05priceelasticityofdemandandsupply 121124221008-phpapp01

Chapter 5
Price Elasticity of
Demand and Supply
• Key Concepts
• Summary
• Practice Quiz
• Internet Exercises
©2000 South-Western College Publishing

2
In this chapter, you will
learn to solve these
economic puzzles:
Can total revenue from a Steel
Porcupines concert remain
unchanged, regardless of
changes in the ticket price?
How sensitive is the
quantity of cigarettes
demanded to changes in
the price of cigarettes?
What happens to the sales of
Mercedes, BMW’s and Jaguars
in the U.S. if Congress prevents
sales of luxury Japanese cars in
this country?

3
How is the percent
increase or decrease of
two numbers calculated?
Percent change is the
difference between the
two numbers divided by
the original number

4
Suppose the price of a
rock concert increases
by 10%, what effect will
this have on sales?
That all depends on the
price elasticity of demand
for this rock concert

5
What is Elasticity?
A term economists use to
describe responsiveness,
or sensitivity, to a
change in price

6
What is Price
Elasticity of Demand?
The ratio of the percentage
change in the quantity
demanded of a product to a
percentage change in its
price

7
% ∆ in Q demanded
% ∆ in price
Ed =
Price Elasticity of Demand

8
Supposing a university’s
enrollment drops by 20%
because tuition rises by
10%, what is the Price

9
Ed=
-20%
+10%
=
-.20
+.10
= 2

10
Why is Elasticity 2 in
the previous example
and not -2?
Economists drop the negative
sign because we know from
the law of demand that
quantity demanded and
price are inversely related

11
If there is an increase
from 3 units to 5, what is
the percentage increase?
2/3 = 66%

12
If there is a decrease
from 5 units to 3, what is
the percentage decrease?
2/5 = 40%

13
Problem - When we
move along a demand curve
between two points, we get
different answers to elasticity
depending on whether we are
moving up or down the
demand curve

15
Economists can solve this
problem of different base points
by using the midpoints as the
base points of changes in prices
and quantity demanded

16
∆ in quantity demanded
sum of quantities/2
divided by
∆ in price
sum of prices/2
Price elasticity equals the

17
What is Elastic Demand?
A condition in which the
percentage change in
quantity demanded is
greater than the percentage
change in price

18
$40
$30
$20
$10
10 20 30 40
A
B
Elastic Demand Ed > 1
P
Q

19
Why is the Demand
curve in the previous
slide Elastic?
The percentage change in
the quantity demanded is
greater than the
percentage change in price

20
Price decrease
Increase in total
revenue
Elastic Demand

21
10
15
= .66% change in Q =
% change in P = 10
25
= .40
Ed = % change in Q
% change in P
=
.66
.40
Ed = 1.65

22
$40
$30
$20
$10
10 20 30 40
A
B
Inelastic Demand Ed < 1

23
Why is the Demand
curve in the previous
slide Inelastic?
less than the percentage
change in price

24
Price decrease
Decrease in
total revenue
Inelastic Demand

25
5
13
= .38% change in Q =
% change in P =
10
25
= .40
Ed =
% change in Q
% change in P =
.38
.40

26
What is a Unitary
Elastic Demand Curve?
equal to the percentage
change in price

27
$40
$30
$20
$10
10 20 30 40
E
F
Unitary Elastic Demand Ed = 1
D

28
Price decrease
No change in
total revenue
Unitary Elastic Demand

29
What is a Perfectly
Elastic Demand Curve?
A condition in which a
small percentage
change in price brings
about an infinite
percentage change in
the quantity demanded

30
$40
$30
$20
$10
10 20 30 40
Perfectly Elastic Demand Ed =
8

31
Price change
Infinite change in
quantity demanded
Perfectly Elastic Demand

32
What is a Perfectly
Inelastic Demand Curve?
A condition in which the
quantity demanded
does not change as the
price changes

33
$40
$30
$20
$10
10 20 30 40
Perfectly Inelastic Demand Ed = 0

34
Price change
Zero change in
quantity demanded
Perfectly Inelastic Demand

35
If demand is elastic -
total revenue goes down
If demand is inelastic -
total revenue goes up
If a college raises tuition,
what happens to revenue?

