ECON Notes

This unit looks at: The analysis of market demand (factors determining market demand and price elasticity). The examination of individual demand: a) The theory of the consumer b) Indifference curve analysis c) Budget constraint d) Consumer Choice
The difference between individual and market demand.
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Factors Determining Market Demand

The quantity demanded of a good is impacted by changes in the price of that good.
The factors which influence market demand are: (1) The prices of substitutes and complements. (2) Income (3) Preferences and Tastes

Factors Determining Market Demand (Contd)

(4) Population (5) Expectations regarding the price level. (6) Government policy- e.g. taxation on imports. (7) Seasonal factors- some goods are consumed more at a particular point in time e.g. hams at Christmas time.

Price Elasticity of Demand

Price elasticity of demand is the responsiveness of the quantity demanded of a good in response to a change in the price of that good.

Price Elasticity of Demand (Contd)

Factors Determining the Price Elasticity of Demand (1) The availability of close substitutes and complements: The more substitutes that a good has, then the more elastic will be its demand. The more complements a good has, then the more inelastic its demand will be. (2) Necessities vs. Luxuries: Necessities tend to be more price inelastic i.e. consumers are relatively unresponsive to changes in the goods prices, since they are inexpensive. However, 5 luxuries tend to be price elastic.

Price Elasticity of Demand (Contd)

Factors Determining the Price Elasticity of Demand (3) The definition of the market: The more narrowly defined market (e.g. the ice cream market) has a more elastic demand because of the focus on one good. The more broadly defined market is more inelastic (e.g. the market for food).

(4) Time horizon: The longer the time horizon, then the demand will be more elastic.
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Price Elasticity of Demand (Contd)

(4) Time horizon (contd): The demand is more elastic in the long run due to three reasons: (a) Persons are creatures of habit and so it takes time to change consumption patterns. (b) It takes time to adjust to price changes. ( c) The longer the time horizon, then the more likely it is that more substitutes will emerge. If the number of substitutes is large, then the demand for the good will be more elastic.
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Price Elasticity of Demand (Contd)

(5) The cost of the good relative to buyers income ( or the budget share of the good): If the price of the good represents a small portion of income, then its demand will be price inelastic. If the good has a large budget share, then its demand will be price elastic.

Price Elasticity of Demand (Contd)

Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price.
We can represent price elasticity of demand by the Greek symbol epsilon

Price Elasticity of Demand (Contd)

You should remember that there is an inverse relationship between the quantity demanded of a good and its price. This inverse relationship means that as the price of a good increases, then the quantity demanded of that good decreases and vice versa. Therefore, the calculated price elasticity is usually negative. Since this is the case, then we can express the price elasticity in absolute value. When we express a number in absolute value then it means that we can ignore the actual sign on the number.
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Price Elasticity of Demand (Contd)

There are three types of price elasticity of demand: (1) Elastic Demand (2) Inelastic Demand (3) Unit Elastic Demand

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Price Elasticity of Demand (Contd)

Elastic Demand
We say that demand is price elastic when the calculated value of the elasticity is greater than 1 (in absolute value).

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Price Elasticity of Demand (Contd)

Elastic Demand
In the case of elastic demand, then we find that the quantity demanded of a good responds more than proportionately to a change in its price. For elastic demand, the change in quantity demanded is greater than the change in price. For example, if price increases by 10%, then the quantity demanded falls by 15%.
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Price Elasticity of Demand (Contd)

Inelastic Demand
We say that demand is price inelastic when the calculated value of the elasticity is less than 1 (in absolute value).

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Price Elasticity of Demand (Contd)

Inelastic Demand In the case of inelastic demand, then the quantity demanded of a good responds less than proportionately to a change in the price of that good. For inelastic demand, the change in price is greater than the change in quantity demanded. For example, if the price of a good increases by 10%, then the quantity demanded falls by 5%.
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Price Elasticity of Demand (Contd)

Unit Elastic Demand

The demand is unit elastic when the calculated value of the elasticity is equal to 1 (in absolute value).

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Price Elasticity of Demand (Contd)

Unit Elastic Demand In the case of unit elastic demand, then the quantity demanded of a good responds in proportion to the change in the price of that good. For unit elastic demand, the change in quantity demanded is equal to the change in price.

For example, if the price of a good increases by 10%, then the quantity demanded falls by 10% as well.
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Price Elasticity of Demand (Contd)

A straight line demand curve has different elasticities along its length.

Price ($)

PED >1 Demand Curve PED = 1

PED < 1 Quantity Demanded

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Price Elasticity of Demand (Contd)

At the mid point of the straight line demand curve, the price elasticity of demand (PED) is equal to 1 (unit elastic demand). Above the mid point, the PED is greater than 1 (price elastic). Below the mid point, the PED is less than 1 (price inelastic). NOTE: In this case we are thinking of the PED in absolute value terms.

