Lesson Overview
Chapter 6 Elasticity
The Elasticity Concept
Own Price Elasticity of Demand
The Midpoint Method
Elasticity and Total Revenue
Elasticity and Marginal Revenue
Cross-Price Elasticity
Income Elasticity
The Price Elasticity of Supply
Elasticity Applications
Controversy: Gambling
Summary
Review Questions
BA 210 Lesson I.7 Elasticity
1
The Elasticity Concept
The Elasticity Concept
• How responsive is variable “G = f(S) ” to a change in variable
“S”?
EG , S
•
•
•
•
•
%DG

%DS
(There, %D reads “percent change”.)
One good property: Percentages do not depend on units of
measure: $1 to $2 is a 100% increase in price, and 100 cents to
200 cents is also a 100% increase.
The sign of elasticity indicates a relationship:
If EG,S > 0, then S and G are positively (or directly) related.
If EG,S < 0, then S and G are negatively (or inversely) related.
If EG,S = 0, then S and G are unrelated.
BA 210 Lesson I.7 Elasticity
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Own Price Elasticity of Demand
Own Price Elasticity of Demand
• Negative according to the “law” of demand.
EQX , PX
• Elastic:
EQ X , PX  1
• Inelastic:
EQ X , PX  1
%DQX

%DPX
d
• Unit elastic: EQ X , PX  1
BA 210 Lesson I.7 Elasticity
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Own Price Elasticity of Demand
Some Estimated Price Elasticities of Demand
Good
Inelastic demand
• Eggs
• Beef
• Stationery
• Gasoline
Elastic demand
• Housing
• Restaurant meals
• Airline travel
• Foreign travel
Price elasticity
-0.1
-0.4
-0.5 |Price elasticity of demand| < 1
-0.5
-1.2
-2.3
-2.4 |Price elasticity of demand| > 1
-4.1
BA 210 Lesson I.7 Elasticity
4
Own Price Elasticity of Demand
Predicting Revenue Change from One Product
Suppose that a firm sells only one good. If the price of X
changes, then total revenue will change by:
In that equation, the term %DPX is the fractional percent change
in price (for example, 1% = .01).
For example:
• Suppose you only sell burgers.
• Suppose revenue RX from burgers is $100.
• Suppose the own price elasticity were zero.
• What is the effect on revenue of increasing burger price 10%?
DR = ($100(1+0)) x (0.10) = $10.
BA 210 Lesson I.7 Elasticity
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Own Price Elasticity of Demand
Aggregation
• Goods can sometimes be aggregated, like “cars”
• Goods can always be disaggregated, like “Honda cars” and
“Toyota cars”
• Goods can only be aggregated when disaggregation makes
perfect substitutes for consumers, like “Honda cars” and “Toyota
cars”.
BA 210 Lesson I.7 Elasticity
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Own Price Elasticity of Demand
Perfectly Elastic (Price Taking) and Perfectly Inelastic
Demand --- Is Farmer John sausage perfectly elastic? Is
medical care perfectly inelastic?
Price
Price
D
D
Quantity
PerfectlyElastic( EQX ,PX  )
Quantity
PerfectlyInelastic( EQX ,PX  0)
BA 210 Lesson I.7 Elasticity
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Own Price Elasticity of Demand
Substitution and Income Effects of a Price Increase
• The substitution effect is decreased quantity demanded
because the good is not as good of a deal. --- Examples?
• The income effect is decreased purchasing power (assuming
you do not work for a company making the good), and so
decreased quantity demanded if the good is normal. --Significant Examples? Housing? Salt?
• The gross effect is the substitution plus income effect.
BA 210 Lesson I.7 Elasticity
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Own Price Elasticity of Demand
Factors Affecting Own Price Elasticity
• Available Substitutes
 The more substitutes available for a good, the bigger the
substitution effect and the more elastic the demand. --Medical care?
• Time
 Demand becomes more elastic over time as consumers
find and use available substitutes. --- Examples?
Gasoline? Alternatives?
• Expenditure Share
 Among normal goods, because of the income effect, the
larger the expenditure on a good, the larger the income
effect the more elastic the demand. --- Housing?
BA 210 Lesson I.7 Elasticity
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The Midpoint Method
Using the midpoint method
• The midpoint method is a more accurate technique for
calculating any percent change.
• In this technique, calculate changes in a variable compared with
the average, or midpoint, of the starting and final values.
BA 210 Lesson I.7 Elasticity
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The Midpoint Method
Three formulas
BA 210 Lesson I.7 Elasticity
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The Midpoint Method
Using the Midpoint Method
BA 210 Lesson I.7 Elasticity
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Elasticity and Total Revenue
Total Revenue by Area
Price of crossing
$0.90
Total revenue = price x
quantity = $990
0
D
1,100
Quantity of crossings (per day)
BA 210 Lesson I.7 Elasticity
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Elasticity and Total Revenue
Elasticity and Total Revenue
• When a seller raises the price of a good, there are two
countervailing effects on total revenue (except in the rare case of a
good with perfectly elastic or perfectly inelastic demand):



