Session 2 To 3 - Chp3b Elasticity and Its Application

5
3
Elasticity and Its Application
PowerPoint Slides prepared by:

Andreea CHIRITESCU
Eastern Illinois University
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• Elasticity
* how sensitive supply and demand is to a
change in one of its determinants (e.g.,
price, income)
The Elasticity of Demand
1. Price elasticity of demand

– When there is a change in the price of a
good, how much does quantity demanded
change in response to the price change?
• From “law of demand”, we know the direction
of change in quantity demanded
• But by how much? --Elasticity
• Elastic demand
– Quantity demanded responds
substantially to changes in price
• Inelastic demand
– Quantity demanded responds only slightly
to changes in price
• Determinants of price elasticity of demand
– Availability of close substitutes
• Goods with close substitutes: more elastic
demand
• Why?
• Determinants of price elasticity of demand
– Necessities vs. luxuries
• Necessities: inelastic demand
• Luxuries: elastic demand
– Narrow vs. broad markets
• Narrow markets: more elastic demand
• Broad markets: more inelastic demand
– Time horizon
• Demand is more elastic over longer time
horizons
• Exercise
Which of the following is likely to have the most price inelastic
demand?
a. Mint-flavored toothpaste
b. Toothpaste
c. Colgate mint-flavored toothpaste
d. A generic mint-flavored toothpaste
• Exercise
If the price elasticity of demand for a good is 4, then a 10%
increase in price results in a
a. 0.4% decrease in the quantity demanded.
b. 2.5% decrease in the quantity demanded.
c. 4% decrease in the quantity demanded.
d. 40% decrease in the quantity demanded.
• Variety of demand curves
– Demand is elastic
• Price elasticity of demand > 1
– Demand is inelastic
• Price elasticity of demand < 1
– Demand has unit elasticity
• Price elasticity of demand = 1
• Variety of demand curves
– Demand is perfectly inelastic
• Price elasticity of demand = 0
• Demand curve is vertical
– Demand is perfectly elastic
• Price elasticity of demand = infinity
• Demand curve is horizontal
• The flatter the demand curve
– The greater the price elasticity of demand
• Exercise
Jean-Paul says that he will buy exactly 75 pieces a day of
M&Ms, regardless of the price of M&Ms. Jean-Paul’s demand
for M&Ms is
a. perfectly elastic.
b. unit elastic.
c. perfectly inelastic.
d. None of the above answers is correct.
• Exercise
For a particular good, a 2 percent increase in price causes a 12
percent decrease in quantity demanded. Which of the following
statements is most likely applicable to this good?
a. There are no close substitutes for this good.
b. The good is a luxury.
c. The market for the good is broadly defined.
d. The relevant time horizon is short.
• Midpoint method
– Two points: (Q1, P1) and (Q2, P2)
(Q2 − Q1 )/[(Q2 + Q1 )/ 2 ]
Price elasticity of demand =
(P2 − P1 )/[(P2 + P1 )/ 2 ]
Figure 1
The Price Elasticity of Demand (a, b)
(a) Perfectly Inelastic Demand: (b) Inelastic Demand: Elasticity Is
Elasticity Equals 0 Less Than 1
Price
1. An Demand
increase in
price…
$5
4
2. …leaves
the quantity
demanded
unchanged
0 100
Quantity
The price elasticity of demand determines whether the demand curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
Figure 1
The Price Elasticity of Demand (a, b)
(a) Perfectly Inelastic Demand: (b) Inelastic Demand: Elasticity Is
Price Price
1. An Demand 1. A 22% 2. … leads
increase in to an 11%
increase
price… decrease in
in price… quantity
$5 $5 demanded
4 4
2. …leaves
the quantity Demand
demanded
unchanged
0 100 0 90 100
Quantity Quantity
Figure 1
The Price Elasticity of Demand (c)
(c) Unit Elastic Demand: Elasticity Equals 1

Price
Demand
$5
1. A 22%
4
increase
in price…
2. … leads to a 22%
decrease in quantity
demanded
0 80 100
Quantity
Figure 1
The Price Elasticity of Demand (d, e)
(d) Elastic demand: (e) Perfectly elastic demand:
Elasticity > 1 Elasticity equals infinity
Price
A 22%
increase
in price…
$5
4 Demand
2. … leads to a
67% decrease
in quantity
demanded
0 50 100
Quantity
Figure 1
The Price Elasticity of Demand (d, e)
(d) Elastic demand: (e) Perfectly elastic demand:
Elasticity > 1 Elasticity equals infinity
Price Price 1. At any price