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Price Elasticity of Demand (Contd)

There are two exceptions to the general rule that elasticity decreases along the straight line demand curve. These exceptions are: (1) Perfectly Elastic Demand

(2) Perfectly Inelastic Demand

We will consider these cases next.
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Price Elasticity of Demand (Contd)

Perfectly Elastic Demand

Price ($)

Demand Curve

Quantity Demanded
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Price Elasticity of Demand (Contd)

Perfectly Inelastic Demand

0
Price ($) Demand Curve

Quantity Demanded
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Price Elasticity of Demand (Contd)

Unit Elastic Demand

1
Price ($)

Demand Curve 0 Quantity Demanded

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Price Elasticity of Demand (Contd)

Calculating Price Elasticity of Demand

There are two methods: (A) Point Elasticity (B) Mid-point Elasticity

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Price Elasticity of Demand (Contd)

(A) Point Elasticity
QD

QD P

This translates in to:

PED = New QD Old QD/ Old QD New P Old P / Old P QD- Quantity Demanded P- Price

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Price Elasticity of Demand (Contd)

Suppose that at first 50 units are sold at a price of $120. The price then falls to $100 and quantity demanded increases to 70 units. What is price elasticity of demand? PED = 70 units 50 units / 50 units = 20 / 50 $100- $120/ $120 - 20 / 120

PED = 0.4 / -0.16 = - 2.5

So we can see that the PED is -2.5 (elastic demand).
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Price Elasticity of Demand (Contd)

(B) Mid point Formula Instead of dividing by the original quantity demanded and price, we use the average of the new and old prices and quantities demanded. PED = New QD Old QD/ [ (New QD + Old QD)/ 2] New P Old P / [ (New P + Old P)/ 2 ] QD- Quantity Demanded P- Price
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Price Elasticity of Demand (Contd)

Now using the mid point formula for the same example Old P = $120 Old QD = 50 units New P = $100 New QD = 70 units

Using the mid point formula: PED = 70 units 50 units/ [ (70 units + 50 units)/ 2 ] $100 $120 / [ ($100 + $120)/ 2 ]
PED = 70 units 50 units / 60 units = 20 / 60 = -1.83 $100- $120/ $110 - 20 / 110
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Price Elasticity of Demand (Contd)

Using the point elasticity formula we get an elasticity of -2.5.

However, when we use the mid point formula, then we get an elasticity of -1.83 (which is still elastic).
So both formulas yield different answers. **NOTE WELL: (1) ALWAYS USE THE POINT ELASTICITY METHOD TO CALCULATE THE ELASTICITY (UNLESS YOU ARE TOLD OTHERWISE). (2) ONLY USE THE MID POINT METHOD WHEN YOU ARE EXPRESSLY TOLD TO DO SO!
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Price Elasticity of Demand and Total Expenditure

There is a relationship between the price elasticity of demand and the total expenditure of the consumer on the good. Total Expenditure (TE) = Total Revenue (TR) This is true because what the consumers spend (Total Expenditure) is equal to what the sellers receive (Total Revenue). TE = TR = P x Q The Total Expenditure / Total Revenue is dependent on the price that is charged (P) and the amount that is purchased /sold (Q). We need to consider how Total Expenditure will change as we increase or decrease the price of the good:
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Price Elasticity of Demand and Total Expenditure (Contd)

Elastic Demand (Price elasticity is greater than 1 in absolute value) Recall that elastic demand is where the change in quantity demanded outweighs the change in price.

An increase in price will lead to a reduction in Total Expenditure (TE).

This is because the fall in quantity demanded (from the price increase) will be greater than the increase in price. The greater decrease in quantity demanded will decrease TE.
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Price Elasticity of Demand and Total Expenditure (Contd)

Elastic Demand (Price elasticity is greater than 1 in absolute value)
However, a decrease in price will lead to an increase in TE. This is because the increase in quantity demanded (from the fall in price) will be greater than the decrease in price. The greater increase in quantity demanded will increase TE.
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Price Elasticity of Demand and Total Expenditure (Contd)

Inelastic Demand (Price elasticity is less than 1 in absolute value) Inelastic demand is where the change in quantity demanded is less than the change in price. An increase in price will increase Total Expenditure (TE). This is because the fall in quantity demanded (from the price increase) will be less than the increase in price. The greater price increase will increase the TE.
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Price Elasticity of Demand and Total Expenditure (Contd)

Inelastic Demand (Price elasticity is less than 1 in absolute value)
A decrease in price will decrease Total Expenditure (TE). This is because the increase in quantity demanded (from the fall in price) will be less than the decrease in price. The greater decrease in price will decrease TE.
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Price Elasticity of Demand and Total Expenditure (Contd)

Unit Elastic Demand (Price Elasticity is equal to 1 in absolute value)
Recall that for unit elastic demand, the change in quantity demanded is equal to the change in price. Whether price increases or decreases, the quantity demanded changes in the same proportion but in opposite direction to the price change. Therefore both changes will cancel each other, so Total Expenditure (TE) is left unchanged.

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Price Elasticity of Demand and Total Expenditure (Contd)

To remember the relationship between price changes and the change in total expenditure then: (A) When the price elasticity is greater than 1 (Elastic demand) then the changes in price and Total Expenditure will always move in opposite directions. This is because the price change is smaller. (B) When the price elasticity is less than 1 (Inelastic demand) then the changes in price and Total Expenditure will move in the same direction. This is because the price change is greater. (C) When the price elasticity is equal to 1 (Unit elastic demand) then the Total Expenditure is unchanged.

