Chapter 6

The focus of Chapter 6 is on the concept of elasticity, a measure of the responsiveness of either
quantity demanded or supplied to a change in some other variable.

Price elasticity of demand

The most commonly used elasticity measure is the price elasticity of demand, defined as:

price elasticity of demand (Ed) =

The price elasticity of demand is a measure of the sensitivity of quantity demanded to a change
in the price of a good. Notice that the price elasticity of demand will always be expressed as a
positive number (since the absolute value of a negative number is always positive).

Demand is said to be:

 elastic when Ed > 1,

 unit elastic when Ed = 1, and
 inelastic when Ed < 1.

When demand is elastic, a 1% increase in price will result in a greater than 1% reduction in
quantity demanded. If demand is unit elastic, quantity demanded will fall by 1% when the price
rises by 1%. A 1% price increase will result in less than a 1% reduction in quantity demanded
when demand is inelastic.

Suppose, for example, that we know that the price elasticity of demand for a particular good
equals 2. In this case, we'd say that demand is elastic and would know that a 1% increase in price
will cause quantity demanded to fall by 2%.

One extreme case is given by a perfectly elastic demand curve, as appears in the diagram below.
Demand is perfectly elastic only in the special case of a horizontal demand curve. The elasticity
measure in this case is infinite (notice that the denominator of the elasticity measure equals zero).
The closest we get to observing a perfectly elastic demand curve is the demand curve facing a
firm that produces a very small share of the total quantity produced in a market. In this case, the
firms is such a small share of the market that it must take the market price as given. An
individual farmer, for example, has no control over the price that it receives when it brings its
product to market. Whether it supplies 100 or 20,000 bushels of wheat, the price that it received
per bushel is that day's market price.
At the other extreme, a vertical demand curve is said to be perfectly inelastic. Such a demand
curve appears in the diagram below. Note that the price elasticity of demand equals zero for a
perfectly inelastic demand curve since the % change in quantity demanded equals zero. In
practice, we do not expect to see demand curves that are perfectly inelastic. For some range of
prices, the demand for insulin, dialysis, and other such medical treatments, is likely to be close to
being perfectly inelastic. As the price for these commodities rises, however, we would eventually
expect to see the quantity demanded fall because individuals have limited budgets.

Students considering elasticity for the first time often believe that demand is more elastic when
the demand curve is flat and less elastic when it is steep. Unfortunately, it is not quite as simple
as that... In particular, if we consider the case of any downward sloping linear demand curve, we
will see that elasticity varies continuously along this curve. It is true that a one-unit change in
price always results in a constant change in quantity demanded along a linear demand curve
(since the slope is constant). The ratio of the percentage change in quantity demanded to the
percentage change in price, however, changes continuously along such a curve.

To see why this occurs, it is necessary to consider the distinction between a change in the level
of a variable and the percentage change in the same variable. Suppose we consider the distinction
by discussing the percentage change that results from a $1 increase in the price of a good.

 a price increase from $1 to $2 represents a 100% increase in price,

 a price increase from $2 to $3 represents a 50% increase in price,
 a price increase from $3 to $4 represents a 33% increase in price, and
 a price increase from $10 to $11 represents a 10% increase in price.

Notice that, even though the price increases by $1 in each case, the percentage change in price
becomes smaller when the starting value is larger. Let's use this concept to explain why the price
elasticity of demand varies along a linear demand curve.

Consider the change in price and quantity demanded that are illustrated below. At the top of the
curve, the percentage change in quantity is large (since the level of quantity is relatively low)
while the percentage change in price is small (since the level of price is relatively high). Thus,
demand will be relatively elastic at the top of the demand curve. At the bottom of the curve, the
same change in quantity demanded is a small percentage change (since the level of quantity is
large) while the change in price is now a relatively large percentage change (since the level of
price is low). Thus, demand is relatively inelastic at the bottom of the demand curve.

More generally, we can note that elasticity declines continuously along a linear demand curve.
The top portion of the demand curve will be highly elastic and the bottom is highly inelastic. In
between, elasticity gradually becomes smaller as price declines and quantity rises. At some point,
demand changes from being elastic to inelastic. The point at which that occurs, of course, is the
point at which demand is unit elastic. This relationship is illustrated in the diagram below.

Arc elasticity measure

Suppose that we wish to measure the elasticity of demand in the interval between a price of $4
and a price of $5. In this case, if we start at $4 and increase to $5, price has increased by 25%. If
we start at $5 and move to $4, however, price has fallen by 20%. Which percentage change
should be used to represent a change between $4 and $5? To avoid ambiguity, the most common
measure is to use a concept known as arc elasticity in which the midpoint of the interval is used
as the base value in computing elasticity. Under this approach, the price elasticity formula
becomes:

where:

Let's consider an example. Suppose that quantity demanded falls from 60 to 40 when the price
rises from $3 to $5. The arc elasticity measure is given by:
In this interval, demand is inelastic (since Ed < 1).

