ECONOMICS FOR BUSINESS Chapter 3 Elasticity of Demand and Supply - PowerPoint PPT Presentation

ECONOMICS FOR BUSINESS Chapter 3 – Elasticity of Demand and Supply Delivered by: Sithari Herath MFE(Reading) (UOC), Bsc.Fin(Sp.) (USJP), ACCA, ACMA Elasticity - Economics for Business - IFD 1 1

Scope 1. Price Elasticity of Demand 2. Factors affecting Price Elasticity ofDemand 3. Price Elasticity of Supply 4. Factors affecting Price Elasticity ofSupply 5. Practical use of Price Elasticity ofDemand 6. Income Elasticity ofDemand 7. Cross Elasticity ofDemand Elasticity - Economics for Business - IFD 2

1.Price Elasticity of Demand Price elasticity of Demand (PED) is the degree of sensitivity of demand for a good to changes in price of that good. Degreeof Influence Change inPrice Change inQuantity (%) Demand (%) Degreeof Response Elasticity - Economics for Business - IFD 3

1.Price Elasticity of Demand cont. Calculating PED 𝑄𝑓𝑠𝑑𝑓𝑜𝑢𝑏𝑕𝑓𝐷 ℎ 𝑏𝑜𝑕𝑓 𝑗 𝑜𝑟𝑣𝑏𝑜𝑢𝑗𝑢𝑧𝑒𝑓𝑛𝑏𝑜𝑒𝑓𝑒 𝑄𝐹𝐸 = 𝑄𝑓𝑠𝑑𝑓𝑜𝑢𝑏𝑕𝑓𝑑 ℎ 𝑏𝑜𝑕𝑓𝑗 𝑜𝑞𝑠𝑗𝑑𝑓 using Point Elasticity ofDemand using Arc Elasticity ofDemand P Elasticity over a range or arcof Elasticity of a specific pointon D the demand curve. demand curve. E.g. point(1) E.g. point (1) to(2) 𝑅 2 − 𝑅 1 × 100 ( 𝟐 ) 𝑸 𝑅 𝑄𝐹𝐸 = 𝑅 2 − 𝑅 1 𝑄 2 − 𝑄 1 𝑄 2 − 𝑄 1 × 100 1 × 100 ÷ × 100 𝑄𝐹𝐸 = 𝑄 1 𝑅 1 + 𝑅 2 𝑄 1 + 𝑄 2 ( 𝟑 ) 2 2 𝑸 Q 0 𝑹 𝑹 Elasticity - Economics for Business - IFD 4

1.Price Elasticity of Demand cont. T ypes of Demand Elasticity 𝑄𝐹𝐸 = ∞ 𝑄𝐹𝐸 =0 𝑄𝐹𝐸 =1 PED for mostgoods is negative, so the 𝑄𝐹𝐸 <1 𝑄𝐹𝐸 >1 minus sign is often ignored when taking about PED. For example, we could say that the Perfectly Unitary Perfectly price elasticity of Inelastic Elastic Inelastic Elasticity Elastic demand at point(1) is 4, when strictly speaking it is −4. No Low Equal High Perfect Response Response Response Response Response Elasticity - Economics for Business - IFD 5

1.Price Elasticity of Demand cont. Elasticity and DemandCurves P P D D 𝑑𝐸𝑓𝑛𝑏𝑜𝑒 → 𝑄𝐹𝐸 > 1 𝑑𝐸𝑓𝑛𝑏𝑜𝑒 → 𝑄𝐹𝐸 < 1 𝐹 𝑚 𝑏 𝑡 𝑢 𝑗 𝐽 𝑜 𝑓 𝑚 𝑏 𝑡 𝑢 𝑗 ∆ 𝑄 % ∆ 𝑄 % ∆ 𝑅 % ∆ 𝑅 % Q Q 0 0 When PED>1, demand is relatively When PED<1, demand isrelatively inelastic and the quantity demanded elastic and the quantity demanded is very responsive to pricechanges is not very responsive to pricechanges Elasticity - Economics for Business - IFD 6

