Managerial Economics. Elasticity and Its Application

Transcription

1 Managerial Economics Elasticity and Its Application

2 Outline Define, explain the factors that influence, and calculate the price elasticity of demand. Define, explain the factors that influence, and calculate the price elasticity of supply. Define and explain the factors that influence the cross elasticity of demand and the income elasticity of demand. 2

3 THE ELASTICITY OF DEMAND The 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. Computed as the percentage change in quantity demanded divided by the percentage change in price When we talk about elasticity, that responsiveness is always measured in percentage terms. Specifically, the price elasticity of demand is the percentage change in quantity demanded due to a percentage change in the price. 3

4 Computing the Price Elasticity of Demand The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price. Price elasticity of demand = Percentage change in quantity demanded Percentage change in price 4

5 Computing the Price Elasticity of Demand Percentage Change in Price Suppose Starbucks raises the price of a latte from $3 to $5 a cup. What is the percentage change in price? Percent change in price = New price Initial price Initial Price x 100 Percent change in price = $5 $3 $3 x 100 = percent 5

6 Computing the Price Elasticity of Demand Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as: Price elasticity of demand = Percentage change in quantity demanded Percentage change in price = 20% 10% = 2.00% 6

7 Computing the Price Elasticity of Demand Example: If the price of an ice cream cone decreases from $2.20 to $2.00 and the amount you buy increase from 8 to 10 cones, then your elasticity of demand would be calculated as: Price elasticity of demand = Percentage change in quantity demanded Percentage change in price = 25% 9% = 2.77% 7

8 The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the price change. ( Q Q ) /[( Q Q ) / 2] Price elasticity of demand = ( P2 P ) /[( ) / 2] 1 P2 P1 8

9 The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as: (10 8) (10 8) / 2 22% ( ) 9.5% ( ) /

10 Calculate an elasticity Use the following information to calculate the price elasticity of demand for hotel rooms: if P = $135, Q d = 8600 if P = $165, Q d = 7400 stefanolunardi/shutterstock.com 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

11 The Variety of Demand Curves Inelastic Demand Quantity demanded does not respond strongly to price changes. Price elasticity of demand is less than one. Elastic Demand Quantity demanded responds strongly to changes in price. Price elasticity of demand is greater than one. 12

12 The Variety of Demand Curves Perfectly Inelastic Quantity demanded does not respond to price changes. Perfectly Elastic Quantity demanded changes infinitely with any change in price. Unit Elastic Quantity demanded changes by the same percentage as the price. 13

13 THE PRICE ELASTICITY OF DEMAND Perfectly Elastic Demand. 1. For a small change in the price of spring water, 2. The quantity demanded of spring water changes by a large amount. 3. The demand for spring water is perfectly elastic. 14

14 THE PRICE ELASTICITY OF DEMAND Elastic Demand, Elasticity > 1 1. When the price of a Sony Playstation rises by 10%, 2. The quantity demanded decreases by 20%. 3. Demand for Sony Playstations is elastic. 15

15 THE PRICE ELASTICITY OF DEMAND Unit Elastic Demand, Elasticity = 1 1. When the price of a trip rises by 10%, 2. The quantity demand of decreases by 10%. 3. The demand for trips is unit elastic. 16

16 THE PRICE ELASTICITY OF DEMAND Inelastic Demand, Elasticity < 1 1. When the price of gum rises by 20%, 2. The quantity demanded decreases by 10%. 3. The demand for gum is inelastic. 17

17 THE PRICE ELASTICITY OF DEMAND Perfectly Inelastic Demand. 1. When the price rises, 2. The quantity demanded does not decrease. 3. Demand is perfectly inelastic. 18

18 Does Demand Curve Have Constant Elasticity? 19

19 The Variety of Demand Curves Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve. But it is not the same thing as the slope! 20

