In this chapter, look for the answers to these
questions:
• What is elasticity? What kinds of issues can
elasticity help us understand?
• What is the price elasticity of demand?
How is it related to the demand curve?
How is it related to revenue & expenditure?
• What is the price elasticity of supply?
How is it related to the supply curve?
• What are the income and cross-price
elasticities of demand?
© 2007 Thomson South-Western
A scenario…
You design websites for local businesses.
You charge $200 per website, and currently sell
12 websites per month.
Your costs are rising (including the opp. cost of
your time), so you’re thinking of raising the
price to $250.
The law of demand says that you won’t sell as
many websites if you raise your price. How
many fewer websites? How much will your
revenue fall, or might it increase?
© 2007 Thomson South-Western
Elasticity . . .
• … allows us to analyze supply and demand
with greater precision.
• … is a measure of how much buyers and sellers
respond to changes in market conditions
• Elasticity is a numerical measure of the
responsiveness of Qd or Qs to one of its
determinants.
© 2007 Thomson South-Western
THE ELASTICITY OF DEMAND
• The price elasticity of demand is a measure of
how much the quantity demanded of a good
responds to a change in the price of that good.
• When we talk about elasticity, that
responsiveness is always measured in
percentage terms.
• Specifically, the price elasticity of demand is
the percentage change in quantity demanded
due to a percentage change in the price.
© 2007 Thomson South-Western
© 2007 Thomson South-Western
The Price Elasticity of Demand and Its
Determinants
•
•
•
•
•
Availability of Close Substitutes
Necessities versus Luxuries
Definition of the Market
Time Horizon
Demand tends to be more elastic:
•
•
•
•
the larger the number of close substitutes.
if the good is a luxury.
the more narrowly defined the market.
the longer the time period.
© 2007 Thomson South-Western
1
What determines price elasticity?
To learn the determinants of price elasticity,
we look at a series of examples. Each compares
two common goods.
In each example:
• Suppose the prices of both goods rise by 20%.
• The good for which Qd falls the most (in percent) has
the highest price elasticity of demand.
Which good is it? Why?
• What lesson does the example teach us about the
determinants of the price elasticity of demand?
EXAMPLE 1:
Rice Krispies vs. Sunscreen
• The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
• Rice Krispies has lots of close substitutes
(e.g., Cap’n Crunch, Count Chocula), so buyers
can easily switch if the price rises.
• Sunscreen has no close substitutes, so consumers
would probably not buy much less if its price rises.
• Lesson: Price elasticity is higher when close
substitutes are available.
© 2007 Thomson South-Western
© 2007 Thomson South-Western
EXAMPLE 2:
EXAMPLE 3:
“Blue Jeans” vs. “Clothing”
Insulin vs. Caribbean Cruises
• The prices of both goods rise by 20%.
For which good does Qd drop the most? Why?
• For a narrowly defined good such as
blue jeans, there are many substitutes
(khakis, shorts, Speedos).
• There are fewer substitutes available for broadly
defined goods.
(Can you think of a substitute for clothing,
other than living in a nudist colony?)
• Lesson: Price elasticity is higher for
narrowly defined goods than broadly defined
ones.
• The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
• To millions of diabetics, insulin is a necessity.
A rise in its price would cause little or no decrease
in demand.
• A cruise is a luxury. If the price rises, some
people will forego it.
• Lesson: Price elasticity is higher for luxuries
than for necessities.
© 2007 Thomson South-Western
EXAMPLE 4:
Gasoline in the Short Run vs. Gasoline in the
Long Run
• The price of gasoline rises 20%. Does Qd drop
more in the short run or the long run? Why?
• There’s not much people can do in the
short run, other than ride the bus or carpool.
• In the long run, people can buy smaller cars
or live closer to where they work.
• Lesson: Price elasticity is higher in the
long run than the short run.
© 2007 Thomson South-Western
© 2007 Thomson South-Western
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.
Price elasticity of demand =
Percentage change in quantity demanded
Percentage change in price
• Price elasticity of demand measures how much Qd responds
to a change in P.
