Elasticity - A Measure of Response

Elasticity: A Measure of Response
Can anything be so elegant as to have
few wants, and to serve them one's self?
-Ralph Waldo Emerson
Slide 1 of 50

Eab
Ey
Ed
Es
Elasticity can measure numerous things
Each of these concepts refers to
how sensitive changes in one
variable are to changes in another
variable.
Elasticity of Demand
Elasticity of Supply
Cross Elasticity
Income Elasticity
We’ll use these symbols as shorthand
In this presentation, we’ll look at
four concepts related to elasticity.
They include:
Slide 2 of 50

So far, we have always looked at 45
degree demand curves
In reality, demand curves
can change in slope
depending on how sensitive
quantity demand is to price.
That sensitivity is referred to
as elasticity of demand!
Slide 3 of 50

A demand curve that is more
horizontal is referred to as ‘elastic’
P1
Qd1
P2
Qd2
That is typical of goods that have
very elastic demand.
Consumers are sensitive to price
changes. Even small
increases will scare away a
lot of customers.
Have you ever
changed travel dates or
destinations to save
money on vacation air
fare?
Probably so because
as a vacation air
traveler, you were
sensitive to price.
Consider this very
elastic demand
curve for example.
At a price of P1,
quantity demand is
Qd1.
Now imagine the
price of this good
goes up a little.
Look what happens
to the quantity
demand!
Small changes in
price result in big
changes in quantity
demanded
Examples of goods that have
elastic demand include:
Restaurant food
Vacation air travel
Luxury goods
Slide 4 of 50

Now consider
this very
inelastic demand
curve.
A demand curve that is more
vertical is referred to as ‘inelastic’
P1
Qd1
P2
Qd2
Examples:
Milk & Salt
Business air travel
Habit forming goods
Doctor/Medical Visits
Even big
changes in price
result in only
small changes in
quantity
demanded.
Consultants are business
air travelers. When they
book plane tickets, they
usually don’t care about
price. They want to be on
time for the meeting!
Slide 5 of 50

Real world example of an
inelastic price elasticity of demand
Every year, we seem to see
this outside of big box
stores.
People wait in line for days
for a particular product.
Clearly, these folks are not
sensitive to price.
If upon entering the store,
they found the price to be
higher, would they have
cared?
Based on this behavior, we’d probably classify
their demand as: ______________.Inelastic!
Slide 6 of 50

Price Elasticity of Demand- the
technical definition
Price elasticity of demand (also
simply called elasticity of demand) – The
rate of response of quantity demanded
due to a change in price.
It is commonly referred to as Ed (as it is
in this presentation) or eD (as it is in your
course reading material.
Slide 7 of 50

Price Elasticity of Demand- the
technical definition seen graphically
When we talk about price elasticity of demand,
we are asking how sensitive changes in
quantity demand are…
…to changes in price.
Slide 8 of 50

Individual exercises
1) Identify one item that you
routinely buy that you would be
willing to pay a lot more for if you
had to.
2) Now identify one item that you
would not buy if the price were to
go up even only a little.
Here are mine:
I am insensitive to the price of ESPN. If it doubled, I’d
still pay. My demand for ESPN is inelastic! Don’t tell
them that!
I like pineapples but they are $5 and they are a lot of work. I
only buy them on sale. I am very sensitive to price- my
demand for pineapples is very elastic!
Slide 9 of 50

Different elasticity of
demand scenarios
Unit ElasticElastic Inelastic
Note how the
horizontal demand
curve looks like the
middle flat part of
the “E” for elastic!
Note how the
vertical demand
curve looks like an
“I” for inelastic!
This means a one
unit change in price
(i.e. 1%) results in a
one unit change in
Quantity demand
(i.e. 1%)
Slide 10 of 50
We’ve reached a key learning outcome
here. We are applying the concept of
elasticity of demand to consumer
decisions.
When demand is very elastic, consumers
are quite sensitive to price. When it is
very inelastic, they care much less about
price…they are willing to pay more.

