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Elasticity and Demand

Elasticity and Demand. Price, Income and Cross Elasticity of Demand. Elasticity and Demand. What is elasticity?????. Elasticity – the concept. The responsiveness of one variable to changes in another When price rises, what happens to demand? Demand falls BUT! How much does demand fall?.

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Elasticity and Demand

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  1. Elasticity and Demand Price, Income and Cross Elasticity of Demand

  2. Elasticity and Demand • What is elasticity?????

  3. Elasticity – the concept • The responsiveness of one variable to changes in another • When price rises, what happens to demand? • Demand falls • BUT! • How much does demand fall?

  4. Elasticity – the concept • If price rises by 10% - what happens to demand? • We know demand will fall • By more than 10%? • By less than 10%? • Elasticity measures the extent to which demand will change

  5. Elasticity • 4 basic types used: • Price elasticity of demand • Price elasticity of supply • Income elasticity of demand • Cross elasticity

  6. Elasticity and Demand • What is price elasticity of demand????

  7. Elasticity • Price Elasticity of Demand • The responsiveness of demand to changes in price • Where % change in demand is greater than % change in price –elastic • Where % change in demand is less than % change in price - inelastic

  8. Elasticity The Formula: % Change in Quantity Demanded ___________________________ Ped = % Change in Price If answer is between 0 and -1: the relationship is inelastic If the answer is between -1 and infinity: the relationship is elastic Note: PED has – sign in front of it; because as price rises demand falls and vice-versa (inverse relationship between price and demand)

  9. Elasticity and Demand • Predicting the % Change in Quantity Demanded • e.g if E = 5 %ΔP = 5% what is %ΔQ = ????

  10. Elasticity and Demand • Predicting the % Change in Price • e.g if E = 5 %ΔQ = 25% what is %ΔP = ????

  11. Elasticity Price (£) The demand curve can be a range of shapes each of which is associated with a different relationship between price and the quantity demanded. Quantity Demanded

  12. Elasticity and Demand • What is total revenue????? • What is the relationship between Price Elasticity and TR????

  13. Elasticity Price Total revenue is price x quantity sold. In this example, TR = £5 x 100,000 = £500,000. This value is represented by the grey shaded rectangle. The importance of elasticity is the information it provides on the effect on total revenue of changes in price. £5 Total Revenue D 100 Quantity Demanded (000s)

  14. Elasticity Price If the firm decides to decrease price to (say) £3, the degree of price elasticity of the demand curve would determine the extent of the increase in demand and the change therefore in total revenue. £5 £3 TotalRevenue D 100 140 Quantity Demanded (000s)

  15. Elasticity and Demand • What is price effect????? • What is quantity effect????

  16. Elasticity Price (£) Producer decides to lower price to attract sales 10 % Δ Price = -50% % Δ Quantity Demanded = +20% Ped = -0.4 (Inelastic) Total Revenue would fall 5 Not a good move! D 5 6 Quantity Demanded

  17. Elasticity Price (£) Producer decides to reduce price to increase sales % Δ in Price = - 30% % Δ in Demand = + 300% Ped = - 10 (Elastic) Total Revenue rises 10 Good Move! 7 D 20 5 Quantity Demanded

  18. If demand is price elastic: Increasing price would reduce TR (%Δ Qd > % Δ P) Reducing price would increase TR (%Δ Qd > % Δ P) If demand is price inelastic: Increasing price would increase TR (%Δ Qd < % Δ P) Reducing price would reduce TR (%Δ Qd < % Δ P) Elasticity

  19. Elasticity and Demand • What factors affect price elasticity of demand • Availability of substitutes • Percentage of consumer budget • Time period of Adjustment

  20. Elasticity and Demand • Calculating Price elasticity of demand • E = %ΔQ = ΔQ x 100 = ΔQ x P • %ΔP Q………ΔP Q ΔP x 100 P

  21. Elasticity and Demand • What is Marginal Revenue???? • MR = ΔTR ΔQ

  22. Elasticity and Demand

  23. Elasticity and Demand • What is the relationship between MR & Price Elasticity???? • MR = P ( 1 + 1/E)

  24. Elasticity and Demand • What is Income Elasticity???? • Em = % ΔQ • %ΔM

  25. Elasticity • Income Elasticity of Demand: • The responsiveness of demand to changes in incomes • Normal Good– demand rises as income rises and vice versa • Inferior Good– demand falls as income rises and vice versa

  26. Elasticity • Income Elasticity of Demand: • A positive sign denotes a normal good • A negative sign denotes an inferior good • Calc income elasticity of demand fig6.6 pg105

  27. Elasticity • For example: • Yed = - 0.6: Good is an inferior good but inelastic– a rise in income of 3% would lead to demand falling by 1.8% • Yed = + 0.4: Good is a normal good but inelastic–a rise in incomes of 3% would lead to demand rising by 1.2% • Yed = + 1.6: Good is a normal good and elastic–a rise in incomes of 3% would lead to demand rising by 4.8% • Yed = - 2.1: Good is an inferior good and elastic–a rise in incomes of 3% would lead to a fall in demand of 6.3%

  28. Elasticity and Demand • NB Income elasticity can be measured either over an interval or at a point on the general demand curve.

  29. Elasticity and Demand • When the change income is relatively small the point measure of income elasticity is calculated by multiplying. Slope of ΔQ • ΔM • For linear demand function • Q= a + bP + cM + dPr

  30. Elasticity and Demand • The point of measure of income elasticity is Em = cM Q

  31. Elasticity and Demand • What is Cross Price Elasticity????

  32. Elasticity • Cross Elasticity: • The responsiveness of demand of one good to changes in the price of a related good – either a substitute or a complement % Δ Qd of good t __________________ Xed = % Δ Price of good y

  33. Elasticity • Goods which are complements: • Cross Elasticity will have negative sign (inverse relationship between the two) • Goods which are substitutes: • Cross Elasticity will have a positive sign (positive relationship between the two)

  34. Elasticity • Price Elasticity of Supply: • The responsiveness of supply to changes in price • If Pes is inelastic - it will be difficult for suppliers to react swiftly to changes in price • If Pes is elastic– supply can react quickly to changes in price % Δ Quantity Supplied ____________________ Pes = % Δ Price

  35. Determinants of Elasticity • Time period– the longer the time under consideration the more elastic a good is likely to be • Number and closeness of substitutes–the greater the number of substitutes, the more elastic • The proportion of income taken up by the product– the smaller the proportion the more inelastic • Luxury or Necessity - for example, addictive drugs

  36. Importance of Elasticity • Relationship between changes in price and total revenue • Importance in determining what goods to tax (tax revenue) • Importance in analysing time lags in production • Influences the behaviour of a firm

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