Chapter 4

DEMAND ELASTICITY

The Concept of Elasticity

• In general, elasticity refers to percentage relationship between two variables.

• Coefficient of elasticity=percentage change in A / percentage change in B

• Price elasticity of Demand=percentage change in Q / percentage change in P

• Point elasticity=dQ/dP * P/Q

• Arc Elasticity = Q2 – Q1/(Q1+Q2)/2 divided by P2 – P1/(P1+P2)/2

• =(Q2-Q1)/(Q1+Q2)*(P1+P2)/(P2 – P1)

•

Categories of Elasticity

• A) Elastic: Ep>1 (in absolute terms)

• b) Inelastic? 0<Ep<1 “

• c) Unit elastic: Ep=1

• D) perfectly elastic: Ep=∞ (D curve is horizontal)

• E) perfectly inelastic: Ep=0 (D curve is vertical)

Determinants of Elasticity

• Ease of substitution

• Proportion of total expenditure

• Durability of product

• Length of time period

• Global competition (in recent years, opening of borders increased demand elasticities.

Demand Elasticity and Revenue

• The relationship between the price elasticity of demand and revenue is:

• Price increase TR↓ TR⌐ TR↑

• Price decrease TR↑ TR⌐ TR↓

• Draw figures here

Empirical elasticities

• Based on empirical research, the following results were obtained:– Coffee: -0.2 in short run; -0.33 long run– Appliences: -0.63– Meals at restaurant: -2.27– Computers: -1.44– Air travel: -1.2– First class travel:-0.4– Potatoes: -0.27– Butter: -0.62– Peaches: -1.49– Beer: -0.84– Wine: -0.55Explain this in practical terms

Cross elasticity of demand

• Deals with the impact of a change in the price of related good (substitutes or complements) on the quantity demanded of a particular product.

• Potato chips sold by a company are complement to soft drinks sold by the same company.

• Ex = % change in Qa / % change in Qb– Ex > 0 substitute– Ex < 0 complement

• As a rule of thumb in business, two products are considered good substitutes or complements when Ex > 0.5

Income elasticity• Ey shows the % change in quantity demanded resulting from a 1%

change in income.• Empirical studies revealed the following results:

– Meals at restaurant: 1.6– Air travel: 1.9– Butter: 0.37– Beer: 0.4– Food: 0.5– Eggs: 0.57

• 3 categories:– Ey > 1 superior good– Ey > 0 and < 1 normal good– Ey < 0 inferior good (potatoes and beans)

• Income elasticity concept should also be taken into consideration to or new investment projects. The manager should prefer investment for superior goods in a growing economy.

Other elasticities

• Advertising elasticity is used by marketing consultants and managers. How an increase in advertising expenses would affect his total sales?