Elasticity

Elasticity
MB
MC
MB MC
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Learning Objectives
Define and calculate price elasticity of demand

Determinants of price elasticity of demand
Graphical interpretation of price elasticity of
demand
Understand how changes in price affect total
revenue; relate to price elasticity of demand
Define income elasticity and cross-price elasticity
Define and calculate price elasticity of supply
Determinants of price elasticity of supply
Copyright c 2007 by The McGraw-Hill

Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 2
MB MC
Elasticity
Does a business make more money or less

by offering goods on sale?
Does the government earn higher or lower

tax revenues by raising taxes on goods, say
cigarettes?
Does the total wage earnings of all trade

union members as a whole rise after the
union negotiates a wage hike for its
members?

Slide 3
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Elasticity and Illegal Drugs
Is greater enforcement in the illegal drug market

likely to reduce crime?
Hypothesis
Drug
users steal to buy drugs

Increased drug enforcement will decrease theft
Analysis
Increased enforcement reduces supply of drugs
Price
of drugs increases; Quantity demanded falls
Theft
goes down only if drug users spend less to

buy drugs
How
responsive is quantity demanded to price?

Slide 4
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The Effect of Extra Border

Patrols on the Market for Illicit Drugs
Total Expenditure = P x Q
S
$2500
= $50 x 50
S
$3200
= $80 x 40
P($/ounce)
80
S
50
D
40
50
Q(1,000s of ounces/day)
Slide 5
MB MC
Elasticity
Say the price of salt rises by 50%. By how much

will you reduce your salt consumption?
Not a whole lot because salt does not have very

good substitutes.
Now say the price of only one brand, Morton salt,

rises by 50%. How does your salt consumption
respond?
Buy other brands of salt because for most people

Morton and Wal-Mart brands will be perfect
substitutes.

Slide 6
MB MC
Elasticity
Clearly, for a 50% change in the price, demand for

Morton salt is more responsive than the demand for
salt in general.
We say that the demand for Morton salt is more elastic

than the demand for salt.
Elasticity, in general, is a measure of the extent to

which quantity demanded and/or quantity supplied
responds to variations in price, income, and other
factors.

Slide 7
MB MC
Price Elasticity of Demand
Measure of responsiveness of quantity demanded to

changes in price
It is defined as the absolute value of the percentage
change in the quantity demanded of good A divided by
the percentage change in the price of good A.
=
(-) Percentage change in quantity demanded

Percentage change in price
If the price of pork falls by 2% and the quantity demanded

increases by 6%, then the price elasticity of demand for pork is
6% divided by 2% = 3

Slide 8
MB MC
Price
Another example
A
1.00
B
0.97
400

404
Quantity
Slide 9
MB MC
Old (A)
New (B)
% Change
Price
$1.00 (PA)
$0.97 (PB)
3%
Quantity
400 (QA)
404 (QB)
1%
The elasticity going from A (old) to B (new) is 0.33

[(PB - PA)/PA] x 100 = -3%; [(QB - QA)/QA] x 100 = 1%; Price
elasticity of demand = 0.33
But going from B (old) to A (new) the calculation is:
[(PA - PB)/PB] x 100 = -3.09278%; [(QA - QB)/QB] x 100 =
0.99%; Price elasticity of demand = 3.123
So economists use Midpoint Average Formula.

Slide 10
MB MC
(Q1 Q2) / 0.5 (Q1 + Q2)

Price Elasticity
=
of Demand
(P1 P2) / 0.5 (P1 + P2)
(Q1 Q2) / (Q1 + Q2)

Price Elasticity
=
of Demand
(P1 P2) / (P1 + P2)

Slide 11
MB MC
Suppose that 100 shoes are demanded when price is

$20. When price rises to $40, quantity of shoes
demanded falls to 40. So P1=$20, Q1=100; P2=$40
and Q2=40. Then the price elasticity of demand is:
(Q1 Q2) / (Q1 + Q2)
(P1 P2) / (P1 + P2)
(100 40) / (100 + 40)

(20 40) / (20 + 40)

