Ch4 Managerial Economics

Chapter 4
Demand
Elasticity
Chapter Four
Copyright 2009 Pearson Education, Inc.

Publishing as Prentice Hall.
Overview
The economic concept of
elasticity
The price elasticity of demand
The cross-elasticity of demand
Income elasticity
Other elasticity measures
Elasticity of supply
Chapter Four

Learning objectives
define and measure elasticity
apply concepts of price elasticity, crosselasticity, and income elasticity
understand determinants of elasticity
show how elasticity affects business
revenue
Chapter Four

The economic concept of elasticity
Elasticity: the percentage change in one

variable relative to a percentage change in
another.
Coefficien t of Elasticity
Chapter Four
percent change in A
percent change in B

Price elasticity of demand
Price elasticity of demand: the

percentage change in quantity demanded
caused by a 1 percent change in price
Ep
Chapter Four
% Quantity
% Price
Arc elasticity: elasticity which is

measured over a discrete interval of a
curve
Ep
Q2 Q1
(Q1 Q2 ) / 2
P2 P1
( P1 P2 ) / 2
Ep = coefficient of arc price elasticity

Q1 = original quantity demanded
Q2 = new quantity demanded
P1 = original price
P2 = new price
Chapter Four

Point elasticity: elasticity measured at a

given point of a demand (or a supply)
curve
dQ P1
P =
x
dP Q1
Chapter Four


The point elasticity of a linear demand
function can be expressed as:
Chapter Four
Q P1
P Q1

Elasticity varies
along a linear
demand curve
Chapter Four

Some demand curves have constant

elasticity
such a curve has a nonlinear equation:
Q = aP-b
where b is the elasticity coefficient
Chapter Four

10
Categories of elasticity
Relative elasticity of demand: Ep > 1
Relative inelasticity of demand: 0 < Ep
<1
Unitary elasticity of demand: Ep = 1
Perfect elasticity: Ep =
Perfect inelasticity: Ep = 0
Chapter Four

11
Factors affecting demand elasticity

ease of substitution
proportion of total expenditures
durability of product
possibility of postponing purchase
possibility of repair
used product market
length of time period
Chapter Four

12
Derived demand: the demand for

products or factors that are not directly
consumed, but go into the production of a
another (final) product
The demand for such a product or factor
exists because there is demand for the
final product
Chapter Four

13
The derived demand curve will be more

inelastic:
the more essential is the component
the more inelastic is the demand curve
for the final product
the smaller is the fraction of total cost
going to this component
the more inelastic is the supply curve of
cooperating factors
Chapter Four

14
A long-run demand
curve will generally be
more elastic than a
short-run curve
As the time period
lengthens consumers
find ways to adjust to
the price change, via
substitution or shifting
consumption
Chapter Four

15
The relationship between price and

revenue depends on elasticity
Why? By itself, a price fall will reduce
receipts BUT because the demand curve
is downward sloping, the drop in price will
also increase quantity demanded
Q: which effect will be stronger?

Chapter Four

16
As price decreases
revenue rises when
demand is elastic
revenue falls when
it is inelastic
revenue reaches it
peak if elasticity =1
the lower chart
shows the effect of
elasticity on total
revenue
Chapter Four

17
Marginal revenue: the change in total

revenue resulting from changing quantity
by one unit
MR
Chapter Four
Total Revenue
Quantity

18
marginal revenue
curve is twice as
steep as the
demand
curve
Chapter Four

19
at the point where

marginal revenue
crosses the X-axis,
the demand curve
is unitary elastic
and total revenue
reaches a
maximum
Chapter Four

20
Examples: some real world elasticities

coffee: short run -0.2, long run -0.33
kitchen and household appliances:
-0.63
meals at restaurants: -2.27
airline travel in U.S.: -1.98
beer: -0.84, Wine: -0.55
Chapter Four

21
Examples: some real world elasticities

white pan bread:-0.69
cigarettes: short run -0.4, long run -0.6
wine imports: -0.15
crude oil: -0.06
internet services: -0.6/-0.7
Chapter Four

22
Cross-elasticity of demand
Cross-elasticity of demand: the

percentage change in quantity consumed
of one product as a result of a 1 percent
change in the price of a related product
Ex
Chapter Four
% QA
% PB

