Lecture4_Ch4_Elasticity

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Elasticity September 8, 2011:

Elasticity September 8, 2011 CHAPTER 4

Elasticity of Demand and Supply :

Elasticity of Demand and Supply Objectives: Define the price elasticity of demand and understand how to measure it Explain the determinants of the price elasticity of demand Explain the relationship between the price elasticity of demand and total revenue Define the cross-price elasticity of demand and the income elasticity of demand Their determinants and measurement Define the price elasticity of supply and understand its main determinants and how it is measured

Elasticity of Demand:

Elasticity of Demand Elasticity is a measure of responsiveness Elasticity of Demand: the sensitiveness of the buyers to the changes in price The responsiveness of the quantity demanded of a good to changes in its price is called the price elasticity of demand. How much will the quantity demanded change as a result of a price increase or decrease? Knowledge of this sensitiveness is useful to forecast the effect of price changes on the revenues of producers and expenditures of consumers.

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% change in quantity demanded % change in price Price Elasticity of Demand Price elasticity of demand = Suppose: Price of cars went up by 1% this year and the resulting decline in cars purchased was 2%. What is the price elasticity of demand?

Going Backward Using Price Elasticity of Demand:

Going Backward Using Price Elasticity of Demand Suppose you have a good estimate of the price elasticity demand for the product you sell. You can work backward and use the concept of elasticity to make predictions of changes in quantity demanded in response to price changes. Example: Imagine you own a car dealership and last year you sold 10,000 cars. You know from past experience that the price elasticity of demand for the cars you sell is -2. This year you know that price of each car you sell will go up by 10%. How many fewer cars will you sell?

Going Backward Using Price Elasticity of Demand:

Going Backward Using Price Elasticity of Demand Similarly, you can use price elasticity of demand to formulate price strategies if you own a firm that can control its prices. Example: Imagine you manage a store which sells Apple products, such as IPODs. And you want to increase your quantity--IPOD sales by 20%. You estimate that the price elasticity of demand for your IPOD is -4. How much should you cut prices to increase your sales by 20%?

Price Elasticity of Demand Characteristics:

Price Elasticity of Demand Characteristics It is a number without units of measurement it is because we divide two percentage changes. It is a negative number because the demand curve’s slope is negative. This is because an increase in price will generally result in a decrease in quantity demanded, other things being equal. If the percentage change in price positive, the percentage change in quantity demand is negative so elasticity is negative.

Price Elasticity of Demand Characteristics:

Price Elasticity of Demand Characteristics It is the magnitude, or absolute value, of the price elasticity of demand tells us how responsive demand is (we ignore the negative sign). When a good is said to have a “high” price elasticity of demand, this means that its price elasticity is large in absolute value, indicating that the quantity demanded is highly responsive to changes in price. When a good is said to have a “low” price elasticity of demand, this means absolute value of elasticity is small, indicating that the quantity demanded is relatively unresponsive to changes in price.

Elastic Demand:

Elastic Demand The larger the number after the (-) sign, the more elastic the demand. Example: Elasticity of coats= - 5 ; Elasticity of sweatshirts= - 2. Demand is elastic if the value of price elasticity of demand (ignoring the sign) exceeds 1. The % change in quantity demanded caused by a price change will exceed the % change in the price (ignoring the direction of the change). Example: Elasticity of cars = - 2 and Elasticity of bread = -0.5.

Inelastic and Unit Elastic Demands:

Inelastic and Unit Elastic Demands Demand is inelastic if the value of price elasticity of demand (ignoring the sign) is between 0 and 1. The % change in quantity demanded will be less than the % change in price that caused it. Example: elasticity of milk = - 0.8 and elasticity of aspirin= - 0.5 Demand is unit elastic if the value of price elasticity of demand (ignoring the sign) is 1. The % change in quantity demanded will be equal to the % change in price that caused it.

