2. 6-2
Price Elasticity of Demand
The Total-Revenue Test
Determinants of Price Elasticity of Demand
Price Elasticity of Supply
Cross Elasticity and Income Elasticity of Demand
6-2
3. 6-3
Elasticity
• Elasticity is a measure of a variable's sensitivity to a change
in another variable, most commonly this sensitivity is the
change in price relative to changes in other factors.
• Business and government can use the elasticity to predict
how much consumers or producers change their quantity
demanded or the quantity supplied in response to price or
income changes.
• Unlike slope, the elasticity is free from units of
measurement.
4. 6-4
Four Major Types of Elasticity
• Measurement of consumers’ response in quantity
demanded:
• Price elasticity of demand: How a change in price affects consumers’
quantity demanded.
• Cross elasticity of demand: How a change in price of one good affects
consumers’ quantity demanded of the other good
• Income elasticity of demand: How a change in income affects
consumers’ quantity demanded.
• Measurement of producers’ response in quantity supplied:
• Price elasticity of supply: How a change in price affects producers’
quantity supplied.
5. 6-5
Elasticity Formula
• In case of price elasticity of demand, one variable is “Quantity demanded” and
another variable is “Price“.
• In case of cross elasticity of demand, one variable is “Quantity demanded of Good X”
and another variable is “Price of Good Y”.
• In case of income elasticity of demand, one variable is “Quantity demanded” and
another variable is “Income”.
• In case of price elasticity of supply, one variable is “Quantity supplied” and another
variable is “Price”.
E =
Percentage change in one variable
Percentage change in another variable
6. 6-6
Two Practical Elasticity Formula
• Mid-point formula: used for a straight-line demand curve
between two coordinates (Q1, P1) and (Q2, P2).
• Point formula: used for a curved demand curve at a point.
E =
ΔQ/Q
ΔP/P
=
ΔQ
ΔP
P
Q
x
E =
(Q2 – Q1)/[(Q2 + Q1)/2]
(P2 – P1)/[(P2 + P1)/2]
7. 6-7
Numerical Examples
• Mid-point formula: When a price is $10, a quantity demanded is 20.
When a price increases to $12, a quantity demanded decreases to 16.
• Point formula: At $399 of price, a quantity demanded is 20,000. A slope
of demand curve (ΔP/ΔQ) is -0.02.
*Customary, a negative sign is dropped.
E =
(16 – 20)/[(20 + 16)/2]
(12 – 10)/[(12 + 10)/2]
=
-4/18
2/11
= -1.22 E = 1.22
E =
ΔQ
ΔP
P
Q
x =
1
-0.02
399
20,000
x = -1.00 E = 1
9. 6-9
Category of Elasticity
Depending on value of elasticity, the demand or supply is said
• Elastic if E > 1 (quantity changes greatly).
• Unit elastic if E = 1 (quantity changes proportionally).
• Inelastic if E < 1 (quantity changes little).
In extreme cases,
• Perfectly elastic if E = ∞ (quantity change so much).
• Perfectly inelastic if E = 0 (quantity does not change at all).
LO6.1
10. 6-10
Price Elasticity of Demand
• Price Elasticity of Demand measures buyers’
responsiveness to price changes.
• Elastic demand:
• Sensitive to price changes.
• Large change in quantity demanded.
• Inelastic demand:
• Insensitive to price changes.
• Small change in quantity demanded.
LO6.1
12. 6-12
Interpretation of Price Elasticity of Demand
Price elasticity of demand = 0.2 means
• When a price increases by 1%, its quantity demanded will
decrease by 0.2%.
How can business use this information?
• A price elasticity of demand for product is 0.2. Currently, the
price of product is $399 and the total quantity sold is 20,000
units/month. If a firm raises its price to $419, what will
happen to the sales quantity? How about its total revenue?
13. 6-13
Total Revenue Test
• Total Revenue = Price × Quantity
• Total Revenue Test
• Inelastic demand: P and TR move in the same direction.
P Q TR
• Elastic demand: P and TR move in opposite directions.
P Q TR
LO6.2
14. 6-14
Click to edit Master title styleTotal Revenue and Demand Elasticity
• Lower price on elastic demand.
• Blue area exceeds yellow area.
• Total revenue increases.
• Lower price on inelastic demand.
• Yellow area exceeds blue area.
