1. Elasticity and Its Application
Chapter 5
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2. Elasticity . . .
… is a measure of how much buyers and sellers respond to changes in market conditions
… allows us to analyze supply and demand with greater precision. 2 2

3. Price Elasticity of Demand
Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price.
It is a measure of how much the quantity demanded of a good responds to a change in the price of that good. 5 4

4. Determinants of Price Elasticity of Demand
Necessities versus Luxuries
Availability of Close Substitutes
Definition of the Market
Time Horizon 8 13

5. Determinants of Price Elasticity of Demand
Demand tends to be more elastic :
if the good is a luxury.
the longer the time period.
the larger the number of close substitutes.
the more narrowly defined the market. 8 13

6. Computing the Price Elasticity of Demand
The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price. 10 16

7. Computing the Price Elasticity of Demand
Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones then your elasticity of demand would be calculated as:

8. Computing the Price Elasticity of Demand Using the Midpoint Formula
The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change. 10 16

9. Computing the Price Elasticity of Demand
Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones the your elasticity of demand, using the midpoint formula, would be calculated as:

10. Ranges of Elasticity Inelastic Demand Elastic Demand
Quantity demanded does not respond strongly to price changes.
Price elasticity of demand is less than one.
Elastic Demand
Quantity demanded responds strongly to changes in price.
Price elasticity of demand is greater than one. 6 5

11. Computing the Price Elasticity of Demand$5 4
Demand
Demand is price elastic 50
100
Quantity 11 20

12. Ranges of Elasticity Perfectly Inelastic Perfectly Elastic
Quantity demanded does not respond to price changes.
Perfectly Elastic
Quantity demanded changes infinitely with any change in price.
Unit Elastic
Quantity demanded changes by the same percentage as the price. 6 6

13. A Variety of Demand Curves
Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve. 7 7

14. Perfectly Inelastic Demand - Elasticity equals 0
Price
Demand
100 $5
1. An
increase
in price... 4
Quantity
2. ...leaves the quantity demanded unchanged. 7 8

15. Inelastic Demand - Elasticity is less than 1
Price
Demand $5
1. A 22%
increase
in price... 90 4
100
2. ...leads to a 11% decrease in quantity.
Quantity 7 8

16. Unit Elastic Demand - Elasticity equals 1
Price
Demand $5
1. A 22%
increase
in price... 80 4
100
2. ...leads to a 22% decrease in quantity.
Quantity 7 8

17. Elastic Demand - Elasticity is greater than 1
Price
Demand $5
1. A 22%
increase
in price... 50 4
100
2. ...leads to a 67% decrease in quantity.
Quantity 7 8

18. Perfectly Elastic Demand - Elasticity equals infinity
Price
1. At any price
above $4, quantity
demanded is zero.
Demand $4
2. At exactly $4,
consumers will
buy any quantity.
3. At a price below $4,
quantity demanded is infinite.
Quantity 7 8

19. Elasticity and Total Revenue
Total revenue is the amount paid by buyers and received by sellers of a good.
Computed as the price of the good times the quantity sold.
TR = P x Q 15 21

20. Elasticity and Total Revenue
Price $4
P x Q = $400
(total revenue) P
Demand
100
Quantity Q 15 22

21. Elasticity and Total Revenue
With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases. 15 26

22. Elasticity and Total Revenue: Inelastic Demand
Price
Price
…leads to an increase in total revenue from$100 to $240
An increase in price from $1 to $3... $3
Revenue = $240 $1
Demand
Demand
Revenue = $100
100
Quantity 80
Quantity 15 27

23. Elasticity and Total Revenue
With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases. 15 25

24. Elasticity and Total Revenue: Elastic Demand
…leads to a decrease in total revenue from$200 to $100
Price
Price
An increase in price from $4 to $5... $5 $4
Demand
Demand
Revenue = $200
Revenue = $100 50
Quantity 20
Quantity 15 28

25. Computing the Elasticity of a Linear Demand Curve

26. Income Elasticity of Demand
Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income.
It is computed as the percentage change in the quantity demanded divided by the percentage change in income. 19 29

27. Computing Income Elasticity
of Demand
Percentage Change
in Quantity Demanded
in Income = 20 31

28. Income Elasticity - Types of Goods -
Normal Goods
Inferior Goods
Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods. 21 32

29. Income Elasticity - Types of Goods -
Goods consumers regard as necessities tend to be income inelastic Examples include food, fuel, clothing, utilities, and medical services.
Goods consumers regard as luxuries tend to be income elastic. Examples include sports cars, furs, and expensive foods. 21 32

30. Price Elasticity of Supply
Price elasticity of supply is the percentage change in quantity supplied resulting from a percent change in price.
It is a measure of how much the quantity supplied of a good responds to a change in the price of that good. 37

31. Ranges of Elasticity ES = ¥ ES > 1 ES = 1 Perfectly Elastic
Relatively Elastic
ES > 1
Unit Elastic
ES = 1 26 38

32. Ranges of Elasticity ES < 1 ES = 0 Relatively Inelastic
Perfectly Inelastic
ES = 0 26 39

33. Perfectly Inelastic Supply - Elasticity equals 0
Price
Supply
100 $5
1. An
increase
in price... 4
Quantity
2. ...leaves the quantity supplied unchanged. 7 8

