CH 4

Chapter 4
Elasticity
After studying this chapter,
you will be able to…
1. …define, calculate, and explain the factors that
influence the price elasticity of demand
influence the cross elasticity of demand and the
income elasticity of demand
influence the elasticity of supply
Elasticities
4 different elasticities in this chapter
Price elasticity of demand (Ep)
Cross elasticity of demand (Exy)
Income elasticity of demand (Ei)
(Price) Elasticity of supply (Es)
General format:
By looking at percentages, the units of measurement are removed.

Can compare elasticities of different products (e.g. gasoline vs apple)
Price Elasticity of Demand
People do respond to incentives, changing their
behavior as prices, incomes, and prices of related
goods change.
For example, in April 2014 gas was $1.37 a litre, by

December 2014 the price of gas had fallen to $1.04 a litre.
 Gasoline consumption rose by 7.3%.
The first three elasticities these behavioral changes from

consumers (firms respond to incentives too).
The price elasticity of demand is a units-free measure of
the responsiveness of the quantity demanded of a good
to a change in its price when all other influences on
demand remain the same.
A demand curve has a negative slope, so the percentage

changes in price and quantity have opposite signs.
Although demand elasticity is a negative number we

ignore the negative sign and report the elasticity of
demand as a positive number.
In the figures below, a same decrease in supply brings:
A rise in price and a decrease in the quantity demanded.
How can we come up with a sensible way to measure
how much quantity changes when price changes?
One idea is to look at the slope of the demand curve:
But this won’t work, since the value of the slope
depends on the units used to measure on the axes.
We use % changes so that units will be removed.
We are going to use a new way to calculate %
changes!
Calculating the Price Elasticity of Demand (Ep)

The price elasticity of demand is calculated by using the
formula:
• Unit free: The percentages cancel out each other

• Always negative: An increase in price decreases the
quantity demanded, ceteris paribus. By convention, the
minus sign is ignored.
Calculating % Changes
We are using the second way to calculate %

changes for all elasticities. That’s see why.
Calculating the Percentage Changes
From point A to point B, quantity

increased from 1000 to 1200, an
increase of 20%.
However from B to A, quantity

decreases by 16.7%.
This would mean the elasticity from A to

B was different from the elasticity from
B to A, an undesirable characteristic.
Mid Point Formula
The midpoint formula (for both %∆Qd and %∆P)

avoids the confusion of whether we are going from
A to B or from B to A: we use the average of A and
B in the denominator
(Q2  Q1 ) (P2  P1 )
Price elasticity of demand = ÷
 Q1 + Q2   P1 + P2 
   
 2   2 
Calculating Ep
%∆Qd =
%∆P =
Ep =
A 1% decrease (increase) in
price will lead to a _____%
increase (decrease) in
quantity demanded.
Calculating Ep
What if the quantity had only

increased to 2100 (from A to
C)? How does the Ep
compared with (A to B)?
% change in price = −8%
% change in Qd (A to C) =
Ep =
A “smaller” value for the price elasticity of demand means that

quantity demanded changes less in response to a price change.
Terminology
Price elastic: when quantity demanded is quite responsive
to changes in price, Ep > 1
Price inelastic: when quantity demanded is not quite

responsive to changes in price, Ep < 1
Unit price elastic: Ep = 1
A “smaller” value for the price elasticity of demand

means that quantity demanded changes less in
response to a price change.
Product Estimated Elasticity Product Estimated Elasticity
Books (Barnes & Noble) –4.00 Bread –0.40
Books (Amazon) –0.60 Water (residential use) –0.38
DVDs (Amazon) –3.10 Chicken –0.37
Post Raisin Bran –2.50 Cocaine –0.28
Automobiles –1.95 Cigarettes –0.25
Tide (liquid detergent) –3.92 Beer –0.23
Coca-Cola –1.22 Residential natural gas –0.09
Grapes –1.18 Gasoline –0.06
Restaurant meals –0.67 Milk –0.04
Health insurance (low- –0.65 Sugar –0.04

income households)
Extreme Elasticities
Perfectly inelastic demand

• The demand curve is a
vertical line.
• No matter what the price,
the quantity demanded does
not change.
• The demand exhibits zero
responsiveness to price
changes.
Perfectly elastic demand