36
If price increases and the
revenue gained is greater
than the revenue lost, the
demand curve is price
inelastic, < 1

37
If price increases and
the revenue gained is
less than the revenue
lost, the demand curve
is price elastic, > 1

38
If total revenue does
not change when
price increases, the
demand curve is
unitary elastic,
value equals 1

39
$20
$15
$10
$5
5 10 15 20
$25
$30
$35
$40
25 30 35 40 45
Price Elasticity of
Demand RangesElastic
Inelastic
Unitary
elastic

40
$200
$150
$100
$50
5 10 15 20
$250
$300
$350
$400
25 30 35 40 45
Total Revenue Curve
Elastic
Inelastic
Unitary
Elastic

41
What factors influence
Demand sensitivity?
•Availability of substitutes
•Share of budget on the
product
•Adjustment to a price
change over time

42
What do Substitutes have
to do with a price change?
The more substitutes a
product has, the more
sensitive consumers are to a
price change, and the more
elastic the demand curve

43
P
Q0
P
Q0
A B
D D
Which demand curve is for a vital
medicine and which is for candy?

44
Why is A the Demand
Curve for medicine?
Because medicine is a
necessity with few
substitutes, and the
price can change with
little effect on the
quantity demanded

45
Why is B the Demand
curve for candy?
Because candy has many
substitutes, a price
change can bring about a
big change in the
quantity demanded

46
What does the Share of
One’s Budget have to do
with a price change?
The larger the purchase is to
one’s budget, the more
sensitive consumers are to a

47
What does Time have to
do with sensitivity?
The longer consumers have
to adjust, the more
sensitive they are to a

48
What are other
Elasticity measures?
Income elasticity of demand
Cross-elasticity of demand

49
What is Income
demanded of a good to a
given percentage change
in income

50
% ∆ in Q demanded
% ∆ in incomeEd =
Income Elasticity of Demand

51
What is Cross-elasticity
of Demand?
change in quantity
demanded of a good to a
given percentage change
in price of another good

52
% ∆ Q demanded of good A
% ∆ price of good BEc =
Cross-elasticity of Demand

53
What is the Price
Elasticity of Supply?
supplied of a product to
the percentage change in
its price

54
% ∆ in Q supplied
% ∆ in priceEs =
Price Elasticity of Supply

55
$40
$30
$20
$10
10 20 30 40
Perfectly Elastic Supply =
8

56
$40
$30
$20
$10
10 20 30 40
Perfectly Inelastic Supply Es = 0

57
$40
$30
$20
$10
10 20 30 40
Unit Elastic Supply Es = 1
S
.5%
.5%

58
Who pays the tax levied
on sellers of goods such
as gasoline, cigarettes,
and alcoholic beverages?
It all depends; the
corporation pays all, some,
or very little of the tax

59
What decides who
pays what part of the
tax increase?
The more elastic the
demand, the more the
corporation pays; the less
elastic the demand, the
more the consumer pays

60
$1.00
$.75
$.50
$.25
5 10 15 20
$1.25
$1.50
$1.75
$2.00
25 30 35 40 45
s1
s2
D
Buyers
Sellers
Partially shifted tax to buyers

61
Increase in
gasoline tax
Decrease in
supply
Consumers and
suppliers share
burden of tax

62
$1.00
$.75
$.50
$.25
5 10 15 20
$1.25
$1.50
$1.75
$2.00
25 3035 40 45
s1
s2
D
Buyers
Fully shifted tax to buyers

63
Increase in
gasoline tax
Decrease in
supply
Consumers bear
full burden of tax

65
Key Concepts
• What is Elasticity?
• What is Price Elasticity of Demand?
• What is Elastic Demand?
• What is a Unitary Elastic Demand Curve?
• What is a Perfectly Elastic Demand
Curve?
• What is a Perfectly Inelastic Demand
Curve?

66
Key Concepts cont.
• What factors influence Demand
sensitivity?
• What are other Elasticity measures?
• What is Income Elasticity of Demand?
• What is Cross-elasticity of Demand?
• What is the Price Elasticity of Supply?