Price Elasticity of Demand as a Gauge of Demand Responsiveness:

Price Elasticity of Demand as a Gauge of Demand Responsiveness

Calculating Price Elasticity of Demand:

Calculating Price Elasticity of Demand Calculating price elasticity of demand between two points on a demand curve: Let’s say in actual demand data the observed change in price doesn’t happen to be in percentages. For example, a soda vendor at the Pirates game observe that when the price of a bottle of coke drops from $7 to $5, the quantity demanded increases from 300 to 500 bottles a day. In those cases, we can calculate price elasticity of demand as follows:

Price Elasticity of Demand Calculation Between Two Points on a Demand Curve: Midpoint Formula :

Price Elasticity of Demand Calculation Between Two Points on a Demand Curve: Midpoint Formula Price elasticity of demand=

Price Elasticity of Demand Calculation Between Two Points on a Demand Curve: Midpoint Formula :

Price Elasticity of Demand Calculation Between Two Points on a Demand Curve: Midpoint Formula We use average of the initial and new prices and quantities in elasticity formulation By using the average price and average quantity , we get the same elasticity value regardless of whether the price rises or falls.

Extreme Cases: Perfectly Elastic and Perfectly Inelastic Demand:

Extreme Cases: Perfectly Elastic and Perfectly Inelastic Demand Perfectly Inelastic: consumers wouldn’t respond to price changes. Price may increase or decrease, the quantity remains the same. Price elasticity of demand equals to zero. Example? Perfectly elastic: the quantity demanded would be infinitely responsive to price. Price elasticity of demand equals infinity. Example?

Perfectly Inelastic and Perfectly Elastic Demand Curves:

Perfectly Inelastic and Perfectly Elastic Demand Curves

The Determinants of the Price Elasticity of Demand:

The Determinants of the Price Elasticity of Demand Why price elasticites differ among products? The key determinants of the price elasticity of demand are: The availability of close substitutes More and better substitutes exist for an item, the more elastic its demand. Examples: Demand for particular car brand is elastic (many substitutes available). Demand for gasoline is inelastic since we have few alternative

The Determinants of the Price Elasticity of Demand:

The Determinants of the Price Elasticity of Demand Definition of the Market The more narrowly we define a market, the more elastic demand will be In a narrowly defined market consumers have more substitutes available Luxuries versus Necessities Goods that are luxuries will usually have more elastic demand curves than goods that are necessities. Example?

The Determinants of the Price Elasticity of Demand:

The Determinants of the Price Elasticity of Demand Share of the good in the consumer’s budget The demand for goods on which we spend large percentages of our income is likely to be quite elastic. Example? Passage of Time (Time elapsed since price change). Demand tends to become more elastic with time since we find more substitutes for goods over longer periods of time. Example: Reaction to an increase in gas prices over time is to develop substitutes for fuels, such as development of fuel efficient cars.

The Relationship between Price Elasticity of Demand and Total Revenue:

The Relationship between Price Elasticity of Demand and Total Revenue Price elasticity of demand is an important factor to estimate the total revenue that sellers can expect to make. Total revenue is the total amount of funds sellers receives from selling a good or service. Total Revenue is calculated by multiplying price per unit by the number of units sold.

The Relationship between Price Elasticity of Demand and Total Revenue :

The Relationship between Price Elasticity of Demand and Total Revenue A firm is interested in price elasticity because it allows the firm to calculate how changes in price will affect its total revenue. Total Revenue=P Q Total amounts of funds firm receives from selling a good or service. Calculated by multiplying price per unit by the number of units sold.

Total Revenue:

Total Revenue TR = PQ. Total revenue taken in by sellers can be represented by the area whose height is market price and whose length is quantity sold. Price Quantity Supply Demand P Q

What Happens to Total Revenue When Market Price Goes Up?:

What Happens to Total Revenue When Market Price Goes Up? There is no clear answer to this question unless we know the elasticity of demand The increase in price contributes to higher total revenue. However, when the price goes up, quantity demanded falls. A decrease in quantity sold will contribute to decreased revenue. Quantity Supply Price Demand P’ P Q Q’ New supply P Q TR?

