EL ASTICIT Y &

ITS
APPLICATION
 You design websites for local businesses.
You charge $200 per website, and currently sell 12
websites per month.

A SCENARIO… Your costs are rising (including the opp. cost of your
time), so you’re thinking of raising the price to $250.
The law of demand says that you won’t sell as many
websites if you raise your price. How many fewer
websites? How much will your revenue fall, or might it
increase?

CHAPTER 5 ELASTICITY AND ITS APPLICATION

ELASTICITY
• Basic idea: Elasticity measures how much
one variable responds to changes in another variable.
– One type of elasticity measures how much demand for your websites will fall if
you raise your price.
• Definition:
Elasticity is a numerical measure of the responsiveness of Qd or Qs to
one of its determinants.

CHAPTER 5 ELASTICITY
AND ITS APPLICATION
PRICE ELASTICITY OF DEMAND
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.

CHAPTER 5 ELASTICITY
AND ITS APPLICATION
PRICE ELASTICITY OF DEMAND
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
P
Example:
P rises
Price by 10%
P2
elasticity P1
of demand
D
equals
Q
15% Q2 Q1
= 1.5 Q falls
10%
by 15%
CHAPTER 5 ELASTICITY
AND ITS APPLICATION
PRICE ELASTICITY OF DEMAND
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
P
Along a D curve, P and Q move
in opposite directions, which P2
would make price elasticity
negative. P1

We will drop the minus sign D

and report Q
all price elasticities Q2 Q1
as positive numbers.
CHAPTER 5 ELASTICITY
AND ITS APPLICATION
 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

CHAPTER 5 ELASTICITY
AND ITS APPLICATION
 CALCULATING PERCENTAGE
CHANGES 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

CHAPTER 5 ELASTICITY
AND ITS APPLICATION
 CALCULATING PERCENTAGE
CHANGES
• 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, also 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!
CHAPTER 5 ELASTICITY
AND ITS APPLICATION
 CALCULATING PERCENTAGE CHANGES
• 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
CHAPTER 5 ELASTICITY
AND ITS APPLICATION
ACTIVE LEARNING 1:
CALCULATE AN ELASTICITY
Use the following
information to
calculate the
price elasticity
of demand
for hotel rooms:

if P = $70, Qd = 5000

if P = $90, Qd = 3000

11
ACTIVE LEARNING 1:
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%

12
 THE DETERMINANTS OF PRICE EL ASTICIT Y:
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.

CHAPTER 5 ELASTICITY
AND ITS APPLICATION
THE VARIETY OF DEMAND CURVES
• Economists classify demand curves according to their elasticity.
• 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.
• The next 5 slides present the different classifications, from least to most
elastic.

CHAPTER 5 ELASTICITY
AND ITS APPLICATION
 “PERFECTLY INEL ASTIC 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
0
P falls Q
Elasticity: by 10% Q1
0 Q changes
by 0%
CHAPTER 5 ELASTICITY
AND ITS APPLICATION
 “INELASTIC DEMAND”
Price elasticity % change in Q < 10%
= = <1
of demand % change in P 10%

D curve: P
relatively steep
P1
Consumers’
price sensitivity: P2
relatively low D
P falls Q
Elasticity: by 10% Q1 Q2
<1
Q rises less
than 10%
CHAPTER 5 ELASTICITY
AND ITS APPLICATION
 “UNIT ELASTIC DEMAND”
Price elasticity % change in Q 10%
= = =1
of demand % change in P 10%

D curve: P
intermediate slope
P1
Consumers’
price sensitivity: P2
intermediate D

P falls Q
Elasticity: by 10% Q1 Q2
1
Q rises by 10%
CHAPTER 5 ELASTICITY
AND ITS APPLICATION
 “ELASTIC DEMAND”
Price elasticity % change in Q > 10%
= = >1
of demand % change in P 10%

D curve: P
relatively flat
P1
Consumers’
price sensitivity: P2 D
relatively high
P falls Q
Elasticity: by 10% Q1 Q2
>1
Q rises more
than 10%
CHAPTER 5 ELASTICITY
AND ITS APPLICATION
 “PERFECTLY EL ASTIC DEMAND” (THE OTHER EXTREME)

Price elasticity % change in Q any %

= = = infinity
of demand % change in P 0%

D curve: P
horizontal
P2 = P1 D
Consumers’
price sensitivity:
extreme
P changes Q
Elasticity: by 0% Q1 Q2
infinity
Q changes
by any %
CHAPTER 5 ELASTICITY
AND ITS APPLICATION
 ELASTICITY OF A LINEAR DEMAND CURVE

P The slope
$30 E =
200%
= 5.0
of a linear
40% demand
67% curve is
20 E =
67%
= 1.0 constant,
but its
10 E =
40%
= 0.2 elasticity
200% is not.

$0 Q
0 20 40 60

CHAPTER 5 ELASTICITY
AND ITS APPLICATION
 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.

CHAPTER 5 ELASTICITY
AND ITS APPLICATION
 PRICE ELASTICITY AND TOTAL REVENUE
Price elasticity Percentage change in Q
=
of demand Percentage change in P

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.

