CHAPTER 3 ELASTICITY (DEMAND AND SUPPLY)

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1 CHAPTER 3 ELASTICITY (DEMAND AND SUPPLY)

2 Elasticity Elasticity is a measure of responsiveness or sensitivity of a dependant variable to a percentage change in an independent variable. Elasticity is a measure of how much buyers and sellers respond to changes in market conditions.

3 The Elasticity Formula The change in quantity is always the dependant variable. The change in market conditions is the independent variable. Market conditions include price and other determinants of demand and supply.

4 Elasticity of Demand Elasticity of demand is a measure of the responsiveness of quantity demanded to changes in its factors. It measures the extent to which quantity demanded will change following a change in its factors. These factors include products own price, income and price of related goods.

5 Basic Types of Elasticity of Demand 1. Price elasticity of demand: Responsiveness of quantity demanded to a change in a product s price 2. Income elasticity of demand: Responsiveness of quantity demanded to a change in income 3. Cross elasticity of demand: Responsiveness of quantity demanded of one good to changes in the price of another good.

6 1. Price Elasticity of Demand Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good. Price elasticity of demand is the percentage change in quantity demanded given a one percent change in the price. It is a comparison of the size of the change in quantity demanded and the change in price that brought it.

7 Price Elasticity of Demand (Cont) If the price of the product increases by 5% and this result in a 10% decrease in the quantity demanded, ceteris paribus, then; ep 10% 5% The ratio which is 2 is the elasticity coefficient which means that a 1% change in the price of the product will lead to a 2% change in the quantity demanded. 2

8 Pr ice Computing the Price Elasticity of Demand elasticity of demand ( p ) change in quantity % change in in demanded price Example: If the price of an ice cream cone increases from R2.00 to R2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as: % % 10% 2

9 Point Elasticity Formula p % change in quantity % change in price Q Q P P Q Q P P Q Q P P Q P P Q

10 Categories of Price Elasticity of Demand Inelastic Demand (0 < e p <1) Quantity demanded does not respond strongly to price changes. Price elasticity of demand is less than one. Elastic Demand (1 < e p < ) Quantity demanded responds strongly to changes in price. Price elasticity of demand is greater than one.

11 Categories of PED (Cont) Unit Elastic (e p =1) Quantity demanded changes by the same percentage as the price. Perfectly Inelastic (e p = 0) Quantity demanded does not respond to price changes. Perfectly Elastic (e p = ) Quantity demanded changes infinitely with any change in price.

12 Copyright 2003 Southwestern/Thomson Learning (a) Perfectly Inelastic Demand: Elasticity Equals 0 Price Demand 10% A 10 % increase in price Quantity leaves the quantity demanded unchanged.

13 (b) Inelastic Demand: Elasticity is Less Than 1 Price 10% 1. A 10 % increase in price... 2% Demand 0 Quantity leads to an 2 % decrease in quantity demanded.

14 Copyright 2003 Southwestern/Thomson Learning (c) Unit Elastic Demand: Elasticity Equals 1 Price 10% 1. A 10 % increase in price % Demand leads to a 10 % decrease in quantity demanded. Quantity

15 (d) Elastic Demand: Elasticity is Greater Than 1 Price 10% 1. A 10 % increase in price... 15% Demand 0 Quantity leads to an 15 % decrease in quantity demanded.

16 (e) Perfectly Elastic Demand: Elasticity Equals Infinity Price 1. At any price above R4, quantity demanded is zero. R4 Demand 2. At exactly R4, consumers will buy any quantity At a price below R4, quantity demanded is infinite. Quantity

17 The Price Elasticity of Demand and Its Determinants 1. Habit forming products Products such as cigarettes, alcohol, drugs 2. The degree of necessity. Demand for a product that are considered to be necessity tends to be relatively inelastic whereas luxury goods tends to be relatively elastic. 3. Availability of substitute The more substitutes there are for a good and the closer they are, the more people will switch to alternatives when the price of the good rises.

18 The Price Elasticity of Demand and Its Determinants (Cont) 4. The Proportion of Income spent on the product The higher the proportion of our income we spent on a good, the more elastic will be demand. We spent a tiny fraction of our income on salt. Its PED is very low. 5. Advertising Producers use advertising to convince consumers that their products have no real substitutes thereby reducing the elasticity of demand for their products.

19 Price Elasticity of Demand & Total Revenue 1. Inelastic Demand quantity demanded changes by a percentage which is less than the percentage change in the price. There`s an incentive for producers to raise the price of the product since percentage fall in quantity demanded is smaller than the percentage increase in the price. However, there`s no incentive for producers to drop the price of the product since percentage increase in quantity will be smaller than the percentage decrease in the price.

