1. Elasticity

2. Coffee Question
Suppose two partners are arguing about a coffeeshop that is losing money.
One of the partner thinks they need to raise prices - that way they will make more money on each cup of coffee they sell.
The other partner thinks that if the lower prices they will make more money because they will sell a lot more cups of coffee.
Who was right?

3. Coffee Question The answer is - it depends. On what?
If you lower the price - will the new sales offset the loss in revenue on each coffee?
If you raise your price - will the loss in sales be offset by the increase in price of coffee?
In other words, how much will the quantity demanded change when price changes?

4. Demand
We want to know just how much will quantity demanded change when price changes? That is what elasticity of demand measures.

5. Elasticity of Demand
Elasticity of Demand (Ed) measures the responsiveness of Qd of a good to a changein its P.
Ed = % in Qd % in P
Note that  means “change”
Also note that the law of demand implies Ed is negative. We will ignore the negative sign.

6. Price Elasticity of Demand

7. Calculating Elasticity of Demand
There are two methods for calculating elasticity - point and arc methods.
First, we will examine the point method.

8. Point Elasticity
…and let’s say we want to find the Elasticity of Demand as we move from point A to Point B... P A 6 B 5 D Qd 2 3 6 7

9. Point Elasticity We know Ed = % in Qd % in P
%can be calculated as the change divided by starting point

10. Point Elasticity Demand is Elastic
The Elasticity of Demand (or Ed) is 1/2 divided by -1/6 which equals -3. But we ignore the sign and call it 3.
Ed = % in Qd = 1/2 = = - 3 or 3 % in P /
Demand is Elastic
Let’s try that again moving from point C to D on the same curve

11. Point Elasticity P 6 5 C 2 D 1 Qd 2 3 7 8

12. Point Elasticity Demand is Inelastic
The Elasticity of Demand (or Ed) is 1/7 divided by -1/2 which equals But we ignore the sign and call it 0.286
Ed = % in Qd = 1/7 = = % in P /
Demand is Inelastic

13. Point Elasticity
Note that Ed is different at different places along the curve.
Specifically, it gets smaller as you move down the curve
Note that elasticity and slope are NOT the same thing.
One last calculation - let’s find the elasticity of demand going from point D to point C

14. Point Elasticity P 6 5 C 2 D 1 Qd 2 3 7 8

15. Point Elasticity Demand is Inelastic
The Elasticity of Demand (or Ed) is -1/8 divided by 1 which equals But we ignore the sign and call it 0.125
Ed = % in Qd = -1/8 = = % in P /
Demand is Inelastic
But this is a different value than before!

16. Point Elasticity
Note that we get a different elasticity depending on which point we call the starting point.
A solution to this is by using the Arc Method for finding the Elasticity of Demand.

17. . Ed = Refinement: Midpoint Formula Change in quantity Sum of
Quantities/2
price
prices/2 .

18. Calculating Ed - Arc Elasticity
Ed = % in Qd % in P
% in Qd = Qd2 - Qd1 = Qd ____ (Qd1 + Qd2)/2 Average Qd
% in P = P2 - P1 = P___ (P1 + P2)/ Average P

19. Arc Elasticity The arc elasticity of demand is ED = .133/.667 = .2
As you can see from the equations, it doesn’t matter which is the starting point you will get the same number for the elasticity.
Using points C and D we get
% in Q = (1/(7+8)/2) = 1/7.5 = 0.133
% in P = (-1/(1+2)/2) = -1/1.5 = 0.667
The arc elasticity of demand is
ED = .133/.667 = .2

20. Price Elasticity of Demand along a Demand Curve

21. How Do We Interpret Elasticity?
If Ed = 2, means the ratio of %  Q to the %  P is 2 to 1 or:
a 1% change in price will cause a 2% change in quantity demanded.
a 2% change in price will cause a 4% change in quantity demanded, and so on.

22. Degrees of Ed Inelastic Ed = % in Qd % in P Ed < 1
For every 1% change in P,
Qd changes by less than 1%

23. Degrees of Ed Unitary Elastic For every 1% change in P,
Ed = % in Qd % in P
Ed = 1 % in Qd = 1 % in P
Ed = 1
For every 1% change in P,
Qd changes by 1% (in opposite direction)

24. Degrees of Ed Elastic Ed = % in Qd % in P Ed > 1
For every 1% change in P,
Qd changes by more than 1% (in opposite direction)

25. Degrees of Ed Perfectly Elastic
Ed = % in Qd % in P
Ed = % in Qd
The price of the good never changes, no matter how much consumers purchase of the good.

