This document defines and explains concepts related to elasticity, including: - Price elasticity of demand measures how quantity demanded responds to price changes. It depends on availability of substitutes, market definition, budget share, necessity vs luxury, and time horizon. - Total revenue increases with price increases for inelastic demand but decreases for elastic demand. - Income elasticity measures response of quantity demanded to income changes. Goods are normal, inferior, or luxuries. - Cross-price elasticity measures response of quantity demanded of one good to price changes of related goods, which can be substitutes or complements. - Price elasticity of supply measures response of quantity supplied to price changes and depends on flexibility and mobility

1. CHAPTER 5
Elasticity and Its Application

2. Learning Objectives
• Define price elasticity of demand
• Explain its determinants
• Understand how changes in price affect total revenue
• Relate total revenue to price elasticity of demand
• Define income elasticity and cross-price elasticity
• Normal vs. Inferior goods
• Substitute vs. Complement goods
• Define price elasticity of supply
• Explain its determinants
2

3. THE ELASTICITY OF DEMAND
• Price elasticity of demand is a measure of how much the
quantity demanded of a good responds to a change in the
price of that good.
• It captures how sensitive the quantity demanded (i.e.,
buyers behavior) is to changes in the price of a good.
3

4. Determinants of Price Elasticity of
Demand
Elasticity of demand depends on:
• Availability of Close Substitutes
• Definition of the Market
• Share in the budget
• Necessities versus Luxuries
• Time Horizon
4

5. Determinants of Price Elasticity of
Demand
Demand tends to be more elastic:
• the larger the number of close substitutes.
• Coca cola vs. Drinking water
• the more narrowly defined the market.
• Masafi vs. Drinking water
• the larger share in the (household) budget.
• Car vs. Salt
• the good is a luxury.
• Vacation in Bahamas vs. Business travel
• the longer the time period.
• Effects of a gasoline price change in two weeks vs. two years
5

6. Computing the Price Elasticity of Demand
• The price elasticity of demand is computed:
Price Elasticity of Demand =
Precentage change in quantity demanded
percentage change in price
𝐸𝐷
𝑝
=
∆𝑄
𝑄
∆𝑝
𝑝
=
𝑄2 − 𝑄1
𝑄1
𝑝2 − 𝑝1
𝑝1
=
𝑝
𝑄
∆𝑄
∆𝑝
=
𝑝
𝑄
× (𝑠𝑙𝑜𝑝𝑒)
• Note that (𝑠𝑙𝑜𝑝𝑒) is the slope of the demand curve. We need to use
the inverse of the slope or 1/𝑠𝑙𝑜𝑝𝑒 instead, if we use the slope of
the inverse demand curve.
6

7. Examples of Elasticity of Demand
7
Commodity Short-run LR* Justification
Green Peas 2.80 many close substitutes
Restaurant Meals 1.63 many close substitutes
Automobiles 1.35 2.2 lager budget share, some close sub.
- Chevrolets 4.0 narrow definition of the market
Movies 0.87 3.7 relatively small share of budget
Foreign Air Travel 0.77 2.4 no close substitute
Shoes 0.70 broad market definition, no close sub.
Coffee 0.25 no close substitute (addictive)
Opera & Theater 0.18
no close substitute and small budget
share for the interested group
* The long-run elasticities are from other sources than the textbook.

8. Computing the Price Elasticity of Demand
• Example: If the price of an ice cream cone increases from
$2.00 to $2.20 and the amount you buy falls from 10 to 8
cones, then your elasticity of demand is calculated as:
𝐸𝐷
𝑝
=
∆𝑄
𝑄
∆𝑝
𝑝
=
𝑄2 − 𝑄1
𝑄1
𝑝2 − 𝑝1
𝑝1
Price elasticity =
8 − 10
10
× 100
2.2 − 2
2
× 100
=
−20%
10%
= −2
8

9. Computing the Price Elasticity of Demand
• Undesirable property:
• Change from ($2.00, 10) to ($2.20, 8)
Price elasticity =
(8−10)/10
(2.2−2)/2
= -2.00
• Change from ($2.20, 8) to ($2.00, 10)
Price elasticity =
(10−8)/8
(2.0−2.2)/2.2
= -2.75
9