= 9/7
Slide 12
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Elastic, Inelastic and Unit Elastic Demand
Demand is said to be elastic if the price elasticity of demand is

greater than 1.
Percentage
change in quantity is greater than percentage

change in price; quantity demanded is responsive to price
Demand is said to be inelastic if the price elasticity of demand is

less than 1.
Percentage
change in quantity is less than percentage change

in price; quantity demanded is not very responsive to price
Demand is said to be unit elastic if the price elasticity of
demand is equal to 1: price and quantity change by the same
percentage

Slide 13
MB MC
Price Elasticity
Estimates for Selected Products
Good or service
Price elasticity
Green peas
2.80
Restaurant meals
1.63
Automobiles
1.35
Electricity
1.20
Beer
1.19
Movies
0.87
Air travel (foreign)
0.77
Shoes
0.70
Coffee
0.25
Theater, opera
0.18

Slide 14
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Determinants of Price Elasticity of Demand
Nature of the goods - Necessities have rather inelastic

demand. The short run price elasticity of demand for
gasoline is 0.26 (long run 0.58). Luxuries, on the other
hand have relatively elastic demand (e.g., restaurant meals).
Availability of close substitutes - Price Elasticity of

demand is expected to be high for goods with close
substitutes. If the price of Crest toothpaste rises most
people will switch brands and the quantity of Crest
toothpaste demanded will fall by a large amount. The same
cannot be said for toothpaste in general.

Slide 15
MB MC
Determinants of Price Elasticity of Demand
Fraction of Income Spent (budget share) - Lower (higher)

the fraction of income spent on a good, the lower (higher)
will be its price elasticity of demand. Example salt.
Length of time - Price elasticity of demand is greater in the

long run than in the short run. If high-efficiency washers
become cheaper by 25%, many people will buy a washer
immediately. These would be people shopping for a washer
at the time. But as time passes, (assuming electricity and
non he washer prices stay the same) more and more people
will buy these he washers.

Slide 16
MB MC
Economic Naturalist
Will higher taxes on cigarettes curb teenage

smoking?
Although cigarette demand is expected to be
inelastic, they may be quite elastic for teenagers
because the cost may be a fair share of their
budget.
Teenagers smoke because their peers do.
Cutbacks by some will influence peers to cut back
too and the total effect of reduced consumption
may be significant.

Slide 17
MB MC
Economic Naturalist
In 1990 Congress imposed a luxury tax on yachts

costing > $100,000. Instead of yielding higher
revenues, it led to revenue loss and unemployment
in the US boating industry. Why?
Foreign made yachts (which are perfect
substitutes) were exempt from the tax. A tax
imposed on a good with a high price elasticity of
demand stimulates large rearrangements of
consumption but yields little revenue.

Slide 18
MB MC
A Graphical Interpretation
of Price Elasticity
Let P be a small change in price

Then P / P is the percentage change in price
Suppose that when price changes by P, quantity
demanded changes by Q
Then Q/ Q is percentage change in quantity
demanded
So the price elasticity of demand is:
=
Q / Q
P / P
Slide 19
MB MC
A Graphical Interpretation
of Price Elasticity of Demand
P
Pr ice elasticity at A
slope
Price
P
P-
Q+
Quantity
Slide 20
MB MC
Calculating Price Elasticity of Demand
20
vertical intercept
20
slope
4
horizontal intercept
5
16
8 1 8 2
A x
3 4 12 3
Price
12
8
4
Quantity
Slide 21
MB MC
Price Elasticity and the

Steepness of the Demand Curve
12
What is the price elasticity of

Demand for D1 & D2 when P = $4?
D1
4
D1
4
Price
6
4
D2
1
1
12 2
6
4 1
D2
2
4
12
12
Quantity
Slide 22
MB MC
Price Elasticity and the

Steepness of the Demand Curve
Observation
12
Price
If two demand curves have a

point in common, the steeper
curve must be less elastic with
respect to price at that point
D1
D2
12
Quantity
Slide 23
MB MC
Price Elasticity Regions along

a Straight-Line Demand Curve
Observation
Price elasticity varies at
every point along a straightline demand curve
Price
1
1
a/2
b/2
Quantity
Slide 24
MB MC
Perfectly Elastic Demand Curve

Perfectly elastic
demand (elasticity )
Price
Slope of the demandc curve 0
Quantity

Slide 25
MB MC
Perfectly Inelastic Demand Curve
Price
Perfectly inelastic
demand (elasticity 0)
Slope of the demandc curve
Quantity

Slide 26
MB MC
Elasticity and Total Expenditure
When will a university generate higher

revenues by raising tuition?
When
the demand for education at the university

is inelastic.
When will a business earn higher revenues

by cutting prices?
When
the demand for the good is elastic.

