Chapter 4: Demand Section 3

Chapter 4: DemandSection 3

Objectives1. Explain how to calculate elasticity ofdemand.2. Identify factors that effect elasticity.3. Explain how firms use elasticity andrevenue to make decisions.Chapter 4, Section 3Copyright Pearson Education, Inc.Slide 2

Key Terms elasticity of demand: a measure of howconsumers respond to price changes inelastic: describes demand that is not verysensitive to price changes elastic: describes demand that is very sensitiveto a change in price unitary elastic: describes demand whoseelasticity is exactly equal to 1 total revenue: the total amount of money acompany receives by selling goods or servicesChapter 4, Section 3Copyright Pearson Education, Inc.Slide 3

Introduction What factors affect elasticity of demand?– Economists have developed a way tocalculate how strongly consumers will react toa change in price.– Original price and how much you want aparticular good are both factors that willdetermine your demand for a particularproduct.Chapter 4, Section 3Copyright Pearson Education, Inc.Slide 4

Consumer Response Elasticity of demand is the way that consumersrespond to price changes; it measures howdrastically buyers will cut back or increase theirdemand for a good when the price rises or falls.– Your demand for a good that you will keep buyingdespite a price change is inelastic.– If you buy much less of a good after a small priceincrease, your demand for that good is elastic.Chapter 4, Section 3Copyright Pearson Education, Inc.Slide 5

Elastic Demand Elastic Demand comes from one or moreof these factors:– The availability of substitute goods– A limited budget that does not allow for pricechanges– The perception of a good as a luxury item.Chapter 4, Section 3Copyright Pearson Education, Inc.Slide 6

Calculating Elasticity of Demand In order to calculate elasticity of demand, take thepercentage change in the quantity of the gooddemanded and divide this number by thepercentage change in the price of the good. Theresult is the elasticity of demand for the good.– The law of demand implies that the result will alwaysbe negative. This is because increases in the price ofa good will always decrease the quantity demanded,and a decrease in the price of a good will alwaysincrease the quantity demanded.Chapter 4, Section 3Copyright Pearson Education, Inc.Slide 7

Measuring Elasticity If the elasticity ofdemand for a goodat a certain price isless than 1, thedemand is inelastic.If the elasticity isgreater than 1,demand is elastic. Ifelasticity is exactlyequal to 1, demandis unitary elastic.Chapter 4, Section 3According to the cartoon, grazingsheep are this homeowner’s solutionto the high price of gasoline.Copyright Pearson Education, Inc.Slide 9

Factors Affecting Elasticity Availability ofSubstitutes– If there are a fewsubstitutes for a good,then even when itsprice rises greatly, youmight still buy it.– If the lack ofsubstitutes can makedemand inelastic, awide choice ofsubstitute goods canmake demand elastic.Chapter 4, Section 3Copyright Pearson Education, Inc.Slide 10

Other Factors Relative Importance– A second factor in determining a good’selasticity of demand is how much of yourbudget you spend on a good. Necessities v. Luxuries– Whether a person considers a good to be anecessity or a luxury has a great impact on aperson’s elasticity of demand for that good.Chapter 4, Section 3Copyright Pearson Education, Inc.Slide 11

Other Factors, cont. Change Over Time– Consumers do not always react quickly to aprice increase, because it takes time to findsubstitutes. Because they cannot respondquickly to price changes, their demand isinelastic in the short term. Demand sometimes becomes more elasticover time as people eventually find substitutes.Chapter 4, Section 3Copyright Pearson Education, Inc.Slide 12

Total Revenue Elasticity is important to the study of economicsbecause elasticity helps us measure how consumersrespond to price changes for different products.– The elasticity ofdemand determineshow a change in pricewill affect a firm’s totalrevenue or income.Chapter 4, Section 3Copyright Pearson Education, Inc.Slide 13

Total Revenue and Elastic Demand The law of demand states that an increase inprice will decrease the quantity demanded. When a good has elastic demand, raising theprice of each unit sold by 20% will decrease thequantity sold by a larger percentage. Thequantity sold will drop enough to reduce thefirm’s total revenue. The same process can also work in reverse. Ifthe price is reduced by a certain percentage, thequantities demanded could rise by an evengreater percentage. In this case, total revenueswould increase.Chapter 4, Section 3Copyright Pearson Education, Inc.Slide 14

Total Revenue and Inelastic Demand If demand is inelastic,consumers’ demandis not very responsiveto price changes. Ifprices increase, thequantity demandedwill decrease, but byless than thepercentage of theprice increase. Thiswill result in highertotal revenues.Chapter 4, Section 3Copyright Pearson Education, Inc.Slide 15

Elasticity and Revenue Elasticity of demand determines the effect of aprice change on total revenues.– Why will revenue fall ifa firm raises the priceof a good whosedemand is elastic?– What happens to totalrevenue when pricedecreases, but demandis inelastic?Chapter 4, Section 3Copyright Pearson Education, Inc.Slide 16

Elasticity and Price Policies Checkpoint: Why does a firm need to knowwhether demand for its product is elastic orinelastic?– Knowledge of how the elasticity of demand can affecta firm’s total revenues helps the firm make pricingdecisions that lead to the greatest revenue. If a firm knows that the demand for its product is elasticat the current price, it knows that an increase in pricewould reduce total revenue. If a firm knows that the demand for its product isinelastic at its current price, it knows that an increase inprice will increase total revenue.Chapter 4, Section 3Copyright Pearson Education, Inc.Slide 17

Review Now that you have learned what factorsaffect elasticity of demand, go back andanswer the Chapter Essential Question.– How do we decide what to buy?Chapter 4, Section 3Copyright Pearson Education, Inc.Slide 18

Measuring Elasticity If the elasticity of demand for a good at a certain price is less than 1, the demand is inelastic. If the elasticity is greater than 1, demand is elastic. If elasticity is exactly equal to 1, demand is unitary elastic. According to the cartoon, grazing sheep are this homeowner’s solution to the high price of gasoline.