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CHAPTER
4 In this chapter,
look for the answers to these questions:
 What is elasticity? What kinds of issues can
elasticity help us understand?
Elasticity and its Application  What is the price elasticity of demand?
How is it related to the demand curve?
How is it related to revenue & expenditure?
 What is the price elasticity of supply?
How is it related to the supply curve?
 What are the income and cross-price elasticities of
demand?
© 2009 South-Western, a part of Cengage Learning, all rights reserved 1

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A scenario… Elasticity
You design websites for local businesses.  Basic idea:
You charge $200 per website, Elasticity measures how much one variable
and currently sell 12 websites per month. responds to changes in another variable.
 One type of elasticity measures how much
Your costs are rising demand for your websites will fall if you raise
(including the opportunity cost of your time), your price.
so you consider raising the price to $250.
 Definition:
The law of demand says that you won’t sell as Elasticity is a numerical measure of the
many websites if you raise your price. responsiveness of Qd or Qs to one of its
How many fewer websites? How much will your determinants.
revenue fall, or might it increase?
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Price Elasticity of Demand Price Elasticity of Demand

Price elasticity Percentage change in Qd Price elasticity Percentage change in Qd
= =
of demand Percentage change in P of demand Percentage change in P
P
 Price elasticity of demand measures how Example:
much Qd responds to a change in P. P rises
Price elasticity by 10%
P2

 Loosely speaking, it measures the price- of demand P1

equals
sensitivity of buyers’ demand. D
15% Q
= 1.5 Q2 Q1
10%
Q falls
by 15%
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Price Elasticity of Demand Calculating Percentage Changes

Price elasticity Percentage change in Qd Standard method
= of computing the
of demand Percentage change in P
Demand for percentage (%) change:
P your websites
Along a D curve, P and Q P end value – start value
x 100%
move in opposite directions, P2 start value
which would make price B
P1 $250
elasticity negative. A Going from A to B,
D $200 the % change in P equals
We will drop the minus sign
and report all price D
Q ($250–$200)/$200 = 25%
elasticities as Q2 Q1 Q
positive numbers. 8 12

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Calculating Percentage Changes Calculating Percentage Changes

Problem:  So, we instead use the midpoint method:
The standard method gives
Demand for different answers depending end value – start value
x 100%
your websites on where you start. midpoint
P  The midpoint is the number halfway between
From A to B,
B P rises 25%, Q falls 33%, the start & end values, the average of those
$250
A elasticity = 33/25 = 1.33 values.
$200
D
From B to A,  It doesn’t matter which value you use as the
P falls 20%, Q rises 50%, “start” and which as the “end” – you get the
Q elasticity = 50/20 = 2.50 same answer either way!
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Calculating Percentage Changes ACTIVE LEARNING 1

 Using the midpoint method, the % change Calculate an elasticity
in P equals Use the following
$250 – $200 information to
x 100% = 22.2% calculate the
$225
price elasticity
 The % change in Q equals of demand
12 – 8 for hotel rooms:
x 100% = 40.0%
10 if P = $70, Qd = 5000
 The price elasticity of demand equals if P = $90, Qd = 3000
40/22.2 = 1.8

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ACTIVE LEARNING 1 What determines price elasticity?
Answers
Use midpoint method to calculate
% change in Qd
(5000 – 3000)/4000 = 50%
% change in P
($90 – $70)/$80 = 25%
The price elasticity of demand equals
50%
= 2.0
25%
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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.
ELASTICITY AND ITS APPLICATION
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To learn the determinants of price elasticity,
we look at a series of examples.
Each compares two common goods.
In each example:
 Suppose the prices of both goods rise by 20%.
 The good for which Qd falls the most (in percent)
has the highest price elasticity of demand.
Which good is it? Why?
 What lesson does the example teach us about the
determinants of the price elasticity of demand?
12 ELASTICITY AND ITS APPLICATION 13
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EXAMPLE 2:
“Blue Jeans” vs. “Clothing”
 The prices of both goods rise by 20%.
For which good does Qd drop the most? Why?
 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.)
 Lesson: Price elasticity is higher for narrowly
defined goods than broadly defined ones.
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EXAMPLE 3:
Insulin vs. Caribbean Cruises
 The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
 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.
ELASTICITY AND ITS APPLICATION
16
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
ELASTICITY AND ITS APPLICATION
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EXAMPLE 4:
Gasoline in the Short Run vs. Gasoline
in the Long Run
 The price of gasoline rises 20%. Does Qd drop
more in the short run or the long run? Why?
 There’s not much people can do in the
short run, other than ride the bus or carpool.
 In the long run, people can buy smaller cars
or live closer to where they work.
 Lesson: Price elasticity is higher in the
long run than the short run.
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The Variety of Demand Curves
 The price elasticity of demand is closely related
to the slope of the demand curve.
 Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
 Five different classifications of D curves.…
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“Perfectly inelastic demand” (one extreme case) “Inelastic demand”