Slide 27
MB MC
Elasticity and Total Expenditure
Total Expenditure = P x Q
Market
demand measures the quantity (Q)

at each price (P)
Total Expenditure = Total Revenue

Slide 28
MB MC
The Demand Curve for Movie Tickets
12
Price ($/ticket)
10
Total Expenditure
= $1,000/day
8
6
4
2
0
Quantity (100s of tickets/day)

Slide 29
MB MC
The Demand Curve for Movie Tickets
12
Price ($/ticket)
10
Total Expenditure
= $1,600/day
8
6
4
2
0
Quantity (100s of tickets/day)

Slide 30
Slide 31
MB MC
Quantity Demanded and Total

Expenditure as a Function of Price
Demand for movie Tickets again
Price
$12
$10
$8
$6
$4
$2
$0
Quantity
100
200
300
400
500
600
Expenditure
$0
$1,000
$1,600
$1,800
$1,600
$1,000
$0
Elasticity
1.00
0.05
0.02

Slide 32
MB MC
Total Expenditure
as a Function of Price
Total revenue is at a maximum at the
midpoint on a straight-line demand curve
Price ($/ticket)
10
1, P , Q , TE
1,600
8
6
4
2
0
1, P , Q , TE
1,000
Quantity (100s of
tickets/day)
1,800
Total expenditure ($/day)
12
Price ($/ticket)
Slide 33
10
12
MB MC
Income Elasticity of Demand

The
percentage by which quantity

demanded changes in response to a 1
percent change in income

Slide 34
MB MC
Income Elasticity
=
of Demand
(Q1 Q2) / 0.5 (Q1 + Q2)

(I1 I2) / 0.5 (I1 + I2)
Income Elasticity
=
of Demand
(Q1 Q2)
(Q1 + Q2)
(I1 + I2)
(I1 - I2)
35

04/06/15
Sudeshna C.
Bandyopadhy
7.8 Income Elasticity of Demand

MB MC
Suppose that when income is $1000 per week, the

number of CDs demanded (per week) is 4. When
income rises to $2000, weekly demand for CDs rises
to 7. So I1=$1000 Q1=4; I2=$2000 and Q2=7. Then
the income elasticity of demand for CDs is:
eI
(4 7)
(4
+ 7)
(1000 + 2000)
(1000 - 2000)
= 9/11
36

04/06/15
Sudeshna C.
Bandyopadhy
MB MC

Good A is a normal good if the income
elasticity of demand is positive.
Good A is an inferior good if the income
elasticity of demand is negative.
37
04/06/15
Sudeshna C.
Bandyopadhy
MB MC
Cross Price Elasticity of Demand
Cross-Price Elasticity of Demand

The
cross price elasticity of demand for X is

the percentage by which quantity demanded
of X changes in response to a 1 percent
change in the price of a different good, Y.

Slide 38
MB MC
Cross Price Elasticity

of Demand for X
Cross Price Elasticity

of Demand for X
(Q1X Q2X) / 0.5 (Q1X + Q2X)

(P1Y P2Y) / 0.5 (P1Y + P2Y)
(Q1X Q2X )
(Q1X + Q2X )
**
(P1Y + P2Y )
(P1Y
- P2Y )
39

04/06/15
Sudeshna C.
Bandyopadhy
MB MC
Substitutes
Consider an example with substitute goods. Suppose that
25 two liter bottles of coke are demanded when Pepsi sells
for $1 per 2 liter bottle. When the price of a bottle of Pepsi
rises to $1.50, quantity of coke demanded rises to 100
bottles. So P1Y = $1, Q1X = 25; P2Y = $1.50, Q2X = 100.
Then the cross price elasticity of demand for coke (good
X) is:
eX,Y
(25 100)
(25
**
+ 100)
(1.00 + 1.50)
(1.00 1.50)
= 3
40

