Elasticity

Chapter No 5
 Elasticity . . .
… allows us to analyze supply and
demand with greater precision.

… is a measure of how much buyers and

sellers respond to changes in market
conditions
THE ELASTICITY OF DEMAND
Price elasticity of demand is a measure of
how much the quantity demanded of a good
responds to a change in the price of that
good.

Price elasticity of demand is the percentage

change in quantity demanded given a
percent change in the price.
Computing the Price Elasticity of
Demand
The price elasticity of demand is computed
as the percentage change in the quantity
demanded divided by the percentage
change in price.

P ercen tag e ch an g e in q u an tity d em an d ed

P rice elasticity o f d em an d =
P ercen tag e ch an g e in p rice
Computing the Price Elasticity of
Demand
P ercen tag e ch an g e in qu an tity d em an ded
P rice elasticity o f d em an d =
P ercen tag e ch an g e in price

Example: If the price of an ice cream cone

increases from $2.00 to $2.20 and the
amount you buy falls from 10 to 8 cones,
then your elasticity of demand would be
calculated as: ( 10  8 )
1 0 0 20%
10  2
( 2 .2 0  2 .00 )
1 0 0 1 0 %
2 .0 0
The Midpoint Method: A Better Way to
Calculate Percentage Changes and
Elasticities
The midpoint formula is preferable when
calculating the price elasticity of demand
because it gives the same answer
regardless of the direction of the change.
( Q 2  Q 1 ) / [( Q 2  Q 1 ) / 2 ]
P rice elasticity o f d em an d =
(P2  P1 ) / [( P2  P1 ) / 2 ]
The Midpoint Method: A Better Way to
Calculate Percentage Changes and
Elasticities
Example: If the price of an ice cream cone
increases from $2.00 to $2.20 and the
amount you buy falls from 10 to 8 cones,
then your elasticity of demand, using the
midpoint formula, would be calculated as:
(1 0  8 )
(1 0  8 ) / 2 22%
  2 .3 2
( 2 . 2 0  2 .0 0 ) 9 .5 %
( 2 .0 0  2 .2 0 ) / 2
 What determines price
elasticity?
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?
 Determinants of Elasticity
Whether close substitutes are available
Broadly defined goods vs. narrowly
defined goods
Necessities vs. Luxuries
How much of the consumer’s budget is
spent on the good
Long run vs. Short run
 EXAMPLE 1:
Rice Krispies vs. Sunscreen
The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
– Rice Krispies has lots of close substitutes
(e.g., Cap’n Crunch, Count Chocula),
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 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.
(Can you think of a substitute for clothing)
Lesson: Price elasticity is higher for narrowly
defined goods than broadly defined ones.
 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.
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.
 How much of the consumer’s
budget is spent on the good
When a good represents a large share of a
consumer’s budget, a price increase importantly
reduces the amount of the good that a consumer
is able to buy
– The amount demanded will decrease significantly.
When the good represents a smaller share of
the consumer’s budget, the consumer’s overall
income and purchasing power are less effected
by an increase in price.
– Therefore, demand is less price elastic in these
cases.
 Percentage of Income
The higher the percentage of the
consumer's income that the product's price
represents, the higher the elasticity tends to
be, as people will pay more attention when
purchasing the good because of its cost.
(Income effect)
When the goods represent only a small
portion of the budget the income effect will
be insignificant and demand inelastic
The Price Elasticity of Demand and Its
Determinants
Demand tends to be more elastic :
– the larger the number of close substitutes.
– if the good is a luxury.
– the more narrowly defined the market.
– the longer the time period.
– Percentage of income
The Variety of Demand Curves

Inelastic Demand
– Quantity demanded does not respond
strongly to price changes.
– Price elasticity of demand is less than one.
Elastic Demand
– Quantity demanded responds strongly to
changes in price.
– Price elasticity of demand is greater than one.
The Variety of Demand Curves

Perfectly Inelastic
– Quantity demanded does not respond to price
changes.
Perfectly Elastic
– Quantity demanded changes infinitely with any
change in price.
Unit Elastic
– Quantity demanded changes by the same
percentage as the price.
The Variety of Demand Curves

Because the price elasticity of demand

measures how much quantity demanded
responds to the price, it is closely related
to the slope of the demand curve.
Figure 1 The Price Elasticity of Demand

(a) Perfectly Inelastic Demand: Elasticity Equals 0

Price
Demand

$5

4
1. An
increase
in price . . .

0 100 Quantity

2. . . . leaves the quantity demanded unchanged.

