Ch 3

Quantitative Demand Analysis

Elasticity
Question: If the price of EF3440A increases from $6300 to $63000, what happen to the quantity demanded of it? Drop, the Law of demand. By HOW MUCH? UNKOWN!

Elasticity
Law of Demand:
Price drops, Qd increases, vice versa Directional Change Magnitude is not given (it does not tell how much the Qd will response to a change in price) Dependent

Elasticity

variable

Independe Measures the responsiveness of one variable nt variable to changes in another variable. The percentage change in one variable that arises to a given percentage change in

Elasticity
Types of Elasticity 1. Price Elasticity of Demand 2. Income Elasticity of Demand 3. Cross-Price Elasticity of Demand

Price Elasticity of Demand

The responsiveness of Qd to a change in price. The % change in Qd when price changes by 1% %Q Dependent variable Ed %P Independent variable Mathematically: =d (Qd/Qdold)x100% Ed = (P/Pold)x100 % Qd Pold Ed = P x Qdold

Price Elasticity of Demand

Demand
Px

Qdx = -10Px + 1500 100 150

0 500

Qdx

50 1000

0 1500

Q: What is the Ed if the price moves from $100 to $50? Qd Pold

Ed = P x Qdold (1000-500) x 100 Ed = (50-100) 50 0 Ed =-2

Price Elasticity of Demand

Question: What does it mean by Ed = -2? The increase in Qd is 2% when price decreases by 1%. The decrease in Qd is 2% when price increases by 1%.

Price Elasticity of Demand

Demand
Px

Qdx = -10Px + 1500 100 150

0 500

Qdx

50 1000

0 1500

Q: Do you expect that if we go back from $50 to $100, the Ed is the same, -2? No!

Qd Pold Ed = P x Qdold (500-1000) x 50 Ed = (100-50) 1000 Ed =-0.5

The Old point changed

Price Elasticity of Demand

The value of an Ed depends on the direction of changes. There are two ways to remove this effect:
Arc price elasticity of demand Qd Pold new+Pold)/2 x (P Edarc = P (Qdold +Qdold)/2 Qd new Point price elasticity of demand

Arc Price Elasticity of Demand

Px Qdx Px 150 100 75 50 A C B 500 750 1000 Demand Curve EdA EdB 150 0 100 500 50 1000 0 1500

1500

Qdx

Price Elasticity of Demand

Question: What is the Sign of Ed, positive or negative? Negative
P ,Q P ,Q The Law of demand

Qd Pold Ed = P x Qdold
(-) (-)

Remark: as it must be negative, we usually ignore the sign and take the absolute

Price Elasticity of Demand

Question: What is the Size of Ed? %Q Ed =d %P Depends on the magnitude of the change of Qd. 0

Price Elasticity of Demand

According to the size, Ed can be divided into five types: 1.Elastic 2.Inelastic 3.Unitarily elastic 4.Perfectly elastic 5.Perfectly inelastic

Elastic
Definition:

% in Qd > % in P
10% 15% P Qd

%Q >1 Ed =d %P
When Ed > 1, the demand is elastic.

Elastic
Graphical representation of Elastic
Px

P Qd D Qdx

Usually, we will use a flat demand curve to represent elastic.

Inelastic
Definition:

% in Qd < % in P
20% 10% P Qd

%Q <1 Ed =d %P
When Ed < 1, the demand is inelastic.

Inelastic
Graphical representation of Inelastic
Px

P Qd D Qdx

Usually, we will use a steep demand curve to represent inelastic.

Unitarily elastic
Definition:

% in Qd = % in P
15% 15% P Qd

%Q =1 Ed =d %P
When Ed = 1, the demand is unitarily elastic.

Unitarily elastic
Graphical representation of Unitarily Elastic
Px

P Qd

D Qdx

Usually, we will use a Rectangular Parabola demand curve to represent unitarily elastic.

