You are on page 1of 21

Q1: The price elasticity of demand equals

magnitude of the _________.


A change in the price divided by the change in quantity
demanded
B change in the quantity demanded divided by the
change in price
C percentage change in the price divided by the
percentage change in the quantity demanded
D percentage change in the quantity demanded divided
by the percentage change in the price

2012 Pearson Addison-Wesley


2012 Pearson Addison-Wesley

Q2: Last October, due to an early frost, the price of


a pumpkin increased by 10 percent compared to the
previous years price. As a result, the quantity
demanded decreased from 2 million to 1.5 million.
Based on this statement, the _______.

A demand for pumpkins is elastic


B demand for pumpkins is inelastic
C demand for pumpkins is unit elastic
D demand for pumpkins increased

2012 Pearson Addison-Wesley


2012 Pearson Addison-Wesley

Price Elasticity of Demand


Elasticity Along a Linear
Demand Curve

First calculate the


elasticity at the mid-point.
We first choose a small
range where the point we
want to calculate is in the
middle.
The change in price is $5
and the average price is
$12.50.

2012 Pearson Addison-Wesley

Price Elasticity of Demand


The quantity demanded
increases from 20 to 30
pizzas an hour.
So the average quantity
is 25 pizzas.
The price elasticity is
(10/25)/(5/12.5), which
equals 1.
How much is the elasticity
at a price of $20? At a
price of $5?

2012 Pearson Addison-Wesley

Price Elasticity of Demand


For example, if the price
falls from $25 to $15, the
quantity demanded
increases from 0 to 20
pizzas an hour.
The average price is $20
and the average quantity
is 10 pizzas.
The price elasticity of
demand is (20/10)/(10/20),
which equals 4.
2012 Pearson Addison-Wesley

Price Elasticity of Demand


If the price falls from
$10 to $0, the quantity
demanded increases
from 30 to 50 pizzas an
hour.
The average price is $5
and the average quantity
is 40 pizzas.
The price elasticity is
(20/40)/(10/5), which
equals 1/4.
2012 Pearson Addison-Wesley

Price Elasticity of Demand


For any linear
demand curve:
At prices above the
mid-point of the
demand curve,
demand is elastic.
At prices below the
mid-point of the
demand curve,
demand is inelastic.
At the mid-point of the
demand curve,
demand is unit elastic.
2012 Pearson Addison-Wesley

The elasticity is always decreasing as we


move down along the demand curve!

Price Elasticity of Demand


If the percentage change in
the quantity demanded
equals the percentage
change in price,
Then the price elasticity of
demand equals 1 and the
good has unit elastic
demand.
Figure 4.3(b) illustrates this
casea demand curve with
ever declining slope.
2012 Pearson Addison-Wesley

Price Elasticity of Demand


Total Revenue and Elasticity
Elasticity can help firms to decide whether they should
increase or cut the price.
The total revenue from the sale of good or service equals
the price of the good multiplied by the quantity sold.
When the price changes, total revenue also changes.
But a rise in price doesnt always increase total revenue.
The key determination here is elasticity!

2012 Pearson Addison-Wesley

Price Elasticity of Demand


The change in total revenue due to a change in price
depends on the elasticity of demand:

If demand is elastic, a 1 percent price cut increases


the quantity sold by more than 1 percent, and total
revenue increases.
EX the elasticity of pizza is 4 when price is $20 and
quantity demanded is 10 per hour. The total revenue is
$20* 10 = $200 per hour.
Now the firm cut the price by 10% to $18 , the quantity
would increase by 40% (10%*4) to 14 per hour,
therefore the total revenue is $18 * 14 =$252.
2012 Pearson Addison-Wesley

Price Elasticity of Demand

If demand is inelastic, a 1 percent price cut increases


the quantity sold by less than 1 percent, and total
revenues decreases.

If demand is unit elastic, a 1 percent price cut


increases the quantity sold by 1 percent, and total
revenue remains unchanged.
Decrease in revenue caused by price cut is exactly
offset by increase in revenue caused by rise in sale.

2012 Pearson Addison-Wesley

Price Elasticity of Demand


The relationship between
elasticity of demand and the
total revenue:
As the price falls from $25 to
$12.50, the quantity demanded
increases from 0 to 25 pizzas.
Total revenue is 0 at a price of
$25 and $312.50($12.50*25) at
a price of $12.50.
Between these two points,
demand is elastic, and total
revenue increases as price
falls.

2012 Pearson Addison-Wesley

Price Elasticity of Demand

In part (b), as the quantity


increases from 0 to 25
pizzas, demand is elastic,
and total revenue
increases.

2012 Pearson Addison-Wesley

Price Elasticity of Demand


At $12.50, demand is
unit elastic and total
revenue stops
increasing.

2012 Pearson Addison-Wesley

Price Elasticity of Demand


When price is $12.50 and
quantity demanded is 25,
demand is unit elastic, and total
revenue is at its maximum.

2012 Pearson Addison-Wesley

Price Elasticity of Demand


As the price falls from
$12.50 to zero, the
quantity demanded
increases from 25 to 50
pizzas.
But total revenue would
decrease from $312.50
to 0.
Between the two points,
demand is inelastic, and
total revenue decreases.
2012 Pearson Addison-Wesley

Price Elasticity of Demand

As the quantity increases


from 25 to 50 pizzas,
demand is inelastic, and
total revenue decreases.

2012 Pearson Addison-Wesley

Price Elasticity of Demand


When we know the change in total revenue that results
from a price change, we can estimate the elasticity.
This method is called the total revenue test;
If a price cut increases total revenue, demand is
elastic.

If a price cut decreases total revenue, demand is


inelastic.

If a price cut leaves total revenue unchanged, demand


is unit elastic.

2012 Pearson Addison-Wesley

Price Elasticity of Demand


The Factors That Influence the Elasticity of Demand
The elasticity of demand for a good depends on:

The closeness of substitutes


The proportion of income spent on the good
The time elapsed since a price change

2012 Pearson Addison-Wesley

Price Elasticity of Demand


Closeness of Substitutes
The closer the substitutes for a good or service, the more
elastic are the demand for the good or service.
Necessities, such as food or housing, generally have
inelastic demand, while luxuries, such as super bowl
tickets, generally have elastic demand.
Is the demand for gasoline elastic?
What about the demand for the gasoline in a Shell gas station,
where an Exxon gas station is located nearby?

2012 Pearson Addison-Wesley

Price Elasticity of Demand


Proportion of Income Spent on the Good
The greater the proportion of income consumers spend on a
good, the larger is the elasticity of demand for that good.
EX: think of your demand for gums and the demand for housing,
suppose the price of both double at the same time

Time Elapsed Since Price Change


The more time consumers have to adjust to a price change, or
the longer that a good can be stored without losing its value, the
more elastic is the demand for that good.
EX: think of a price increase in air ticket happened one week before
your vacation, or one month

2012 Pearson Addison-Wesley