Chapter 4 – Elasticity
The price elasticity of demand – a units-free measure of the responsiveness of the quantity demanded
of a good to a change in its price when all other influences on buying plans remain the same
Price elasticity of demand = percentage change in quantity demanded / percentage change in price
 Calculating by using the average price and average quantity
o In order to get the same value of elasticity regardless of whether the price falls or rises
 Midway between the original point and the new point
Price elasticity of demand = percentage change in demand / percentage change in price
Change in price = (triangle) P / Pave x 100
Change in quantity = (triangle) Q / Qave x 100
Percentages cancel out when we divide the two
It is a unit free measure because the percentage change in each variable is independent of the units
which the variable is measured
When the price of a good rises, brings a negative change in demand, the price elasticity of demand is a
negative number but it is always put out as an absolute number
Perfectly inelastic demand – the quantity demanded remains constant when the price changes; price
elasticity of demand = 0
 Ex. insulin
 Vertical demand line
Unit elastic demand – the percentage change in the quantity demanded equals the percentage change
in the price; price elasticity of demand = 1
 Changes as price changes
 Curving down
Inelastic demand – the percentage change in the quantity demanded is more than the percentage
change in price; the price elasticity = 1
 Ex. food, shelter
Perfectly elastic demand – the quantity demanded changes by an infinitely large percentage in response
to a tiny price change; the price elasticity = 1 to infinity
 Ex. pop
 Horizontal demand line
 Goods that have perfect substitute are perfectly elastic
Elastic demand – the percentage change in the quantity demanded is less than the percentage change in
price; price elasticity = 0 to 1
 Ex. furniture, automobiles
Perfectly inelastic demand
unit elastic demand
Elastic demand
perfectly elastic demand
inelastic demand
Elasticity changes alone a straight-line demand curve
 It can be inelastic as points below the midpoint
 It can be elastic above the midpoint
 It can be unit elastic at the midpoint
Total revenue = price of good x the quantity sold
 If demand is elastic, a 1 percent price cut increases the quantity sold by more than 1 percent
and total revenue increases
o If price cut increases total revenue, demand is elastic
 If demand is inelastic, a 1 percent price cut increase the quantity sold by less than 1 percent and
total revenue is decrease
o If price cut decreases total revenue, demand is inelastic
 If demand is unit elastic, a 1 percent price cut increase the quantity sold by 1 percent and total
revenue does not change
o If price cut leaves total revenue unchanged, demand is unit elastic
The total revenue test – a method of estimating the price of elasticity of demand by observing the
change in total revenue that results from a change in the price, when all other influences on the
quantity sold remain the same
 Price cut in the elastic range brings an increase in total revenue
o The percentage increase in the quantity demanded is greater than the percentage
decrease in price
o 0 to increasing point
 Price cut in the inelastic range brings a decrease in total revenue
o The percentage increase in the quantity demanded is less than the percentage decrease
in price
o Max point to 0 , declining
 At unit elasticity
o
o
Total revenue is at maximum
Max point
When price changes, the change in your expenditure on the good depends on your elasticity of demand
 If your demand is elastic, a 1 percent price cut increases the quantity you buy by more than 1
percent and your expenditure on the item increases
 If your demand is inelastic, a 1 percent price cut increases the quantity you buy by less than 1
percent and your expenditure on the item decrease
 If your demand is unit elastic, a 1 percent price cut increases the quantity you buy by 2 percent
and your expenditure on the item does not change
*so if you spend more on item when its price falls, your demand for that item is elastic; if you spend the
same amount, your demand is unit elastic; and if you spend less, your demand is inelastic
The elasticity of demand for a good depends on
 The closeness of substitutes
 The proportion of income spent on the good
 The time elapsed since a price change
Closeness of substitutes
 The close the substitutes for a good or service, the more elastic is the demand for it
o Ex. inelastic demand – oil
o Ex. elastic demand – plastics
 The degree of substitutability between two goods also depends on how narrowly (or broadly)
we define them
 Necessities – a good that has poor substitutes and that are crucial for our well-being
o Inelastic demand
o Ex. food and shelter
 Luxury – a good that usually has many substitutes, one of which is not buying it
o Elastic demand
o Ex. a vacation
Proportion of income spent on the good
 The greater the income spent on the good, the more elastic is the demand
