1. Elasticity and Its Applications
Chapter 5
Elasticity and Its Applications 1

2. QUESTION
You have just been hired by Crayola Crayon. The company would like to increase its revenue. The CEO comes to you for advice. She wants to know if the company should lower product prices or raise product prices to increase total revenue. What do you advise?

3. Elasticity . . .
… is a measure of how much buyers and sellers respond to changes in market conditions. . .
… means responsiveness. 2

4. Price Elasticity of Demand
The percentage (%) change in Quantity Demanded . . .
. . . given a percentage change in Price. 3

5. Three Types of Elasticities. . .
Price
Price Elasticity of Demand
Income Elasticity
Price Elasticity of Supply
Quantity 4

6. Price Elasticity of Demand
The percentage change in the quantity demanded given. . .
. . . a percentage change in the price. A B Q 5

7. Ranges of Elasticity . . . (Figure 5-1)
Perfectly Inelastic Consumers are “totally unresponsive” to price changes.
Perfectly Elastic Consumers are “totally responsive” to price changes.
Unit Elastic Response is “equal to” change in price. 6

8. Determinants of Price Elasticity of Demand
Demand tends to be more elastic:
if the good is a luxury;
the longer the time period;
the greater the number of close substitutes; and
the more narrowly defined the market. 8

9. Determinants of Price Elasticity of Demand
Demand tends to be more inelastic:
if the good is a necessity;
the shorter the adjustment time;
if there are few good substitutes; and
the more broadly defined the market. 9

10. Computing Elasticity Coefficient
Percentage Change in
Quantity Demanded
Price Elasticity
of Demand =
Percentage Change
in Price
Computed as the percentage change in the quantity demanded divided by the percentage change in price. 10

11. Computing Elasticity Coefficient Midpoint Formula
Demand for
Ice Cream ED =
Change in QD / avg Q
2.20
Change in P / avg P
2.00 8 10 11

12. Computing Elasticity Coefficient
Demand for
Ice Cream ED =
(8-10) / (8+10) / 2
2.20
( ) / ( )/2
2.00 8 10 11

13. Computing Elasticity Coefficient
Demand for
Ice Cream
Demand is Elastic ED
2.33
2.20 =
2.00 8 10 14

14. Elasticity and Linear Demand Curves
Elasticity varies over Price ranges on the same linear demand curve.

15. Elasticity and Total Revenue
Over the Elastic Range of
prices and quantity
the relationship between price and total revenue is
INDIRECT or OPPOSITE 15

16. Elasticity and Total Revenue
ED > 1 then P Q TR
and 16

17. Elasticity and Total Revenue
Over the Inelastic Range of prices and quantity
the relationship between price and total revenue is
DIRECT or THE SAME 17

18. Elasticity and Total Revenue
ED < 1 then P Q TR
and 18

19. Income Elasticity of Demand
The percentage change in the quantity demanded
given a percentage change in income. 19

20. Computing Income Elasticity
Percentage Change in
Quantity Demanded
Income Elasticity
of Demand =
Percentage Change
in Income
Computed as the percentage change in the quantity demanded divided by the percentage change in Income. 20

21. Income Elasticity... Types
YD > 0 Normal Goods
YD < 0 Inferior Goods
YD = 0 Income-neutral Goods 21

22. Income Elasticity... Types
Goods consumers regard as “necessities” tend to be income inelastic...
Examples include: food, fuel, clothing, utilities, & medical services. 22

23. Income Elasticity... Types
Goods consumers regard as “luxuries” tend to be income elastic...
Examples include: Sports cars, furs, and expensive foods. 23

24. Price Elasticity of Supply
The percentage change in quantity supplied
resulting from a percentage change in price. B A
Quantity 25

25. Ranges of Elasticity Perfectly Elastic infinite
Relatively Elastic >1
Unitary or Unit =1
Relatively Inelastic <1
Perfectly Inelastic = 0 26

26. Determinants of Elasticity of Supply
Flexibility or ability of sellers to change the amount of the good they produce.
Beachfront land verses books, cars, manufactured goods, etc.
More elastic in the long run. 28

27. Computing Elasticity Coefficient
Percentage Change in
Quantity Supplied
Elasticity
of Supply =
Percentage Change
in Price
Computed as the percentage change in the quantity supplied divided by the percentage change in price. 29

28. Applications of Elasticity
“Can Good News for Farming Be Bad News For Farmers?”
What happens to wheat farmers and the market for wheat when university agronomists discover a new wheat hybrid that is more productive than existing varieties? 31

29. Apply Comparative Statics (Chapter 4)
Examine whether the supply or demand curve shifts.
Consider the direction the curve shifts.
Use supply-and-demand diagram to see how the market equilibrium changes. 32

30. Examine whether the supply or demand curve shifts.SA
Price
$4.00 DA
2000
Quantity 33

31. Consider which direction the curve shifts.SA
Price SB
Technology
causes an increase
in supply.
$4.00 DA
2000
Quantity 34

32. Use Supply-and-Demand diagram to see how the market changes.SA
Price SB
$4.00
$2.60 DA
2000
2400
Quantity 35

33. ED = ED = Compute Elasticity (2400 - 2000) / (2000)
($ $4.00) / ($4.00)
ED =
0.57 (Inelastic) 36

34. Observe the Change in Total RevenueSA
Price SB
TRSA = $8,000
$4.00
$2.60
TRSB = $5,760! DA
2000
2400
Quantity 37