26. Elasticity P
Perfectly
Elastic Qd

27. Elasticity P
Perfectly
Inelastic Qd

28. Generalizing about Elasticity
Notice that the vertical D curve has an elasticity of zero and the flat D curve has an elasticity of infinity.
As the demand curve goes from vertical to horizontal the elasticity is going from 0 to infinity
In other words, the flatter the demand curve, the greater the elasticity

29. Elasticity P
Relatively
Elastic Qd

30. Elasticity
Relatively
Inelastic P
Relatively
Elastic Qd

31. The Coffee Problem
Back to the Coffeehouse question - should they raise or lower price?
We said that depended on how much sales will change when they change price
In other words, it depends on the elasticity

32. Total Revenue Total Revenue = P x Q
The coffeehouse is interested in how TR (total revenue) changes as p and q change

33. Total Revenue Calculation - Example
Price $1 Qd = 100 TR = $100
Price $2 Qd = TR = $140

34. Total Revenue and Elasticity
Let’s say demand is inelastic. Then if the coffeehouse raises prices 10%, the sales will drop by less than 10%
In other words, the gain in revenue from higher prices is greater than the loss in revenue from lost sales.Therefore, Total Revenue will rise

35. Total Revenue and Elasticity
If they lowered prices, though, the loss of revenue from higher prices would be greater than the gain from increased sales, so Total Revenue will fall

36. Elasticity and Total RevenueP
Loss in
Revenue
Gain in Revenue
Relatively
Inelastic Qd

37. Total Revenue Test
If P and TR
or P and TR
Demand is Inelastic

38. Total Revenue and Elasticity
Let’s say demand is elastic. Then if the coffeehouse raises prices 10%, the sales will drop by more than 10%
In other words, the gain in revenue from higher prices is less than the loss in revenue from lost sales.Therefore, Total Revenue will fall

39. Total Revenue and Elasticity
If they lowered prices, though, the loss of revenue from higher prices would be less than the gain in revenue from increased sales, so Total Revenue will rise

40. Elasticity and Total RevenueP
P TR
Loss in
Revenue
Relatively
Elastic
Gain in Revenue Qd

41. Total Revenue Test
If P and TR
or P and TR
Demand is Elastic

42. Total Revenue and Elasticity
Unitary
Inelastic

43. Total Revenue and Demand
Elastic $
Elasticity = 1
Inelastic
Demand Q $
Total Revenue Q

44. Elasticity and Total RevenueP
Loss in
Revenue
Gain in Revenue
Unitary
Elastic Qd

45. Total Revenue Test
If P and
TR is unchanged
Demand is Unitary

46. Elasticity and Total Revenue
Inelastic
Unitary

47. Determinants of Ed Availability of Substitutes Example:
As there are more substitutes, demand is more elastic (and vice versa)
Example:
Insulin has no substitutes if diabetic and demand is very inelastic.
Wal-Mart Brand Cola has many substitutes and hence, demand is very elastic

48. Determinants of Ed Amount of Consumers Budget Example:
The less expensive a good is as a fraction of our total budget, the more inelastic the demand for the good is (and vice versa).
Example:
Price of cars go up 10% (from $20,000 to $22,000)
Price of soda goes up 10% (from $0.50 to $0.55)
Demand is more effected by the price of cars increasing.

49. Determinants of Ed Time Example - Price of Gasoline Increases
The longer the time frame is, the more elastic the demand for a good is (and vice versa).
Example - Price of Gasoline Increases
Immediately: can’t do much, still need to get to work, school, etc.
Short-run: find a car pool, ride bike, etc.
Long-run: next car you buy uses less gas.

50. Determinants of Ed Necessities vs. Luxuries Example: Insulin
The more necessary a good is, the more inelastic the demand for the good (and vice versa).
Example: Insulin

51. Income Elasticity of Demand
Income Elasticity of Demand (Ey) - measures the responsiveness of quantity demanded to changes in income.
Ey = % in Qd % in Y
Note that the sign IS important!

