2 elasticity of demand
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    2 elasticity of demand 2 elasticity of demand Presentation Transcript

    • Elasticity…. Elasticity and its managerial applications By Prof. Ravi KumarFaculty of Finance and Economics, The IIPM,AMITY,MANIPAL
    • In this discussion youwill…• Learn the meaning of the elasticity of demand.• Examine what determines the elasticity of demand.• Learn the meaning of the elasticity of supply.• Examine what determines the elasticity of supply.• Apply the concept of elasticity in different markets.The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • THE ELASTICITY OF DEMAND• … allows us to analyze supply and demand with greater precision.• … is a measure of how much buyers and sellers respond to changes in market conditionsThe Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Price Elasticity of Demand• Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good.• Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price.The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • The Price Elasticity of Demand and Its Determinants • Availability of Close Substitutes • Necessities versus Luxuries • Definition of the Market • Time HorizonThe Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • The Price Elasticity of Demand and Its Determinants• Demand tends to be more elastic: – the larger the number of close substitutes. – if the good is a ‘luxury’. – the more narrowly defined the market. – the longer the time period.The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Computing the Price Elasticity of Demand • The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price. Percentage change in quantity demandedPrice elasticity of demand = Percentage change in price The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities• The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change. (Q2 - Q1) / [(Q2 + Q1) / 2]Price elasticity of demand = (P2 - P1) / [(P2 + P1) / 2]The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities • Point A: Price = $4 Quantity = 120 • Point B: Price = $6 Quantity = 80 • From Point A to Point B: Price rise = 50% and Quantity fall = 33% • From Point B to Point A: Price fall = 33% and Quantity rise = 50% (80 - 120) / [(80 + 120)/ 2]Price elasticity of demand = (6 - 4) / [(6 + 4)/ 2] Mid point method = 1 The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • A Variety of Demand Curves• Inelastic Demand – Quantity demanded does not respond strongly to price changes. – Price elasticity of demand is less than one.• Elastic Demand – Quantity demanded responds strongly to changes in price. – Price elasticity of demand is greater than one.The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • A Variety of Demand Curves• Perfectly Inelastic – Quantity demanded does not respond to price changes.• Perfectly Elastic – Quantity demanded changes infinitely with any change in price.• Unit Elastic – Quantity demanded changes by the same percentage as the price.The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Perfectly Inelastic Demand Price Demand E=0 $5.00 $4.001. An increasein price… 0 100 Quantity 2. …leaves the quantity demanded unchanged. The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Inelastic Demand Price Demand E<1 $5.00 $4.001. A 25%increase inprice… 0 90 100 Quantity 2. … Leads to a 10% decrease in quantity demanded. The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Unit Elastic Demand Price E=1 Demand $5.00 $4.001. A 25%increase inprice… 0 80 100 Quantity 2. … Leads to a 25% decrease in quantity demanded. The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Elastic Demand Price E>1 Demand $5.00 $4.001. A 25%increase inprice… 0 50 100 Quantity 2. … Leads to a 50% decrease in quantity demanded. The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Perfectly Elastic Demand Price E=∞ 1. At any price above $4, quantity demanded is zero.$4.00 Demand 2. At exactly $4, consumers will buy any quantity. 3. At any price below $4, quantity demanded is infinite. 0 Quantity The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Total Revenue and the Price Elasticity of Demand• Total revenue is the amount paid by buyers and received by sellers of a good.• Computed as the price of the good times the quantity sold. TR = P x QThe Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Total Revenue Price$4.00 P x Q = $400 (revenue) Demand 0 100 Quantity The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • How Total Revenue Changes When Prices Changes: Inelastic Demand Price$3.00 P x Q = $400 (revenue)$1.00 P x Q = $100 (revenue) Demand 0 80 100 Quantity The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • How Total Revenue Changes When Prices Changes: Elastic Demand Price Change in Total Revenue when Price Changes$5.00$4.00 Demand Revenue = $200 Revenue = $100 0 20 50 Quantity The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Elasticity and Total Revenue along a Linear Demand Curve• With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases.The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Table 5-1. Elasticity and Total Revenuealong a Linear Demand CurveThe Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Figure 5-5: A Linear Demand CurvePrice 7 Elasticity is larger than 1. 6 5 4 Elasticity is smaller 3 than 1. 2 1 0 4 14 Quantity 2 6 8 10 12The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Other Demand Elasticities • Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income. • It is computed as the percentage change in the quantity demanded divided by the percentage change in income. P e rc e n ta g e c h a n g e in q u a n tity d e m a n d e dIn c o m e e la s tic ity o f d e m a n d = P e rc e n ta g e c h a n g e in in c o m e The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Other Demand Elasticities• Types of Goods – Normal Goods – Inferior Goods• Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods.The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Other Demand Elasticities• Goods consumers regard as necessities tend to be income inelastic – Examples include food, fuel, clothing, utilities, and medical services.