Elasticity

Netflix

Read the two articles on Netflix and their change in price.

What was Netflix hoping would happen?

What information would have been useful to them before they made the decision about the pricing of their product?

Price Elasticity of Demand

“The responsiveness of consumers to a price change …”

For some products a minor change in price has no impact on the quantity demanded for the product- Inelastic

For other products, a minor change in the price has a significant impact on the quantity demanded for the product- Elastic

Quote is from the text Essentials of Economics.

Elasticity of Demand Formula E(d)

E(d) = % change in quantity demanded of X % change in price of X

Since we want the elasticity for price increase to be comparable to the elasticity for price decreases, we use the average of the quantities and prices for the numerator and the denominator.

The negative sign is ignored in the calculation.

Problems

Calculate the elasticity of demand for the following :

Price Quantity Demanded

$2.00 100 $3.00 70 $4.00 20

Calculations

Change from $2 to $3: (Change in Q/Change in P)

30/((100+70) /2)=30/85= 0.35

1/((2+3)/2)=1/2.5= 0.4

The elasticity is then 0.35/0.40 which is 0.875. The demand is said to be inelastic.

Calculations

Change from $3 to $4: (Change in Q/Change in P)

50/((70+20)/2)=50/45= 1.11

1/((3+4)/2)= 1/3.5= 0.285

The elasticity is then 1.11 divided by .285 which is 3.89. The demand is said to be elastic.

Interpretation

Elastic Demand- If the % change in price is less than the % change in quantity demanded (answer is greater than 1).

Inelastic Demand- If the % change in price is greater than the % change in quantity demanded (answer is less than 1).

Unit Elasticity- If the % change in price equals the % change in quantity demanded. (answer is 1)

Perfection

Perfectly Inelastic- There is no change in demand in response to a price change (answer is 0).

Examples: Drug addictions

Perfectly Elastic- A small price reduction will cause consumers to increase their purchases to all they desire of the product (answer is infinite).

Perfectly Inelastic Demand

Price

Perfectly inelastic (E(d)=0

Quantity

Perfectly Elastic Demand

Price

Perfectly elastic (E(d)=infinity

Quantity

Total Revenue

For a firm selling a product, their total revenue will equal the price of a unit times the number of units they can sell:

P x Q= Total Revenue

Total Revenue Problem

Based on the information we looked at previously, what is the total revenue in each of these situations?

Price Quantity Demanded Total Revenue Elasticity

$2.00 100 ? $3.00 70 ? ? $4.00 20 ? ?

How does total revenue change with these price changes, and how does it relate to the elasticity of the product?

Elasticity and Total Revenue

For products with an elastic demand, when the price is lowered, the quantity demanded will increase by more, and thus a firm will increase its total revenue.

For products with an inelastic demand, when the price is lowered, the quantity demanded will increase by less, and thus a firm will decrease its total revenue.

For products with an unit elastic demand, a price change will not cause a change in the total revenue.

Determinants of Elasticity of Demand

Substitutability: more substitutes, the greater the elasticity

Proportion of Income: the higher the price relative to your income, the greater the elasticity

Luxuries versus Necessities: the more a good is considered a luxury, the greater the elasticity

Time: the longer the time period, the greater the elasticity

Price Elasticity of Supply

The basic definition is similar the one for demand:

E(s)= % change in quantity supplied of X % change in price of X

The degree of elasticity of supply depends primarily on how easy a supplier can shift its efforts to an alternate use.

Price Elasticity: Market Period

Time immediately after a price change that is too short for the producer to respond to a change in price.

Time period will differ depending on the product.

Supplier is price inelastic during this period. S Price

D2

D1

Quantity

Price Elasticity: The Short Run

The short run is a period of time too short to change the productive capacity of the supplier (example plant capacity), but long enough to change the way the capacity is used.

Supplier is more price elastic in the short run.

Price S

D2

D1

Quantity

Price Elasticity: The Long Run

The long run is a period of time long enough for firms to change their productive capacity or for others to enter or leave the market.

Price S

D2

D1

Quantity

Income Elasticity

This measures the change in demand as a result in a change in income.

E(i)= % change in quantity demanded % change in income

For normal or superior goods, the elasticity is positive as more goods are demanded as income rises.

For inferior goods, the more income a consumer gets, the less of these goods that are demanded.

Insights

Why do we care about elasticity?

What can it tell producers (suppliers)?

What can it tell us about the economy and economic changes (recession, expansion)?