• Loosely speaking, it measures the price-sensitivity of buyers’
demand.
© 2007 Thomson South-Western
2
Computing the Price Elasticity of Demand
• 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:
Price elasticity of demand =
Percentage change in quantity demanded
Percentage change in price
(10 − 8)
× 100
20%
10
=
=2
(2.20 − 2.00)
× 100 10%
2.00
Calculating Percentage Changes
Standard method
of computing the
percentage (%) change:
Demand for
your websites
end value – start value
x 100%
start value
P
$250
B
Going from A to B,
the % change in P equals
A
$200
D
8
12
($250–$200)/$200 = 25%
Q
© 2007 Thomson South-Western
Calculating Percentage Changes
Demand for
your websites
P
$250
B
A
$200
D
8
12
Q
© 2007 Thomson South-Western
Calculating Percentage Changes
Problem:
The standard method gives
different answers depending
on where you start.
From A to B,
P rises 25%, Q falls 33%,
elasticity = 33/25 = 1.33
• So, we instead use the midpoint method:
From B to A,
P falls 20%, Q rises 50%,
elasticity = 50/20 = 2.50
• It doesn’t matter which value you use as
the “start” and which as the “end” – you
get the same answer either way!
end value – start value
x 100%
midpoint
• The midpoint is the number halfway
between the start & end values, also the
average of those values.
© 2007 Thomson South-Western
© 2007 Thomson South-Western
The Midpoint Method: A Better Way to Calculate
Percentage Changes and Elasticities
The Midpoint Method: A Better Way to Calculate
Percentage Changes and Elasticities
• The midpoint formula is preferable when
calculating the price elasticity of demand
because it gives the same answer regardless of
the direction of the price change.
• 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,
using the midpoint formula, would be calculated as:
(Q − Q1 ) /[(Q2 + Q1 ) / 2]
Price elasticity of demand = 2
( P2 − P1 ) /[( P2 + P1 ) / 2]
© 2007 Thomson South-Western
(8 − 10)
− 2
2
2
10
= 10 = −
×
= −2
(2.20 − 2.00)
0.2
10 0.2
2.00
2.00
© 2007 Thomson South-Western
3
Calculate an elasticity
The Variety of Demand Curves
Use the following information to calculate the
price elasticity of demand for hotel rooms:
• Inelastic Demand
• Quantity demanded does not respond strongly to
price changes.
• Price elasticity of demand is less than one.
if P = $70, Qd = 5000
if P = $90, Qd = 3000
• Elastic Demand
Use midpoint method to calculate
% change in Qd (3000 – 5000)/4000 = -50%
• Quantity demanded responds strongly to changes in
price.
• Price elasticity of demand is greater than one.
% change in P ($90 – $70)/$80 = 25%
The price elasticity of demand equals -50%/25% = -2
18
© 2007 Thomson South-Western
The Variety of Demand Curves
Computing the Price Elasticity of Demand
(100 − 50)
ED =
Price
(100 + 50)/2
(4.00− 5.00)
(4.00+ 5.00)/2
Demand
=
• Perfectly Inelastic
• Quantity demanded does not respond to price
changes.
• Perfectly Elastic
$5
4
© 2007 Thomson South-Western
67 percent
= −3
− 22 percent
• Quantity demanded changes infinitely with any
change in price.
• Unit Elastic
0
50
100 Quantity
Demand is price elastic.
• Quantity demanded changes by the same percentage
as the price.
© 2007 Thomson South-Western
© 2007 Thomson South-Western
The Variety of Demand Curves
Figure 1 The Price Elasticity of Demand
• 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.
• But it is not the same thing as the slope!
(a) Perfectly Inelastic Demand: Elasticity Equals 0
Price
Demand
$5
4
1. An
increase
in price . . .
0
100
Quantity
2. . . . leaves the quantity demanded unchanged.
