Managerial Economics Thomas

eighth edition Maurice

Chapter 6

Elasticity and Demand

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Price Elasticity of Demand (E)

• Measures responsiveness or sensitivity
of consumers to changes in the price of
a good
%∆Q
• E=
%∆P
• P & Q are inversely related by the law of
demand so E is always negative
• The larger the absolute value of E, the more
sensitive buyers are to a change in price
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Price Elasticity of Demand (E)

Table 6.1
Elasticity Responsiveness E
Elastic %∆Q>% ∆P E> 1
Unitary Elastic %∆Q=% ∆P E= 1
Inelastic %∆Q<% ∆P E< 1

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Price Elasticity of Demand (E)

• Percentage change in quantity
demanded can be predicted for a given
percentage change in price as:
• %∆ Qd = %∆ P x E
• Percentage change in price required for
a given change in quantity demanded
can be predicted as:
• %∆ P = %∆ Qd ÷ E

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Price Elasticity & Total Revenue

Table 6.2
Elastic Unitary elastic Inelastic
%∆Q>% ∆P %∆Q=% ∆P %∆Q<% ∆P
Q-effect dominates No dominant effect P-effect dominates

Price
TR falls No change in TR TR rises
rises
Price
TR rises No change in TR TR falls
falls

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Factors Affecting Price Elasticity
of Demand
• Availability of substitutes
• The better & more numerous the substitutes
for a good, the more elastic is demand
• Percentage of consumer’s budget
• The greater the percentage of the
consumer’s budget spent on the good, the
more elastic is demand
• Time period of adjustment
• The longer the time period consumers have to
adjust to price changes, the more elastic is
demand

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Calculating Price Elasticity of
Demand
• Price elasticity can be calculated
by multiplying the slope of demand
(∆ Q/∆ P) times the ratio of price to
quantity (P/Q)
∆Q
× 100
%∆Q Q ∆Q P
E= = = ×
%∆P ∆P ∆P Q
× 100
P
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Calculating Price Elasticity of
Demand
• Price elasticity can be measured at
an interval (or arc) along demand,
or at a specific point on the
demand curve
• If the price change is relatively small, a
point calculation is suitable
• If the price change spans a sizable arc
along the demand curve, the interval
calculation provides a better measure

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Computation of Elasticity Over an
Interval
• When calculating price elasticity of
demand over an interval of
demand, use the interval or arc
elasticity formula

∆Q Average P
E= ×
∆P Average Q

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Computation of Elasticity at a
Point
• When calculating price elasticity at a
point on demand, multiply the slope of
demand (∆ Q/∆ P), computed at the point
of measure, times the ratio P/Q, using the
values of P and Q at the point of measure
• Method of measuring point elasticity
depends on whether demand is linear or
curvilinear

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Point Elasticity When Demand is
Linear
• Given Q = a + bP + cM + dPR , let income &
price of the related good take specific
values M ˆ and Pˆ , respectively
R

• Then express demand as Q = a' + bP , where

ˆ + dPˆ and the slope parameter
a' = a + cM R
is b = ∆Q ∆P

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Point Elasticity When Demand is
Linear
• Compute elasticity using either of the two
formulas below which give the same value
for E
P P
E =b or E =
Q P−A

Where P and Q are values of price and quantity demanded

at the point of measure along demand, and A ( = −a'/ b )
is the price-intercept of demand

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Point Elasticity When Demand is
Curvilinear
• Compute elasticity using either of two
equivalent formulas below

∆Q P P
E= × =
∆P Q P − A

Where ∆Q ∆P is the slope of the curved demand at

the point of measure, P and Q are values of price and
quantity demanded at the point of measure, and A is
the price-intercept of the tangent line extended to
cross the price-axis

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Elasticity (Generally) Varies
Along a Demand Curve
• For linear demand, price and Evary directly
• The higher the price, the more elastic is
demand
• The lower the price, the less elastic is demand
• For curvilinear demand, no general rule about
the relation between price and quantity

•Special case of Q = aP b which has a constant

price elasticity (equal to b) for all prices
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Constant Elasticity of Demand
(Figure 6.3)

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Computation of Elasticity Over an
Interval
• Marginal revenue (MR) is the change
in total revenue per unit change in
output
• Since MR measures the rate of
change in total revenue as quantity
changes, MR is the slope of the total
revenue (TR) curve
∆TR
MR =
∆Q
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Demand & Marginal Revenue
(Table 6.3)
Unit sales (Q) Price TR = P × Q MR = ∆ TR/∆ Q
$ 0 --
0 $4.50 $4.00 $4.00
1 4.00
$7.00 $3.00
2 3.50
$9.30 $2.30
3 3.10
$11.20 $1.90
4 2.80
5 2.40 $12.00 $0.80
6 2.00 $12.00 $0
7 1.50 $10.50 $-1.50
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Demand, MR, & TR (Figure 6.4)

Panel A Panel B

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Demand & Marginal Revenue

• When inverse demand is linear, P
= A + BQ
• Marginal revenue is also linear,
intersects the vertical (price) axis at
the same point as demand, & is twice
as steep as demand
MR = A + 2BQ

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Linear Demand, MR, & Elasticity
(Figure 6.5)

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MR, TR, & Price Elasticity

Table 6.4
Marginal Total revenue Price elasticity of
revenue demand
MR > 0 Elastic (E>
TR increases as Elastic
Q increases 1) (E> 1)
MR = 0 TR is maximized Unit
Unit elastic
elastic
(E= 1)
(E= 1)
MR < 0 TR decreases as Inelastic
Inelastic(E<
Q increases 1) (E< 1)
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Marginal Revenue & Price Elasticity

• For all demand & marginal revenue
curves, the relation between marginal
revenue, price, & elasticity can be
expressed as

 1
MR = P 1 + 
 E

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Income Elasticity
• Income elasticity (EM) measures the
responsiveness of quantity demanded
to changes in income, holding the price
of the good & all other demand
determinants constant
• Positive for a normal good
• Negative for an inferior good
%∆Qd ∆Qd M
EM = = ×
%∆M ∆M Qd
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Cross-Price Elasticity
• Cross-price elasticity (EXY) measures the
responsiveness of quantity demanded of
good X to changes in the price of related
good Y, holding the price of good X & all
other demand determinants for good X
constant
• Positive when the two goods are substitutes
• Negative when the two goods are complements
%∆Q X ∆QX PY
E XY = = ×
%∆PY ∆PY QX
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Interval Elasticity Measures

• To calculate interval measures of
income & cross-price elasticities, the
following formulas can be employed
∆Q Average M
EM = ×
∆M Average Q

∆Q Average PR
E XR = ×
∆PR Average Q

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Point Elasticity Measures

• For the linear demand function
Q X = a + bPX + cM + dPY , point
measures of income & cross-price
elasticities can be calculated as
M
EM =c
Q

PR
E XR =d
Q
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