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Elasticity and Its Applications

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.
It is the percentage change in quantity
demanded when there is a one percent
change in the price (and all other
factors that also affect the quantity
demanded remain unchanged).

Computing the Price Elasticity of


Demand
P ric e e la s tic ity o f d e m a n d =

P e rc e n ta g e c h a n g e in q u a n tity d e m a n d e d
P e rc e n ta g e c h a n g e in p ric e

Suppose
the price of ice-cream increases by 10%, and
the quantity demanded decreases by 20%.

The PED is 20/10 = 2.


That is, a 1% change in the price will
change the quantity demanded by 2%.

Computing the Percentage of a


Price ChangeUsual Method
Percent Change = [(New Value Old Value) / Old
Value] 100
Old Price
New Price
Increase
% Increase

$2.00
$2.20
2.20 2.00 = $0.20
[(2.20 2.00)/2.00] 100 = 10%
4

Computing the Percentage of a


Quantity ChangeUsual Method
Percent Change = [(New Value Old Value) / Old
Value] 100
Old Quantity
New Quantity
Increase
% Increase

10
8
8 10 = 2
[(8 10)/10] 100 = 20%
5

Computing the Price Elasticity of Demand:


Traditional Method
P ric e e la s tic ity o f d e m a n d =

P e rc e n ta g e c h a n g e in q u a n tity d e m a n d e d
P e rc e n ta g e c h a n g e in p ric e

The price of an ice cream cone increases from


$2.00 to $2.20
The amount you buy falls from 10 to 8 cones
What is your elasticity of demand?
(1 0 8 )
100
20%
10

2
( 2 .2 0 2 .0 0 )
100 10%
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 ric e e la s tic ity o f d e m a n d =
(P 2 P 1 ) / [(P 2 P 1 ) / 2 ]

Midpoint Formula: example


The price of an ice cream cone increases
from $2.00 to $2.20
The amount you buy falls from 10 to 8 cones
Whats your elasticity of demand?
use the midpoint formula

(1 0 8 )
22%
(1 0 8 ) / 2

2 .3 2
( 2 .2 0 2 .0 0 )
9 .5 %
( 2 .0 0 2 .2 0 ) / 2

Elastic, Unit-Elastic and Inelastic


Demand
Demand can be
Inelastic
Unit-elastic
Elastic

It all depends on the magnitude of the


PED

Inelastic Demand: PED < 1


Suppose:
Price changes by 10%
Quantity demanded changes by 5%.
% change in quantity is smaller than the % change in price

Here PED = 5/10 = 0.5


Demand is inelastic

P e rc e n ta g e c h a n g e in q u a n tity d e m a n d e d
P ric e e la s tic ity o f d e m a n d =
P e rc e n ta g e c h a n g e in p ric e

Unit-Elastic Demand: PED = 1


Suppose:
Price changes by 10%
Quantity demanded changes by 10%.
% change in quantity is equal to the % change in price

Here PED = 10/10 = 1


Demand is unit-elastic

P ric e e la s tic ity o f d e m a n d =

P e rc e n ta g e c h a n g e in q u a n tity d e m a n d e d
P e rc e n ta g e c h a n g e in p ric e

Elastic Demand: PED > 1


Suppose:
Price changes by 10%
Quantity demanded changes by 30%.
% change in quantity is greater than the % change in price

Here PED = 30/10 = 3


Demand is elastic

P e rc e n ta g e c h a n g e in q u a n tity d e m a n d e d
P ric e e la s tic ity o f d e m a n d =
P e rc e n ta g e c h a n g e in p ric e

Computing the Price Elasticity of


Demand: Example
(100 - 50)
PED

Price
$5
4

(4.00 5.00)/2

67 percent

-3
- 22 percent

Demand

50

(4.00 - 5.00)

(100 50)/2

100 Quantity

Demand is price elastic

Perfectly Inelastic and Perfectly Elastic


Demand
Perfectly Inelastic: Quantity demanded
does not respond to price changes.
PED = 0.
Perfectly Elastic: Quantity demanded
changes infinitely with any change in
price. PED = infinity.

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.
The higher the price elasticity of
demand, the flatter 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 . . .

100

Quantity

2. . . . leaves the quantity demanded unchanged.

Figure 1 The Price Elasticity of Demand


(b) Inelastic Demand: Elasticity Is Less Than 1
Price

$5
4
1. A 22%
increase
in price . . .

Demand

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
Demand

1. A 22%
increase
in price . . .

80

100

Quantity

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

Copyright2003 Southwestern/Thomson Learning

Figure 1 The Price Elasticity of Demand


(d) Elastic Demand: Elasticity Is Greater Than 1
Price

$5
4

Demand

1. A 22%
increase
in price . . .

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
3. At a price below $4,
quantity demanded is infinite.

Quantity

Total Revenue and the Price Elasticity


of Demand
Total revenue (TR) is the amount paid
by buyers (and, therefore, received by
sellers) of a good.
It is computed as the price of the good
times the quantity sold.
TR = P x Q

Figure 2 Total Revenue


Price

$4

P Q = $400
(revenue)

Demand

100
Q

Quantity

Elasticity and Total Revenue:


Inelastic Demand
Suppose demand is
inelastic
Specifically, suppose
TR = P Q
+6%

+10%

- 4%

Price increases by
10%, and
Quantity demanded
decreases by 4%.