© 2007 Thomson South-Western
© 2007 Thomson South-Western
4
Figure 1 The Price Elasticity of Demand
Figure 1 The Price Elasticity of Demand
(c) Unit Elastic Demand: Elasticity Equals 1
(b) Inelastic Demand: Elasticity Is Less Than 1
Price
Price
$5
$5
4
4
1. A 22%
increase
in price . . .
1. A 22%
increase
in price . . .
Demand
0
90
0
Quantity
100
Demand
80
Quantity
100
2. . . . leads to a 22% decrease in quantity demanded.
2. . . . leads to an 11% decrease in quantity demanded.
© 2007 Thomson South-Western
Figure 1 The Price Elasticity of Demand
© 2007 Thomson South-Western
Figure 1 The Price Elasticity of Demand
(d) Elastic Demand: Elasticity Is Greater Than 1
(e) Perfectly Elastic Demand: Elasticity Equals Infinity
Price
Price
1. At any price
above $4, quantity
demanded is zero.
$5
4
Demand
$4
Demand
1. A 22%
increase
in price . . .
2. At exactly $4,
consumers will
buy any quantity.
0
50
100
Quantity
2. . . . leads to a 67% decrease in quantity demanded.
Quantity
0
3. At a price below $4,
quantity demanded is infinite.
© 2007 Thomson South-Western
Total Revenue and the Price Elasticity of
Demand
• Total revenue is the amount paid by buyers and received
by sellers of a good.
• Continuing our scenario, if you raise your price
from $200 to $250, would your revenue rise or fall?
Revenue = P x Q
• A price increase has two effects on revenue:
• Higher P means more revenue on each unit you sell.
• But you sell fewer units (lower Q), due to Law of
Demand.
© 2007 Thomson South-Western
Figure 2 Total Revenue
Price
When the price is $4, consumers
will demand 100 units, and spend
$400 on this good.
$4
P × Q = $400
(revenue)
P
Demand
• Which of these two effects is bigger?
It depends on the price elasticity of demand.
0
100
Q
Quantity
© 2007 Thomson South-Western
© 2007 Thomson South-Western
5
Elasticity and Total Revenue along a
Linear Demand Curve
• With an inelastic demand curve, an increase in price
leads to a decrease in quantity that is proportionately
smaller. Thus, total revenue increases.
• Total revenue = P x Q
• If demand is inelastic, then
price elast. of demand < 1
% change in Q < % change in P
• The fall in revenue from lower Q is smaller
than the increase in revenue from higher P,
so revenue rises.
Figure 3 How Total Revenue Changes When Price Changes:
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
Demand
Revenue = $100
Demand
Quantity
100
0
Quantity
80
0
© 2007 Thomson South-Western
© 2007 Thomson South-Western
Elasticity and Total Revenue along a Linear Demand
Curve
• 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.
• Total Revenue = P x Q
• If demand is elastic, then
price elast. of demand > 1
Figure 3 How Total Revenue Changes When Price Changes:
Elastic Demand
Price
Price
An Increase in price from $4
to $5 …
… leads to an decrease in
total revenue from $200 to
$100
$5
$4
Demand
Demand
Revenue = $200
Revenue = $100
% change in Q > % change in P
• The fall in revenue from lower Q is greater than the
increase in revenue from higher P, so revenue falls.
Quantity
50
0
0
Quantity
20
Note that with each price increase, the Law of Demand still holds – an
increase in price leads to a decrease in the quantity demanded. It is the
change in TR that varies!
© 2007 Thomson South-Western
© 2007 Thomson South-Western
Elasticity of a Linear Demand Curve
Figure 4 Elasticity of a Linear Demand Curve
Demand is elastic;
demand is responsive
to changes in price.
Price
$7
When price increases from
$4 to $5, TR declines from
$24 to $20.
Elasticity is > 1 in this range.
6
5
Elasticity is < 1 in this range.
4
Demand is inelastic; demand is
not very responsive to changes
in price.
When price increases from
$2 to $3, TR increases from
$20 to $24.
