Elasticity and Expenditure

1. Elasticity and Expenditure

2. Definitions • Elasticity = responsiveness of quantity demanded to price. • Coefficient of elasticity = Percent change in quantity Percent change in price • Percent change in Q = Change in Q / Q = Q2 - Q1 divided by Q1 • Percent change in P = Change in P / P = P2 - P1 divided by P1

3. Relationship to expenditure • % Δ (PQ) = % Δ P + % Δ Q • If % Δ P = 3 percent and % Δ Q = -10 % , then % Δ (PQ) = - 7 % or revenue declines • Coef of elas = ε = % Δ Q divided by % Δ P hence in the above example ε = 10 / 3 = 3.33 The coefficient of elasticity is greater than 1, so demand is ELASTIC

4. Problem: % Δ Q = - 10 %, and % Δ P = 4 % a. what is the coefficient of elasticity? b. is demand elastic or inelastic? c. what is the percent change in consumer expenditure? [See next slide for answers…but not before trying to solve the problem]

5. Solution: % Δ Q = - 10 %, and % Δ P = 4 % • what is the coefficient of elasticity? ε = % Δ Q / % Δ P = 10 / 4 = 2.5 b. is demand elastic or inelastic? -- since ε > 1.0, demand is elastic. We should expect that consumer expenditure will decline with an increase in price. c. what is the percent change in consumer expenditure? Since % Δ PQ = % Δ P + % Δ Q, we have % Δ PQ = 4 % - 10 % = - 6 %

6. Problem: % Δ Q = + 10 %, and % Δ Revenue = 3 % a. what is the percent change in price? b. what is the coefficient of elasticity? c. is demand elastic or inelastic? d. what is the percent change in consumer expenditure? [See next slide for answers…but not before trying to solve the problem]

7. Solution: % Δ Q = + 10 %, and % Δ Revenue = + 3 % a. what is the percent change in price? Since % Δ PQ = % Δ P + % Δ Q 3 % = % Δ P + 10 % Price must have fallen by 7 percent b. what is the coefficient of elasticity? Since ε = % Δ Q / % Δ P = 10 % / 7 % = 1.43 c. is demand elastic or inelastic? Elastic demand – a reduction in price leads to an increase in revenue -- the coefficient of elasticity is greater than 1. d. what is the percent change in consumer expenditure? The same as the percent change in revenue, + 3 %

8. Problem: % Δ P = + 10 %, and % Δ Revenue = - 3 % a. what is the percent change in quantity? b. what is the coefficient of elasticity? c. is demand elastic or inelastic? d. what is the percent change in consumer expenditure? [See next slide for answers…but not before trying to solve the problem]

9. Solution: % Δ Q = + 10 %, and % Δ Revenue = - 3 % a. what is the percent change in price? Since % Δ PQ = % Δ P + % Δ Q - 3 % = % Δ P + 10 % Price must have fallen by 13 percent b. what is the coefficient of elasticity? Since ε = % Δ Q / % Δ P = 10 % / 13 % = c. is demand elastic or inelastic? Inelastic demand – a reduction in price leads to a decrease in revenue -- the coefficient of elasticity is less than 1. d. what is the percent change in consumer expenditure? The same as the percent change in revenue, - 3 %

10. Problem: % Δ P = + 10 %, and ε = 2.5 a. what is the percent change in quantity? b. is demand elastic or inelastic? c. what is the percent change in consumer expenditure? [See next slide for answers…but not before trying to solve the problem]

11. Solution: % Δ P = + 10 %, and ε = 2.5 a. what is the percent change in quantity? Since ε = 2.5 = % Δ Q / % Δ P = % Δ Q / 10 We have % Δ Q = - 25 % (when price goes up, Q down) b. is demand elastic or inelastic? Since ε = 2.5, demand is ELASTIC; we should expect consumer expenditure to decrease when price increases. c. what is the percent change in consumer expenditure? Since % Δ PQ = % Δ P + % Δ Q, we have % Δ PQ = + 10 - 25 % = - 15%

12. Problem: % Δ P = + 5 %, and ε = 1/4 a. what is the percent change in quantity? b. is demand elastic or inelastic? c. what is the percent change in consumer expenditure? [See next slide for answers…but not before trying to solve the problem]

13. Solution: % Δ P = + 5 %, and ε = ¼ a. what is the percent change in quantity? Since ε = ¼ = % Δ Q / % Δ P = % Δ Q / 5 We have % Δ Q = - 1.25 % (when price goes up, Q down) b. is demand elastic or inelastic? Since ε = ¼ , demand is INELASTIC; we should expect consumer expenditure to increase when price increases. c. what is the percent change in consumer expenditure? Since % Δ PQ = % Δ P + % Δ Q, we have % Δ PQ = + 5 % - 1.25 % = + 3.75%

14. Calculating elasticity from a table

15. Calculating elasticity from a table

16. Elasticity and slope The table was derived from the demand equation: Q = 200 - 20 P Note that for each dollar price goes up, Q goes down by 20 units. In mathematical symbolism, Δ Q / Δ P = - 20 This is close to the formula for the coefficient of elasticity, but not quite the same. What is the difference? [Pause for thought…]

17. Elasticity and slope Slope = Δ Q / Δ P = - 20 But coefficient of elasticity = Δ Q / Q divided by Δ P / P The expression for the coefficient of elastictity can be rearranged to get ε = Δ Q / Δ P times P / Q Which can be a handy computational rule for elasticity AT a point.

18. Problem: given the demand equation Q = 1500 – 25 P What is the coefficient of elasticity at: P = 10 ? First note that Q = 1500 – 250 = 1250, So that the coefficient of elasticity is: ε = Δ Q / Δ P times P / Q ε = 25 (10) / 1250 = 250 / 1250 ε = 0. 20

19. Problem: given the demand equation Q = 1500 – 25 P What is the coefficient of elasticity at: P = 50 ? First note that Q = 1500 – 1250 = 250, So that the coefficient of elasticity is: ε = Δ Q / Δ P times P / Q ε = 25 (50 / 250) = 1250 / 250 ε = 5.0