Elasticity and Straight-Line
Demand Curves
Price
Since equal dollar increases (vertical
arrows) are smaller and smaller
percentage increases . . .
3
2
and since equal quantity decreases
(horizontal arrows) are larger and
larger percentage decreases . . .
1
demand becomes more and more
elastic as we move leftward and
upward along a straight-line
demand curve.
D
Quantity
Categorizing Goods by Elasticity
Price elasticity of demand
Between 0 and -1
Demand
Equal to 0
Absolute Value > 1
Perfectly
Inelastic
Elastic
Equals 1
Unitary Elastic
Approaches minus infinity
Perfectly
(infinitely) Elastic
Inelastic
Categorizing Goods by Elasticity
• Inelastic Demand
Inelastic Demand 
% Change in Quantity Demanded
 1.0
% Change in Price
|% Change in Quantity Demanded| < |% Change in Price|
Elastic Demand
Price elasticity of demand with absolute value > 1
% Change in Quantity Demanded
Elastic Demand 
1
% Change in Price
Extreme Cases of Demand
(a)
Price
per
Unit
(b)
Price
per
Unit
D
$4
3
2
$4
Perfectly Inelastic
Demand
1
3
Perfectly Elastic
Demand
2
D
1
20 40 60 80 100
Quantity
20 40 60 80 100
Quantity
Elasticity and Total Revenue
• Total revenue (TR) of all firms in the market is
defined as
• TR = P x Q
• When two numbers are both changing, percentage
change in their product is (approximately) the sum
of their individual percentage changes
– Applying this to total revenue
• % Change in TR = % Change in Price + % Change in Quantity
Demanded
• Assume demand is unitary elastic and Q rises by
10%
– % Change in TR = 10% + (-10%) = 0
Elasticity and Total Revenue
• If demand is inelastic, a 10% rise in price
will cause quantity demanded to fall by
less than 10%
– % change in TR = 10% + (something less
negative than –10%) > 0
• If demand is elastic, so that Q falls by
more than 10%
– TR will fall
• % Change in TR = 10% + (something more
negative than -10%) < 0
Elasticity and Total Revenue
• Where demand is inelastic, total revenue moves
in same direction as price
• Where demand is elastic, total revenue moves in
opposite direction from price
• Where demand is unitary elastic, total revenue
remains the same as price changes
• At any point on a demand curve sellers’ total
revenue (buyers’ total expenditure) is the area of
a rectangle
– Width equal to quantity demanded
– Height equal to price
Figure 6: Elasticity and Total
Expenditure
Price
per
Laptop
$3,500
3,000
2,500
2,000
1,500
1,000
2. At point B, revenue
is $750 million.
1. At point A , where
price is $1,000 and
600,000 laptops are
demanded, revenue
is $600 million.
3. Moving from A to B,
expenditure increases,
so demand must be
inelastic over that range.
B
A
D
500
100,000 200,000 300,000 400,000 500,000 600,000
Quantity of
Laptops
What affects Elasticity?
Availability of Substitutes
• Demand is more elastic
– If close substitutes are easy to find and
buyers can cut back on purchases of the good
in question
• Demand is less elastic
– If close substitutes are difficult to find and
buyers can not cut back on purchases of the
good in question
Narrowness of Market
• More narrowly we define a good, easier it
is to find substitutes
– More elastic is demand for the good
• More broadly we define a good
– Harder it is to find substitutes and the less
elastic is demand for the good
• Different things are assumed constant
when we use a narrow definition
compared with a broader definition
Necessities vs. Luxuries
• The more “necessary” we regard an item,
the harder it is to find a substitute
– Expect it to be less price elastic
• The less “necessary” (luxurious) we regard
an item, the easier it is to find a substitute
– Expect it to be more price elastic
Time Horizon
• Short-run elasticity
– Measured a short time after a price change
• Long-run elasticity
– Measured a year or more after a price change
• Usually easier to find substitutes for an item in
the long run than in the short run
– Therefore, demand tends to be more elastic in the
long run than in the short run
Importance in the Buyer’s Budget
• The more of their total budgets that
households spend on an item
– The more elastic is demand for that item
• The less of their total budgets that
households spend on an item
– The less elastic is demand for that item
Using Price Elasticity of Demand:
The War on Drugs
• Every year U.S. Government spends about $20
billion on efforts to restrict the supply of drugs
• Figure A
– Market for heroin without government intervention
• Figure B
– Result of government efforts to restrict supply (current
policy)
• Figure C
– Results of an effective policy of reducing demand
Figure A: The War on Drugs
(a)
Price per
Unit
S1
A
P1
D1
Q1
Quantity
Figure B: The War on Drugs
(b)
Price per
Unit
S2
B
S1
P2
A
P1
D1
Q2 Q1
Quantity
Figure C: The War on Drugs
(c)
Price per
Unit
S1
A
P1
P3
C
D1
D2
Q3
Q1
Quantity
Using Price Elasticity of Demand:
Mass Transit
• Elasticity studies show that long-run demand for
mass transit is inelastic
– Therefore, a rise in fare would increase revenues
• However, most cities do not raise transit fares
due to
– Desire to provide low-income households with
affordable transportation
– Desire to manage traffic congestion
– Desire to limit air pollution in the city
• An increase in fares would increase revenue
– Would also decrease ridership and require the city to
sacrifice these other goals
Using Price Elasticity of Demand:
An Oil Crisis
•
•
For the past five decades, Middle East has been a geopolitical hot spot
Both military and economic government agencies ask “What if” questions
– If an event in the Middle East were to disrupt oil supplies, what would happen
to the price of oil on world markets?