10. The Midpoint Method: A Better Way to
Calculate Elasticities
• The midpoint formula is preferable when calculating the
price elasticity of demand using discrete points because it
gives the same answer regardless of which point is used
as starting point.
Price elasticity of demand =
𝑄2 − 𝑄1
𝑄2 + 𝑄1 2
𝑝2 − 𝑝1
𝑝2 + 𝑝1 2
=
(𝑝1 + 𝑝2) 2
(𝑄1 + 𝑄2) 2
×
∆𝑄
∆𝑝
=
𝑝
𝑄
×
∆𝑄
∆𝑝
10

11. The Midpoint Method: A Better Way to
Calculate Elasticities
• Example: If the price of an ice cream cone increases from
$2.00 to $2.20 and the amount you buy falls from 10 to 8
cones, then your elasticity of demand, using the midpoint
formula, would be calculated as:
8 − 10
8 + 10 2
2.2 − 2
2.2 + 2 2
= −
22%
9.5%
= −2.32
11

12. The Variety of Demand Curves
• Perfectly Inelastic (𝐸𝐷
𝑝
= 0)
• Quantity demanded does not respond to price changes.
• Inelastic Demand (0 < 𝐸𝐷
𝑝
< 1)
• Quantity demanded does not respond strongly to price changes.
• Unit Elastic ( 𝐸𝐷
𝑝
= 1)
• Quantity demanded changes by the same percentage as the price.
• Elastic Demand (1 < 𝐸𝐷
𝑝
)
• Quantity demanded responds strongly to changes in price.
• Perfectly Elastic ( 𝐸𝐷
𝑝
= ∞ )
• Quantity demanded changes infinitely with any change in price.
12

13. Computing the Price Elasticity of Demand
13
Demand is price elastic.
$5
4
Demand
Quantity
100
0 50
Price 𝐸𝐷
𝑝
=
100 − 50
(100 + 50) 2
4 − 5
(4 + 5)/2
=
67%
−22%
= −3

14. Figure 1 The Price Elasticity of Demand
Copyright©2003 Southwestern/Thomson Learning
(a) Perfectly Inelastic Demand: Elasticity Equals 0
$5
4
Quantity
Demand
100
0
1. An
increase
in price . . .
2. . . . leaves the quantity demanded unchanged.
Price
14

15. Figure 1 The Price Elasticity of Demand
(b) Inelastic Demand: Elasticity Is Less Than 1
Quantity
0
$5
90
Demand
1. A 22%
increase
in price . . .
Price
2. . . . leads to an 11% decrease in quantity demanded.
4
100
15

16. Figure 1 The Price Elasticity of Demand
Copyright©2003 Southwestern/Thomson Learning
2. . . . leads to a 22% decrease in quantity demanded.
(c) Unit Elastic Demand: Elasticity Equals 1
Quantity
4
100
0
Price
$5
80
1. A 22%
increase
in price . . .
Demand
16

17. Figure 1 The Price Elasticity of Demand
(d) Elastic Demand: Elasticity Is Greater Than 1
Demand
Quantity
4
100
0
Price
$5
50
1. A 22%
increase
in price . . .
2. . . . leads to a 67% decrease in quantity demanded.
17

18. Figure 1 The Price Elasticity of Demand
(e) Perfectly Elastic Demand: Elasticity Equals Infinity
Quantity
0
Price
$4 Demand
2. At exactly $4,
consumers will
buy any quantity.
1. At any price
above $4, quantity
demanded is zero.
3. At a price below $4,
quantity demanded is infinite.
18