A price effect: After a price increase, each unit sold sells at a
higher price, which tends to raise revenue.
A quantity effect: After a price increase, fewer units are sold,
which tends to lower revenue.
The gross effect on revenue will depend on elasticity
BA 210 Lesson I.7 Elasticity
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Elasticity and Total Revenue
Effect of a Price Increase on Total Revenue
Price of crossing
Price effect of price
increase: higher price for
each unit sold
Quantity effect of
price increase:
fewer units sold
$1.10
C
0.90
B
0
A
900
D
1,100
BA 210 Lesson I.7 Elasticity
Quantity of crossings (per day)
15
Elasticity and Total Revenue
Own-Price Elasticity and Total Revenue
• Elastic
 E < -1, so 1+E < 0, so %DP > 0 implies DR < 0.
 Increased price implies decreased total revenue.
 Lower price to increase revenue, but profits may
decrease because supply costs increase.
BA 210 Lesson I.7 Elasticity
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Elasticity and Total Revenue
Own-Price Elasticity and Total Revenue
• Inelastic
 E > -1, so 1+E > 0, so %DP > 0 implies DR > 0.
 Increased price implies increased total revenue.
 Increase price to increase profit (increase revenue and
decrease supply cost).
 It is most profitable to have inelastic (rather than
elastic) demand, so distinguish your product. --Examples? --- How can you distinguish gasoline?
(Chevron with Techron.)
BA 210 Lesson I.7 Elasticity
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Elasticity and Total Revenue
Own-Price Elasticity and Total Revenue
• Unit Elastic
 Total revenue is maximized (unaffected by small price
changes) at the point where demand is unit elastic.
BA 210 Lesson I.7 Elasticity
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Elasticity and Total Revenue
Elasticity, Total Revenue and Linear Demand
P
100
TR
0
10
20
30
40
50
Q
0
BA 210 Lesson I.7 Elasticity
Q
19
Elasticity and Total Revenue
Elasticity, Total Revenue and Linear Demand
P
100
TR
80
800
0
10
20
30
40
50
Q
0
10
BA 210 Lesson I.7 Elasticity
20
30
40
50
Q
20
Elasticity and Total Revenue
Elasticity, Total Revenue and Linear Demand
P
100
TR
80
1200
60
800
0
10
20
30
40
50
Q
0
10
BA 210 Lesson I.7 Elasticity
20
30
40
50
Q
21
Elasticity and Total Revenue
Elasticity, Total Revenue and Linear Demand
P
100
TR
80
1200
60
40
800
0
10
20
30
40
50
Q
0
10
BA 210 Lesson I.7 Elasticity
20
30
40
50
Q
22
Elasticity and Total Revenue
Elasticity, Total Revenue and Linear Demand
P
100
TR
80
1200
60
40
800
20
0
10
20
30
40
50
Q
0
10
BA 210 Lesson I.7 Elasticity
20
30
40
50
Q
23
Elasticity and Total Revenue
Where quantity is less than 25, a price decrease causes a
quantity increase and an increase in revenue. So demand is
elastic since price and revenue are negatively related.
P
100
TR
Elastic
80
1200
60
40
800
20
0
10
20
30
40
50
Q
0
10
20
30
40
50
Q
Elastic
BA 210 Lesson I.7 Elasticity
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Elasticity and Total Revenue
Where quantity is greater than 25, a price decrease causes a
quantity increase and a decrease in revenue. So demand is
inelastic since price and revenue are positively related.
P
100
TR
Elastic
80
1200
60
Inelastic
40
800
20
0
10
20
30
40
50
Q
0
10
Elastic
BA 210 Lesson I.7 Elasticity
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30
40
50
Q
Inelastic
25
Elasticity and Total Revenue
Unit elasticity divides elasticity from inelasticity.
P
100
TR
Unit elastic
Elastic
Unit elastic
80
1200
60
Inelastic
40
800
20
0
10
20
30
40
50
Q
0
10
Elastic
BA 210 Lesson I.7 Elasticity
20
30
40
50
Q
Inelastic
26
Elasticity and Marginal Revenue
Marginal Revenue is the extra revenue from increasing
output. It is positive when output is less than 25 and demand
is elastic, and is negative when output is greater than 25 and
demand
is inelastic.
P
TR
100
Unit elastic
Elastic
Unit elastic
80
1200
60
Inelastic
40
800
20
0
10
20
30
40
50
Q
0
10
Elastic
BA 210 Lesson I.7 Elasticity
20
30
40
50
Q
Inelastic
27
Elasticity and Marginal Revenue
Elastic
For a linear demand curve, the
marginal revenue curve has the
same intercept on the price axis
but twice the slope. So
• MR > 0, where demand is
elastic
Unit elastic
• MR = 0, where demand is unit
elastic
Inelastic • MR < 0, where demand is
inelastic
20
40
P
100
80
60
40
20
0
10
50
Q
MR
BA 210 Lesson I.7 Elasticity
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Elasticity and Total Revenue
Summary
• Elastic




