Chapter 5 Elasticity

• Price elasticity of demand

• Income elasticity of demand
• Cross-price elasticity of demand
• Price elasticity of supply

• How strongly do customers or sellers react

via quantity demanded or supplied when
price, income, or the price of related goods
change.
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Chapter 5 Elasticity
• Price elasticity of demand is influenced by
1) Availability of close substitutes (eggs vs. agave & honey)
2) Necessities vs. luxuries (medicine vs. jewelry)
3) Definition of the market (how specific we are)
(Food vs. ice cream vs. vanilla ice cream)

4) Time horizon—people can not change their behavior immediately

but can become more elastic over a longer period of time.

2
 Chapter 5 Elasticity
• Variety of demand curves
– Demand is perfectly inelastic
• Elasticity = 0
• Demand curve - vertical
– Demand is perfectly elastic
• Elasticity = infinity
• Demand curve - horizontal
– The flatter the demand curve
• The greater the price elasticity of demand

3
Figure 1
The price elasticity of demand (a, b)
(a) Perfectly inelastic demand: (b) Inelastic demand:
Elasticity = 0 Elasticity < 1
Price Price
Demand Demand
1. An 1. A 22%
increase increase
in price… in price… 2. … leads to
Dhs 5 Dhs 5 an 11% decrease
in quantity
4 1. an 4 1. an demanded
2. …leaves
the quantity
demanded
unchanged

0 100 0 90 100
Quantity 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.
4
Figure 1
The price elasticity of demand (c)
(c) Unit elastic demand:
Elasticity = 1
Price
Demand

Dhs 5
1. A 22%
increase 4 1. an
in price…
2. … leads to
A 22% decrease
in quantity
demanded

0 80 100
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.
5
Figure 1
The price elasticity of demand (d, e)
(d) Elastic demand: (e) Perfectly elastic demand:
Elasticity > 1 Elasticity equals infinity
Price Price
1. A 22% 1. At any price
increase above Dhs4, quantity
in price… demanded is zero 2. At exactly Dhs4
consumers will
Dhs 5 buy any quantity

4 1. an Demand Dhs 4 1. an
Demand
2. … leads to 3. At any price
a 67% decrease below Dhs4, quantity
in quantity demanded is infinite
demanded

0 50 100 0
Quantity 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.
6
Figure 2
Total Revenue (Sales) = Price x Quantity = P x Q
Price

Dhs 4
1. an
P ˣ Q= Dhs400
Demand
P (revenue)

0 100
Quantity
Q
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 Dhs 4, the
quantity demanded is 100, and total revenue is Dhs 400. 7
 Figure 3
How total revenue changes when price changes (a)
(a) The Case of Inelastic Demand
Price Price

1. an Dhs 3 1. an

Revenue=Dhs240
Dhs 1 Demand Demand
Revenue=Dhs100

0 100 Quantity 0 80 Quantity

The impact of a price change on total revenue (p x q) 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 Dhs1 to Dhs3 causes the quantity demanded to fall from
100 to 80. Total revenue rises from Dhs100 to Dhs240. 8
 Figure 3
How total revenue changes when price changes (b)
(b) The Case of Elastic Demand
Price Price

Dhs 5

Dhs 4
1. an 1. an
Revenue
=Dhs200
Revenue=Dhs100

Demand Demand

0 50 Quantity 0 20 Quantity

The impact of a price change on total revenue (p x q) 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 Dhs4 to Dhs5 causes the quantity demanded to fall from
50 to 20. Total revenue falls from Dhs200 to Dhs100. 9
Figure 4
Elasticity of a linear demand curve (graph)
Price

Dhs 7 Elasticity
is larger
6 than 1
5
4 1. an
Elasticity
3 is smaller
than 1
2
Demand
1

0 2 4 6 8 10 12 14 Quantity

The slope of a linear demand curve is constant, but its elasticity is not. The demand
schedule in the table was used to calculate the price elasticity of demand by the midpoint
method. At points with a low price and high quantity, the demand curve is inelastic. At
points with a high price and low quantity, the demand curve is elastic. 10
Figure 4
Elasticity of a linear demand curve (schedule)
Percentage Percentage
Total revenue Change Change in
Price Quantity (Price ˣ Quantity) in Price Quantity Elasticity Description
7
Dhs O 0
Dhs
15 200 13.0 Elastic
6 2 12
18 67 3.7 Elastic
5 4 20
22 40 1.8 Elastic
4 6 24
29 29 1.0 Unit elastic
3 8 24
40 22 0.6 Inelastic
2 10 20
67 18 0.3 Inelastic
1 12 12
200 15 0.1 Inelastic
0 14 0