Why is this important?
Understanding elasticity is important for
economists because it lets us measure
what the impact that a price change had,
is having, or will have on the amount of
product that is demanded.
Let’s look at a case study on the next few
slides to see how this can be applied.
Slide 11 of 50

Case study: the Dulles Greenway
The Dulles Greenway
is a 14 mile road that
opened in 1995.
It allowed people to
avoid all the stoplights
on Route 7 as they
made their way into
Tyson’s Corner, the
nation’s tenth largest
employment center.
They thought people would be willing to pay a big
toll to avoid stoplights on alternate routes.
Slide 12 of 50

Elasticity of demand, misread
$1.75
The Bryant’s hired a consultant to
determine how much people would
be willing to pay to use the road. In
other words, they wanted to know
the price elasticity of demand for
this road!
The consultants estimated that the
demand curve would take the
following shape.
That meant that if the toll was set at
$1.75, about 30,000 cars would use
the toll road every day.
The owners determined that would
generate enough money to meet
their obligations…
In reality, the demand curve was
much more elastic.
At $1.75 per trip, full time use
would cost $910 per year.
People were sensitive to this price!
Instead of attracting 30,000 cars
per day, they attracted about
10,000.
At least at first, the roadway lost
money in what must have been a
painful learning experience about
elasticity of demand!
Slide 13 of 50

Factors that determine
elasticity of demand
• Availability of close substitutes
– Example: margarine and butter are close substitutes
so they are more elastic
• Necessity versus Luxury
– Doctor’s costs are not likely to respond as much to
price increases as the cost of 60” plasma TV
• Definition of Market
– Elasticity of demand for any market will depend on
how the market is defined. Broad definitions, such
as food will have fewer substitutes and will be more
inelastic. Conversely, snow peas, will have many
substitutes and will be more elastic.
• Time Horizon
– Goods tend to be more elastic over time as markets
adjust to changes in price
Slide 14 of 50

How can time
impact elasticity?
Typical car in 1960 Typical car just 12 years later
Weighed up to 5,000 pounds
35 MPG
10 MPG
Weighed only 2,600 pounds
We are seeing another broad and dramatic change in our
fleet now. A movement to electric and hybrid cars!
In the 1970s, the supply of
oil was reduced for a
number of reasons and on
a number of occasions.
At that time, what could we
do? Not much. We still
had to drive to work. So
we still bought gas. Our
demand for gas was
inelastic in the short run.
Over time, what could we
do? Change our behavior
so we demanded less gas.
Slide 15 of 50

Calculating elasticity of demand
If a small change in price
results in a big change in
quantity demand, then price
elasticity of demand for that
good is high - it is elastic!
-50%
+1%
= 50
If a BIG change in price
results in a SMALL change in
quantity demand, then price
elasticity of demand for that
good is low- it is INELASTIC!
-1%
+50%
= .02
Note: this ratio will always be negative.
For this first example, -50%/1% is
actually -50.
For this second example, -1%/50% is
actually -.02.
Since we know the sign will always be
negative, we ignore it.
Slide 16 of 50

Here are some possible price
elasticity of demand scenarios
Slide 17 of 50

Examples of some elasticity's for
selected goods
Source: Mackinac Center
for Public Policy
Slide 18 of 50

A closer look at the demand curve
Elasticity's differ at different points
along the demand curve
Slide 19 of 50

The demand schedule and curve
Let’s start with the demand
schedule and curve shown
here:
Slide 20 of 50

Calculating Elasticity
Assume price falls from $9 to $8, what is the
elasticity of demand?
• Step 1: Calculate the percent change in
Quantity Demanded (Qd)
– Quantity demanded increases from 1 to 2.
– The percent change in Qd = change/first or
1/1=100%
Price
– The price decreased by 1
– The percent change in price = change/first or
(-1)/9 or -11.1%
• Step 3: Calculate Elasticity
– Divide the percent change in Qd by the
percent change in price
– Ed = 100%/11% = 9
• Step 4: Interpret the results
– This is elastic! (it is greater than one)
Note: we dropped the negative
sign. Since the demand curve
represents a negative relationship,
this figure is always negative. The
negative sign is understood and is
therefore ignored!
Slide 21 of 50

elasticity?
1/2=50%
Price
(-1)/8 or -12.5%
– Ed = 50%/12.5% = 4
Slide 22 of 50

elasticity?
1/8=12.5%
Price
(-1)/2 or -50%
– Ed = 12.5%/50% = .25
– This is inelastic! (it is less than one)
Slide 23 of 50

