price elasticity of demand overheads. how much would your roommate pay to watch a live fight? how...
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Price Elasticity of Demand
Overheads
How much would your roommate payto watch a live fight?
How does Showtime decide howmuch to charge for a live fight?
What about Hank and Son’s Concrete?
How much should they charge per square foot?
Can ISU raise parking revenue by raising parking fees?
Or will the increase in price drive demanddown so far that revenue falls?
All of these pricing issues revolve around the issue of how responsive the quantity demanded is to price.
Elasticity is a measure of how responsiveone variable is to changes in another variable?
The Law of Demand
The law of demand states that whenthe price of a good rises,and everything else remains the same, the quantity of the good demanded will fall.
The real issue is how far it will fall.
Q D h(P, ZD)
The demand function is given by
QD = quantity demanded
P = price of the good
ZD = other factors that affect demand
The inverse demand function is given by
P h 1(Q D , ZD)
P g(Q D , ZD )
To obtain the inverse demand function wejust solve the demand function for Pas a function of Q
Examples
QD = 20 - 2P
2P + QD = 20
2P = 20 - QD
P = 10 - 1/2 QD
Slope = - 1/2
Examples
QD = 60 - 3P
3P + QD = 60
3P = 60 - QD
P = 20 - 1/3 QD
Slope = - 1/3
The slope of a demand curve is given by thechange in Q divided by the change in P
One measure of responsiveness is slope
Q D h(P, ZD)
slope ΔQ D
ΔP
For demand
The slope of an inverse demand curve is given bythe change in P divided by the change in Q
P g(Q D, ZD)
slope ΔP
ΔQ D
For inverse demand
QD = 60 - 3P
Examples
Slope = - 1/3
Slope = - 3
P = 20 - 1/3 QD
QD = 20 - 2P
Examples
Slope = - 1/2
Slope = - 2
P = 10 - 1/2 QD
We can also find slope from tabular data
Q P0 102 94 86 78 610 5
Q P
slope ΔQ D
ΔP 2
1 2
Q P0 101 9.52 93 8.54 85 7.56 77 6.58 69 5.510 511 4.512 413 3.514 315 2.516 217 1.518 119 0.520 0
Demand for Handballs
Q P0 101 9.52 93 8.54 85 7.56 77 6.58 69 5.510 511 4.512 413 3.514 315 2.516 217 1.518 119 0.520 0
Demand for Handballs
0
1
2
3
4
5
6
7
8
9
10
11
0 2 4 6 8 10 12 14 16 18 20 22
Quantity
Pri
ce
P
Q P0 101 9.52 93 8.54 85 7.56 77 6.58 69 5.510 511 4.512 413 3.514 315 2.516 217 1.518 119 0.520 0
Demand for Handballs
0
1
2
3
4
5
6
7
8
9
10
11
0 2 4 6 8 10 12 14 16 18 20 22
Quantity
Pri
ce
Q P
Q = 2 - 4 = -2Q = 2 - 4 = -2
P = 9 - 8 = 1P = 9 - 8 = 1
slope ΔP
ΔQ D 1
2
Problems with slope as a measure of responsiveness
Slope depends on the units of measurement
The same slope can be associated withThe same slope can be associated withvery different percentage changesvery different percentage changes
Examples
QD = 200 - 2P
2P + QD = 200
2P = 200 - QD
P = 100 - 1/2 QD
slope ΔP
ΔQ D 1
2
Q P0 1001 99.52 993 98.54 985 97.56 977 96.58 969 95.510 9511 94.512 9413 93.514 93
