CHAPTE

R 20

Elasticity

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 INTHISCHAPT
ER 20-1 Elasticity: Part 1
20-2 Elasticity: Part 2
20-3 Other Elasticity Concepts
20-4 The Relationship Between Taxes
and Elasticity

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 20-1 Elasticity: Part 1 (1 of 8)

The law of demand states that price and quantity demanded are
inversely related, ceteris paribus, but it doesn’t tell us by what
percentage the quantity demanded changes as price changes
The notion of price elasticity of demand can help answer this
question
► 20-1a Price Elasticity of Demand
• Price Elasticity of Demand: A measure of the responsiveness of
quantity demanded to changes in price

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 20-1 Elasticity: Part 1 (2 of 8)

► 20-1a Price Elasticity of Demand (cont)

• The coefficient of price elasticity of demand (Ed) is:

• Dividing a negative 20% by a positive 10%, we get -2

• But by convention, economists simplify things by using the
absolute value of the price elasticity of demand; thus they
drop the minus sign

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 20-1 Elasticity: Part 1 (3 of 8)

► 20-1a Price Elasticity of Demand (cont)

• Using percentage changes to calculate price elasticity of
demand can lead to conflicting results, so economists use the
following
formula to calculate price elasticity
of demand (midpoint formula):

• For the data on price and quantity

demanded in Exhibit 1, the
calculation is:

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 EXHIBIT 1
Calculating Price Elasticity of Demand

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 20-1 Elasticity: Part 1 (4 of 8)

► 20-1b Elasticity is Not Slope

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 20-1 Elasticity: Part 1 (5 of 8)

► 20-1c From Perfectly Elastic to Perfectly Inelastic

Demand
• Elastic Demand: The demand that occurs when the
percentage change in quantity demanded is greater than the
percentage change in price. Quantity demanded changes
proportionately more than price changes
• Inelastic Demand: The demand that occurs when the
percentage change in quantity demanded is less than the
percentage change in price. Quantity demanded changes
proportionately less than price changes
• Unit Elastic Demand: The demand that occurs when the
percentage change in quantity demanded is equal to the
percentage change in price. Quantity demanded changes
proportionately to price changes
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 EXHIBIT 2
Price Elasticity of Demand

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 EXHIBIT 3
Graphical Representation of Price
Elasticity of Demand

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 20-1 Elasticity: Part 1 (6 of 8)

► 20-1c From Perfectly Elastic to Perfectly Inelastic Demand

• Perfectly Elastic Demand: The demand that occurs when the
percentage a small percentage change in price causes an
extremely large percentage change in quantity demanded
(from buying all to buying nothing).
• Perfectly Inelastic Demand: The demand that occurs when
quantity demanded does not change as price changes

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 20-1 Elasticity: Part 1 (7 of 8)

► 20-1d Price Elasticity of Demand and Total Revenue (Total

Expenditure)
• Total Revenue (TR): Price times quantity sold
• Whether total revenue rises, falls, or remains constant after a
price change depends on whether the percentage change in the
quantity demanded is, respectively, less than, greater than, or
equal to the percentage change in price
• Thus, price elasticity of demand influences total revenue

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 20-1 Elasticity: Part 1 (7 of 8)

► 20-1e Elastic Demand and Total Revenue

• If demand is elastic, a price rise decreases total revenue

• If demand is elastic, a price decline increases total revenue

• Exhibit 4(a) shows the relationship when demand is elastic

• Exhibit 4(b) shows the relationship when demand is inelastic

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 EXHIBIT 4
Price Elasticity of Demand and Total
Revenue

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 EXHIBIT 5
Drug Busts and Drug-Related Crime

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 EXHIBIT 6
Elasticities, Price Changes, and Total
Revenue

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 20-2 Elasticity: Part 2 (1 of 5)

► 20-2a Price Elasticity of Demand Along a Straight-Line

• The price elasticity of demand for a straight-line downward-
sloping demand curve varies from highly elastic to highly
inelastic
• When price has fallen enough that we move into the inelastic
range of the demand curve in part (a), further price declines
simply lower total revenue, as shown in part (b)
• Therefore, total revenue is at its highest when price elasticity of
demand equals 1

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 EXHIBIT 7
Price Elasticity of Demand Along a
Straight-Line Demand Curve

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 20-2 Elasticity: Part 2 (2 of 5)

► 20-2b Determinants of Price Elasticity of Demand

• Four factors are relevant:
1. Number of substitutes
2. Necessities versus luxuries
3. Percentage of one’s budget spent on the good
4. Time
• Because all four factors interact, we hold all other things
constant as we discuss each factor

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 20-2 Elasticity: Part 2 (3 of 5)

► 20-2b Determinants of Price Elasticity of Demand (cont)