• The demand curve is a
horizontal line.
• It has only one price for
every quantity.
• The slightest increase in
price leads to zero quantity
demanded.
Question
Do people respond to changes in the price of
gasoline?
Say the OPEC reduces oil production
Factors that Determines Ep
Why does the demand elasticity of gasoline (0.06) is smaller

than the demand of Coca-Cola (1.22)?
Three common factors that determines Ep:

1) Existence of substitutes
2) Share of the budget
3) The length of time allowed for adjustment
Existence of substitutes:
The closer the substitutes and the more substitutes there are, the more
elastic is demand.
Example:
Demand for gasoline is inelastic as there are few substitutes.
But demand for gasoline from a specific gas station will be more elastic
as there are many substitutes (other stations).
Share of the budget:

The greater the share of the consumer’s total budget spent on a good, the greater is the
price elasticity.
Example:
Sugar: You might buy sugar once a year or less; changes in its price will not affect very much
how much you buy.
Housing: Changes in the price of housing do affect where people choose to live.
The length of time allowed for adjustment:

The longer any price change persists, the greater the elasticity of demand, other
things held constant.
Example:
If the price of gasoline rises, it takes a while for people to adjust their gasoline
consumption. How might they do that?
•Buying a more fuel-efficient car
•Moving closer to work
Elasticity and Total Revenue
Why is Coca-Cola often on sale?
If you are a business owner, you need to decide how to price your product.
“How many customers will I gain if I cut my price?”
“What will happen to my total revenue if I cut my price?”
Total revenue = Price X Quantity Demanded
Knowing the price elasticity of demand for your product can help to answer
these questions.
If demand is relatively price inelastic:

Customers are not very sensitive to the price of
your product. As you decrease the price, you
expect to gain only a few additional customers.
The few additional customers do not compensate

for the lost revenue, so overall revenue goes down.
If demand is relatively price elastic:

Customers are very sensitive to the price of your
product.
As you decrease the price, you expect to gain many
additional customers.
The many additional customers more than compensate

for the lost revenue, so overall revenue goes up.
How do firms know whether the demand for an item is elastic or inelastic
in the real world?
Total revenue test is a method of estimating the price elasticity of demand by

observing the change in total revenue that results from a price change.
Price Elasticity of Blank Effect of Price Change Blank

Demand (Ep) on Total Revenues
(TR)
Blank Blank Price Decrease Price Increase
Inelastic (Ep < 1) TR ↓ TR ↑
Unit-elastic (Ep = 1) No change in TR No change in TR
Elastic (Ep > 1) TR ↑ TR ↓
In 2014, Amazon had a dispute with Hachette (a
large book publisher). Amazon wanted Hachette
to reduce the price of its ebooks. Hachette was
charging between $14.99 to $19.99. Amazon
wanted to sell them for $9.99.
Amazon argued that the elasticity of demand for

ebooks was −1.74.
If this was correct, the lower price would be more

revenue for the publisher, Amazon, and authors.
Hachette countered that for ebooks in general

the elasticity might be −1.74, but for specialty
books with few substitutes, demand was likely
much less elastic.
Your Expenditure and Your Elasticity
Consumers expenditure = Total Revenue of the

firm
If your demand for an item is elastic (like Cola), a

1% price cut would increase the quantity you buy
by >1% and your expenditure on the item
increase.
Question
To increase its total revenue,

A) a firm facing an inelastic demand will always
raise its price marginally.
B) a firm facing an elastic demand will always raise
its price marginally.
C) a firm will always charge the highest price
possible regardless of the elasticity of demand.
D) None of the above options is correct.
Cross Elasticities of Demand
Why would McDonald’s sell drinks for $1 or