34. Inelastic Supply - Elasticity is less than 1
Price
Supply $5
1. A 22%
increase
in price...
110 4
100
2. ...leads to a 10% increase in quantity.
Quantity 7 8

35. Unit Elastic Supply - Elasticity equals 1
Price
Supply $5
1. A 22%
increase
in price...
125 4
100
2. ...leads to a 22% increase in quantity.
Quantity 7 8

36. Elastic Supply - Elasticity is greater than 1
Price
Supply $5
1. A 22%
increase
in price...
200 4
100
2. ...leads to a 67% increase in quantity.
Quantity 7 8

37. Perfectly Elastic Supply - Elasticity equals infinity
Price
1. At any price
above $4, quantity
supplied is infinite.
Supply $4
2. At exactly $4,
producers will
supply any quantity.
3. At a price below $4,
quantity supplied is zero.
Quantity 7 8

38. Determinants of Elasticity of Supply
Ability of sellers to change the amount of the good they produce.
Beach-front land is inelastic.
Books, cars, or manufactured goods are elastic.
Time period.
Supply is more elastic in the long run. 28 45

39. Computing the Price Elasticity of Supply
The price elasticity of supply is computed as the percentage change in the quantity supplied divided by the percentage change in price. 29 46

40. Application 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 50

41. Application of Elasticity
Examine whether the supply or demand curve shifts.
Determine the direction of the shift of the curve.
Use the supply-and-demand diagram to see how the market equilibrium changes. 32 51

42. An Increase in Supply in the Market for Wheat
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An Increase in Supply in the Market for Wheat
Price of
Wheat S1 $3
Demand
100
Quantity of Wheat 33 52

43. An Increase in Supply in the Market for Wheat
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An Increase in Supply in the Market for Wheat
Price of
Wheat
1. When demand is inelastic,
an increase in supply... S1 S2
2. ...leads
to a large
fall in
price... $3 2
Demand
100
110
Quantity of Wheat
3. ...and a proportionately smaller
increase in quantity sold. As a result,
revenue falls from $300 to $220. 33 54

44. Compute Elasticity 36 59

45. Compute Elasticity
Demand is inelastic 36 59

46. Summary
Price elasticity of demand measures how much the quantity demanded responds to changes in the price.
If a demand curve is elastic, total revenue falls when the price rises.
If it is inelastic, total revenue rises as the price rises.

47. Summary
The price elasticity of supply measures how much the quantity supplied responds to changes in the price.
In most markets, supply is more elastic in the long run than in the short run.

48. Supply, Demand and Government Policies
Chapter 6
Copyright © 2001 by Harcourt, Inc. All rights reserved.   Requests for permission to make copies of any part of the work should be mailed to:
Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida

49. Supply, Demand, and Government Policies
In a free, unregulated market system, market forces establish equilibrium prices and exchange quantities.
While equilibrium conditions may be efficient, it may be true that not everyone is satisfied.
One of the roles of economists is to use their theories to assist in the development of policies. 2 2

50. Price Controls...
Are usually enacted when policymakers believe the market price is unfair to buyers or sellers.
Result in government-created price ceilings and floors. 3 3

51. Price Ceilings & Price Floors
A legally established maximum price at which a good can be sold.
Price Floor
A legally established minimum price at which a good can be sold. 4 4

52. Price Ceilings
Two outcomes are possible when the government imposes a price ceiling:
 The price ceiling is not binding if set above the equilibrium price.
 The price ceiling is binding if set below the equilibrium price, leading to a shortage. 5 5

53. A Price Ceiling That Is Not Binding...
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A Price Ceiling That Is Not Binding...
Price of
Ice-Cream
Cone
Supply $4
Price
ceiling 3
Equilibrium
price
Demand
100
Quantity of
Ice-Cream
Cones
Equilibrium
quantity 6 7

54. A Price Ceiling That Is Binding...
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A Price Ceiling That Is Binding...
Price of
Ice-Cream
Cone
Supply
Equilibrium
price $3 2
Price
ceiling 75
Quantity
supplied
125
Quantity
demanded
Shortage
Demand
Quantity of
Ice-Cream
Cones 7 10

55. Effects of Price Ceilings
A binding price ceiling creates ...
shortages because QD > QS.
Example: Gasoline shortage of the 1970s
nonprice rationing
Examples: Long lines, Discrimination by sellers 11 14

56. What was responsible for the long gas lines?
Lines at the Gas Pump
In 1973 OPEC raised the price of crude oil in world markets. Because crude oil is the major input used to make gasoline, the higher oil prices reduced the supply of gasoline.
What was responsible for the long gas lines?
Economists blame government regulations that limited the price oil companies could charge for gasoline.

