Elasticity PP

Chapter Outline
• The economic concept of elasticity

• The price elasticity of demand
• The cross-elasticity of demand
• Income elasticity
• Other elasticity measures
• Elasticity of supply
Copyright ©2014 Pearson Education, Inc. All rights reserved. 1

Learning Objectives
• Define and measure elasticity
• Apply the concepts of price elasticity,

cross-elasticity, and income elasticity
• Understand the determinants of elasticity
• Show how elasticity affects revenue

The Economic Concept of Elasticity
• Elasticity: the percentage change in one

variable relative to a percentage change in
another.

Price Elasticity of Demand
• Price elasticity of demand: the percentage

change in quantity demanded divided by the
percentage change in price

• Arc price elasticity: elasticity which is measured

over a discrete interval of the demand curve
Ep = arc price elasticity

Q1 = original quantity demanded
Q2 = new quantity demanded
P1 = original price
P2 = new price

• Point elasticity: elasticity measured at a given

point of a demand (or supply) curve. Instead of
estimating over a range of prices, it is the elasticity
at a specific price. The point elasticity of a linear
demand function can be expressed as:

• When demand is nonlinear, the calculation of

ΔQ/ΔP is somewhat more complicated because the
slope of a curve changes. This slope is obtained
using the calculus concept of derivative. In this
instance,
Ed= dQ/dP * P1/Q1
• The derivative of Q with respect to P (i.e., dQ/dP)

is simply the instantaneous version of slope.

Slope and Elasticity
FIGURE 5.1 Slope Is Not a Useful Measure of Responsiveness

Changing the unit of measure from pounds to ounces changes the numerical value of the
demand slope dramatically, but the behavior of buyers in the two diagrams is identical. 8
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
▪ Price elasticity of demand measures how

much Qd responds to a change in P.
▪ Loosely speaking, it measures the

price-sensitivity of buyers’ demand.
ELASTICITY AND ITS APPLICATION 9

=
P
Example:
P rises
Price elasticity P2
by 10%
of demand P1
equals D
15% Q
= 1.5 Q2 Q1
10%
Q falls
by 15%
=
P
Along a D curve, P and Q
move in opposite directions, P2
which would make price
P1
elasticity negative.
D
We will drop the minus sign
and report all price elasticities Q
Q2 Q1
as
positive numbers.

Calculating Percentage Changes
Standard method
of computing the
Demand for percentage (%) change:
your websites
P end value – start value
x 100%
start value
B
$250
A Going from A to B,
$200
the % change in P equals
D
($250–$200)/$200 = 25%
Q
8 12

Problem:
The standard method gives
Demand for different answers depending
your websites on where you start.
P
From A to B,
B P rises 25%, Q falls 33%,
$250
A elasticity = 33/25 = 1.33
$200
From B to A,
D
P falls 20%, Q rises 50%,
Q elasticity = 50/20 = 2.50
8 12

▪ So, we instead use the midpoint method:
end value – start value
x 100%
midpoint
▪ The midpoint is the number halfway between the

start & end values, the average of those values.
▪ It doesn’t matter which value you use as the “start”
and which as the “end” – you get the same answer
either way!
▪ Using the midpoint method, the % change
in P equals
$250 – $200
x 100% = 22.2%
$225
▪ The % change in Q equals
12 – 8
x 100% = 40.0%
10
▪ The price elasticity of demand equals

40/22.2 = 1.8

Calculating Elasticities
The Midpoint Formula
16
• An example of a nonlinear demand curves

is one with constant elasticity
• such a curve has a nonlinear equation:
Q = aP-b
• where –b is the elasticity coefficient

• Categories of elasticity
• Relative elasticity of demand: Ep > 1

• Relative inelasticity of demand: 0 < Ep < 1
• Unitary elasticity of demand: Ep = 1
• Perfect elasticity: Ep = ∞
• Perfect inelasticity: Ep = 0

• Factors affecting demand elasticity

– ease of substitution
– proportion of total expenditures
– length of time period
– durability of product
• possibility of postponing purchase
• possibility of repair
• used product market

• Derived demand: the demand for items that go

into the production of a final commodity, such as
materials, machinery, and labor.
– The demand for such components of a final
product is called derived demand.
– The demand for such a product or factor exists
because there is demand for the final product.

