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Principles of MicroPrinciples of Micro
Chapter 5: “Elasticity and Its Application ”Chapter 5: “Elasticity and Its Application ”
by Tanya Molodtsova, Fall 2005
We Will Learn:We Will Learn: The Meaning of the Elasticity The Meaning of the Elasticity
of Demand and Supplyof Demand and Supply What Determines the What Determines the
Elasticity of Demand and Elasticity of Demand and SupplySupply
Elasticity:Elasticity:
1.1. allows us to analyze supply and allows us to analyze supply and demand with greater precision.demand with greater precision.
2.2. is a measure of how much buyers is a measure of how much buyers and sellers respond to changes in and sellers respond to changes in market conditionsmarket conditions
I. I. The Elasticity of DemandThe Elasticity of Demand price elasticity of demandprice elasticity of demand: a : a
measure of how much the measure of how much the quantity demanded of a good quantity demanded of a good responds to a change in the responds to a change in the price of that goodprice of that good
How much consumers are How much consumers are willing to move away from the willing to move away from the good when its price increases good when its price increases
It’s the percentage change in It’s the percentage change in quantity demanded divided quantity demanded divided by the percentage change in by the percentage change in price.price.
Determinants of Price Determinants of Price Elasticity of DemandElasticity of Demand
Availability of Close SubstitutesAvailability of Close Substitutes: : the more substitutes a good has, the more substitutes a good has, the more elastic its demand.the more elastic its demand.
Necessities versus LuxuriesNecessities versus Luxuries: : necessities are more price necessities are more price inelastic. inelastic.
Definition of the marketDefinition of the market: narrowly : narrowly defined markets (ice cream) have defined markets (ice cream) have more elastic demand than broadly more elastic demand than broadly defined markets (food).defined markets (food).
Time HorizonTime Horizon: goods tend to have : goods tend to have more elastic demand over longer more elastic demand over longer time horizons.time horizons.
Determinants of Price Determinants of Price Elasticity of DemandElasticity of Demand
Demand tends to be more elastic Demand tends to be more elastic (people can (people can move away from the move away from the
good when its price increases)good when its price increases)1.1. the larger the number of close the larger the number of close
substitutessubstitutes2.2. if the good is a luxuryif the good is a luxury3.3. the more narrowly defined the the more narrowly defined the
marketmarket4.4. the longer the time periodthe longer the time period
Computing the Price Computing the Price Elasticity of DemandElasticity of Demand
Price Elasticity of Demand =Price Elasticity of Demand =
% change in quantity demanded% change in quantity demanded
% change in price % change in price Example: Example: If the price of an ice cream If the price of an ice cream
cone increases from $2.00 to $2.20 cone increases from $2.00 to $2.20 and the amount you buy falls from 10 and the amount you buy falls from 10 to 8 cones, then your elasticity of to 8 cones, then your elasticity of demand would be calculated as:demand would be calculated as:
( )
( . . ).
1 0 81 0
1 0 0
2 2 0 2 0 02 0 0
1 0 0
2 0 %
1 0 %2
Computing the Price Computing the Price Elasticity of DemandElasticity of Demand
The Midpoint MethodThe Midpoint Method: A Better : A Better Way to Calculate % Changes and Way to Calculate % Changes and ElasticitiesElasticities
1.1. it gives the same answer it gives the same answer regardless of the direction of the regardless of the direction of the change.change.
2.2. The midpoint method involves The midpoint method involves calculating the % changes by calculating the % changes by dividing the change in the variable dividing the change in the variable by the midpoint between the by the midpoint between the initial and final levels rather than initial and final levels rather than by the initial level itself.by the initial level itself.
P rice e las tic ity o f d em an d =( ) / [( ) / ]
( ) / [( ) / ]
Q Q Q QP P P P2 1 2 1
2 1 2 1
2
2
Computing the Price Computing the Price Elasticity of DemandElasticity of Demand
Example: Example: If the price of an ice If the price of an ice cream cone increases from $2.00 cream cone increases from $2.00 to $2.20 and the amount you buy to $2.20 and the amount you buy falls from 10 to 8 cones, then your falls from 10 to 8 cones, then your elasticity of demand, using the elasticity of demand, using the midpoint formula, would be midpoint formula, would be calculated as:calculated as:
( )( ) /
( . . )( . . ) /
..