1.Price Elasticity of Demand cont. Elasticity and DemandCurves P P P D D D Rectangular hyperbola Q Q Q 0 0 0 𝑄𝑓𝑠𝑔𝑓𝑑𝑢𝑚𝑧𝐽 𝑜 𝑓 𝑚 𝑏 𝑡 𝑢 𝑗 𝑑𝐸𝑓𝑛𝑏𝑜𝑒 𝑄𝑓𝑠𝑔𝑓𝑑𝑢𝑚𝑧𝐹 𝑚 𝑏 𝑡 𝑢 𝑗 𝑑𝐸𝑓𝑛𝑏𝑜𝑒 𝑉𝑜𝑗𝑢𝑏𝑠𝑧𝐹 𝑚 𝑏 𝑡 𝑢 𝑗 𝑑𝐸𝑓𝑛𝑏𝑜𝑒 𝑄𝐹𝐸 = ∞ 𝑄𝐹𝐸 =0 𝑄𝐹𝐸 =1 The same quantity will be A very small change inprice Percentage change in demanded, regardless ofthe results in and infinitelylarge demand will equal to price. change in demand. percentage change in quantity demanded. Elasticity - Economics for Business - IFD 7

1.Price Elasticity of Demand cont. PED on a straight – line demand curve PED (point elasticity) is different at different points of a demand curve, even if that “curve” is a straight line. P 𝑄𝐹𝐸 = ∞ 𝑄𝐹𝐸 >1 D 𝑄𝐹𝐸 =1 𝑄𝐹𝐸 <1 Mid point 𝑄𝐹𝐸 =0 Q 0 Elasticity - Economics for Business - IFD 8

1.Price Elasticity of Demand cont. Positive PED Example: Goods bought for the purpose of ostentation, Giffengoods P Potatoes Meat D Potato Price Demanded Demanded Q 0 Elasticity - Economics for Business - IFD 9

2. Factors affecting Price Elasticity of Demand The price of the product in relation to totalspending 1 The availability of substitutes 2 3 The relative importance of price in relation to other influences ondemand Habitual consumption 4 Time 5 Elasticity - Economics for Business - IFD 10

3. Price Elasticity ofSupply Price elasticity of Supply (PES) is the degree of sensitivity ofsupply of a good to changes in price of that good. Degreeof Influence Change inPrice Change inQuantity (%) Supply (%) Degreeof Response Elasticity - Economics for Business - IFD 11

3. Price Elasticity of Supply cont. Calculating PES 𝑄𝑓𝑠𝑑𝑓𝑜𝑢𝑏𝑕𝑓𝐷 ℎ 𝑏𝑜𝑕𝑓 𝑗 𝑜𝑟𝑣𝑏𝑜𝑢𝑗𝑢𝑧𝑇𝑣𝑞𝑞𝑚𝑧 𝑄𝐹𝑇 = 𝑄𝑓𝑠𝑑𝑓𝑜𝑢𝑏𝑕𝑓𝑑 ℎ 𝑏𝑜𝑕𝑓𝑗 𝑜𝑞𝑠𝑗𝑑𝑓 using Point Elasticity ofSupply using Arc Elasticity ofSupply P Elasticity over a range or arcof Elasticity of a specific pointon S the Supply curve. Supply curve. E.g. point (1) E.g. point (1) to(2) ( 𝟐 ) 𝑅 2 − 𝑅 1 × 100 𝑸 𝑅 𝑄𝐹𝑇 = 𝑅 2 − 𝑅 1 𝑄 2 − 𝑄 1 𝑄 2 − 𝑄 1 × 100 1 × 100 ÷ × 100 𝑄𝐹𝑇 = 𝑄 1 𝑅 1 + 𝑅 2 𝑄 1 + 𝑄 2 ( 𝟑 ) 2 2 𝑸 Q 0 𝑹 𝑹 Elasticity - Economics for Business - IFD 12

3. Price Elasticity of Supply cont. T ypes of SupplyElasticity 𝑄𝐹𝑇 = ∞ 𝑄𝐹𝑇 =0 𝑄𝐹𝑇 =1 PES for mostgoods is positive, so the 𝑄𝐹𝑇 <1 𝑄𝐹𝑇 >1 positive sign is often ignored when taking about PES. For example, we could say that the Perfectly Unitary Perfectly price elasticity of Inelastic Elastic Inelastic Elasticity Elastic supply at point (1) is 4, when strictly speaking it is +4. No Low Equal High Perfect Response Response Response Response Response Elasticity - Economics for Business - IFD 13