Copyright©2003 Southwestern/Thomson Learning

 Figure 1 The Price Elasticity of Demand

(b) Inelastic Demand: Elasticity Is Less Than 1

Price
ΔQ<ΔP

$5

4
1. A 22% Demand
increase
in price . . .

0 90 100 Quantity

2. . . . leads to an 11% decrease in quantity demanded.

Figure 1 The Price Elasticity of Demand

(c) Unit Elastic Demand: Elasticity Equals 1

Price

$5

4
1. A 22% Demand
increase
in price . . .

0 80 100 Quantity

2. . . . leads to a 22% decrease in quantity demanded.

Copyright©2003 Southwestern/Thomson Learning

 Figure 1 The Price Elasticity of Demand

(d) Elastic Demand: Elasticity Is Greater Than 1

Price
ΔQ>ΔP

$5

4 Demand
1. A 22%
increase
in price . . .

0 50 100 Quantity

2. . . . leads to a 67% decrease in quantity demanded.

 Figure 1 The Price Elasticity of Demand

(e) Perfectly Elastic Demand: Elasticity Equals Infinity

Price

1. At any price
above $4, quantity
demanded is zero.
$4 Demand

2. At exactly $4,
consumers will
buy any quantity.

0 Quantity
3. At a price below $4,
quantity demanded is infinite.
Total Revenue and the Price Elasticity
of Demand
Total revenue is the amount paid by
buyers and received by sellers of a good.
Computed as the price of the good times
the quantity sold.

TR = P x Q
 Figure 2 Total Revenue

Price

$4

P × Q = $400
P
(revenue) Demand

0 100 Quantity

Q
Copyright©2003 Southwestern/Thomson Learning
Elasticity and Total Revenue along a
Linear Demand Curve
With an inelastic demand curve, an
increase in price leads to a decrease in
quantity that is proportionately smaller.
Thus, total revenue increases.
 Figure 3 How Total Revenue Changes When Price
Changes: Inelastic Demand

Price Price
An Increase in price from $1 … leads to an Increase in
to $3 … total revenue from $100 to
$240

$3

Revenue = $240
$1
Revenue = $100 Demand Demand

0 100 Quantity 0 80 Quantity

Copyright©2003 Southwestern/Thomson Learning

Elasticity and Total Revenue along a
Linear Demand Curve
With an elastic demand curve, an increase
in the price leads to a decrease in quantity
demanded that is proportionately larger.
Thus, total revenue decreases.
 Figure 4 How Total Revenue Changes When Price
Changes: Elastic Demand

Price Price

An Increase in price from $4 … leads to an decrease in

to $5 … total revenue from $200 to
$100

$5

$4

Demand
Demand

Revenue = $200 Revenue = $100

0 50 Quantity 0 20 Quantity

Copyright©2003 Southwestern/Thomson Learning

 Elasticity & Total Revenue Test
Elastic > 1 if P decreases
=> TR increases; if P
increases TR decreases
Unit elastic = 1 if ΔP => no
ΔTR
Inelastic < 1 if P decreases
=> TR decreases; if P
increases TR increases
Figure 19-2 The Relationship Between Price Elasticity of
Demand and Total Revenues for Cellular Phone Service,
Panel (b)
Figure 19-2 The Relationship Between Price Elasticity of
Demand and Total Revenues for Cellular Phone Service,
Panel (c)
Relationship Between Price Elasticity of Demand
and Total Revenues
Income Elasticity of Demand

Income elasticity of demand measures

how much the quantity demanded of a
good responds to a change in consumers’
income.
It is computed as the percentage change
in the quantity demanded divided by the
percentage change in income.
Computing Income Elasticity

P ercen tag e ch ang e

in q u antity d em and ed
In co m e elasticity o f d em an d =
P ercen tag e ch ang e
in in co m e
Income Elasticity

Types of Goods
– Normal Goods
– Inferior Goods
Higher income raises the quantity
demanded for normal goods but lowers
the quantity demanded for inferior goods.
Income Elasticity

Goods consumers regard as necessities

tend to be income inelastic
– Examples include food, fuel, clothing, utilities,
and medical services.
Goods consumers regard as luxuries tend
to be income elastic.
– Examples include sports cars, furs, and
expensive foods.
 Cross-Price Elasticity of
Demand
A measure of how much the quantity demanded of one
good responds to a change in the price of another good
Cross-price elasticity of demand = percentage change
in quantity demanded of good 1/percentage change in
the price of good 2
Substitute goods – cross-price elasticity of demand is
positive
Complement goods – cross-price elasticity of demand is
negative
THE ELASTICITY OF SUPPLY
Price elasticity of supply is a measure of
how much the quantity supplied of a good
responds to a change in the price of that
good.
Price elasticity of supply is the percentage
change in quantity supplied resulting from
a percent change in price.
Figure 6 The Price Elasticity of Supply

(a) Perfectly Inelastic Supply: Elasticity Equals 0

Price
Supply

$5

4
1. An
increase
in price . . .