1 0 81 0 8 2
2 2 0 2 0 02 0 0 2 2 0 2
2 2 %
9 5 %2 3 2
The Variety of Demand The Variety of Demand CurvesCurves
Inelastic DemandInelastic Demand
- Quantity demanded does not - Quantity demanded does not respond strongly to price changes.respond strongly to price changes.
- Price elasticity of demand < 1- Price elasticity of demand < 1 Elastic DemandElastic Demand
- Quantity demanded responds - Quantity demanded responds strongly to changes in price.strongly to changes in price.
- Price elasticity of demand > 1- Price elasticity of demand > 1
Computing the Price Computing the Price Elasticity of DemandElasticity of Demand
Demand is price elastic
-3percent 22-percent 67
5.00)/2(4.005.00)-(4.00
50)/2(10050)-(100
ED
$5
4
Demand
Quantity1000 50
Price
The Variety of Demand The Variety of Demand CurvesCurves
Perfectly InelasticPerfectly Inelastic
- - Quantity demanded does not Quantity demanded does not respond to price changes at all.respond to price changes at all.
Perfectly ElasticPerfectly Elastic
- - Quantity demanded changes Quantity demanded changes infinitely with any change in price.infinitely with any change in price.
Unit ElasticUnit Elastic
- Quantity demanded changes by - Quantity demanded changes by the same percentage as the price.the same percentage as the price.
The Variety of Demand The Variety of Demand CurvesCurves
Because the price elasticity of Because the price elasticity of demand measures how much demand measures how much quantity demanded responds to quantity demanded responds to the price, it is closely related to the price, it is closely related to the slope of the demand curvethe slope of the demand curve..
Perfectly Inelastic Perfectly Inelastic Demand: Elasticity =0Demand: Elasticity =0
(a) Perfectly Inelastic Demand: Elasticity Equals 0
$5
4
Quantity
Demand
1000
1. Anincrease
in price . . .
2. . . . leaves the quantity demanded unchanged.
Price
Inelastic Demand: Elasticity Inelastic Demand: Elasticity < 1< 1
(b) Inelastic Demand: Elasticity Is Less Than 1
Quantity0
$5
90
Demand1. A 22%increasein price . . .
Price
2. . . . leads to an 11% decrease in quantity demanded.
4
100
Unit Elastic Demand: Unit Elastic Demand: Elasticity = 1Elasticity = 1
Copyright©2003 Southwestern/Thomson Learning
1. A 22%
increase
in price . . .
2. . . . leads to a 22% decrease in quantity demanded.
(c) Unit Elastic Demand: Elasticity Equals 1
Quantity
4
1000
Price
$5
80
Demand
Elastic Demand: Elasticity Elastic Demand: Elasticity > 1> 1
(d) Elastic Demand: Elasticity Is Greater Than 1
Demand
Quantity
4
1000
Price
$5
50
1. A 22%increasein price . . .
2. . . . leads to a 67% decrease in quantity demanded.
Perfectly Elastic Demand: Perfectly Elastic Demand: Elasticity = infinityElasticity = infinity
(e) Perfectly Elastic Demand: Elasticity Equals Infinity
Quantity0
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.
Total Revenue and the Total Revenue and the Price Elasticity of DemandPrice Elasticity of Demand total revenuetotal revenue: the amount : the amount
paid by buyers and received paid by buyers and received by sellers of a good by sellers of a good
computed as the price of computed as the price of the good times the quantity the good times the quantity sold.sold.