• The derived demand curve will be more

inelastic:
– the more essential is the component
– the more inelastic is the demand curve for the
final product
– the smaller is the fraction of total cost going to
this component
– the more inelastic is the supply curve of
cooperating factors

• Elasticity examples
– coffee: short run -0.2, long run -0.33

– kitchen and household appliances: -0.63
– meals at restaurants: -2.27
– airline travel in U.S.: -1.98
– U.S. oil demand: short run -.06, long run -.45

Elasticity Changes Along a Straight-Line Demand Curve
TABLE 5.3 Demand Schedule for

Office Dining Room
Lunches
Price (per Quantity Demanded
Lunch) (Lunches per Month)
$11 0
10 2
9 4
8 6
7 8
6 10
5 12
4 14
3 16
2 18
1 20
0 22 FIGURE 5.3 Demand Curve for
Lunch at the Office Dining Room
Between points A and B, demand is quite elastic at -6.4.
Between points C and D, demand is quite inelastic at -.294.
27
Refer to the figure. Using the midpoint
formula, calculate the values of
elasticity between points A and B,
and then between points C and D.
Those values are, respectively:
a. –6.4 and –0.294
b. –0.1 and –4.54
c. –0.15 and –3.40
d. –0.5 and –0.5. Elasticity is the same
for both sets of points because the
demand curve is linear; thus, the
slope of the line remains constant.
28
Cross-price Elasticity of Demand
• Cross-price elasticity of demand: the

percentage change in quantity consumed of one
product as a result of a 1 percent change in the
price of a related product

• Arc cross-elasticity-relates the percentage

change in quantity to the percentage change
in the price of another product (either a
substitute or a complement).

• The sign of cross-elasticity for substitutes is

positive
– The sign of cross-elasticity for complements is

negative.
– Two products are considered good substitutes or

complements when the coefficient is larger than
0.5 (in ab. value).

• Cross-price elasticity of demand examples:

– Residential demand for electric energy with
respect to prices of gas energy was low, about
+0.13.
– The cross-elasticity of demand for beef with

respect to pork prices was calculated to be about
+0.25. With respect to prices of chicken, it was
about +0.12. Both numbers indicate that the
products are substitutes.

Cross Elasticity
▪ Cross Elasticity is the percentage change in
quantity demanded because of percentage
change in the price of another good (say z).
= %ΔQ/%ΔPz
Other Elasticities
▪ Cross-price elasticity of demand:
measures the response of demand for one good
to changes in the price of another good
d
Cross-price elast. % change in Q for good 1
=
of demand % change in price of good 2
▪ For substitutes, cross-price elasticity > 0

(e.g., an increase in price of beef causes an
increase in demand for chicken)
▪ For complements, cross-price elasticity < 0
(e.g., an increase in price of computers causes
decrease in demand for software)
Income Elasticity
• Income elasticity of demand: the

percentage change in quantity demanded caused
by a 1 percent change in income
(Y is shorthand for income)

Income Elasticity
• Categories of income
elasticity
– superior goods:
EY > 1
– normal goods:
0 ≤ EY ≤ 1
– inferior goods:
EY < 0

Income Elasticity
• Income elasticity examples

– Short-run income elasticity for food expenditure
is about 0.5 and the elasticity of restaurant
meals 1.6.
– The short-run income elasticity for jewelry and
watches appeared to be 1.0, long run is 1.6.
– For gasoline the short-run income elasticity is
between 0.35 and 0.55, long run between 1.1
and 1.3.

Income Elasticity
▪ Income Elasticity is the percentage change in
quantity demanded because of percentage
change in income
= %ΔQ/%ΔY
Income Elasticities
▪ Income elasticity of demand: measures the
response of Qd to a change in consumer income
Income elasticity Percent change in Qd

=
of demand Percent change in income
▪ Recall from Chapter 4: An increase in income

causes an increase in demand for a normal good.
▪ Hence, for normal goods, income elasticity > 0.

▪ For inferior goods, income elasticity < 0.
Other Demand Elasticity
• Elasticity is encountered every time a

change in some variable affects demand
such as:
– advertising expenditures
– interest rates
– population size

Elasticity of Supply
• Price elasticity of supply: the percentage

change in quantity supplied as a result of a 1
percent change in price
The coefficient of supply elasticity is a

normally a positive number

Elasticity of Supply
• When the supply curve is more elastic, the effect of

a change in demand will be greater on quantity
than on the price of the product
• When the supply curve is less elastic, a change in

demand will have a greater effect on price than on
quantity

Global Application
There are substantial differences in elasticities

around the world.

