Elasticity and Its
Application
Chapter 5
Copyright © 2001 by Harcourt, Inc.
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Elasticity . . .
… is a measure of how much buyers and
sellers respond to changes in market
conditions
X
… allows us to analyze supply and
demand with greater precision.
X
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Price Elasticity of Demand
X
Price elasticity of demand is the
percentage change in quantity demanded
given a percent change in the price.
X
It is a measure of how much the quantity
demanded of a good responds to a change
in the price of that good.
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Determinants of
Price Elasticity of Demand
X
Necessities versus Luxuries
X
Availability of Close Substitutes
X
Definition of the Market
X
Time Horizon
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Determinants of
Price Elasticity of Demand
Demand tends to be more elastic :
if the good is a luxury.
X the longer the time period.
X the larger the number of close
substitutes.
X the more narrowly defined the market.
X
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Computing the Price Elasticity
of Demand
The price elasticity of demand is computed
as the percentage change in the quantity
demanded divided by the percentage
change in price.
Percentage Change
in Quantity Demanded
Price Elasticity of Demand =
Percentage Change
in Price
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Computing the Price Elasticity
of Demand
Price elasticity of demand =
Percentage change in quatity demanded
Percentage change in price
Example: If the price of an ice cream cone increases
from $2.00 to $2.20 and the amount you buy falls from
10 to 8 cones then your elasticity of demand would be
calculated as:
(10 − 8 )
× 100
20 percent
10
=
=2
( 2.20 − 2.00 )
10
percent
× 100
2.00
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Computing the Price 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.
(Q2 − Q1 )/[(Q2 + Q1 )/2]
Price Elasticity of Demand =
(P2 − P1 )/[(P2 + P1 )/2]
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Computing the Price Elasticity
of Demand
(Q2 − Q1 )/[(Q2 + Q1 )/2]
Price Elasticity of Demand =
(P2 − P1 )/[(P2 + P1 )/2]
Example: If the price of an ice cream cone increases
from $2.00 to $2.20 and the amount you buy falls from
10 to 8 cones the your elasticity of demand, using the
midpoint formula, would be calculated as:
(10 − 8)
22 percent
(10 + 8) / 2
=
= 2.32
(2.20 − 2.00)
9.5 percent
(2.00 + 2.20) / 2
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Ranges of Elasticity
Inelastic Demand
X Quantity demanded does not respond strongly to
price changes.
X Price elasticity of demand is less than one.
Elastic Demand
X Quantity demanded responds strongly to changes
in price.
X Price elasticity of demand is greater than one.
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Computing the Price Elasticity
of Demand
(100- 50)
(100 + 50)/2
ED =
(4.00- 5.00)
(4.00+ 5.00)/2
Price
$5
4
Demand
67 percent
=
= -3
- 22 percent
Demand is price elastic
0
50
100
Quantity
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Ranges of Elasticity
X
Perfectly Inelastic
Quantity demanded does not respond to price
changes.
X
Perfectly Elastic
Quantity demanded changes infinitely with any
change in price.
X
Unit Elastic
Quantity demanded changes by the same
percentage as the price.
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A Variety of Demand Curves
Because the price elasticity
of demand measures how
much quantity demanded
responds to the price, it is
closely related to the slope of
the demand curve.
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Perfectly Inelastic Demand
- Elasticity equals 0
Price
Demand
$5
1. An
increase
in price... 4
Quantity
100
2. ...leaves the quantity demanded unchanged.
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Inelastic Demand
- Elasticity is less than 1
Price
1. A 22% $5
increase
in price... 4
Demand
Quantity
90 100
2. ...leads to a 11% decrease in quantity.
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Unit Elastic Demand
- Elasticity equals 1
Price
1. A 22% $5
increase
in price... 4
Demand
Quantity
80
100
2. ...leads to a 22% decrease in quantity.
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Elastic Demand
- Elasticity is greater than 1
Price
1. A 22% $5
increase
in price... 4
Demand
Quantity
50
100
2. ...leads to a 67% decrease in quantity.
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Perfectly Elastic Demand
- Elasticity equals infinity
Price
1. At any price
above $4, quantity
demanded is zero.
Demand
$4
2. At exactly $4,
consumers will
buy any quantity.
3. At a price below $4,
quantity demanded is infinite.