68
Price elasticity of demand is a
measure of the responsiveness of the
quantity demanded to a change in price.
Specifically, price elasticity of demand
is the ratio of the percentage change in
quantity demanded to the percentage
change in price.

69
% ∆ in Q demanded
% ∆ in price
Ed =
Price Elasticity of Demand

70
What is the midpoint formula for
the price elasticity of demand?

71
∆ in quantity demanded
sum of quantities/2
divided by
∆ in price
sum of prices/2
Price elasticity equals the

72
Elastic demand is a change of
more than one percent in quantity
demanded in response to a one percent
change in price. Demand is elastic
when the elasticity coefficient is greater
than one and total revenue (price time
quantity) varies inversely with the
direction of the price change.

73
$40
$30
$20
$10
10 20 30 40
Elastic Demand

74
Inelastic demand is a change of
less than one percent in quantity
demanded in response to a one
percent change in price. Demand is
inelastic when the elasticity
coefficient is less than one and total
revenue varies directly with the
direction of the price change.

75
$40
$30
$20
$10
10 20 30 40
Inelastic Demand

76
Unitary elastic demand is a one
percent change in quantity demanded in
response to a one percent change in
price. Demand is unitary elastic when
the elasticity coefficient equals one and
total revenue remains constant as the
price changes.

77
$40
$30
$20
$10
10 20 30 40
Unitary elastic Demand

78
Perfectly elastic demand is a
decline in quantity demanded to zero
for even the slightest rise or fall in
price. This is an extreme case in which
the demand curve is horizontal and the
elasticity coefficient equals infinity.

79
$40
$30
$20
$10
10 20 30 40
Perfectly Elastic Supply =
8

80
Perfectly inelastic demand is no
change quantity demanded in response
to price changes. This is an extreme
case in which the the demand curve is
vertical and the elasticity coefficient
equals zero.

81
$40
$30
$20
$10
10 20 30 40
Perfectly Inelastic Supply Es = 0

82
Determinants of price elasticity of
demand include (a) the availability of
substitutes, (b) the percentage of
budget spent on the product, and (c) the
length of time allowed for adjustment.
Each of these factors is directly related
to the elasticity coefficient.

83
Income elasticity of demand is the
percentage change in quantity
demanded divided by the percentage
change in income. For a normal good
or service, income elasticity of demand
is positive. For an inferior good or
service, income elasticity of demand is
negative.

84
Cross elasticity of demand is the
percentage change in the quantity
demanded of one product caused by a
change in the price of another product.
When the cross-elasticity of demand is
negative, the two products are
complements.

85
Price elasticity of supply is a
measure of the responsiveness of the
quantity demanded to a change in
price. Price elasticity of supply is the
ratio of the percentage change in
quantity supplied to the percentage
change in price.

86
Tax incidence is the share of a
tax ultimately paid by buyers and
sellers. Facing a downward-sloping
demand curve and an upward-
sloping supply curve, sellers cannot
raise the price by the full amount of
the tax. If the demand curve is
vertical, sellers will raise the price
by the full amount of a tax.

87
$1.00
$.75
$.50
$.25
5 10 15 20
$1.25
$1.50
$1.75
$2.00
25 3035 40 45
s1
s2
D
Buyers
Fully shifted tax to buyers

88
$1.00
$.75
$.50
$.25
5 10 15 20
$1.25
$1.50
$1.75
$2.00
25 30 35 40 45
s1
s2
D
Buyers
Sellers
Partially shifted tax to buyers

90
1. If an increase in bus fares in Charlotte, North
Carolina reduces total revenue of the public
transit system, this is evidence that demand is
a. price elastic.
b. price inelastic
c. unitary elastic
d. perfectly elastic
A. When price increases and the total revenue
decreases, by definition, this represents an
elastic demand curve. The revenue lost from
selling fewer units is not offset by the revenue
gained by charging a higher price.

91
2. Which of the following is the result of an
increase in total revenue?
a. Price increases when demand is elastic.
b. Price decreases when demand is elastic.
c. Price increases when demand is unitary
elastic.
d. Price decreases when demand is inelastic.
B. When price decreases and the total
revenue increases, the revenue gained by
the increase in sales more than offsets the
revenue lost from the lower price. By
definition, this represents an elastic
demand curve.