20 Elasticity Slope Elasticity = % Q x % P x = Q x/q x P x /P x = Q x P x P x Q x Slope = P x Q x 21

21 Elasticity Slope P Elastic Unit elastic Inelastic Q 22 22

22 The Price Elasticity of Demand Availability of Close Substitutes Necessities versus Luxuries Definition of the Market Time Horizon Proportion of Income Spent 23

23 The Price Elasticity of Demand Demand tends to be more elastic: the larger the number of close substitutes. if the good is a luxury the more narrowly defined the market. the longer the time period. 24

24 What determines price elasticity? To learn the determinants of price elasticity, we look at a series of examples. Each compares two common goods. In each example: Suppose the prices of both goods rise by 20%. The good for which Q d falls the most (in percent) has the highest price elasticity of demand. Which good is it? Why? What lesson does the example teach us about the determinants of the price elasticity of demand?

25 EXAMPLE 1 Breakfast Cereal vs. Sunscreen The prices of both of these goods rise by 20%. For which good does Q d drop the most? Why? Breakfast cereal has close substitutes (e.g., pancakes, Eggo waffles, leftover pizza), so buyers can easily switch if the price rises. Sunscreen has no close substitutes, so a price increase would not affect demand very much. Lesson: Price elasticity is higher when close substitutes are available.

26 EXAMPLE 2 Blue Jeans vs. Clothing The prices of both goods rise by 20%. For which good does Q d drop the most? Why? For a narrowly defined good such as blue jeans, there are many substitutes (khakis, shorts, Speedos). There are fewer substitutes available for broadly defined goods. (Are there any substitutes for clothing?) Lesson: Price elasticity is higher for narrowly defined goods than for broadly defined ones.

27 EXAMPLE 3 Insulin vs. Caribbean Cruises The prices of both of these goods rise by 20%. For which good does Q d drop the most? Why? To millions of diabetics, insulin is a necessity. A rise in its price would cause little or no decrease in demand. A cruise is a luxury. If the price rises, some people will forego it. Lesson: Price elasticity is higher for luxuries than for necessities.

28 EXAMPLE 4 Gasoline in the Short Run vs. Gasoline in the Long Run The price of gasoline rises 20%. Does Q d drop more in the short run or the long run? Why? There s not much people can do in the short run, other than ride the bus or carpool. In the long run, people can buy smaller cars or live closer to work. Lesson: Price elasticity is higher in the long run than the short run.

29 Total Revenue and the Price Elasticity of Demand Total revenue is the amount paid by buyers and received by sellers of a good. Computed as the price of the good times the quantity sold. TR P Q 30

30 Total Revenue 31 31

31 Elasticity and Total Revenue along a Linear Demand Curve With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases. 32

32 Price Elasticity and Total Revenue Now, demand is inelastic: elasticity = 0.82 If P = $200, Q = 12 and revenue = $2400. If P = $250, Q = 10 and revenue = $2500. $250 $200 P increased revenue due to higher P Demand for your websites lost revenue due to lower Q D When D is inelastic, a price increase causes revenue to rise Q

33 Elasticity and Total Revenue along a Linear Demand Curve With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases. 34

34 Price Elasticity and Total Revenue Elastic demand (elasticity = 1.8) If P = $200, Q = 12 and revenue = $2400. If P = $250, Q = 8 and revenue = $2000. When D is elastic, a price increase causes revenue to fall. $250 $200 P increased revenue due to higher P 8 Demand for your websites 12 lost revenue due to lower Q D Q

35 PRICE ELASTICITY & TOTAL REVENUE When prices are low, P Total revenue rises with price to a point... TR So is total revenue then declines 36 36