TR = P x QTR = P x Q
Total RevenueTotal Revenue
Demand
Quantity
Q
P
0
Price
P × Q = $400(revenue)
$4
100
Elasticity of Demand and Elasticity of Demand and Total RevenueTotal Revenue
If a demand curve is inelastic, If a demand curve is inelastic, an increase in price leads to a an increase in price leads to a decrease in quantity that is decrease in quantity that is proportionately smaller. proportionately smaller.
total revenue increases when total revenue increases when price rises price rises
How Total Revenue Changes How Total Revenue Changes When Price Increases: Inelastic When Price Increases: Inelastic DemandDemand
Demand
Quantity0
Price
Revenue = $100
Quantity0
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
Elasticity of Demand and Elasticity of Demand and Total RevenueTotal Revenue
If a demand curve is elastic, an If a demand curve is elastic, an increase in the price leads to a increase in the price leads to a decrease in quantity demanded decrease in quantity demanded that is proportionately larger.that is proportionately larger.
total revenue decreases when total revenue decreases when price increases.price increases.
How Total Revenue Changes How Total Revenue Changes When Price Increases: Elastic When Price Increases: Elastic DemandDemand
Demand
Quantity0
Price
Revenue = $200
$4
50
Demand
Quantity0
Price
Revenue = $100
$5
20
An Increase in price from $4 to $5 …
… leads to an decrease in total revenue from $200 to $100
Other Demand ElasticitiesOther Demand Elasticities
income elasticity of demandincome elasticity of demand: : a measure of how much the a measure of how much the quantity demanded of a quantity demanded of a good responds to a change good responds to a change in consumers’ income, in consumers’ income,
the percentage change in the percentage change in quantity demanded divided quantity demanded divided by the percentage change in by the percentage change in income.income.
Income ElasticityIncome Elasticity Income Elasticity of Demand =Income Elasticity of Demand = % change in quantity demanded% change in quantity demanded % change in income% change in income Types of GoodsTypes of Goods
Normal Goods: Income Elasticity > 0Normal Goods: Income Elasticity > 0 Inferior Goods: Income Elasticity < 0Inferior Goods: Income Elasticity < 0
Higher income raises the quantity Higher income raises the quantity demanded for normal goods but demanded for normal goods but lowers the quantity demanded for lowers the quantity demanded for inferior goodsinferior goods
Income ElasticityIncome Elasticity Goods consumers regard as Goods consumers regard as
necessities tend to be income necessities tend to be income inelasticinelastic Examples: food, fuel, clothing, Examples: food, fuel, clothing,
utilities, and medical services.utilities, and medical services. Goods consumers regard as Goods consumers regard as
luxuries tend to be income luxuries tend to be income elastic.elastic. Examples: sports cars, furs, and Examples: sports cars, furs, and
expensive foods.expensive foods.
Cross-Price ElasticityCross-Price Elasticity
cross-price elasticity of demandcross-price elasticity of demand: a : a measure of how much the quantity measure of how much the quantity demanded of one good responds to a demanded of one good responds to a change in the price of another good change in the price of another good
computed as the percentage change in computed as the percentage change in the quantity demanded of the 1st good the quantity demanded of the 1st good divided by the percentage change in the divided by the percentage change in the price of the 2nd good.price of the 2nd good.
Cross-Price Elasticity of Demand =Cross-Price Elasticity of Demand =
% change in quantity demanded of good 1% change in quantity demanded of good 1
% change in price of good 2% change in price of good 2
The Elasticity of SupplyThe Elasticity of Supply price elasticity of supplyprice elasticity of supply: a measure of : a measure of
how much the quantity supplied of a how much the quantity supplied of a good responds to a change in the price good responds to a change in the price of that good of that good
computed as the percentage change in computed as the percentage change in quantity supplied divided by the quantity supplied divided by the percentage change in price.percentage change in price.
Price Elasticity of Supply =Price Elasticity of Supply =
% change in quantity supplied% change in quantity supplied
% change in price% change in price
The Elasticity of SupplyThe Elasticity of Supply
Elastic Supply
Extreme CasesExtreme Cases
Determinants of Price Determinants of Price Elasticity of SupplyElasticity of Supply
Flexibility of sellers: goods Flexibility of sellers: goods that are somewhat fixed in that are somewhat fixed in supply (beachfront supply (beachfront property) have inelastic property) have inelastic supplies.supplies.
Time horizon: Time horizon: supply is more supply is more elastic in the long runelastic in the long run
The Elasticity of SupplyThe Elasticity of Supply ExampleExample: the price of milk : the price of milk
increases from $2.85 per gallon to increases from $2.85 per gallon to $3.15 per gallon and the quantity $3.15 per gallon and the quantity supplied rises from 9,000 to 11,000 supplied rises from 9,000 to 11,000 gallons per month. gallons per month.