20 Price Elasticity of Demand & Total Revenue 2. Elastic Demand When the percentage change in quantity demanded is greater than the percentage change in price. Producers can increase TR by lowering the price of the product. However, there are no incentive to increase their prices since, the resulting decrease in the quantity demanded will be proportionately greater than the increase in the price.

21 Price Elasticity of Demand & Total Revenue 3. Unit Elastic Demand Producers cannot raise TR by decreasing or increasing the price. Because the percentage change in price will be exactly offset by a corresponding percentage change in the quantity demanded. TR will remain unchanged.

22 Relationship between PED & Total Revenue When price is changed, the impact on a firm s total revenue (TR) will depend upon the price elasticity of demand Elasticity Demand is elastic Demand is unit elastic Demand is inelastic For a price increase For a price decrease TR decreases TR increases TR does not change TR increases TR does not change TR decreases

23 2. Income Elasticity of Demand Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers income (Y). It enables us to predict how much the demand curve will shift for a given change in income. It is computed as the percentage change in the quantity demanded divided by the percentage change in income.

24 Computing Income Elasticity Income elasticity of demand = Percentage change in quantity demanded Percentage change in income Example: A 2% rise in income causing an 8% rise in the demand for a product. y ED 8% 2% 4

25 Income Elasticity Types of Goods Normal Goods (positive income elasticity) Inferior Goods (negative income elasticity) Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods.

26 Income Elasticity The major determinant of income elasticity is the degree of necessity of the good. Goods consumers regard as necessities tend to be income inelastic Examples include food, fuel, clothing, utilities, and medical services. Goods consumers regard as luxuries tend to be income elastic. Examples include sports cars, expensive clothes or foods.

27 Cross Price Elasticity It measures the responsiveness of demand for one product to a change in the price of another (either substitute or a complement) It enables us to predict how much the demand curve for the first product will shift when the price of the second product changes. Calculated as: CED AB % Q % P B DA

28 Cross Price Elasticity If good B is a substitute for good A, A`s demand will rise as B`s price rises. Hence CED will be positive. If good B is complementary to good A, A`s demand will fall as B`s price rises. Hence CED will be negative.

29 THE ELASTICITY OF SUPPLY Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good. Price elasticity of supply is the percentage change in quantity supplied resulting from a percent change in price.

30 Copyright 2003 Southwestern/Thomson Learning The Price Elasticity of Supply (a) Perfectly Inelastic Supply: Elasticity Equals 0 Price Supply 1. An increase in price... R Quantity leaves the quantity supplied unchanged.

31 Copyright 2003 Southwestern/Thomson Learning The Price Elasticity of Supply Price (b) Inelastic Supply: Elasticity Is Less Than 1 R5 Supply 1. A 25% increase in price Quantity leads to a 10% increase in quantity supplied.

32 Copyright 2003 Southwestern/Thomson Learning (c) Unit Elastic Supply: Elasticity Equals 1 Price R5 Supply 4 1. A 25% increase in price Quantity leads to a 25% increase in quantity supplied.

33 Copyright 2003 Southwestern/Thomson Learning (d) Elastic Supply: Elasticity Greater Than 1 Price (d) Elastic Supply: Elasticity Is Greater Than 1 Supply R5 1. A 25% increase in price Quantity leads to a 50 % increase in quantity supplied.

34 Copyright 2003 Southwestern/Thomson Learning (e) Perfectly Elastic Supply Elasticity Equals Infinity Price (e) Perfectly Elastic Supply: Elasticity Equals Infinity 1. At any price above R4, quantity supplied is infinite. R4 Supply 2. At exactly R4, producers will supply any quantity At a price below R4, quantity supplied is zero. Quantity

35 Total Revenue and Elasticity When a price changes, the change in producers total revenue depends on the elasticity of demand.

36 Total Revenue and Elasticity Elastic demand: a 1 percent price cut increases the quantity sold by more than 1 percent and total revenue increases. Unit elastic demand: a 1 percent price cut increases the quantity sold by 1 percent and so total revenue does not change. Inelastic demand: a 1 percent price cut increases the quantity sold by less than 1 percent and total revenue decreases.

37 Total Revenue (billions of dollars) Price (dollars per pizza) Elastic demand Unit elastic Inelastic demand When demand is elastic, price cut increases total revenue Maximum total revenue When demand is inelastic, price cut decreases total revenue Quantity (pizza per hour)

38 QUESTIONS *Question 1 (Tutorial III) a.explain five categories of price elasticity of demand with the aid of appropriate diagrams. (15) b.discuss how the knowledge of price elasticity of demand can assist producers to increase their total revenue. (9) c.discuss the various factors that influence/determine elasticity of demand. (10) *Question 2 (Tutorial III) c. Using the elasticity concepts & diagrams, explain your answer above. (5)