Data for Calculating Elasticity at shaded section
Px Pz Y Qx
10 7 550 1
9 9 500 2
8 11 450 3
7 13 400 4
6 15 350 5
5 17 300 6
4 19 250 7
3 21 200 8
2 23 150 9
1 25 100 10
Price Point Elasticity:
(5-4)/ (6-7)*7/4 = -1.75
▪ Comment: We found negative but elastic relationship
between price and quantity demanded, which is
normal.
Income Elasticity:
(5-4) / (350-400)*400/4 = -2
▪ Comment: The income elasticity is negative. It is elastic. Negative
elasticity means the good concerned is an inferior goods.
▪ Cross Elasticity:
▪ (5-4) / (15-13)*13/4 = +1.63
▪ Comments: The cross elasticity is positive and elastic. It means
the good concerned is a substitute.
The Determinants of Demand Elasticity
Availability of Substitutes
Perhaps the most obvious factor affecting demand

elasticity is the availability of substitutes.
The Importance of Being Unimportant

When an item represents a relatively small part of
our total budget, we tend to pay little attention to its
price.
The Time Dimension
The elasticity of demand in the short run may be

very different from the elasticity of demand in the
long run. In the longer run, demand is likely to
become more elastic, or responsive, simply
because households make adjustments over time
and producers develop substitute goods.
48
EXAMPLE 1:
Breakfast cereal vs. Sunscreen
▪ The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
▪ Breakfast cereal has close substitutes
(e.g., pancakes, Eggo waffles, leftover pizza),
so buyers can easily switch if the price rises.
▪ Sunscreen has no close substitutes,
so consumers would probably not
buy much less if its price rises.
▪ Lesson: Price elasticity is higher when close
substitutes are available.
EXAMPLE 2:
“Blue Jeans” vs. “Clothing”
▪ The prices of both goods rise by 20%.
▪ For a narrowly defined good such as
blue jeans, there are many substitutes
(khakis, shorts, Speedos).
▪ There are fewer substitutes available for broadly
defined goods.
(There aren’t too many substitutes for clothing,
other than living in a nudist colony.)
▪ Lesson: Price elasticity is higher for narrowly
defined goods than broadly defined ones. 50
ELASTICITY AND ITS APPLICATION
EXAMPLE 3:
Insulin vs. Caribbean Cruises
▪ The prices of both of these goods rise by 20%.
▪ To millions of diabetics, insulin is a necessity.
A rise in its price would cause little or no
decrease in demand.
▪ A cruise is a luxury. If the price rises,
some people will forego it.
▪ Lesson: Price elasticity is higher for luxuries
than for necessities.

The Determinants of Price Elasticity:
A Summary
The price elasticity of demand depends on:

▪ the extent to which close substitutes are
available
▪ whether the good is a necessity or a luxury
▪ how broadly or narrowly the good is defined
▪ the time horizon – elasticity is higher in the
long run than the short run

Types of Elasticity
TABLE 5.1 Hypothetical Demand Elasticities for Four Products

Product % Change
% Change In In Quantity
Price Demanded Elasticity
(% ΔP) (% ΔQD) (% ΔQD ÷ %ΔP)
Insulin +10% 0% .0 Perfectly inelastic
Basic telephone service +10% -1% -.1 Inelastic
Beef +10% -10% -1.0 Unitarily elastic

Bananas +10% -30% -3.0 Elastic
perfectly inelastic demand Demand in which

quantity demanded does not respond at all to a
change in price.
53
Types of Elasticity
FIGURE 5.2 Perfectly Inelastic and Perfectly Elastic Demand Curves

Figure 5.2(a) shows a perfectly inelastic demand curve for insulin. Price elasticity of demand
is zero. Quantity demanded is fixed; it does not change at all when price changes.
Figure 5.2(b) shows a perfectly elastic demand curve facing a wheat farmer. A tiny price
increase drives the quantity demanded to zero. In essence, perfectly elastic demand implies
that individual producers can sell all they want at the going market price but cannot charge a
higher price.
54
Types of Elasticity
inelastic demand Demand that responds