04/06/15
Sudeshna C.
Bandyopadhy
MB MC
Complements
Suppose that 30 bottles of soda is demanded when a

slice of Pizza sells for $1 per slice. When the price of a
slice of pizza rises to $2 per slice, the quantity of soda
demanded falls to 10 bottles. Here good X is soda and
good Y is pizza. So P1Y = $1, Q1X = 30; P2Y = $2, Q2X =
10. Then the cross price elasticity of demand for soda
(good X) is:
41
04/06/15
Sudeshna C.
Bandyopadhy
MB MC
Complements
Consider and example with complement goods. Suppose
that 30 bottles of soda is demanded when a slice of Pizza
sells for $1 per slice. When the price of a slice of pizza
rises to $2 per slice, the quantity of soda demanded falls to
10 bottles. Here good X is soda and good Y is pizza. So
P1Y = $1, Q1X = 30; P2Y = $2, Q2X = 10. Then the cross
price elasticity of demand for soda (good X) is:
eX,Y
(30 10)
(30 + 10)
(1.00 + 2.00)
(1.00 2.00)
= -3/2
42

04/06/15
Sudeshna C.
Bandyopadhy
MB MC

The cross price elasticity of demand is
negative for complements.
positive for substitutes.
zero for goods which are unrelated in
consumption.
43
04/06/15
Sudeshna C.
Bandyopadhy
MB MC
The Price Elasticity of Supply
Price Elasticity of Supply

The
percentage change in the quantity

supplied that occurs in response to a 1
percent change in price
Q Q
Price elasticity of supply
P P
P
Price elasticity of supply
Q
slope
Slide 44
MB MC
Price Elasticity of Supply Declines as Quantity

Rises for a supply curve with a +ve Y Intercept
A 8 2 1 2 2
B
10
A
Price
5
B 10 31 2
3
Quantity
Slide 45
MB MC
A Supply Curve with zero intercept has

Price Elasticity of Supply = 1
A 4 / 12 12 / 4 1
B
A
Q
Price
B 5 / 1515 / 5 1
12
15
Quantity
Slide 46
MB MC
Mid point Average Formula
(Q1 Q2) / 0.5 (Q1 + Q2)

Price Elasticity
=
of Supply
(P1 P2) / 0.5 (P1 + P2)
(Q1 Q2) / (Q1 + Q2)

Price Elasticity
=
of Supply
(P1 P2) / (P1 + P2)

Slide 47
MB MC
Determinants of Supply Elasticity
Flexibility of inputs
Uses
adaptable inputs, more elastic
Mobility of inputs
Resources
Ability to use substitute inputs

Alternative
move where needed, more elastic

inputs easy to find, more elastic
Time
Long
run, more elastic

Slide 48
MB MC
A Perfectly Inelastic Supply Curve
Price ($/acre)
Elasticity = 0 at every
point along a vertical
supply curve
Slope of a vertical
supply curve = infinity
Quantity

Slide 49
MB MC
Examples of Perfectly Inelastic

Supply
Land on Manhattan
Supply is completely fixed
Any one-of-a-kind item has perfectly inelastic
supply
Work of art (Mona Lisa)
Hope Diamond
LO 4
Copyright c 2007
by-The McGraw-Hill
Companies, Inc.
6 All rights reserved.
MB MC
A Perfectly Elastic Supply Curve
Price (cents/cup)
Supply elasticity is infinite for a

horizontal straight line supply
curve; Slope = 0. Happens when
MC is constant
S
14
0
Quantity of lemonade
(cups/day)
Slide 51
MB MC
Examples of Perfectly Elastic

Supply
Infinite price elasticity of supply

Sell all you can at a fixed price
Inputs purchased at a constant price
No volume discounts
Constant proportions of production
Lemonade example
Cost of production is 14 at all levels of Q
Marginal cost
P = 14

Slide 52
MB MC
Economic Naturalist
Why are gasoline prices so much more

volatile than car prices?
Differences in markets
Demand
for gasoline is more inelastic

Gasoline market has larger and more frequent
supply shifts
Price volatility is seen in markets where

demand is relatively inelastic and supply
fluctuates sharply and often.

