Elasticity and Demand

Elasticity and Demand

• The law of demand tells us that there is an inverse relationship between price and quantity demanded.

• But it does not tell us how responsive consumers are to price changes.

Elasticity and Demand

• To find out exactly how responsive consumers are to a price change, we need the price elasticity of demand for that good or service.

• Price elasticity of demand:– A measure of how responsive people are to

price changes.

Elastic vs. Inelastic

• Elastic demand – occurs when slight changes in price produce very large changes in quantity demanded.

• Inelastic demand- occurs when large price change produce only small changes in quantity demanded.

Computing Price Elasticity

• Price elasticity of demand = EP.

• Ep = percentage change in quantity demanded of a product divided by the percentage change in the price of that product.

EP = % ^ QD.

% ^ P .• If EP > 1.00 then we have elastic demand.

• If EP < 1.00 then we have inelastic demand.

Elasticity and Total RevenueElastic demand 

• If demand is elastic, a decrease in price will result in an increase in revenue.

• The price cut will lead to a very large increase in quantity demanded. (Sales)

• This increase in sales swamps the lower price per unit.

Elastic demand 

• If demand is elastic what will happen to revenue when prices are increased?

• The price hike will lead to a very large decrease in quantity demanded. (Sales)

• This decrease in sales swamps the higher price per unit.

Inelastic Demand

• If demand is in inelastic, a decrease in price will result in a decrease in revenue.

• The price cut will lead to a very small

• Increase in quantity demanded. (Sales)

• But the lower price per unit swamps the slight increase in sales.

Inelastic Demand

• If demand is inelastic what will happen to revenue when prices are increased?

• The price hike will lead to a very small decrease in quantity demanded. (Sales)

• But the higher price per unit swamps the slight decrease in sales.

Determinants of Elasticity of Demand

A. Substitutes• The greater the number of substitutes

available, the easier it is to switch between products.

• Therefore, the greater the number of substitutes available, the higher the elasticity of demand for a good.

Determinants of Elasticity of Demand

B. Closeness of the Substitutes• The closer the substitutes are to the

original product, the easier it is to switch between products.

• Therefore, the closer the substitutes are to the original, the higher the elasticity of demand for a product.

Determinants of Elasticity of Demand

C. Luxuries vs. Necessities• Necessities have low elasticity's of

demand.

• Luxuries have a high elasticity of demand.

Determinants of Elasticity of Demand

D. Time• The longer the time period, the more

time people have to search for substitutes.

• The longer the time, the more elastic the demand will be.

Elasticity Problems• Discuss and explain why the demand for the good

is elastic or inelastic.1    oranges2    cigarettes 3    Winston cigarettes4    gasoline5    butter6   diamond engagement rings7    automobiles 8    tickets to a live, professional football game9   your econ textbook, from 1 week before the semester

starts to 1 week after the end of the semester

Accounting vs. Economic Profits

• Accountants and economists count costs and profits differently!

 

Accounting vs. Economic Profits

1.  Accountants

• Total profits = total revenues –total costs

Accounting Profits

• A dentist has a practice that generates revenues of $500,000.

• All expenses total $400,000.

• Accounting profits equal $100,000.

Economists’ Profits

2. Economists

• Economic profits = total revenues –

total costs –total implicit

costs

Economists’ Profits

• The total revenues of the same dentist are $500,000.

• Total explicit, direct costs are $400,000.

Opportunity or Implicit Costs

• What are implicit costs?

• The opportunity costs.

• Opportunity cost is the value of the best alternative given up.

Opportunity Cost of Capital

• Suppose the dentist had used $400,000 of his or her own money to start this business. What if they had taken this money and invested it for an annual rate of return of 10%? What did they give up when they invested this money in their business?

• Opportunity cost of capital = $40,000.

Opportunity Cost of Labor

• Suppose the dentist could have earned $50,000 working for a company. What did they give up in order to set up their own business?

• Opportunity cost of labor = $50,000

• Total opportunity costs =

• $40,000 + $50,000

Total Opportunity Costs

• The total opportunity costs are:

• $40,000 + $50,000 = $90,000

Total Economic Profits

Economic Profits = Total Revenues

– Total Costs– Total Opportunity Costs

• $500,000 - $400,000 - $90,000 = $10,000.

Total Economic Profits

Economic Profits =

$500,00- $400,000- -$90,000

- = $10,000

Short Run vs. the Long Run

Short Run• Short Run = the time period in which

all inputs of production are fixed.

• Often defined as:= All inputs of production

except labor, are fixed.

Short Run vs. Long Run

Long Run• Long Run = the time period in which

all inputs of production can be varied.

• In other words, firms can make all the necessary adjustments to changing market conditions.