A 22% above $4, quantity
increase demanded is zero 2. At exactly $4,
in price… consumers will
$5 buy any quantity
4 Demand $4
Demand
2. … leads to a 3. At a price
67% decrease
below $4, quantity
in quantity
demanded demanded is infinite
0 50 100 0
Quantity Quantity
• Exercise 10
Price
8
A
7
6
B
5
4
Demand
3
2 4 6 8 10 12 14 16 18 20 22 24 26 Quantity
Between point A and point B,

a. the slope is equal to -1/4 and the price elasticity of demand is equal to 2/3.
b. the slope is equal to -1/4 and the price elasticity of demand is equal to 3/2.
c. the slope is equal to -3/2 and the price elasticity of demand is equal to 1/4.
d. the slope is equal to -2/3 and the price elasticity of demand is equal to 3/2.
• Exercise 10
Price
8
A
7
6
B
5
4
Demand
3
2 4 6 8 10 12 14 16 18 20 22 24 26 Quantity
Between point A and point B on the graph, demand is

a. perfectly elastic.
b. inelastic.
c. unit elastic.
d. elastic, but not perfectly elastic.
Next:
Price elasticity of demand can be
important when a business is thinking
about attracting more customers by
changing the price of its product!
3. Total revenue, TR
– Amount paid by buyers and received by
sellers of a good
– Price of the good times the quantity sold
(P ˣ Q)
•For a price increase
– If demand is inelastic, TR increases
– If demand is elastic, TR decreases
• For a price decrease
– If demand is inelastic, TR decreases
– If demand is elastic, TR increases
Figure 2
Total Revenue
Price
$4
P ˣ Q=$400 Demand
P (revenue)
0 100 Quantity
The total amount paid by buyers, and received as revenue by sellers, equals the area
of the box under the demand curve, P × Q. Here, at a price of $4, the quantity
demanded is 100, and total revenue is $400.
Figure 3
How Total Revenue Changes When Price Changes (a)
(a) The Case of Inelastic Demand
Price
1. When the demand
curve is inelastic . . .
2. . . . the extra
$5
revenue from
A
selling at a 4
higher price . . . Demand
B 3. . . . is greater than
the lost revenue from
selling fewer units.
0 90 100 Quantity
The impact of a price change on total revenue (the product of price and quantity) depends on
the elasticity of demand. In panel (a), the demand curve is inelastic. In this case, an increase in
the price leads to a decrease in quantity demanded that is proportionately smaller, so total
revenue increases. Here an increase in the price from $4 to $5 causes the quantity demanded to
fall from 100 to 90. Total revenue rises from $400 to $450.
Figure 3
How Total Revenue Changes When Price Changes (b)
(b) The Case of Elastic Demand
Price
1. When the demand
curve is elastic . . .
2. . . . the extra $5
revenue from A
selling at a 4
higher price . . . 3. . . . is less
Demand than the lost
B revenue from
selling fewer
units.
0 70 100 Quantity
The impact of a price change on total revenue (the product of price and quantity) depends on
the elasticity of demand. In panel (b), the demand curve is elastic. In this case, an increase in
the price leads to a decrease in quantity demanded that is proportionately larger, so total
revenue decreases. Here an increase in the price from $4 to $5 causes the quantity demanded
to fall from 100 to 70. Total revenue falls from $400 to $350.
• When demand is inelastic (elasticity < 1)
– P and TR move in the same direction
• If P ↑, TR also ↑
• When demand is elastic (elasticity > 1)
– P and TR move in opposite directions
• If P ↑, TR ↓
• If demand is unit elastic (elasticity = 1)
– Total revenue remains constant when the
price changes
• Exercise 10
Price
8
A
7
6
B
5
4
Demand
3
2 4 6 8 10 12 14 16 18 20 22 24 26 Quantity
Currently the owner of the business charges a price of 6. If he wants to increase total
revenue, he should
a. increase the price to 7 to attract more customers.
b. increase the price to 7, because this earns him more money for each unit sold.
c. decrease the price to 5, simply because he can sell more units.
d. decrease the price to 5, because demand is elastic between the two prices.
4. Other Types of Elasticity of Demand
a) Income elasticity of demand
– How much the quantity demanded of a
good responds to a change in consumers’
income
– Percentage change in quantity demanded
divided by the percentage change in income
– Calculation: midpoint method
note: do not drop the sign!

• Normal goods
– Positive income elasticity
– “richer, buy more; poorer, buy less”
• Inferior goods
– Negative income elasticities
– “richer, buy less; poorer, buy more”
Other Elasticity of Demand
• Exercise
When her income increased from $10,000 to $20,000, Heather's consumption
of movies decreased from 10 to 5 and her consumption of concerts increased
from 2 to 4. We can conclude that for Heather,
a. movie and concerts are both normal goods with income elasticities equal
to 1.
b. movie is an inferior good and concerts are normal goods; both have
income elasticities of 1.
c. movie is an inferior good with an income elasticity of -1 and concerts are

normal goods with an income elasticity of 1.
d. movie and concerts are both inferior goods with income elasticities equal
to -1.
b) Cross-price elasticity of demand
– How much the quantity demanded of one good
responds to a change in the price of another
good
– Percentage change in quantity demanded of the
first good divided by the percentage change in
price of the second good
– Calculation: midpoint method
note: do not drop the sign!