Elasticity and total revenue

The concept of price elasticity of demand is extensively used by firms that are investigating the
effects of a change in the prices of their commodities. Total revenue is defined as:
total revenue = price x quantity

Suppose that a firm is facing a downward sloping demand curve for its product. How will it's
revenue change if it lowers its price?

The answer, it turns out, is somewhat ambiguous. When the price declines, quantity demanded
by consumers rises. The lower price received for each unit of output lowers total revenue while
the increase in the number of units sold raises total revenue. Total revenue will rise when the
price falls if quantity rises by a large enough percentage to offset the reduction in price per unit.
In particular, we can note that total revenue will increase if quantity demanded rises by more
than one percent when the price falls by one percent. Alternatively, total revenue will decline if
quantity demanded rises by less than one percent when the price declines by one percent. If the
price falls by one percent and quantity demanded falls by one percent, total revenue will remain
unchanged (since the changes will offset each other). A careful observer will note that this comes
down to a question of the magnitude of the price elasticity of demand. As defined above, this
equals:

price elasticity of demand (Ed) =

Using the logic discussed above, we can note that a reduction in price will lead to:

 an increase in total revenue when demand is elastic,

 no change in total revenue when demand is unit elastic, and
 a decrease in total revenue when demand is inelastic.

In a similar manner, an increase in price will lead to:

 a reduction in total revenue when demand is elastic,
 no change in total revenue when demand is unit elastic, and
  an increase in total revenue when demand is inelastic.

The diagram below illustrates the relationship that exists between total revenue and demand
elasticity along a linear demand curve.

As this diagram illustrates, total revenue increases as quantity increases (and price decreases) in
the region in which demand is unit elastic. Total revenue falls as quantity increases (and price
decreases) in the inelastic portion of the demand curve. Total revenue is maximized at the point
at which demand is unit elastic.

Does this mean that firms will choose to produce at the point at which demand is unit elastic?
This would only be the case if they had no production costs. Firms are assumed to be concerned
with maximizing their profits, not their revenue. The optimal level production can be determined
only when we consider both revenue and costs. This topic will be extensively addressed in future
chapters.
Price discrimination

Firms that have some control over their market price can sometimes use that control to enhance
their profits by charging different prices to different customers. In particular, a firm engaging in
price discrimination increases its profits by charging higher prices to those customers who have
the most inelastic demand for the product and lower prices to those customers who have a more
elastic demand. In essence, this strategy involves charging the highest prices to those customers
who are willing to buy the commodity at a high price and charging lower prices to those
customers who are more sensitive to price differentials.

A classic example of price discrimination occurs with airline fares. There are two general
categories of customers: those traveling on vacations and those traveling for business purposes. It
is likely that the demand for air travel by business travelers is less sensitive to price changes than
is true for those on vacation. Airlines are able to charge different prices to these two groups by
offering a high base fare and a "super saver" fare that requires a weekend stay, the purchase of
the tickets several weeks in advance, and similar restrictions. Since those traveling for vacation
purposes are more likely to satisfy these requirements than business travelers, airlines
accomplish the goal of charging higher prices to the business travelers with less elastic demand
and lower prices to those customers with more elastic demand who are flying for vacation
purposes.

The use of cents-off coupons in the Sunday newspapers is another example of price
discrimination that offers a lower price to those customers who have more elastic demands (since
low-wage workers are more likely to be sensitive to price changes and are more likely to use
coupons).

Child and senior citizen discounts at restaurants and movie theaters are also examples of price
discrimination that result in lower prices being charged to those customers with the most elastic
demand for the products.

Determinants of price elasticity of demand

The price elasticity of demand is likely to be relatively high when:

 close substitutes are available,
 the good or service is a large share of the consumer's budget, and

 a longer time period is considered.

Let's consider each of these factors.

When there a large number of substitutes are available, consumers respond to a higher price of a
good by buying more of the substitute goods and less of the relatively more expensive
commodity. Thus, we would expect a relatively high price elasticity of demand for goods or
services with many close substitutes, but would expect a relatively inelastic demand for
commodities such as insulin or AZT with few close substitutes.
If the good is a small share of a consumer's budget, a change in the price of the good will have
little impact on the individual's purchasing power. In this case, a price change will have
relatively little impact on the quantity consumed. A doubling of the price of salt, for example,
would not have much of an impact on a typical consumer's budget. But, when a good is a
relatively large share of a person's spending, a price increase has a larger effect on their
purchasing power. To take an extreme example, suppose that a person spends 50% of his or her
income on a commodity and the price doubled. It's likely that the individual will substantially
reduce their spending in response to the higher price when spending on the good comprises a
larger share of a consumer's budget. Thus, demand will tend to be more elastic for goods that are
a small share of a typical consumer's budget.

Consumers often have more possibilities for substitutes for a good when a longer time period is
considered. Consider, for example, the effect of a higher price for fuel oil or natural gas. In the
short run, individuals may lower the temperature and wear warmer clothes, but are unlikely to
reduce their energy consumption by very much. Over a longer time period, however, consumers
may install more energy efficient furnaces, better insulation, and more energy efficient windows
and doors. Thus, we would expect that the demand for either fuel oil or natural gas would be
more elastic in the long run than in the short run.