2 in the summer?
Cross Price Elasticity of Demand (Exy)
The cross price elasticity of demand is a measure of the

responsiveness of demand for a good (X) to a change in the
price of a substitute or a complement (Y), other things
remaining the same.
Cross-price elasticity of demand measures the strength of

substitute or complement relationships between goods
The cross price elasticity of demand:
Exy > 0  substitutes
Exy < 0  complements
Exy
What do you expect to happen to the demand for

cigarettes or other illegal drugs (e.g. fentanyl) when
marijuana became legal next year?
The cross price elasticity of demand:
Exy > 0  substitutes
Exy < 0  complements
Income Elasticities of Demand
Income Elasticity of Demand (Ei)
If your income increases, will you have dinner at

1) Keg Steakhouse more or
2) McDonald’s more?
The income elasticity of demand measures how

the quantity demanded of a good responds to a
change in income (not price), other things
remaining the same.
The income elasticity of demand measures how the

quantity demanded of a good responds to a change in
income (not price), other things remaining the same.
Income elasticity of demand measures the strength

of the effect of income on quantity demanded
Normal goods: Goods and services for which the quantity

demanded increases as income increases
Inferior goods: Goods and services for which the quantity

demanded falls as income increases
If the income elasticity of then the good Example
demand is … is …
positive but less than 1 normal and a Bread
necessity.
positive and greater than 1 normal and a Caviar
luxury.
negative inferior. High-fat meat
More Elasticities of Demand
Christopher Ruhm of the University
of Virginia and colleagues Price elasticity of −0.30
estimated elasticities for various demand for beer
alcoholic beverages.
Cross-price elasticity of −0.83
According to their study: demand between beer
i) Demand for beer is price inelastic. and wine
ii) Beer and wine are complements. Cross-price elasticity of −0.50
iii) Beer and spirits are also demand between beer
complements, but the relationship is and spirits
not as strong.
iv) Beer is a normal good; a Income elasticity of 0.09
demand for beer
necessity.
More Elasticities of Demand
Answer question a) to f) based on the information in the table below:
P of Pepsi Q of Pepsi Income P of Cola
$10 2 $1000 $2
$8 4 $1000 $2
$6 6 $1000 $2
$6 8 $1500 $2
$6 10 $1000 $4
a) Calculate the cross elasticity of Pepsi and Cola given the information in the
table.
b) How would you interpret the answer in a)?
c) When you want to calculate cross elasticity of Pepsi and Cola, what factors
have to be constant?
d) Calculate the income elasticity of Pepsi given the information in the table.
e) How would you interpret the answer in c)?
f) When you want to calculate income elasticity of Pepsi, what factors have to
be constant?
Price Elasticity of Supply
In the figures below, a same increase in demand brings:
An increase in both price and quantity supplied.
(Price) Elasticity of Supply
The elasticity of supply measures the responsiveness of the quantity
supplied to a change in the price of a good when all other influences on
supply remain the same.
• Unit free: The percentages cancel out each other

• Always positive: An increase in price increases the quantity supplied, ceteris
paribus.
The same sort of calculation methods for Ep apply here (midpoint

formula, etc.)
Elasticity of Supply
Terminology
Price elastic: when quantity supplied is quite

responsive to changes in price, Es > 1
Price inelastic: When quantity supplied is not

quite responsive to changes in price, Es < 1
Unit price elastic: Es = 1

Perfectly inelastic supply

• The supply curve is a
vertical line.
• No matter what the price,
the quantity supplied does not
change.
• The supply exhibits zero
responsiveness to price
changes.
Perfectly elastic supply