52. Ey = Income Elasticity of Demand Normal Goods - Positive Sign
Percentage change in
quantity demanded
Ey =
Percentage change
in income
Normal Goods - Positive Sign
Inferior Goods - Negative Sign

53. Normal Goods
Typically, if our income rises, we buy more and visa versa. These types of goods are called normal goods.
Ey > 0 - normal good
Normal Goods can be split into two categories: Luxury and Necessity Goods

54. Inferior Goods
There are some good we buy less of as our income grows and more of as our income falls.
For instance, in college you probably eat Macaroni & Cheese. But when you get a good job (as all SMSU-WP grads do) you will probably buy less Mac and Cheese.
If a goods elasticity is Ey < 0 it is an inferior good

55. Cross Price Elasticity of Demand
Another type of elasticity is the Cross Price Elasticity. This gets at how changes in price of one good can effect the demand of another
Cross Price Elasticity of Demand (Ex,y) - measures the responsiveness of quantity demanded of good one when the price of good 2 changes.

56. Cross Price Elasticity of Demand
Ex,y = % in Qd of Good X %  in P of Good Y
Note that the sign DOES matter for this elasticity also!

57. Percentage change in quantity
Cross Price
Elasticity of Demand
Percentage change in quantity
demanded of good X
Exy =
Percentage change in
the price of good y
Substitute Goods - Positive Sign
Complementary Goods - Negative Sign
Independent Goods - Zero or near-zero value

58. Substitute Goods
Consider Coke and Pepsi. If the price of Coke goes up, what would you expect to happen to the quantity demanded of Pepsi?
It will rise, since people will buy less Coke and more Pepsi. Thus the Demand for Pepsi will rise.
So the bottom of the elasticity fraction is positive and top of the elasticity fraction is positive.

59. This relationship is called substitutes and can be seen when
Substitute Goods
This relationship is called substitutes and can be seen when
Ex,y > 0.

60. Complement goods
Consider Washing Machines and Dryers. If the price of Washing Machines goes up, what would you expect to happen to the quantity demanded of Dryers?
It will fall, since people will buy less washers at the new price, they will need less dryers.
So the bottom of the elasticity fraction is positive and top of the elasticity fraction is negative.

61. Complement Goods
This relationship is called complements and can be seen when Ex,y < 0

62. Elasticity of Supply
This one is just same as price elasticity of demand, except we substitute the word supply for demand. It is measured the same and is inelastic, elastic, and unit elastic.
Elasticity of Supply (Es) - measures the responsiveness of quantity supplied to changes in price of the good.

63. Elasticity of Supply Es = % in Qs % in P
Law of Supply tells us this number is generally positive.

64. Determinants of Elasticity of Supply
If supply is getting more (or less) elastic, we are saying that the firms can change supply in larger (or smaller) quantities when price changes.
Generally, anything that can effect a firms ability to change production easily will effect the elasticity of supply.

65. Determinants of Elasticity of Supply
For instance:
more time
specific difficulties of increasing output
how cost changes at the firm increases Q
To consider: what would the supply curve of Picasso paintings look like?

66. Elasticity of Supply P Picasso paintings Es = % in Qs Qd Perfectly
Inelastic Supply
Picasso paintings
Es = % in Qs
% in P = 0 Qd

67. Elasticity of Supply P Es = % in Qs < 1 Qd Relatively
Inelastic Supply
Es = % in Qs < 1
% in P Qd

68. Elasticity of Supply P Es = % in Qs > 1 Qd Highly Elastic Supply
% in P Qd

69. Elasticity of Supply Immediate market period SM P An increase in
demand without
enough time to
change supply
causes only P to increase Po D2 D1 Q

70. Elasticity of Supply Short run SSR P An increase in demand with
no expansion of capital use
causes only a
small Qs Po D2 D1 Q Qo

71. Elasticity of Supply Long run SLR An increase in P demand in the
long run allows
greater Qs P
SLR Po D2 D1 Q Qo

72. KEY TERMS price elasticity of demand elastic demand inelastic demand
unitary elasticity
perfectly inelastic demand
perfectly elastic demand
point elasticity
arc elasticity
total revenue
total-revenue test
cross-price elasticity of demand
income elasticity of demand
elasticity of supply
market period
short run
long run