somewhat, but not a great deal, to changes
in price. Inelastic demand always has a
numerical value between zero and -1.
A warning: You must be very careful
about signs. Because it is generally
understood that demand elasticities are
negative (demand curves have a
negative slope), they are often reported
and discussed without the negative sign.
55
Types of Elasticity
unitary elasticity A demand relationship in which the
percentage change in quantity of a product demanded
is the same as the percentage change in price in
absolute value (a demand elasticity of -1).
elastic demand A demand relationship in which the

percentage change in quantity demanded is larger than
the percentage change in price in absolute value (a
demand elasticity with an absolute value greater than
1).
perfectly elastic demand Demand in which quantity
drops to zero at the slightest increase in price.
56
“Perfectly inelastic demand” (one extreme case)
Price elasticity % change in Q 0%
= = =0
of demand % change in P 10%
D curve: P
D
vertical
P1
Consumers’
price sensitivity: P2
none
P falls Q
Elasticity: by 10% Q1
0 Q changes
by 0%
“Inelastic demand”
Price elasticity % change in Q < 10%
= = <1
D curve: P
relatively steep
P1
Consumers’
relatively low D
P falls Q
Elasticity: by 10% Q1 Q2
<1
Q rises less
than 10%
“Unit elastic demand”
Price elasticity % change in Q 10%
= = =1
D curve: P
intermediate slope
P1
Consumers’
intermediate D
P falls Q
1
Q rises by 10%

“Elastic demand”
Price elasticity % change in Q > 10%
= = >1
D curve: P
relatively flat
P1
Consumers’
price sensitivity: P2 D
relatively high
P falls Q
>1
Q rises more
than 10%
“Perfectly elastic demand” (the other extreme)
Price elasticity % change in Q any %
= = = infinity
D curve: P
horizontal
P2 = P1 D
Consumers’
price sensitivity:
extreme
P changes Q
infinity
Q changes
by any %
• The relationship between price and revenue

depends on elasticity

• Marginal revenue: the change in total revenue

resulting from changing quantity by one unit

• As price decreases
– revenue rises when
demand is elastic
– revenue falls when it
is inelastic
– revenue reaches its
peak if elasticity =1
The lower chart shows

the effect of elasticity on
total revenue.

• Marginal revenue curve

is twice as steep as the
demand curve

• At the point where

marginal revenue
crosses the X-axis,
the demand curve is
unitary elastic and
total revenue reaches
a maximum.

Price Elasticity and Total Revenue
▪ Continuing our scenario, if you raise your price
from $200 to $250, would your revenue rise or fall?
Revenue = P x Q
▪ A price increase has two effects on revenue:
▪ Higher P means more revenue on each unit
you sell.
▪ But you sell fewer units (lower Q),
due to Law of Demand.
▪ Which of these two effects is bigger?
It depends on the price elasticity of demand.
Price elasticity Percentage change in Q
=
Revenue = P x Q
▪ If demand is elastic, then

price elast. of demand > 1
% change in Q > % change in P
▪ The fall in revenue from lower Q is greater

than the increase in revenue from higher P,
so revenue falls.
Elastic demand Demand for
(elasticity = 1.8) your websites
P lost
revenue
If P = $200,
due to
Q = 12 and lower Q
$250
revenue = $2400.
$200
If P = $250, D
Q = 8 and
revenue = $2000.
When D is elastic, Q
8 12
a price increase
causes revenue to fall.
Price elasticity Percentage change in Q
=
Revenue = P x Q
▪ If demand is inelastic, then
price elast. of demand < 1
% change in Q < % change in P
▪ The fall in revenue from lower Q is smaller
than the increase in revenue from higher P,
so revenue rises.
▪ In our example, suppose that Q only falls to 10
(instead of 8) when you raise your price to $250.
Now, demand is Demand for
inelastic: your websites
elasticity = 0.82 P lost
If P = $200, revenue
due to
Q = 12 and
$250 lower Q
revenue = $2400.
$200
If P = $250,
Q = 10 and D
revenue = $2500.
When D is inelastic, Q
a price increase 10 12
causes revenue to rise.
Elasticity and Total Revenue
In any market, P x Q is total revenue (TR) received

by producers:
TR = P x Q
total revenue = price x quantity
When price (P) declines, quantity demanded (QD)

increases. The two factors, P and QD move in
opposite directions:
Effects of price changes

on quantity demanded:
75
Because total revenue is the product of P and Q,

whether TR rises or falls in response to a price
increase depends on which is bigger: the
percentage increase in price or the percentage
decrease in quantity demanded.
Effects of price increase on