• Substitutes
– Goods typically used in place of one
another
– Positive cross-price elasticity
• Complements
– Goods that are typically used together
– Negative cross-price elasticity
Other Elasticity of Demand
• Exercise
Last month, sellers of good Y took in $100 in total revenue on sales of
50 units of good Y. This month sellers of good Y raised their price and
took in $120 in total revenue on sales of 40 units of good Y. At the
same time, the price of good X stayed the same, but sales of good X
increased from 20 units to 40 units. We can conclude that
a. substitutes, and have a cross-price elasticity of 0.60.
b. complements, and have a cross-price elasticity of -0.60.
c. substitutes, and have a cross-price elasticity of 1.67.
d. complements, and have a cross-price elasticity of -1.67.
Next:
The Elasticity of Supply
1. Price elasticity of supply
– How much the quantity supplied of a good
responds to a change in the price of that
good
– Depends on the flexibility of sellers to
change the amount of the good they
produce
• Elastic supply
– Quantity supplied responds substantially
to changes in the price
• Inelastic supply
– Quantity supplied responds only slightly to
changes in the price
• Determinant of price elasticity of supply
– Time period
• Supply is more elastic in long run
2. Computing price elasticity of supply
– Percentage change in quantity supplied
divided by percentage change in price
– Always positive
• Midpoint method
– Two points: (Q1, P1) and (Q2, P2)
(Q2 − Q1 ) / [(Q2 + Q1 ) / 2 ]
Price elasticity of supply =
(P2 − P1 ) / [(P2 + P1 ) / 2 ]
• Variety of supply curves
– Supply is unit elastic
• Price elasticity of supply = 1
– Supply is elastic
• Price elasticity of supply > 1
– Supply is inelastic
• Price elasticity of supply < 1
• Variety of supply curves
– Supply is perfectly inelastic
• Price elasticity of supply = 0
• Supply curve is vertical
– Supply is perfectly elastic
• Price elasticity of supply = infinity
• Supply curve is horizontal
Figure 5
The Price Elasticity of Supply (a, b)
(a) Perfectly Inelastic Supply: (b) Inelastic Supply: Elasticity Is
Price Price
1. An Supply 1. A 22% Supply
increase increase
in price… in price…
$5 $5 2. … leads to
4 2. …leaves 4 a 10% increase
the quantity in quantity
supplied supplied
unchanged
0 100 0 100 110

Quantity Quantity
The price elasticity of supply determines whether the supply curve is steep or flat.
Figure 5
The Price Elasticity of Supply (c)
(c) Unit Elastic Supply: Elasticity Equals 1
Price
1. A 22% Supply
increase
in price…
$5
4 2. … leads to
a 22% increase
in quantity
supplied
0 100 125
Quantity
Figure 5
The Price Elasticity of Supply (d, e)
(d) Elastic Supply: Elasticity Is (e) Perfectly Elastic Supply:
Greater Than 1 Elasticity Equals Infinity
Price Price 1. At any
1. A 22% price above
increase $4, quantity 2. At exactly $4,
Supply supplied is
in price… producers will
infinite
$5 supply any quantity
4 2. … leads to $4
Supply
a 67% increase 3. At any price
in quantity below $4, quantity
supplied supplied is zero
0 100 150 0
Quantity Quantity
Extra: Case of Smoking
• Why do societies generally discourage

smoking?
• If we want to reduce smoking, what
methods can you think of?
– Target supply? Target demand? What
happens to equilibrium price and quantity?
1. Tax the manufacturer

– Result: supply shift to the left, higher
price
2. Shift the demand curve for cigarettes

– Smoking bans?
– Mandatory health warnings on cigarette
packages?
– Public education, Prohibition of cigarette
advertising
– Etc.
• Which method do you think would be

more effective?
– Is smoking elastic or inelastic?
– What type of consumer is more likely to
quit smoking?
– Need data to confirm
• Taxes (higher price) significantly reduce

smoking
• More effective in younger people,
especially in terms of the extensive
margin
– Lewit and Coate (1982) Journal of Health
Economics
– Evans and Farrelly (1998) RAND Journal
of Economics
• Would higher tobacco taxes lead to higher

cannabis consumption?
– The question here is, are cigarettes and
marijuana complements or substitutes?
– Need data to confirm
• Would higher tobacco taxes lead to higher

cannabis consumption?
– According to some studies, they are
complements.
– E.g., Williams et al. (2004) Health
Economics
• If instead of reducing smoking, we are

talking about illegal drugs,
– What are the elasticities like?
– Target supply or target demand?
– Any “side effects” on the society?
• Could higher price lead to higher crime rate?

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1. Price elasticity of demand

(c) Unit Elastic Demand: Elasticity Equals 1

Price Price 1. At any price

Between point A and point B,

Between point A and point B on the graph, demand is

4. Other Types of Elasticity of Demand

note: do not drop the sign!

c. movie is an inferior good with an income elasticity of -1 and concerts are

note: do not drop the sign!

a. substitutes, and have a cross-price elasticity of 0.60.

b. complements, and have a cross-price elasticity of -0.60.

c. substitutes, and have a cross-price elasticity of 1.67.

d. complements, and have a cross-price elasticity of -1.67.

0 100 0 100 110

• Why do societies generally discourage

1. Tax the manufacturer

2. Shift the demand curve for cigarettes

• Which method do you think would be

• Taxes (higher price) significantly reduce

• Would higher tobacco taxes lead to higher

• Would higher tobacco taxes lead to higher

• If instead of reducing smoking, we are

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