Individual and Market Demand III' Price Elasticity of Demand

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Individual and Market Demand III. Price
Elasticity of Demand

• ApEc3001
• Lecture 9
• Fall 2009

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Objectives

• I. Price elasticity of demand (EP)
• Definition and Calculation of EP
• II. Application of the price elasticity of
  demand
• III. Factors that affect the price elasticity of
  demand

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I. Price Elasticity of Demand

• Price elasticity of demand (EP) the percentage
  change in the quantity demanded of a good
  resulting from a one-percent change in its own
  price.
• Can calculate EP in two equivalent ways

OR
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Example 1 Calculate price elasticity of demand

• When price of gasoline increases from
  3.50/gallon to 4.0/gallon, a consumer reduces
  his gas consumption from 12 gallon to 11 gallon.
  Calculate his price elasticity of demand for
  gasoline.

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Arc Elasticity (Optional)

• In Example 1, value of ?P depends on the
  direction of price change.
• P decreases from 4 to 3.5,
• P increases from 3.5 to 4,
• ?Q has the same problem.
• When calculating EP between two points on demand
  curve - arc elasticity, (P1,Q1) and (P2, Q2),
  midpoint formula is preferable because it gives
  the same answer regardless of the direction of
  the change.

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Example 2 Calculate EP of linear demand function

• D1 Q 6 0.5P
• Calculate EP at the point P 4 and Q 4.
• We are calculating point elasticity here.

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• EP measures how responsive consumers are to
  change in price.
• Most goods satisfy the Law of Demand, so EP is
  negative for most goods.

Absolute value of EP
Elastic ?Q gt ?P. When P increases by 1,
consumers reduce quantity demanded by more than
1.
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The steeper is the demand curve, the less
elastic is the demand.
Perfectly Inelastic demand (EP 0)
D1
D2 is more elastic than D1
D2
Perfectly Elastic demand EP - 8
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II. Application of EP
Example 1. Water Pricing policy

• We are running out of water resources. Since
  water is a normal good, it always obeys the Law
  of Demand-higher prices lower water demand.
  President Obama is considering using higher water
  prices to curb water demand in order to save
  water. You are a member of the Council of
  Economic Advisers, with the following information
  at hand
• EP of water demand in agriculture - 0.03
• EP of water demand in residential use - 1.5
• How would you advise the president?
• Should the president increase water price in
  agriculture?
• Should the president increase water price in
  residential use?

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Another application of EP Total Revenue

• Consumer Total expenditure PQ
• Total revenue (TR) the sellers receive Total
  expenditure consumers / buyers pay.

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Business advice from EP
When demand inelastic, should increase price.
When demand elastic, should NOT increase price,
instead reduce price.
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Example 2. MARTA Total Revenue

• (Textbook, p153) In 1987, the Metropolitan
  Atlanta Rapid Transit Authority (MARTA) was
  charging 60 per ride. The MARTA was facing a
  rising budge deficit. They were trying to
  increase the total revenue from providing the
  transit service. A research found that the price
  elasticity of demand for the MARTA ride, EP, is
  0.2144, should MARTA increase or decrease
  price?

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III. Factors that affect the price elasticity of
demand

• Substitution possibilities
• Budget share
• Time short-run versus long-run

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Substitution Possibilities affect EP

• If good X has lots of close substitutes, when PX
  ?, consumers can easily substitute away from X,
  then ?QX will be large, leading to large EP.

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Budget Share affects EP

• Budget share
• In general, the smaller the budget share of X is,
  the less elastic demand for X will be.
• Salt Demand is ___elastic ____ inelastic
• P 0.5/can 4 cans/year M 50,000/year
• Budget Share 40.5/50,000 0.004
• ?P barely changes the purchasing power. ?Q small
  in response to ?P.
• House Demand is ___elastic ____ inelastic
• On average households spend 25 of income on
  housing.
• A 1 ?P can range from 2,500 to 10,000. This
  significantly reduces purchasing power. ?Q large
  in response to ?P.

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Type of goods and EP

• In general, demand for normal goods is more
  elastic than demand for inferior goods.
• Normal good income effect and substitution
  effect work in the same direction reinforce
  each other.
• Inferior good income effect and substitution
  effect work in the opposite direction offset
  each other.
• In general, demand for luxury goods is more
  elastic than demand for necessity goods.
• Luxury goods take up higher budget share.

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Time affects EP

• Short run Only short time is allowed to pass.
  Consumers don't have enough time to adjust fully
  to the price change.
• Long run Enough time is allowed for consumers or
  to adjust fully to the price change.
• For many goods, demand is more price elastic in
  the long run than in the short run, because it
  takes time to change consumption habits.
  (Example Demand for gasoline. )
• Demand for some goods (e.g., durable goods ) are
  more elastic in the short run than in the long
  run.
• When P of refrigerator ?, in short run can defer
  purchase, so ?Q small.
• In the long run, old refrigerators wear out and
  must be replaced thus ?Q would eventually pick
  up.

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Study guide

• Key Terms
• What you should be able to do
• Be able to calculate price elasticity of demand
  when given a demand function.
• Be able to apply EP to give policy advice (e.g.,
  water pricing policy) or business advice from the
  relationship between EP and TR (whether price
  should be increased or not).
• Be able to judge whether demand for a good is
  elastic.