1. Elasticity and Its Application4
Elasticity and Its Application

2. The Elasticity of Demand
Measures responsiveness of quantity demanded or quantity supplied
Percentage change in quantity demanded (∆Qd/Qd)
Percentage change in quantity supplied (∆Qs/Qs)
To a change in one of its determinants
Demand-side
(own) price <-> demand elasticity (∆Qx/Qx)/ (∆Px/Px )
Price of substitute/complement <-> cross-price (∆Qx/Qx)/(∆Py/Py )
Income <-> income elasticity ((∆Qx/Qx)/ (∆I/I )

3. The Elasticity of Demand
(Own) Price elasticity of demand
Elastic demand (e.g. price elasticity)
Quantity demanded responds substantially to changes in the price
value > 1
∆Qd/Qd > ∆P/P
Inelastic demand
Quantity demanded responds only slightly to changes in the price
Value < 1 (closer to zero)
∆Qd/Qd < ∆P/P

4. The price elasticity of demand (d, e)1
The price elasticity of demand (d, e)
(d) Elastic demand:
Elasticity > 1
(e) Perfectly elastic demand:
Elasticity equals infinity
1. an
Price
1. an
Price
A 22%
increase
in price…
1. At any price
above $4, quantity
demanded is zero
Demand
2. At exactly $4,
consumers will
buy any quantity $5 50 4
Demand $4
100
3. At any price
below $4, quantity
demanded is infinite
2. … leads to
a 67% decrease
in quantity
demanded
Quantity
Quantity
The price elasticity of demand determines whether the demand curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.

5. The Elasticity of Demand
Determinants of (own) price elasticity of demand
Availability of close substitutes
Goods with close substitutes
More elastic demand
Necessities vs. luxuries
Necessities – inelastic demand
Luxuries – elastic demand
Definition of the market
Narrowly defined markets – more elastic demand
Time horizon
More elastic over longer time horizons

6. The Elasticity of Demand (own)
Computing the price elasticity of demand
Percentage change in quantity demanded
Divided by percentage change in price
Use absolute value (drop the minus sign)
It’s always negative (own-price)
Midpoint method
Two points: (Q1, P1) and (Q2, P2)

7. The Elasticity of Demand
Variety of (own-price) demand curves
Demand is elastic
Elasticity > 1
Demand is inelastic
Elasticity < 1
Demand has unit elasticity
Elasticity = 1

8. The Elasticity of Demand
Cigarettes (US)[41]
-0.3 to -0.6 (General)
-0.6 to -0.7 (Youth) – proportion of income?
Soft drinks
-0.8 to -1.0 (general)[51] (broadly defined)
-3.8 (Coca-Cola)[52] (narrow)
-4.4 (Mountain Dew)[52] (narrow)
Car fuel[45]
-0.25 (Short run) (same car – reduce trips)
-0.64 (Long run) (new car?)

9. The Elasticity of Demand
Total revenue
Amount paid by buyers
Received by sellers of a good
Computed as: price of the good times the quantity sold (P ˣ Q)

10. 2 Total revenue Price 1. an $4 P ˣ Q=$400 (revenue) Demand P 100
Quantity Q
The total amount paid by buyers, and received as revenue by sellers, equals the area of the box under the demand curve, P × Q. Here, at a price of $4, the quantity demanded is 100, and total revenue is $400.

