Elasticity and its Applications

Elasticity and its Applications

Elasticity and its Applications

• Learn the meaning of the elasticity of demand.

• Examine what determines the elasticity of demand.

• Learn the meaning of the elasticity of supply.

• Examine what determines the elasticity of supply.

• Apply the concept of elasticity in three different markets.

• Learn the meaning of the elasticity of demand.

• Examine what determines the elasticity of demand.

• Learn the meaning of the elasticity of supply.

• Examine what determines the elasticity of supply.

• Apply the concept of elasticity in three different markets.

In this chapter you will…In this chapter you will…

• … allows us to analyze supply and demand with greater precision.

• … is a measure of how much buyers and sellers respond to changes in market conditions

• … allows us to analyze supply and demand with greater precision.

• … is a measure of how much buyers and sellers respond to changes in market conditions

THE ELASTICITY OF DEMANDTHE 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.

• Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price.

• 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.

• Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price.

Price Elasticity of DemandPrice Elasticity of Demand

• Availability of Close Substitutes• Necessities versus Luxuries• Definition of the Market• Time Horizon

• Availability of Close Substitutes• Necessities versus Luxuries• Definition of the Market• Time Horizon

The Price Elasticity of Demand and Its The Price Elasticity of Demand and Its DeterminantsDeterminants

• Demand tends to be more elastic:– the larger the number of close

substitutes.– if the good is a luxury.– the more narrowly defined the market.– the longer the time period.

• Demand tends to be more elastic:– the larger the number of close

substitutes.– if the good is a luxury.– the more narrowly defined the market.– the longer the time period.

The Price Elasticity of Demand and Its The Price Elasticity of Demand and Its DeterminantsDeterminants

• The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price.

• The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price.

Computing the Price Elasticity of DemandComputing the Price Elasticity of Demand

Price elasticity of demand=Percentage change in quantity demanded

Percentage change in price

• The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change.

• point Method: A Better Way to Calculate Percentage Changes and Elasticities

• The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change.

• point Method: A Better Way to Calculate Percentage Changes and Elasticities

The Midpoint Method: A Better Way to The Midpoint Method: A Better Way to Calculate Percentage Changes and ElasticitiesCalculate Percentage Changes and Elasticities

(Q2 - Q1) / [(Q2 + Q1) / 2]

(P2 - P1) / [(P2 + P1) / 2]Price elasticity of demand =

• From Point A to Point B: Price rise = 50% and Quantity fall = 33%

• From Point B to Point A: Price fall = 33% and Quantity rise = 50%

• From Point A to Point B: Price rise = 50% and Quantity fall = 33%

• From Point B to Point A: Price fall = 33% and Quantity rise = 50%

The Midpoint Method: A Better Way to The Midpoint Method: A Better Way to Calculate Percentage Changes and ElasticitiesCalculate Percentage Changes and Elasticities

(80 - 120) / [(80 + 120)/ 2]

(6 - 4) / [(6 + 4)/ 2]Price elasticity of demand =

• Point A: Price = $4 Quantity = 120• Point B: Price = $6 Quantity = 80

• Point A: Price = $4 Quantity = 120• Point B: Price = $6 Quantity = 80

= 1Mid point method

• Inelastic Demand– Quantity demanded does not respond

strongly to price changes.– Price elasticity of demand is less than

one.• Elastic Demand

– Quantity demanded responds strongly to changes in price.

– Price elasticity of demand is greater than one.

• Inelastic Demand– Quantity demanded does not respond

strongly to price changes.– Price elasticity of demand is less than

one.• Elastic Demand

– Quantity demanded responds strongly to changes in price.

– Price elasticity of demand is greater than one.

A Variety of Demand CurvesA Variety of Demand Curves

• Perfectly Inelastic– Quantity demanded does not respond to

price changes.• Perfectly Elastic

– Quantity demanded changes infinitely with any change in price.

• Unit Elastic– Quantity demanded changes by the

same percentage as the price.

• Perfectly Inelastic– Quantity demanded does not respond to

price changes.• Perfectly Elastic

– Quantity demanded changes infinitely with any change in price.

• Unit Elastic– Quantity demanded changes by the

same percentage as the price.


• Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve.

• Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve.


E = 0

0 Quantity

Price Demand

100

1. An increase in price…

$4.00

$5.00

2. …leaves the quantity demanded unchanged.

Figure 5-1 a): Perfectly Inelastic DemandFigure 5-1 a): Perfectly Inelastic Demand

E < 1

0 Quantity

Price

100

1. A 22% increase in price…

$5.00

2. … Leads to a 11% decrease in quantity demanded.

Demand

$4.00

90

Figure 5-1 b): Inelastic DemandFigure 5-1 b): Inelastic Demand

E = 1

0 Quantity

Price

100


$5.00


Demand

$4.00

80

Figure 5-1 c): Unit Elastic DemandFigure 5-1 c): Unit Elastic Demand

E > 1

0 Quantity

Price

100


$5.00


Demand

$4.00

50

Figure 5-1 d): Elastic DemandFigure 5-1 d): Elastic Demand

E =

0Quantity

Price

2. At exactly $4, consumers will buy any quantity.

$4.00 Demand

1. At any price above $4, quantity demanded is zero.

3. At any price below $4, quantity demanded is infinite.

Figure 5-1 e): Perfectly Elastic DemandFigure 5-1 e): Perfectly Elastic Demand

• Total revenue is the amount paid by buyers and received by sellers of a good.

