MBA 502 – Elasticity & Demand
Price: Clearly one of the most important decisions for the firm How will consumers react to a price change?
Buy less as price increases, but how much less?
How does a price change affect revenues?
Consumer adjustment to a change in price:
Law of demand – price and quantity are inversely related…what happens when price changes? Substitution effect: Buy more (less) of a good when price falls (rises) relative to price of other good Income effect: Can buy more (less) of all goods when price falls (rises) Increases real income
Price Elasticity of Demand
Indicates how responsive consumers are to variation in price When price increases, buy more…but how much more?
Percent change in quantity divided by percent change in price Similar to miles per hour (100 mi in 2 hours…50 mph)
# is how much more (less) you buy when price falls (rises) $1 NOT slope!
Take absolute value because it is almost always negative
Examples: % ∆ Q = -40%, % ∆ P = 25%....ε = 1.6
% ∆ Q = 5%, % ∆ P = 25%....ε = 0.2
Elasticity: Comparing the % ∆ Q to the % ∆ P…for a 1% price change, how much does quantity demanded change? Relatively elastic: ε > 1 - quantity demanded changes more than price Relatively inelastic: ε < 1 - quantity demanded changes less than price Unit Elastic: ε = 1 - quantity demanded changes exactly as price Perfectly elastic: ε = infinity - quantity demanded changes infinitely with price Perfectly inelastic: ε > 0 - quantity demanded doesn’t change with price
Who cares anyway? Huge impact on pricing for the firm.
Also…huge impact for taxation. How would a $1 tax affect a relatively elastic good (a particular brand of potato chips) vs. a relatively inelastic good (cigarettes)
Use arc elasticity (take average of old and new price and quantity)…could use point, but not as representative of demand
So far, looking at the general overall elasticity of a good…I could say demand for gas is relatively inelastic But...
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