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Price Elasticity of Demand

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  • 1. Elasticity of Demand and Supply Calculating Percentage Change Significance of Price Elasticity of Demand (Ep) Determinants of Price Elasticity of Demand (Ep) Price Elasticity of Demand (Ep) For Next Time
  • 2. Price Elasticity of Demand A measure of the extent to which the quantity demanded of a good changes when the price of the good changes, ceteris paribus. We know if we raise a price, the Qd will decline, but we don’t know how much. Elasticity answers the “how much” question. In Business, we want to know the relationship between Qd and Price Ep = % Change in Quantity Demanded % Change in Price
  • 3. Price of Latte Suppose a retail gourmet coffee outlet is selling its premium “Latte” for $3/cup. The store generally is selling 15 cups of “Latte” per hour, and the store manager is thinking seriously of raising the price to $5/cup. He knows he will lose some sales but thinks that most of his customers are willing to pay more. Help him quantify his decision by determining how many fewer cups he can sell and still generate more revenue per hour.
  • 4. Calculating Percentage Change Percentage Change measures how much a value has changed from one time period to another For Example, if a firm’s sales for the current month amounted to $100 million and the previous month, the same firm’s sales were $90 million. What was the percentage change? There are two methods of calculating the percentage change • Simple Method • Midpoint Method
  • 5. Calculating Percentage Change Simple MethodPercentage Change = Current Value-Previous Value Previous Value or, = $100m - $90 m = $10m = 11.1% $90m $90m Very Common Usage, especially in the business world
  • 6. Calculating Percentage Change Midpoint Method Percentage Change = Current Value – Previous Value (Current Value + Previous Value)/ 2 Or, = $100m -$90m = $10m = 10.5% ($100m + $90m)/2 $95m The midpoint method is the better method because it gives similar results whether we are measuring forward or backward
  • 7. Price Elasticity of Demand From Formula Ep = % Change in Qd % Change in Price If Price Elasticity of Demand > 1, demand is elastic If Price Elasticity of Demand = 1, demand is unit elastic If Price Elasticity of Demand < 1, demand is inelastic
  • 8. Demand Elasticity Elastic Demand – When % Change in Quantity Demanded > % Change in Price Unit Elastic Demand – When % Change in Quantity Demanded = % Change in Price Inelastic Demand – When % Change in Quantity Demanded < % Change in Price Perfectly Elastic Demand – When Quantity Demanded Changes by a very large percentage in response to an almost zero Change in Price Perfectly Inelastic Demand – When the Quantity Demanded remains constant as Price changes
  • 9. Perfectly Elastic Demand Curve 14 12 10 8 D 6 4 2 5 10 15 20 25 30 Quantity The elasticity of a perfectly elastic demand curve is infinityCopyright ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. 18-10
  • 10. Perfectly Inelastic Demand Curve D 30 25 20 15 10 5 5 10 15 20 25 Quantity The elasticity of a perfectly inelastic demand curve is 0Copyright ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. 18-11
  • 11. Relativity Elasticity of Demand Curves D1 D2 QuantityCopyright ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. 18-12
  • 12. Elasticity of Straight Line Demand Curve 11 Very elastic 10 e = 6.33 9 8 Slightly elastic 7 Unit elastic 6 e = 1.0 Slightly inelastic 5 4 3 e = .29 Very inelastic 2 1 D 0 0 1 2 3 4 5 6 7 8 9 10 11 QuantityCopyright ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. 18-14
  • 13. Significance of Price Elasticity of Demand Profit maximization requires that business set a price that will maximize the firm’s profit Elasticity tells the firm how much control it has over using price to raise profit If Ep > 1, then the % Change in Qd > % Change is Price and demand is said to be elastic • An increase in price will reduce total revenue • A decrease in price will increase total revenue
  • 14. Significance of Price Elasticity of Demand If Ep < 1, then the % change in Qd < % change in price, and demand is said to be inelastic • An increase in price will increase total revenue • A decrease in price will decrease total revenue If Ep = 1, then the % change in Qd = % change in Price, and demand is said to be unit elastic • An increase in price will have no impact on total revenue • A decrease in price will have no impact on total revenue
  • 15. Price Elasticity of Demand Influences Substitute Product Availability (key determinant) -- Luxury or Necessity (Ep for luxury items is >) -- How narrowly it is defined (coffee is inelastic but latte may have more substitutes and therefore is more elastic) -- Time elapsed since price change (>time, >elasticity; more time to find substitutes or manage consumption) Income Effects -- The greater the proportion of income spent on the good, greater a price change impacts Quantity Demanded
  • 16. Advertising  Purpose – Product Differentiation (Branding)  To make the demand for a product greater  To make the demand for a product more inelastic D DCopyright ©2002 by The McGraw-Hill Companies, Inc. All rights reserved. 18-18
  • 17. Elasticity Thoughts Demand Curve Slope and Elasticity (Steeper the slope, lower the elasticity) A Units-Free Measure (% Change – Absolute Value) Elasticity Along a Linear Demand Curve -- Slope is constant but elasticity varies Elasticity and Total Revenue -- Price and Total Revenue change in opposite directions, demand is elastic -- Price Change leaves Total Revenue unchanged, demand is unit elastic -- Price and Total Revenue change in same direction, demand is inelastic
  • 18. Price Elasticity of Supply A measure of the extent to which the quantity supplied of a good changes when the price of the good changes, and all other influences on seller’s plans remain the same (cateris paribus)
  • 19. Price Elasticity of Supply Perfectly Elastic Supply – When the quantity supplied changes by a very large percentage in response to an almost zero increase in price Elastic Supply – When the % change in the quantity supplied > the % change in the price Unit Elastic Supply – When the % change in the quantity supplied = the % change in price Inelastic Supply – When the % change in the quantity demanded is < the % change in price Perfectly Inelastic Supply – When the quantity supplied remains the same as the price changes
  • 20. Influences on Price Elasticity of Supply Production Possibilities – page 124 -- Opportunity Costs constant or gently rising opportunity costs = elastic price elasticity -- Fixed Production = inelastic price elasticity -- Time Elapse – longer time, > price elasticity
  • 21. Influences of Price Elasticity of Supply Storage Possibilities The better the storability, the more elastic is the price elasticity of supply
  • 22. Computing Price Elasticity of Supply Percentage change in quantity supplied Percentage change in price• If Price Elasticity of Supply > 1, Supply is elastic• If Price Elasticity of Supply = 1, Supply is unit elastic• If price elasticity of supply< 1, Supply is inelastic
  • 23. Cross Elasticity of Demand A measure of the extent to which the demand for a good changes when the price of a substitute or complement changes, ceteris paribus % Change in Quantity Demanded % Change in Price of one of its substitutes or complements
  • 24. Income Elasticity of Demand A measure of the extent to which the demand for a good changes when income changes, ceteris paribus % Change in Quantity Demanded % Change in Income
  • 25. Income Elasticity of Demand If income elasticity of demand > 1 the demand for the good is income elastic If income elasticity of demand is between 0 and 1, the demand is income inelastic * If income elasticity of demand < 0 the demand is negative income elastic

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