• Computed as the price of the good times the quantity sold.

TR = P x Q

• Total revenue is the amount paid by buyers and received by sellers of a good.

• Computed as the price of the good times the quantity sold.

TR = P x Q

Total Revenue and the Price Elasticity of Total Revenue and the Price Elasticity of DemandDemand

Price

Quantity0 100

Demand

P x Q = $400(revenue)

$4.00

Figure 5-2: Total RevenueFigure 5-2: Total Revenue

Price

Quantity0 80

Demand

$3.00

P x Q = $400(revenue)

P x Q = $100 (revenue)

$1.00

100

Figure 5-3: How Total Revenue Changes Figure 5-3: How Total Revenue Changes When Prices Changes: Inelastic DemandWhen Prices Changes: Inelastic Demand

Price

Quantity

Change in Total Revenue when Price Changes

0 50

Demand

$4.00

$5.00

20

Revenue = $100

Revenue = $200

Figure 5-4: How Total Revenue Changes Figure 5-4: How Total Revenue Changes When Prices Changes: Elastic DemandWhen Prices Changes: Elastic Demand

• With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases.

• With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases.

Elasticity and Total Revenue along a Linear Elasticity and Total Revenue along a Linear Demand CurveDemand Curve

Table 5-1. Elasticity and Total Revenue Table 5-1. Elasticity and Total Revenue along a Linear Demand Curvealong a Linear Demand Curve

Price

Quantity2 4 6 8 10 120

6

5

4

3

2

1

7

14

Elasticity is larger than 1.

Elasticity is smaller than 1.

Figure 5-5: A Linear Demand CurveFigure 5-5: A Linear Demand Curve

• Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income.

• It is computed as the percentage change in the quantity demanded divided by the percentage change in income.

• Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income.

• It is computed as the percentage change in the quantity demanded divided by the percentage change in income.

Other Demand ElasticitiesOther Demand Elasticities

In co m e e la stic ity o f d em an d =

P ercen tag e ch an g e in q u an tity d em an d ed

P ercen tag e ch an g e in in co m e

• Types of Goods– Normal Goods– Inferior Goods

• Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods.

• Types of Goods– Normal Goods– Inferior Goods

• Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods.


• Goods consumers regard as necessities tend to be income inelastic– Examples include food, fuel, clothing,

utilities, and medical services.• Goods consumers regard as luxuries tend

to be income elastic.– Examples include sports cars, furs, and

expensive foods.

• Goods consumers regard as necessities tend to be income inelastic– Examples include food, fuel, clothing,

utilities, and medical services.• Goods consumers regard as luxuries tend

to be income elastic.– Examples include sports cars, furs, and

expensive foods.


• Cross-Price elasticity of demand measures how much the quantity demanded of a good responds to a change in the price of another good.

• It is computed as the percentage change in the quantity demanded divided by the percentage change in the price of the second good.

• Cross-Price elasticity of demand measures how much the quantity demanded of a good responds to a change in the price of another good.

• It is computed as the percentage change in the quantity demanded divided by the percentage change in the price of the second good.


Income elasticity of demand =

Percentage change in quantity demandedPercentage change

in the price of good 2.

• 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.

• Price elasticity of supply is the percentage change in quantity supplied given a percent change in the price.

• 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.

• Price elasticity of supply is the percentage change in quantity supplied given a percent change in the price.

PRICE ELASTICITY OF SUPPLYPRICE ELASTICITY OF SUPPLY

• Ability of sellers to change the amount of the good they produce.– Beach-front land is inelastic.– Books, cars, or manufactured goods are

elastic.• Time period.

– Supply is more elastic in the long run.

• Ability of sellers to change the amount of the good they produce.– Beach-front land is inelastic.– Books, cars, or manufactured goods are

elastic.• Time period.

– Supply is more elastic in the long run.

The Price Elasticity of Supply and Its The Price Elasticity of Supply and Its DeterminantsDeterminants

• The price elasticity of supply is computed as the percentage change in the quantity supplied divided by the percentage change in price.

• The price elasticity of supply is computed as the percentage change in the quantity supplied divided by the percentage change in price.

Computing the Price Elasticity of SupplyComputing the Price Elasticity of Supply

P rice e las tic ity o f su p p ly =

P ercen tag e ch an g e in q u an tity su p p lied

P ercen tag e ch an g e in p rice

• … using the midpoint method, we calculate the percent change in the price as (2.10 - 1.90) / 2.00 x 100 = 10%

• Similarly, we calculate the percent change in the quantity supplied as (11 000 - 9000) / 10 000 x 100 = 20%

• … using the midpoint method, we calculate the percent change in the price as (2.10 - 1.90) / 2.00 x 100 = 10%

• Similarly, we calculate the percent change in the quantity supplied as (11 000 - 9000) / 10 000 x 100 = 20%

20%Price elasticity of supply =

• Suppose an increase in the price of milk from $1.90 to $2.10 a litre raises the amount that dairy farmers produce from 9000 to 11 000 L per month…

• Suppose an increase in the price of milk from $1.90 to $2.10 a litre raises the amount that dairy farmers produce from 9000 to 11 000 L per month…

= 2.0

Computing the Price Elasticity of SupplyComputing the Price Elasticity of Supply

10%

E = 0

0 Quantity

Price Supply

1. An increase in price…

$5.00

2. …leaves the quantity supplied unchanged.

