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Price Elasticity of Demand – continued_

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Price Elasticity of Demand – continued_ Powered By Docstoc
					Elasticity – a measure of responsiveness
Q2  Q2  %Q   I. Price Elasticity of Demand: e p  P2 %P  P2    Q1  Q1   2  . This is the midpoint formula for ep.  P1  P1   2 

Example: Original Q Cheese: 116,250 New Q 123,750 202,500 %∆Q Cheese: T – Shirts: 7500/120,000 = 0.0625 5000/200,000 = 0.025 Avg. Q 120,000 200,000 Orig. P 3.40 16.20 New P 3.00 15.80 %∆P – 0.40/3.20 = – 0.125 – 0.40/16.00 = – 0.025 Avg. P 3.20 16.00

T – Shirts: 197,500

Elasticity Cheese: T – Shirts: 0.0625/0.125 = ½ 0.025/0.025 = 1

A. Terms 1. Inelastic (demand): 0 < ep < 1 2. Elastic (demand): ep > 1 3. Unit elastic: ep = 1 4. Perfectly inelastic demand: ep = 0. Qd is not at all responsive to price changes. $

D Q 5. Perfectly elastic demand: ep → ∞. $

D

Q

B. Demand curves rarely have the same elasticity over every part of the curve. Example: P = 5 – 1/2Q P

5

4

3

2

1

0 2 4 6 8 10 Q

The elasticity of demand will be different at different points on the demand curve.

Elasticity of demand between prices of P1 = $5 and P2 = $4:

20 [(2  0) / 2] ep  9 45 [(4  5) / 2]

Elasticity of demand between prices of P1 = $1 and P2 = $0:

10  8 [(10  8) / 2] ep   1/ 9 0 1 [(0  1) / 2]

Even though a $1 reduction in the price always leads to an increase in the Qd by 2, the elasticity changes as we move along the curve. A demand curve with a constant slope does not mean that there will be constant elasticity – do not confuse the two concepts. C. Elasticity and Revenue Total Revenue (TR) = P*Q

For an increase in the price: 1. If %∆P > %∆Q then revenues will increase. Thus, if demand is inelastic, then price and revenue are positively related. 2. If %∆P < %∆Q then revenues will decrease. Thus, if demand is elastic, then price and revenue are negatively related. Revenue curve for P = 5 – 1/2Q: P 5 4 3 2 1 0 Q 0 2 4 6 8 10 TR 0 8 12 12 8 10

TR

ep=1 12.50

ep<1

ep>1

0

2.50

P

D. Determinants of Price Elasticity of Demand 1. Substitutes – If a product has more substitutes the %∆Q will be higher for any given price change (%).

Some example US demand elasticities: Potatoes Cigarettes Clothing Beef Furniture 0.3 0.5 0.6 1.0 1.2

2. Definition of the Product – Any one of a group of related products will have a greater elasticity than the group as a whole. There will be more substitutes 3. Necessity v. Luxury

Luxuries have more substitutes (including savings) 4. Time: Long Run (LR) v. Short Run (SR) It takes time to develop satisfactory substitutes and adjust consumption habits.

LR demand for a product will tend to have a higher elasticity than the SR demand.

II. Income Elasticity of Demand (eI) = (%∆QD)/(%∆I) all else constant.

A. Measures 1. Normal goods: an increase in income leads to an increase in demand (and quantity demanded, all else constant), thus eI > 0. 2. Inferior goods: an increase in income leads to a decrease in demand (and quantity demanded, all else constant), thus eI < 0. Example income elasticities: Whole milk Pig products Wine (France) Poultry Wine (US) Restaurant meals -0.5 -0.2 0.1 0.3 1.4 2.4

B. Determinants of eI: 1. The more basic an item is in the consumption patterns of consumers, the lower is its income elasticity (e.g. wine in France v. wine in the US)

2. Different stages of economic development can affect income elasticities The income elasticity in the US for poultry is 0.3, whereas in Sri Lanka it is 2.0

III. Cross-Price Elasticity of Demand (eAB) eAB = (%∆QA)/(%∆PB) all else held constant Cross elasticities could vary from -∞ to +∞ 1. Complements: e.g. SUVs and gasoline – an increase in the price of gas will decrease the quantity demanded of gas, which in turn decreases demand for SUVs (and the quantity demanded all else held constant). The cross-price elasticity of demand for complements is < 0. 2. Substitutes: eAB > 0

IV. Elasticity of Supply: es = (%∆Qs/%∆P) A. Terms – note that es is always positive because of the law of supply 1. inelastic supply: es < 1 2. elastic supply: es > 1 3. perfectly inelastic supply: es = 0

P S

Q

4. perfectly elastic supply: es = ∞ P

S

Q

B.

Determinants of es 1. ease of substitution in production 2. how costs change as production changes

3. LR v. SR – it may be difficult to change production in the SR


				
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