• Total revenue decreases.
$3
2
1
0 10 20 30 40
Q
P
a
b
D1
Elastic
c
d
D2
$4
3
2
1
0 10 20
Q
P
Inelastic
15. 6-15
Total Revenue with Unit-Elastic Demand
• Lower price on unit-elastic demand.
• Blue area equals yellow area.
• Total revenue does not change.
LO6.2
$3
2
1
0 10 20 30
Q
P
e
f
D3
Unit-elastic
16. 6-16
Total Revenue Test Example
LO6.2
0 1 2 3 4 5 6 7 8
Price
$8
7
6
5
4
3
2
1
Elastic
Ed > 1
Unit-elastic
Ed = 1
D
Quantity demanded (thousands)
(a) Demand curve
a
b
c
d
e
f
g
h
Inelastic
Ed < 1
0 1 2 3 4 5 6 7 8 9
Totalrevenue
(Thousandsofdollars)
$20
18
16
14
12
10
8
6
4
2
Quantity demanded (thousands)
(b) Total-revenue curve
TR
17. 6-17
Application of Total Revenue Test
• When a firm is facing an inelastic demand, should it raise or
reduce its price in order to increase its revenue?
• When a firm is facing an elastic demand, should it raise or
reduce its price in order to increase its revenue?
• Example: A price elasticity of demand for product is 0.2.
Currently, the price of product is $399 and the total quantity
sold is 20,000 units/month. If a firm raises its price to $419
by 5.0%, then its sales quantity will decrease to 19,800
units/month by 1% (0.2 x 5.0%). Total revenue will increase
from $7.98 million/month to $8.30 million/month.
18. 6-18
Price Elasticity of Demand: A Summary
Absolute Value of
Elasticity Coefficient Demand Is: Description
Impact on Total Revenue of a:
Price Increase Price Decrease
Greater than 1
(Ed > 1)
Elastic or relatively
elastic
Quantity demanded
changes by a larger
percentage than does
price
Total revenue
decreases
Total revenue
increases
Equal to 1
(Ed = 1)
Unit- or unitary elastic Quantity demanded
changes by the same
percentage as does
price
Total revenue is
unchanged
Total revenue
is unchanged
Less than 1
(Ed < 1)
Inelastic or relatively
inelastic
Quantity demanded
changes by a smaller
percentage than does
price
Total revenue
increases
Total revenue
decreases
LO6.2
19. 6-19
Determinants of Price Elasticity of Demand
• Substitutability: More substitutes, demand is more
elastic.
• Proportion of income: Higher proportion of income,
demand is more elastic.
• Luxuries versus necessities: Luxury goods, demand is
more elastic.
• Time: More time available, demand is more elastic.
LO6.3
20. 6-20
Selected Price Elasticities of Demand
Product or Service
Coefficient of Price
Elasticity of Demand (Ed) Product or Service
Coefficient of Price
Elasticity of Demand (Ed)
Newspapers .10 Milk .63
Electricity (household) .13 Household appliances .63
Bread .15 Liquor .70
Major League Baseball tickets .23 Movies .87
Cigarettes .25 Beer .90
Telephone service .26 Shoes .91
Sugar .30 Motor vehicles 1.14
Medical care .31 Beef 1.27
Eggs .32 China, glassware, tableware 1.54
Legal services .37 Residential land 1.60
Automobile repair .40 Restaurant meals 2.27
Clothing .49 Lamb and mutton 2.65
Gasoline .58 Fresh peas 2.83
LO6.3
21. 6-21
Applications of Price Elasticity of Demand
• Large crop yields: Inelastic demand, lower total
revenue
• Excise taxes: Inelastic demand, more total revenue
• Decriminalization of illegal drugs: Inelastic demand,
more total revenue
LO6.3
22. 6-22
Price Elasticity of Supply
• Price elasticity of supply measures sellers’
responsiveness to price changes.
• Elastic supply, producers are responsive to price
changes.
• Inelastic supply, producers are not as responsive to
price changes.
LO6.4
23. 6-23
Price Elasticity of Supply and Time
• Time is primary determinant of elasticity of supply.
• Time periods considered:
• Immediate market period: perfectly inelastic
• Short run: more elastic than in the immediate market
period.
• Long run: even more elastic than in the short run.