Increased price implies decreased total revenue.
Decreased price implies increased total revenue.
Given the law of demand, increased quantity (decreased price)
implies increased total revenue.
Marginal revenue is positive.
• Inelastic




Increased price implies increased total revenue.
Decreased price implies decreased total revenue.
Given the law of demand, increased quantity (decreased price)
implies decreased total revenue.
Marginal revenue is negative.
• Unit elastic is neither elastic nor inelastic so MR = 0.
BA 210 Lesson I.7 Elasticity
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Cross-Price Elasticity
Cross Price Elasticity of Demand
EQX , PY
%DQX

%DPY
d
If EQX,PY > 0, then X and Y are gross substitutes because as the
price of good Y increases, the demand for good X increases. This
can happen from either of two effects.
• Good X substitutes for Good Y. For example, as the price of Y
= apples increases, the demand for X = oranges increases because
consumers substitute oranges for apples.
• Good X is needed because it is affordable. For example, as the
price of Y = Pepperdine University education increases,
Pepperdine students must economize and consume more
affordable goods, like X = Ramain Noodles.
• Since there are two effects, their sum is called the gross effect.
BA 210 Lesson I.7 Elasticity
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Cross-Price Elasticity
Cross Price Elasticity of Demand
EQX , PY
%DQX

%DPY
d
If EQX,PY < 0, then X and Y are gross complements because as the
price of good Y increases, the demand for good X decreases.
This can happen from either of two effects.
• Good Y complements Good X. For example, as the price of Y =
bread increases, the demand for X = butter decreases because
consumers need less butter when there is less bread.
• Good X is not wanted because it is unaffordable. For example,
as the price of Y = Pepperdine University education increases,
Pepperdine students must economize and consume fewer
unaffordable goods, like X = Filet Mignon.
• Since there are two effects, their sum is called the gross effect.
BA 210 Lesson I.7 Elasticity
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Income Elasticity
Income Elasticity
EQX , M
%DQX

