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A scenario
You design websites for local businesses.
You charge $200 per website, and currently
sell 12 websites per month.
Your costs are rising (including the opp.
cost of your time), so youre thinking of
raising the price to $250.
The law of demand says that you wont sell
as many websites if you raise your price.
How many fewer websites? How much will
your revenue fall, or might it increase?
Elasticity
Definition:
Elasticity is a numerical measure of the
responsiveness of Qd or Qs to one of its
determinants.
Elastic and Inelastic demand and supply.
Percentage change in Qd
=
Percentage change in P
Example:
Price
elasticity
of demand
equals
15%
= 1.5
10%
Percentage change in Qd
=
Percentage change in P
P
P rises
P2
by 10%
P1
D
Q2
Q falls
by 15%
What does elasticity = 1.5 mean?
Q1
Calculate
Price
Elasticity of
Demand
$250
$200
D
8
12
Problem:
From A to B,
P rises 25%, Q falls 33%,
elasticity = 33/25 = -1.33
$250
$200
D
8
12
From B to A,
P falls 20%, Q rises 50%,
elasticity = 50/20 = - 2.50
$250 $200
x 100% = 22.2%
$225
ACTIVE LEARNING
1:
Calculate an elasticity
Use the following
information to
calculate the
price elasticity
of demand
for hotel rooms using
midpoint method:
if P = $70, Qd = 5000
if P = $90, Qd = 3000
10
ACTIVE LEARNING
1:
Answers
Arc Elasticity:
DQ
%DQ Q
DQ p
e
%Dp Dp Dp Q
p
where D indicates change.
Important Note:
Along a D curve, P
and Q move in
opposite directions,
which would make
price elasticity
negative most of the
cases. (E <0)
Example
If a 1% increase in price results in a 3% decrease in
quantity demanded, the elasticity of demand is e = 3%/1% = -3.
Numerical example
Consider a competitive market for which the
quantities demanded and supplied (per
year) at various prices are given as follows:
Price($) Demand (millions) Supply
(millions)
60
22
14
80
20
16
100
18
18
120
16
20
Calculate the price elasticity of demand when
the price is $80. When the price is $100.
.
DP
Q D DP
P
From the above question, with each price increase of $20, the quantity
demanded decreases by 2. Therefore,
DQD 2 0.1.
DP 20
At P = 80, quantity demanded equals 20 and
80
ED
0.1 0.40.
20
Similarly, at P = 100, quantity demanded equals 18 and
100
ED
0.1 0.56.
18
Dp
So, replace by dQ /dP in the Arc elasticity formula,
So the elasticity of demand is:
DQ p
p
e
(dQ / dP)
Dp Q
Q
p
3.30
e (dQ / dP) 20
0.3
Q
220
Numerical Problems
Consider a market with Demand curve q = 16 10p and Supply curve
q = 8 + 20p. (Here q is in millions of kgs and p is in dollars/kg)
(a) Determine the market equilibrium price and quantity and the total
revenue in this market.
(b) Calculate the price elasticity of demand and the price elasticity of
supply at the market equilibrium.
Answer (a):
P = $0.8/kg
Answer (b):
PED = -1
PES = 2
q = 8 million kgs.
TR = $6.4 millions
EXAMPLE 2:
EXAMPLE 3:
EXAMPLE 4:
Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the
elasticity.
D curve:
vertical
P1
Consumers
price sensitivity:
0
Elasticity:
0
=0
P2
P falls
by 10%
Q1
Q changes
by 0%
Inelastic demand
% change in Q < 10%
Price elasticity
=
=
of demand
% change in P 10%
P
D curve:
relatively steep
P1
Consumers
price sensitivity:
relatively low
Elasticity:
<1
<1
P2
D
P falls
by 10%
Q1 Q2
Q rises less
than 10%
D curve:
intermediate slope
P1
Consumers
price sensitivity:
intermediate
Elasticity:
1
=1
P2
P falls
by 10%
D
Q1
Q2
Q rises by 10%
Elastic demand
% change in Q > 10%
Price elasticity
=
=
of demand
10%
% change in P
P
D curve:
relatively flat
P1
Consumers
price sensitivity:
relatively high
Elasticity:
>1
>1
P2
P falls
by 10%
Q1
Q2
Q rises more
than 10%
D curve:
horizontal
Consumers
price sensitivity:
extreme
Elasticity:
infinity
= infinity
P2 = P1
P changes
by 0%
Q1
Q2
Q changes
by any %
200%
E =
= 5.0
40%
$30
67%
E =
= 1.0
67%
20
40%
E =
= 0.2
200%
10
$0
20
40
60
The slope
of a linear
demand
curve is
constant,
but its
elasticity
is not.
Percentage change in Q
Percentage change in P
Revenue = P x Q
increased
revenue due
to higher P
$250
Demand for
your websites
lost
revenue
due to
lower Q
$200
When D is elastic,
a price increase
causes revenue to fall.
12
Percentage change in Q
Percentage change in P
If P = $250,
Q = 10 and
revenue = $2500.
$250
increased
Demand for
revenue
due
your websites
lost
to higher P
revenue
due to
lower Q
$200
When D is inelastic,
a price increase
causes revenue to rise.
10
12
ACTIVE LEARNING
2:
Answers
A.
36
ACTIVE LEARNING
2:
Answers
B. As a result of a fare war, the price of a luxury
Income elasticity
=
of demand
Percent change in income
Arc Elasticity:
DQ
%DQ Q
DQ Y
x
%DY DY DY Q
Y
where Y stands for income.