• The supply curve is a
horizontal line.
• It has only one price for
every quantity.
• The slightest increase in
price leads to zero quantity
supplied.
Short run: a period of time during which at least one of a

firm’s inputs is fixed
Long run: a period of time during which no input is fixed
The Factors That Influence the Elasticity of
Supply
The elasticity of supply depends on:

1) Resource substitution possibilities
2) Time frame for supply decision
Resource Substitution Possibilities
Can a firm produces more fries using ovens?
A firm uses ovens and deep fryers (and workers,

etc) to produce pizza and fries.
Suppose there is an increase in the demand for

fries, would it be easy for the firm to shift resources
(such as capital) from pizza production to fries
production?
Time Frame for Supply Decision
Suppose there is an increase in demand for

classes at UBC now, is it possible for UBC to
provide more classes in a day? A few months?
A year?
The longer the time allowed for adjustment,

the more resources can flow into (out of) an
industry through expansion (contraction) of
existing firms
Time Frame for
Supply Decision
Momentary supply
(S1) is perfectly
inelastic.
Short run supply (S2)
is somewhat elastic.
Long run supply (S3)
is the most elastic.
Why are oil prices so unstable? Elasticities matter (Ep
and Es)!
http://www.macrotrends.net/1369/crude-oil-price-history-chart

CH 4

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CH 4

Uploaded by

Copyright:

Available Formats

Chapter 4

By looking at percentages, the units of measurement are removed.

For example, in April 2014 gas was $1.37 a litre, by

The first three elasticities these behavioral changes from

A demand curve has a negative slope, so the percentage

Although demand elasticity is a negative number we

Calculating the Price Elasticity of Demand (Ep)

• Unit free: The percentages cancel out each other

We are using the second way to calculate %

From point A to point B, quantity

However from B to A, quantity

This would mean the elasticity from A to

The midpoint formula (for both %∆Qd and %∆P)

What if the quantity had only

% change in price = −8%

A “smaller” value for the price elasticity of demand means that

Price inelastic: when quantity demanded is not quite

Unit price elastic: Ep = 1

A “smaller” value for the price elasticity of demand

Books (Barnes & Noble) –4.00 Bread –0.40

Books (Amazon) –0.60 Water (residential use) –0.38

DVDs (Amazon) –3.10 Chicken –0.37

Post Raisin Bran –2.50 Cocaine –0.28

Automobiles –1.95 Cigarettes –0.25

Tide (liquid detergent) –3.92 Beer –0.23

Coca-Cola –1.22 Residential natural gas –0.09

Grapes –1.18 Gasoline –0.06

Restaurant meals –0.67 Milk –0.04

Health insurance (low- –0.65 Sugar –0.04

Perfectly inelastic demand

Perfectly elastic demand

Why does the demand elasticity of gasoline (0.06) is smaller

Three common factors that determines Ep:

Share of the budget:

The length of time allowed for adjustment:

If demand is relatively price inelastic:

The few additional customers do not compensate

If demand is relatively price elastic:

The many additional customers more than compensate

Total revenue test is a method of estimating the price elasticity of demand by

Price Elasticity of Blank Effect of Price Change Blank

Amazon argued that the elasticity of demand for

If this was correct, the lower price would be more

Hachette countered that for ebooks in general

Consumers expenditure = Total Revenue of the

If your demand for an item is elastic (like Cola), a

To increase its total revenue,

Why would McDonald’s sell drinks for $1 or

The cross price elasticity of demand is a measure of the

Cross-price elasticity of demand measures the strength of

What do you expect to happen to the demand for

Income Elasticity of Demand (Ei)

If your income increases, will you have dinner at

The income elasticity of demand measures how

The income elasticity of demand measures how the

Income elasticity of demand measures the strength

Normal goods: Goods and services for which the quantity

Inferior goods: Goods and services for which the quantity

• Unit free: The percentages cancel out each other

The same sort of calculation methods for Ep apply here (midpoint

Price elastic: when quantity supplied is quite

Price inelastic: When quantity supplied is not

Unit price elastic: Es = 1