Price elasticity % change in Q 0% Price elasticity % change in Q < 10%
= = =0 = = <1
of demand % change in P 10% of demand % change in P 10%

D curve: P D curve: P
D
vertical relatively steep
P1 P1
Consumers’ Consumers’
price sensitivity: P2 price sensitivity: P2
none relatively low D
P falls Q P falls Q
Elasticity: by 10% Q1 Elasticity: by 10% Q1 Q2
0 Q changes <1
Q rises less
by 0% than 10%
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“Unit elastic demand” “Elastic demand”

Price elasticity % change in Q 10% Price elasticity % change in Q > 10%
= = =1 = = >1
of demand % change in P 10% of demand % change in P 10%

D curve: P D curve: P
intermediate slope relatively flat
P1 P1
Consumers’ Consumers’
price sensitivity: P2 price sensitivity: P2 D
intermediate D relatively high
P falls Q P falls Q
Elasticity: by 10% Q1 Q2 Elasticity: by 10% Q1 Q2
1 >1
Q rises by 10% Q rises more
than 10%
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“Perfectly elastic demand” (the other extreme) Elasticity of a Linear Demand Curve
Price elasticity % change in Q any %
= = = infinity
of demand % change in P 0% P The slope
200% of a linear
P $30 E = = 5.0
D curve: 40% demand
horizontal curve is
67%
P2 = P1 D 20 E = = 1.0 constant,
Consumers’ 67%
price sensitivity: but its
40%
extreme 10 E = = 0.2 elasticity
200%
is not.
P changes Q
Elasticity: by 0% Q1 Q2 $0 Q
infinity 0 20 40 60
Q changes
by any %
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Price Elasticity and Total Revenue Price Elasticity and Total Revenue
 Continuing our scenario, if you raise your price
Price elasticity Percentage change in Q
from $200 to $250, would your revenue rise or fall? =
of demand Percentage change in P
Revenue = P x Q
 A price increase has two effects on revenue: Revenue = P x Q
 Higher P means more revenue on each unit  If demand is elastic, then
you sell.
price elast. of demand > 1
 But you sell fewer units (lower Q),
% change in Q > % change in P
due to Law of Demand.
 Which of these two effects is bigger?  The fall in revenue from lower Q is greater
It depends on the price elasticity of demand. than the increase in revenue from higher P,
so revenue falls.
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Price Elasticity and Total Revenue Price Elasticity and Total Revenue
Elastic demand increased Price elasticity Percentage change in Q
Demand for =
(elasticity = 1.8) P revenue due of demand Percentage change in P
your websiteslost
to higher P
If P = $200, revenue
due to Revenue = P x Q
Q = 12 and $250 lower Q
 If demand is inelastic, then
revenue = $2400. price elast. of demand < 1
$200 % change in Q < % change in P
If P = $250, D
Q = 8 and  The fall in revenue from lower Q is smaller
revenue = $2000. than the increase in revenue from higher P,
When D is elastic, Q so revenue rises.
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a price increase  In our example, suppose that Q only falls to 10
causes revenue to fall. (instead of 8) when you raise your price to $250.
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Price Elasticity and Total Revenue ACTIVE LEARNING 2