92
3. You are on a committee that is considering
ways to raise money for your city’s
symphony program. You would recommend
increasing the price of symphony tickets only
if you thought the demand curve for these
tickets was
a. inelastic.
b. elastic.
c. unitary elastic.
d. perfectly elastic.
A. When the demand curve is inelastic, the
revenue gained from the higher price more
than offsets the revenue lost from the decline
in sales.

93
4. The price elasticity of demand for a
horizontal demand curve is
a. perfectly elastic.
b. perfectly inelastic.
c. unitary elastic.
d. inelastic.
e. elastic.A. A perfectly elastic demand curve exists
when any increase in price leads to zero
sales. The only curve that would illustrate
this would be a horizontal line at the
beginning price.

94
5. Suppose the quantity of steak purchased by
the Jones family is 110 pounds per year
when the price is $2.10 per pound and 90
pounds per year when the price is $3.90 per
pound. The price elasticity of demand
coefficient for this family is
a. 0.33.
b. 0.50.
c. 1.00.
d. 2.00.
A. 20/100 divided by $1.80/$6.00 = .33

95
6. If a 5 percent reduction in the price of a
good produces a 3 percent increase in the
quantity demanded, the price elasticity of
demand over this range of the demand
curve is
a. elastic.
b. perfectly elastic.
c. unitary elastic.
d. inelastic.
e. perfectly inelastic.
D. Since the percentage change in quantity
demanded is less than the percentage change
in price, this range is defined inelastic

96
7. A manufacturer of Beanie Babies hires an
economist to study the price elasticity of
demand for this product. The economist
estimates that the price elasticity of demand
coefficient for a range of prices close to the
selling price is greater than 1. The
relationship between changes in price and
quantity demanded for this segment of the
demand curve is
a. elastic. e. unitary elastic.
b. inelastic.
c. perfectly elastic.
d. perfectly inelastic.
A. Elasticity > 1 = elastic demand

97
8. A downward-sloping demand curve will have a
a. higher price elasticity of demand coefficient
along the top of the demand curve.
b. lower price elasticity coefficient along the
top of the demand curve.
c. constant price elasticity of demand
coefficient throughout the length of the
demand curve.
d. positive slope.
A. The quantity demanded by consumers is
more sensitive to a price change at higher
prices than at lower prices.

98
9. The price elasticity of demand coefficient for
a good will be less
a. if there are few or no substitutes available.
b. if a small portion of the budget will be
spent on it.
c. in the short run than in the long run.
d. all of the above are true.
D. A low elasticity of demand means that
there is a low sensitivity to a change in
price. When the good has few substitutes,
or the purchase represents a small portion
of one’s budget, or they do not have much
time to adjust to the price change, price
elasticity of demand is inelastic.

99
10. The income elasticity of demand for shoes is
estimated to be 1.50. We can conclude that
shoes
a. have a relatively steep demand curve.
b. have a relatively flat demand curve.
c. are a normal good.
d. are an inferior good.
C. If the income elasticity coefficient is a
positive number, then the good or service
is a normal good.

100
11. To determine whether two goods are
substitutes or complements, an economist
would estimate the
a. price elasticity of demand.
b. income elasticity of demand.
c. cross-elasticity of demand.
d. price elasticity of supply.
C. Cross-elasticity of demand shows what
will happen to the demand for one good if
the price of a complementary good, or a
good that is a substitute, changes.

101
12. If the government wanted to raise tax revenue
and shift most of the tax burden to the sellers, it
would impose a tax on a good with a
a. steep (inelastic) demand curve and a steep
(inelastic) supply curve.
b. steep (inelastic) demand curve and a flat
(elastic) supply curve.
c. flat (elastic) demand curve and a steep
(inelastic) supply curve.
d. flat (elastic) demand curve and a flat (elastic)
supply curve.
C. An elastic demand curve would mean that a
leftward shift in the supply curve would lead
to a big decrease in quantity demanded and
little change in price, so the business would
lose total revenue.

102
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