CHAPTER
Elasticity
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prepared by:
by:
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Andreea CHIRITESCU
CHIRITESCU
Andreea
Eastern Illinois
Illinois University
University
Eastern
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1
Price Elasticity of Demand
• Elasticity
– Sensitivity of one market variable to
another
• Slope = ΔP/ΔQD
– Not a measure of price sensitivity of
demand
•
•
Depends on the arbitrary units of
measurement
Doesn’t tell us the significance of ΔP or ΔQD
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2
Price Elasticity of Demand
• Price elasticity of demand (ED)
– Sensitivity of quantity demanded to price
– Percentage change in quantity demanded
caused by a 1 percent change in price
– The greater the elasticity value the more
sensitive quantity demanded is to price
% Change in Quantity Demanded
Elasticity of Demand =
% Change in Price
%Q D
ED 
%P
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3
Price Elasticity of Demand
• Midpoint formula, percentage change in a
variable
• Change in the variable divided by the average
of the old and new values
• When calculating elasticity values from data
on prices and quantities
P1  P0 

% Change in Price =
  P1  P0  


2


Q1  Q0 

% Change in Quantity Demanded =
  Q1  Q0  


2


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4
Figure 1
Using the Midpoint Formula for Elasticity
Price per
Avocado
3. Elasticity of demand for
the move from A to B is
20% / 40% = 0.5
A
$1.50
B
$1.00
1. Using the midpoint
formula, the
percentage drop in
price is $0.50/$1.25 =
0.40 or 40% …
D
4,500 5,500
Quantity of
Avocados per Week
2. and the percentage rise in quantity
is 1,000 / 5,000 = 0.2 or 20%.
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5
Categorizing Demand
• Inelastic demand
– ED between 0 and 1
– Quantity demanded is relatively insensitive
to price changes
• Elastic demand: ED > 1
– Quantity demanded is relatively sensitive
to price changes
• Unit elastic demand: ED = 1
– Quantity demanded changes by the same
percentage as the price
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6
Categorizing Demand
• Perfectly inelastic demand
– ED = 0
– Vertical demand curve
• Perfectly (infinitely) elastic demand
– ED approaching infinity
– Horizontal demand curve
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7
Figure 2
Categories of Demand Behavior (a, b)
(a) Inelastic Demand (ED < 1)
P
(b) Elastic Demand (ED > 1)
P
Price rises by 20%
Price rises by 20%
$11
$11
9
9
D
D
95
105
Quantity falls
by less than 20%
Q
85
115
Q
Quantity falls
by more than 20%
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8
Figure 2
Categories of Demand Behavior (c, d, e)
(c) Unit-Elastic
Demand (ED = 1)
(d) Perfectly Inelastic
Demand (ED = 0)
P
P
Price rises by 20%
(e) Perfectly Elastic
Demand (ED = ∞)
P
Price rises
D
$11
$11
$9
Consumers will buy
any quantity at $9,
none at a higher
price
D
9
9
D
90
Quantity falls by 20%
110 Q
100 Q
Q
Quantity doesn’t change
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9
Straight-Line Demand Curves
• Straight-line demand curve
– Demand becomes less elastic (ED gets
smaller)
• As we move downward and rightward
– Slope of demand is constant
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10
Figure 3
How Elasticity Changes along a Straight-Line Demand Curve
Price
Each time P
drops by
another $500,
the percentage
drop is larger.
Elasticity falls as we
move rightward along a
straight-line demand
curve.
A
$2,000
B
1,500
C
1,000
D
35,000 Quantity of
Laptops
Each time Q rises by another 10,000, the
percentage rise is smaller.
5,000
15,000
25,000
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11
Elasticity and Total Revenue
• Total revenue (TR = P ˣ Q)
– Price per unit (P) times quantity (Q)
– The area of a rectangle with height equal
to price and width equal to quantity
demanded
• A price increase
– Inelastic demand, ED < 1, then TR ↑
– Elastic demand, ED > 1, then TR ↓
– Unit elastic demand, ED = 1, then TR
doesn’t change
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12
Figure 4
Elasticity and Total Revenue
(a) Inelastic Demand
(b) Elastic Demand
P
P
$11
B
$11
A
9
B
A
9
D
D
95
105
Q
85
115
Q
In panel (a), demand is inelastic, so a rise in price causes total revenue to increase. Specifically,
at a price of $9 (point A), total revenue is $9 × 105 = $945. When price rises to $11 (point B),
total revenue increases to $11 × 95 = $1,045. In panel (b), demand is elastic, so a rise in price
causes total revenue to decrease. Specifically, at a price of $9 (point A), total revenue is $9 ×
115 = $1,035. When price rises to $11 (point B), total revenue falls to $11 × 85 = $935.
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13
Table
1
Effects of Price Changes on Revenue