Example
If a 1% increase in income results in a 3% decrease in
quantity demanded, the income elasticity of demand is x
= -3%/1% = -3.
Numerical Example
a) Suppose the demand for an automobile as a function
of income per capita is given by:
Q = 50,000 + 5I
What is the income elasticity of demand when per capita
income increases from $10,000 to $11,000? (Using midpoint
method)
Numerical Example
a) Suppose the demand for an automobile as a function
of income per capita is given by:
Q = 50,000 + 5I
What is the income elasticity of demand when per capita
income increases from $10,000 to $11,000? (Using midpoint
method)
Solution:
When I1 = 10,000 Q1 = 100,000
When I2 = 11,000, Q2 = 105,000
Percentage Change in Q = 4.88
Percentage Change in I = 9.52
Income Elasticity of Demand = 4.88 / 9.52 = 0.512
Numerical Example
b) Suppose the demand for an automobile as a function
of income per capita is given by:
Q = 50,000 + 5I
What is the income elasticity of demand at the income level
of $10,500?
Solution:
When I = 10,500;
Q = 102,500
dQ / dI = 5
E<0
: Luxuries
Cross-price elast.
=
of demand
% change in price of good 2
Arc Elasticity,
DQ
%DQ
DQ po
Q
Example
If a 1% increase in the price of a related good results in a
3% decrease in quantity demanded, the cross-price
elasticity of demand is = -3%/1% = -3.
Numerical Example
Demand for a publishers book is given as:
Qx = 12,000 5,000Px + 5I + 500Pc
Px = Price of the book = $5
I
= Income per capita = $10,000
Pc = Price of the books from competing
publishers = $6
Numerical Example
1) a) Find Price elasticity of demand for the book.
b) What effect a price increase would have on total
revenues?
Solution:
a) Substituting the values of I and Pc
Qx = 12,000 5,000Px + 5(10000) + 500(6)
Or, Qx = 65,000 5,000Px
When Px = $5 (given), Qx = 40,000
Now, dQx/dPx = - 5000
Therefore, E p = -5000 x (5 / 40000) = - 0.625
b) Since, the demand for the book is inelastic, an
increase in the price of the book would increase
total revenue.
Numerical Example
2) a) Find income elasticity of demand for the book.
b) Find if the book is inferior good, normal good or luxury.
Solution:
a) Substituting the values of Px and Pc
Qx = 12,000 5,000(5) + 5I + 500(6)
Or, Qx = - 10,000 + 5I
When I = $10000 (given), Qx = 40,000
Now, dQx/dI = b = 5
Therefore, E I = 5 x (10000 / 40000) = 1.25
b) Since, the E I > 1 for the book, the book is luxury.
Numerical Example
3) a) Assess the probable impact on demand for the book
if competing publishers raise their prices.
b) Are the books substitute for each other or
Solution:
complements
a) Substituting the values of Px and I
Qx = 12,000 5,000(5) + 5(10000) + 500Pc
Or, Qx = 37,000 + 500Pc
When Pc = $6 (given), Qx = 40,000
Now, dQx/dPc = b = 500
Therefore, Cross price elasticity of demand for the book
E c = 500 x (6 / 40000) = 0.075
1% increase in competitors book price will increase the
demand for the book by 0.075%
b) Since, the E C > 0 for the book, the book is substitute to
competing producers book.
Percentage change in Qs
=
Percentage change in P
Example:
Price
elasticity
of supply
equals
16%
= 2.0
8%
Percentage change in Qs
=
Percentage change in P
P
P rises
P2
by 8%
P1
Q1
Q rises
by 16%
Q2
S curve:
vertical
P2
Sellers
price sensitivity:
0
Elasticity:
0
=0
P1
P rises
by 10%
Q1
Q changes
by 0%
Inelastic
< 10%
% change in Q
Price elasticity
=
=
of supply
10%
% change in P
P
S curve:
relatively steep
S
P2
Sellers
price sensitivity:
relatively low
Elasticity:
<1
<1
P1
P rises
by 10%
Q1 Q2
Q rises less
than 10%
Unit elastic
% change in Q
Price elasticity
=
=
of supply
% change in P
=1
10%
S curve:
intermediate slope
S
P2
Sellers
price sensitivity:
intermediate
Elasticity:
=1
10%
P1
P rises
by 10%
Q1
Q2
Q rises
by 10%
Elastic
> 10%
% change in Q
Price elasticity
>1
=
=
of supply
10%
% change in P
P
S curve:
relatively flat
S
P2
Sellers
price sensitivity:
relatively high
Elasticity:
>1
P1
P rises
by 10%
Q1
Q2
Q rises more
than 10%
S curve:
horizontal
Sellers
price sensitivity:
extreme
Elasticity:
infinity
P2 = P1
P changes
by 0%
Q1
Q2
Q changes
by any %
3:
Elasticity and changes in equilibrium
ACTIVE LEARNING
60
ACTIVE LEARNING
3:
Answers
Beachfront
property (inelastic
supply):
When supply
is inelastic,
P
an increase in
D1 D2
demand has a
bigger impact
on price than P
2
on quantity.
P1
S
B
A
Q 1 Q2
Q
61
ACTIVE LEARNING
3:
Answers
When supply
is elastic,
an increase in
demand has a
bigger impact
on quantity
than on price.
New cars
(elastic supply):
P
D1 D2
S
P2
P1
B
A
Q1
Q2
Q
62
Supply often
becomes
less elastic
as Q rises,
due to
capacity
limits.
S
elasticity
<1
$15
12
elasticity
>1
4
$3
100 200
Q
500 525
Thank you