% change in price = (3.15 – % change in price = (3.15 – 2.85)/3.00 × 100% = 10%2.85)/3.00 × 100% = 10%
% change in quantity supplied = % change in quantity supplied = (11,000 - 9,000)/10,000 × 100% = (11,000 - 9,000)/10,000 × 100% = 20%20%
Price elasticity of supply = Price elasticity of supply = (20%)/(10%) = 2(20%)/(10%) = 2
Three Applications of Three Applications of Supply, Demand, and Supply, Demand, and ElasticityElasticity
New hybrid of wheat is more New hybrid of wheat is more productive than those in the past. productive than those in the past. What happens?What happens?
Supply increases, price falls, and Supply increases, price falls, and quantity demanded rises.quantity demanded rises.
If demand is inelastic, the fall in If demand is inelastic, the fall in price is greater than the increase in price is greater than the increase in quantity demanded and total quantity demanded and total revenue falls.revenue falls.
If demand is elastic, the fall in price If demand is elastic, the fall in price is smaller than the rise in quantity is smaller than the rise in quantity demanded and total revenue rises.demanded and total revenue rises.
An Increase in Supply in the An Increase in Supply in the Market for WheatMarket for Wheat
Quantity ofWheat
0
Price ofWheat
3. . . . and a proportionately smallerincrease in quantity sold. As a result,revenue falls from $300 to $220.
Demand
S1 S2
2. . . . leadsto a large fallin price . . .
1. When demand is inelastic,an increase in supply . . .
2
110
$3
100
Compute the Price Elasticity Compute the Price Elasticity of Demandof Demand
ED
1 0 0 11 01 0 0 11 0 2
3 0 0 2 0 03 0 0 2 0 0 2
0 0 9 5
0 40 2 4
( ) /. .
( . . ) /
.
..
Supply is inelastic
Why Did OPEC Fail to Keep Why Did OPEC Fail to Keep the Price of Oil High?the Price of Oil High?
In the 1970s and 1980s, OPEC In the 1970s and 1980s, OPEC reduced the amount of oil it was reduced the amount of oil it was willing to supply to world markets. willing to supply to world markets. The decrease in supply led to an The decrease in supply led to an increase in the price of oil and a increase in the price of oil and a decrease in quantity demanded. decrease in quantity demanded. The increase in price was much The increase in price was much larger in the short run than the larger in the short run than the long run. Why?long run. Why?
The demand and supply of oil are The demand and supply of oil are much more inelastic in the short much more inelastic in the short run than the long run.run than the long run.
Short Run
Short Run Long Run
SummarySummary Price elasticity of demandPrice elasticity of demand measures measures
how much the quantity demanded how much the quantity demanded responds to changes in the price. responds to changes in the price.
It is calculated as the percentage It is calculated as the percentage change in quantity demanded divided change in quantity demanded divided by the percentage change in priceby the percentage change in price
If a demand curve is elastic, total If a demand curve is elastic, total revenue falls when the price rises.revenue falls when the price rises.
If it is inelastic, total revenue rises as If it is inelastic, total revenue rises as the price rises.the price rises.
SummarySummary The income elasticity of demandThe income elasticity of demand
measures how much the quantity measures how much the quantity demanded responds to changes in demanded responds to changes in consumers’ income.consumers’ income.
The cross-price elasticity of demandThe cross-price elasticity of demand measures how much the quantity measures how much the quantity demanded of one good responds to the demanded of one good responds to the price of another good.price of another good.
The price elasticity of supplyThe price elasticity of supply measures measures how much the quantity supplied how much the quantity supplied responds to changes in the price.responds to changes in the price.
SummarySummary In most markets, supply is more In most markets, supply is more
elastic in the long run than in the elastic in the long run than in the short run.short run.
The price elasticity of supply is The price elasticity of supply is calculated as the percentage calculated as the percentage change in quantity supplied change in quantity supplied divided by the percentage change divided by the percentage change in price.in price.