Lets look more closely
at the demand curve
This portion of the demand curve
is elastic.
Slide 24 of 50

Lets look more closely at the demand curve
is inelastic.
Slide 25 of 50

Lets look more closely at the demand curve
is referred to as “Unit Elastic”. A
change in price results in an equal
percentage change in quantity
demanded.
Percent change in quantity demand = (6-5)/5 = 20%
Percent change in price = (4-5)/5 = 20%
20% / 20% = 1.0. This is unit elastic!
Slide 26 of 50

Note an annoying problem when
calculating Ed
• Elasticities will change in the same portion
of the demand curve depending on
whether prices are increasing or
decreasing
?
Slide 27 of 50

Calculating elasticity,
again
elasticity?
– Quantity demanded increases by 1.
1/1=100%
Price
– The price decreased by 1
(-1)/9 or -11.1%
– Ed = 100%/11% = 9
Note: We previously
determined that Ed is 9
Slide 28 of 50

Calculating Elasticity,
the other direction
Assume price rises from $8 to $9, what is the
elasticity?
– Quantity demanded decreases by 1.
(-1)/2=-50%
Price
– The price increased by 1
(1)/8 or 12.5%
– Ed = -50%/12.5% = 4
– This is elastic! (it is greater than one) Note: We now determine
that Ed is 4…along the
same part of the demand
curve!
Slide 29 of 50

Calculations of elasticity will change
depending on direction
We should be careful…
As we just saw a price decrease
from $9 to $8 gave us an Ed of
9…very elastic.
But an increase in price from $8 to
$9 gave us an Ed of 4…still elastic
but not as much as before.
Using the midpoint formula can
help solve this problem.
Slide 30 of 50

The midpoint formula
As you’ll probably note, the midpoint formula gets
around this problem by taking an average of
these starting points using the formula below.
Let’s try an example.
Slide 31 of 50

The midpoint formula
Regardless of direction, if price moved from
8 to 9 we could use the midpoint formula
to get Ed
• Step 1: Calculate the change in quantity
demanded divided by the average of the two
quantities Demanded (Qd)
– Change in Qd is 1.
– The average of the Qd’s is 1.5
– This ratio is 1/1.5 or 66.6%
• Step 2: Calculate the change in price
divided by the average of the two prices The
price increased by 1
– Change in P is 1.
– The average of the P’s is 8.5
– This ratio is 1/8.5 or 11.7%
– Divide the results from step one by the results
from step two
– Ed = 66.6%/11.7% = 5.7
Slide 32 of 50

WHEW!
• I know that the material related to calculating elasticity of
demand was heavy. In addition, having two
methodologies to calculate it that are closely related
makes it confusing.
• On a test, be prepared to calculate elasticity of demand
using either formula (you don’t need to know both).
Slide 33 of 50

Part II - Income Elasticity of Demand
Income Elasticity - A measure of how sensitive
quantity demand is to changes in income
It is commonly referred to as Ey
Normal Goods
(Like this steak)
Inferior Goods
(like this Spam?)
Income Elasticity
When we discuss income elasticity, we are
talking about normal versus inferior goods
Slide 34 of 50

Calculating Income Elasticity
Income Elasticity
Notice: as your income goes up,
you may demand more normal goods
Let’s assume your income increases by 10%
Let’s assume that in response, your demand for steaks increases by 10%
10%
10%
Ey would equal one (10%/10% = 1)
Slide 35 of 50

Calculating Income Elasticity
Income Elasticity
Notice: as your income goes up,
you may demand less inferior goods
Let’s assume your income increases by 10%
Let’s assume that in response, your demand for SPAM falls by 10%
10%
-10%
Ey would equal one (-10%/10% = -1)
Slide 36 of 50

Interpreting Income Elasticity
• If income elasticity of demand is greater
than zero, than goods are normal
– i.e., as you make more money, you demand
more of these goods
– Example: your income goes up so you buy
more clothes
• If income elasticity of demand is less
than zero, than goods are inferior
– i.e. as your income goes down, you buy more of
these goods
– Example: your income goes down so you buy
Raman noodles
Income Elasticity
Slide 37 of 50

Inferior goods…a subjective
classification
Keep in mind that your perceptions of normal and inferior
goods may differ. You may love Spam!
Some stores however specialize in the sale of what most
of us consider inferior goods. Can you name one?
Slide 38 of 50