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Quantity
Elasticity and Total Revenue
Total revenue is the amount paid by
buyers and received by sellers of a good.
X Computed as the price of the good times
the quantity sold.
X
TR = P x Q
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Elasticity and Total Revenue
Price
$4
P x Q = $400
(total revenue)
P
0
Q
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Demand
100
Quantity
Elasticity and Total Revenue
With an inelastic demand
curve, an increase in price
leads to a decrease in quantity
that is proportionately
smaller. Thus, total revenue
increases.
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Elasticity and Total Revenue:
Inelastic Demand
Price
Price
An increase in price
from $1 to $3...
…leads to an increase
in total revenue
from$100 to $240
$3
Revenue = $240
$1
0
Demand
Revenue = $100
100
Quantity
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Demand
0
80
Quantity
Elasticity and Total Revenue
With an elastic demand curve,
an increase in the price leads to
a decrease in quantity demanded
that is proportionately larger.
Thus, total revenue decreases.
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Elasticity and Total Revenue:
Elastic Demand
Price
An increase in price
from $4 to $5...
…leads to a decrease
in total revenue
from$200 to $100
Price
$5
$4
Demand
Demand
Revenue = $200
0
50
Quantity
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Revenue = $100
0
20
Quantity
Computing the Elasticity of a
Linear Demand Curve
Price
$0
1
2
3
4
5
6
7
Quantity
14
12
10
8
6
4
2
0
Total Revenue
(Price x
Percent Change
Quantity)
in Price
$0
200%
12
67
20
40
24
29
24
22
20
18
12
15
0
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Percent
Change
in Quantity
15%
18
22
29
40
67
200
Elasticity
0.1
0.3
0.6
1
1.8
3.7
13
Description
Inelastic
Inelastic
Inelastic
Unit elastic
elastic
elastic
elastic
Income Elasticity of Demand
Income elasticity of demand measures
how much the quantity demanded of a
good responds to a change in consumers’
income.
X It is computed as the percentage change
in the quantity demanded divided by the
percentage change in income.
X
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Computing Income Elasticity
Income Elasticity =
of Demand
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Percentage Change
in Quantity Demanded
Percentage Change
in Income
Income Elasticity
- Types of Goods Normal Goods
X Inferior Goods
X Higher income raises the quantity
demanded for normal goods but lowers
the quantity demanded for inferior
goods.
X
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Income Elasticity
- Types of Goods X
Goods consumers regard as necessities
tend to be income inelastic
Examples include food, fuel, clothing, utilities,
and medical services.
X
Goods consumers regard as luxuries tend
to be income elastic.
Examples include sports cars, furs, and
expensive foods.
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Price Elasticity of Supply
Price elasticity of supply is the
percentage change in quantity supplied
resulting from a percent change in price.
X It is a measure of how much the quantity
supplied of a good responds to a change
in the price of that good.
X
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Ranges of Elasticity
X Perfectly
Elastic
ES = ∞
X Relatively
Elastic
ES > 1
X Unit
Elastic
ES = 1
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Ranges of Elasticity
X Relatively
Inelastic
ES < 1
X Perfectly
Inelastic
ES = 0
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Perfectly Inelastic Supply
- Elasticity equals 0
Price
Supply
$5
1. An
increase
in price... 4
Quantity
100
2. ...leaves the quantity supplied unchanged.
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Inelastic Supply
- Elasticity is less than 1
Price
Supply
1. A 22% $5
increase
in price... 4
Quantity
100 110
2. ...leads to a 10% increase in quantity.
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Unit Elastic Supply
- Elasticity equals 1
Price
Supply
1. A 22% $5
increase
in price... 4
Quantity
100
125
2. ...leads to a 22% increase in quantity.
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Elastic Supply
- Elasticity is greater than 1
Price
Supply
1. A 22% $5
increase
in price...
4
100
200 Quantity
2. ...leads to a 67% increase in quantity.
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Perfectly Elastic Supply
- Elasticity equals infinity
Price
1. At any price
above $4, quantity
supplied is infinite.
Supply
$4
2. At exactly $4,
producers will
supply any quantity.
3. At a price below $4,
quantity supplied is zero.
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Quantity
Determinants of
Elasticity of Supply
XAbility of sellers to change the amount of
the good they produce.
X Beach-front
land is inelastic.
