Principles of Economics
Session 2
Topics To Be Covered
Price Elasticity of Demand
Income Elasticity of Demand
Cross-Price Elasticity of Demand
Elasticity of Supply
Application of Elasticity
Networks and Positive Feedback
Elasticity
 Elasticity is a measure of how much
buyers and sellers respond to changes in
market conditions
 It allows us to analyze supply and
demand with greater precision.
Price Elasticity of Demand
Price elasticity of demand is the
percentage change in quantity demanded
given a percent change in the price.
It is a measure of how much the quantity
demanded of a good responds to a change
in the price of that good.
Computing the Price Elasticity
of Demand
The price elasticity of demand (Ed) is
computed as the percentage change in the
quantity demanded divided by the
percentage change in price.
Percentage Change
in Quantity Demanded %Q Q / Q
Ed =


Percentage Change
%P P / P
in Price
Computing the Price Elasticity
of Demand
Percentage Change
in Quantity Demanded %Q
Ed =

Percentage Change
%P
in Price
Example: If the price of an ice cream cone increases
from $0.50 to $1.00 and the amount customers buy falls
from 10 to 8 cones then the elasticity of demand would
be calculated as:
(10  8)
100%
20%
10

 0.2
(1.00  0.50)
100
%
100%
0.50
Computing the Arc Elasticity of
Demand
P
$3.00
2.50
2.00
1.50
Ed=0.2
1.00
0.50
0 1
2 3 4 5 6 7 8 9 10 11 12
Qd
Computing the Arc Elasticity of
Demand
Percentage Change
in Quantity Demanded %Q
Ed =

Percentage Change
%P
in Price
Example: If the price of an ice cream cone decreases
from $1.00 to $0.50 and the amount customers buy
increases from 8 to 10 cones then the elasticity of
demand would be calculated as:
(10  8)
 100%
25%
8

 0.5
(1.00  0.50)
50%
 100%
1.00
Computing the Arc Elasticity of
Demand
P
$3.00
2.50
2.00
1.50
Ed=0.5
1.00
0.50
0 1
2 3 4 5 6 7 8 9 10 11 12
Qd
Computing the Arc Elasticity of
Demand Using the Midpoint
Formula
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  Q1 )/[(Q 2  Q1 )/2]
Price Elasticity of Demand =
(P2  P1 )/[(P2  P1 )/2]
Computing the Arc Elasticity of
Demand
(Q 2  Q1 )/[(Q 2  Q1 )/2]
Price Elasticity of Demand =
(P2  P1 )/[(P2  P1 )/2]
Example: If the price of an ice cream cone increases
from 0.50 to $1.00 and the amount customers buy falls
from 10 to 8 cones the your elasticity of demand, using
the midpoint formula, would be calculated as:
(10  8)
22.2%
(10  8) / 2

 0.33
(1.00  0.50)
66.6%
(1.00  0.50) / 2
Computing the Arc Elasticity of
Demand
P
$3.00
2.50
2.00
1.50
Ed=0.33
1.00
0.50
0 1
2 3 4 5 6 7 8 9 10 11 12
Qd
Ranges of Elasticity
Inelastic (E＜ 1)
Quantity demanded does not respond
strongly to price changes.
Elastic (E ＞ 1)
Quantity demanded responds strongly to
changes in price.
Ranges of Elasticity
Unit Elastic (E= 1)
Quantity demanded changes by the same
percentage as the price.
Perfectly Inelastic (E = 0)
Quantity demanded does not respond to
price changes.
Perfectly Elastic (E =∞)
Quantity demanded changes infinitely
with any change in price.
Inelastic Demand
Price
1. A 22% $5
increase
in price... 4
E＜ 1
Demand
Quantity
90 100
2. ...leads to a 11% decrease in quantity.
Elastic Demand
Price
1. A 22% $5
increase
in price... 4
E＞1
Demand
Quantity
50
100
2. ...leads to a 67% decrease in quantity.
Unit Elastic Demand
Price
1. A 22% $5
increase
in price... 4
E= 1
Demand
Quantity
80
100
2. ...leads to a 22% decrease in quantity.
Perfectly Inelastic Demand
Price
Demand
$5
1. An
increase
in price... 4
E=0
Quantity
100
2. ...leaves the quantity demanded unchanged.
Perfectly Elastic Demand
Price
1. At any price
above $4, quantity
demanded is zero.
$4
E =∞
Demand
2. At exactly $4,
consumers will
buy any quantity.
Quantity
Computing the Arc Elasticity of
Demand
P Ed = ∞
$3.00
Ed＞1
2.50
Ed = 1
2.00
Linear Demand Curve
Qd = a + bP
Qd =12 – 4P
1.50
Ed＜1
1.00
0.50
Ed = 0
0 1
2 3 4 5 6 7 8 9 10 11 12
Qd
Arc Elasticity
vs. Point Elasticity
Arc Elasticity
It is calculated over a portion of demand
curve.
Point Elasticity
It is computed at a point on demand
curve.
Computing the Point Elasticity
of a Linear Demand Curve
P E =∞
d
$3.00
%Q Q / Q Q P
Ed =