36 The Relationship Between Price Elasticity and Total Revenue Elasticity and Revenue with a Linear Demand Curve IF DEMAND IS... THEN... BECAUSE... elastic elastic inelastic inelastic unit-elastic unit-elastic an increase in price reduces revenue a decrease in price increases revenue an increase in price increases revenue a decrease in price reduces revenue an increase in price does not affect revenue a decrease in price does not affect revenue the decrease in quantity demanded is proportionally greater than the increase in price. the increase in quantity demanded is proportionally greater than the decrease in price. the decrease in quantity demanded is proportionally smaller than the increase in price. the increase in quantity demanded is proportionally smaller than the decrease in price. the decrease in quantity demanded is proportionally the same as the increase in price. the increase in quantity demanded is proportionally the same as the decrease in price. 37

37 Elasticity and expenditure/revenue A. Pharmacies raise the price of insulin by 10%. Does total expenditure on insulin rise or fall? B. As a result of a fare war, the price of a luxury cruise falls 20%. Does luxury cruise companies total revenue rise or fall? 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 38 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

38 Other Demand Elasticities Income Elasticity of Demand Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers income. It is computed as the percentage change in the quantity demanded divided by the percentage change in income. 41

39 Other Demand Elasticities Computing Income Elasticity Income elasticity of demand = Percentage change in quantity demanded Percentage change in income Remember, all elasticities are measured by dividing one percentage change by another 42

40 Other Demand Elasticities Income Elasticity Types of Goods Normal Goods Inferior Goods Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods. 43

41 Other Demand Elasticities Income Elasticity 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, furs, and expensive foods. 44

42 Other Demand Elasticities IF THE INCOME ELASTICITY OF DEMAND IS... THEN THE GOOD IS... EXAMPLE Positive, but less than 1 Normal and a necessity Milk Positive and greater than 1 Normal and a luxury Caviar Negative Inferior High-fat meat 45

43 Other Demand Elasticities Cross-price elasticity of demand A measure of how much the quantity demanded of one good responds to a change in the price of another good, computed as the percentage change in quantity demanded of the first good divided by the percentage change in the price of the second good Cross - price elasticity of demand %change in quantity demanded of good1 %change in price of good 2 46

44 Other Demand Elasticities IF THE PRODUCTS ARE... THEN THE CROSS-PRICE ELASTICITY OF DEMAND WILL BE... EXAMPLE Substitutes Positive Two brands of printers Complements Negative Printers and toner cartridges Unrelated Zero Printers and peanut butter 47

45 Pizzas and burgers are substitutes. Cross elasticity is positive. Pizzas and soda are complements. Cross elasticity is negative. 48

46 Orange Prices and Total Revenue Price elasticity of demand for agricultural products (oranges) is 0.4. So if a frost cuts supply of oranges (and demand doesn t change), a 1 percent decrease in the quantity harvested will lead to a 2.5 percent rise in the price. Q: Is the price elasticity of orange elastic or inelastic? Q: What happen with the total revenue increase or decrease? 49

47 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 percentage change in price. 52

48 THE PRICE ELASTICITY OF SUPPLY Perfectly Elastic Supply. 1. A small rise in the price, 2. Decreases the quantity supplied by a very large amount, 3. Supply is perfectly elastic. 53

49 THE PRICE ELASTICITY OF SUPPLY Elastic Supply, Elasticity > 1 1. A 10% rise in the price of a book, 2. Increases the quantity supplied by 20%. 3. The supply of books is elastic. 54

50 THE PRICE ELASTICITY OF SUPPLY Unit Elastic Supply, Elasticity = 1 1. A 10 % rise in the price of fish, 2. Increases the quantity supplied of fish by 10%. 3. The supply of fish is unit elastic. 55

51 THE PRICE ELASTICITY OF SUPPLY Inelastic Supply, Elasticity < 1 1. A 20% rise in the price of a hotel room, 2. Increases the quantity supplied of hotel rooms by 10%. 3. The supply of hotel rooms is inelastic. 56

52 THE PRICE ELASTICITY OF SUPPLY Perfectly Inelastic Supply. 1. A small rise in the price of a beachfront lot, 2. Increases the quantity supplied by 0%. 3. The supply of beachfront lots is perfectly inelastic. 57