3
2
1
0
© 2007 Thomson South-Western
2
4
6
8
10
12
14
Quantity
© 2007 Thomson South-Western
6
Elasticity and expenditure/revenue
A.
B.
Other Demand Elasticities
Pharmacies raise the price of insulin by 10%. Does
total expenditure on insulin rise or fall?
Expenditure = P x Q
Since demand is inelastic, Q will fall less than 10%, so
expenditure rises.
As a result of a fare war, the price of a luxury cruise
falls 20%. Does luxury cruise companies’ total revenue
rise or fall?
Revenue = P x Q
The fall in P reduces revenue, but Q increases, which
increases revenue. Which effect is bigger?
Since demand is elastic, Q will increase more than
20%, so revenue rises.
• Income Elasticity of Demand
• Income elasticity of demand measures how much
the quantity demanded of a good responds to a
change in consumers’ income.
• It is computed as the percentage change in the
quantity demanded divided by the percentage
change in income.
36
© 2007 Thomson South-Western
© 2007 Thomson South-Western
Other Demand Elasticities
Other Demand Elasticities
• Income Elasticity
• Types of Goods
• Normal Goods
• Inferior Goods
• Computing Income Elasticity
• Recall from chap.4: An increase in income causes an increase in
demand for a normal good.
• Hence, for normal goods, income elasticity > 0.
• For inferior goods, income elasticity < 0.
• Higher income raises the quantity demanded for normal goods but
lowers the quantity demanded for inferior goods.
Remember, all elasticities are
measured by dividing one
percentage change by another
• Goods consumers regard as necessities tend to be income inelastic
• Examples include food, fuel, clothing, utilities, and medical
services.
• Goods consumers regard as luxuries tend to be income elastic.
• Examples include sports cars, furs, and expensive foods.
© 2007 Thomson South-Western
© 2007 Thomson South-Western
Other Demand Elasticities
• Cross-price elasticity of demand
A measure of how much the quantity demanded of one good responds
to a change in the price of another good,
• Cross Price Elasticity= % change in quantity demanded of Good Y
•
of Demand
% change in price of Good X
Substitutes have positive cross-price elasticities, while complements
have negative cross-price elasticities.
The price of apples rises from $1.00 per pound to $1.50 per pound.
As a result, the quantity of oranges demanded rises from 8,000 per
week to 9,500.
% change in quantity of oranges demanded = (9,500-8,000)/8,750 =
.1714 = 17.14%
% change in price of apples = (1.50-1.00)/1.25 = .40 = 40%
cross-price elasticity = 17.14% / 40% = 0.43
Because the cross-price elasticity is positive, the two goods are
substitutes.
© 2007 Thomson South-Western
THE ELASTICITY OF SUPPLY
• Price elasticity of supply is a measure of how
much the quantity supplied of a good responds
to a change in the price of that good.
• Price elasticity of supply is the percentage
change in quantity supplied resulting from a
percentage change in price.
© 2007 Thomson South-Western
7
Figure 5 The Price Elasticity of Supply
Figure 5 The Price Elasticity of Supply
(a) Perfectly Inelastic Supply: Elasticity Equals 0
(b) Inelastic Supply: Elasticity Is Less Than 1
Price
Price
Supply
Supply
$5
$5
4
4
1. An
increase
in price . . .
1. A 22%
increase
in price . . .
100
0
Quantity
100
0
110
Quantity
2. . . . leads to a 10% increase in quantity supplied.
2. . . . leaves the quantity supplied unchanged.
© 2007 Thomson South-Western
Figure 5 The Price Elasticity of Supply
© 2007 Thomson South-Western
Figure 5 The Price Elasticity of Supply
(c) Unit Elastic Supply: Elasticity Equals 1
(d) Elastic Supply: Elasticity Is Greater Than 1
Price
Price
Supply
Supply
$5
$5
(If SUPPLY is unit
elastic and linear, it will
begin at the origin.)
4
1. A 22%
increase
in price . . .
100
0
125
Quantity
2. . . . leads to a 22% increase in quantity supplied.
