Demand Elasticities

Chapter 4
 Why Should Managers Study
Elasticity?
• Own-price elasticity helps managers
understand the impact that price changes
will have on their revenue.
• Income elasticity can help managers
understand what income groups to target
their product to.
• Cross-price elasticity can help managers
understand who their closest competitors
are.
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 Demand Elasticity
• Demand elasticity is the responsiveness of
quantity demanded to changes in the
factors that influence demand, product
price, income, or prices of related
products.

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Own Price Elasticity of Demand
• Measured as the
percentage change in
quantity demanded of
a given good, relative
to a percentage ep = %ΔQx ÷ %ΔPx
change in its price, all
else constant.

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Own Price Elasticity of Demand
– Graphical Representation
P

A
P1
%∆P
B
P2

%∆Q

Q1 Q2 Q

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 Examples of Own-Price
Elasticity
• Cereal: -0.55
• Fish: -0.29
• Neuman’s Own Pasta Sauce: -2.32
• Orange juice: -1.39

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Own Price Elasticity and Total
Revenue
Value of price
elasticity Elasticity Relationship among Impact on revenue
coefficient definition variables
Price increase results in lower total
Elastic revenue.
|ep| > 1 demand %ΔQd > %ΔPx Price decrease results in higher total
revenue.
Price increase results in higher total
Inelastic revenue.
|ep| < 1 demand %ΔQd < %ΔPx Price decrease results in lower total
revenue.
Unit or Price increase or decrease has no
|ep| = 1 unitary %ΔQd = %ΔPx impact on total revenue.

elastic

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Graphical Representation of Relationship Between
Price Elasticity and Total Revenue

If demand is elastic,a decrease

P in price results in an increase P If demand is inelastic,a decrease
in total revenue, and an increase In price results in a decrease in
in price results in a decrease in total revenue, and an increase
total revenue. in price results in a increase in
A total revenue.
P1
Y B
P2

A
P1
X Y B
P2
X
Q1 Q2 Q Q1 Q2 Q
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 Determinants of Own Price
Elasticity
• The number of Demand is generally more
inelastic:
substitute goods.
• The fewer the number of
• The percent of a substitutes or perceived
consumer’s income substitutes available.
that is spent on the • The smaller the percent of
the consumer’s income that
product.
is spent on the product.
• The time period under • The shorter the time period
consideration. under consideration.

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Perfectly Elastic and Inelastic
Demand

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 Income Elasticity of Demand
• The percentage
change in the quantity
demanded of a given
good, X, relative to a
percentage change in • ei = %ΔQx ÷ %ΔI
consumer income,
assuming all other
factors constant.

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 Normal Good
• Good X is a normal • Cream
good if the demand – ei = 1.72
for good X moves in • Apples
the same direction as
– ei = 1.32
a change in income.
• Potatoes
– ei = 0.15

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 Inferior Good
• Good X is an inferior • Chicken
good if the demand – ei = -0.106
for good X moves in
the opposite direction
of a change in
income.

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 Cross-Price Elasticity of
Demand
• The percentage
change in the quantity
demanded of a given
good, X, relative to a
percentage change in • exy = %ΔQx ÷ %ΔPy
the price of good Y,
assuming all other
factors constant.

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 Substitutes
• Two goods with a • Boiler chickens and
positive cross-price beef
elasticity of demand – exy = 0.20
coefficient are said to • Boiler chickens and
be substitute goods. pork
– exy = 0.28

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 Complements
• If two goods have a • Bread and eggs
negative cross-price – exy = -0.03
elasticity of demand
coefficient, they are
called complementary
goods.

16
 Consumer Tastes and
Preferences
• Preference orderings are complete.
• More of the goods are preferred to less of
the goods.
• Consumers are selfish.
• The goods are continuously divisible so
that consumers can always purchase one
more or one less unit of the goods.

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 Indifference Curves
• A consumer’s
indifference curve that
shows alternative
combinations of the
two goods that
provide the same Y1
level of satisfaction or ΔY
utility. Y2
U2
ΔX U1

X1 X2

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 Marginal Rate of Substitution
• The ratio ΔY/ΔX, which shows the rate at
which the consumer is willing to trade off
one good for another and still maintain a
constant utility level, is called the marginal
rate of substitution (MRSxy).

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 The Budget Constraint
• The consumer’s
budget constraint
shows all the
combinations of two
goods that can be
purchased with a
given income and
given the prevailing
prices of the two
goods.
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 Shifts in the Budget Constraint

Y1
B2

B1

Increase in income Increase in price of good X

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 Consumer Choice
• The consumer
maximizes utility by
choosing a combination
of good X and Y, lying
on the budget
constraint and
simultaneously lying on
the indifference curve
furthest from the origin.

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 Changes in Consumer Choice
Increase in income Increase in price

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