100

$4.00

Figure 5-6 a): Perfectly Inelastic SupplyFigure 5-6 a): Perfectly Inelastic Supply

E < 0

0 Quantity

PriceSupply

100


$5.00

2. …leads to a 10% increase in quantity supplied.

$4.00

110

Figure 5-6 b): Inelastic SupplyFigure 5-6 b): Inelastic Supply

E = 1

0 Quantity

Price

Supply

100


$5.00


$4.00

125

Figure 5-6 c): Unit Elastic SupplyFigure 5-6 c): Unit Elastic Supply

E > 1

0 Quantity

Price

Supply

100


$5.00


$4.00

200

Figure 5-6 d): Elastic SupplyFigure 5-6 d): Elastic Supply

E =

0Quantity

Price

2. At exactly $4, producers will supply any quantity.

$4.00 Supply

1. At any price above $4, quantity supplied is infinite.

3. At any price below $4, quantity supplied is zero.

Figure 5-6 e): Perfectly Elastic SupplyFigure 5-6 e): Perfectly Elastic Supply

0Quantity

Price

$3

100

$4

200

$12

500

$15

525

Elasticity is greater than 1

Elasticity is less than 1

Figure 5-7: Figure 5-7: How the price elasticity of supply How the price elasticity of supply can varycan vary

• Good news bad news for farmers• OPEC• Drugs and crime

• Good news bad news for farmers• OPEC• Drugs and crime

THREE APPLICATIONS OF SUPPLY, THREE APPLICATIONS OF SUPPLY, DEMAND, AND ELASTICITYDEMAND, AND ELASTICITY

Increase in Supply

Demand

S1

$3

Quantity of Wheat

Price of Wheat

S2

2. … leads to a fall in price…

3. …and a proportionately smaller increase in quantity sold. As a result revenue falls from $300 to $220.

1. When demand is inelastic, an increase in supply…

110100

$2

Figure 5-8: Figure 5-8: An Increase in Supply in the An Increase in Supply in the Market for WheatMarket for Wheat

Demand

S1

Quantity of Oil

Price of Oil

S2

1. In the short run, when supply and demand are inelastic, a shift in supply…

2. … leads to a large increase in price…

P1

P2

Demand

S1

Quantity of Oil

S2

1. In the long run, when supply and demand are elastic, a shift in supply…

2. … leads to a small increase in price…

P1

P2

Price of Oil

(a) Oil Market in the Short Run (b) Oil Market in the Long Run

Figure 5-9: Figure 5-9: A Reduction in Supply in the A Reduction in Supply in the World Market for OilWorld Market for Oil

Demand

S1

Quantity of Drugs

Price of Drugs

S2

1. Drug interdiction reduces the supply of drugs…

2. … which raises the price…

P1

P2

D1

Supply

1. Drug education reduces the demand for drugs…

2. … which reduces the price…

(a) Drug Interdiction (b) Drug Education

Q1Q2

3. … and reduces the quantity sold.

Q2

3. … and reduces the quantity sold.

Quantity of Drugs

Price of Drugs

D2

P1

Q1

P2

Figure 5-10: Figure 5-10: Policies to Reduce the of Illegal Policies to Reduce the of Illegal DrugsDrugs

• Price elasticity of demand measures how much the quantity demanded responds to changes in the price.

• Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price.

• If a demand curve is elastic, total revenue falls when the price rises.

• If it is inelastic, total revenue rises as the price rises.

• Price elasticity of demand measures how much the quantity demanded responds to changes in the price.

• Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price.

• If a demand curve is elastic, total revenue falls when the price rises.

• If it is inelastic, total revenue rises as the price rises.

SummarySummary

• The income elasticity of demand measures how much the quantity demanded responds to changes in consumers’ income.

• The cross-price elasticity of demand measures how much the quantity demanded of one good responds to the price of another good.

• The price elasticity of supply measures how much the quantity supplied responds to changes in the price.

• The income elasticity of demand measures how much the quantity demanded responds to changes in consumers’ income.

• The cross-price elasticity of demand measures how much the quantity demanded of one good responds to the price of another good.

• The price elasticity of supply measures how much the quantity supplied responds to changes in the price.

SummarySummary

• In most markets, supply is more elastic in the long run than in the short run.

• The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price.

• The tools of supply and demand can be applied in many different types of markets.

• In most markets, supply is more elastic in the long run than in the short run.

• The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price.

• The tools of supply and demand can be applied in many different types of markets.

SummarySummary

The EndThe End

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Elasticity and its Applications