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Chapter 6Elasticity

Key Terms• price elasticity of

demand

• midpoint formula

• elastic demand• inelastic demand• unit elasticity• perfectly inelastic demand• perfectly elastic demand• total revenue (TR)• total-revenue test

• price elasticity of supply

• market period• short run• long run• cross elasticity of demand

• income elasticity of demand

• consumer surplus• producer surplus• efficiency losses (deadweight

losses)

6-2

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

LO1

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Ed =

Price Elasticity of Demand Formula• Formula for price elasticity of demand

percentage change in quantitydemanded of product X

percentage change in priceof product X

LO1

Price Elasticity of Demand Formula Continued• Use the midpoint formula• Ensures consistent results

Ed = ÷Change in quantitySum of quantities/2

Change in priceSum of prices/2

LO1

Price Elasticity of Demand Formula Concluded• Use percentages• Unit free measure• Compare elasticities across products

• Eliminate the minus sign• Easier to compare elasticities

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Interpretation of Elasticity of Demand• Ed > 1 demand is elastic• Ed = 1 demand is unit elastic• Ed < 1 demand is inelastic• Extreme cases• Ed = 0 demand is perfectly inelastic• Ed = ∞ demand is perfectly elastic

LO1

Extreme Cases

D1P

Perfectly inelastic demand

Perfectly inelastic demand(Ed = 0)

0

LO1

Extreme Cases Continued

Perfectly elastic demand

P

D2

Perfectly elasticdemand(Ed = ∞)

0

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Total Revenue Test

• Total Revenue = Price × Quantity• Total Revenue Test• Inelastic demand• P and TR move in the same direction

• Elastic demand• P and TR move in opposite directions

LO2

Total Revenue Test with Elastic Demand• Lower price and elastic demand• Blue gain exceeds yellow loss

$3

2

1

0 10 20 30 40 Q

P

a

bD1

LO2

Total Revenue Test with Inelastic Demand• Lower price and inelastic demand• Yellow loss exceeds blue gain

$4

3

2

1

0 10 20 Q

P

c

d

D2

LO2

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Total Revenue Test with Unit-Elastic Demand• Lower price and unit elastic demand• Blue gain equals yellow loss

$3

2

1

0 10 20 30 Q

P

e

f

D3

LO2

Total Revenue Test Continued

(1)Total Quantity of

Tickets Demandedper Week, Thousands

(2)Price per Ticket

(3)Elasticity

Coefficient (Ed)

(4)Total Revenue

(1) X (2)

(5)Total-Revenue

Test

12345678

$87654321

5.002.601.571.000.640.380.20

$ 8,00014,00018,00020,00020,00018,00014,000

8,000

ElasticElasticElastic

Unit-elasticInelasticInelasticInelastic

]]]]]]]

]]]]]]]

Price Elasticity of Demand for Movie Tickets as Measured by the Elasticity Coefficient and the Total Revenue Test

LO2

0 1 2 3 4 5 6 7 8

0 1 2 3 4 5 6 7 8

Quantity demanded

Quantity demanded

Pric

eTo

tal r

even

ue(T

hous

ands

of d

olla

rs) $20

18161412108642

$87654321

a

bc

de

fg

h

ElasticEd > 1

Unit elasticEd = 1

InelasticEd < 1

D

TR

LO2

Total Revenue Test Concluded

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Summary of Price Elasticity of Demand

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

Qd changes by a larger percentage than does price

Total Revenue decreases

Total Revenue increases

Equal to 1(Ed = 1)

Unit or unitary elastic

Qd 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

Qd changes by a smaller percentage than does price

Total revenue increases

Total revenue decreases

LO2

Determinants of Price Elasticity of Demand• Substitutability• More substitutes, demand is more

elastic• Proportion of income• Higher proportion of income, demand is

more elastic

LO3

Determinants of Price Elasticity of Demand Continued• Luxuries versus necessities• Luxury goods, demand is more elastic

• Time • More time available, demand is more

elastic

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Selected Price Elasticities of Demand

Selected Price Elasticities of Demand

Product or ServicePrice Elasticity of

Demand (Ed) Product or ServicePrice Elasticity of

Demand (Ed)

Newspapers .10 Milk .63

Electricity (household) .13 Household appliances .63

Bread .15 Liquor .70

MLB 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 .60 Fresh peas 2.83

LO3

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

LO3

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

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Price Elasticity of Supply Formula• Formula for price elasticity of supply

LO4

percentage change in quantitysupplied of product X

percentage change in priceof product X

Es =

Price Elasticity of Supply Continued• Es > 1 supply is elastic• Es = 1 supply is unit elastic• Es < 1 supply is inelastic• Additionally,• Es = 0 supply is perfectly inelastic

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Price Elasticity of Supply and Time• Time is primary determinant of elasticity

of supply• Time periods considered• Immediate market period• Short run• Long run

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The Immediate Market Period

• Perfectly inelastic supply

P

QD1

D2

Sm

Q0

Pm

P0

LO4

The Short Run

• Short run supply is more elastic than in the immediate market period

P

QD1

D2

Ss

Q0

Ps

P0

QsLO4

The Long Run

• Long run supply is even more elastic than in the short run

LO4

P

QD1

D2

SL

Q0

Pl

P0

Ql

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Applications of Elasticity of Supply• Antiques• Inelastic supply

• Reproductions• More elastic supply

• Volatile gold prices• Inelastic supply

LO4

Cross Elasticity of Demand

• Formula for cross elasticity of demand

Exy =

percentage change in quantity demanded of product X

percentage change in priceof product Y

LO5

Cross Elasticity of Demand Continued• Measures responsiveness of purchases of one

good to change in the price of another good• Substitute goods if elasticity is positive• Complement goods if elasticity is negative• Independent goods if elasticity is 0

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Cross Elasticity of Demand Concluded• Applications of cross elasticity of demand• Should a company change a price?• Should the government allow a merger?

LO5

Income Elasticity of Demand

• Formula for income elasticity of demand

LO5

Ei =percentage change in quantity demanded

percentage change in income

Income Elasticity of Demand Continued• Measures responsiveness of buyers to

changes in their income• Normal goods if elasticity is positive• Inferior goods if elasticity is negative

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Income Elasticity Insights

• High income elasticities• Most affected by a recession

• Low or negative income elasticity• Not affected that much by a recession

LO5

Cross and Income ElasticitiesCross and Income Elasticities of Demand

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

LO5

Elasticity and Pricing Power

• Charge different prices to different buyers based on price elasticities

• Business air travelers• Children discounts• College tuition