Elasticity of Demand and Supply

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1 Elasticity of Demand and Supply Price Elasticity of Demand (Ep) Calculating Percentage Change Significance of Price Elasticity of Demand (Ep) Determinants of Price Elasticity of Demand (Ep) For Next Time

2 Price Elasticity of Demand A measure of the extent to which the quantity demanded of a good changes when the price of the good changes, ceteris paribus. We know if we raise a price, the Qd will decline, but we don t know how much. Elasticity answers the how much question. In Business, we want to know the relationship between Qd and Price Ep = % Change in Quantity Demanded % Change in Price

3 Price of Latte Suppose a retail gourmet coffee outlet is selling its premium Latte for $3/cup. The store generally is selling 15 cups of Latte per hour, and the store manager is thinking seriously of raising the price to $5/cup. He knows he will lose some sales but thinks that most of his customers are willing to pay more. Help him quantify his decision by determining how many fewer cups he can sell and still generate more revenue per hour.

4 Calculating Percentage Change Percentage Change measures how much a value has changed from one time period to another For Example, if a firm s sales for the current month amounted to $100 million and the previous month, the same firm s sales were $90 million. What was the percentage change? There are two methods of calculating the percentage change Simple Method Midpoint Method

5 Calculating Percentage Change Simple Method Percentage Change = Current Value-Previous Value Previous Value or, = $100m - $90 m = $10m = 11.1% $90m $90m Very Common Usage, especially in the business world

6 Calculating Percentage Change Midpoint Method Percentage Change = Current Value Previous Value (Current Value + Previous Value)/ 2 Or, = $100m -$90m = $10m = 10.5% ($100m + $90m)/2 $95m The midpoint method is the better method because it gives similar results whether we are measuring forward or backward

7 Price Elasticity of Demand From Formula Ep = % Change in Qd % Change in Price If Price Elasticity of Demand > 1, demand is elastic If Price Elasticity of Demand = 1, demand is unit elastic If Price Elasticity of Demand < 1, demand is inelastic

8 Demand Elasticity Elastic Demand When % Change in Quantity Demanded > % Change in Price Unit Elastic Demand When % Change in Quantity Demanded = % Change in Price Inelastic Demand When % Change in Quantity Demanded < % Change in Price Perfectly Elastic Demand When Quantity Demanded Changes by a very large percentage in response to an almost zero Change in Price Perfectly Inelastic Demand When the Quantity Demanded remains constant as Price changes

9 Perfectly Elastic Demand Curve D Quantity The elasticity of a perfectly elastic demand curve is infinity Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved

10 Perfectly Inelastic Demand Curve D Quantity The elasticity of a perfectly inelastic demand curve is 0 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved

11 Relativity Elasticity of Demand Curves D 1 Quantity D 2 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved

12 Elasticity of Straight Line Demand Curve V ery elastic e = Slightly elastic Unit elastic e = 1.0 Slightly inelastic e =.29 Very inelastic Quantity D Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved

13 Significance of Price Elasticity of Demand Profit maximization requires that business set a price that will maximize the firm s profit Elasticity tells the firm how much control it has over using price to raise profit If Ep > 1, then the % Change in Qd > % Change is Price and demand is said to be elastic An increase in price will reduce total revenue A decrease in price will increase total revenue

14 Significance of Price Elasticity of Demand If Ep < 1, then the % change in Qd < % change in price, and demand is said to be inelastic An increase in price will increase total revenue A decrease in price will decrease total revenue If Ep = 1, then the % change in Qd = % change in Price, and demand is said to be unit elastic An increase in price will have no impact on total revenue A decrease in price will have no impact on total revenue

15 Price Elasticity of Demand Influences Substitute Product Availability (key determinant) -- Luxury or Necessity (Ep for luxury items is >) -- How narrowly it is defined (coffee is inelastic but latte may have more substitutes and therefore is more elastic) -- Time elapsed since price change (>time, >elasticity; more time to find substitutes or manage consumption) Income Effects -- The greater the proportion of income spent on the good, greater a price change impacts Quantity Demanded

16 Advertising Purpose Product Differentiation (Branding) To make the demand for a product greater To make the demand for a product more inelastic D D Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved

17 Elasticity Thoughts Demand Curve Slope and Elasticity (Steeper the slope, lower the elasticity) A Units-Free Measure (% Change Absolute Value) Elasticity Along a Linear Demand Curve -- Slope is constant but elasticity varies Elasticity and Total Revenue -- Price and Total Revenue change in opposite directions, demand is elastic -- Price Change leaves Total Revenue unchanged, demand is unit elastic -- Price and Total Revenue change in same direction, demand is inelastic

18 Price Elasticity of Supply A measure of the extent to which the quantity supplied of a good changes when the price of the good changes, and all other influences on seller s plans remain the same (cateris paribus)

19 Price Elasticity of Supply Perfectly Elastic Supply When the quantity supplied changes by a very large percentage in response to an almost zero increase in price Elastic Supply When the % change in the quantity supplied > the % change in the price Unit Elastic Supply When the % change in the quantity supplied = the % change in price Inelastic Supply When the % change in the quantity demanded is < the % change in price Perfectly Inelastic Supply When the quantity supplied remains the same as the price changes

20 Influences on Price Elasticity of Supply Production Possibilities page Opportunity Costs constant or gently rising opportunity costs = elastic price elasticity -- Fixed Production = inelastic price elasticity -- Time Elapse longer time, > price elasticity

21 Influences of Price Elasticity of Storage Possibilities Supply The better the storability, the more elastic is the price elasticity of supply

22 Computing Price Elasticity of Supply Percentage change in quantity supplied Percentage change in price If Price Elasticity of Supply > 1, Supply is elastic If Price Elasticity of Supply = 1, Supply is unit elastic If price elasticity of supply< 1, Supply is inelastic

23 Cross Elasticity of Demand A measure of the extent to which the demand for a good changes when the price of a substitute or complement changes, ceteris paribus % Change in Quantity Demanded % Change in Price of one of its substitutes or complements

24 Income Elasticity of Demand A measure of the extent to which the demand for a good changes when income changes, ceteris paribus % Change in Quantity Demanded % Change in Income

25 Income Elasticity of Demand If income elasticity of demand > 1 the demand for the good is income elastic If income elasticity of demand is between 0 and 1, the demand is income inelastic * If income elasticity of demand < 0 the demand is negative income elastic

26 For Next Time Define the term Price Elasticity of Supply. What does this concept tell us? What are the main determinants of supply elasticity? How do they impact supply? If government taxes a product (excise tax), how can we determine how much of the tax will be passed on to the buyer and how much will have to be paid by the seller?

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