Consider data on racquets
Let P change from 95 to 96
P = 96 - 95 = 1
Q = 8 - 10 = -2
Q P
A $1.00 price change when P = $95.00 is tiny
Graphically for racquetsDemand for Racquets
88
90
92
94
96
98
100
102
0 2 4 6 8 10 12 14 16 18
Quantity
Pri
ce
Large % change in Q
Small % change in P
Slope = - 1/2
Graphically for hand balls
Large % change in Q Large % change in P
Slope = - 1/2
Demand for Handballs
0
1
2
3
4
5
6
7
8
9
10
11
0 2 4 6 8 10 12 14 16 18 20 22
Quantity
Pri
ceP
P = 7 - 6 = 1
Q = 6 - 8 = -2
So slope is not such a good measureof responsiveness
Instead of slope we use percentage changes
The ratio of the percentage change in one variableto the percentage change in another variableis called elasticityelasticity
εD %ΔQ D
%ΔP
ΔQ D
Q D
ΔPP
The Own Price Elasticity of DemandOwn Price Elasticity of Demandis given by
There are a number of ways to computepercentage changes
InitialInitial point method for computing
The Own Price Elasticity of DemandOwn Price Elasticity of Demand
εD %ΔQ D
%ΔP
ΔQ D
Q D
ΔPP
Price Elasticity of Demand (Initial Point Method) P Q
6 85.5 95 104.5 114 12
εD
(8 10)8
(6 5)6
(8 10)8
6(6 5)
QP
28
61
128
1.5
FinalFinal point method for computing
The Own Price Elasticity of DemandOwn Price Elasticity of Demand
Price Elasticity of Demand (Final Point Method) P Q
6 85.5 95 104.5 114 12
εD
(8 10)10
(6 5)5
(8 10)10
5(6 5)
QP
210
51
1010
1.0
εD %ΔQ D
%ΔP
ΔQ D
Q D
ΔPP
The answer is very differentThe answer is very differentdepending on the choice of the depending on the choice of the base pointbase point
So we usually useSo we usually use
The midpointThe midpoint method for computing
The Own Price Elasticity of DemandOwn Price Elasticity of Demand
ΔQ D Q1 Q0 or Q0 Q1
Elasticity of Demand Using the Mid-Point
εD %ΔQ D
%ΔP
ΔQ D
Q D
ΔPP
Q D 12
(Q1 Q0)
For QD we use the midpoint of the Q’s
Similarly for pricesSimilarly for prices
ΔP P1 P0 or P0 P1
P 12
(P1 P0)
For P we use the midpoint of the P’s
ε
(Q1 Q0 )
12
(Q1 Q0)
(P1 P0 )
12
(P1 P0)
(Q1 Q0 )
(Q1 Q0)
(P1 P0)
(P1 P0)
εD %ΔQ D
%ΔP
ΔQ D
Q D
ΔPP
Price Elasticity of Demand (Mid-Point Method) Q P
8 69 5.510 511 4.512 4
(Q1 Q0)
(P1 P0)
(P1 P0)
(Q1 Q0)
(Q1 Q0)
(Q1 Q0)
(P1 P0)
(P1 P0)
εD %ΔQ D
%ΔP
ΔQ D
Q D
ΔPP
(8 10)(6 5)
(6 5)(8 10)
( 2)(1)
(11)(18)
2218
119
Classification of the elasticity of demand
Inelastic demand
When the numerical value of the elasticity of demand is between 0 and -1.0, we say that demand is inelasticinelastic.
%ΔQ D
%ΔP< 1
%ΔQ D < %ΔP
Classification of the elasticity of demand
Elastic demand
When the numerical value of the elasticity of demand
is less than -1.0, we say that demand is elasticelastic.
%ΔQ D
%ΔP> 1
%ΔQ D > %ΔP
Classification of the elasticity of demand
Unitary elastic demand
When the numerical value of the elasticity of demand is equal to -1.0, we say that demand is unitary elasticunitary elastic.
