1 The Elasticity of Demand
Elasticity is a measure of how much quantity demanded or supplied changes when one of its determinants changes.
1.1 The Determinants of Price Elasticity of Demand
Price Elasticity of Demand is a measure of how much quantity
demanded changes when the price of a good changes.
Determinants of price elasticity of demand:
1. Necessities versus luxuries. Good that have high price elasticity (more than one) are luxury goods. Example: Sailboats.
Good that have low price elasticity (less than one) are necessities. Example: visits to doctor.
2. Availability of close substitutes. If a good has several close
substitutes, its demand is probably more elastic. Example:
transportation. If a good has no close substitutes, its demand
is probably less elastic. Example: University education.
3. Denition of market. Narrow markets (vanilla ice cream)
have more elastic demands than broad markets (food) as it
is easier to nd subsitutes for narrow goods.
4. Time horizon. As time horizon increases, demand becomes
more and more elastic. Example: price of gasoline.
1.2 Three Ways to Calculate the Price Elasticity of Demand
Relative change in quantity demanded
Relative change in price
QD =QD
=;
P =P
QD P
=;
P QD
1. The easy way. Suppose that an increase in the price of an icecream cone from $2.00 to $2.20 causes the amount of ice cream
you buy to fall from 10 to 8 cones per month. The most obvious
way to calculate the price demand is
;(8 ; 10)=10
Price elasticity of demand = =
(2:20 ; 2:00)=2:00
0:2
= = 2:
0:1
The problem with this method is that if price changes back from
$2.20 to $2.00, the elasticity won't be the same:
(10 ; 8)=8
Price elasticity of demand = =
;(2:00 ; 2:20)=2:20
0:25
=
= 2:75:
0:091
Price elasticity of demand =
2. The hard way. One solution to this problem is to divide by the
midpoint:
;(8 ; 10)=9
Price elasticity of demand = =
(2:20 ; 2:00)=2:10
0:222
= 2:34
=
0:095
and
(10 ; 8)=9
Price elasticity of demand = =
;(2:00 ; 2:20)=2:10
0:222
=
= 2:34:
0:095
3. The right way is to think about very small ( > 0) changes,
QD = QD (P + ) ; QD (P ) and let ! 0:
QD P
Price elasticity of demand = ;
P QD
P
QD (P + ) ; QD (P )
= ; lim
D
!0
=;
( )
dQD P
dP
QP
D
Q
1.3 Total Revenue and the Price Elasticity of Demand
Total revenue is the total amount paid by buyers and received
by sellers of a good. It is simply the price of a good times the
quantity sold.
When the demand is inelastic, an increase in the price will lead
to a higher total revenue.
When the demand is elastic, an increase in the price will lead to
a lower total revenue.
Suppose you run an art museum and want to raise the total
revenue. Should you increase or decrease the admission price?
Suppose you have the only gas station in town and want to raise
the total revenue. Should you increase or decrease the gasoline
price?
1.4 The Income Elasticity of Demand
Relative change in quantity demanded
Relative change in income
QD =QD
=
M=M
QD M
=
M QD
If the income elasticity of demand is positive, we have a normal
good.
If the income elasticity of demand is negative, we have an inferior
good.
Income elasticity of demand =
2 The Elasticity of Supply
2.1 The Determinants of Price Elasticity of Supply
Price Elasticity of Supply is a measure of how much quantity
supplied changes when the price of a good changes.
Determinants of price elasticity of demand:
1. Availability of input goods. If there are no microchips available, you can't make computers.
2. Time horizon. As time horizon increases, supply becomes
more and more elastic.
3 Applications
3.1 Technological Innovation in Farming
What happens to wheat farmers' income and the market for
wheat when university agronomists discover a new wheat hybrid
that is more productive than existing varieties? Key questions:
1. Will the demand curve move? If so, how?
2. Will the supply curve move? If so, how?
3. Is demand elastic or inelastic? What happens to farmers'
income?
4. If the farmers are made worse o by this innovation, why do
they adopt it?
5. What has happened to the share of population that lived on
farms? Why?
6. If the government wants to increase the farmers income, what
should it do?
7. Is this socially optimal?
Suppose ooding destroyes 50% of the wheat elds in Illinois.
What happens to the farmers' income in Iowa?
3.2 What Happened to OPEC?
In the 1970's, the members of the Organization of Petroleum
Exporting Countries (OPEC) decided to raise the world price of
oil to increase their incomes. Questions:
1. What happens in the short run? Will the demand curve
move? If so, how? Will the supply curve move? If so, how?
Are the supply and demand elastic or not?
2. What happens in the long run? Will the demand curve
move? If so, how? Will the supply curve move? If so, how?
Are the supply and demand elastic or not?
3.3 How to Reduce Drug-Related Crime?
1. What is the eect of reducing cocaine supply by burning the
coca elds in Columbia to drug-related crime?
2. What is the eect of reducing cocaine demand by education to
drug-related crime?
3. What is the eect of legalizing cocaine to drug-related crime?
Would the legalizing be socially optimal?