•
Flipping the elasticity equation like so
1
E
D
•
•

% Change in Price
% Change in Quantity Demanded
Tells us percentage rise in price that would bring about a 1 percent
decrease in quantity demanded
– Enables us to make reasonable forecasts about the impact of various
events on oil prices
Once we have established our forecasted oil prices we can then use that
data to examine effect that higher oil prices would have on many broader
issues
– Effect on U.S. inflation rate
– Effect on number of flights offered by U.S. airlines
Income Elasticity of Demand
• Percentage change in quantity demanded
divided by the percentage change in income
– With all other influences on demand—including the
price of the good—remaining constant
EY 
% change in Quantity Demanded
% Change in Income
• Interpret this number as percentage increase in
quantity demanded for each 1% rise in income
Income Elasticity of Demand
• Income elasticities vs. price elasticities of
demand
– Price elasticity of demand
• Measures effect of change in price of good
– Assumes that other influences on demand, including income,
remain unchanged
– Income elasticity
• Measures effect on demand we would observe if income
changed and all other influences on demand—including price
of the good—remained the same
• Instead of letting price vary and holding income
constant, now we are letting income vary and
holding price constant
Income Elasticity of Demand
• Another difference between price and
income elasticity of demand
– Price elasticity measures sensitivity of
demand to price as we move along a demand
curve from one point to another
– Income elasticity tells us relative shift in
demand curve—increase in quantity
demanded at a given price
• While a price elasticity is virtually always
negative
– Income elasticity can be positive or negative
Income Elasticity of Demand
• Economic necessity
– Good with an income elasticity of demand between 0 and 1
• Economic luxury
– Good with an income elasticity of demand greater than 1
• An implication follows from these definitions
– As income rises, proportion of income spent on economic
necessities will fall
• While proportion of income spent on economic luxuries will rise
• But, it is important to remember that economic
necessities and luxuries are categorized by actual
consumer behavior
– Not by our judgment of a good’s importance to human survival
Cross-Price Elasticity of Demand
• Cross-price elasticity of demand
– Percentage change in quantity demanded of one good caused
by a 1% change in price of another good
• While all other influences on demand remain unchanged
EXZ 
% Change in Quantity of X Demanded
% Change in Price of Z
• While the sign of the cross-price elasticity helps us
distinguish substitutes and complements among related
goods
• Its size tells us how closely the two goods are related
– A large absolute value for EXZ suggests that the two goods are close
substitutes or complements
– While a small value suggests a weaker relationship
Price Elasticity of Supply
• Percentage change in quantity of a good
supplied that is caused by a 1% change in the
price of the good
– With all other influences on supply held constant
ES 
% Change in Quantity Supplied
% Change in Price
Price Elasticity of Supply
• When do we expect supply to be price elastic,
and when do we expect it to be price inelastic?
– Ease with which suppliers can find profitable activities
that are alternatives to producing the good in question
• Supply will tend to be more elastic when suppliers can switch
to producing alternate goods more easily
– When can we expect suppliers to have easy alternatives?