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Income Elasticity of Demand

Income Elasticity of Demand is a measure of the responsiveness of the demand for a good in response to a change in income. Income Elasticity of Demand (IED) is calculated as the percentage change in demand divided by the percentage change in income: IED = Percentage change in demand for a good Percentage change in income OR IED = New Demand Old Demand / Old Demand New Income Old Income / Old Income

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Income Elasticity of Demand (Contd)

Now in the case of income elasticity, the sign of the elasticity is very important. NOTE WELL: Therefore, we do not express income elasticity in absolute value. Normal Good: The income elasticity is positive. Inferior Good: The income elasticity is negative. Necessities: The income elasticity is positive and less than 1. Luxuries: The income elasticity is positive but greater than 38 1.

Income Elasticity of Demand (Contd)

Example: If the income of a household increases from $30,000 to $40,000 and the demand for a good increases from 10 to 15 units, what is the income elasticity of demand? IED = Percentage change in demand for a good Percentage change in income = New Demand Old Demand / Old Demand New Income Old Income / Old Income = 15 units 10 units / 10 units = 5/10 = 0.5/0.33 $40,000-$30,000/ $30,000 10,000/30000 = 1.51
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Income Elasticity of Demand (Contd)

So the calculated value of the income elasticity of demand is 1.51. This means that the good is a normal good as the elasticity is positive.

The good is also a luxury good as the income elasticity of demand is greater than 1.
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Income Elasticity of Demand (Contd)

The Mid Point Method to calculate Income Elasticity of Demand (IED) NOTE: Always use the Point Elasticity Method. Only use the Mid Point Method if you are expressly asked to do so. IED (Mid Point Method) New Demand Old Demand [ (New Demand + Old Demand) / 2] New Income Old Income [(New Income + Old Income) / 2]

_
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CrossPrice Elasticity of Demand

Cross-Price Elasticity of Demand is a measure of the responsiveness of the demand for one good (Good A) to a change in the price of another good (Good B). Cross-Price Elasticity of Demand (CED) is calculated as: CED = Percentage change in the demand for Good A Percentage change in the price of Good B The following slide shows the breakdown of the numerator and denominator of the above formula:
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Cross-Price Elasticity of Demand (Contd)

The percentage change in the demand for Good A is calculated as: New Demand for Good A Old Demand for Good A Old Demand for Good A The percentage change in the price for Good B is calculated as: New Price for Good B Old Price for Good B Old Price for Good B
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Cross-Price Elasticity of Demand (Contd)

Again, like the case of income elasticity, we do not express cross-price elasticity in absolute value. The sign of the cross-price elasticity is very important. Substitutes: The cross-price elasticity of demand is positive. This means that an increase in the price of Good B results in an increase in demand for Good A and vice versa. Complements: The cross-price elasticity of demand is negative. This means that an increase in the price of Good B results in a reduction in demand for Good A and vice versa.
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Cross-Price Elasticity of Demand (Contd)

Example: If the price of milk increases from $50 to $80 per tin and the demand for coffee falls from 25 packs to 10 packs, what is the cross-price elasticity of demand? Percentage change in the demand for Good A Percentage change in the price of Good B = 10 packs - 25 packs / 25 packs = -15 / 25 = -0.6 / 0.6 $80 - $50 / $50 30/ 50 =-1
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Cross-Price Elasticity of Demand (Contd)

The cross-price elasticity of demand is -1. This means that milk is a complement for coffee.

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Cross-Price Elasticity of Demand (Contd)

The Mid Point Method for calculating the Cross-Price Elasticity of Demand (CED) NOTE: Always use the Point Elasticity Method. Only use the Mid Point Method if you are expressly asked to do so. CED = Percentage change in the demand for Good A Percentage change in the price of Good B The following slide shows the breakdown of the numerator and denominator of the above formula when using the Mid 47 Point Method:

Cross-Price Elasticity of Demand (Contd)

The percentage change in the demand for Good A is calculated as: New Demand for Good A Old Demand for Good A [(New Demand for Good A + Old Demand for Good A) / 2] The percentage change in the price for Good B is calculated as: New Price for Good B Old Price for Good B [( New Price for Good B + Old Price for Good B) / 2]
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The Interpretation of Elasticities

Examples: If we have a price elasticity of -2.5, then it means that a 1% increase in price will lead to a 2.5% decrease in quantity demanded. If we have an income elasticity of 1.8, then a 1% increase in income will lead to a 1.8% increase in the demand for the good. Also the good is a luxury good since the income elasticity is greater than 1.
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The Interpretation of Elasticities (Contd)

If the cross-price elasticity is equal to -0.9, then a 1% increase in the price of Good B leads to a 0.9% decrease in the demand for Good A. Since the elasticity is negative, then we have complements.
If the cross-price elasticity is equal to 2.5, then a 1% increase in the price of Good B leads to a 2.5% increase in the demand for Good A. Since the elasticity is positive, then we have substitutes.

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