Chapter 5
Professor Chen
Elasticity of
Demand and
Supply
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5-1 Price Elasticity of Demand
• Price elasticity of demand (ED)
– How responsive quantity demanded is to a
price change
– % change in Qd divided by % change in price
– Takes absolute value; always positive
– Example. When price of cigarette increases by
10%, Qd for cigarette drops by 4 %. What is
the price elasticity of demand?
– Answer: ED =
4%
10%
= 0.4
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5-1a Calculating Price Elasticity of Demand
Percent formula:
ED 
% change in q
% change in p
Mid-point formula:
qa  qb
pa  pb
ED 

(qa  qb ) / 2 ( pa  pb ) / 2
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Exhibit 1
Price of cheese per pound
Demand Curve for Cheese
a
$2.00
b
$1.00
D
0
9
10
Q
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5-1a Calculating Price Elasticity of Demand
Find ED between point a and b.
9  10
2 1
ED 

(9  10) / 2 ( 2  1) / 2
1 1


9.5 1.5
 ( 0.105)  (0.667)
  0.16
 0.16
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Exhibit 2
Demand Curve for candy
a
Price of candy
$2
b
$1
0
2
10
Q
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5-1a Calculating Price Elasticity of Demand
Find ED between point a and b.
2  10
2 1
ED 

(2  10) / 2 (2  1) / 2
8 1


6 1.5
 (1.33)  (0.667)
 2
2
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5-1b Categories of ED
a) ED between 0 and 1: Inelastic demand
–
–
•
•
•
•
Demand curve is more steep
Determinants:
necessities
few substitutes
need it in short time
small proportion of income spent
b) ED = 1: Unit elastic demand
– D is rectangular hyperbola, or midpoint of a straight line
– Movies, shoes, cars
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5-1b Categories of ED
c) ED greater than 1: Elastic demand
–
–
•
•
•
•
D is flatter
Determinants:
Luxuries
many substitutes
longer time to adjust
Large proportion of income spent
d) ED = 0: Perfectly inelastic demand
- D is vertical
e) ED = ∞: Perfectly elastic demand
– D is horizontal (example in next slide)
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Constant Elasticity Demand Curves
• Perfectly elastic demand curve
• Any price increase would reduce quantity
demanded to zero
– Consumers don’t tolerate price increases
– Example: Assume you notice the gas price is $1.65 in
several gas stations when you drive around town. As
you try to add gas from your favorite gas station, you
see the price there is $1.75! You decide to get gas
somewhere else. Your quantity demanded for gas from
your favorite gas station drops to zero when you see
the price is higher - Your demand is perfectly elastic
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5-1d Price Elasticity and Linear Demand Curve
• Linear demand curve (straight line)
– Constant slope but varying elasticity
• Demand becomes less elastic as we move
downward
– Upper half: elastic
– Lower half: inelastic
– Midpoint: unit elastic
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Exhibit 3
Price per unit
Demand for cheese
$11
10
(a) Demand and price elasticity
a
Elastic, ED >1
b
Unit elastic, ED =1
?
c
2
1
Inelastic, ED <1
d
0
1
2
?
D
e
10 11
Q
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5-1c Elasticity and Total Revenue
• Total revenue = (price)(Qd at this price)
• TR= p ˣ q
• As price decreases
– If demand is elastic, TR increases
– If demand is inelastic, TR decreases
– If demand is unit elastic, TR constant
Vice Versa.
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5-1c Elasticity and Total Revenue
Question 1. Refer to the demand for cheese.
Suppose the store is selling the product at $2. If the
owner wants to increase sales, should he increase
the price to $3, or decrease the price to $1?
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Case Study
Case 1.
Price = $2 TR = $2x9 = $18
Price = $3 TR = $3x8 = $24
Price = $1 TR = $1x10 = $10
Answer: TR increase if he increases the price to $3.
Case 2. What if the price is increased to $4? To $5?
Case 3. Which price maximize TR?
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Exhibit 4
Price per unit
Total Revenue reaches the maximum at the midpoint
$11
10
(a) Demand and price elasticity
a
Elastic, ED >1
b
Unit elastic, ED =1
5.5
c
Inelastic, ED <1
d
1
0
1
2
5.5
Where the demand curve
is elastic, a lower price
increases total revenue.
Total revenue reaches a
maximum at the rate of
output where the demand
curve is unit elastic.
D
e
10 11
Quantity
(b) Total revenue
Total revenue
$30.25
Total
revenue
0
5.5
11
Where the demand curve
is inelastic, further
decreases in price reduce
total revenue.
Quantity per period
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5-1c Elasticity and Total Revenue
Classroom activity.
Refer to the demand for candy. Suppose the store
is selling the product at $2. If the owner wants to
increase sales,
1. Should he increase the price to $3, or decrease
the price to $1?
2. Which price maximizes total revenue?
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5-3 Price Elasticity of Supply
• Price elasticity of supply
– Responsiveness of quantity supplied to a
price change
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5-3 Price Elasticity of Supply
%q
ES 
%p
q  q'
p  p'
ES 

(q  q' ) / 2 ( p  p' ) / 2
• ES positive
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Exhibit 5
Price per unit
Price Elasticity of Supply
S
$2.50
2.00
0
100
200
Quantity per period
The diagram above contains information to solve Question 2 in the following slide.
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5-3 Price Elasticity of Supply
Question 2. Refer to Exhibit 7-1 in the
previous slide. If the price increases
from $2.00 to $2.50, the quantity
supplied increases from 100 to 200.
What is the price elasticity of supply?
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Answers
Question 2.
200  100
2.50  2.00
Es 

(200  100) / 2 (2.50  2.00) / 2
100 0.50


150 2.25
0.667

0.222
Es  3.005
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5-3 Price Elasticity of Supply
Categories:
a) ES between 0 and 1: Inelastic supply
• Curve is more steep
• Determinants: cost a lot to increase Q,
time too short to adjust
b) ES = 1: Unit elastic supply
• Straight line goes through origin
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5-3 Price Elasticity of Supply
Categories:
c) ES greater than 1: Elastic supply
• Curve is flat
• Determinant: cost a little, longer
adjustment time
d) ES = 0: Perfect inelastic supply
• Curve is vertical
e) ES = ∞: Perfect elastic supply
• Curve is horizontal
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Exhibit 6
Supply Becomes More Elastic Over Time
Sw
Sm
Sy
Price per unit
$1.25
1.00
0
100 110 140
200
Quantity per day
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Question
Question 3. What is the price elasticity of
supply for paintings by Van Gogh?
Es = 0
The supply of paintings by Van Gogh is
perfectly inelastic because no matter how
high the price goes, Van Gogh can’t be
alive again and paint more.
The quantity supplied can’t be changed.
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