Conclusion: When demand


is inelastic, price and total
revenue move in the same
direction.
CHAPTER 5 ELASTICITY AND ITS APPLICATION

24

Elasticity and Total Revenue:


Elastic Demand
Suppose demand is
elastic
Specifically, suppose
TR = P Q
- 15%

+10%

- 25%

Price increases by
10%, and
Quantity demanded
decreases by 25%.

Conclusion: When demand


is elastic, price and total
revenue move in opposite
directions.
CHAPTER 5 ELASTICITY AND ITS APPLICATION

25

Elasticity and Total Revenue: Unitelastic Demand


Suppose demand is
unit-elastic
Specifically, suppose
TR = P Q
No Change

+10%

- 10%

Price increases by
10%, and
Quantity demanded
decreases by 10%.

Conclusion: When demand


is unit-elastic, price has
no effect on total revenue.

CHAPTER 5 ELASTICITY AND ITS APPLICATION

26

Elasticity of a Linear Demand


Curve

Note that demand can change from elastic


to unit-elastic to inelastic as the price
changes

What does the PED depend on?


Why is the demand for gas less elastic
than the demand for, say, movies?

CHAPTER 5 ELASTICITY AND ITS APPLICATION

32

Determinants of Price Elasticity of


Demand
PED tends to be higher
the larger the number of close substitutes.
if the good is a luxury. That is, if the
goods income elasticity of demand (to be
defined later) is high
if spending on the good is a large portion of
total spending
the more narrowly defined the market.
the longer the time period.

Income Elasticity of Demand


Income elasticity of demand is the percentage
increase in the quantity demanded of a good after
a one-percent increase in consumers income
assuming all other factors that affect the quantity
demanded are unchanged

% increase in quantity demanded


Income Elasticity of Demand
% increase in income

Computing Income Elasticity


% increase in quantity demanded
Income Elasticity of Demand
% increase in income

Suppose:
income increases 10%, and
quantity demanded decreases 20%. Then
income elasticity of demand is -20/+10 = -2.

Note that IED can be positive, negative, or


zero.

Income Elasticity
Normal Goods: IED > 0
Inferior Goods: IED < 0
Higher income raises the quantity
demanded for normal goods but lowers
the quantity demanded for inferior
goods.
Examples

Necessities and Luxuries


When IED < 1, the good is called
income inelastic or a necessity
Examples include food, fuel, clothing,
utilities, and medical services.

When IED > 1, the good is called


income elastic or a luxury
Examples include sports cars, furs, and
expensive foods.

High Income Elasticity Implies High


Price Elasticity
The effect of a change in the price of a
good on its quantity demanded is the
sum of:
The substitution effect, and
The income effect.

The higher the IED, the bigger the


income effect. Therefore,
The higher the IED, the higher the PED.

Low IED implies low PED


1. When the price of Coke
decreases

2. Consumers
feel richer

3. Consumption of Coke
and other goods
increases, but only a little,
because IED is small
4. So, a decrease in the
price of Coke leads to a
small increase in the
consumption of Coke

Clothes

Coke

Books

Movies

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

Pepsi
39

High IED implies high PED


1. When the price of Coke
decreases

2. Consumers
feel richer

3. Consumption of Coke
and other goods increases
by a big amount, because
IED is large
4. So, a decrease in the
price of Coke leads to a
big increase in the
consumption of Coke

Clothes

Coke

Books

Movies

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

Pepsi
40

Cross Price Elasticity of Demand


The cross price elasticity of demand
(CPED) measures the
responsiveness of the quantity
demanded of one good to changes
in the price of some other good.
Suppose:
The price of Coke increases 2%, and
The consumption of Pepsi increases
20%.
The CPED for Coke with respect to
Pepsi is +20/+2 = +10.

Substitutes: CPED > 0


When the CPED for one good with
respect to another is positive, the two
goods are called substitutes.
In the last slides example, the CPED
for Coke with respect to Pepsi was +10,
which is positive.
This confirms our common-sense
intuition that Coke and Pepsi are
substitutes.

Complements: CPED < 0


When the CPED for one
good with respect to
another is negative, the
two goods are called
complements.
Suppose:

the price of gasoline


increases 50%
the sale of cars decreases
10%
The CPED is -10/+50 =
-0.2, which is negative.

This is what one would


expect, given our
common-sense notion
that gas and cars are
complements.

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
It is assumed that all other factors that affect
the quantity suppliedsuch as technology
and the prices of raw materials and laborare
unchanged

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 e rc e n ta g e c h a n g e
in q u a n tity s u p p lie d
P ric e e la s tic ity o f s u p p ly =
P e rc e n ta g e c h a n g e in p ric e

Figure 6 The Price Elasticity of Supply


(a) Perfectly Inelastic Supply: Elasticity Equals 0
Price
Supply
$5
4
1. An
increase
in price . . .

100

Quantity

2. . . . leaves the quantity supplied unchanged.

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 . . .

100

110

Quantity

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

Figure 6 The Price Elasticity of Supply


(c) Unit Elastic Supply: Elasticity Equals 1
Price
Supply
$5
4
1. A 22%
increase
in price . . .

100

125

Quantity

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

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 . . .

100

200

Quantity

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

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

Quantity

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.
Supply is more elastic in the long run.

THREE APPLICATIONS OF SUPPLY,


DEMAND, AND 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?

CHAPTER 5 ELASTICITY AND ITS APPLICATION

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CHAPTER 5 ELASTICITY AND ITS APPLICATION

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CHAPTER 5 ELASTICITY AND ITS APPLICATION

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