Chapter
5
Elasticity and Its Application
Types of Elasticities
• Generally 3 categories we are concerned about
– Price elasticity
• Own-price:
– How quantity demanded changes with the (own) price
• Cross-price
– How quantity demanded changes with another (cross)
good’s price changes
– Income
• How quantity demanded changes with a change in your income
– Supply elasticity
• How quantity supplied changes with a change in (own/market) price
Table 4.1
Factors That Shift the Demand Curve
Own-Price (Demand) Elasiticity
• Economist use the (own) price elasticity of demand to
summarize how responsive quantity demanded is to price
• Demand curves are not always linear; and responsiveness can
change with price
% change in Qd
elasticity 
% change in price
1
The own-price elasticity of demand (d, e)
(d) Elastic demand:
Elasticity > 1
(e) Perfectly elastic demand:
Elasticity equals infinity
Price
Price
1. A 22%
increase
in price…
1. At any price
above $4, quantity
demanded is zero
$5
Demand
1. an
4
2. At exactly $4,
consumers will
buy any quantity
1. an
$4
Demand
3. At any price
below $4, quantity
demanded is infinite
2. … leads to
a 67% decrease
in quantity
demanded
0
50
100
Quantity
0
Quantity
The price elasticity of demand determines whether the demand curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
5
The (own-price) Elasticity of Demand
• Determinants of (own) price elasticity of
demand
– Availability of close substitutes
• Goods with close substitutes
– More elastic demand
– Necessities vs. luxuries
• Necessities – inelastic demand
• Luxuries – elastic demand
– Definition of the market
• Narrowly defined markets – more elastic demand
– Time horizon
– More elastic over longer time horizons
6
The (own-price) Elasticity of Demand
• Variety of demand curves: own-price
(absolute value)
– Demand is elastic
• Elasticity > 1 => ΔQ/Q > ΔP/P
raise price => ΔTot Rev < 0
– Demand is inelastic
• Elasticity < 1 => ΔQ/Q < ΔP/P
raise price => ΔTot Rev > 0
– Demand has unit elasticity
• Elasticity = 1 => ΔQ/Q = ΔP/P => ΔTot Rev = 0
7
The Elasticity of Demand
• Cigarettes (US)[41]
– -0.3 to -0.6 (General)
– -0.6 to -0.7 (Youth) – proportion of income?
• Soft drinks
– -0.8 to -1.0 (general)[51] (broadly defined)
– -3.8 (Coca-Cola)[52] (narrow)
– -4.4 (Mountain Dew)[52] (narrow)
• Car fuel[45]
– -0.25 (Short run) (same car – reduce trips)
– -0.64 (Long run) (new car?)
8
The Elasticity of Demand
• Total revenue
– Amount paid by buyers
– Received by sellers of a good
– Computed as: price of the good times the
quantity sold (P ˣ Q)
9
Figure 2
Total revenue
Price
$4
1. an
P ˣ Q=$400
(revenue)
P
0
Demand
100
Quantity
Q
The total amount paid by buyers, and received as revenue by sellers, equals the
area of the box under the demand curve, P × Q. Here, at a price of $4, the
quantity demanded is 100, and total revenue is $400.
10
The Elasticity of Demand
• When demand is inelastic
– Price and total revenue move in the same
direction
• When demand is elastic
– Price and total revenue move in opposite
directions
• If demand is unit elastic
– Total revenue remains constant when the
price changes
11
The Elasticity of Demand
• Elasticity and total revenue along a linear
demand curve
• Linear demand curve
– Constant slope
– Different elasticities
• Points with low price & high quantity
– Inelastic
• Points with high price & low quantity
– Elastic
12
Figure 4
Elasticity of a linear demand curve (graph)
Price
Elasticity
is larger
than 1
$7
6
5
4
1. an
3
2
Demand
1
0
Elasticity
is smaller
than 1
2
4
6
8
10 12 14
Quantity
The slope of a linear demand curve is constant, but its elasticity is not. The demand
schedule in the table was used to calculate the price elasticity of demand by the midpoint
method. At points with a low price and high quantity, the demand curve is inelastic. At
points with a high price and low quantity, the demand curve is elastic.
13
Figure 4
Elasticity of a linear demand curve (schedule)
Price
Quantity
Total revenue
(Price ˣ Quantity)
$7
6
5
4
3
2
1
0
O
2
4
6
8
10
12
14
$0
12
20
24
24
20
12
0
Percentage
Change
in Price
Percentage
Change in
Quantity
Elasticity
Description
15
18
22
29
40
67
200
200
67
40
29
22
18
15
13.0
3.7
1.8
1.0
0.6
0.3
0.1
Elastic
Elastic
Elastic
Unit elastic
Inelastic
Inelastic
Inelastic
The slope of a linear demand curve is constant, but its elasticity is not. The
demand schedule in the table was used to calculate the price elasticity of
demand by the midpoint method. At points with a low price and high quantity,
the demand curve is inelastic. At points with a high price and low quantity, the
demand curve is elastic.
14
Figure
The Elasticity of Demand
• Income elasticity of demand
– Measure of how much the quantity demanded of a good
responds
• To a change in consumers’ income
– Percentage change in quantity demanded
• Divided by the percentage change in income
– Normal goods: positive income elasticity
• Necessities: smaller income elasticities (~0, <1)
• Luxuries: large income elasticities ( > 1)
– Inferior goods: negative income elasticities (<0)
15
Figure
The Elasticity of Demand
• Cross-price elasticity of demand
– Measure of how much the quantity demanded of one good
responds
• To a change in the price of another/different good
– [∆Qx/Qx] / [∆Py/Py ]
– Sign matters -> tells whether substitute or complement
• Magnitude (<1 or >1) -> how “good” a substitute/essential a
complement
– Substitutes: Positive cross-price elasticity
• >1 -> “close” or good substitute as big shift with small price change
– Complements: Negative cross-price elasticity
• >1 -> “essential” to be used/consumed together (cars and gas)
16
Figure
Table 4.2
Factors That Shift the Supply Curve