Now, demand is Elasticity and expenditure/revenue
increased
Demand for
inelastic:
revenue due
your websites A. Pharmacies raise the price of insulin by 10%.
elasticity = 0.82 P to higher P lost
revenue Does total expenditure on insulin rise or fall?
If P = $200,
Q = 12 and due to
lower Q
B. As a result of a fare war, the price of a luxury
revenue = $2400. $250
cruise falls 20%.
If P = $250, $200 Does luxury cruise companies’ total revenue
Q = 10 and D rise or fall?
revenue = $2500.
When D is inelastic, Q
10 12
a price increase
causes revenue to rise.
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ACTIVE LEARNING 2 ACTIVE LEARNING 2

Answers Answers
A. Pharmacies raise the price of insulin by 10%. B. As a result of a fare war, the price of a luxury
Does total expenditure on insulin rise or fall? cruise falls 20%.
Does luxury cruise companies’ total revenue
Expenditure = P x Q
rise or fall?
Since demand is inelastic, Q will fall less
Revenue = P x Q
than 10%, so expenditure rises.
The fall in P reduces revenue,
but Q increases, which increases revenue.
Which effect is bigger?
Since demand is elastic, Q will increase more
than 20%, so revenue rises.
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Exercise Exercise: Answer

 Suppose that business travelers and vacationers have
the following demand for airline tickets from Chicago to
Miami:
a) For business travelers, the price elasticity of demand when the price
of tickets rises from $200 to $250 is
[(2,000 – 1,900)/1,950]/[(250 – 200)/225] = 0.05/0.22 = 0.23.
For vacationers, the price elasticity of demand when the price of tickets
rises from $200 to $250 is
[(800 – 600)/700] / [(250 – 200)/225] = 0.29/0.22 = 1.32.

 a. As the price of tickets rises from $200 to $250, what is
the price elasticity of demand for (i) business travelers
and (ii) vacationers? (Use the midpoint method in your
calculations.)
b) The price elasticity of demand for vacationers is higher than the
elasticity for business travelers because vacationers can choose more
easily a different mode of transportation (like driving or taking the train).
Business travelers are less likely to do so because time is more
important to them and their schedules are less adaptable.

 b. Why might vacationers and business travelers have

different elasticities
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Other Elasticities Other Elasticities

 Income elasticity of demand: measures the  Cross-price elasticity of demand:
measures the response of demand for one good to
response of Qd to a change in consumer income
changes in the price of another good
Income elasticity Percent change in Qd % change in Qd for good 1
= Cross-price elast.
of demand =
Percent change in income of demand % change in price of good 2

 Recall from Chapter 3: An increase in income
causes an increase in demand for a normal good.
 Hence, for normal goods, income elasticity is (+)ve.
 For inferior goods, income elasticity is (-)ve.
ELASTICITY AND ITS APPLICATION
 For substitutes, cross-price elasticity is positive
(e.g., an increase in price of beef causes an
increase in demand for chicken)
 For complements, cross-price elasticity is negative
(e.g., an increase in price of computers causes
decrease in demand for software)
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Cross-Price Elasticities in the News Price Elasticity of Supply

“As Gas Costs Soar, Buyers Flock to Small Cars” Percentage change in Qs
Price elasticity
-New York Times, 5/2/2008 =
of supply Percentage change in P
“Gas Prices Drive Students to Online Courses”
-Chronicle of Higher Education, 7/8/2008  Price elasticity of supply measures how much
“Gas prices knock bicycle sales, repairs into higher gear” Qs responds to a change in P.
-Associated Press, 5/11/2008
 Loosely speaking, it measures sellers’
“Camel demand soars in India” price-sensitivity.
(as a substitute for “gas-guzzling tractors”)
-Financial Times, 5/2/2008  Again, use the midpoint method to compute the
percentage changes.
“High gas prices drive farmer to switch to mules”
-Associated Press, 5/21/2008
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Price Elasticity of Supply Price Elasticity of Supply

Percentage change in Qs  For example, suppose that an increase in the price of milk from $2.85
Price elasticity to $3.15 a gallon raises the amount that dairy farmers produce from
=
of supply Percentage change in P 9,000 to 11,000 gallons per month.
 Using the midpoint method, we calculate the percentage change in
P price as
Example: S
Percentage change in price = (3.15-2.85) /3.00 *100 = 10 percent.
P rises
Price P2  Similarly, we calculate the percentage change in quantity supplied as
by 8%
elasticity P1 Percentage change in quantity supplied = (11,000-9,000) /10, 000 *100
of supply = 20 percent.
equals  In this case, the price elasticity of supply is
Q
16% Q1 Q2 Price elasticity of supply 20 percent / 10 percent = 2.
= 2.0
8% Q rises In this example, the elasticity of 2 indicates that the quantity supplied
by 16% changes proportionately twice as much as the price.