X Books, cars, or manufactured goods are
elastic.
XTime period.
XSupply is more elastic in the long run.
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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
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Application of Elasticity
XCan
good news for farming be bad news for
farmers?
XWhat happens to wheat farmers and the market
for wheat when university agronomists discover a
new wheat hybridthat is more productive than
existing varieties?
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Application of Elasticity
Examine whether the supply or demand
curve shifts.
X Determine the direction of the shift of the
curve.
X Use the supply-and-demand diagram to
see how the market equilibrium changes.
X
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An Increase in Supply in the
Market for Wheat
Price of
Wheat
S1
$3
Demand
0
100
Quantity of Wheat
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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
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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
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Summary
X Price
elasticity of demand measures
how much the quantity demanded
responds to changes in the price.
X If a demand curve is elastic, total
revenue falls when the price rises.
X If it is inelastic, total revenue rises as
the price rises.
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Summary
X The
price elasticity of supply measures
how much the quantity supplied
responds to changes in the price.
X In most markets, supply is more elastic
in the long run than in the short run.
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Graphical
Review
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Computing the Price Elasticity
of Demand
(100- 50)
(100 + 50)/2
ED =
(4.00- 5.00)
(4.00+ 5.00)/2
Price
$5
4
Demand
67 percent
=
= -3
- 22 percent
Demand is price elastic
0
50
100
Quantity
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Perfectly Inelastic Demand
- Elasticity equals 0
Price
Demand
$5
1. An
increase
in price... 4
Quantity
100
2. ...leaves the quantity demanded unchanged.
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Inelastic Demand
- Elasticity is less than 1
Price
1. A 22% $5
increase
in price... 4
Demand
Quantity
90 100
2. ...leads to a 11% decrease in quantity.
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Unit Elastic Demand
- Elasticity equals 1
Price
1. A 22% $5
increase
in price... 4
Demand
Quantity
80
100
2. ...leads to a 22% decrease in quantity.
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Elastic Demand
- Elasticity is greater than 1
Price
1. A 22% $5
increase
in price... 4
Demand
Quantity
50
100
2. ...leads to a 67% decrease in quantity.
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Perfectly Elastic Demand
- Elasticity equals infinity
Price
1. At any price
above $4, quantity
demanded is zero.
Demand
$4
2. At exactly $4,
consumers will
buy any quantity.
3. At a price below $4,
quantity demanded is infinite.
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Quantity
Elasticity and Total Revenue
Price
$4
P x Q = $400
(total revenue)
P
0
Q
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Demand
100
Quantity
Elasticity and Total Revenue:
Inelastic Demand
Price
Price
An increase in price
from $1 to $3...
…leads to an increase
in total revenue
from$100 to $240
$3
Revenue = $240
$1
0
Demand
Revenue = $100
100
Quantity
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Demand
0
80
Quantity
Elasticity and Total Revenue:
Elastic Demand
Price
An increase in price
from $4 to $5...
…leads to a decrease
in total revenue
from$200 to $100
Price
$5
$4
Demand
Demand
Revenue = $200
0
50
Quantity
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Revenue = $100
0
20
Quantity
Perfectly Inelastic Supply
- Elasticity equals 0
Price
Supply
$5
1. An
increase
in price... 4
Quantity
100
2. ...leaves the quantity supplied unchanged.
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Inelastic Supply
- Elasticity is less than 1
Price
Supply
1. A 22% $5
increase
in price... 4
Quantity
100 110
2. ...leads to a 10% increase in quantity.
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Unit Elastic Supply
- Elasticity equals 1
Price
Supply
1. A 22% $5
increase
in price... 4
Quantity
100
125
2. ...leads to a 22% increase in quantity.
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Elastic Supply
- Elasticity is greater than 1
Price
Supply
1. A 22% $5
increase
in price...
4
100
200 Quantity
2. ...leads to a 67% increase in quantity.
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Perfectly Elastic Supply
- Elasticity equals infinity
Price
1. At any price
above $4, quantity
supplied is infinite.
Supply
$4
2. At exactly $4,
producers will
supply any quantity.
3. At a price below $4,
quantity supplied is zero.
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Quantity
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An Increase in Supply in the
Market for Wheat
Price of
Wheat
S1
$3
Demand
0
100
Quantity of Wheat
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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.