CHAPTER 20

Elasticity

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 INTHISCHAPTER
20-1 Elasticity: Part 1
20-2 Elasticity: Part 2
20-3 Other Elasticity Concepts
20-4 The Relationship Between
Taxes and Elasticity

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 20-1 Elasticity: Part 1 (1 of 8)

The law of demand states that price and quantity

demanded are inversely related, ceteris paribus, but it
doesn’t tell us by what percentage the quantity demanded
changes as price changes
The notion of price elasticity of demand can help answer
this question
► 20-1a Price Elasticity of Demand
• Price Elasticity of Demand: A measure of the
responsiveness of quantity demanded to changes in
price

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 20-1 Elasticity: Part 1 (2 of 8)

► 20-1a Price Elasticity of Demand (cont)

• The coefficient of price elasticity of demand (Ed) is:

• Dividing a negative 20% by a positive 10%, we get -2

• But by convention, economists simplify things by
using the absolute value of the price elasticity of
demand; thus they drop the minus sign

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 20-1 Elasticity: Part 1 (3 of 8)

► 20-1a Price Elasticity of Demand (cont)

• Using percentage changes to calculate price elasticity
of demand can lead to conflicting results, so
economists use the following
formula to calculate price elasticity
of demand (midpoint formula):

• For the data on price and quantity

demanded in Exhibit 1, the
calculation is:

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 EXHIBIT 1
Calculating Price Elasticity of Demand

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 20-1 Elasticity: Part 1 (4 of 8)

► 20-1b Elasticity is Not Slope

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 20-1 Elasticity: Part 1 (5 of 8)

► 20-1c From Perfectly Elastic to Perfectly Inelastic

Demand
• Elastic Demand: The demand that occurs when the
percentage change in quantity demanded is greater than
the percentage change in price. Quantity demanded
changes proportionately more than price changes
• Inelastic Demand: The demand that occurs when the
percentage change in quantity demanded is less than the
percentage change in price. Quantity demanded changes
proportionately less than price changes
• Unit Elastic Demand: The demand that occurs when the
percentage change in quantity demanded is equal to the
percentage change in price. Quantity demanded changes
proportionately to price changes

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 EXHIBIT 2
Price Elasticity of Demand

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 EXHIBIT 3
Graphical Representation of Price
Elasticity of Demand

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 20-1 Elasticity: Part 1 (6 of 8)

► 20-1c From Perfectly Elastic to Perfectly Inelastic

Demand
• Perfectly Elastic Demand: The demand that occurs
when the percentage a small percentage change in
price causes an extremely large percentage change in
quantity demanded (from buying all to buying
nothing).
• Perfectly Inelastic Demand: The demand that
occurs when quantity demanded does not change as
price changes

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 20-1 Elasticity: Part 1 (7 of 8)

► 20-1d Price Elasticity of Demand and Total Revenue

(Total Expenditure)
• Total Revenue (TR): Price times quantity sold
• Whether total revenue rises, falls, or remains
constant after a price change depends on whether the
percentage change in the quantity demanded is,
respectively, less than, greater than, or equal to the
percentage change in price
• Thus, price elasticity of demand influences total
revenue

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 20-1 Elasticity: Part 1 (7 of 8)

► 20-1e Elastic Demand and Total Revenue

• If demand is elastic, a price rise decreases total
revenue

• If demand is elastic, a price decline increases total

revenue

• Exhibit 4(a) shows the relationship when demand is

elastic
• Exhibit 4(b) shows the relationship when demand is
inelastic

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 EXHIBIT 4
Price Elasticity of Demand and Total
Revenue

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 EXHIBIT 5
Drug Busts and Drug-Related Crime

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 EXHIBIT 6
Elasticities, Price Changes, and Total
Revenue

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 20-2 Elasticity: Part 2 (1 of 5)

► 20-2a Price Elasticity of Demand Along a Straight-Line

• The price elasticity of demand for a straight-line
downward-sloping demand curve varies from highly
elastic to highly inelastic
• When price has fallen enough that we move into the
inelastic range of the demand curve in part (a), further
price declines simply lower total revenue, as shown in
part (b)
• Therefore, total revenue is at its highest when price
elasticity of demand equals 1

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 EXHIBIT 7
Price Elasticity of Demand Along a
Straight-Line Demand Curve

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 20-2 Elasticity: Part 2 (2 of 5)

► 20-2b Determinants of Price Elasticity of Demand

• Four factors are relevant:
1. Number of substitutes
2. Necessities versus luxuries
3. Percentage of one’s budget spent on the good
4. Time
• Because all four factors interact, we hold all other
things constant as we discuss each factor

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 20-2 Elasticity: Part 2 (3 of 5)

► 20-2b Determinants of Price Elasticity of Demand (cont)