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Price Elasticity of Supply The Variety of Supply Curves

 Exercise:
Suppose that an increase in the price of mineral
water from Tk 20 to Tk 25 per liter raises the supply
from 8,000,000 to 12,000,000 liters per month.
Calculate the price elasticity of supply using the
midpoint method.
 The slope of the supply curve is closely related to
price elasticity of supply.
 Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
 Five different classifications.…

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“Perfectly inelastic” (one extreme) “Inelastic”

Price elasticity % change in Q 0% Price elasticity % change in Q < 10%
= = =0 = = <1
of supply % change in P 10% of supply % change in P 10%

S curve: P S curve: P
S S
vertical relatively steep
P2 P2
Sellers’ Sellers’
price sensitivity: P1 price sensitivity: P1
none relatively low
P rises Q P rises Q
Elasticity: by 10% Q1 Elasticity: by 10% Q1 Q2
0 <1
Q changes Q rises less
by 0% than 10%
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“Unit elastic” “Elastic”

Price elasticity % change in Q 10% Price elasticity % change in Q > 10%
= = =1 = = >1
of supply % change in P 10% of supply % change in P 10%

S curve: P S curve: P
intermediate slope S relatively flat S
P2 P2
Sellers’ Sellers’
price sensitivity: P1 price sensitivity: P1
intermediate relatively high
P rises Q P rises Q
Elasticity: by 10% Q1 Q2 Elasticity: by 10% Q1 Q2
=1 >1
Q rises Q rises more
by 10% than 10%
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“Perfectly elastic” (the other extreme) The Determinants of Supply Elasticity

Price elasticity % change in Q any %
= = = infinity  The more easily sellers can change the quantity
of supply % change in P 0% they produce, the greater the price elasticity of
P
supply.
S curve:
horizontal  Example: Supply of beachfront property is
P2 = P1 S harder to vary and thus less elastic than
Sellers’ supply of new cars.
price sensitivity:
extreme  For many goods, price elasticity of supply
is greater in the long run than in the short run,
P changes Q
Elasticity: by 0% Q1 Q2 because firms can build new factories,
infinity or new firms may be able to enter the market.
Q changes
by any %
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ACTIVE LEARNING 3 ACTIVE LEARNING 3

Elasticity and changes in equilibrium Answers
 The supply of beachfront property is inelastic. Beachfront property
The supply of new cars is elastic. When supply (inelastic supply):
is inelastic, P
 Suppose population growth causes an increase in
demand for both goods to double demand has a D1 D2 S
(at each price, Qd doubles). bigger impact
on price than B
 For which product will P change the most? on quantity.
P2

 For which product will Q change the most? P1 A

Q
Q1 Q2
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ACTIVE LEARNING 3 How the Price Elasticity of Supply Can Vary

Answers
New cars P Supply often
When supply S
(elastic supply): elasticity becomes
is elastic, P $15 <1 less elastic
an increase in as Q rises,
demand has a D1 D2 12 due to
bigger impact S elasticity capacity
on quantity
B >1 limits.
than on price. 4
P2
A
P1 $3
Q
100 200
500 525
Q
Q1 Q2
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APPLICATION: Does Drug Interdiction Increase
or Decrease Drug-Related Crime?
 One side effect of illegal drug use is crime:
Users often turn to crime to finance their habit.
 We examine two policies designed to reduce
illegal drug use and see what effects they have
on drug-related crime.
 For simplicity, we assume the total dollar value
of drug-related crime equals total expenditure
on drugs.
 Demand for illegal drugs is inelastic, due to
addiction issues.
ELASTICITY AND ITS APPLICATION
APPLICATION: Does Drug Interdiction Increase
or Decrease Drug-Related Crime?
 A persistent problem facing our society is the use of illegal
drugs. Drug use has several adverse effects. One is that drug
dependence can ruin the lives of drug users and their families.
Another is that drug addicts often turn to robbery and other
violent crimes to obtain the money needed to support their
habit. To discourage the use of illegal drugs, the U.S.
government devotes billions of dollars each year to reducing
the flow of drugs into the country. Let’s use the tools of supply
and demand to examine this policy of drug interdiction.
 Suppose the government increases the number of federal
agents devoted to the war on drugs. What happens in the
market for illegal drugs?
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Policy 1: Interdiction Policy 2: Education