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14
Determinants of Elasticity
• Availability of substitutes
– Close substitutes are available for a
product
– More elastic demand
• Necessities versus luxuries
– Necessities tend to have less elastic
demand than luxuries
• Importance in buyers’ budgets
– Larger proportion of families’ budgets
– More elastic demand
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15
Table
2
Some Short-Run Price Elasticities of Demand
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16
Determinants of Elasticity
• Time horizon
– The longer the time horizon, the more
elastic the demand
• Short-run elasticity
– Measured just a short time after a price
change
• Long-run elasticity
– Measured a year or more after a price
change
– Larger than short-run elasticity
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17
Table
3
Short-Run versus Long-Run Elasticities
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18
Table
4
Adjustments After a Rise in the Price of Gasoline
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19
Figure 5
Short-Run versus Long-Run Price Elasticity of Demand
Price per
gallon
$3.00
E
B
A
2.00
DSR
320
360
DLR
400 Quantity of Gasoline (millions of
gallons per day)
When the price of gasoline rises by $1, the decrease in quantity demanded (and the price
elasticity of demand) depends on how long we wait before measuring buyers’ response. If we
waited just a few months after the price change, we’d move along demand curve DSR, from point
A to point B. If we waited a year or longer, we’d move from point A to point E along demand
curve DLR, with quantity demanded falling even more.
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20
Elasticity and Mass Transit
• Elasticity and mass transit
– Inelastic demand
• Both short and long run
– A rise in fares would likely raise masstransit revenue for a city
– Why cities don’t raise fares:
• Elasticity estimates come from past data
• Want to provide affordable transportation,
reduce traffic congestion on city streets, and
limit pollution
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21
Price Elasticity of Supply
• Price elasticity of supply
– Percentage change in quantity supplied
caused by a 1 percent change in its price
– Sensitivity of quantity supplied to price
changes
• As we move along the supply curve
% Change in Quantity Supplied
Elasticity of Supply =
% Change in Price
%Q S
Elasticity of Supply =
%P
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22
Determinants of Supply Elasticity
• Easier to find alternatives in production
– The more elastic the supply
• The narrow the market definition
– The more elastic the supply
• The longer the time horizon
– The more elastic the supply
• Long-run supply elasticities are greater
than short-run supply elasticities
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23
Figure 6
Short-Run versus Long-Run Price Elasticity of Supply
Price per
bushel
SSR
SLR
B
$5.50
4.50
C
A
190
210
230 Quantity (millions of bushels per week)
When the price of corn rises from $4.50 to $5.50 per bushel, the increase in quantity supplied (and the
price elasticity of supply) depends on how long we wait before measuring the response. If we wait just
a few months after the price change, we’d move along supply curve SSR, from point A to point B. If we
wait a year or longer, we’d move along supply curve SLR, from point A to point C. The same rise in
price causes a greater increase in quantity supplied after a year or longer, because farmers can make
further adjustments in quantity supplied if given more time.
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Income Elasticity of Demand
• Income elasticity of demand
– The percentage change in quantity
demanded caused by a 1 percent change
in income
– Relative shift in the demand curve
– Is > 0 for normal goods
– Is < 0 for inferior goods
% Change in Quantity Demanded
Income elasticity =
% Change in Income
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25
Cross-Price Elasticity of Demand
• Cross-price elasticity of demand
– The percentage change in the quantity
demanded of one good (X)
• Caused by a 1 percent change in the price of
another good (Z)
– If > 0 → substitutes
– If < 0 → complements
% Change in Quantity Demanded of X
% Change in Price of Z
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26
The war on drugs:
should we fight supply or demand?
• Every year, the U.S. government
– Sends about $10 billion intervening in the
market for illegal drugs
• Most of this money is spent on efforts to
restrict the supply of drugs
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27
Figure 7
The War on Drugs
Price
per
unit
Price
per
unit
(a)
S1
P2
A
P1
P1
(b)
S2
B
(c)
Price
per
unit
S1
A
S1
A
P1
C
P3
D1
D1
D1
D2
Q1 Quantity