4
1. A 22%
increase
in price . . .
100
0
200
© 2007 Thomson South-Western
• Ability of sellers to change the amount of the
good they produce.
(e) Perfectly Elastic Supply: Elasticity Equals Infinity
Price
1. At any price
above $4, quantity
supplied is infinite.
• Beach-front land is inelastic.
• Books, cars, or manufactured goods are elastic.
Supply
• Time period
2. At exactly $4,
producers will
supply any quantity.
0
3. At a price below $4,
quantity supplied is zero.
© 2007 Thomson South-Western
The Price Elasticity of Supply and Its
Determinants
Figure 5 The Price Elasticity of Supply
$4
Quantity
2. . . . leads to a 67% increase in quantity supplied.
• Supply is more elastic in the long run.
Quantity
© 2007 Thomson South-Western
© 2007 Thomson South-Western
8
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
Price elasticity of supply =
Percentage change in price
THREE APPLICATIONS OF SUPPLY,
DEMAND, AND ELASTICITY
• Can good news for farming be bad news for
farmers?
• What happens to wheat farmers and the market
for wheat when university agronomists
discover a new wheat hybrid that is more
productive than existing varieties?
© 2007 Thomson South-Western
Can Good News for Farming Be Bad News
for Farmers?
• Examine whether the supply or demand curve
shifts.
• Determine the direction of the shift of the
curve.
• Use the supply-and-demand diagram to see how
the market equilibrium changes.
© 2007 Thomson South-Western
Figure 7 An Increase in Supply in the Market for Wheat
Price of
Wheat
2. . . . leads
to a large fall
in price . . .
1. When demand is inelastic,
an increase in supply . . .
S1
S2
$3
2
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.
© 2007 Thomson South-Western
© 2007 Thomson South-Western
Compute the Price Elasticity of Demand When There Is a
Change in Supply
• Supply and Demand can behave differently in
the short run and the long run
100 − 110
(100 + 110) / 2
ED =
3.00 − 2.00
(3.00 + 2.00) / 2
=
Why Did OPEC Fail to Keep the Price of
Oil High?
• In the short run, both supply and demand for oil are
relatively inelastic
• But in the long run, both are elastic
−0.095
≈ −0.24
0.4
• Production outside of OPEC
• More conservation by consumers
Demand is inelastic.
© 2007 Thomson South-Western
© 2007 Thomson South-Western
9
Does Drug Interdiction Increase or Decrease
Drug-Related Crime?
• One side effect of illegal drug use is crime: Users
often turn to crime to finance their habit.
• We examine two policies designed to reduce
illegal drug use and see what effects they have on
drug-related crime.
• For simplicity, we assume the total dollar value of
drug-related crime equals total expenditure
on drugs.
Does Drug Interdiction Increase or
Decrease Drug-Related Crime?
• Drug interdiction impacts sellers rather than
buyers.
• Demand is unchanged.
• Equilibrium price rises although quantity falls.
• Drug education impacts the buyers rather than
sellers.
• Demand is shifted.
• Equilibrium price and quantity are lowered.
• Demand for illegal drugs is inelastic, due to
addiction issues.
© 2007 Thomson South-Western
Policy 1: Interdiction
Interdiction
reduces
Price of
Drugs
the supply
of drugs.
P2
Since demand
for drugs is
inelastic,
P1
P rises proportionally more
than Q falls.
Result: an increase in
total spending on drugs,
and in drug-related crime
© 2007 Thomson South-Western
Policy 2: Education
new value of drugrelated crime
S2
D1
S1
initial value
of drugrelated
crime
Q2 Q1
Quantity
of Drugs
© 2007 Thomson South-Western
Education
reduces the
demand for
drugs.
Price of
Drugs
new value of drugrelated crime
D2
D1
S
P and Q fall.
Result:
A decrease in
total spending
on drugs, and
in drug-related
crime.
initial value
of drugrelated
crime
P1
P2
Q2 Q1
Quantity
of Drugs
© 2007 Thomson South-Western
10