1
Economics 221: Economics Principles
Capt Len Cabrera, 3-3549
Fall 2002
Lesson 11: Demand: The Benefit Side of the Market
Elasticity
-----------------------------------------------------------
Why Elasticity Matters....
Attempts to reduce supply of illegal drugs tend to raise market price of drugs (S↓), BUT
crime associated with drugs is based on total expenditure for drugs so you need to know
if P↑
TR↑
Should a company raise price? AOL raised price 9%... expects increase revenue of $200M
Total Expenditure = Total Revenue - total dollar amount consumers spend of a product equals
total dollar amount sellers receive; equals number of units bought times price for each unit
TR = P*Q
Total Revenue Test - price increase will produce increase in TR whenever it's greater, in
percentage terms, than corresponding percentage reduction in quantity demanded
(i.e., %∆P > |%∆Q|)
ELASTICITY
Elasticity - "responsiveness"; how something reacts to a change in the environment (e.g.,
How far does a rubber band stretch when you apply 5 lbs of force to it?
How does behavior change when a reward is given?
P
How does quantity demanded change when price drops $5?)
More elastic
More inelastic
Not Slope - although slope gives some indication, can't use it for
100
two reasons:
90
Wrong Units - slope is dependent on units used to plot demand
D1
80
curve; can't compare slopes for different goods measured in
unrelated units (e.g., cars/dollar vs. paperclips/dollar); also
slope changes based on unit of measure (e.g., Coke in 12oz
D2
cans vs. 6 packs vs. 12 packs vs. 2 liter bottles)
Elasticity Varies - price elasticity may not be constant along the
5 10
Q
20
demand curve (usually isn't)
Price Elasticity of Demand (εεd) - unit-free measure of the responsiveness of quantity
demanded of a good to a change in its price (all other factors constant)
Sign - because demand slopes downward (i.e., positive change in price brings negative
change in quantity demanded), εd should be negative; but we know it's always negative
so we only worry about the magnitude
εd =
%∆
∆Q
%∆
∆P
=
∆Q
∆P
Q
P
P
=
Q
1
*
Slope
Red:
90/10 (11-9)/(100-80) = 0.9
Blue:
90/10 (20-5)/(100-80) = 6.75
2
P
Class Example 1/Slope = 1/(7/14) = 1/0.5 = 2
P
Q
TR εd
7
0
0
6
2
12 (6/2)*2 = 6
5
4
20 (5/4)*2 = 5/2 (2.5)
4
6
24 (4/6)*2 = 4/3 (1.33)
3.5 7
24.5 (3.5/7)*2 = 1
3
8
24 (3/8)*2 = 3/4 (0.75)
2
10 20 (2/10)*2 = 2/5 (0.4)
1
12 12 (1/12)*2 = 1/6
0
14 0
(0/14)*2 = 0
8
7
Elastic
εd > 1; TR↑
6
5
Unit Elastic
εd = 1; TR max
4
Inelastic
εd < 1; TR↓
3
2
1
2
4
6
8
10
12
14
16
Q
Total Revenue Test (revisited) - method of estimating εd by
observing change in TR:
P↓
TR↑
εd > 1 (elastic)
P↓
TR constant
εd = 1 (unit elastic)
P↓
TR↓
εd < 1 (inelastic)
*** NOTE: If ∆TR = 0 (i.e., εd = 1), TR is maximized ***
Types of εd
Perfectly Inelastic Demand (εεd = 0) - quantity demanded
remains constant when price changes
Inelastic Demand (0 < εd < 1) - percentage change in quantity
demanded is less than percentage change in price (e.g.,
food, housing)
Unit Elastic Demand (εεd = 1) - percentage change in quantity
demanded equal percentage change in price
Elastic Demand (εεd > 1) - percentage change in quantity
demanded exceeds percentage change in price (e.g., cars,
furniture, most consumer durables)
Perfectly Elastic Demand (εεd = ∞) - quantity demand3ed
changes by an infinitely large percentage in response to a
tiny price change
Linear Demand - at high prices & small quantities, elasticity is
large because relative change in quantity exceeds change in
price; at low prices & large quantities the opposite occurs;
*** elasticity is always unitary in the midpoint ***
P
εd = 0
Perfectly inelastic
εd = ∞
Perfectly elastic
Q
3
Factors that Influence εd:
Closeness of Substitutes - closer substitutes means more elastic demand
Broad vs. Narrow - broadly defined goods (e.g., meat; transportation) are more
inelastic; narrowly defined goods (e.g., [beef, lamb, chicken], [car, bus, subway]) are
more elastic
Necessities - have poor substitutes & are crucial for wellbeing (food, shelter); inelastic
Luxuries - usually have many substitutes, one of which is not buying it; elastic
Proportion of Income - greater percentage of income spent on good makes it more elastic;
*** explains why P↑
εd↑ ***
Time Since Price Change - longer the time elapsed since price change, more elastic
e.g., Pgas↑... 1 month εd = 0.1... 2 years εd = 1.5
INCOME ELASTICITY OF DEMAND
%∆
∆Q
Income Elasticity of Demand (εεY) - measure of responsiveness
εY =
of demand for good or service to change in income, other
%∆
∆Y
things remaining constant
Normal Good, Income Elastic - εY > 1; demand increases faster than income (e.g., cruises,
international travel, jewelry, works of art)
Normal Good, Income Inelastic - 0 < εY < 1; demand increases, but not as fast as income
(e.g., food, clothing, newspapers, magazines)
Inferior Good - εY < 0; demand decreases as income rises
Transition - most goods transition between income inelastic and inferior good based on
level of income (e.g., small motorcycles, potatoes, rice)... buy more initially as income
rises, but eventually replace those goods with superior alternatives (e.g., fruit,
vegetables, & meat replace rice & potatoes)
** εY depends on starting amount of income **
CROSS ELASTICITY OF DEMAND
Cross-Price Elasticity of Demand (εεcp) - measure of responsiveness of demand for a good to
a change in the price of another good (substitute, compliment, or independent)
Perfect Substitutes - εcp = ∞; smallest possible increase in price of one good causes
infinitely large increase in quantity demanded o other good (e.g., two soda machines
next to each other)
Substitute - εcp > 0 (PB↑
QA↑); larger value means closer substitutes & greater shift in the
demand curve (e.g., brand names of same good)
Independent - εcp = 0 (PB↑
QA doesn't change; e.g., newspapers & orange juice)
Compliment - εcp < 0 (PB↑
QA↓); larger absolute value means closer compliments &
greater shift in the demand curve (e.g., movies & popcorn)
%∆
∆ QA
εcp =
%∆
∆PB