23
Arc cross-elasticity
EX
Chapter Four
Q2 A Q1 A
P2 B P1B
(Q1 A Q2 A ) / 2 ( P1B P2 B ) / 2

24
Point cross-elasticity
EX
Chapter Four
QA
QA
PB
PB

25
The sign of cross-elasticity for substitutes

is positive
The sign of cross-elasticity for
complements is negative
Two products are considered good

substitutes or complements when the
coefficient is larger than 0.5 (in ab. value)
Chapter Four

26
Income elasticity
Income elasticity of demand: the

percentage change in quantity demanded
caused by a 1 percent change in income
EY
% Q
% Y
Y is shorthand for income

Chapter Four

27
Income elasticity
Arc income elasticity
EY
Chapter Four
Q2 Q1
Y2 Y1
(Q1 Q2 ) / 2 (Y1 Y2 ) / 2

28
Income elasticity
Categories of income
elasticity
superior goods:
EY > 1
normal goods: 0
EY 1
inferior goods:
EY < 0
Chapter Four

29
Other demand elasticities
Examples: elasticity is encountered every

time a change in some variable affects
demand
advertising expenditure
interest rates
population size
Chapter Four

30
Price elasticity of supply: the

percentage change in quantity supplied as
a result of a 1 percent change in price
ES
% Quantity Supplied
% Price
The coefficient of supply elasticity is a

normally a positive number
Chapter Four

31
Arc elasticity of supply
Es
Chapter Four
Q2 Q1
(Q1 Q2 ) / 2
P2 P1
( P1 P2 ) / 2

32
When the supply curve is more elastic, the

effect of a change in demand will be
greater on quantity than on the price of
the product
When the supply curve is less elastic, a
change in demand will have a greater
effect on price than on quantity
Chapter Four

33
Global application
Example: price elasticities in Asia

imports almost always price inelastic
if exports price inelastic, export
earnings will rise as prices rise
if exports price elastic, export earnings
will rise with world incomes
Chapter Four

34

Ch4 Managerial Economics

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Chapter 4

Copyright 2009 Pearson Education, Inc.

Copyright 2009 Pearson Education, Inc.

Copyright 2009 Pearson Education, Inc.

The economic concept of elasticity

Elasticity: the percentage change in one

Copyright 2009 Pearson Education, Inc.

Price elasticity of demand

Price elasticity of demand: the

Price elasticity of demand

Arc elasticity: elasticity which is

Ep = coefficient of arc price elasticity

Copyright 2009 Pearson Education, Inc.

Price elasticity of demand

Point elasticity: elasticity measured at a

Copyright 2009 Pearson Education, Inc.

Price elasticity of demand

Copyright 2009 Pearson Education, Inc.

Price elasticity of demand

Copyright 2009 Pearson Education, Inc.

Price elasticity of demand

Some demand curves have constant

where b is the elasticity coefficient

Copyright 2009 Pearson Education, Inc.

Price elasticity of demand

Copyright 2009 Pearson Education, Inc.

Price elasticity of demand

Factors affecting demand elasticity

Copyright 2009 Pearson Education, Inc.

Price elasticity of demand

Derived demand: the demand for

Copyright 2009 Pearson Education, Inc.

Price elasticity of demand

The derived demand curve will be more

Copyright 2009 Pearson Education, Inc.

Price elasticity of demand

Copyright 2009 Pearson Education, Inc.

Price elasticity of demand

The relationship between price and

Q: which effect will be stronger?

Copyright 2009 Pearson Education, Inc.

Price elasticity of demand

Copyright 2009 Pearson Education, Inc.

Price elasticity of demand

Marginal revenue: the change in total

Copyright 2009 Pearson Education, Inc.

Price elasticity of demand

Copyright 2009 Pearson Education, Inc.

Price elasticity of demand

at the point where

Copyright 2009 Pearson Education, Inc.

Price elasticity of demand

Examples: some real world elasticities

Copyright 2009 Pearson Education, Inc.

Price elasticity of demand

Examples: some real world elasticities

Copyright 2009 Pearson Education, Inc.

Cross-elasticity of demand: the

Copyright 2009 Pearson Education, Inc.

Copyright 2009 Pearson Education, Inc.

Copyright 2009 Pearson Education, Inc.

The sign of cross-elasticity for substitutes

Two products are considered good