o Ex. housing
 The greater the proportion of income spent on a good, the more elastic is the demand
 The smaller the amount of income spend on the good, the inelastic the demand is
o Ex. gum
 You will move into a place with lower rent but you won’t change the quantity of gum you buy
because the proportion it takes noticeable and unnoticeable
Time elapsed since price change
 The longer the time that has elapsed since a price change, the more elastic is the demand
Cross elasticity of demand – a measure of the responsiveness of demand for a good to a change in the
price of a substitute or complement, other things remaining the same (influence of a change in the price
of substitute or complement)
Cross elasticity of demand = percent change in quantity demanded / percentage change in price of
substitute or complement
 Can be positive or negative
o Positive for a substitute
o Negative for complement
 The rise in the price of substitute brings an increase in demand so it is positive, the demand
curve moves rightward
 The rise in the price of complement brings an decrease in demand so it’s negative, the demand
curve moves leftward
 The magnitude of the cross elasticity of demand determines how far the demand curve shifts
o The larger the cross elasticity (absolute value), the greater is the change in demand, the
greater is the shift
 If two items are close substitutes, their cross elasticity is large
 If two items are somewhat unrelated to each other, their cross elasticity is small or 0
Income elasticity of demand – a measure of the responsiveness of the demand for a good or service to
change in income, other things remaining the same
Income elasticity of demand = percentage change in quantity demanded / percentage change in income
 Can be positive or negative
 Greater than 1 (normal good, income elastic)
o Percentage of income spent on that good increases as income increases
 Positive and less than 1 (normal good, income inelastic)
o Percentage of income spent decreases as income increases
 Negative (inferior good)
o The quantity demanded and the amount spent both decrease
Elasticity of Supply
Elasticity of supply – measures the responsiveness of the quantity supplied to a change in the price of a
good when all other influences on selling plans remain the same
Elasticity of supply = percentage change in quantity supplied / percentage change in price
 If the quantity supplied is fixed regardless of the price
o Supply curve, vertical
o The elasticity of supply = 0
o Supply = perfectly inelastic
 When the percentage change in price equals the percentage change in quantity
o Supply is unit elastic
o Moves from one supply curve from the origin to another “V”
 If there is a price at which sellers are willing to offer any quantity for sale
o Supply curve is horizontal
o The elasticity of supply is infinite
o Supply = perfectly elastic
The elasticity of supply of a good depends on
 Resource substitution possibilities
 Time frame for the supply decision
Resources substitution possibilities
 Some goods and services can be produced only by using unique or rare productive resources
o Have low or even zero elasticity of supply
 Other goods and services can be produced by using commonly available resources that could be
allocated to a wide variety of alternative tasks
o High elasticity of supply
 When a good is produced in many different countries, the supply of the good is high elastic
 If few producing countries, supply of the good is low elastic
 Quantity produced increases with higher cost such goods have a elasticity of supply between 0
and infinite
Time frame for the supply decision
Three time frames:
 Momentary supply – the response of the quantity supplied immediately following the price
change
o No matter whether the price rises or falls , there is a fixed output
 Ex. fruits – have to be planned out before but the price doesn’t impact it
because it is already shifted or fixed for the day
 Vertical supply curve – perfectly inelastic momentary supply
o Perfectly elastic momentary supply
 Ex. long distance phone calls
 Long-run supply – the response of the quantity supplied to a price change after all the
technologically possible ways of adjusting supply have been exploited
o The long run adjustment occurs only after a completely new production plan has been
built
o Workers have been trained to operate it
o Might take several years
 Short-run supply – how the quantity supplied responds to a price change when only some of the
technologically possible adjustments to production have been made
o Sequence of adjustments
 First – labour employed; increase or decrease
 Additional adjustments – training additional workers, buying more equipments
o Slops upward since producers can take actions quickly to change the quantity supplied
in responsive to the price change
 Ex. price of oranges falls can leave them to rot on the tree or if price rises use
better fertilizers to increase the yields of the existing trees
Figure 4.1 on pg. 99