11. The Elasticity of Demand
Total revenue and price elasticity of demand
Inelastic demand
Increase in price
Increase in total revenue
Elastic demand
Decrease in total revenue

12. The Elasticity of Demand
When demand is inelastic
Price and total revenue move in the same direction
When demand is elastic
Price and total revenue move in opposite directions
If demand is unit elastic
Total revenue remains constant when the price changes

13. The Elasticity of Demand
Elasticity and total revenue along a linear demand curve
Linear demand curve
Constant slope
Different elasticities
Points with low price & high quantity
Inelastic
Points with high price & low quantity
Elastic

14. Elasticity of a linear demand curve (graph)4
Elasticity of a linear demand curve (graph)
Price
Elasticity
is larger
than 1
1. an
Demand $7 14 6 2 5 4 4
Elasticity
is smaller
than 1 6 3 8 2 10 1 12
Quantity
The slope of a linear demand curve is constant, but its elasticity is not. The demand schedule in the table was used to calculate the price elasticity of demand by the midpoint method. At points with a low price and high quantity, the demand curve is inelastic. At points with a high price and low quantity, the demand curve is elastic.

15. Elasticity and Total Revenue

16. Elasticity of a linear demand curve (schedule)4
Elasticity of a linear demand curve (schedule)
Price
Quantity
Total revenue
(Price ˣ Quantity)
Percentage
Change
in Price
Change in
Elasticity
Description $7 6 5 4 3 2 1 O 8 10 12 14 $0 20 24 15 18 22 29 40 67
200
13.0
3.7
1.8
1.0
0.6
0.3
0.1
Elastic
Unit elastic
Inelastic
The slope of a linear demand curve is constant, but its elasticity is not. The demand schedule in the table was used to calculate the price elasticity of demand by the midpoint method. At points with a low price and high quantity, the demand curve is inelastic. At points with a high price and low quantity, the demand curve is elastic.

17. The Elasticity of Demand
Income elasticity of demand
Measure of how much the quantity demanded of a good responds
To a change in consumers’ income
Percentage change in quantity demanded
Divided by the percentage change in income
Normal goods: positive income elasticity
Necessities: smaller income elasticities (~0, <1)
Luxuries: large income elasticities ( > 1)
Inferior goods: negative income elasticities (<0)

18. The Elasticity of Demand
Cross-price elasticity of demand
Measure of how much the quantity demanded of one good responds
To a change in the price of another/different good
[∆Qx/Qx] / [∆Py/Py ]
Sign matters -> tells whether substitute or complement
Magnitude (<1 or >1) -> how “good” a substitute/essential a complement
Substitutes: Positive cross-price elasticity
>1 -> “close” or good substitute as big shift with small price change
Complements: Negative cross-price elasticity
>1 -> “essential” to be used/consumed together (cars and gas)

19. The Elasticity of Supply
Price elasticity of supply
Measure of how much the quantity supplied of a good responds
To a change in the price of that good
Percentage change in quantity supplied
Divided by the percentage change in price
Depends on the flexibility of sellers to change the amount of the good they produce

20. The Elasticity of Supply
Price elasticity of supply
Elastic supply
Quantity supplied responds substantially to changes in the price
Inelastic supply
Quantity supplied responds only slightly to changes in the price
Determinant of price elasticity of supply
Time period
Supply is more elastic in long run

21. The Elasticity of Supply
Computing price elasticity of supply
Percentage change in quantity supplied
Divided by percentage change in price
Variety of supply curves
Supply is perfectly inelastic
Elasticity =0
Supply curve – vertical
Supply is perfectly elastic
Elasticity = infinity
Supply curve – horizontal

22. The Elasticity of Supply
Variety of supply curves
Unit elastic supply
Elasticity =1
Elastic supply
Elasticity >1
Inelastic supply
Elasticity < 1

23. The price elasticity of supply (a, b)5
The price elasticity of supply (a, b)
Perfectly inelastic supply:
Elasticity = 0
(b) Inelastic supply:
Elasticity < 1
1. an
Price
1. an
Price
Supply
100
Supply An
increase
in price…
A 22%
increase
in price…
2. … leads to
a 10% increase
in quantity
supplied $5 $5
110 4 4
100
2. …leaves
the quantity
supplied
unchanged
Quantity
Quantity
The price elasticity of supply determines whether the supply curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.