CHAPTER 5 ELASTICITY
AND ITS APPLICATION
 PRICE ELASTICITY AND TOTAL REVENUE
Demand for
Elastic demand increased your websites
(elasticity = 1.8) P revenue due
lost
to higher P
If P = $200, revenue
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.
CHAPTER 5 ELASTICITY
AND ITS APPLICATION
 PRICE ELASTICITY AND TOTAL REVENUE

Price elasticity Percentage change in Q

=
of demand Percentage change in P

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.
CHAPTER 5 ELASTICITY
AND ITS APPLICATION
 PRICE ELASTICITY AND TOTAL
REVENUE
Now, demand is
inelastic:
increased
Demand for
your websites
revenue due
elasticity = 0.82 P to higher P lost
If P = $200, revenue
due to
Q = 12 and
$250 lower Q
revenue = $2400.
If P = $250, $200
Q = 10 and D
revenue = $2500.
When D is inelastic, Q
a price increase 10 12
causes revenue to rise.
CHAPTER 5 ELASTICITY
AND ITS APPLICATION
ACTIVE LEARNING 2:
ELASTICITY AND EXPENDITURE/REVENUE
A. Pharmacies raise the price of insulin by 10%. Does total expenditure on
insulin rise or fall?
B. As a result of a fare war, the price of a luxury cruise falls 20%.
Does luxury cruise companies’ total revenue
rise or fall?

26
ACTIVE LEARNING 2:
ANSWERS
A. Pharmacies raise the price of insulin by 10%. Does total expenditure on
insulin rise or fall?
Expenditure = P x Q
Since demand is inelastic, Q will fall less
than 10%, so expenditure rises.

27
ACTIVE LEARNING 2:
ANSWERS
B. As a result of a fare war, the price of a luxury cruise falls 20%.
Does luxury cruise companies’ total revenue
rise or fall?
Revenue = P x Q
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.

28
• which good would you expect to have more elastic demand and why?
• required textbooks or mystery novels
• Mystery novels have more elastic demand than required textbooks, because mystery novels
have close substitutes and are a luxury good, while required textbooks are a necessity with no
close substitutes. If the price of mystery novels were to rise, readers could substitute other
types of novels, or buy fewer novels altogether. But if the price of required textbooks were to
rise, students would have little choice but to pay the higher price. Thus the quantity demanded
of required textbooks is less responsive to price than the quantity demanded of mystery
novels.
PRICE ELASTICITY OF SUPPLY
Price elasticity Percentage change in Qs
=
of supply Percentage change in P
• Price elasticity of supply measures how much Qs responds to a change
in P.

 Loosely speaking, it measures the price-

sensitivity of sellers’ supply.
 Again, use the midpoint method to compute the
percentage changes.

CHAPTER 5 ELASTICITY
AND ITS APPLICATION
PRICE ELASTICITY OF SUPPLY
Price elasticity Percentage change in Qs
=
of supply Percentage change in P
P
Example: S
P rises
Price P2
by 8%
elasticity P1
of supply
equals
Q
16% Q1 Q2
= 2.0
8% Q rises
by 16%
CHAPTER 5 ELASTICITY
AND ITS APPLICATION
THE VARIETY OF SUPPLY CURVES

• Economists classify supply curves according to their elasticity.

• 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.
• The next 5 slides present the different classifications, from least to most elastic.

CHAPTER 5 ELASTICITY
AND ITS APPLICATION
 “PERFECTLY INELASTIC” (ONE EXTREME)
Price elasticity % change in Q 0%
= = =0
of supply % change in P 10%

S curve: P
S
vertical
P2
Sellers’
price sensitivity: P1
0
P rises Q
Elasticity: by 10% Q1
0
Q changes
by 0%
CHAPTER 5 ELASTICITY
AND ITS APPLICATION
 “INELASTIC”
Price elasticity % change in Q < 10%
= = <1
of supply % change in P 10%

S curve: P
S
relatively steep
P2
Sellers’
price sensitivity: P1
relatively low
P rises Q
Elasticity: by 10% Q1 Q2
<1
Q rises less
than 10%
CHAPTER 5 ELASTICITY
AND ITS APPLICATION
 “UNIT ELASTIC”
Price elasticity % change in Q 10%
= = =1
of supply % change in P 10%

S curve: P
intermediate slope S
P2
Sellers’
price sensitivity: P1
intermediate
P rises Q
Elasticity: by 10% Q1 Q2
=1
Q rises
by 10%
CHAPTER 5 ELASTICITY
AND ITS APPLICATION
 “ELASTIC”
Price elasticity % change in Q > 10%
= = >1
of supply % change in P 10%

S curve: P
relatively flat S
P2
Sellers’
price sensitivity: P1
relatively high
P rises Q
Elasticity: by 10% Q1 Q2
>1
Q rises more
than 10%
CHAPTER 5 ELASTICITY
AND ITS APPLICATION
 “PERFECTLY ELASTIC” (THE OTHER EXTREME)
Price elasticity % change in Q any %
= = = infinity
of supply % change in P 0%

S curve: P
horizontal
P2 = P1 S
Sellers’
price sensitivity:
extreme
P changes Q
Elasticity: by 0% Q1 Q2
infinity
Q changes
by any %
CHAPTER 5 ELASTICITY
AND ITS APPLICATION
THE DETERMINANTS OF SUPPLY ELASTICITY
• The more easily sellers can change the quantity they produce, the greater
the price elasticity of supply.
• Example: Supply of beachfront property is harder to vary and thus less
elastic than
supply of new cars.
• For many goods, price elasticity of supply is greater in the long run than in
the short run,
because firms can build new factories, or
new firms may be able to enter the market.

CHAPTER 5 ELASTICITY
AND ITS APPLICATION