Depends on
» Nature of the good itself
» Narrowness of the market definition—especially
geographic narrowness
» Time horizon—longer we wait after a price change, greater
the supply response to a price change
Price Elasticity of Supply
• Extreme cases of supply elasticity
– Perfectly inelastic supply curve is a vertical
line
• Many markets display almost completely inelastic
supply curves over very short periods of time
– Perfectly elastic supply curve is a horizontal
line
Figure 8: Extreme Cases of Supply
(a)
(b)
Price
per
Unit
Price
per
Unit
S
P2
Perfectly Inelastic
Supply
Perfectly Elastic
Supply
S
P1
Quantity per Period
Quantity per Period
The Tax on Airline Travel: Taxes
and Market Equilibrium
• A tax on a particular good or service is called an
excise tax
– Shifts market supply curve upward by amount of tax
• For each quantity supplied, the new, higher curve tells us
firms’ gross price, and the original, lower curve tells us the
net price
• Who really pays excise taxes?
– Buyers and sellers share in the payment of an excise
tax
• Called tax shifting
– Process that causes some of tax collected from one side of
market (sellers) to be paid by other side of market (buyers)
The Tax on Airline Travel
Price per
Ticket
(a)
4. and then find the minimum price needed
for the market to supply that quantity.
SBefore Tax
$300
$260
1. One way to use the supply
curve is to start with the
price . . .
3. But another way
is to start with a
quantity . . .
A
7
10
Millions of
Tickets per Year
2. and then find the quantity
supplied at that price.
The Tax on Airline Travel
Price per
Ticket
(b)
SAfter Tax
$360
A'
SBefore Tax
$300
A
3. But another way is to start
with a quantity . . .
10
4. and then find the minimum price needed for the
market to supply that quantity.
Millions of
Tickets per Year
Effect of Excise Tax on Airlines
2. The $60 tax shifts the
supply curve up by $60.
Price per Ticket
SAfter Tax
B
$340
3. In the new
equilibrium,
buyers pay
$340.
SBefore Tax
$300
A
1. Before the tax,
the supply curve
is SBefore Tax and
the price is $300.
$280
4. And, net of the
tax, sellers
receive $280.
D
Millions of Tickets per Year
Tax Incidence and Demand
Elasticity
• In most cases excise tax will be shared by
both buyer and seller
– For a given supply curve, the more elastic is
demand, the more of an excise tax is paid by
sellers
– The more inelastic is demand, the more of the
tax is paid by buyers
Figure 11: Tax Incidence and
Demand Elasticity
(a)
Price per
Ticket
D
(b)
Price per
SAfter Tax Ticket
SAfter Tax
SBefore Tax
SBefore Tax
B
$360
$300
A
10
$300
Millions of
Tickets per Year
B
A
2
10
D
Millions of
Tickets per Year
Tax Incidence and Supply Elasticity
• Although there are extreme cases of
supply elasticity, in general the following is
true
– For a given demand curve, the more elastic is
supply, the more of an excise tax is paid by
buyers
– The more inelastic is supply, the more of the
tax is paid by sellers
Tax Incidence and Supply Elasticity
(a)
Price per
Ticket
(b)
SBefore and After Tax
Price per
Ticket
$360
$300
A
$240
B
SAfter Tax
A
$300
D
10
Millions of
Tickets per Year
SBefore Tax
D
8
10
Millions of
Tickets per Year
The Market For Food
• Shrinking and unstable incomes are problems
for farmers
• The market for farm goods would reach an
equilibrium if it were allowed to do so
• But farming seems to be special
– Notion of small family farm has tremendous political
appeal
– Farmers have banded together to form powerful and
effective government lobbies
• Result has been continual government
interference with supply and demand in
agricultural markets around the world
The Market For Food
(a)
(b)
per
SOld Technology Price
Unit of
Price per
Unit of
Food
Food
A
SNew Technology
P1
P2
SBad Weather
A
SGood Weather
P1
B
B
P2
D
Q1 Q2
D
Quantity of
Food
Q1 Q2
Quantity of
Food
Health Insurance and the Market
for Health Care
• Health insurance has definite benefits to
our society
• Our current health care system keeps
patients from facing the full opportunity
cost of their health care decisions
– Can cause people to over consume health
care
• Health insurance reduces buyers’
incentives to monitor their health care
expenditures closely or to shop around for
high-quality low-cost care
The Market For Health Care With
Coinsurance
Price per D
After Insurance
Examination
$100
S
DBefore Insurance
B
70
50
A
100,000 150,000
Examinations per Year