0 100 Quantity

2. . . . leaves the quantity supplied unchanged.

Copyright©2003 Southwestern/Thomson Learning

Figure 6 The Price Elasticity of Supply

(b) Inelastic Supply: Elasticity Is Less Than 1

Price

Supply
$5

4
1. A 22%
increase
in price . . .

0 100 110 Quantity

2. . . . leads to a 10% increase in quantity supplied.

Copyright©2003 Southwestern/Thomson Learning

Figure 6 The Price Elasticity of Supply

(c) Unit Elastic Supply: Elasticity Equals 1

Price

Supply
$5

4
1. A 22%
increase
in price . . .

0 100 125 Quantity

2. . . . leads to a 22% increase in quantity supplied.

Copyright©2003 Southwestern/Thomson Learning

Figure 6 The Price Elasticity of Supply

(d) Elastic Supply: Elasticity Is Greater Than 1

Price

Supply

$5

4
1. A 22%
increase
in price . . .

0 100 200 Quantity

2. . . . leads to a 67% increase in quantity supplied.

Copyright©2003 Southwestern/Thomson Learning

Figure 6 The Price Elasticity of Supply

(e) Perfectly Elastic Supply: Elasticity Equals Infinity

Price

1. At any price
above $4, quantity
supplied is infinite.

$4 Supply

2. At exactly $4,
producers will
supply any quantity.

0 Quantity
3. At a price below $4,
quantity supplied is zero.

Copyright©2003 Southwestern/Thomson Learning

Determinants of Elasticity of Supply

Ability of sellers to change the amount of

the good they produce.
– Beach-front land is inelastic.
– Books, cars, or manufactured goods are
elastic.
Time period. (Key determinant)
– The amount of time a seller has to change the
amount of the good they can produce
– Supply is more elastic in the long run.
Elasticity of Supply – Slope of
Curve
Immediately
– Inelastic supply
– Vertical or steep
Short Run
– More elastic due to the
firm’s intense use of
fixed resources
Elasticity of Supply – Slope of
Curve
Long run
– All resources can
change
– Elastic supply:
horizontal flat
Computing the Price Elasticity of
Supply
The price elasticity of supply is computed
as the percentage change in the quantity
supplied divided by the percentage
change in price.
P ercentage chang e
in qu an tity sup plied
P rice elasticity o f su pp ly =
P ercen tage ch an g e in price
 APPLICATION of ELASTICITY
Can good news for farming be bad news
for farmers?
What happens to wheat farmers and the
market for wheat when university
agronomists discover a new wheat hybrid
that is more productive than existing
varieties?
THE APPLICATION OF SUPPLY,
DEMAND, AND ELASTICITY
Examine whether the supply or demand
curve shifts.
Determine the direction of the shift of the
curve.
Use the supply-and-demand diagram to
see how the market equilibrium changes.
Figure 8 An Increase in Supply in the Market for
Wheat
Price of
Wheat 1. When demand is inelastic,
2. . . . leads an increase in supply . . .
to a large fall S1
in price . . . S2

$3

Demand

0 100 110 Quantity of

Wheat
3. . . . and a proportionately smaller
increase in quantity sold. As a result,
revenue falls from $300 to $220.
Copyright©2003 Southwestern/Thomson Learning
Compute the Price Elasticity of Supply
1 0 0 1 1 0
(1 0 0  1 1 0 ) / 2
ED 
3 .0 0  2 .0 0
( 3 .0 0  2 . 0 0 ) / 2