What happens to total revenue when market price goes up?:

What happens to total revenue when market price goes up? If you know the price elasticity of demand for the good, we can forecast the change in TR=P Q. Can use price elasticity of demand to predict the relative magnitudes of upward and downward forces influencing revenue. Suppose demand for the good is inelastic and say price increases; This means that the percentage reduction in quantity demanded will be SMALLER then the percentage increase in price. With inelastic demand, this implies that total revenue on a good will increase

What happens to total revenue when market price goes up?:

What happens to total revenue when market price goes up? Suppose demand for the good is elastic and price increases; The percentage reduction in quantity demanded would exceed the percentage increase in price that caused it. Decrease in quantity demanded is large enough to offset the increase in price, therefore total revenue would DECLINE. Suppose the demand for a product is Unit Elastic Any given percentage change in price will result in an equal by opposite percentage change in quantity demanded. The net effect would be NO CHANGE in total revenue.

Total Revenue and Elasticity:

Total Revenue and Elasticity The change in total revenue due to a change in price depends on the elasticity of demand: If demand is elastic, a 1% price cut increases the quantity sold by more than 1%, and total revenue increases. If demand is inelastic, a 1% price cut increases the quantity sold by less than 1%, and total revenues decreases. If demand is unitary elastic, a 1% price cut increases the quantity sold by 1%, and total revenue remains unchanged.

Total Revenue and Elasticity:

Total Revenue and Elasticity Exercises: If a price cut increases total revenue, Can you find elasticity of demand? Is demand elastic, inelastic or unit elastic? If a price cut decreases total revenue, Is demand elastic, inelastic or unit elastic? If a price cut leaves total revenue unchanged, Is demand elastic, inelastic or unit elastic?

Income Elasticity of Demand:

Income Elasticity of Demand Income elasticity of demand is a number that measures the sensitivity of consumer purchases to given percentage changes in income. We know that if the quantity demanded of a good increases as income increases, then the good is a normal good.

Income Elasticity of Demand: Positive or Negative:

Income Elasticity of Demand: Positive or Negative If the income elasticity of demand is positive and greater than 1 then the good is normal good and income is elastic (luxury goods). The quantity demanded is very responsive to changes in income If the income elasticity of demand is positive , but less than 1 then the good is normal and income is inelastic (necessities). The quantity demanded is not very responsive to changes in income If the income elasticity of demand is negative then the good is inferior good. The quantity demanded falls when income increases.

Example:

Example During the late 1990s, the rapid increases in income resulted in large increase in demand for luxuries, Such as meals in expensive restaurants, luxury apartments, and high-performance automobiles During the recessions, falling consumer income can cause firms to experience increases in demand for inferior goods, Supermarkets will find the demand for hamburger increasing relative to the demand for steak. The demand for bus trips will also increase as consumers cut back on air travel.

Cross-Price Elasticity of Demand:

Cross-Price Elasticity of Demand Measures the sensitivity of consumer purchase of one good to percentage changes in the price of another good. Suppose you work at HP and you need to predict the effect of an increase in the price of Canon printers on the quantity of HP printers demanded, holding other factors constant. Can you predict this?

Cross-price Elasticity of Demand:

Cross-price Elasticity of Demand You can do this by calculating the cross-price elasticity of demand: % change in the quantity of HP printers divided by % change in the price of Canon printers. What do you expect the sign will be? Positive or Negative?

Cross-price Elasticity of Demand:

Cross-price Elasticity of Demand Substitutes: Products that can be used for the same purpose, such as two brands of printers. Complements: Products that are used together, such as printers and printer toner cartridges. Substitute Goods: Have positive cross-price elasticity of demand An increase in the price of a substitute will lead to an increase in quantity demanded, so the cross-price elasticity will be positive.

Cross-price Elasticity of Demand:

Cross-price Elasticity of Demand Complement Goods: Have negative cross-price elasticity of demand An increase in the price of a complement will lead to a decrease in quantity demanded, so the cross-price elasticity will be negative. If two goods are unrelated, cross-price elasticity will be zero.

