Price Elasticity of Demand: Overheads

Price Elasticity of Demand
Overheads
How much would your roommate pay

to watch a live fight?
How does Showtime decide how

much to charge for a live fight?
What about Hank and Sons Concrete?

How much should they charge per square foot?
Can ISU raise parking revenue by raising parking fees?
Or will the increase in price drive demand

down so far that revenue falls?
All of these pricing issues revolve around the issue

of how responsive the quantity demanded is to price.
Elasticity is a measure of how responsive

one variable is to changes in another variable?
The Law of Demand

The law of demand states that when
the price of a good rises,
and everything else remains the same,
the quantity of the good demanded will fall.
The real issue is how far it will fall.
The demand function is given by

Q
h(P, ZD )
QD = quantity demanded
P = price of the good
ZD = other factors that affect demand
The inverse demand function is given by

1
P h (Q , ZD )
D
P g(Q , ZD )
To obtain the inverse demand function we
just solve the demand function for P
as a function of Q
Examples
QD = 20 - 2P
2P + QD = 20
2P = 20 - QD
P = 10 - 1/2 QD
Slope = - 1/2
Examples
QD = 60 - 3P
3P + QD = 60
3P = 60 - QD
P = 20 - 1/3 QD
Slope = - 1/3
One measure of responsiveness is slope

For demand
h(P, ZD )
The slope of a demand curve is given by the

change in Q divided by the change in P
D
Q
slope
P
For inverse demand

D
P g(Q , ZD )
The slope of an inverse demand curve is given by
the change in P divided by the change in Q
P
slope
D
Q
Examples
QD = 60 - 3P
Slope = - 3
P = 20 - 1/3 QD
Slope = - 1/3
Examples
QD = 20 - 2P
Slope = - 2
P = 10 - 1/2 QD
Slope = - 1/2
We can also find slope from tabular data
Q
0
2
4
6
8
10
P
10
9
8
7
6
5
D
Q
2
slope
2
P
1
Demand for Handballs
Q
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
P
10
9.5
9
8.5
8
7.5
7
6.5
6
5.5
5
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
P
10
9.5
9
8.5
8
7.5
7
6.5
6
5.5
5
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0

11
Price
Q
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
10
9
8
7
6
5
4
3
2
1
0
0
10 12 14 16 18 20 22
Quantity
P
10
9.5
9
8.5
8
7.5
7
6.5
6
5.5
5
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0

11
Price
Q
0
1
2
3 P
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
10
Q = 2 - 4 = -2
9
8
P = 9 - 8 = 1
7
6
5
4
3
slope
2
1
P
1

2
Q D
0
0
10 12 14 16 18 20 22
Quantity
Problems with slope as a measure of responsiveness
Slope depends on the units of measurement

The same slope can be associated with
very different percentage changes
Examples
QD = 200 - 2P
2P + QD = 200
2P = 200 - QD
P = 100 - 1/2 QD
P
1
slope

D
2
Q
Consider data on racquets

Let P change from 95 to 96
P = 96 - 95 = 1
Q = 8 - 10 = -2
Q
Q
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
P
100
99.5
99
98.5
98
97.5
97
96.5
96
95.5
95
94.5
94
93.5
93
A $1.00 price change when P = $95.00 is tiny
Graphically for racquets

Price
Demand for Racquets

102
100
98
96
Slope = - 1/2
94
92
90
88
0
Large % change in Q
10
12
14
16
18
Quantity
Small % change in P
Graphically for hand balls

P=7-6=1
Price
11
10
9
8
7
Q = 6 - 8 = -2
Slope = - 1/2
5
4
3
2
1
0
0
10 12 14 16 18 20 22
Quantity
Large % change in Q
Large % change in P
So slope is not such a good measure

of responsiveness
Instead of slope we use percentage changes
The ratio of the percentage change in one variable
to the percentage change in another variable
is called elasticity
The Own Price Elasticity of Demand

D
is given by
Q
D
%Q
D
%P
Q
P
P
There are a number of ways to compute

percentage changes
Initial point method for computing


(Initial Point Method)
Q D
D
D
%Q
Q
D
%P
P
P
(8 10)
8
D
(6 5)
6
2
8
P
6
5.5
5
4.5
4
( 8 10)
6
8
(6 5)
6 12 1.5
8
1
Q
8
9
10
11
12
Final point method for computing


(Final Point Method)
Q D
D
D
%Q
Q
D
%P
P
P
( 8 10)
10
D
(6 5)
5
2
10
P
6
5.5
5
4.5
4
( 8 10)
5
10
(6 5)
5 10 1.0
10
1
Q
8
9
10
11
12
The answer is very different

depending on the choice of the
base point
So we usually use
The midpoint method for computing
Elasticity of Demand Using the Mid-Point
Q D
D
D
%Q
Q
D
%P
P
P
Q D Q1 Q0 or Q0 Q1
For QD we use the midpoint of the Qs