• Number of Substitutes
• The more substitutes a good has, the higher the
price elasticity of demand will be
• The fewer substitutes a good has, the lower the
price elasticity of demand will be
• Restated:
• The more broadly defined the good, the fewer the number of
substitutes it will have
• The more narrowly defined the good, the more the number of
substitutes it will have

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 20-2 Elasticity: Part 2 (4 of 5)

► 20-2b Determinants of Price Elasticity of Demand (cont)

• Necessities versus Luxuries
• Generally, the more a good is considered a luxury
(a good we can do without) rather than a necessity
(a good we cannot do without), the higher the price elasticity
of demand will be
• Percentage of One’s Budget Spent on the Good
• The greater the percentage of one’s budget that goes to
purchase a good, the higher the price elasticity of demand
will be
• The smaller the percentage of one’s budget that goes to
purchase a good, the lower the price elasticity of demand will
be

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 20-2 Elasticity: Part 2 (5 of 5)

► 20-2b Determinants of Price Elasticity of Demand (cont)

• Time
• The more time that passes (since the price
change), the higher the price elasticity of
demand for the good will be
• The less time that passes, the lower the
price elasticity of demand for the good will be

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 20-3 Other Elasticity Concepts (1 of 5)

► 20-3a Cross Elasticity of Demand

• Cross Elasticity of Demand: A measure of the
responsiveness in quantity demanded of one good to
changes in the price of another good
• This concept is often used to determine whether two goods
are substitutes for or complements to each other, and the
degree to which one good is a substitute for or a
complement to the other

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 20-3 Other Elasticity Concepts (3 of 5)

► 20-3b Income Elasticity of Demand

• Income Elasticity of Demand: A measure of the
responsiveness of quantity demanded to changes in income
• Income Elastic: The condition that exists when the
percentage change in quantity demanded of a good is greater
than the percentage change in income
• Income Inelastic: The condition that exists when the
percentage change in quantity demanded of a good is less than
the percentage change in income
• Income Unit Elastic: The condition that exists when the
percentage change in quantity demanded of a good is equal to
the percentage change in income

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 20-3 Other Elasticity Concepts (4 of 5)

► 20-3c Price Elasticity of Supply

• Price Elasticity of Supply: A measure of the responsiveness
of quantity supplied to changes in price
• In the case of perfectly elastic supply, a small change in price
changes the quantity supplied by an infinitely large amount
(and thus the supply curve, or a portion of it, is horizontal;
Exhibit 8d
• In the case of perfectly inelastic supply, a change in price
brings no change in quantity supplied (and thus the supply
curve, or a portion of the overall supply curve, is vertical;
Exhibit 8e
• See Exhibit 9 for a summary of concepts related to elasticity

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 EXHIBIT 8
Price Elasticity of Supply (1 of 2)

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 EXHIBIT 8 (cont)
Price Elasticity of Supply (1 of 2)

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 EXHIBIT 9
Summary of the Four Elasticity Concepts

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 20-3 Other Elasticity Concepts (5 of 5)

► 20-3d Price Elasticity of Supply and Time

• For goods whose quantity supplied can increase with time
(most goods) the longer the period of adjustment is to a
change in price, the higher the price elasticity of supply
will be

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 EXHIBIT 10
House Prices and Elasticity of Supply

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 20-4 The Relationship Between
Taxes and Elasticity (1 of 3)
► 20-4a Who Pays the Tax?
• The placement of a tax is not the same as its payment
• Example: the DVD tax:
• Although the full tax was place don the sellers, they paid
only ½ of it
• Although none of the tax was placed on buyers, they paid ½
of it, too
• Lesson: government can place a tax on whomever it wants, but
the laws of supply and demand determine who actually ends up
paying it

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 20-4 The Relationship Between Taxes and Elasticity (2 of 3)

► 20-4b Elasticity and the Tax

• The buyer can pay the full tax if demand for the good is
perfectly inelastic, as in Exhibit 12(a)
• Parts (b) through (d) of Exhibit 12 show other cases
• (b) demand is perfectly elastic; sellers must pay the full
tax
• (c) supply is perfectly elastic, and buyers pay the full tax
• (d) a change in price causes no change in quantity
supplied; if sellers try to charge a higher price, trying to
get buyers to pay some of the tax, a surplus will result,
driving the price back down, and sellers pay the full tax

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 20-4 The Relationship Between Taxes and Elasticity (3 of 3)

► 20-4c Degree of Elasticity and Tax Revenue

• Suppose two sellers, A (facing a perfectly inelastic
demand for her product), and B (facing an elastic
demand for his product)
• If government is seeking to place a tax, to maximize tax
revenues, it should tax seller A, because that seller is
facing the inelastic demand curve

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 EXHIBIT 11
Who Pays the Tax?

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 EXHIBIT 12
Different Elasticities and
Who Pays the Tax (1 of 2)

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 EXHIBIT 12
Different Elasticities and
Who Pays the Tax (2 of 2)

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 EXHIBIT 13
Maximizing Tax Revenues

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