Q2 Q1 Quantity
Q3
Q1 Quantity
Panel (a) shows the market for heroin in the absence of government intervention. Total
expenditures—and total receipts of drug dealers—are given by the area of the shaded
rectangle. Panel (b) shows the effect of a government effort to restrict supply: Price rises, but
total expenditure increases. Panel (c) shows a policy of reducing demand: Price falls, and so
does total expenditure.
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28
The war on drugs:
should we fight supply or demand?
• No government intervention
– Equilibrium: P1, Q1
– Total revenue by sellers = Total
expenditure by buyers: P1 ˣ Q1
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29
The war on drugs:
should we fight supply or demand?
• Decreasing Supply
– Vigilant customs inspections; arrest and
stiff penalties for drug dealers; efforts to
reduce drug traffic
– Equilibrium: Higher price P2, Lower
quantity Q2
– Demand: very price inelastic
– Total revenue by sellers = Total
expenditure by buyers = Higher, P2 ˣ Q2
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30
The war on drugs:
should we fight supply or demand?
• Decreasing Demand
– Stiffer penalties on drug users; heavier
advertising against drug use; greater
availability of treatment centers for addicts;
more effort against drug retailers
– Equilibrium: Lower price P3, Lower
quantity Q3
– Total revenue by sellers = Total
expenditure by buyers = Lower, P3 ˣ Q3
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31
Forecasting Price in an Oil Crisis
• Oil supply disruptions
– Increased output by other producers (due
to the rise in oil’s price or a decision by
OPEC) offset some of the lost production
• What if a major supply disruption occurred
– And only a price hike could restore the
market to equilibrium?
– Elasticity
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32
Table
5
Oil Supply Disruptions
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33
Forecasting Price in an Oil Crisis
• Initial equilibrium
– Price = $100 per barrel
– Quantity = 90 million barrels per day
• Suppose that 9 million barrels of oil were
temporarily removed from the market
– The supply curves shift leftward
– Excess demand of 9 million barrels at the
original price
– The price will rise to restore market
equilibrium
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34
Forecasting Price in an Oil Crisis
• Very elastic supply and demand in the
short run (unrealistic)
– Only a relatively small price increase is
needed to increase quantity supplied and
decrease quantity demanded
• Very inelastic supply and demand in the
short run (realistic)
– A much larger price increase is needed to
restore market equilibrium
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35
Figure 8
A Decrease in Oil Supply: Elastic versus Inelastic Demand
Price per
Barrel
Price per
Barrel
(a)
$211.00
(b)
S2
B
S1
S2
B
$102.50
$100.00
A
S1
A
$100.00
D
81
90
Barrels per Day (millions)
D
81
90
Barrels per Day (millions)
If either supply or demand is very elastic, only a relatively small price increase will be needed to restore
equilibrium after decrease in supply. Panel (a) illustrates the case in which both supply and demand are
very elastic. The leftward shift in the supply curve causes equilibrium price to rise from $100 to $102.50.
Panel (b) has the same leftward shift in the supply curve, but with much less elastic supply and demand. A
much larger rise in price (from $100 to $211) is needed to restore equilibrium after the decrease in supply.
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36
Spikes in Food Prices
• From mid-2010 to mid-2011
– Prices for wheat, corn, soybeans, sugar,
and other food crops spiked around the
world
– Increase in demand
– Decrease in supply
• Bad weather for crops in several parts of the
world
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37
Spikes in Food Prices
• Demand is inelastic
– Staples like wheat or corn are commonly
regarded as necessities
– In large parts of the world only a small
percentage of income is spent on these
foods
• Supply is inelastic (in the short run)
– Farm output depends on
• Planting decisions made many months earlier
• Weather conditions while crops are growing
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38
Figure 9
Bad Weather and Food Prices with Inelastic Supply and
Demand Price per
Bushel
S2011
B
$8.16
S2010
A
$4.16
D
Q2
Q1
Quantity of wheat (millions
of bushels per month)
When the supply of wheat decreased from mid-2010 to mid-2011, creating an excess demand
at the original price of $4.16 per bushel, the price spiked upward. A large price rise was needed
to eliminate the excess demand because both the supply and the demand for wheat are so
inelastic in the short run.
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39