Chapter 5
Elasticity
You are responsible for reading Chapter 4!!!
What have we done?
• Chapter 3 gave us downward sloping
demand curves
– Law of demand
• Now want to see how Qd changes when
price changes
Elasticity
• Response of one variable to a change in
another variable
• Price elasticity of demand
– Measure of the responsiveness of Qd of a
product to a change in the price of that
product
%Q
Ed 
%P
Qd
Q
Ed 
P
P
So…
• What if Ed = 3?
– If price was increased from the prevailing
point the % change in Qd would be 3 times
the change in price
• Shouldn’t it be negative?
– So price increases and Qd decreases?
• Yes!!
– For ease we look at the absolute value, but
know that the law of demand holds
Point elasticity
• Measures the change between two
observed points.
Qb  Qa
Qd
Qa
Q
Ed 

P
Pb  Pa
P
Pa
example
•
•
•
•
•
•
•
P1 = 10
P2 = 12
Q1 = 100
Q2 = 50
Elasticity??
Which is Point A???
Big Problem!!!
50  100
100
A  1;
 2 .5
12  10
10
100  50
50
A  2;
6
10  12
12
Problem
• Answers vary depending on where you
start
• Becomes more important the larger the
change
Arc Elasticity
• To avoid the endpoint problem take elasticity at the
midpoint (average) of the two points
Qd
Qd 1  Qd 2
 Qd 1  Qd 2 
 Qd 1  Qd 2 




2
2




Ed 

P
P1  P2
 P1  P2 
 P1  P2 




 2 
 2 
Differences
• With arc elasticity it is clear which points
are used
• P1 is the first price
• P2 is the second price
• Qd and Qd are the first and second
quantity demanded respectively
1
2
Price elasticity of demand can
yield 5 basic results
•
•
•
•
•
•
Numerator > Denominator
Numerator < Denominator
Numerator = Denominator
Numerator = 0
Denominator = 0
Each has a specific name and result
Elastic Demand
• Ed > 1
• % change in quantity demanded > %
change in price
• FLATTER CURVE
• What are some examples of an elastic
good???
Inelastic Demand
• Ed<1
• % change in the price > percent change in
quantity demanded
• STEEPER CURVE
• What are some examples of an inelastic
good?
Price Elasticity of Demand
Price
Part (a)
Price
Part (b)
Ed < 1
Inelastic
Ed > 1
Elastic
P2
P1
P2
10%
10%
P1
D
20%
4%
D
0
Q2
Q1
Quantity Demanded
0
Q2 Q1
Quantity Demanded
Unit Elastic Demand
• Ed=1
• % change in price = % change in quantity
demanded
• Change in price brings a proportionate
change in quantity demanded
• CURVE
Price Elasticity of Demand
Part (c)
Price
Ed = 1
Unit Elastic
P2
P1
10%
D
10%
0
Q2 Q1
Quantity Demanded
Perfectly Elastic Demand

• Ed =
(denominator = 0)
• % change in quantity demanded is A LOT in
response to a change in price
• Price increases and quantity demanded goes
to 0
• Totally flat --- horizontal
• Extreme
• Examples???
Perfectly inelastic demand
• Ed = 0
• % change in quantity demanded
DOESN’T CHANGE in response to a
change in price
• Totally steep --- vertical
• Extreme
• Examples???
Price
Price
Elasticity
of
Demand
Part (d)
Part (e)
Price
D
P2
P1
0
Ed = 0
Perfectly Inelastic
Ed = 
Perfectly Elastic
1%
P2
D
Q1
Quantity Demanded
P1
0
10%
Q1
Quantity Demanded
Aren’t demand curve downward
sloping?
• Because the extremes (perfectly inelastic
and perfectly elastic) are not.
• Use as points of reference only
How does a change in price affect Total
Revenue of a Firm?
• Revenue depends on elasticity
• Michael Jordan and Nike shoes
– No substitutes -- inelastic demand
• What happens to Qd if price increases?
– Substitutes – elastic demand
• What happens to Qd if price increases?
What is total revenue??
• Total revenue = price*quantity
• Firm uses to decide if to produce more or
less
examples
• Elastic demand
– Price increase
– Price decrease
• Inelastic demand
– Price increase
– Price decrease
• Unit elastic demand
– Price increase
– Price decrease
P
TR 
P
TR 
P
TR 
P
TR 
P
TR
P
TR
Ed > 1
Ed < 1
Ed = 1
Elasticities,
Price
Changes, and
Total
Revenue
Important to look at because…
• Elasticity of the demand determines if with
a price increase…
– Total revenue increases
– Total revenue decreases
– Total revenue remains the same
Price elasticity of demand and a
straight line
• Demand is downward sloping
• Along the line elasticity varies from highly
elastic to highly inelastic
• But…remember SLOPE is constant
Point
A
B
C
D
E
F
G
P
8
7
6
5
4
3
2
Qd
3
4
5
6
7
8
9
Price Elasticity of Demand
along a Demand
Curve
Price (dollars)
(3)
(1)
(2)
QUANTITY (4)
POINT PRICE DEMANDED Ed
Elastic
Range
8
A
7
Unit Elastic
Range
B
A
$8
3
2.14
B
7
4
1.44
C
6
5
1.00
D
5
6
0.69
E
F
G
4
7
3
C
5
Inelastic
Range
D
4
E
3
F
0.47
2
0.29
1
8
2
6
G
9
1
(a)
2
3 4 5 6 7 8
Quantity Demanded
(b)
9
D
Summary
• Upper end of Demand Curve
– Qd is low and price is high
– Freak out more when price is high
• Lower end of Demand Curve
– Qd is high and price is low
– Freak out less when price is low
So…
• As move down the demand curve from
higher prices to lower the price elasticity of
demand goes from elastic to inelastic
Determinates of price elasticity
of demand
• Number of substitutes available
– Increase substitutes increases elasticity
– More narrowly defined goods have more
substitutes (compared to broadly defined)
• Example: Fords vs all cars
More determinates
• Percentage of one’s budget that is spent
on the good
– More expensive??? More elastic
– More affected by price (even small changes)
Final determinate
• Amount of time that passed since price
change
– Increase time passed gives more opportunity
to change behavior or react to price change
– Overtime can look for substitutes
– Increase time increases elasticity
– More elastic in long term than short
Cross Elasticity of Demand
• Measures the responsiveness of quantity
demanded to a change in price of
Qx 2  Qx1
ANOTHER good
 Qx 2  Qx1 