Example: Cross-price Elasticity of Demand:

Example: Cross-price Elasticity of Demand Cross-price elasticity of demand is important to firm managers because it allows them to measure whether products sold by other firms are close substitutes for their products. For example, Amazon.com and Barnes&noble.com are the leading online book sellers. We might predict that if Amazon raises the price of a new novel, many consumers will buy it from Barnes&noble.com instead.

Example: Amazon.com vs. Barns&noble.com:

Example: Amazon.com vs. Barns&noble.com But, Amazon’s chief executive officer has argued ordering book from Barnes&noble.com is not a good substitute for ordering book from Amazon.com. because of Amazon’s reputation for good customer service, and more customers are familiar with the site, In effect, he is arguing that the cross-price elasticity between Amazon’s book and Barns&noble’s books is low. However, two economists have used data on prices and quantities of books sold on these Web sites to estimate the cross-price elasticity.

Example: Amazon.com vs. Barns&noble.com:

Example: Amazon.com vs. Barns&noble.com They have found that cross-price elasticity of demand between books at Amazon.com and books at Barns&noble was 3.5. What does this mean? How much will quantity of books demanded on Barns&noble.com increase, when Amazon raises its price by 10% ? This result indicates that contrary to the Amazon’s chief executive’s argument, consumers do consider books sold on the two Web sites to be close substitutes.

Price Elasticity of Supply:

Price Elasticity of Supply Measures the responsiveness of firms to a change in price. Measures the sensitivity of changes in quantity supplied to changes in price of a good or service. Price elasticity of supply is a positive number (Why?) . Price elasticity of supply % change in quantity supplied % change in price =

Price Elasticity of Supply:

Price Elasticity of Supply Law of Supply says when the price of a product increases, the quantity supplied increases. To measure how much quantity supplied increases when price increases, we use the price elasticity of supply. The greater the price elasticity of supply of an item, the more responsive, or elastic, is the quantity supplied to given percentage price change.

Price Elasticity of Supply:

Price Elasticity of Supply We categorize the price elasticity of supply the same way we categorized the price elasticity of demand. If the price elasticity of supply < 1, then the supply is inelastic For example, if the price elasticity of supply of gasoline is about 0.20, it is inelastic. A 10% increase in the price of gasoline will result in only 2% increase in the quantity supplied. If the price elasticity of supply > 1, then the supply is elastic. If the price elasticity of supply = 1, then the supply is unit-elastic.

Price Elasticity of Supply as a Gauge of Supply Responsiveness:

Price Elasticity of Supply as a Gauge of Supply Responsiveness

Extreme Cases: Perfectly Inelastic Supply and Perfectly Elastic Supply:

Extreme Cases: Perfectly Inelastic Supply and Perfectly Elastic Supply Perfectly Inelastic Supply: Supply of a land is close to perfectly inelastic. No matter how much the price of land changes, there is unlikely to be any appreciable changes in the total amount of usable land in the country. Elasticity of supply close to zero for very short period of time: supply of fresh fish on a given day after the fishing fleet has brought in its catch will be perfectly inelastic. It takes time catch more. Over time supply of fish will be more elastic.

Examples:

Examples Perfectly Elastic Supply: The horizontal line: any change in demand results in a change in quantity supplied but no change in price is necessary to induce sellers to supply more The supply curve of cheeseburgers from McDonald’s, you can buy all the cheeseburgers you want to an established price without causing the price to go up. (Any particular buyer in a competitive market , the supply curve of a good will be perfectly elastic).

The Determinants of the Price Elasticity of Supply:

The Determinants of the Price Elasticity of Supply Time frame for the supply decision Often times firms have difficulty increasing the quantity of the product they supply during any short period of time. Supply of products will be inelastic if we measure it over a short period of time, but increasingly elastic the longer the period of time. Existing firms produce more (when the price of an item increases) as well as additional firms are attracted to production of the item. Since this takes time for the new firms start producing an item, supply tends to become more elastic over time

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