Q
(Q1 Q0 )
2
Similarly for prices

P P1 P0 or P0 P1
For P we use the midpoint of the Ps
1
P
( P1 P0 )
2
Q D
D
D
%Q
Q
D
%P
P
P
(Q1 Q0 )

1
( Q1 Q0 )
2
(P1 P0 )
1
( P1 P0 )
2
(Q1 Q0 )
(Q1 Q0 )
(P1 P0 )
( P1 P0 )

(Mid-Point Method)
Q D
%Q D
QD
D
%P
P
P
Q
8
9
10
11
12
P
6
5.5
5
4.5
4
(Q1 Q0 )
(Q1 Q0 )
(P1 P0 )
(P1 P0 )
(Q1 Q0 ) (P1 P0 )
(P1 P0 ) (Q1 Q0 )
(8 10) (6 5)
(6 5) (8 10)
( 2) (11)
22
11
(1) (18)
18
9
Classification of the elasticity of demand

Inelastic demand
When the numerical value of the elasticity of demand
is between 0 and -1.0, we say that demand is inelastic.
%Q D
%P < 1
%Q D
<
%P

Elastic demand
is less than -1.0, we say that demand is elastic.
%Q D
%P > 1
%Q D
>
%P

Unitary elastic demand
is equal to -1.0, we say that demand is unitary elastic.
%Q D
%P 1
%Q D
%P

Perfectly elastic - D = -
Perfectly inelastic - D = 0
horizontal
vertical
Elasticity of demand with linear demand

Consider a linear inverse demand function
P A BQ D
The slope is (-B) for all values of P and Q
For example,
P 12 0.5Q D
The slope is -0.5 = - 1/2
Price
Demand for Diskettes

13
12
11
10
9
8
7
6
5
4
3
2
1
0
P
0
10 12 14 16 18 20 22
Quantity
Q D
2.0
P
P
12
11.5
11
10.5
10
9.5
9
8.5
8
7.5
7
6.5
6
5.5
5
4.5
4
3.5
3
Q
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
Q
Q
The slope is constant but the

elasticity of demand will vary
Q D
%
Q D
QD
D
%P
P
P
(P1 P0 )
Q
P (Q1 Q0 )
(8 10) (8 7)
(8 7) (8 10)
( 2) (15)
30
5
(1) (18)
18
3
P
12
11.5
11
10.5
10
9.5
9
8.5
8
7.5
7
6.5
6
5.5
5
4.5
4
3.5
3
Q
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18

Q D
%
Q D
QD
D
%P
P
P
(P1 P0 )
Q
P (Q1 Q0 )
(14 16) (5 4)
(5 4 ) (14 16)
( 2) (9)
18
3
(1) (30)
30
5
P
12
11.5
11
10.5
10
9.5
9
8.5
8
7.5
7
6.5
6
5.5
5
4.5
4
3.5
3
Q
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18

A linear demand curve becomes more inelastic
as we lower price and increase quantity
P smaller
D
(P1 P0 )
%
Q
Q
D
%P
P ( Q1 Q0 )
The elasticity gets closer to zero
Q larger

Q
0
2
4
6
8
10
12
14
16
18
20
22
24
P
12
11
10
9
8
7
6
5
4
3
2
1
0
Elasticity
0
-23.0000
-7.0000
-3.8000
-2.4286
-1.6667
-1.1818
-0.8462
-0.6000
-0.4118
-0.2632
-0.1429
-0.0435
Expenditure
22
40
54
64
70
72
70
64
54
40
22
0

Q
0
2
4
6
8
10
12
14
16
18
20
22
24
P
12
11
10
9
8
7
6
5
4
3
2
1
0
Elasticity
0
-23.0000
-7.0000
-3.8000
-2.4286
-1.6667
-1.1818
-0.8462
-0.6000
-0.4118
-0.2632
-0.1429
-0.0435
Expenditure
22
40
54
64
70
72
70
64
54
40
22
0
Note
We do not say that demand is elastic
or inelastic ..
We say that demand is elastic or
inelastic at a given point
Example
D
Q
D
D
%Q
Q
D
%P
P
P
Q (P1 P0 )
P (Q1 Q0 )
Constant with linear demand

and Total Expenditure on an Item
How do changes in an items price affect
expenditure on the item?
If I lower the price of a product, will the increased
sales make up for the lower price per unit?
Expenditure for the consumer

is equal to revenue for the firm
Revenue = R = price x quantity = PQ
Expenditure = E = price x quantity = PQ
Modeling changes in price and quantity

P = change in price
Q = change in quantity
The Law of Demand says that
as P increases Q will decrease
So
P = initial price
P = change in price
P + P = final price
Q = initial quantity
Q = change in quantity
Q + Q = final quantity
So
Initial Revenue = PQ
P + P = final price
Q + Q = final quantity
Final Revenue = (P + P) (Q + Q)
= P Q + P Q + P Q + P Q
Now find the change in revenue