a product with inelastic demand:
If the percentage decline in quantity demanded

following a price increase is larger than the
percentage increase in price, total revenue will fall.
Effects of price increase on

a product with inelastic demand:
76
The opposite is true for a price cut. When demand

is elastic, a cut in price increases total revenues:
effect of price cut on a product

with elastic demand:
When demand is inelastic, a cut in price reduces

total revenues:
effect of price cut on a product

with inelastic demand:
77
Summary
• Elasticity is defined as the sensitivity of one variable to

another.
• Price elasticity of demand is the percentage change in the
quantity demanded of a product caused by a percentage
change in its own price.
• When demand is elastic, revenue rises as quantity demanded
increases; revenue reaches its peak at the point of unitary
elasticity and descends as quantity rises on the demand
curve’s inelastic sector.
• Cross-price elasticity, the relationship between the demand
for one product and the price of another.
• Income elasticity, measures the sensitivity of demand for a
product to changes in the income of the population.

REVIEW TERMS AND CONCEPTS
cross-price elasticity of demand inelastic demand

elastic demand midpoint formula
elasticity perfectly elastic demand
elasticity of labor supply perfectly inelastic demand
elasticity of supply price elasticity of demand
income elasticity of demand unitary elasticity
79

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Chapter Outline

• The economic concept of elasticity

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1

• Define and measure elasticity

• Apply the concepts of price elasticity,

• Understand the determinants of elasticity

• Show how elasticity affects revenue

Copyright ©2014 Pearson Education, Inc. All rights reserved. 2

• Elasticity: the percentage change in one

Copyright ©2014 Pearson Education, Inc. All rights reserved. 3

• Price elasticity of demand: the percentage

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4

• Arc price elasticity: elasticity which is measured

Ep = arc price elasticity

Copyright ©2014 Pearson Education, Inc. All rights reserved. 5

• Point elasticity: elasticity measured at a given

Copyright ©2014 Pearson Education, Inc. All rights reserved. 6

• When demand is nonlinear, the calculation of

Ed= dQ/dP * P1/Q1

• The derivative of Q with respect to P (i.e., dQ/dP)

Copyright ©2014 Pearson Education, Inc. All rights reserved. 7

Slope and Elasticity

FIGURE 5.1 Slope Is Not a Useful Measure of Responsiveness

▪ Price elasticity of demand measures how

▪ Loosely speaking, it measures the

ELASTICITY AND ITS APPLICATION 9

ELASTICITY AND ITS APPLICATION 11

ELASTICITY AND ITS APPLICATION 12

ELASTICITY AND ITS APPLICATION 13

▪ The midpoint is the number halfway between the

▪ The price elasticity of demand equals

ELASTICITY AND ITS APPLICATION 15

The Midpoint Formula

• An example of a nonlinear demand curves

• such a curve has a nonlinear equation:

• where –b is the elasticity coefficient

Copyright ©2014 Pearson Education, Inc. All rights reserved. 17

• Relative elasticity of demand: Ep > 1

Copyright ©2014 Pearson Education, Inc. All rights reserved. 18

• Factors affecting demand elasticity

Copyright ©2014 Pearson Education, Inc. All rights reserved. 19

• Derived demand: the demand for items that go

Copyright ©2014 Pearson Education, Inc. All rights reserved. 20

• The derived demand curve will be more

Copyright ©2014 Pearson Education, Inc. All rights reserved. 21

– coffee: short run -0.2, long run -0.33

Copyright ©2014 Pearson Education, Inc. All rights reserved. 22

TABLE 5.3 Demand Schedule for

• Cross-price elasticity of demand: the

Copyright ©2014 Pearson Education, Inc. All rights reserved. 30

• Arc cross-elasticity-relates the percentage

Copyright ©2014 Pearson Education, Inc. All rights reserved. 31

• The sign of cross-elasticity for substitutes is

– The sign of cross-elasticity for complements is

– Two products are considered good substitutes or

Copyright ©2014 Pearson Education, Inc. All rights reserved. 32

• Cross-price elasticity of demand examples:

– The cross-elasticity of demand for beef with

Copyright ©2014 Pearson Education, Inc. All rights reserved. 33

▪ For substitutes, cross-price elasticity > 0

• Income elasticity of demand: the

(Y is shorthand for income)

Copyright ©2014 Pearson Education, Inc. All rights reserved. 36