Chapter 4
Elasticity
©1999 South-Western College Publishing
3/24/20
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What is Elasticity?
A term economists use to
describe sensitivity
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How do we measure the
Price Elasticity of Demand?
The percentage change in
quantity demanded
divided by the percentage
change in price
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Price Elasticity of
Demand
Ed
=
% change in Q
% change in P
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Notes on Ed
• Ed negative, but ignore
negative
• use of % change-not
affected by units of
measurement
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Classifying Ed
• Ed = 1 Unitary elasticity
• Ed > 1 Elastic demand
• Ed < 1 Inelastic demand
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Extreme elasticities
• Ed = 0 Perfectly inelastic
(vertical demand curve)
• Ed =  Perfectly elastic
(horizontal demand
curve)
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Perfectly inelastic
demand
Perfectly elastic
demand
P
P
D
D
Q
Q
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When consumers are very
sensitive to a price change
what does the demand
curve look like?
Very horizontal
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When consumers are less
sensitive to a price change
what does the demand
curve look like?
Very vertical
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Problem - When we
move along a demand curve
between two points, we get
different answers to elasticity
depending if we are moving
up or down the demand curve
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If there is an increase
from 3 units to 5, what is
the percentage increase?
2/3 = 66%
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If there is a decrease from
5 units to 3, what is the
percentage decrease?
2/5 = 40%
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If we go from 3 to 5,
the percentage change is
2/3 , but if we go from 5
to 3, the percentage
change is 2/5 , so the
elasticities are different
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The answer to this
problem is to work with
averages ...
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Price elasticity equals the
change in quantity demanded
sum of quantities/2
divided by
change in price
sum of prices/2
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Quantity
Bananas
200
Oranges
240
400
280
Price
$20
$18
$40
$70
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7
What is the Price Elasticity of Demand
for bananas?
2
40
=
220
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40 X 19
760
=
2
220
440
= 1.727
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What is the Price Elasticity
of Demand for oranges?
120
30
=
340
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120 X 55
6,600
=
30
340
10,200
= .647
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Practice: calculating Ed
You usually buy 4 cd’s per
month at a price of $14, but
when the price rises to $18,
you purchase only 3 per
month. What is your
elasticity of demand for cd’s
over this range of prices?
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Elasticity and Total
Revenue (TR)
TR = PQ, price times
quantity
Ed = % change in Q
% change in P
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When price increases,
what two things happen?
• more money per unit
• fewer units are sold
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If total revenue does
not change when
price increases, the
demand curve is
unitary elastic,
value equals 1
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If price increases and
the revenue gained is
less than the revenue
lost, the demand curve
is price elastic, > 1
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If price increases and the
revenue gained is greater
than the revenue lost, the
demand curve is price
inelastic, < 1
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Summary, elasticity, price changes,
and total revenue
Price
increase
Total
revenue
same
Price
Decrease
Total
revenue
same
Ed > 1
Total
revenue
falls
Total
revenue
rises
Ed < 1
Total
revenue
rises
Total
revenue
falls
Ed = 1
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What factors influence Demand
Sensitivity (elasticity)?
• Number and
closeness of
Substitute goods
• % of income a good
makes up
• Basic goods or
“needs”
• Time to adjust
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What do substitutes have to
do with sensitivity?
The more substitutes a
good has, the more
sensitive consumers are to
a price change
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A
P
P
D
D
0
Q
B
0
Q
Which demand curve is for spark
plugs and which for Coca-Cola?
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What does % of income a good makes
up have with sensitivity?
The lower the % of ones
budget a good is, the less
sensitive consumers are to a
price change
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What do basic goods have
to do with sensitivity?
The greater the need a good
has to the consumer, the less
sensitive the consumer is to
a price change
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What does time have to
do with sensitivity?
The more time to adjust, the
more sensitive consumers
are to a price change
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If a college raises tuition,
what happens to revenue?
If demand is elastic revenue goes down
If demand is inelastic revenue goes up
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What strategies do CocaCola and Pepsi use to
make the demand for their
products less elastic?
http://www.cocacola.com
http://www.pepsi.com
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What is Cross Elasticity
of Demand?
The percentage change in
the quantity demanded of
one commodity resulting
from a 1 percent change in
price of another commodity
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E c = % Quantity of X
% Price of Y
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If negative - complements (steak &
steak sauce)
If positive - substitutes (butter &
margarine)
Unrelated goods should have a cross
elasticity close to zero
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What is Income
Elasticity of Demand?
The ratio of the percentage
change in quantity
demanded to the percentage
change in income
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E i = %  Quantity
% Income
• E i > 0 Normal goods
• E i < 0 Inferior goods
• E i > 1 Luxury goods
• 0 < E i < 1 Necessities
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When does a good face
an income elastic
demand curve?
A 1% change in income
generates a greater than
1% change quantity
demanded
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When does a good face
an income inelastic
demand curve?
A 1% change in income
generates a less than
1% change quantity
demanded
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What is an
Inferior Good?
Something that people
will buy less of as
their incomes increase
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What is a
Normal Good?
Something that people
will buy more of as their
incomes increase
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What is Price Elasticity
of Supply?
The ratio of the percentage
change in quantity
supplied to the percentage
change in price
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E s = %  Q supplied
%  Price
• E s = 1 Unitary
• E s > 1 Elastic
• E s < 1 Inelastic
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Extreme cases of E s
• E s = 0, perfectly inelastic
(vertical supply curve
• E s = , perfectly elastic
(horizontal supply curve)
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Does time effect Supply
Elasticities?
Yes! The more time,
the more elastic the
supply curve
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Applications of Elasticity
• The farm problem
• Illegal drugs
• The volunteer army
• Tax incidence
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The Farm Problem
• Inelastic demand for
many farm goods
• Low income elasticity of
demand also
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S
P
S1
P1
P2
D
Q
Q1
Q2
Since farmers face volatile supply, with inelastic
demand, % change in Price is greater than %
change in quantity, making for more fluctuating
of incomes
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Recall with inelastic demand, lower prices
do not increase quantity by the same %,
leading to lower revenue, yet costs are
higher due to increased quantity, resulting
in lower farm profits.
Low income elasticity means that farming is
not a “growth” industry, as our incomes rise
we tend to allocate that income to other
goods, not as much to food products.
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S (illegal)
P
S1 (legal)
P1
P2
D inelastic
Q
Q1
Q2
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Which type of good
would be best to tax to
raise the most revenue?
Goods that face a price
inelastic demand curve will
generate the most revenue
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• What factors influence Demand
Sensitivity?
• What is Elasticity?
• How do we measure the Price
Elasticity of Demand?
• What is Cross Elasticity of
Demand?
• What is Income Elasticity of
Demand?
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END
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