1. Chapter 5 Elasticity and its Application

2. What is Elasticity?
Measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants

3. Price Elasticity of Demand
Measure of how much quantity demanded responds to a change in price
Can be computed as % change in quantity demanded divided by % change in price

4. Determinants of Price Elasticity of Demand
Availability of Close Substitutes: More substitutes available, more elastic demand is
Necessities vs. Luxuries: Necessities are less elastic
Definition of the market: Narrowly defined are more elastic than broadly defined ones
Time Horizon: Goods tend to be more elastic over longer time periods

5. Let’s practice:
Put the following into its likely order from most elastic to least elastic:
Beef
Salt
European Vacation
Steak
New Honda Accord
Dijon mustard

6. Answers European Vacation New Honda Accord Steak Dijon Mustard Beef
Salt

7. Computing Price Elasticity of Demand
Formula is:
Price Elasticity of Demand =
% Change in Quantity Demanded
% Change in Price
So… if the price of of ice cream rises by 10% and quantity demanded falls by 20%
Price elasticity of demand = 2

8. Of the following, what will have the greatest elastic effect on demand?
Good A, which has few if any substitutes
Good A, which has many substitutes
Good A, which is seen as a necessity
Good A, which is defined very broadly (like market for soap)
None of the above

9. A 5 percent decrease in the price of good X leads to a 20 percent increase in the quantity demanded of Good X. The elasticity coefficient of demand is: 24 4
.25
2.25 1

10. Put the following in order from most elastic to least elastic:
Eggs
Rice
Beef
Mountain Dew
Healthcare
Housing
Restaurant Meals

11. Midpoint Method
The elasticity is calculated by going from one point to another on demand curve, which will be different at different parts on curve
So, you get around it using midpoint method
Price Elasticity of Demand =
(Q2 – Q1)/{(Q1+Q2)/2}
(P2 – P1)/{(P1+P2)/2}
Rarely, need to use this – big idea is that you use it to counteract differences in elasticities

12. Midpoint Method Example:
Calculate Price Elasticity of Demand if the price rises from $4 to $6 and the resulting quantity demanded falls from 120 to 80
Answer = 1

13. Variety of Demand Curves
Demand is elastic if elasticity is greater than 1
Demand is inelastic if elasticity is less than 1
Demand is unit elastic if elasticity is exactly 1

14. Rule of Thumb for Elasticity
Flatter the demand curve, the greater the price elasticity of demand
The steeper the curve, the smaller the price elasticity of demand

15. Special Cases
Perfectly Elastic Perfectly Inelastic

16. Of the following, which is not a factor that will determine elasticity of a good?
Percent of income spent on a good
How the market is defined
Time in which the market is viewed
Number of substitutes available
Change in income

17. If any change in price leads to no change in quantity demanded, then demand for this good:
Is relatively elastic
Is perfectly inelastic
Is relatively inelastic
Is perfectly elastic
The answer cannot be determined based on the information given

18. A good that may be perfectly inelastic is:
Toothpaste
Bottled Water
Pencils
Insulin
Granny Smith apples

19. Total Revenue
Total Revenue = Amount paid by buyers and received by sellers of the good (P x Q)
Rules about TR as it relates to Elasticity
When demand is inelastic, price & total revenue move in the same direction
When demand is elastic, price & total revenue move in opposite directions
If demand is unit elastic, total revenue remains constant as price changes

20. Linear Demand Curves
Slope is constant, but elasticity isn’t

21. Income Elasticity of Demand
Income Elasticity Demand =
% Change in Quantity Demanded
% Change in Income
Normal = positive income elasticity
Inferior = negative income elasticity
Necessities = small income elasticity
Luxuries = large income elasticity

22. Cross-Price Elasticity of Demand
Shows if goods are substitutes or complements
% Change in Quantity Demanded of Good 1
% Change in Price of Good 2
Substitutes = Positive Cross-Price Elasticity
Complements = Negative Cross-Price

23. Price Elasticity of Supply
% Change in Quantity Supplied
% Change in Price
Depends on flexibility of sellers to change the amount of the good they produce
Time period is key determinant (more elastic in long run)

24. Variety of Supply Curves
Flat supply curves show more elasticity; more vertical supply curve is more inelastic
Perfectly Inelastic = Vertical;
Perfectly Elastic = Horizontal