%P P / P P Q
Ed=5
2.50
Qd  12  4 P
Q
 4
P
Ed=2
2.00
Ed = 1
1.50
Ed=0.5
1.00
Ed=0.2
0.50
Ed = 0
0 1
2 3 4 5 6 7 8 9 10 11 12
Qd
Computing the Point Elasticity
of a Linear Demand Curve
P
A
C
B
O
D
Q P OE BO BC BO
Ed =
 



P Q AO OD AB OD
BO CE DE



AB AC OD
E
Qd
Elasticity vs. Slope
P
$3.00
2.50
2.00
Ed=1
1.50
1.00
Ed=0.43
0.50
0 1
2 3 4 5 6 7 8 9 10 11 12
Qd
Computing the Point Elasticity
of a Curvilinear Demand
P
$3.00
2.50
A
●
2.00
Ed=2
1.50
B
●
1.00
Ed=1
0.50
0 1
2 3 4 5 6 7 8 9 10 11 12
Qd
Elasticity and Total Revenue
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
Elasticity and Total Revenue
Price
$4
P x Q = $400
(total revenue)
P
0
Q
Demand
100
Quantity
Elasticity and Total Revenue
P
$3.00
With inelastic demand (Ed＜1),
an increase in price leads to an
increase in total revenue.
2.50
2.00
1.50
1.00
TRB=1.0×8=8
0.50
B
Ed＜1
A
0 1
TR=P ×Q
TRA=0.5×10=5
2 3 4 5 6 7 8 9 10 11 12
Qd
Elasticity and Total Revenue
P
TRB=2.5×2=5
$3.00
B
2.50
Ed＞1
TR=P ×Q
With elastic demand
(Ed＞1), an increase
in price leads to a
decrease in total
revenue.
A
2.00
1.50
1.00
0.50
TRA=2×4=8
0 1
2 3 4 5 6 7 8 9 10 11 12
Qd
Elasticity and Total Revenue
P
$3.00
With unit-elastic demand (Ed=1),
an increase in price leads to no
change in total revenue.
TRB=1.75×5=8.75
B
1.75
Ed=1
TR=P ×Q
A
1.25
TRA=1.25×7=8.75
0 1
2 3 4 5 6 7 8 9 10 11 12
Qd
Determinants of
Price Elasticity of Demand
Necessities versus Luxuries
Availability of Close Substitutes
Definition of the Market
Time Horizon
Determinants of
Price Elasticity of Demand
Demand tends to be more elastic :
if the good is a luxury.
the longer the time period.
the larger the number of close
substitutes.
the more narrowly defined the market.
Price Elasticity of Demand
Beef
Eggs
0.956
0.263
Fruit
3.021
GM Pontiac Catalina
16.99
Gasoline (short run)
0.43
Gasoline (long run)
1.50
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
Income Elasticity
of Demand
=
Percentage Change
in Quantity Demanded
Percentage Change
in Income
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
- Types of Goods 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.
Income Elasticity of Demand
Automobiles
Furniture
2.50
0.53
Books
1.40
Clothing
1.00
Tobacco
0.64
Eggs
0.37
Cross-Price Elasticity of
Demand
The cross-price elasticity of a
good measures the
responsiveness of quantity
demanded of one good to
changes in the price of
another good.
Computing Cross-Price Elasticity
of Demand
E XY
%Q X Q X / Q X Q X PY




%PY
PY / PY
PY Q X
Cross-Price Elasticity of
Demand
Beef and Chicken
Margarine and Butter
0.350
1.526
Catalinas and Impalas
19.3
Price Elasticity of Supply
Price elasticity of supply is the
percentage change in quantity supplied
resulting from a percent change in price.
It is a measure of how much the quantity
supplied of a good responds to a change
in the price of that good.
Ranges of Elasticity
 Relatively
Inelastic
ES < 1
 Relatively Elastic
ES > 1
 Unit Elastic
ES = 1
Ranges of Elasticity
 Perfectly
Elastic
ES = 
 Perfectly Inelastic
ES = 0
Inelastic Supply
Price
Supply
1. A 22% $5
increase
in price... 4
E＜ 1
Quantity
100 110
2. ...leads to a 10% increase in quantity.
Elastic Supply
Price
Supply
1. A 22% $5
increase
in price...
4
E＞1
100
200 Quantity
2. ...leads to a 67% increase in quantity.
Unit Elastic Supply
Price
Supply
1. A 22% $5
increase
in price... 4
E= 1
Quantity
100
125
2. ...leads to a 22% increase in quantity.
Perfectly Elastic Supply
Price
E =∞
Supply
$4
1. At exactly $4,
producers will
supply any quantity.
2. At a price below $4,
quantity supplied is zero.
Quantity
Perfectly Inelastic Supply
Price
$5
1. An
increase
in price... 4
Supply
E=0
Quantity
100
2. ...leaves the quantity supplied unchanged.
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.
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.
Percentage Change in
Quantity Supplied
Elasticity of Supply =
Percentage Change
in Price
Application of 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.
Bumper Harvest 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?
An Increase in Supply in the
Market for Wheat
Price of
Wheat
S1
$3
Demand
0
100
Quantity of Wheat
An Increase in Supply in the
Market for Wheat
Price of
Wheat
1. When demand is inelastic,
an increase in supply...
S1
S2
2. ...leads $3
to a large
2
fall in
price...
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.
Compute Elasticity
100 - 110
ED =
3.00 - 2.00
(100  110)/2
(3.00  2.00)/2
- 0.095