LO6.4
24. 6-24
Time Period and Price Elasticity of Supply
Perfectly inelastic supply
LO6.4
P
Q
D1
D2
Sm
Qo
Pm
Po
0
(a)
Immediate market period
D1
D2
Ss
Ps
Po
P
Q
0 Qo Qs
(b)
Short run
P
Q
D1
D2
SL
Qo
PI
Po
Ql0
(c)
Long run
More elastic than in the
immediate market period
Even more elastic than in
the short run
25. 6-25
Cross Elasticity of Demand
• Cross elasticity of demand measures responsiveness of
purchases of one good to change in the price of another
good.
• Based on a sign of elasticity, a relationship between two
goods is classified in to three:
• Substitute goods if elasticity is positive: two goods are
substitute. Example: Papa John pizza and Domino pizza
• Complementary goods if elasticity is negative: two goods are
used together. Example: Chip and dip.
• Independent goods if elasticity is zero or near-zero.LO6.5
26. 6-26
Applications of Cross Elasticity of Demand
• Should a company change a price?
• Should McDonald’s increase prices of hamburgers? How
will it affect sales of drinks and fries?
• Should the government allow a merger?
• Do two companies provide substitutes? If so, will it
increase monopoly power?
LO6.5
27. 6-27
Income Elasticity of Demand
• Income elasticity of demand measures responsiveness of
buyers to changes in their income.
• Depending on a sign, goods can be classified into two:
• Normal goods if elasticity is positive.
• Most goods are considered as normal goods, because
consumers will consume more with higher income.
• Example: restaurant meals, brand-name clothing.
• Inferior goods if elasticity is negative.
• Consumers consume less when their incomes rise.
• Example: Instant Ramen noodle, second-hand clothing.LO6.5
28. 6-28
Income Elasticity Insights
• Because the economic condition affects incomes of
many workers, it affects demand for certain products.
• High income elasticities: Most affected by a recession.
• Example: luxury boats, private jets
• Low or negative income elasticity: Not affected that much
by a recession.
• Example: goods at Dollar Tree
LO6.5
29. 6-29
Cross and Income Elasticities
Value of Coefficient Description Type of Good(s)
Cross elasticity:
Positive (Ewz > 0)
Negative (Exy < 0)
Quantity demanded of W changes
in same direction as change in price
of Z
Quantity demanded of X changes in
opposite direction from change in
price of Y
Substitutes
Complements
Income elasticity:
Positive (Ei > 0)
Negative (Ei < 0)
Quantity demanded of the product
changes in same direction as
change in income
Quantity demanded of the product
changes in opposite direction from
change in income
Normal or superior
Inferior
LO6.5
31. 6-31
Last Word: Elasticity and Pricing Power:
Why Different Consumers Pay Different Prices
• Charge different prices to different buyers based on
price elasticities.
• Air travelers: Economy class vs. First class.
• Movie theaters: Adult fare and children discount.
• Lunch vs. dinner menu prices
LO6.5
Both the elasticity coefficient and the total revenue test for measuring price elasticity of demand are presented in this chapter. The text discusses the major determinants of price elasticity. The chapter reviews a number of applications and presents empirical estimates for a variety of products. Cross and income elasticities of demand and price elasticity of supply are also examined. The Last Word is about how firms and colleges use price elasticities to set their price.
Learning Objectives
LO6.1 Explain and calculate price elasticity of demand.
LO6.2 Explain the usefulness of the total-revenue test.
LO6.3 List the factors that affect price elasticity of demand.
LO6.4 Describe and apply price elasticity of supply.
LO6.5 Apply cross elasticity of demand and income elasticity of demand.
Elasticity is used to predict how much consumers or producers change their behavior in response to price or income changes. It is similar to a slope formula, but the elasticity does not depend on units of measurement, so one can compare an elasticity of one good with another, such as price elasticity of demand for milk (unit measured in gallons or litters) and price elasticity of demand for peanuts butter (unit measured in ounces or grams).
Quantitative measure of elasticity, Ed = percentage change in quantity/percentage change in price. It can be restated as the change in the quantity demanded of X over the original quantity demanded of X divided by the change in the price of X over the original price of X.
Using traditional calculations, the measured elasticity over a given range of prices is sensitive to whether one starts at the higher price and goes down or starts at the lower price and goes up. The midpoint formula calculates the average elasticity over a range of prices to avoid that problem.