The slope of a linear demand curve is constant, but its elasticity is not. The
demand schedule in the table was used to calculate the price elasticity of
demand by the midpoint method. At points with a low price and high quantity,
the demand curve is inelastic. At points with a high price and low quantity, the
demand curve is elastic.
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Income Elasticity of Demand
• How strongly quantity demanded changes
when a person’s income changes
Percent change in quantity demanded
Percent change in income
[(Q2 – Q1)/midpoint] / [(Inc2 – Inc1)/midpoint]
Shamsa’s income = 15000 Dhs per month. She buys 6 bottles of sparkling water
and 10 bottles of still water. Shamsa’s income increases to 20000 Dhs per month.
Now she buys 10 bottles of sparkling water and 8 bottles of still water. What is
Shamsa’s income elasticity of demand with respect to sparkling water? With
respect to still water?

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Cross-Price Elasticity of Demand
• How strongly quantity of 1 good demanded
changes when the price of a second good
changes
Percent change in quantity demanded item(A)
Percent change in price item(B)
[(Q2A– Q1A)/midpointA]
[(P2B– P1B/midpointB]

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Cross-Price Elasticity of Demand
When Shamsa goes to the market each week she buys 4 packs of
blueberries (Dhs20 per pack) and 4 packs of pomegranate seeds
(Dhs22 per pack). One week she sees that pomegranates have
increased to Dhs26 per pack, so she buys only 2 packs of
pomegranate seeds and 6 packs of blueberries instead.

She also buys 6 bags of chips (Dhs10 each) and 6 packs of avocado
dip (Dhs12 each). One week avocado dip has increased in price to
Dhs 16, so she only buys 4 bags of chips and 4 packs of avocado
dip.

What is her cross-price elasticity of demand for blueberries? For

chips?

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Figure 5
The price elasticity of supply (a, b)
(a) Perfectly inelastic supply: (b) Inelastic supply:
Elasticity = 0 Elasticity < 1
Price Price
Supply Supply
1. An 1. A 22%
increase increase
in price… in price…
2. … leads to
Dhs 5 Dhs 5 a 10% increase
4 1. an 4 1. an in quantity
supplied
2. …leaves
the quantity
supplied
unchanged

0 100 0 100 110

Quantity Quantity

The price elasticity of supply determines whether the supply curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
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Figure 5
The price elasticity of supply (c)
(c) Unit elastic supply: Elasticity =1
Price
Supply
1. A 22%
increase
in price…
Dhs 5
2. … leads to
4 1. an a 22% increase
in quantity
supplied

0 100 125
Quantity

The price elasticity of supply determines whether the supply curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
16
Figure 5
The price elasticity of supply (d, e)
(d) Elastic supply: (e) Perfectly elastic supply:
Elasticity > 1 Elasticity equals infinity
Price Price
1. At any price
1. A 22% above Dhs4, quantity
increase supplied is infinite
in price… Supply
2. At exactly Dhs4,
producers will
Dhs 5 supply any quantity
4 1. an Dhs 4 1. an
Supply
2. … leads to 3. At any price
a 67% increase below Dhs4, quantity
in quantity supplied is zero
supplied

0 100 200 0
Quantity Quantity

The price elasticity of supply determines whether the supply curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
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Applications of Supply, Demand, & Elasticity
• Does drug interdiction increase or decrease
drug-related crime?
– Government increases the number of federal
agents devoted to the war on drugs
• Illegal drugs - Supply curve shifts left
– Higher price; lower quantity
– Amount of drug-related crimes
• Inelastic demand for drugs
• Higher drugs price – higher total revenue
• Increase drug-related crime
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Applications of Supply, Demand, & Elasticity
• Does drug interdiction increase or decrease
drug-related crime?
– Policy of drug education
• Reduce demand for illegal drugs
• Left shift of demand curve
• Lower quantity; lower price
• Reduce drug-related crime

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 Figure 9
Policies to reduce the use of illegal drugs
(a) Drug Interdiction (b) Drug Education
1. Drug interdiction reduces
Price the supply of drugs. . . Price 1. Drug education reduces
the demand for drugs . . .
2. … which S2 2. . . . which
raises the S1 reduces the
price . . . Supply
price . . .
P2
1. an P1 1. an
3. … and P2
P1 reduces the
quantity sold

3. … and reduces
Demand D2 D1
the quantity sold

0 Q2 Q 1 Quantity 0 Q2 Q1 Quantity

Drug interdiction reduces the supply of drugs from S1 to S2, as in panel (a). If the demand
for drugs is inelastic, then the total amount paid by drug users rises, even as the amount of
drug use falls. By contrast, drug education reduces the demand for drugs from D1 to D2, as
in panel (b). Because both price and quantity fall, the amount paid by drug users falls 20