%ΔQ D
%ΔP 1
%ΔQ D %ΔP
Classification of the elasticity of demand
Perfectly elastic - D = -
Perfectly inelastic - D = 0
horizontalhorizontal
verticalvertical
Elasticity of demand with linear demand
Consider a linear inverse demand function
P A BQ D
P 12 0.5Q D
The slope is (-B) for all values of P and Q
For example,
The slope is -0.5 = - 1/2
P Q12 011.5 111 210.5 310 49.5 59 68.5 78 87.5 97 106.5 116 125.5 135 144.5 154 163.5 173 18
Demand for Diskettes
0123456789
10111213
0 2 4 6 8 10 12 14 16 18 20 22
Quantity
Pri
ce
ΔQ D
ΔP 2.0
P Q
P Q
ΔQΔP
(P1 P0)
(Q1 Q0)
εD %ΔQ D
%ΔP
ΔQ D
Q D
ΔPP
(8 10)(8 7)
(8 7)(8 10)
( 2)(1)
(15)(18)
3018
53
The slope is constant but the elasticity of demand will vary
P Q12 011.5 111 210.5 310 49.5 59 68.5 78 87.5 97 106.5 116 125.5 135 144.5 154 163.5 173 18
P Q
εD %ΔQ D
%ΔP
ΔQ D
Q D
ΔPP
(14 16)(5 4)
(5 4)(14 16)
( 2)(1)
(9)(30)
1830
35
The slope is constant but the elasticity of demand will vary
P Q12 011.5 111 210.5 310 49.5 59 68.5 78 87.5 97 106.5 116 125.5 135 144.5 154 163.5 173 18
P Q
ΔQΔP
(P1 P0)
(Q1 Q0)
The slope is constant but the elasticity of demand will vary
A linear demand curve becomes more inelasticas we lower price and increase quantity
εD %ΔQ D
%ΔP ΔQ
ΔP
(P1 P0)
(Q1 Q0)
P smaller
Q larger
The elasticity gets closer to zero
Q P Elasticity Expenditure0 12 02 11 -23.0000 224 10 -7.0000 406 9 -3.8000 548 8 -2.4286 6410 7 -1.6667 7012 6 -1.1818 7214 5 -0.8462 7016 4 -0.6000 6418 3 -0.4118 5420 2 -0.2632 4022 1 -0.1429 2224 0 -0.0435 0
The slope is constant but the elasticity of demand will vary
Q P Elasticity Expenditure0 12 02 11 -23.0000 224 10 -7.0000 406 9 -3.8000 548 8 -2.4286 6410 7 -1.6667 7012 6 -1.1818 7214 5 -0.8462 7016 4 -0.6000 6418 3 -0.4118 5420 2 -0.2632 4022 1 -0.1429 2224 0 -0.0435 0
The slope is constant but the elasticity of demand will vary
NoteNoteWe do not say that demand is We do not say that demand is elasticelasticor or inelasticinelastic ….. …..
We say that demand is elastic or We say that demand is elastic or inelastic inelastic at a given pointat a given point
εD %ΔQ D
%ΔP
ΔQ D
Q D
ΔPP
ΔQΔP
(P1 P0)
(Q1 Q0)
ExampleExample
Constant with linear demandConstant with linear demand
The Own Price Elasticity of DemandOwn Price Elasticity of Demandand Total Expenditure on an ItemTotal Expenditure on an Item
How do changes in an items price affectHow do changes in an items price affectexpenditure on the item?expenditure on the item?
If I lower the price of a product, will the increasedIf I lower the price of a product, will the increasedsales make up for the lower price per unit?sales make up for the lower price per unit?
Expenditure for the consumerExpenditure for the consumeris equal to revenue for the firmis equal to revenue for the firm
Revenue = R = price x quantity = PQRevenue = R = price x quantity = PQ
Expenditure = E = price x quantity = PQExpenditure = E = price x quantity = PQ
P = change in price
Modeling changes in price and quantity
Q = change in quantity
The Law of Demand says that
as P increases Q will decrease
P P Q Q
P = initial price
P = change in price
So
P + P = final price
Q = initial quantity
Q = change in quantity
Q + Q = final quantity
Initial Revenue = PQ
So
P + P = final price
= P Q + P Q + P Q + P Q
Q + Q = final quantity
Final Revenue = (P + P) (Q + Q)
Now find the change in revenue
R = final revenue - initial revenue
= P Q + P Q + P Q + P Q - P Q
= P Q + P Q + P Q
%R = R / R = R / P Q
ΔRPQ
ΔP Q P ΔQ ΔP ΔQPQ
ΔRPQ
ΔP QPQ
P ΔQPQ
ΔP ΔQPQ
We can rewrite this expression as follows
%ΔR ΔPP
ΔQQ
ΔP ΔQPQ
%ΔR %ΔP %ΔQ
Classification of the elasticity of demandInelastic demand
%ΔQ D
%ΔP< 1 %ΔQ D < %ΔP
%ΔR %ΔP %ΔQ
% Q and % P are of opposite sign so%R has the same sign as %P
+ -
Classification of the elasticity of demandInelastic demand
%ΔQ D
%ΔP< 1 %ΔQ D < %ΔP
%ΔR %ΔP %ΔQ
% Q and % P are of opposite sign so%R has the same sign as %P
- +
Lower price lower revenue
Higher price higher revenue
Classification of the elasticity of demandElastic demand
%ΔQ D
%ΔP> 1 %ΔQ D > %ΔP
%ΔR %ΔP %ΔQ
% Q and % P are of opposite sign so%R has the opposite sign as %P
Higher price lower revenue
Lower price higher revenue
+ -
Classification of the elasticity of demandUnitary elastic demand
%ΔQ D
%ΔP 1 %ΔQ D %ΔP
%ΔR %ΔP %ΔQ
% Q and % P are of opposite sign so theireffects will cancel out and %R = 0.
