1. THE PRICE ELASTICITY OF
DEMAND
Learning Objectives
1. Explain the concept of price elasticity of
demand and its calculation.
2. Explain what it means for demand to be price
inelastic, unit price elastic, price elastic,
perfectly price inelastic, and perfectly price
elastic.
3. Explain how and why the value of the price
elasticity of demand changes along a linear
demand curve.
4. Understand the relationship between total
revenue and price elasticity of demand.
5. Discuss the determinants of price elasticity of
demand.
1. THE PRICE ELASTICITY OF
DEMAND
•
The price elasticity of demand is the
percentage change in quantity
demanded of a particular good or service
divided by the percentage change in the
price of that good or service, all other
things unchanged.
eD = % change in quantity demanded
% change in price
1.1 Computing the Price
Elasticity of Demand
•
arc elasticity is a measure of elasticity
based on percentage changes relative to
the average value of each variable
between two points.
EQUATION 1.2

Q/Q
eD

P/P
Responsiveness and Demand
1
0.9
A
Price per ride
0.8
B
0.7
Movement from Point A to B (or B to A)
shows that a $.10 change in price
changes the number of rides per day by
20,000.
0.6
0.5
0.4
0.3
Demand
0.2
0.1
0
0
20
40
60
80
100 120 140 160
Quantity of rides per day (in thousands)
180
200
1.2 Price Elasticities Along a Linear
Demand Curve
1
0.9
0.7
0.6
eD = -1.00
0.5
0.4
eD = -.33
0.3
0.2
0.1
0
0
10
20
30
40
50
60
70
80
90
100
110
120
130
140
150
160
170
180
190
200
Price per ride
0.8
eD = -3.00
Quantity of rides per day (in thousands)
1.3 The Price Elasticity of Demand
and Changes in Total Revenue
•
•
•
•
Total Revenue (TR=P*Q) is a firm’s
output multiplied by the price at which it
sells that output.
Price elastic refers to a situation in
which the absolute value of the price
elasticity of demand is greater than 1.
Unit price elastic refers to a situation
in which the absolute value of the price
elasticity of demand is equal to 1.
Price inelastic refers to a situation in
which the absolute value of the price of
elasticity of demand is less than 1.
Changes in Total Revenue and a
Linear Demand Curve
Elastic Region
Unit elastic
A
B
Inelastic Region
E
F
1.3 The Price Elasticity of Demand
and Changes in Total Revenue
Price Elastic
An increase in price ...
reduces total revenue.
A reduction in price...
Increases total revenue.
Total revenue moves in the direction of the quantity change.
Price Inelastic
An increase in price…
Increases total revenue.
A reduction in price…
Reduces total revenue.
Total revenue moves in the direction of the price change.
Unit price Elastic
An increase in price…
No change in total revenue.
A reduction in price…
No change in total revenue.
Total revenue does not change as price changes.
1.4 Constant Price Elasticity of
Demand Curves
•
•
Perfectly inelastic (insensitive to price
changes) refers to a situation in which
the price elasticity of demand is zero.
Perfectly elastic (sensitive to price
changes) refers to a situation in which
the price elasticity of demand is infinite.
Demand Curves with Constant Price
Elasticity
Panel (b)
10
10
8
8
Price per unit
Price per unit
Panel (a)
6
4
2
0
6
4
2
0
0 1 2 3 4 5 6 7 8 9 10
Quantity per period
0 1 2 3 4 5 6 7 8 9 10
Quantity per period
Panel (d)
10
10
8
8
Price per unit
Price per unit
Panel (c)
6
4
2
0
0 1 2 3 4 5 6 7 8 9 10
Quantity per period
6
4
2
0
0
1
2
3 4 5 6 7 8
Quantity per period
9 10
1.5 Determinants of the Price
Elasticity of Demand
•
Availability of substitutes
–
•
If there are lots of close substitute goods to
choose from consumers can switch easily
Importance in household budgets
–
•
Price of good relative to income
Time
–
In the short run it is often difficult to find
substitutes.
2. RESPONSIVENESS OF DEMAND
TO OTHER FACTORS
Learning Objectives
1. Explain the concept of income elasticity of
demand and its calculation.
2. Classify goods as normal or inferior depending
on their income elasticity of demand.
3. Explain the concept of cross price elasticity of
demand and its calculation.
4. Classify goods as substitutes or complements
depending on their cross price elasticity of
demand.
2.1 Income Elasticity of Demand
•
Income elasticity of demand is the
percentage change in quantity demanded at a
specific price divided by the percentage change
in income that produced the demand change,
all other things unchanged.
EQUATION 2.1
%
change
in
quanti
dema
e

