Elasticity

Copyright 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Managerial Economics, 9e
Managerial Economics
Thomas
Maurice
ninth edition
Copyright 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
Managerial Economics, 9e
Managerial Economics
Thomas
Maurice
ninth edition
Chapter 6
Elasticity and Demand
Managerial Economics Managerial Economics
6-2
P & Q are inversely related by the law of
demand so E is always negative
The larger the absolute value of E, the more
sensitive buyers are to a change in price
Price Elasticity of Demand (E)

% Q
E
% P
A
=
A
Measures responsiveness or sensitivity
of consumers to changes in the price of
a good
6-3
Elasticity Responsiveness
|E|
Elastic
Unitary Elastic
Inelastic
% Q % P| | A |>| A
% Q % P| | A |=| A
% Q % P| | A |<| A
E | |> 1
E | |= 1
E | |< 1
Table 6.1
6-4
Percentage change in quantity
demanded can be predicted for a given
percentage change in price as:
%AQ
d
= %AP x E
Percentage change in price required for
a given change in quantity demanded
can be predicted as:
%AP = %AQ
d
E
6-5
Price Elasticity & Total Revenue
Elastic

Quantity-effect
dominates
Unitary elastic

No dominant
effect
Inelastic

Price-effect
dominates
Price
rises
Price
falls
TR falls
TR rises
No change in TR
No change in TR
TR rises
TR falls
% Q % P| | A |>| A % Q % P| | A |=| A % Q % P| | A |<| A
Table 6.2
6-6
Factors Affecting Price Elasticity
of Demand
Availability of substitutes
The better & more numerous the
substitutes for a good, the more elastic is
demand
Percentage of consumers budget
The greater the percentage of the
consumers budget spent on the good, the
more elastic is demand
Time period of adjustment
The longer the time period consumers have
to adjust to price changes, the more elastic
is demand
6-7
Calculating Price Elasticity of
Demand
Price elasticity can be calculated
by multiplying the slope of demand
(AQ/AP) times the ratio of price to
quantity (P/Q)
% Q
E
% P
A
=
A
Q
Q
P
P
A

=
A

100
100
Q P
P Q
A
=
A
6-8
Calculating Price Elasticity of
Demand
Price elasticity can be measured at
an interval (or arc) along demand,
or at a specific point on the
demand curve
If the price change is relatively small, a
point calculation is suitable
If the price change spans a sizable arc
along the demand curve, the interval
calculation provides a better measure
6-9
Computation of Elasticity Over an
Interval
When calculating price elasticity of
demand over an interval of
demand, use the interval or arc
elasticity formula
Q P
E
P Q
A
=
A
Average
Average
6-10
Computation of Elasticity at a
Point
When calculating price elasticity at a
point on demand, multiply the slope of
demand (AQ/AP), computed at the point
of measure, times the ratio P/Q, using
the values of P and Q at the point of
measure
Method of measuring point elasticity
depends on whether demand is linear or
curvilinear

6-11
Point Elasticity When Demand is
Linear

-
R
R
,
Q a bP cM dP

M P
= + + + Given , let income &
price of the related good take specific
values and respectively
-
R
Q a' bP

a' a cM dP
b Q P
= +
= + +
= A A
Then express demand as , where
and the slope parameter
is
6-12
Linear
Compute elasticity using either of the two
formulas below which give the same value
for E
P P
E b E
Q P A
= =
or
Where and are values of price and quantity demanded
at the point of measure along demand, and
is the price-intercept of demand

P Q
A ( a'/ b ) =
6-13
Curvilinear
Compute elasticity using either of two
equivalent formulas below
Q P P
E
P Q P A
A
= =
A
Where is the slope of the curved demand at
the point of measure, and are values of price and
quantity demanded at the point of measure, and is
the price-intercept of the tangent line extende

Q P
P Q
A
A A
d to
cross the price-axis
6-14
Elasticity (Generally) Varies
Along a Demand Curve
For linear demand, price and |E|vary
directly
The higher the price, the more elastic is
demand
The lower the price, the less elastic is
demand
For curvilinear demand, no general rule
about the relation between price and
quantity

Special case of which has a constant
price elasticity (equal to ) for all prices
b
Q aP
b
=
-
Special case of which has a constant
price elasticity (equal to ) for all prices
b
Q aP
b
=
-
6-15
Constant Elasticity of Demand
(Figure 6.3)

6-16
Marginal Revenue
Marginal revenue (MR) is the change
in total revenue per unit change in
output
Since MR measures the rate of
change in total revenue as quantity
changes, MR is the slope of the total
revenue (TR) curve
TR
MR
Q
A
=
A
6-17
Demand & Marginal Revenue
(Table 6.3)
Unit sales (Q) Price TR = P Q MR = ATR/AQ
0 $4.50
1 4.00
2 3.50
3 3.10
4 2.80
5 2.40
6 2.00
7 1.50
$ 0
$4.00
$7.00
$9.30
$11.20
$12.00
$12.00
$10.50
--
$4.00
$3.00
$2.30
$1.90
$0.80
$0
$-1.50
6-18
Demand, MR, & TR (Figure 6.4)
Panel A Panel B
6-19
Demand & Marginal Revenue
When inverse demand is linear,
P = A + BQ (A > 0, B < 0)
Marginal revenue is also linear,
intersects the vertical (price) axis at
the same point as demand, & is twice
as steep as demand
MR = A + 2BQ

6-20
Linear Demand, MR, & Elasticity
(Figure 6.5)
6-21
MR, TR, & Price Elasticity
Marginal
revenue
Total revenue
Price elasticity
of demand
MR > 0 Elastic
(|E|> 1)
MR = 0 Unit elastic
(|E|= 1)
MR < 0 Inelastic
(|E|< 1)
Unit elastic
(|E|= 1)
Inelastic
(|E|< 1)
Elastic
(|E|> 1)
Table 6.4
TR decreases as
Q increases
(P decreases)
TR is maximized
TR increases as
Q increases
(P decreases)
6-22
Marginal Revenue & Price Elasticity
For all demand & marginal revenue
curves, the relation between marginal
revenue, price, & elasticity can be
expressed as
1
1 MR P
E
| |
= +
|
\ .
6-23
Income Elasticity
Income elasticity (E
M
) measures the
responsiveness of quantity demanded
to changes in income, holding the price
of the good & all other demand
determinants constant
Positive for a normal good
Negative for an inferior good
d d
M
d
% Q Q
M
E
% M M Q
A A
= =
A A
6-24
Cross-Price Elasticity
Cross-price elasticity (E
XY
) measures the
responsiveness of quantity demanded of
good X to changes in the price of related
good Y, holding the price of good X & all
other demand determinants for good X
constant
Positive when the two goods are substitutes
Negative when the two goods are complements
X X Y
XY
Y Y X
% Q Q P
E
% P P Q
A A
= =
A A
6-25
Interval Elasticity Measures
To calculate interval measures of
income & cross-price elasticities, the
following formulas can be employed
M
Q M
E
M Q
A
=
A
Average
Average
R
XR
R
P
Q
E
P Q
A
=
A
Average
Average
6-26
Point Elasticity Measures
-
X X Y
Q a bP cM dP , = + + +
For the linear demand function
point
measures of income & cross-price
elasticities can be calculated as
M
M
E c
Q
=
R
XR
P
E d
Q
=

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