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The focus of this lecture is the elasticity. Students will learn about the price elasticity of demand, price elasticity of supply, cross elasticity and income elasticity. OBJECTIVES 1. Understand the definition of elasticity. 2. Be able to compute the elasticity coefficients. 3. Analyze the elasticity characteristics. 4. Illustrate the determinants of the elasticity. 5. Explain the total revenue test and understand the relationship between total revenue and price elasticity of demand. TOPICS Please read all the following topics. PRICE ELASTICITY OF DEMAND DETERMINANTS OF Ed TOTAL REVENUE TEST PRICE ELASTICITY OF SUPPLY CROSS ELASTICITY OF DEMAND INCOME ELASTICITY OF DEMAND
Characteristics:
Ed approaches infinity, demand is perfectly elastic. Consumers are very sensitive to price change. Ed > 1, demand is elastic. Consumers are relatively responsive to price changes. Ed = 1, demand is unit elastic. Consumers response and price change are in same proportion. Ed < 1, demand is inelastic. Consumers are relatively unresponsive to price changes. Ed approaches 0, demand is perfectly inelastic. Consumers are very insensitive to price change. Ed is usually greater in the higher price range than in lower price range. Demand is more elastic in upper left portion of the demand curve than in the lower right portion of the curve. However, it is impossible to judge elasticity of a demand curve by its flatness or steepness. Along a linear demand curve, its elasticity changes. This relationship is demonstrated in the following example:
An Example
DEMAND FUNCTION FOR PRODUCT X: P = 2.5-0.01Q P = PRICE; Q = QUANTITY, TR = TOTAL REVENUE Ed = PRICE ELASTICITY OF DEMAND
A B C D E F G H I J 0 50 100 150 200 250 300 350 400 450 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0 17 5 2.6 1.57 1 0.64 0.38 0.2 0.06
Q: P: Ed:
The total revenue test is a method of estimating the price elasticity of demand. As Ed will impact the total revenue, we can estimate the Ed by looking at the movement of the total revenue.
Total Revenue Test Ed > 1, total revenue will decrease as price increases. P and TR moves in opposite directions. Producers can increase total revenue ( TR = Price x Quantity) by lowering the price. Therefore, most department stores will have sales to attract customers. Apparel's demand is elastic. Ed < 1, total revenue will increase as price increases. P and TR moves in the same direction. Producers can increase total revenue by raising the price. Inelastic demand for agricultural products helps to explain why bumper crops depress the prices and total revenues for farmers. You may look at the movement of TR in the example below. It demonstrated the relationship described above.
TR Test Example
DEMAND FUNCTION FOR PRODUCT X: P = 2.50.01Q P = PRICE; Q = QUANTITY, TR = TOTAL REVENUE Ed = PRICE ELASTICITY OF DEMAND
A B Q: 0 50 P: 4.5 4 TR: 0 200 Ed: 17 5 C 100 3.5 350 D E F G H 150 200 250 300 350 3 2.5 2 1.5 1 450 500 500 450 350 2.6 1.57 1 0.64 0.38 I J 400 450 0.5 0 200 0 0.2 0.06
ELASTICITY OF DEMAND; FROM A TO E Ed >1 TR increases FROM E TO F Ed =1 TR remains same. FROM F TO J Ed <1 TR decreases.
Definition: Cross elasticity (Exy) tells us the relationship between two products. it measures the sensitivity of quantity demand change of product X to a change in the price of product Y. Formula: Exy = percentage change in Quantity demanded of X / percentage change in Price of Y.
If the percentage change is not given in a problem, it can be computed using the following formula: Percentage change in Qx = (Q1-Q2) / [1/2 (Q1+Q2)] where Q1 = initial Qd of X, and Q2 = new Qd of X. Percentage change in Py = (P1-P2) / [1/2 (P1 + P2)] where P1 = initial Price of Y, and P2 = New Price of Y. Putting the two above equations together: Exy = {(Q1-Q2) / [1/2 (Q1+Q2)] } / {(P1-P2) / [1/2 (P1 + P2)]} Characteristics: Exy > 0, Qd of X and Price of Y are directly related. X and Y are substitutes. Exy approaches 0, Qd of X stays the same as the Price of Y changes. X and Y are not related. Exy < 0, Qd of X and Price of Y are inversely related. X and Y are complements. Examples: 1. If the price of Product A increased by 10%, the quantity demanded of B increases by 15 %. Then the coefficient for the cross elasticity of the A and B is : Exy = percentage change in Qx / percentage change in Py = (15%) / (10%) = 1.5 > 0, indicating A and B are substitutes. 2. If the price of Product A increased by 10%, the quantity demanded of B decreases by 15 %. Then the coefficient for the cross elasticity of the A and B is : Exy = percentage change in Qx / percentage change in Py = (- 15%) / (10%) = - 1.5 < 0, indicating A and B are complements.