Y
%
change
in
incom
2.1 Income Elasticity of Demand
Normal Good (e.g. DVD’s)
An increase in income…
Increases demand.
A decrease in income…
Decreases demand.
Inferior Good (e.g. used clothing)
An increase in income…
Decreases demand.
A decrease in income…
Increases demand.
2.2 Cross Price Elasticity of Demand
•
Cross price elasticity of demand is the
percentage change in the quantity demanded of
one good or service at a specific price divided
by the percentage change in the price of a
related good or service.
EQUATION 2.2
%
change
in
quant
dem
of
go
A
e

A
,
B
%
chang
in
price
of
goo
B
2.2 Cross Price Elasticity of Demand
Normal Good (e.g. DVD’s)
An increase in PB…
Increases demand for good A.
A decrease in PB…
Decreases demand for good A.
Inferior Good (e.g. used clothing)
An increase in PB…
Decreases demand for good A.
A decrease in PB…
Increases demand for good A.
3. PRICE ELASTICITY OF SUPPLY
Learning Objectives
1. Explain the concept of elasticity of supply and
its calculation.
2. Explain what it means for supply to be price
inelastic, unit price elastic, price elastic,
perfectly price inelastic, and perfectly price
elastic.
3. Explain why time is an important determinant
of price elasticity of supply.
4. Apply the concept of price elasticity of supply to
the labor supply curve.
3. PRICE ELASTICITY OF SUPPLY
•
Price elasticity of supply is the ratio of the
percentage change in quantity supplied of a
good or service to the percentage change in its
price, all other things unchanged.
EQUATION 3.1
%
change
in
quanti
supp
e

s
%
change
in
price
Rent per apartment per month
Increase in Apartment Rents Depends
on How Responsive Supply Is
S1
S2
R1
R2
R0
D1
Q0
Q1
Q2
Quantity of apartments per month
D2
Increase in Apartment Rents Depends
on How Responsive Supply Is
Rent per apartment per month
10
S
9
8
7
eS = ∞
6
5
S
eS = 0
4
3
2
1
0
0
1
2
3
4
5
6
7
Quantity of apartments per month
8
9
10
3.1 Time: An Important Determinant of
the Elasticity of Supply
•
•
In the short run supply is likely to
be inelastic.
In the long run supply is likely to be
more elastic.
Selected Elasticity Estimates
Product
Price
elasticity
Income
elasticity
-2.58
0.20
Alcohol with respect to
the price of heroin
-0.05
-0.90 to -1.50
0.40
Fuel with respect to the
price of transport
-0.48
Heroin
-1.00
0.00
Beer with respect to the
price of wine
0.00
Coke
-1.90
0.60
Poultry with respect to
the price of ground beef
0.23
Pepsi
-2.22
1.72
Coke with respect to
the price of Pepsi
0.61
Gasoline
(short-run)
-0.10
-----
Pepsi with respect to
the price of Coke
0.80
Transportation
(long-run)
-2.08
-----
Food
(long-run)
Beer
Product
Cross price
elasticity
Selected Elasticity Estimates
Product
Price
elasticity of
supply
Physicians (specialist)
-0.30
Physicians (primary
care)
0.00
Physician (young
male)
0.20
Physicians (young
female)
0.50
Milk (short run)
0.36
Milk (long run)
0.50
Child care labor
2.00