19. Price Elasticity of Linear Demand
Q
Price
4
8
2
4
E = -1
E = 0
E = -
Elastic
Inelastic
Demand Curve
𝑸 = 𝟖 − 𝟐𝑷
19

20. Price Elasticity of Linear Demand
• Using the linear demand curve equation, it is easy to
calculate the price elasticity of the demand.
• Demand curve is give by: 𝑄𝐷 = 8 − 2𝑃. Therefore, the
inverse demand curve is: 𝑃 = 4 − 𝑄𝐷/2.
• The slope of the demand curve is −2, and the slope of the inverse
demand curve is −1/2.
• Thus, the price elasticity of demand at 𝑃 = 2, 𝑄 = 4 is:
𝜀𝐷
𝑃
=
𝑃
𝑄
Δ𝑄
Δ𝑃
=
2
4
−2 = −1 (unit elastic)
• Similarly at 𝑃 = 1, the quantity is 𝑄𝐷 = 6, and elasticity is:
𝜀𝐷
𝑃
=
𝑃
𝑄
Δ𝑄
Δ𝑃
=
1
6
−2 = −0.33 (inelastic)
20

21. Total Revenue and Total Expenditure
• Total revenue (TR) is the amount paid by buyers and
received by sellers of a good. This is also shows the total
expenditure (TE) by consumers.
𝑇𝑅 = 𝑇𝐸 = 𝑃 × 𝑄
21

22. Figure 2 Total Revenue
Demand
Quantity
Q
P
0
Price
P × Q = $400
(revenue)
$4
100
22

23. Elasticity and Total Revenue along a
Linear Demand Curve
• With an inelastic demand curve, an increase in price
leads to
an increase in total revenue.
23

24. Figure 3 How Total Revenue Changes When Price Changes:
Inelastic Demand
Demand
Quantity
0
Price
Revenue = $100
Quantity
0
Price
Revenue = $240
Demand
$1
100
$3
80
An Increase in price from $1
to $3 …
… leads to an Increase in
total revenue from $100 to
$240
24

25. Elasticity and Total Revenue along a
Linear Demand Curve
• With an elastic demand curve, an increase in the price
leads to
a decrease in total revenue.
25

26. Figure 4 How Total Revenue Changes When Price Changes: Elastic
Demand
Demand
Quantity
0
Price
Revenue = $200
$4
50
Demand
Quantity
0
Price
Revenue = $100
$5
20
An Increase in price from $4
to $5 …
… leads to an decrease in
total revenue from $200 to
$100
26

27. Elasticity of a Linear Demand Curve
27

28. Elasticity of a Linear Demand Curve
28

29. Elasticity of a Linear Demand Curve
29

30. Price Changes and Total Expenditure
Changes
Price $12 $10 $8 $6 $4 $2 $0
Quantity 0 100 200 300 400 500 600
Expenditure $0 $1,000 $1,600 $1,800 $1,600 $1,000 $0
1,800
Price ($/ticket)
Total
expenditure
($/day)
2 6 10
1,600
1,000
12
Quantity (00s of tickets/day)
Price
($/ticket)
1 3 4 5 6
10
8
6
4
2
2
30

31. Elasticity and Total Revenue
• Thus, the total revenue in a market is maximized where
the price elasticity of the demand is -1 or the demand it
unit elastic.
31

32. Income Elasticity of Demand
• Income elasticity of demand measures how much the
quantity demanded of a good responds to a change in
consumers’ income.
Income Elasticity of Demand =
Precentage change in quantity demanded
Percentage change in Income
𝐸𝐷
𝐼
=
∆𝑄
𝑄
∆𝐼
𝐼
=
𝐼
𝑄
∆𝑄
∆𝐼
32

33. Income Elasticity
• Types of goods based on their income effects:
• Normal Goods
𝐼 ↑ 𝑄 ↑ or 𝐸𝐷
𝐼
> 0
• Inferior Goods
𝐼 ↑ 𝑄 ↓ or 𝐸𝐷
𝐼
< 0
33

34. Income Elasticity
• Even among the normal goods:
• Goods consumers regard as necessities tend to be
income inelastic.
0 < 𝐸𝐷
𝐼
< 1
• Examples include food, fuel, clothing, utilities, and medical services.
• Goods consumers regard as luxuries tend to be income
elastic.
1 < 𝐸𝐷
𝐼
• Examples include sports cars, furs, and expensive foods.
34