Absolute changes depend on the choice of units. For example, a change in the price of a $10,000 car by $1 is very different than a change in the price of a $1 can of beer by $1. The auto’s price is rising by a fraction of a percent, while the beer’s price is rising 100 percent.
Percentages also make it possible to compare elasticity of demand for different products.
Because of the inverse relationship between price and quantity demanded, the actual elasticity of demand will be a negative number. However, we ignore the minus sign and use absolute value. This makes it less confusing to interpret the elasticity coefficient.
When the elasticity coefficient is greater than 1, it means that the percentage change in quantity demanded is greater than the percentage change in price (based on the formula), indicating that consumers are sensitive to the change in price, so demand is elastic.
When the elasticity coefficient is less than 1, the percentage change in quantity demanded is less than the percentage change in price (based on the formula), indicating that consumers are not very sensitive to price changes.
When the elasticity coefficient equals 1, this is a special case called unit elasticity. This means that the percentage change in price and the percentage change in quantity are exactly equal.
Perfectly inelastic demand means that consumers will buy exactly the same amount no matter how high or low the price. Perfectly elastic demand means that nothing will be purchased if there is any deviation from the current price.
The law of demand tells us that consumers will respond to a price decrease by buying more of a product (other things remaining constant), but it does not tell us how much more. The degree of responsiveness or sensitivity of consumers to a change in price is measured by the concept of price elasticity of demand.
If demand is elastic, there is a large change in quantity demanded even when price changes by a small amount. When demand is inelastic, there is a very small change in quantity demanded even when there is a large change in price.
This extreme situation is called perfectly inelastic demand, and it is very rare. The demand curve would be vertical and graph as a line parallel to the vertical axis. The elasticity coefficient is 0. An example of a perfectly inelastic demand might be a diabetic’s demand for insulin.
This extreme situation, in which a small price reduction would cause buyers to increase their purchases from zero to all that is possible to obtain, is perfectly elastic demand, and the demand curve would be horizontal. The elasticity coefficient is infinite. An example of a perfectly elastic demand is a firm’s demand curve in a purely competitive industry, such as the mining industry, that is unable to change the price.
The total-revenue test is the easiest way to judge whether demand is elastic or inelastic. This test can be used in place of the elasticity formula, unless there is a need to determine the elasticity coefficient. The total revenue test is important for understanding the relationship between price elasticity and total revenue.
Demand is inelastic if a decrease in price results in a decrease in total revenue or if an increase in price results in a rise in total revenue.
Demand is elastic if a decrease in price results in a rise in total revenue or if an increase in price results in a decline in total revenue.
Demand is unit elastic if total revenue does not change when the price changes.
A lower price and elastic demand means that total revenue will rise. Blue gain (extra total revenue from extra sales) exceeds yellow loss (the loss in total revenue from the higher price).
A lower price and inelastic demand means that total revenue will fall. Blue gain (extra total revenue from extra sales) is less than the yellow loss (the loss in total revenue from the higher price).
A lower price and unit-elastic demand means that total revenue is unchanged. Blue gain (extra total revenue from extra sales) is exactly equal to the yellow loss (the loss in total revenue from the higher price).
Notice that in the high-price region, demand for movie tickets is elastic, and revenues increase as price falls. Midway demand for movie tickets is unit elastic, and revenues stay the same as price falls. In the low-price region, elasticities of demand are inelastic, and revenues fall as the price falls.
The first graph shows the relationship between price elasticity of demand for movie tickets and total revenue. Demand curve D is based on Table 6.1 and is marked to show that the hypothetical weekly demand for movie tickets is elastic at higher price ranges and inelastic at lower price ranges. The total-revenue curve, TR, is derived from demand curve D in the first graph. When price falls and TR increases, demand is elastic; when price falls and TR is unchanged, demand is unit elastic; and when price falls and TR declines, demand is inelastic.
This is a summary of the rules and concepts related to the elasticity of demand.
With more substitutes available, consumers have more alternative options, so when there is a change in price, there is a greater percentage change in quantity demanded, making the demand more elastic. The broader the definition of the market, the more elastic the demand. With a narrower definition of the market, demand is more inelastic.
The greater the proportion of income needed to buy the good, the more elastic the demand. Consumers will be more sensitive to changes in prices because the price change can result in thousands of dollars difference.