24. The price elasticity of supply (c)5
The price elasticity of supply (c)
(c) Unit elastic supply: Elasticity =1
1. an
Price
Supply
A 22%
increase
in price… $5
2. … leads to
a 22% increase
in quantity
supplied
125 4
100
Quantity
The price elasticity of supply determines whether the supply curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.

25. The price elasticity of supply (d, e)5
The price elasticity of supply (d, e)
(d) Elastic supply:
Elasticity > 1
(e) Perfectly elastic supply:
Elasticity equals infinity
1. an
Price
1. an
Price
1. At any price
above $4, quantity
supplied is infinite
A 22%
increase
in price…
Supply
2. At exactly $4,
producers will
supply any quantity $5 50 4
Supply $4
100
2. … leads to
a 67% increase
in quantity
supplied
3. At any price
below $4, quantity
supplied is zero
Quantity
Quantity
The price elasticity of supply determines whether the supply curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.

26. How the price elasticity of supply can vary6
How the price elasticity of supply can vary
1. an
Price
Supply
Elasticity is small
(less than 1).
$15
525 12
500
Elasticity is large
(greater than 1). 4 3
200
100
Quantity
Because firms often have a maximum capacity for production, the elasticity of supply may be very high at low levels of quantity supplied and very low at high levels of quantity supplied. Here an increase in price from $3 to $4 increases the quantity supplied from 100 to 200. Because the 67 percent increase in quantity supplied (computed using the midpoint method) is larger than the 29 percent increase in price, the supply curve is elastic in this range. By contrast, when the price rises from $12 to $15, the quantity supplied rises only from 500 to 525. Because the 5 percent increase in quantity supplied is smaller than the 22 percent increase in price, the supply curve is inelastic in this range.

27. Applications of Supply, Demand, & Elasticity
Can good news for farming be bad news for farmers?
New hybrid of wheat – increase production per acre 20%
Supply curve changes
Supply curve shifts to the right
Higher quantity; lower price
Demand – inelastic
Total revenue falls
Paradox of public policy
Induce farmers not to plant crops

28. An increase in supply in the market for wheat7
An increase in supply in the market for wheat
Price of
Wheat
1. When demand is inelastic,
an increase in supply . . . S1
Demand
2. … leads
to a large fall
in price. . . S2 $3
100
3. … and a proportionately smaller
increase in quantity sold. As a result,
revenue falls from $300 to $220. 2
110
Quantity of Wheat
When an advance in farm technology increases the supply of wheat from S1 to S2, the price of wheat falls. Because the demand for wheat is inelastic, the increase in the quantity sold from 100 to 110 is proportionately smaller than the decrease in the price from $3 to $2. As a result, farmers’ total revenue falls from $300 ($3 × 100) to $220 ($2 × 110).

29. Applications of Supply, Demand, & Elasticity
Why did OPEC fail to keep the price of oil high?
1970s: OPEC reduced supply of oil
Increase in prices and
Short-run: supply is inelastic
Decrease in supply: large increase in price
– price of oil decreased
Long-run: supply is elastic
Decrease in supply: small increase in price

30. A reduction in supply in the world market for oil8
A reduction in supply in the world market for oil
(a) The Oil Market in the Short Run
(b) The Oil Market in the Long Run
1. an
Price
1. In the short run, when supply and demand are inelastic, a shift in supply. . .
1. an
Price
1. In the long run, when supply and demand are elastic, a shift in supply. . . S2 S1
Demand S2 S1 P2
Demand
2. … leads to a
large increase
in price P2 P1 P1
2. … leads to a
small increase
in price
Quantity
Quantity
When the supply of oil falls, the response depends on the time horizon. In the short run, supply and demand are relatively inelastic, as in panel (a). Thus, when the supply curve shifts from S1 to S2, the price rises substantially. By contrast, in the long run, supply and demand are relatively elastic, as in panel (b). In this case, the same size shift in the supply curve (S1 to S2) causes a smaller increase in the price.