 -0.24
0.4
Compute Elasticity
100 - 110
ED =
3.00 - 2.00
(100  110)/2
(3.00  2.00)/2
- 0.095

 -0.24
0.4
Demand is inelastic
Taxes and Elasticity
Governments levy taxes to
raise revenue for public
projects.
Taxes
 Tax
incidence is the study of who
bears the burden of a tax.
 Taxes result in a change in market
equilibrium.
 Buyers pay more and sellers receive
less, regardless of whom the tax is
levied on.
Impact of Tax Levied on Buyers
Price of
Ice-Cream
Cone
Supply, S1
A tax on buyers
shifts the demand
curve downward
by the size of
the tax ($0.50).
3.00
D1
D2
0
90 100
Quantity of
Ice-Cream Cones
Impact of Tax Levied on Buyers
Price of
Ice-Cream
Cone
Price
buyers
pay
Price
without
tax
$3.30
3.00
2.80
Price
sellers
receive
Supply, S1
Equilibrium without tax
Tax ($0.50)
Equilibrium
with tax
D1
D2
0
90 100
Quantity of
Ice-Cream Cones
What was the impact of tax?
 Taxes discourage market activity.
 When a good is taxed, the quantity sold
is smaller.
 Buyers and sellers share the tax
burden.
Impact of Tax Levied on Sellers
Price of
Ice-Cream
Cone
Price
buyers
pay
Price
without
tax
$3.30
3.00
2.80
S2
Equilibrium
with tax
S1
Tax ($0.50)
A tax on sellers
shifts the
supply curve
upward by the
amount of the
tax ($0.50).
Equilibrium without tax
Price
sellers
receive
Demand, D1
0
90 100
Quantity of
Ice-Cream Cones
A Payroll Tax
Wage
Tax reduces
labor supply
Labor
supply
Wage firms
pay
Wage Tax wedge
without tax
Wage workers
receive
Labor
demand
0
Quantity of
Labor
The Incidence of Tax
 In
what proportions is the burden of
the tax divided?
 How do the effects of taxes on sellers
compare to those levied on buyers?
The answers to these questions
depend on the elasticity of demand
and the elasticity of supply.
Elastic Supply, Inelastic Demand
Tax reduces
labor supply
Price
1. When supply is more
elastic than demand...
Price buyers pay
Supply
Tax
Price without tax
Price sellers receive
3. ...than on
producers.
0
2. ...the
incidence of the
tax falls more
heavily on
consumers...
Demand
Quantity
Inelastic Supply, Elastic Demand
Tax reduces
labor supply
1. When demand is more
elastic than supply...
Price
Supply
Price buyers pay
Price without tax
3. ...than on consumers.
Tax
Price sellers receive
0
Demand
2. ...the
incidence of
the tax falls more
heavily on producers...
Quantity
$1.0 of Tax on Gasoline
S’
Retail Price
2.0
1.8
S
0.8
1.0
0.2
0.8
D
0
90 100
Quantity
So, how is the burden of the
tax divided?
The burden of a
tax falls more
heavily on the side
of the market that
is less elastic.
Networks and Positive
Feedback
Positive Feedback
Strong get stronger, weak get weaker
Negative feedback: stabilizing
Makes a market “tippy”
Examples: VHS v. Beta, Wintel v. Apple
“Winner take all markets”
Sources of Positive
Feedback
Supply side economies of scale
 Declining
average cost
 Marginal cost less than average cost
 Example: information goods
Demand side economies of scale
 Network
effects
 In general: fax, email, Web
 In particular: Sony v. Beta, Wintel v. Apple
Network Effects
Real networks
Virtual networks
Number of users
 Metcalfe’s
Law:
Value of network of size n proportional to n2
Importance of expectations
Lock-In and Switching
Costs
Network effects lead to substantial
collective switching costs
Even worse than individual lock-in
Due to coordination costs
Example: QWERTY
Chicken & Eggs
Fax and fax machines
VCRs and tapes
Internet browsers and Java
Historical Examples of
Positive Feedback
RR gauges
AC v. DC
Telephone networks
Color TV
HD TV
Assignment
Review Chapter 4
Answer questions on P78-79
Preview Chapter 5
Thanks