• Number of Substitutes
• The more substitutes a good has, the higher the
price elasticity of demand will be
• The fewer substitutes a good has, the lower the
price elasticity of demand will be
• Restated:
• The more broadly defined the good, the fewer the
number of substitutes it will have
• The more narrowly defined the good, the more the
number of substitutes it will have

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 20-2 Elasticity: Part 2 (4 of 5)

► 20-2b Determinants of Price Elasticity of Demand (cont)

• Necessities versus Luxuries
• Generally, the more a good is considered a luxury
(a good we can do without) rather than a necessity
(a good we cannot do without), the higher the price
elasticity of demand will be
• Percentage of One’s Budget Spent on the Good
• The greater the percentage of one’s budget that goes
to purchase a good, the higher the price elasticity of
demand will be
• The smaller the percentage of one’s budget that goes
to purchase a good, the lower the price elasticity of
demand will be
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 20-2 Elasticity: Part 2 (5 of 5)

► 20-2b Determinants of Price Elasticity of Demand (cont)

• Time
• The more time that passes (since the price
change), the higher the price elasticity of
demand for the good will be
• The less time that passes, the lower the
price elasticity of demand for the good will be

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 20-3 Other Elasticity Concepts (1 of 5)

► 20-3a Cross Elasticity of Demand

• Cross Elasticity of Demand: A measure of the
responsiveness in quantity demanded of one good to
changes in the price of another good
• This concept is often used to determine whether
two goods are substitutes for or complements to
each other, and the degree to which one good is a
substitute for or a complement to the other

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 20-3 Other Elasticity Concepts (3 of 5)

► 20-3b Income Elasticity of Demand

• Income Elasticity of Demand: A measure of the
responsiveness of quantity demanded to changes in
income
• Income Elastic: The condition that exists when the
percentage change in quantity demanded of a good is
greater than the percentage change in income
• Income Inelastic: The condition that exists when
the percentage change in quantity demanded of a
good is less than the percentage change in income
• Income Unit Elastic: The condition that exists
when the percentage change in quantity demanded of
a good is equal to the percentage change in income

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 20-3 Other Elasticity Concepts (4 of 5)

► 20-3c Price Elasticity of Supply

• Price Elasticity of Supply: A measure of the
responsiveness of quantity supplied to changes in
price
• In the case of perfectly elastic supply, a small change
in price changes the quantity supplied by an infinitely
large amount (and thus the supply curve, or a portion
of it, is horizontal; Exhibit 8d
• In the case of perfectly inelastic supply, a change in
price brings no change in quantity supplied (and thus
the supply curve, or a portion of the overall supply
curve, is vertical; Exhibit 8e
• See Exhibit 9 for a summary of concepts related to
elasticity

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 EXHIBIT 8
Price Elasticity of Supply (1 of 2)

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 EXHIBIT 8 (cont)
Price Elasticity of Supply (1 of 2)

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 EXHIBIT 9
Summary of the Four Elasticity
Concepts

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 20-3 Other Elasticity Concepts (5 of 5)

► 20-3d Price Elasticity of Supply and Time

• For goods whose quantity supplied can increase
with time (most goods) the longer the period of
adjustment is to a change in price, the higher the
price elasticity of supply will be

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 EXHIBIT 10
House Prices and Elasticity of Supply

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 20-4 The Relationship Between
Taxes and Elasticity (1 of 3)
► 20-4a Who Pays the Tax?
• The placement of a tax is not the same as its payment
• Example: the DVD tax:
• Although the full tax was place don the sellers, they
paid only ½ of it
• Although none of the tax was placed on buyers, they
paid ½ of it, too
• Lesson: government can place a tax on whomever it
wants, but the laws of supply and demand determine
who actually ends up paying it

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 20-4 The Relationship Between Taxes and Elasticity (2 of 3)

► 20-4b Elasticity and the Tax

• The buyer can pay the full tax if demand for the
good is perfectly inelastic, as in Exhibit 12(a)
• Parts (b) through (d) of Exhibit 12 show other cases
• (b) demand is perfectly elastic; sellers must pay
the full tax
• (c) supply is perfectly elastic, and buyers pay the
full tax
• (d) a change in price causes no change in quantity
supplied; if sellers try to charge a higher price,
trying to get buyers to pay some of the tax, a
surplus will result, driving the price back down,
and sellers pay the full tax
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 20-4 The Relationship Between Taxes and Elasticity (3 of 3)

► 20-4c Degree of Elasticity and Tax Revenue

• Suppose two sellers, A (facing a perfectly
inelastic demand for her product), and B (facing
an elastic demand for his product)
• If government is seeking to place a tax, to
maximize tax revenues, it should tax seller A,
because that seller is facing the inelastic
demand curve

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 EXHIBIT 11
Who Pays the Tax?

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 EXHIBIT 12
Different Elasticities and
Who Pays the Tax (1 of 2)

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 EXHIBIT 12
Different Elasticities and
Who Pays the Tax (2 of 2)

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 EXHIBIT 13
Maximizing Tax Revenues

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