% Qdx 
2

Ec 

Py 2  Py1
% Py
 Py 2  Py1 


2


When would you use Cross
Price Elasticity?
• To determine if goods are substitutes or compliments
• Ec>0 – substitutes
– % change in quantity demanded and price move
in same direction
• Ec<0 – compliments
– % change in quantity demanded and price move
in opposite directions
• Ec=0 – goods unrelated
Income elasticity of demand
• Measures the responsiveness of
quantity demanded to the change in
income
Qx 2  Qx1
 Qx 2  Qx1 


%Qd
2


Ey 

Y2  Y1
%income
 Y2  Y1 


 2 
Why use income elasticity of
demand?
• Use to determine if a good is normal or
inferior
• Ey>0 – normal good
– As income increases Qd increases
• Ey<0 – inferior good
– As income increases Qd decreases
Can also say…
• If |Ey| > 1
– % change in Qd > % change in Y
– Income elastic
• If |Ey| < 1
– % change in Qd < % change in Y
– Income inelastic
• If |Ey| = 1
– % change in Qd = % change in Y
– Income unit elastic
Can we use income elasticity in
the real world??
• If invest in the stock market do you want to
invest in a normal or inferior good?
• Normal
• Why
• Increase income would increase quantity
bought and increase stock prices
Price Elasticity of Supply
• Measures the responsiveness of quantity supplied of
a good to the change in the price of that good
Qs1  Qs 2
%Qs  Qs1  Qs 2 


Qs
2


Es 

%P
P1  P2
P
 P1  P2 


 2 
Classification is like demand
• Es > 1
– Elastic
• Es < 1
– Inelastic
• Es = 1
– Unit elastic
• Each of these will result in a “normal” upward
sloped supply curve
Any extreme elasticities???
• Yes!!
• Es =
 elastic or horizontal
– Perfectly
• Es = 0
– Perfectly inelastic or vertical
Price Elasticity of Supply
Price
Part (a)
Price
Part (b)
S
Es > 1
Elastic
P2
P1
S
P2
10%
P1
20%
0
Q1
Q2
Quantity Supplied
Es < 1
Inelastic
10%
4%
0
Q1 Q2
Quantity Supplied
Price Elasticity of Supply
Part (c)
Price
S
P2
P1
Es = 1
Unit Elastic
10%
10%
0
Q1 Q2
Quantity Supplied
Price Elasticity of Supply
Price
Part (d)

Es = •
Perfectly Elastic
P1
0
P2
S
Q1
Quantity Supplied
Part (e)
S
Price
P1
0
Es = 0
Perfectly
Inelastic
10%
Q1
Quantity Supplied
Does time play a role in
elasticity of supply?
• Yes!!
• Overtime producers are able to adjust their
behavior and production patterns
• Supply becomes more elastic as time
passes
Elasticity and taxes
• If government levies a tax on a product
who pays the tax??
• Producers?? Consumers?? Share??
• Depends on the elasticity of demand and
supply
How find??
•
•
•
•
Find equilibrium price
Supply shifts left in the amount of the tax
Find new equilibrium
Find point of second equilibrium on ORGINAL
supply curve
– Shows the actual price realized by firm or
equilibrium price – tax = point in question
• Difference between points determines how much of
tax you pay
Who
Pays
the
Tax?
Price
(dollars)
Part of tax paid
by consumers in
terms of higher
price paid.
S2 (after tax)
S1 (before tax)
9.00
8.50
B
A
$1 Tax
8.00
7.50
Part of tax paid
by producers in
terms of lower
price kept.
D1
0
Q2 Q1
Quantity of VCR Tapes
Who pays more of the tax??
•
•
•
•
Perfectly inelastic demand
Perfectly elastic demand
Demand more elastic than supply
Supply more elastic than demand
Different Elasticities and Who Pays the Tax
Part (a)
Price (dollars)
Part (b)
Price (dollars)
S2
D1
Producers pay
full tax
S1
9.00
S2
S1
$1 Tax
B
$1 Tax
B
8.00
A
A
8.00
D1
0
Q2
Q1
Quantity of VCR Tapes
Consumers pay
full tax
0
Q1
Quantity of VCR Tapes
Different Elasticities and Who Pays the Tax
Part (b)
Part (a)
Price (dollars)
Price (dollars)
S2
D1
Producers pay
full tax
S1
9.00
S2
S1
$1 Tax
B
$1 Tax
B
8.00
8.00
A
A
D1
Consumers pay
full tax
0
Q1
Quantity of VCR Tapes
0
Q1
Q2
Quantity of VCR Tapes
Summary
• Ed > Es producer bears most of the tax
burden
• Ed < Es consumer bears most of the tax
burden
• Ed = Es equally share the tax burden
Homework
Numbers 5, 6, and 8
Working with Graphs and Numbers
1, 2, and 4
Do we understand
Chapter 5??