%DM
d
If EQX,M > 0, then X is a normal good. Higher income M
implies higher demand.
If EQX,M < 0, then X is a inferior good. Higher income M
implies lower demand.
BA 210 Lesson I.7 Elasticity
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The Price Elasticity of Supply
The Price Elasticity of Supply is the percent change in supply
divided by the percent change in price. It is always positive.
BA 210 Lesson I.7 Elasticity
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Elasticity Applications
Business Applications of Elasticity
• Pricing and managing cash flows.
• Effect of changes in competitors’ prices.
BA 210 Lesson I.7 Elasticity
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Elasticity Applications
Example 1: Pricing and Cash Flows
• According to an FTC Report by Michael Ward, AT&T’s own
price elasticity of demand for long distance services is -8.64.
• AT&T needs to boost revenues in order to meet it’s marketing
goals.
• To accomplish this goal, should AT&T raise or lower it’s
price?
BA 210 Lesson I.7 Elasticity
35
Elasticity Applications
Answer: Lower price.
• Since demand is elastic, a reduction in price will increase
quantity demanded by a greater percentage than the price
decline, resulting in more revenues for AT&T.
BA 210 Lesson I.7 Elasticity
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Elasticity Applications
Example 2: Quantifying the Change
• If AT&T lowered price by 3 percent, what would happen to
the volume of long distance telephone calls routed through
AT&T?
BA 210 Lesson I.7 Elasticity
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Elasticity Applications
Answer
• Calls would increase by 25.92 percent.
EQX , PX
%DQX
 8.64 
%DPX
d
%DQX
 8.64 
 3%
d
 3%   8.64  %DQX
d
%DQX  25.92%
d
BA 210 Lesson I.7 Elasticity
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Elasticity Applications
Example 3: Effect of a change in a competitor’s price
• According to an FTC Report by Michael Ward, AT&T’s cross
price elasticity of demand for long distance services is 9.06.
• If competitors reduced their prices by 4 percent, what would
happen to the demand for AT&T services?
BA 210 Lesson I.7 Elasticity
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Elasticity Applications
Answer
• AT&T’s demand would fall by 36.24 percent.
EQX , PY
%DQX
 9.06 
%DPY
d
%DQX
9.06 
 4%
d
 4%  9.06  %DQX
d
%DQX  36.24%
d
BA 210 Lesson I.7 Elasticity
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Controversy: Gambling
Controversy: Gambling
BA 210 Lesson I.7 Elasticity
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Controversy: Sweatshop Labor
A lottery is a form of gambling which involves the drawing of
lots for a prize. Some governments outlaw it, while others
endorse it to the extent of organizing a national or state lottery. At
the beginning of the 20th century, most forms of gambling,
including lotteries and sweepstakes, were illegal in many
countries, including the U.S.A. and most of Europe. This
remained so until after World War II. In the 1960s casinos and
lotteries began to appear throughout the world as a means to raise
revenue in addition to taxes.
BA 210 Lesson I.7 Elasticity
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Controversy: Sweatshop Labor
Lotteries and gambling are an effective way to raise revenue
because there are few substitutes. As the government taxes any
good, it raises the price, and so consumers lower demand, which
lowers tax revenue. But with few substitutes, the demand for
gambling is very inelastic, and so consumers’ demand is only
slightly lower, which means tax revenue is only slightly lower.
Lotteries and gambling are controversial, however, if you believe
most gamblers are irrational. If irrational, a gambler could hurt
themselves by saying yes to gambling when they should have
said no.
BA 210 Lesson I.7 Elasticity
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Summary
Summary
1. Elasticity is a general measure of responsiveness that can be
used to answer various questions.
2. The price elasticity of demand — the percent change in the
quantity demanded divided by the percent change in the price
(dropping the minus sign) — is a measure of the
responsiveness of the quantity demanded to changes in the
price.
BA 210 Lesson I.7 Elasticity
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Summary
Summary
3. The responsiveness of the quantity demanded to price can
range from perfectly inelastic demand, where the quantity
demanded is unaffected by the price, to perfectly elastic
demand, where there is a unique price at which consumers
will buy as much or as little as they are offered. When
demand is perfectly inelastic, the demand curve is vertical;
when it is perfectly elastic, the demand curve is horizontal.
4. The price elasticity of demand is classified according to
whether it is more or less than 1. If it is greater than 1,
demand is elastic; if it is exactly 1, demand is unit-elastic; if
it is less than 1, demand is inelastic. This classification
determines how total revenue, the total value of sales,
changes when the price changes.
BA 210 Lesson I.7 Elasticity
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Summary
Summary
5. The price elasticity of demand depends on whether there are
close substitutes for the good, whether the good is a necessity
or a luxury, the share of income spent on the good, and the
length of time that has elapsed since the price change.
6. The cross-price elasticity of demand measures the effect of a
change in one good’s price on the quantity of another good
demanded.
7. The income elasticity of demand is the percent change in the
quantity of a good demanded when a consumer’s income
changes divided by the percent change in income. If the
income elasticity is greater than 1, a good is income elastic;
if it is positive and less than 1, the good is income-inelastic.
BA 210 Lesson I.7 Elasticity
46
Summary
Summary
8. The price elasticity of supply is the percent change in the
quantity of a good supplied divided by the percent change in
the price. If the quantity supplied does not change at all, we
have an instance of perfectly inelastic supply; the supply
curve is a vertical line. If the quantity supplied is zero below
some price but infinite above that price, we have an instance
of perfectly elastic supply; the supply curve is a horizontal
line.
9. The price elasticity of supply depends on the availability of
resources to expand production and on time. It is higher
when inputs are available at relatively low cost and the
longer the time elapsed since the price change.
BA 210 Lesson I.7 Elasticity
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Review Questions
Review Questions
 You should try to answer some of the following questions
before the next class.
 You will not turn in your answers, but students may request
to discuss their answers to begin the next class.
 Your upcoming Exam 1 and cumulative Final Exam will
contain some similar questions, so you should eventually
consider every review question before taking your exams.
BA 210 Lesson I.7 Elasticity
48
Review Questions
Follow the link
http://faculty.pepperdine.edu/jburke2/ba210/PowerP1/Set6Answers.pdf
for review questions for Lesson I.7 that practices these skills:
 Use the midpoint method for calculating percent change.
 Compute price elasticity of demand.
 Identify elastic and inelastic demand according to the price elasticity of
demand.
 For elastic demand, apply the negative relation between price and revenue.
 For inelastic demand, apply the positive relation between price and revenue.
 Remember demand is more elastic when there are more substitutes or closer
substitutes.
 Compute the price elasticity of supply.
 Compute cross-price elasticities of demand.
 Relate cross-price elasticities of demand to gross substitutes and gross
complements.
 Identify elastic and inelastic portions of a linear demand curve.
 Compute income elasticity of demand.
BA 210 Lesson I.7 Elasticity
49
BA 210
Introduction to Microeconomics
End of Lesson I.7
BA 210 Lesson I.7 Elasticity
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