Perfectly Elastic
Definition: = % in Qd > % in P
10%

P Qd

%Q = Ed =d %P
When Ed = , the demand is perfectly elastic.

Perfectly Elastic
Graphical representation of Perfectly Elastic
Px

P1

P = 0

Qdx

Usually, we will use a horizontal demand curve to represent perfectly elastic. Implication: Price must set at P1

Perfectly Inelastic
Definition:
=0

% in Qd < % in P
10% 0 P Qd

%Q =0 Ed =d %P
When Ed = 0, the demand is perfectly inelastic.

Perfectly Inelastic
Graphical representation of Perfectly Px D inelastic
Qd = 0

Q1

Qdx

Usually, we will use a vertical demand curve to represent perfectly elastic. Implication: Quantity will not response according to a price change.

Elasticity vs Total Revenue

When price increases, what happen to the producers total revenue?
P
P2 P1 Q2 Q1 D Q At P1, TR = (P1 x Q1) =

At P2, TR = (P2 x Q2) =

Unknown, unless we know Ed. Remark: If P and Qd go to opposite direction, Ed is essential for the

Total Revenue (Ed >1)

If Ed >1 (% in Qd > % in P)
P At P1, TR = (P1 x Q1) = Los s Q2 Q1 D Q

P2 Gai P n
1

At P2, TR = (P2 x Q2) =

P increases, TR drops (Gain < Loss) P decreases, TR rises (Gain > Loss)

Total Revenue (Ed >1)

Another way to shows this result Ed >1 (% in Qd > % in P)
(% in Qd > % Price increases TR = P x Q Price decreases(% in Qd > % in P)

in P)

TR = P x Q

Total Revenue (Ed <1)

If Ed <1 (% in Qd < % in P)
P P2 Gai P1 n At P1, TR = (P1 x Q1) = D Q

At P2, TR = (P2 x Q2) =

P increases, TR rises (Gain > Loss) P decreases, TR drops (Gain < Loss)

Los s Q2 Q1

Total Revenue (Ed <1)

Another way to shows this result Ed <1 (% in Qd < % in P)
(% in Qd < % Price increases TR = P x Q Price decreases(% in Qd < % in P)

in P)

TR = P x Q

Application of Elasticity
What happen to producers expenditure under the minimum wage law?
P
wagemin wage

Q2 Q1

Price increases, Qt decreases TE is uncertain (lower if Ed <1)

Application of Elasticity
Government set a per unit tax = t Supply shifts up vertically by t P Results:
Price rises Quantity drops Government tax revenue = t x Q2 How much is shared by Consumers / Producers P2 tax P1 revenue

S2
t S1

D
Q2 Q1 Q

Application of Elasticity
Total tax burden
Tax x Qnew t x Q2
S2 P t S1

P2 CB Consumer burden (CB)P1 PB P0 Price increase x Qnew (P2 P1) x Q2

D Q2 Q1

Producer burden (PB)

Total tax burden CB (P1 P0) x Q2

Application of Elasticity
Which situation will the consumers pay more than producers?
Consumers with smaller Ed tend to pay more tax. S2 S2 P P t S1 t S1
P2 CB P1 PB P0 D Q2 Q1 Q Q2Q1 P2 CB

P1 PB P0

D Q

Application of Elasticity
Question: In April 2009, HK Government announced to raise the tobacco tax by 50%. Do you expect the smokers or the producers to pay more? Smokers!
Smokers Ed is low

Determinants of Ed
1. When there is no close substitute for a good, demand for it tends to be less price elastic.
eg. MTR

2. When a good is necessity, demand for it tends to be less elastic.

eg. Drugs

3. When the expenditure on a good is large (either in absolute terms or relative to total expenditure), demand tends to be more price elastic.
eg. Rent

Ed along a Linear Demand Curve

The slope of a demand curve is just an approximation of Ed. %Q Qd Ed =d %P 1/slope = P For one demand curve, different points will give different Ed. Qd Pold Ed = P x Qdold