• Goods consumers regard as luxuries tend to be income elastic. – Examples include sports cars, furs, and expensive foods.The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Other Demand Elasticities • Cross-Price elasticity of demand measures how much the quantity demanded of a good responds to a change in the price of another good. • It is computed as the percentage change in the quantity demanded divided by the percentage change in the price of the second good. Percentage change in quantity demandedIncome elasticity of demand = Percentage change in the price of good 2. The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • PRICE ELASTICITY OF SUPPLY• Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good.• Price elasticity of supply is the percentage change in quantity supplied given a percent change in the price.The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • The Price Elasticity of Supply and Its Determinants• Ability of sellers to change the amount of the good they produce. – Beach-front land is inelastic. – Books, cars, or manufactured goods are elastic.• Time period. – Supply is more elastic in the long run.The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Computing the Price Elasticity of Supply • The price elasticity of supply is computed as the percentage change in the quantity supplied divided by the percentage change in price. P e rc e n ta g e c h a n g e in q u a n tity s u p p lie dP ric e e la s tic ity o f s u p p ly = P e rc e n ta g e c h a n g e in p ric e The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Computing the Price Elasticity of Supply• Suppose an increase in the price of milk from $1.90 to $2.10 a litre raises the amount that dairy farmers produce from 9000 to 11 000 L per month…• … using the midpoint method, we calculate the percent change in the price as (2.10 - 1.90) / 2.00 x 100 = 10%• Similarly, we calculate the percent change in the quantity supplied as (11 000 - 9000) / 10 000 x 100 = 20% 20%Price elasticity of supply = = 2.0 10%The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Figure 5-6 a): Perfectly Inelastic Supply Price Supply E=0 $5.00 $4.001. An increasein price… 0 100 Quantity 2. …leaves the quantity supplied unchanged. The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Figure 5-6 b): Inelastic Supply Price E<0 Supply $5.00 $4.001. A 22%increase inprice… 0 100 110 Quantity 2. …leads to a 10% increase in quantity supplied. The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Figure 5-6 c): Unit Elastic Supply Price E=1 Supply $5.00 $4.001. A 22%increase inprice… 0 100 125 Quantity 2. …leads to a 22% increase in quantity supplied. The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Figure 5-6 d): Elastic Supply Price E>1 Supply $5.00 $4.001. A 22%increase inprice… 0 100 200 Quantity 2. …leads to a 67% increase in quantity supplied. The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Figure 5-6 e): Perfectly Elastic Supply Price E=∞ 1. At any price above $4, quantity supplied is infinite.$4.00 Supply 2. At exactly $4, producers will supply any quantity. 3. At any price below $4, quantity supplied is zero. 0 Quantity The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Figure 5-7: How the price elasticity of supply can varyPrice$15 Elasticity is less than 1$12 Elasticity is greater than 1 $4 $3 0 100 200 500 525 Quantity The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • THREE APPLICATIONS OF SUPPLY, DEMAND, AND ELASTICITY• Good news bad news for farmers• OPEC• Drugs and crimeThe Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Figure 5-8: An Increase in Supply in the Market for Wheat Price of Wheat Increase in Supply 1. When demand is inelastic, an increase in supply… S1 S2 $3 $22. … leadsto a fall inprice… Demand 100 110 Quantity of Wheat 3. …and a proportionately smaller increase in quantity sold. As a result revenue falls from $300 to $220. The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Figure 5-9: A Reduction in Supply in the World Market for Oil (a) Oil Market in the Short Run (b) Oil Market in the Long Run Price Price of Oil 1. In the short run, when supply of Oil and demand are inelastic, a shift in supply… S2 1. In the long run, when supply and demand are elastic, a shift in supply… S1 S2 S1 P2 P2 P1 P1 2. … leads Demand2. … leads to a smallto a large increase inincrease in price…price… Demand Quantity of Oil Quantity of Oil The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Figure 5-10: Policies to Reduce the of Illegal Drugs (a) Drug Interdiction (b) Drug Education Price of Price of Drugs 1. Drug interdiction reduces the Drugs supply of drugs… 1. Drug education reduces the S2 demand for drugs… S1 Supply P2 P1 P2 P1 D1 2. … which2. … which reduces theraises the price…price… D2 Demand Q2 Q1 Quantity of Drugs Q2 Q1 Quantity of Drugs 3. … and reduces the 3. … and reduces the quantity quantity sold. sold. The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Summary• Price elasticity of demand measures how much the quantity demanded responds to changes in the price.• Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price.• If a demand curve is elastic, total revenue falls when the price rises.• If it is inelastic, total revenue rises as the price rises.The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Summary• The income elasticity of demand measures how much the quantity demanded responds to changes in consumers’ income.• The cross-price elasticity of demand measures how much the quantity demanded of one good responds to the price of another good.• The price elasticity of supply measures how much the quantity supplied responds to changes in the price.The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU
    • Summary• In most markets, supply is more elastic in the long run than in the short run.• The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price.• The tools of supply and demand can be applied in many different types of markets.The Faculty of Finance and Economics, The IBS,AMITY,IIPM,MU