3. Price Elasticity of Supply cont. Elasticity and SupplyCurves 𝑑𝑇𝑣𝑞𝑞𝑚𝑧 → 𝑄𝐹𝑇 <1 P P 𝐽 𝑜 𝑓 𝑚 𝑏 𝑡 𝑢 𝑗 𝑑𝑇𝑣𝑞𝑞𝑚𝑧 → 𝑄𝐹𝑇 >1 𝐹 𝑚 𝑏 𝑡 𝑢 𝑗 S S ∆ 𝑄 % ∆ 𝑄 % ∆ 𝑅 % ∆ 𝑅 % Q Q 0 0 When PES>1, supply is relatively When PES<1, supply isrelatively inelastic and the quantity supplied is elastic and the quantity supplied is very responsive to price changes not very responsive to price changes Elasticity - Economics for Business - IFD 14

3. Price Elasticity of Supply cont. Elasticity and SupplyCurves P P P S S S Q Q Q 0 0 0 𝑄𝑓𝑠𝑔𝑓𝑑𝑢𝑚𝑧𝐽 𝑜 𝑓 𝑚 𝑏 𝑡 𝑢 𝑗 𝑑𝑇𝑣𝑞𝑞𝑚𝑧 𝑄𝑓𝑠𝑔𝑓𝑑𝑢𝑚𝑧𝐹 𝑚 𝑏 𝑡 𝑢 𝑗 𝑑𝑇𝑣𝑞𝑞𝑚𝑧 𝑉𝑜𝑗𝑢𝑏𝑠𝑧𝐹 𝑚 𝑏 𝑡 𝑢 𝑗 𝑑𝑇𝑣𝑞𝑞𝑚𝑧 𝑄𝐹𝑇 = ∞ 𝑄𝐹𝑇 =0 𝑄𝐹𝑇 =1 The same quantity will be A very small change inprice Percentage change in price supplied, regardless ofthe results in and infinitelylarge will equal to percentage price. change in supply . change in quantity supplied. Elasticity - Economics for Business - IFD 15

4. Factors affecting Price Elasticity of Supply The existence of surplus capacity 1 Length of the production process 2 Ease of entry into themarket 3 4 Alternative uses and availability offactors Time 5 Elasticity - Economics for Business - IFD 16

5. Practical use of Price Elasticity ofDemand PED andRevenue 𝑶𝒑𝒖𝒇 : 𝑈𝑝𝑢𝑏𝑚𝑆𝑓𝑤𝑓𝑜𝑣𝑓 ( 𝑈𝑆 ) = 𝑄 × 𝑅 𝑑𝐸𝑓𝑛𝑏𝑜𝑒 → 𝑄𝐹𝐸 =1 𝑉𝑜𝑗𝑢𝑏𝑠𝑧𝐹 𝑚 𝑏 𝑡 𝑢 𝑗 P T otalRevenue Change in Price 𝑻𝒃𝒏𝒇 𝑻𝒃𝒏𝒇 𝑈 = 10 × 10 = 100 𝟐𝟏 𝑈 = 5 × 20 = 100 𝟔 D Q 0 𝟐𝟏 𝟑𝟏 Elasticity - Economics for Business - IFD 17

5. Practical use of Price Elasticity of Demand cont. PED andRevenue 𝑶𝒑𝒖𝒇 : 𝑈𝑝𝑢𝑏𝑚𝑆𝑓𝑤𝑓𝑜𝑣𝑓 ( 𝑈𝑆 ) = 𝑄 × 𝑅 𝑑𝐸𝑓𝑛𝑏𝑜𝑒 → 𝑄𝐹𝐸 > 1 𝐹 𝑚 𝑏 𝑡 𝑢 𝑗 P T otalRevenue Change in Price 𝑈 = 10 × 50 = 500 𝟐𝟏 𝑈 = 6 × 150 = 900 𝟕 D Q 0 𝟔𝟏 𝟐𝟔𝟏 Elasticity - Economics for Business - IFD 18

5. Practical use of Price Elasticity of Demand cont. PED andRevenue 𝑶𝒑𝒖𝒇 : 𝑈𝑝𝑢𝑏𝑚𝑆𝑓𝑤𝑓𝑜𝑣𝑓 ( 𝑈𝑆 ) = 𝑄 × 𝑅 𝑑𝐸𝑓𝑛𝑏𝑜𝑒 → 𝑄𝐹𝐸 < 1 𝐽 𝑜 𝑓 𝑚 𝑏 𝑡 𝑢 𝑗 P T otalRevenue Change in Price 𝑈 = 12 × 10 = 120 𝟐𝟑 𝑈 = 5 × 15 = 75 𝟔 D Q 0 𝟐𝟏 𝟐𝟔 Elasticity - Economics for Business - IFD 19