53 The Price Elasticity of Supply and Its Determinants Ability of sellers to change the amount of the good they produce. Beach-front land is inelastic. Books, cars, or manufactured goods are elastic. Time period Supply is more elastic in the long run. 58

54 Computing the Price Elasticity of Supply The price elasticity of supply is computed as the percentage change in the quantity supplied divided by the percentage change in price. Price elasticity of supply = Percentage change in quantity supplied Percentage change in price 59

55 THREE APPLICATIONS OF SUPPLY, DEMAND, AND ELASTICITY University agronomists discover a new wheat hybrid that is more productive than existing varieties? Is this good news or bad news for farmers? What happens to wheat farmers and the market for wheat? 60

56 Can Good News for Farming Be Bad News for Farmers? Examine whether the supply or demand curve shifts. Determine the direction of the shift of the curve. Use the supply-and-demand diagram to see how the market equilibrium changes. 61

57 An Increase in Supply in the Market for Wheat What is elasticity of wheat? Is it inelastic or elastic? Is farmer better off? 62 62

58 Why Did OPEC Fail to Keep the Price of Oil High? Price Started to decline Price rise because OPEC jointly reduced the supply of oil Source: 64

59 OPEC and oil prices: Short run Supply of oil decline Consumers have no time to change car to NGV. Other suppliers cannot dig out more oil in a short notice. Both demand and supply are relatively inelastic 65 65

60 OPEC and oil prices: Long run High price induce more oil exploration and building new extraction capacity. Consumer response to high price by replacing old car with more fuel efficiency. Demand and supply in long run are relatively elastic

61 Why Did OPEC Fail to Keep the Price of Oil High? Supply and Demand can behave differently in the short run and the long run In the short run, both supply and demand for oil are relatively inelastic But in the long run, both are elastic Production outside of OPEC More conservation by consumers 67

62 Policies to Reduce the Use of Illegal Drugs Government try to reduce the use of illegal drugs by 1. Increasing the number of police officers devoted to war on drugs. 2. Educating the young about the danger of illegal drugs What will happen with demand and supply? Which policy is more efficient? 68

63 Policies to Reduce the Use of Illegal Drugs Demand declines Price decreases Quantity declines 69 69

64 Policies to Reduce the Use of Illegal Drugs Supply declines Price increases Quantity declines How s about in long run? 70 70

65 Does Drug Interdiction Increase or Decrease Drug-Related Crime? Drug interdiction impacts sellers rather than buyers. Demand is unchanged. Equilibrium price rises although quantity falls. Drug education impacts the buyers rather than sellers. Demand is shifted. Equilibrium price and quantity are lowered.

66 summary Price elasticity of demand measures how much the quantity demanded responds to changes in the price. Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. If a demand curve is elastic, total revenue falls when the price rises. If it is inelastic, total revenue rises as the price rises. 72

67 summary The income elasticity of demand measures how much the quantity demanded responds to changes in consumers income. The cross-price elasticity of demand measures how much the quantity demanded of one good responds to the price of another good. The price elasticity of supply measures how much the quantity supplied responds to changes in the price. 73

68 summary In most markets, supply is more elastic in the long run than in the short run. The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price. The tools of supply and demand can be applied in many different types of markets. 74

69 Q1: Pricing and Cash Flows According to an FTC Report by Michael Ward, AT&T s own price elasticity of demand for long distance services is AT&T needs to boost revenues in order to meet it s marketing goals To accomplish this goal, should AT&T raise or lower it s price? 75

70 Q 2: Quantifying the Change If AT&T lowered price by 3 percent, what would happen to the volume of long distance telephone calls routed through AT&T? 77

71 Q3: Impact of a change in a competitor s price According to an FTC Report by Michael Ward, AT&T s cross price elasticity of demand for long distance services is If competitors reduced their prices by 4 percent, what would happen to the demand for AT&T services? 79