Part III - Cross Elasticity of Demand
Cross Elasticity - A measure of how sensitive quantity demand is to
price changes for related goods
Commonly referred to as Ea,b
Cross Elasticity
For example, if the price of this goes up, do you buy more of this?
Slide 39 of 50

Calculating Cross Elasticity
Notice: as price of B (Pepsi) goes up,
you may demand more of A (Coke)
Cross Elasticity
Let’s assume Pepsi prices go up by 10%
Let’s assume that in response, demand for Coke increased by 10%
10%
10%
Ea,b would equal one (10%/10% = 1)
Slide 40 of 50

Interpreting Cross Elasticity (part 1)
• If cross elasticity of demand is greater
than zero, than goods are substitutes
– Example: Price of DVDs goes up so you
demand more Blu-ray Discs
Cross Elasticity of Blu-ray and DVDs
Price of DVDs increases 100%
Change in quantity of Blu-ray discs demanded increases 20%
Cross elasticity of demand = 20%/100% = +0.2
These goods are substitutes!
Cross Elasticity
Slide 41 of 50

Interpreting Cross Elasticity (part 2)
• If cross elasticity of demand is less than
zero, than goods are compliments
– Price of ketchup goes up so you demand
fewer french fries
Cross Elasticity of french fries and ketchup
Price of ketchup increases 300%
Change in quantity of french fries demanded decreases 10%
Cross elasticity of demand = -10%/300% = -0.03
These goods are compliments!
Cross Elasticity
Slide 42 of 50

Part IV – Elasticity of Supply
For this one,
Imagine that you
are a tomato
farmer….
Lastly, let’s turn to
the fourth and
final elasticity
Slide 43 of 50

First a definition: what is price
elasticity of supply
Price Elasticity of Supply (Es)- A measure of how
sensitive quantity supplied is to price
In other words, how do changes in price effect the
amount of a product (for you, that means tomatoes)
that suppliers will provide?
That depends a lot on the time.
Slide 44 of 50

What does “That depends a
lot on the time” mean?
We’ll analyze three time periods:
Market Period: a time where producers
are unable to change supply given a change in price.
In other words, right now.
Short run: a time horizon where plant capacity cannot be
changed but the intensity to which that capacity is used can be.
In other words, this season.
Long run: a time horizon where plant size can be
adjusted, firms can enter and exit market.
In other words, next season or beyond.
A plant is a physical
establishment that
performs one or more
functions in the
production of goods or
services. For you, the
tomato farmer, it is your
farm.
Slide 45 of 50

In the “market period”, there is
no time to change output
• In the market period: You’re truck
is loaded with tomatoes and you
are on the way to sell them. You
can either sell the tomatoes or let
them spoil.
• Supply is perfectly inelastic
Note how Qs does not change
regardless of price! The production
decision has been made and is
irreversible.
Qs
Slide 46 of 50

In the “short run”, output can be
changed a little
• Short run: you’ve planted the
crops. All you can do now is
perhaps adjust the fertilizers or
hire more crop pickers to
maximize your harvest.
• Supply is more elastic but is
still pretty inelastic
Note how Qs changes only slightly
with a change in price. The “plant” (or
farm) decision has been made and
only the intensity with which it is
worked can be altered.
QsQs2
Slide 47 of 50

In the “long run”, output can be
changed a lot
• Long run: You could buy more
land. You could alter crops to
more productive produce.
• Supply is more much elastic
Note how Qs changes significantly
with a change in price. The “plant” (or
farm) decision has not been made and
can be significantly altered.
Qs Qs2
That is what I mean by “the price
elasticity of supply has a lot to do with
time.”
Slide 48 of 50

Interpreting Elasticity of Supply
Market Period
Short run
Long run
Slide 49 of 50

In Summary
We’ve learned that an elasticity refers
to a sensitivity
We’ve studied four of those here –
elasticity to price, elasticity to income,
elasticity to prices of other goods, and
elasticity of supply.
These are important concepts,
particularly for a business owner
considering a change in price.
Depending on how sensitive
consumers are, price changes could
drastically change quantity demand!
Slide 50 of 50

Elasticity - A Measure of Response

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