Elasticity and Demand and

Supply Applications
Review:
Changes in quantity demand and supplied or
movements along the curves
Changes in demand and supply or shifts of the curve
Comparative Statics
Changes in demand
Increase in demand: price increases, quantity increases
Decrease in demand: price decreases, quantity decreases
Changes in supply
Increase in supply: price decreases, quantity increases
Decrease in supply: price increases, quantity decreases
Changes in both

Increase in
Demand
Decrease in
Demand
Increase in
Supply
P ambiguous
Q increases
P decreases
Q ambiguous
Decrease in
Supply
P increases
Q ambiguous
P ambiguous
Q decreases
Dynamics
Shifts in demand or supply create surpluses or shortages
Surpluses cause price to fall and shortages cause price to
rise
Increases in prices cause quantity demanded to decrease
(law of demand) and quantity supplied to increase (law of
supply)
Decreases in prices cause quantity demanded to increase
(law of demand) and quantity supplied to decrease (law of
supply)
These price changes occur until surpluses or shortages are
eliminated at the new equilibrium price and quantity
Using Demand and Supply
Step 1: Determine if the change in the
determinant affects the demand or supply
curve.
Step 2: Determine which way it shifts the
curve
Step 3: Determine how the equilibrium
price and quantity change (dynamic
adjustment)
Elasticity: Responsiveness versus
Directions
Demand and Supply analysis allows us to
see the direction of changes in the
equilibrium price and quantity
We need another concept to see how
responsive demand and supply are to
change in their determinants
The concept that helps us measure that
sensitivity is elasticity
Price Elasticity of Demand
The concept of elasticity helps understand how
responsive demand is to price changes
Intuitively, if we are a businessperson and we
want to increase revenues, one important question
is whether we increase price or decrease price
Increases in price decreases the quantity demanded, but we get
more for each unit we sell
Decreases in price increases the quantity demanded, but we get
less for each unit we sell
How can we tell whether the price or the quantity effect wins
out to increase our revenues
The answer is the concept of elasticity
Definition of Elasticity
Price elasticity of demand =
%change in quantity demanded/
% change in price
Or using symbols: E
p
= %Q
d
/%P
For example, if the %Q
d
= 10% and the
%P = 2%, the price elasticity of demand =
5, OR for every 1% change in price the
quantity demand changes by 5%.

E
p
> 1 Responsive or elastic
%Q
d
> %P
E
p
< 1 Not responsive or inelastic
%Q
d
< %P
E
p
= 1 unit elastic
%Q
d
= %P
BUT I Hate Percentages!!!
OK, but they come in mighty handy. Why?
They always measure the change relative to a starting
point. (e.g. a $1 increase in your hourly wage is
different if you make $5/hr. or $100/hr.)
Absolute changes are affected by changes in the units
with which they are measured ( 100 boxes of apples =
5,000 apples, but the later looks like a bigger change)
Percentages are everywhere!!!! (Stores usually use
percentage discounts during sales, increases in pay are
generally in percentages, batting averages are in
percentages, grades are given in percentages)
The Farmers Dilemma
For many crops, a strange situation arises a bad crop year
results in a good year for farm incomes, and a good crop
year results in a bad year for farm incomes. How can this
be?
Price elasticity gives us the answer:
Bad crop year: supply decreases, prices for farm products rise, but
quantity demanded doesnt fall very much. The quantity
demanded of farm products is not very responsive to changes in
prices
Good crop year: supply increases, prices for farm products fall, but
quantity demanded doesnt increase very much. The quantity
demanded of farm products is not very responsive to changes in
prices
It is easy to show this with a graph. But first we need yet
another concept: Total Revenue = Price x Quantity

Elasticity and Total Revenue
TR = P x Q
If P goes down Q goes up, but what
happens to TR?
If P goes up Q goes down, but what
happens to TR?
Elasticity can answer the question.
Elasticity to the Rescue.
E
p
> 1 Responsive or elastic
%Q
d
(10%) > %P (5%) if P goes down (up) total
revenue goes up (down)
E
p
< 1 Not responsive or inelastic
%Q
d
(5%) < %P (10%) if P goes down (up) total
revenue goes down (up)

E
p
= 1 unit elastic
%Q
d
(5%)= %P (5%) if P goes down (up) total
revenue stays the same
The Farm Example
During bad crop years, prices rise and
quantity falls (but not that much) so total
revenue to farmers goes up.
During good crop years, prices fall and
quantity increases (but not that much) so
total revenue to farmers goes down.
The graphs.

Figure 8 An Increase in Supply in the Market for Wheat
Copyright2003 Southwestern/Thomson Learning
Quantity of
Wheat
0
Price of
Wheat
3. . . . and a proportionately smaller
increase in quantity sold. As a result,
revenue falls from $300 to $220.
Demand
S
1

S
2

2. . . . leads
to a large fall
in price . . .

1. When demand is inelastic,
an increase in supply . . .
2
110
$3
100
Can Elasticity Tell Us More?
What a minute, first we need to talk about what
increases or decreases the price elasticity of
demand.
Determinants of Price Elasticity
Availability of close substitutes
Necessity versus luxury
Definition of the market
Time horizon
Percentage of consumer budget



Price elasticity of demand
Elasticity of Demand
elasticity coefficient
item short run long run
Airline travel 0.1 2.4
Medical care 0.3 0.9
Natural gas 1.4 2.1
Auto tires 0.9 1.2
Stationery 0.5 0.6
Gasoline 0.2 0.7
Housing 0.3 1.9
Automobiles 1.9 2.2
Movies 0.9 3.7
Jewelry & watches 0.4 0.7
Radio & TV repair 0.5 3.8
Foreign travel 0.1 1.8
Glass, china, etc. 1.5 2.5
Estimated price elasticities of demand
E
d

Percentage Change in
Quantity Demanded
Percentage Change in Price
Elasticity of Supply
How how about the price elasticity of supply?
How responsive are suppliers to changes in price?
Price elasticity of supply = %change in quantity
supplied/% change in price
Determinants of elasticity of supply:
Flexibility in altering the amount of a good produced.
Time period
Price elasticity of supply
Elasticity of Supply
Price elasticity
Vegetable short run long run
Lima beans 0.10 1.70
Cabbage 0.36 1.20
Carrots 0.14 1.00
Cucumbers 0.29 2.20
Onions 0.34 1.00
Green peas 0.31 4.40
Green peppers 0.07 0.26
Tomatoes 0.16 0.90
Cauliflower 0.14 1.10
Celery 0.14 0.95
Spinach 0.20 4.70
Estimated price elasticities of supply
E
s

Percentage Change in
Quantity Supplied
Percentage Change in Price
Further Examples of Elasticity
Inelastic demand and addictive drugs:
Supply side prevention
Demand side prevention
Luxury Taxes
Who pays a tax? But with elasticity we find
out
Who really pays the tax? (tax incidence or
burden).