Since luxuries are goods that consumers can go without, they will change the amount they purchase by a greater amount, even if the price changes by a small amount.
It takes time to alter the amount being purchased, so the more time available, the more elastic the demand. A person doing his or her Christmas shopping on Christmas Eve has a very inelastic demand because he or she doesn’t have the time to look around for alternative purchases.
Some of the elasticities of the goods in this table are surprising. Use the determinants of demand to discuss why major league baseball tickets are not only inelastic, but also more inelastic than gasoline. What makes newspapers, movies, and beer inelastic?
Large crop yields mean that the supply of crops increases and shifts to the right. When this occurs, the equilibrium price falls. Since demand is inelastic, the lower price leads to lower revenue for farmers. Farmers are worse off when there is a large crop yield.
When government wants to impose taxes on goods, it is important for them to understand the elasticity of demand for the good. If they place a tax on a good with an inelastic demand, the higher price won’t decrease the quantity purchased by much, thereby increasing the amount of tax revenue that government collects.
If heroin and cocaine were legalized, their prices would decline according to proponents of legalization. Demand for illegal drugs like this are inelastic for a drug addict, so if the price dropped, the amount consumed at that lower price wouldn’t change by much. Crime would subsequently decline since the addicts wouldn’t need to steal as much to support their habit. Opponents of legalization say that lower prices for these drugs would simply increase the quantity demanded for them and not benefit society at all.
At higher prices, firms are willing and able to produce more, whereas at lower prices, firms are willing and able to produce less. Price elasticity of supply measures how sensitive firms are to price changes. If supply is elastic, small changes in price will result in firms greatly altering the quantity being produced. On the other hand, when supply is inelastic, the firm is unresponsive to price changes and therefore will not change the amount being produced by much, even when the change in price is large.
The ease of shifting resources between alternative uses is very important in price elasticity of supply because it will determine how much flexibility a producer has to adjust its output to a change in the price. The degree of flexibility, and therefore the time period, will be different in different industries.
The immediate market period means that there is no time to adjust output in response to a price change. Some industries may not have an immediate market period if they are able to store their product.
The short run means that there is enough time to adjust output by increasing or decreasing the variable inputs but not the fixed inputs.
The long run means that there is enough time to adjust output by increasing or decreasing all inputs.
In the immediate market period, there is no time for sellers to adjust to a price change, making supply perfectly inelastic. With a perfectly inelastic supply, the increase in demand does not change the quantity demanded at all.
Cross elasticity of demand refers to the effect of a change in a product’s price on the quantity demanded for another product. If the goods are substitutes, they will have a positive cross elasticity of demand since the change in the price of one good and the change in the demand for its substitute move in the same direction. If the goods are complements, they will have a negative cross elasticity of demand since the change in the price of one good and the demand for its complement move in opposite directions. If the goods are unrelated, they will show a cross elasticity of zero.
Companies can use cross-price elasticity to determine whether raising the price of one of their products will affect sales of another of their products.
Government can use it to determine whether to allow a proposed merger of two companies or not. If there is a high cross-price elasticity between the two companies’ products, the government will likely not allow the merger.
Consumption of a good can also be affected by a change in income. Income elasticity of demand is a measurement that reflects the percentage change in quantity demanded due to some percentage change in consumer income.
Most goods are normal goods that have a positive income elasticity, but the value of elasticity of income can vary widely among these goods. Consumers decrease their purchases of inferior goods when their income rises.
Those industries with products that are income elastic will expand at a higher rate as the economy grows.
Income elasticity helps us understand which products and industries will be most affected when household incomes fall during economic downturns.
This table summarizes many of the characteristics of cross-price elasticity and income elasticity.
This chart shows that the income elasticity of gasoline demand varies widely across countries and is larger in lower-income countries.
Some firms have “market power” or “pricing power” that allows them to set their product at prices that are in their best interests. For some goods and services, firms may find it advantageous to determine differences in price elasticity of demand and then charge different prices to different buyers.
Business air travelers have a more inelastic demand for air travel, so they are charged higher prices since they will pay it. Families are sensitive to prices, so firms will charge lower prices for children as a result of the more elastic demand.
Students from low income households are offered assistance with paying for college since they have a higher price elasticity of demand; students from higher income households will pay full price for their education unless they receive some type of merit-based scholarship.
