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Demand Elasticities

Chapter 3

Why Should Managers Study


Elasticity?
Own-price

elasticity helps managers


understand the impact that price changes will
have on their revenue.
Income elasticity can help managers
understand what income groups to target their
product to.
Cross-price elasticity can help managers
understand who their closest competitors are.
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Demand Elasticity
Demand

elasticity is the responsiveness of


quantity demanded to changes in the factors
that influence demand, product price, income,
or prices of related products.

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Own Price Elasticity of Demand


Measured

as the
percentage change
in quantity
demanded of a given
good, relative to a
percentage change
in its price, all else
constant.

ep = %Qx %Px

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Own Price Elasticity of Demand


Graphical Representation
P

P1
%P

P2
%Q
Q1

Q2

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Examples of Own-Price Elasticity


Cereal:

-0.55
Fish: -0.29
Neumans Own Pasta Sauce: -2.32
Orange juice: -1.39

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Own Price Elasticity and Total


Revenue
Value of
price
elasticity
coefficient

|ep| > 1

Elasticity
definition

Elastic
demand

Relationship
among
variables

%Qd >
%Px

|ep| < 1

Inelastic
demand

%Qd <
%Px

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or 2010 Pearson Education, Inc.

Impact on revenue

Price increase results in


lower total revenue.
Price decrease results in
higher total revenue.
Price increase results in
higher total revenue.
Price decrease results in
lower total revenue.
Price increase or decrease

Graphical Representation of Relationship


Between Price Elasticity and Total Revenue
If demand is elastic,a decrease
in price results in an increase
in total revenue, and an increase
in price results in a decrease in
total revenue.

P1
P2

If demand is inelastic,a decrease


In price results in a decrease in
total revenue, and an increase
in price results in a increase in
total revenue.

A
Y

P1

P2

A
Y

B
X

Q1

Q2

Q
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Publishing as Prentice Hall

Q1 Q2

Determinants of Own Price


Elasticity
The

number of
substitute goods.
The percent of a
consumers income
that is spent on the
product.
The time period
under consideration.
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Demand is generally more


inelastic:
The fewer the number of
substitutes or perceived
substitutes available.
The smaller the percent of
the consumers income that
is spent on the product.
The shorter the time period
under consideration.

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Perfectly Elastic and Inelastic


Demand

10

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Income Elasticity of Demand


The

percentage
change in the quantity
demanded of a given
good, X, relative to a
percentage change in
consumer income,
assuming all other
factors constant.

11

ei

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= %Qx %I

Normal Good
Good

X is a normal
good if the demand
for good X moves in
the same direction as
a change in income.

Cream

Apples

ei = 1.32

Potatoes

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ei = 1.72

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ei = 0.15

Inferior Good
Good

X is an inferior
good if the demand
for good X moves in
the opposite direction
of a change in
income.

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Chicken

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ei = -0.106

Cross-Price Elasticity of Demand


The

percentage
change in the quantity
demanded of a given
good, X, relative to a
percentage change in
the price of good Y,
assuming all other
factors constant.

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exy

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= %Qx %Py

Substitutes
Two

goods with a
positive cross-price
elasticity of demand
coefficient are said to
be substitute goods.

Boiler

beef

exy = 0.20

Boiler

chickens and

pork

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chickens and

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exy = 0.28

Complements
If

two goods have a


negative cross-price
elasticity of demand
coefficient, they are
called
complementary
goods.

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Bread

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and eggs

exy = -0.03

Demand Elasticities

Appendix 3A

Consumer Tastes and Preferences


Preference

orderings are complete.


More of the goods are preferred to less of the
goods.
Consumers are selfish.
The goods are continuously divisible so that
consumers can always purchase one more or
one less unit of the goods.
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Indifference Curves
A consumers

indifference curve that


shows alternative
combinations of the
two goods that
provide the same
level of satisfaction or
utility.
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Y1
Y
Y2

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U1

X
X1

X2

U2

Marginal Rate of Substitution


The

ratio Y/X, which shows the rate at which


the consumer is willing to trade off one good
for another and still maintain a constant utility
level, is called the marginal rate of substitution
(MRSxy).

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The Budget Constraint

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The consumers
budget constraint
shows all the
combinations of two
goods that can be
purchased with a given
income and given the
prevailing prices of the
two goods.
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Shifts in the Budget Constraint

Y1

B2
B1

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Increase in income

Increase in price of good X

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Consumer Choice

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The consumer
maximizes utility by
choosing a
combination of good X
and Y, lying on the
budget constraint and
simultaneously lying on
the indifference curve
furthest from the origin.
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Changes in Consumer Choice

Increase in income

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Increase in price

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