R = final revenue - initial revenue
= P Q + P Q + P Q + P Q - P Q
= P Q + P Q + P Q
%R = R / R = R / P Q
R
P Q P Q P Q
PQ
PQ
We can rewrite this expression as follows
R
P Q
P Q
P Q
PQ
PQ
PQ
PQ
P
Q
P Q
%R
P
Q
PQ
%R %P %Q

Inelastic demand
D
%Q
%P < 1
%Q D
+
%R %P %Q
<
%P
% Q and % P are of opposite sign so

%R has the same sign as %P

Inelastic demand
D
%Q
%P < 1
%Q D
+
%R %P %Q
<
%P

%R has the same sign as %P
Lower price lower revenue
Higher price higher revenue

Elastic demand
%Q D
%Q D
%P > 1
+
%R %P %Q
>
%P

%R has the opposite sign as %P
Higher price lower revenue
Lower price higher revenue

Unitary elastic demand
%Q D
%Q D
%P 1
+
%R %P %Q
%P
% Q and % P are of opposite sign so their

effects will cancel out and %R = 0.
Tabular data
Q
Price falls 0
2
4
6
8
10
12
Price falls 14
16
18
20
22
24
P
12
11
10
9
8
7
6
5
4
3
2
1
0
Elastic
Elasticity
0
-23.0000
-7.0000
-3.8000
-2.4286
-1.6667
-1.1818
-0.8462
-0.6000
-0.4118
-0.2632
-0.1429
-0.0435
Revenue
22
40
54
64
70
72
70
64
54
40
22
0
Revenu
e rises
Inelastic
Revenue falls
Graphical analysis
Price
Demand
13
12
11
10
9
8
7
6
5
4
3
2
1
0
P0, Q0
P1, Q1
C
0
0
2
4
6
8
10
12
14
16
18
20
22
24
12
11
10
9
8
7
6
5
4
3
2
1
0
10 12 14 16 18 20 22
Quantity
Lose B, gain A, revenue rises
Elasticity Revenue
0
-23.0000 22
-7.0000 40
-3.8000 54
-2.4286 64
-1.6667 70
-1.1818 72
-0.8462 70
-0.6000 64
-0.4118 54
-0.2632 40
-0.1429 22
-0.0435 0
Graphical analysis
Price
Demand
13
12
11
10
9
8
7
6
5
4
3
2
1
0
P0, Q0
P1, Q1
A
B
0
0
2
4
6
8
10
12
14
16
18
20
22
24
12
11
10
9
8
7
6
5
4
3
2
1
0
10 12 14 16 18 20 22
Quantity
Lose A, gain B, revenue falls
Elasticity Revenue
0
-23.0000 22
-7.0000 40
-3.8000 54
-2.4286 64
-1.6667 70
-1.1818 72
-0.8462 70
-0.6000 64
-0.4118 54
-0.2632 40
-0.1429 22
-0.0435 0
Factors affecting the elasticity of demand

Availability of substitutes
Importance of item in the buyers budget
Availability of substitutes
The easier it is to substitute for a good,
the more elastic the demand
With many substitutes, individuals will
move away from a good whose price increases
Examples of goods with easy substitution

Gasoline at different stores
Soft drinks
Detergent
Airline tickets
Local telephone service
Narrow definition of product

The more narrowly we define an item,
the more elastic the demand
With a narrow definition, there will lots of
substitutes
Examples of narrowly defined goods

Lemon-lime drinks
Corn at a specific farmers market
Vanilla ice cream
Food
Transportation
Necessities tend to have inelastic demand
Necessities tend to have few substitutes
Examples of necessities
Salt
Insulin
Food
Trips to Hawaii
Sailboats
Demand is more elastic in the long-run

There is more time to adjust in the long run
Examples of short and long run elasticity

Postal rates
Gasoline
Sweeteners
Factors affecting the elasticity of demand

Importance of item in the buyers budget
The more of their total budget consumers
spend on an item,
the more elastic the demand for the good
The elasticity is larger because the item has
a large budget impact
Big ticket items and elasticity

Housing
Big summer vacations
Table salt
College tuition
The End

Price Elasticity of Demand: Overheads

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Price Elasticity of Demand

How much would your roommate pay

How does Showtime decide how

What about Hank and Sons Concrete?

Or will the increase in price drive demand

All of these pricing issues revolve around the issue

Elasticity is a measure of how responsive

The Law of Demand

The real issue is how far it will fall.

The demand function is given by

The inverse demand function is given by

One measure of responsiveness is slope

The slope of a demand curve is given by the

For inverse demand

We can also find slope from tabular data

Demand for Handballs

Demand for Handballs

Demand for Handballs

Problems with slope as a measure of responsiveness

Slope depends on the units of measurement

Consider data on racquets

A $1.00 price change when P = $95.00 is tiny

Graphically for racquets

Demand for Racquets

Graphically for hand balls

So slope is not such a good measure

The Own Price Elasticity of Demand

There are a number of ways to compute

Initial point method for computing