of demandThe relationship between price and
revenue depends on elasticity Why? By itself, a price fall will
reduce receipts BUT because the demand curve is downward sloping,
the drop in price will also increase quantity demanded
Q: which effect will be stronger?
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Price elasticity of demandAs price decreasesrevenue rises when
demand is elasticrevenue falls when it is inelasticrevenue reaches
it peak if elasticity =1 the lower chart shows the effect of
elasticity on total revenue
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Price elasticity of demandMarginal revenue: the change in total
revenue resulting from changing quantity by one unit
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Price elasticity of demand
marginal revenue curve is twice as steep as the demand curve
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Price elasticity of demandat the point where marginal revenue
crosses the X-axis, the demand curve is unitary elastic and total
revenue reaches a maximum
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Price elasticity of demandExamples: some real world
elasticities
coffee: short run -0.2, long run -0.33kitchen and household
appliances: -0.63meals at restaurants: -2.27airline travel in U.S.:
-1.98beer: -0.84, Wine: -0.55
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Price elasticity of demandExamples: some real world
elasticities
white pan bread:-0.69cigarettes: short run -0.4, long run
-0.6wine imports: -0.15crude oil: -0.06internet services:
-0.6/-0.7
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Cross-elasticity of demandCross-elasticity of demand: the
percentage change in quantity consumed of one product as a result
of a 1 percent change in the price of a related product
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Cross-elasticity of demandArc cross-elasticity
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Cross-elasticity of demandPoint cross-elasticity
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Cross-elasticity of demandThe sign of cross-elasticity for
substitutes is positive
The sign of cross-elasticity for complements is negative
Two products are considered good substitutes or complements when
the coefficient is larger than 0.5 (in ab. value)
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Income elasticityIncome elasticity of demand: the percentage
change in quantity demanded caused by a 1 percent change in
income
Y is shorthand for income
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Income elasticityArc income elasticity
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Income elasticityCategories of income elasticity
superior goods: EY > 1
normal goods: 0 EY 1
inferior goods: EY < 0
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Other demand elasticitiesExamples: elasticity is encountered
every time a change in some variable affects demand
advertising expenditureinterest ratespopulation size
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Elasticity of supplyPrice elasticity of supply: the percentage
change in quantity supplied as a result of a 1 percent change in
price
The coefficient of supply elasticity is a normally a positive
number
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Elasticity of supplyArc elasticity of supply
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Elasticity of supplyWhen the supply curve is more elastic, the
effect of a change in demand will be greater on quantity than on
the price of the product
When the supply curve is less elastic, a change in demand will
have a greater effect on price than on quantity
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Global applicationExample: price elasticities in Asia
imports almost always price inelasticif exports price inelastic,
export earnings will rise as prices riseif exports price elastic,
export earnings will rise with world incomes
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