35. Cross-Price Elasticity of Demand
• Cross-Price Elasticity of Demand measures how much
the quantity demanded of a good responds to a change in
the price of another (related) good.
Cross Price Elasticity of Demand =
Precentage change in quantity demanded
Percentage change in price of related good
𝐸𝐷
𝑝𝑟
=
∆𝑄
𝑄
∆𝑝𝑟
𝑝𝑟
=
𝑝𝑟
𝑄
∆𝑄
∆𝑝𝑟
35

36. Cross-Price Elasticity of Demand
• Two Types of Goods
• Substitute Goods
𝑃𝑟 ↑ 𝑄 ↑ or 𝐸𝐷
𝑃𝑟
> 0
• Complement Goods
𝑃𝑟 ↑ 𝑄 ↓ or 𝐸𝐷
𝑃𝑟
< 0
36

37. THE ELASTICITY OF SUPPLY
• Price elasticity of supply is a measure of how much the
quantity supplied of a good responds to a change in the
price of that good.
• It captures how sensitive the quantity supplied (sellers
behavior) is to changes in the price of a good.
37

38. Determinants of Price Elasticity of Supply
• The main factor in determining elasticity of supply is the
ability of sellers to change the amount of the good they
produce and sell. In other words, the elasticity of supply
captures the flexibility of production.
• Land is inelastic because there is no flexibility in supply more land.
• Books, cars, and other manufactured goods are, however, elastic.
• Flexibility of Inputs
• Lemonade (low skilled workers) vs. houses (land is inflexible)
• Mobility of Inputs
• Wheat (farm workers are mobile) vs. houses (land is immobile)
• Substitutability of Inputs
• Diamond Jewelry vs. eye glasses or cultivated land vs. fences
• Time horizon: Supply is more elastic in the long run
• Apartment units in the next 6 months vs. in the next 5 years
38

39. Computing the Price Elasticity of Supply
• The price elasticity of supply is computed:
Price elasticity of supply =
Precentage change in quantity supplied
percentage change in price
𝐸𝑆
𝑝
=
∆𝑄
𝑄
∆𝑝
𝑝
=
𝑝
𝑄
∆𝑄
∆𝑝
=
𝑝
𝑄
× (𝑠𝑙𝑜𝑝𝑒)
• Note that (𝑠𝑙𝑜𝑝𝑒) is the slope of the supply curve. We need to use the
inverse of the slope or (1 𝑠𝑙𝑜𝑝𝑒) instead, if we use the slope of the
inverse supply curve.
39

40. Figure 6 The Price Elasticity of Supply
(a) Perfectly Inelastic Supply: Elasticity Equals 0
$5
4
Supply
Quantity
100
0
1. An
increase
in price . . .
2. . . . leaves the quantity supplied unchanged.
Price
40

41. Figure 6 The Price Elasticity of Supply
(b) Inelastic Supply: Elasticity Is Less Than 1
110
$5
100
4
Quantity
0
1. A 22%
increase
in price . . .
Price
2. . . . leads to a 9.5% increase in quantity supplied.
Supply
41

42. Figure 6 The Price Elasticity of Supply
(c) Unit Elastic Supply: Elasticity Equals 1
125
$5
100
4
Quantity
0
Price
2. . . . leads to a 22% increase in quantity supplied.
1. A 22%
increase
in price . . .
Supply
42

43. Figure 6 The Price Elasticity of Supply
(d) Elastic Supply: Elasticity Is Greater Than 1
Quantity
0
Price
1. A 22%
increase
in price . . .
2. . . . leads to a 67% increase in quantity supplied.
4
100
$5
200
Supply
43

44. Figure 6 The Price Elasticity of Supply
(e) Perfectly Elastic Supply: Elasticity Equals Infinity
Quantity
0
Price
$4 Supply
3. At a price below $4,
quantity supplied is zero.
2. At exactly $4,
producers will
supply any quantity.
1. At any price
above $4, quantity
supplied is infinite.
44

45. How the Price Elasticity of Supply Can Vary
45

46. Applications
Can Good News for Farming Be Bad News for
Farmers?
• New hybrid of wheat – increase production per acre by
20%
• Supply curve shifts to the right
• Higher quantity and lower price
• Demand is inelastic: total revenue falls!
• Paradox of public policy
• Induce farmers not to plant crops
46

47. An Increase in Supply in the Market for Wheat
47