Cross-price elasticity of demand

The cross-price elasticity of demand is a measure of the responsiveness of a change in the price
of a good to a change in the price of some other good. The cross-price elasticity of demand
between the goods j and k can be expressed as:

Notice that this cross-price elasticity measure does not have an absolute value sign around it. In
fact, the sign of the cross-price elasticity of demand tells us about the nature of the relationship
between the goods j and k. A positive cross-price elasticity occurs if an increase in the price of
good k is associated with an increase in the demand for good j. As noted earlier (in Chapter 3),
this occurs if and only if these two goods are substitutes.

A negative cross-price elasticity of demand occurs when an increase in the price of good k is
associated with a decline in the demand for good j. This occurs if and only if goods j and k are
complements.

Thus, the cross-price elasticity of demand between two goods tells us whether the two goods are
substitutes or complements. Estimates of the magnitude of the cross-price elasticity can be used
by firms in making pricing and output decisions. McDonald's Corporation, for example, might
want to know the cross-price elasticity of demand between it's chicken sandwiches and its Big
Macs if it is considering the effect of a 20% decrease in the price of its Big Macs. If the cross-
price elasticity of demand is 0.5, then a 20% decrease in the price of its Big Mac sandwiches
would result in a 10% decrease in the number of chicken sandwiches sold. A -.9 cross-price
elasticity of demand between Big Macs and french fries, though, would indicate that a 20%
decrease in the price of Big Mac sandwiches would result in an 18% increase in the sale of
french fries. This sort of information would be useful in determining what prices to charge and in
planning for the impact of such a price change.

Income elasticity of demand

The income elasticity of demand is a measure of how sensitive demand for a good is to a
change in income. Income elasticity of demand is measured as:

As in the case of cross-price elasticity, the sign of income elasticity of demand may be either
positive or negative. A positive value for the income elasticity occurs when an increase in
income results in an increase in the demand for a good. In this case, the good is said to be a
normal good. In practice, most goods seem to be normal goods (and therefore have a positive
income elasticity).

A good is said to be an inferior good if an increase in income results in a reduction in the

quantity of the good demanded. An inspection of the definition of the income elasticity of
demand should make it clear that an inferior good will have a negative income elasticity. Generic
foods, used cars, and similar commodities are likely to be inferior goods for many consumers.

Another distinction that is commonly made (although not mentioned in your text at this point) is
between luxuries and necessities. An increasing share of income is spent on luxury goods as
income increases. This means a 10% increase in income must be associated with a greater than
10% increase in spending on luxury goods. Using the definition of income elasticity of demand,
we can see that a luxury good must have an income elasticity that is greater than one.

A smaller share of income is spent on necessities as income rises. This means that necessities
have an income elasticity that is less than one.

Note that all luxury goods are normal goods while all inferior goods are necessities. (If this is not
immediately obvious, note that an income elasticity that is greater than one must necessarily be
greater than zero while an income elasticity that is less than zero must be less than one.) Normal
goods may be either necessities or luxuries.

Price elasticity of supply

We can also apply the concept of elasticity to supply. The price elasticity of supply is defined
as:
Note that the absolute value sign is not used when measuring the price elasticity of supply since
we do not expect to observe a downward sloping supply curve.

A perfectly inelastic supply curve is vertical (as in the diagram below). The price elasticity of
supply is zero when supply is perfectly inelastic. While your text suggests that the supply of
Monet paintings is perfectly inelastic, this in not entirely correct. If someone offers $.50 for a
Monet painting, how many paintings are likely to be offered for sale? What is meant in the text is
that, for prices above a particular threshold, the supply curve becomes perfectly inelastic for
some goods for which only a finite quantity is available. This is also true for highly perishable
commodities that must be sold on the day they are brought to market. A fisherman with no
storage facilities, for example, must sell all of the fish caught at the end of a given day at
whatever price can be received.

A perfectly elastic supply curve is horizontal (as illustrated in the diagram below). The supply
curve facing a single buyer in a market in which there are a very large number of buyers and
sellers is likely to appear to be perfectly elastic (or close to this, anyway). This will occur when
each buyer is a "price-taker" who has no effect on the market price.
Economists classify time in terms of the "short run" and the "long run." The short run is defined
as the period of time in which capital is fixed. All inputs are variable in the long run. Notice that
the length of the short run and long run will vary from industry to industry. In the lawnmowing
industry, the long run may be as short as the few hours that may be required to buy an additional
lawn mower. In the automotive manufacturing industry, the short run may last for several years
(since it takes a long time to design and build new capital in this industry).

It is expected that supply will be more elastic in the long run than in the short run since firms can
expand or contract their capital in the long run. In the short run, an increase in the price of
personal computers may result in increased employment, more overtime, and additional shifts in
computer factories. In the long run, though, higher prices will lead to a larger expansion in
output as new factories are built.

Tax incidence

As your text notes, the distribution of the burden of a tax depends on the elasticities of demand
and supply. When supply is more elastic than demand, consumers bear a larger share of the tax
burden. Producers bear a larger share of the burden of a tax when demand is more elastic than
supply.