57. The Price Ceiling on Gasoline Is Binding...
Price of
Gasoline
2. …but when supply falls... S1 P2
Price
ceiling
4. …resulting in a shortage.
3. …the price ceiling becomes binding... P1
Demand
Quantity of
Gasoline Q1 6 7

58. Price Floors
When the government imposes a price floor, two outcomes are possible.
The price floor is not binding if set below the equilibrium price.
The price floor is binding if set above the equilibrium price, leading to a surplus. 12 15

59. A Price Floor That Is Binding...
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A Price Floor That Is Binding...
Price of
Ice-Cream
Cone
Supply
Surplus $4
Price floor 80
Quantity
demanded
120
Quantity
supplied $3
Equilibrium
price
Demand
Quantity of
Ice-Cream
Cones 8 17

60. Effects of a Price Floor
A price floor prevents supply and demand from moving toward the equilibrium price and quantity.
When the market price hits the floor, it can fall no further, and the market price equals the floor price. 15 24

61. Effects of a Price Floor
A binding price floor causes . . .
a surplus because QS >QD.
nonprice rationing is an alternative mechanism for rationing the good, using discrimination criteria.
Examples: The minimum wage, Agricultural price supports 15 25

62. The Minimum Wage
An important example of a price floor is the minimum wage. Minimum wage laws dictate the lowest price possible for labor that any employer may pay.

63. The Minimum Wage A Free Labor Market Labor supply Labor demand Wage
Equilibrium
wage
Equilibrium
employment
Labor
demand
Quantity of
Labor

64. A Labor Market with a Minimum Wage
The Minimum Wage
A Labor Market with a Minimum Wage
Wage
Labor
supply
Labor surplus
(unemployment)
Minimum
wage
Quantity
demanded
Quantity
supplied
Labor
demand
Quantity of
Labor

65. Governments levy taxes to raise revenue for public projects.20 29

66. What are some potential impacts of taxes?
Taxes discourage market activity.
When a good is taxed, the quantity sold is smaller.
Buyers and sellers share the tax burden. 22 30

67. Taxes Tax incidence is the study of who bears the burden of a tax.
Taxes result in a change in market equilibrium.
Buyers pay more and sellers receive less, regardless of whom the tax is levied on. 21 31

68. Impact of a 50¢ Tax Levied on Buyers...
Copyright © 2001 by Harcourt, Inc. All rights reserved
Impact of a 50¢ Tax Levied on Buyers...
Price of
Ice-Cream
Cone
Supply, S1 D2
3.00
A tax on buyers
shifts the demand
curve downward
by the size of
the tax ($0.50). D1
100
Quantity of
Ice-Cream Cones 23 33

69. Impact of a 50¢ Tax Levied on Buyers...
Copyright © 2001 by Harcourt, Inc. All rights reserved
Impact of a 50¢ Tax Levied on Buyers...
Price of
Ice-Cream
Cone
Supply, S1
$3.30
Price
buyers
pay
Equilibrium without tax
Tax ($0.50)
Price
without
tax
3.00
2.80
Price
sellers
receive
Equilibrium
with tax D1 D2 90
100
Quantity of
Ice-Cream Cones 23 38

70. What was the impact of tax?
Taxes discourage market activity.
When a good is taxed, the quantity sold is smaller.
Buyers and sellers share the tax burden. 22 30

71. Impact of a 50¢ Tax on Sellers...
Copyright © 2001 by Harcourt, Inc. All rights reserved
Impact of a 50¢ Tax on Sellers...
Price of
Ice-Cream
Cone
A tax on sellers shifts the supply curve upward by the amount of the tax ($0.50).
$3.30
Price buyers pay S2
Equilibrium
with tax S1 90
Tax ($0.50)
3.00
Price without tax
Equilibrium without tax
2.80
Price sellers receive
Demand, D1
100
Quantity of
Ice-Cream Cones

72. The Incidence of Tax
In what proportions is the burden of the tax divided?
How do the effects of taxes on sellers compare to those levied on buyers?
The answers to these questions depend on the elasticity of demand and the elasticity of supply. 29 39

73. Elastic Supply, Inelastic Demand...
Price
1. When supply is more
elastic than demand...
Price buyers pay
Tax
2. ...the
incidence of the
tax falls more
heavily on
consumers...
Supply
Price without tax
3. ...than on
producers.
Price sellers receive
Demand
Quantity 32 44

74. Inelastic Supply, Elastic Demand...
1. When demand is more
elastic than supply...
Price
Supply
Price buyers pay
Tax
3. ...than on consumers.
Price without tax
2. ...the
incidence of
the tax falls more
heavily on producers...
Demand
Price sellers receive
Quantity 32 51

75. So, how is the burden of the tax divided?
The burden of a tax falls more heavily on the side of the market that is less elastic. 30 41

76. Summary Price controls include price ceilings and price floors.
A price ceiling is a legal maximum on the price of a good or service. An example is rent control.
A price floor is a legal minimum on the price of a good or a service. An example is the minimum wage.

77. Summary Taxes are used to raise revenue for public purposes.
When the government levies a tax on a good, the equilibrium quantity of the good falls.
A tax on a good places a wedge between the price paid by buyers and the price received by sellers.

78. Summary
The incidence of a tax refers to who bears the burden of a tax.
The incidence of a tax does not depend on whether the tax is levied on buyers or sellers.
The incidence of the tax depends on the price elasticities of supply and demand.