Ed of Linear Demand Curve

What is the Ed of A, B, C, D and E?
Px a A Ed = B Ed > 1

As Price increases, Ed gets higher

a/2

Ed = 1 C
Ed < 1 D Ed = 0 E Qd x b

b/2

Ed of Linear Demand Curve

Question As the prices of the following two goods drop by 50%, which one do you care more?
$2 $1

$1000 0 $500 0

Income Elasticity of Demand

The responsiveness of Qd to a change in Income (Y). The % change in Qd when income changes by 1% Mathematically: %Q EY = d %Y (Qd/Qdold)x100% EY = (Y/Yold)x100 % Qd Yold EY = Y x Qdold

Income Elasticity of Demand

Y Qdx 1000 0 2000 500 3000 1000 4000 1500

Q: What is the EY if the income rises from $2000 to $3000? Qd Yold EY= Y x Qdold
(1000-500) x 2000 EY = (3000500 2000)

EY = 2

Income Elasticity of Demand

Question: What does it mean by EY = 2? When income decreases by 1%, Qd increase by 2%. When income increases by 1%, Qd decreases by 2%.

Income Elasticity of Demand

Question: What is the Sign of EY, positive or Positive negative? Negative
Y ,Q
Normal (Superior) Good

Y ,Q
Inferior Good

Remark: EY can be either + or , depends on whether it is Normal or Inferior Good.

Income Elasticity of Demand

Question: What is the Size of EY? %Q EY = d %Y Depends on the magnitude of the change of Qd. -

Income Elasticity of Demand

Less will be consumed with More will be consumed with higher income. higher income. Inferior Normal Good Good

Income NecessityLuxury
0 1

Neutral Good The same quantity will be consumed even with higher income.

Income Elasticity of Demand

Is Sushi a normal, inferior or income neutral?

Income Elasticity of Demand

Is a cheeseburger a normal, inferior or income neutral?

Income Elasticity of Demand

Is a toilet paper a normal, inferior or income neutral?

The responsiveness of Qd of good x to a change in Price of good y (EPy). The % change in Qdx when Py changes by 1% %Qdx Mathematically: EPy = %P y (Qdx/Qdxold)x100 EPy =%(P / P old)x100% y y Qdx Py old EPy = P x Qdxold y

Cross-Price Elasticity of Demand

Cross-Price Elasticity of Demand

Question: What is the Sign of EPy, positive or Positive negative? Negative
Py , Qx
Substitutes

Py , Qx
Complements

Remark: EPy can be either + or , depends on whether the goods are

Cross-Price Elasticity of Demand

Question: What is the Size of EPy? %Qdx EPy = %P y Depends on the magnitude of the change of Qdx. -

Cross-Price Elasticity of Demand

Complements Substitutes

Increasing degree of Substitutability

Cross-Price Elasticity of Demand

Question Which pair of goods give a larger EPy?

Price Elasticity of Supply

The responsiveness of Qs to a change in price. The % change in Qs when price changes by 1% %Q Es Mathematically: = s%P (Qs/Qsold)x100% Es = (P/Pold)x100 % Qs Pold Es = P x Qsold

Price Elasticity of Supply

Question: What is the Sign of Es, positive or negative? Positive
P ,Q P ,Q The Law of supply

Qs Pold Ed = P x Qsold
(+) (+)

Remark: Es must be positive

Price Elasticity of Supply

According to the size, Es can be divided into five types: Flat 1.Elastic % in Qs > % in P Es >1 2.Inelastic % in Qs < % in P Es <1
S

Steep S

3.Unitarily % in Qs = % in P elastic

Es =1
0

Price Elasticity of Supply

4. Perfectly % in Qs = Es = elastic
Horizontal S

5. Perfectly % in Qs = 0 inelastic

vertical S

Es = 0