Interdiction new value of drug- new value of drug-
reduces Price of related crime Education Price of related crime
the supply Drugs S2 reduces the Drugs
D1
of drugs. S1 demand for D2 D1
P2 drugs. S
Since demand
for drugs is P and Q fall.
inelastic, P1 initial value P1 initial value
P rises propor- of drug- Result: of drug-
tionally more related A decrease in P2 related
than Q falls. crime total spending crime

Result: an increase in on drugs, and

Q2 Q1 Quantity in drug-related Q2 Q1 Quantity
total spending on drugs, of Drugs of Drugs
and in drug-related crime crime.

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APPLICATION: Can Good News for Farming Be

Bad News for Farmers? APPLICATION
 APPLICATION: Can Good News for Farming Be
 Imagine you’re a Kansas wheat farmer. Because you earn all your
income from selling wheat, you devote much effort to making your Bad News for Farmers?
land as productive as possible. You monitor weather and soil
conditions, check your fields for pests and disease, and study the
latest advances in farm technology. You know that the more wheat
you grow, the more you will have to sell after the harvest, and the
higher your income and standard of living will be.
 One day, Kansas State University announces a major discovery.
Researchers in its agronomy department have devised a new hybrid
of wheat that raises the amount farmers can produce from each acre
of land by 20 percent. How should you react to this news? Does this
discovery make you better off or worse off than you were before?

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APPLICATION: Why Did OPEC Fail to Keep the

Price of Oil High? APPLICATION
 Many of the most disruptive events for the world’s economies over the past several
decades have originated in the world market for oil. In the 1970s, members of the
 APPLICATION: Why Did OPEC Fail to Keep the
Organization of Petroleum Exporting Countries (OPEC) decided to raise the world price
of oil to increase their incomes. These countries accomplished this goal by agreeing to
Price of Oil High?
jointly reduce the amount of oil they supplied. As a result, the price of oil (adjusted for
overall inflation) rose more than 50 percent from 1973 to 1974. Then, a few years later,
OPEC did the same thing again. From 1979 to 1981, the price of oil approximately
doubled.
 Yet OPEC found it difficult to maintain such a high price. From 1982 to 1985, the price of
oil steadily declined about 10 percent per year. Dissatisfaction and disarray soon
prevailed among the OPEC countries. In 1986, cooperation among OPEC members
completely broke down, and the price of oil plunged 45 percent. In 1990, the price of oil
(adjusted for overall inflation) was back to where it began in 1970, and it stayed at that
low level throughout most of the 1990s. (During the first two decades of the 21st century,
the price of oil fluctuated substantially once again, but the main driving force was not
OPEC supply restrictions. Instead, booms and busts in economies around the world
caused demand to fluctuate, while advances in fracking technology caused large
increases in supply.)
 The OPEC episodes of the 1970s and 1980s show how supply and demand can behave
differently in the short run and in the long run.
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CHAPTER SUMMARY CHAPTER SUMMARY

 Elasticity measures the responsiveness of  Demand is less elastic in the short run,
Qd or Qs to one of its determinants. for necessities, for broadly defined goods,
or for goods with few close substitutes.
 Price elasticity of demand equals percentage
change in Qd divided by percentage change in P.  Price elasticity of supply equals percentage
When it’s less than one, demand is “inelastic.” change in Qs divided by percentage change in P.
When greater than one, demand is “elastic.” When it’s less than one, supply is “inelastic.”
When greater than one, supply is “elastic.”
 When demand is inelastic, total revenue rises
when price rises. When demand is elastic, total  Price elasticity of supply is greater in the long run
revenue falls when price rises. than in the short run.
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CHAPTER SUMMARY

 The income elasticity of demand measures how

much quantity demanded responds to changes in
buyers’ incomes.
 The cross-price elasticity of demand measures
how much demand for one good responds to
changes in the price of another good.

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