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Elasticity of demand

Elasticity of demand. Responsiveness to price change Or “So. How many more Big Macs would you buy if they were only $1??” “How much LESS gas would you use if it was $10 a gallon?”. Elasticity. The law of demand says that as prices change, so does the quantity demanded; inverse relationship.

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Elasticity of demand

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  1. Elasticity of demand Responsiveness to price change Or “So. How many more Big Macs would you buy if they were only $1??” “How much LESS gas would you use if it was $10 a gallon?”

  2. Elasticity • The law of demand says that as prices change, so does the quantity demanded; inverse relationship. • Elasticity measures just HOW much the price change affects the quantity. • Elasticity of demand varies greatly for different type products.

  3. 3Methods • 3 ways to help determine the elasticity of a product. • They vary from an exact mathematical calculation ( the most exact) to an approximation of relative elasticity( least exact, but pretty easy to guess). • The Coefficient Formula • The Total Revenue Test • The Determinants of Ed

  4. The coefficient Formula • This method assigns a coefficient ( a number) to measure the elasticity : • Elastic ( very responsive to price change): Ed> 1 • Inelastic ( not very responsive to price change): Ed< 1 • Unit or Unitary elastic (response is in proportion to price change): Ed = 1 This one’s easy to remember because “unit” usually means one.

  5. The coefficient Formula • To get the coefficient: • take the % change in Qd/divide by the % change in Price • Ed = % Qd % P • Remember : we are looking at the response to price change, so we have two different prices ( P1 and P2, and two different quantities Q 1 and Q2). • The answer is the coefficient. • Easy, right?

  6. The coefficient Formula • Not exactly… • Because the elasticity applies no matter if we raise or lower the price ( which way we move on the Demand curve), we need to have the Ed constant between two prices. • To get the % change in price and quantity, we have to use the Mid-Point Formula

  7. The coefficient Formula:Mid-Point Formula • To get the %Qd : (Q2-Q1)(Q2+ Q1)/2 the average of the Qs • Do this for Price also: (P2-P1) (P2+P1)/2 • Eduses absolute values; NO NEGATIVE. • That means we can simply say, to get the %, use the difference divided by the average for both the Quantity demanded and the Price.  • Then just plug those numbers into the coefficient formula • Ed = % Qd %  P

  8. The total revenue Test • We can also determine if an item is elastic , inelastic or unit by seeing what happens to total revenue when the price changes. • Total revenue is measured by multiplying the price and the quantity: P x Q = TR • If TR moves in same direction as P, it’s Inelastic • If TR moves in the opposite direction as P, ( which means it’s moving with the Q) it’s Elastic • If TR doesn’t change when the price changes, it’s Unitary E.

  9. The total revenue Test • Some examples: Let’s say I’m selling cookies for $1 each. If I can sell 10 cookies @ $1 each, my TR is $10. The law of demand says I’ll be able to sell more cookies if I lower the price, but we now know that depends on the Elasticity of the demand for cookies! • I want to make more money, so I lower the price to $ .50. If I sell 20 cookies, my TR is still only $10. The demand for cookies is______?

  10. The total revenue Test • Unitiaryelastic because the TR stayed the same when the price changed. People “responded” in direct proportion to the price change.

  11. The total revenue Test • Well, suppose when I lowered the price to $ .50, I sold 100 cookies. My TR would be ___________. • The demand for cookies is______?

  12. The total revenue Test • Elastic, because the lower price brought such an increase in the quantity demanded that it raised the TR to $50.00! • Or to say it another way, the % Qd is greater than the% P. In the coefficient formula, if the top number is bigger, the answer will be >1, Elastic.

  13. The total revenue Test • Next, let’s suppose that when I lower the price from $1 to .$50, the quantity demanded increases from 10 to 15. What will happen to my TR? The demand for cookies is _________________?

  14. The total revenue Test • Inelastic because the drop in price pulled the TR down with it, even though there was an increase in the quantity demanded. The consumers were “not very” responsive to the price change. TR dropped to $7.50 from $10.00. • Or to put it another way, the% Qdwas smaller than the % P. If the top number is smaller in the coefficient formula, the answer ( the Ed) will be < 1, Inelastic.

  15. The total revenue Test • The results we got for Elasticity of demand with this example would still be the same if we raised prices instead of lowering them. Just see what happens to TR in relation to Price change! Easy!

  16. Determinants of Elasticity • This method won’t tell us the exact coefficient of elasticity, or even if it’s definitely elastic or inelastic as with the TR test. But it will give us an idea of relative elasticity when compared to something else. • There are 4 things that help DETERMINE Ed.

  17. Determinants of Elasticity • Necessity or a Luxury • Necessities tend to be more inelastic when compared to luxuries because we need them more. Consumers won’t respond to price change as much. This doesn’t mean they won’t respond, just not as much as if the item is a luxury. • Luxuries tend to be more elastic when compared to necessities. We can do without them (may not want to) if price is too high; we respond more.

  18. Determinants of Elasticity • Number of Substitutes • More substitutes there are for an item, the more elastic it is. We can easily switch to another item when the price goes up. • Fewer substitutes, less elastic, or more inelastic. It’s not easy to find another replacement for the item. This doesn’t mean it’s a necessity, however.

  19. Determinants of Elasticity • % of income an item makes up • The larger the % of income, the more elastic. If something is very expensive, like a house or a car, consumers will respond more to a price change. • The smaller the % of income, the more inelastic. If salt doubled or tripled in price, I’d probably buy pretty much the same amount; not because it’s a necessity, or there are no substitutes, but because it’s such a relatively small amount of my income that I’m not going to respond by buying less. It’s still pretty cheap!

  20. Determinants of Elasticity • The amount of time to respond • Less time, more inelastic: I’m out of gas and have to be at work in 30 minutes. I have no time to find other solutions, so I buy the gas even if it has gone up significantlyin price. • More time, more elastic: Over time, I can find alternative ways to use less gas. I might carpool, buy a more fuel efficient vehicle, use public transit, move, etc.

  21. Elasticity and the Demand Curve • Perfectly inelastic demand Perfectly elastic demand P P D D Q Q We don’t see curves like this very often.

  22. Elasticity and the Demand Curve • Most Demand curves are downward slopping. That means that there are areas that are Elastic, Unit, and Inelastic all on the same curve. • The higher prices are ELASTIC • The lower prices are INELASTIC • Where they change is UNIT ELASTIC • To find the exact point they change requires some calculations, but this gives you an idea of where you will find these elasticities on the demand curve

  23. Elasticity and the Demand Curve P Elastic Unit Inelastic D Qd

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