Slide 53
MB MC
Gasoline Market
S
Price ($/gallon)
S
1.69
1.02
D
Gasoline:
Inelastic
demand; large
and frequent
supply shifts
6 7.2
Quantity
(millions of gallons/day)

Slide 54
MB MC
Price Volatility
Price volatility is also common in markets

where supply is highly inelastic and demand
curves fluctuates sharply.
Supply
of electricity in the short run is essentially

fixed. If demand increases significantly, prices
can rise dramatically story of Californias
unregulated market for wholesale electricity in
summer 2000.

Slide 55
MB MC
Automobile Market
Cars: Relatively elastic demand;
small supply shifts
Price ($1,000s/car)
S
S
17
16.4
D
11 12
Quantity
(1,000s of cars/day)
Cars
Slide 56
MB MC
Supply Bottlenecks
Why do star players get paid in hundreds of

millions of dollars for a contract?
Because
they supply unique and essential inputs

in the production process, which are the true
supply bottlenecks, thereby significantly
reducing the elasticity of supply in the long run.

Slide 57
End of
Chapter
MB
MC

Elasticity

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Elasticity

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Elasticity

Define and calculate price elasticity of demand

Copyright c 2007 by The McGraw-Hill

Does a business make more money or less

Does the government earn higher or lower

Does the total wage earnings of all trade

Copyright c 2007 by The McGraw-Hill

Elasticity and Illegal Drugs

Is greater enforcement in the illegal drug market

users steal to buy drugs

of drugs increases; Quantity demanded falls

goes down only if drug users spend less to

responsive is quantity demanded to price?

Copyright c 2007 by The McGraw-Hill

The Effect of Extra Border

Say the price of salt rises by 50%. By how much

Not a whole lot because salt does not have very

Now say the price of only one brand, Morton salt,

Buy other brands of salt because for most people

Copyright c 2007 by The McGraw-Hill

Clearly, for a 50% change in the price, demand for

We say that the demand for Morton salt is more elastic

Elasticity, in general, is a measure of the extent to

Copyright c 2007 by The McGraw-Hill

Price Elasticity of Demand

Measure of responsiveness of quantity demanded to

(-) Percentage change in quantity demanded

If the price of pork falls by 2% and the quantity demanded

Copyright c 2007 by The McGraw-Hill

Price Elasticity of Demand

Copyright c 2007 by The McGraw-Hill

Price Elasticity of Demand

The elasticity going from A (old) to B (new) is 0.33

Copyright c 2007 by The McGraw-Hill

Price Elasticity of Demand

(Q1 Q2) / 0.5 (Q1 + Q2)

(Q1 Q2) / (Q1 + Q2)

Copyright c 2007 by The McGraw-Hill

Price Elasticity of Demand

Suppose that 100 shoes are demanded when price is

(100 40) / (100 + 40)

Copyright c 2007 by The McGraw-Hill

Elastic, Inelastic and Unit Elastic Demand

Demand is said to be elastic if the price elasticity of demand is

change in quantity is greater than percentage

Demand is said to be inelastic if the price elasticity of demand is

change in quantity is less than percentage change

Copyright c 2007 by The McGraw-Hill

Air travel (foreign)

Copyright c 2007 by The McGraw-Hill

Determinants of Price Elasticity of Demand

Nature of the goods - Necessities have rather inelastic

Availability of close substitutes - Price Elasticity of

Copyright c 2007 by The McGraw-Hill

Determinants of Price Elasticity of Demand

Fraction of Income Spent (budget share) - Lower (higher)

Length of time - Price elasticity of demand is greater in the

Copyright c 2007 by The McGraw-Hill

Will higher taxes on cigarettes curb teenage

Copyright c 2007 by The McGraw-Hill

In 1990 Congress imposed a luxury tax on yachts

Copyright c 2007 by The McGraw-Hill

Let P be a small change in price

Calculating Price Elasticity of Demand