0 .0 9 5
  0 .2 4
0 .4 Supply is inelastic
 Summary
Price elasticity of demand measures how much the
quantity demanded responds to changes in the
price.
Price elasticity of demand is calculated as the
percentage change in quantity demanded divided
by the percentage change in price.
If a demand curve is elastic, total revenue falls
when the price rises.
If it is inelastic, total revenue rises as the price rises.
 Summary
The income elasticity of demand measures how
much the quantity demanded responds to
changes in consumers’ income.
The cross-price elasticity of demand measures
how much the quantity demanded of one good
responds to the price of another good.
The price elasticity of supply measures how much
the quantity supplied responds to changes in the
price. .
 Summary
In most markets, supply is more elastic in
the long run than in the short run.
The price elasticity of supply is calculated
as the percentage change in quantity
supplied divided by the percentage
change in price.
The tools of supply and demand can be
applied in many different types of markets.
 Demand Elasticity
Demand elasticity – the extent to which a
change in price causes a change in the quantity
demanded.
A given change in price will cause a relatively
larger, a relatively smaller, or a proportional
change in quantity demanded.
A corporation must estimate if they change the
price either up or down will demand increase,
decrease or stay the same.
 Elastic
Elastic – when the change in price causes a relatively
larger change in quantity demanded
During the summer price of vegetables decreases so the
amount purchased is increased.
But during the winter the price of vegetables increases
so the amount purchased decreases drastically. A big
change in the amount purchased over the seasons.
If a change in price causes a relatively large change
in the quantity demanded, demand is elastic.
 Inelastic
Inelastic – means that a given change in the price
causes a relatively smaller change in quantity
demanded.
If table salt dropped in price by half going from $1 to $.50
then demand would not change because you can
consume only so much salt. And if salt goes from $1 to
$2 then demand would not change because it is still a
small percentage of your budget.
If change in price causes a relatively smaller change in
quantity demanded, demand is inelastic
 Unit elastic
Unit elastic – a given change in price
causes a proportional change in quantity
demanded
So if there is a 5% change in price then
there will be a 5% change in quantity.
 Price elasticity
Price elasticity = percentage change in quantity
percentage change in price
Perfectly inelastic: elasticity equals 0
Inelastic: elasticity is less than 1
Unit elastic: elasticity equals 1
Elastic: elasticity is greater than 1
Perfectly elastic: elasticity equals infinity
 “Perfectly inelastic demand” (one
extreme case)
% change in Q 0%
Price elasticity
= = =0
% change in P 10%
of demand
D P
D
curve: vertical
P1
Consumers’
price sensitivity: P2
0
P falls Q
Elasticity: by 10% Q1
0 Q changes
by 0%
 “Inelastic demand”
Price elasticity % change in Q < 10%
= = <1
% change in P 10%
of demand
D P
curve: relatively steep
P1
Consumers’
price sensitivity: P2
relatively low D
P falls Q
Elasticity: < 1 by 10% Q1 Q2

Q rises less
than 10%
 “Unit elastic demand”
Price elasticity % change in Q 10%
= = =1
% change in P 10%
of demand
D curve: P
intermediate slope
P1
Consumers’
price sensitivity: P2
D
intermediate
P falls Q
Elasticity: 1 by 10% Q1 Q2

Q rises by 10%
 “Elastic demand”
Price elasticity % change in Q > 10%
= = >1
% change in P 10%
of demand
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%
 “Perfectly elastic demand” (the
other extreme)
% change in Q any %
Price elasticity
= = = infinity
% change in P 0%
of demand
D curve: P
horizontal
P2 = P1 D
Consumers’
price sensitivity:
extreme
P changes Q
Elasticity: by 0% Q1 Q2
infinity Q changes
by any %
 Elasticity of a Linear Demand
Curve
P
200%
$30 E = = 5.0
40% The slope
67% of a linear
20 E = = 1.0
67%
demand
40% curve is
10 E = = 0.2
200% constant,
but its
$0 Q elasticity
0 20 40 60
is not.
 Supply Elasticity
Supply Elasticity – describes how a change in quantity
supplied responds to a change in price
What is the difference between supply elasticity and
demand elasticity?
– If quantities are being purchased, the concept is demand
elasticity. If quantities are being brought to market for sale, the
concept is supply elasticity
If supply is elastic, a given change in price will cause a
more than proportional change in quantity supplied.
If supply is inelastic, a given change in price will cause a
less than proportional change in quantity supplied.
If supply is unit elastic, a given change in price will cause
a proportional change in quantity supplied.
 Price Elasticity Problems
Are the following examples elastic,
inelastic, or unit elastic
1) change in price = 30%;
change in quantity demanded = 50%
2) change in price = 30%;
change in quantity supplied = 30%
3) change in price = 30%
change in quantity demanded = 15%
 Price Elasticity Answers
1) 50/30 = 1.66… Elastic demand
2) 30/30 = 1 Unit Elastic supplied
3) 15/30 = 0.50 Inelastic demand
 A C T I V E L E A R N I N G 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?

72
 A C T I V E L E A R N I N G 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.

73
 A C T I V E L E A R N I N G 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.
74
 Calculating Percentage Changes

Demand for
your websites
P
B
$250
A
$200
D
Q
8 12
 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!
 Calculating Percentage
Changes
Using the midpoint method, the % change
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
 A C T I V E L E A R N I N G 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

78
 A C T I V E L E A R N I N G 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%

79