Elasticity of Demand The relationship of the price to quantity demanded and how it relates to total revenue is technically called the price and elasticity of demand. Technically, the percentage change in quantity demanded divided by the percentage change in the price that caused the change in the quantity demanded (QD1 QD2)/QD1 (P1 P2) / P1 The upper portion above the midpoint (dotted line), is the elastic range where price increase causes revenue to fall. The lower half and the inelastic range, price increase causes revenue to rise. This is counterintuitive to most people. - 1 -
Economic Newsletter for the New Millennium Elasticity: Movement along the demand curve Flattening demand curve Elastic Range Midpoint /Unitary Elastic Elastic Range Midpoint /Unitary Elastic Inelastic Range Further on Elasticity of Demand: Shifting; flattening and/or steepening; increasing competition, rotating the demand curve to a flatter position (price elasticity at each price increases) When demand curve shifts to the right, price elasticity decreases with each price --- (greater ability to increase revenue with price increase) - 2 -
Product differentiation (advertising) aims to reduce competition/ substitution effect --- (greater ability to increase revenue with price increase) As just explained, the relationship of the price of a good to the quantity demanded, (QD) of that good is normally negative and thus has an inverse relationship when price rises, the quantity demanded of that good falls and price falls, quantity demanded of that good rises. The degree to which QD responds to price depends upon substitution effects & income effects. As we saw, most goods are normal, so more often than not, the income effect does reinforce the substitution effect. TR = P X QD The total revenue a firm receives from selling a product depends upon the product of times Demanded (P X QD) price times quantity demanded equals revenue (P X QD = Revenue). Now you have to stop and pause and think about this. All else equal (ceteris paribus), Profits = Revenue Expense (cost) When revenue rises, profits rise When revenue falls, profits fall ignoring cost for the moment Again, technically, the percentage change in quantity demanded divided by the percentage change in the price that caused the change in the quantity demanded (QD1 QD2)/QD1 (P1 P2) / P1 Note: In other words we have to rule out all the factors that influence the quantity demanded. If we don t, then we don t have price elasticity of demand that has to be understood. So if you are trying to do this in real life measure price elasticity, you would have to have complicated statistical routines which were able to mute the effects of all the changes that influence quantity demanded - 3 -
Economic Newsletter for the New Millennium other than the price of that good itself. Average Revenue (top) and Total Revenue (bottom) $3 Midpoint/Unitary Elastic $2 $1 Demand = Average Revenue / Line 1 2 3 Demanded Total Revenue Thousands $40 $30 Total Revenue = 0 10,000 20,000 30,000 Demanded Using the above illustration Starting with the top picture (Average Revenue/Demand Curve) from a rate of $1 moving up to $2, the quantity demanded moves from 30,000 classes to 20,000. In looking at the Total Revenue picture below, you find that the movement, in spite of the drop in quantity demanded, still translates into greater revenues (from total revenue of $30,000 to $40,000). However, if you continue to raise prices higher (past the Midpoint/Unitary Elastic point shown above), your revenue will fall (going from total revenue of $40,000 to $30,000). - 4 -
Marginal Revenue Marginal revenue is the incremental revenue as the quantity sold changes by one unit. Marginal Revenue = 4 4 Marginal Revenue 3 2 1 at the Midpoint Demand = Average Revenue / Line 1 2 3 Demanded Marginal Revenue = 0 Marginal Revenue = -4-5 -
Substitution Effect (competition and its effect) In flattening, the demand curve becomes more price elastic at each price (see figure below: movement from D1 to D2). Competition increases, at a given price, demand becomes more price elastic at each price. If the price elasticity increases to such an extent, that what was formerly price inelastic is now price elastic, an increase in price will cause a fall in revenue. Flattening Demand Curve: Resistance to price hikes D1 D2-6 -
Elasticity in Demand (when demand shifts) When demand increases, more or less a parallel shift, price elasticity demand decreases and price increases in that range are more revenue enhancing. So, if the good in question is a normal good, and income is rising, it is going to shift the demand curve to the right. Demand Shift: (Rightward) Decreases Elasticity of Demand (price increase more revenue enhancing) New Midpoint Old Midpoint D1 D2-7 -
Change in Demanded Now we should stop here and point out when we say the demand curve we are talking about the relationship of the price of that good to the quantity and demand of that good, everything else held constant (see figure: higher price movement from QD1 to QD2). Change in Demand: movement along the demand curve QD 2 QD 1-8 -
Shift in the Demand Curve If it is a normal good and income rises, it will cause the demand curve to shift rightward (higher income: shift in demand D1 to D2). Changes in income, population distribution, wealth, etc., change (shift) demand the demand curve, not just quantity demanded. Demand Shift for Normal Good: (Rightward) higher income D1 D2 The aim of advertising is to reduce the substitution effect; thereby causing the demand curve to become steeper or more parallel to the price axis, and thus reduces price elasticity demand of each price (this is the opposite of what we saw earlier). - 9 -
Advertising Steepened Demand Curve promoting higher profits Assumption: operating in the inelastic range (price increases are revenue D1 D2 Summary ( Elasticity of Demand) So we have several reasons why price elasticity can change, one is that when you move along the demand curve (almost all the demand curves, linear and curvilinear up to a point where they become hyperbolic), it means that you change the price; price elasticity decreases because you go down the demand curve and increases as you go up. Starting from the quantity axis (X-axis) you go through an inelastic range, where a price increase causes revenue to rise but at a decreasing rate. You reach the midpoint where price elasticity is unitary (or one), where price increases in that narrow range (or decreases) do not change the revenue. Then into the upper half of the demand curve (be it a linear curve or curvilinear), where price increases cause total revenue to fall. That s the basic concept of price elasticity for a given demand curve. Further on Elasticity of Demand: Shifting; flattening and/or steepening - 10 -
When competition increases, rotating the demand curve to a flatter position, price elasticity at each price increases When demand curve shifts to the right, price elasticity decreases with each price Product differentiation (advertising) is, in effect, a reduction in competition, reducing the substitution effect; convincing people that other goods are not as substitutable and that causes the curve to rotate and become steeper and more parallel to the price axis This is extremely important because the basic business decision to know what to produce, how much to produce, when to expand, when to contract production, etc., depends upon the relationship of revenue, cost, and profits (Profit = Revenue cost) - 11 -