+ -
Q P Elasticity Revenue0 12 02 11 -23.0000 224 10 -7.0000 406 9 -3.8000 548 8 -2.4286 6410 7 -1.6667 7012 6 -1.1818 7214 5 -0.8462 7016 4 -0.6000 6418 3 -0.4118 5420 2 -0.2632 4022 1 -0.1429 2224 0 -0.0435 0
Tabular data Elastic
Revenue risesInelastic
Revenue falls
Price falls
Price falls
0 12 0 2 11 -23.0000 22 4 10 -7.0000 40 6 9 -3.8000 54 8 8 -2.4286 6410 7 -1.6667 7012 6 -1.1818 7214 5 -0.8462 7016 4 -0.6000 6418 3 -0.4118 5420 2 -0.2632 4022 1 -0.1429 2224 0 -0.0435 0
Graphical analysisQ P Elasticity RevenueDemand for Diskettes
0123456789
10111213
0 2 4 6 8 10 12 14 16 18 20 22
Quantity
Pri
ce
Demand
A
B
CC
P0, Q0
P1, Q1
Lose B, gain A, revenue rises
0 12 0 2 11 -23.0000 22 4 10 -7.0000 40 6 9 -3.8000 54 8 8 -2.4286 6410 7 -1.6667 7012 6 -1.1818 7214 5 -0.8462 7016 4 -0.6000 6418 3 -0.4118 5420 2 -0.2632 4022 1 -0.1429 2224 0 -0.0435 0
Graphical analysisQ P Elasticity RevenueDemand for Diskettes
0123456789
10111213
0 2 4 6 8 10 12 14 16 18 20 22
Quantity
Pri
ce
Demand
P1, Q1
Lose A, gain B, revenue falls
P0, Q0
AAB
Factors affecting the elasticity of demand
Availability of substitutes
Importance of item in the buyer’s budget
Availability of substitutes
The easier it is to substitute for a good,
the more elastic the demand
With many substitutes, individuals willmove away from a good whose price increases
Examples of goods with “easy “substitution
Gasoline at different stores
Soft drinks
Detergent
Airline tickets
Local telephone service
Narrow definition of product
The more narrowly we define an item,
the more elastic the demand
With a narrow definition, there will lots ofsubstitutes
Examples of narrowly defined goods
Lemon-lime drinks
Corn at a specific farmer’s market
Vanilla ice cream
Food
Transportation
“Necessities” tend to have inelastic demand
Necessities tend to have few substitutes
Examples of necessities
Salt
Insulin
Food
Trips to Hawaii
Sailboats
Demand is more elastic in the long-run
There is more time to adjust in the long run
Examples of short and long run elasticity
Postal rates
Gasoline
Sweeteners
Factors affecting the elasticity of demand
Importance of item in the buyer’s budget
The more of their total budget consumersspend on an item,
the more elastic the demand for the good
The elasticity is larger because the item hasThe elasticity is larger because the item hasa large budget impacta large budget impact
“Big ticket” items and elasticity
Housing
Big summer vacations
Table salt
College tuition
The End