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Chapter 4

Chapter 4. DEMAND ELASTICITY. The Concept of Elasticity. In general, elast icity refers to percentage relationship between two variables. Coefficient of elasticity=percentage change in A / percentage change in B Price elasticity of Demand=percentage change in Q / percentage change in P.

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Chapter 4

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  1. Chapter 4 DEMAND ELASTICITY

  2. The Concept of Elasticity • In general, elasticity refers to percentage relationship between two variables. • Coefficient of elasticity=percentage change in A / percentage change in B • Price elasticity of Demand=percentage change in Q / percentage change in P

  3. Point elasticity=dQ/dP * P/Q • Arc Elasticity = Q2 – Q1/(Q1+Q2)/2 divided by P2 – P1/(P1+P2)/2 • =(Q2-Q1)/(Q1+Q2)*(P1+P2)/(P2 – P1)

  4. Categories of Elasticity • A) Elastic: Ep>1 (in absolute terms) • b) Inelastic? 0<Ep<1 “ • c) Unit elastic: Ep=1 • D) perfectly elastic: Ep=∞ (D curve is horizontal) • E) perfectly inelastic: Ep=0 (D curve is vertical)

  5. Determinants of Elasticity • Ease of substitution • Proportion of total expenditure • Durability of product • Length of time period • Global competition (in recent years, opening of borders increased demand elasticities.

  6. Demand Elasticity and Revenue • The relationship between the price elasticity of demand and revenue is: • Price increase TR↓ TR⌐ TR↑ • Price decrease TR↑ TR⌐ TR↓ • Draw figures here

  7. Empirical elasticities • Based on empirical research, the following results were obtained: • Coffee: -0.2 in short run; -0.33 long run • Appliences: -0.63 • Meals at restaurant: -2.27 • Computers: -1.44 • Air travel: -1.2 • First class travel:-0.4 • Potatoes: -0.27 • Butter: -0.62 • Peaches: -1.49 • Beer: -0.84 • Wine: -0.55 Explain this in practical terms

  8. Cross elasticity of demand • Deals with the impact of a change in the price of related good (substitutes or complements) on the quantity demanded of a particular product. • Potato chips sold by a company are complement to soft drinks sold by the same company. • Ex = % change in Qa / % change in Qb • Ex > 0 substitute • Ex < 0 complement • As a rule of thumb in business, two products are considered good substitutes or complements when Ex > 0.5

  9. Income elasticity • Ey shows the % change in quantity demanded resulting from a 1% change in income. • Empirical studies revealed the following results: • Meals at restaurant: 1.6 • Air travel: 1.9 • Butter: 0.37 • Beer: 0.4 • Food: 0.5 • Eggs: 0.57 • 3 categories: • Ey > 1 superior good • Ey > 0 and < 1 normal good • Ey < 0 inferior good (potatoes and beans) • Income elasticity concept should also be taken into consideration to or new investment projects. The manager should prefer investment for superior goods in a growing economy.

  10. Other elasticities • Advertising elasticity is used by marketing consultants and managers. How an increase in advertising expenses would affect his total sales?

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