1. Elasticity and Its Applications5
Elasticity and Its Applications

2. Elasticity We have seen that
The quantity demanded of a consumer good is affected by
its price, the prices of other goods, buyers’ incomes, etc.
The quantity supplied of a good is affected by
its price, the prices of raw materials, technology, etc.
Elasticity is a measure of the strengths of these various effects

3. Elasticity = Responsiveness
Suppose there are two variables, x and y
The “x elasticity of y” is a measure of the effect on y of changes in x
when all other factors that affect y are unchanged
In other words, the “x elasticity of y” is a measure of the responsiveness of y to changes in x

4. Elasticity: definition
The “x elasticity of y” is the percent increase in y when there is a one percent increase in x
and all other factors that affect y are unchanged

5. Elasticity: examples
The price elasticity of demand is the percent increase in the quantity demanded of a commodity when there is a one percent increase in the price of the commodity
and all other factors that affect quantity demanded are unchanged

6. Elasticity: examples
The income elasticity of demand is the percent increase in the quantity demanded of a commodity when there is a one percent increase in the buyers’ income
and all other factors that affect quantity demanded are unchanged

7. Elasticity: examples
The cross-price elasticity of demand is the percent increase in the quantity demanded of a commodity when there is a one percent increase in the price of another commodity
and all other factors that affect quantity demanded are unchanged

8. Elasticity: examples
The price elasticity of supply is the percent increase in the quantity supplied of a commodity when there is a one percent increase in the price of the commodity
and all other factors that affect quantity supplied are unchanged

9. Elasticity
For each of the elasticities we have just seen, we need to know
how to measure it, and
what makes it high in some situations and low in other situations, and
why it is useful

10. Price elasticity of demand

11. THE ELASTICITY OF DEMAND
Price elasticity of demand is a measure of how strongly the quantity demanded of a good responds to a change in the price of that good.
See for various measures of elasticity of demand for various food products.

12. PED Computation
The price elasticity of demand is the percent increase in the quantity demanded of a commodity when there is a one percent increase in the price of the commodity
and all other factors that affect quantity demanded are unchanged

13. PED Computation Suppose PED = − (− 20)/10 = 2.
the price of ice-cream increases by 10%, and
the quantity demanded decreases by 20%.
This is an increase of −20%
PED = − (− 20)/10 = 2.
That is, a 1% change in the price will change the quantity demanded by 2%.

14. Price elasticity of demand
The law of demand says that the quantity demanded of a product will decrease if there is an increase in its price
Suppose
the price of ice-cream increases by 10%, and
the quantity demanded decreases by 20%.
Any decrease is a negative increase
For example, a 20% decrease is a -20% increase
Therefore, PED = -20/10 = -2
But the law of demand implies that PED will always be a negative number
Therefore, by convention, the negative sign is usually left out for the PED
We will adopt this convention here. So,
The PED in our example is 2 (not -2)

15. What does the PED depend on?
Which commodity will have the lower price elasticity of demand:
gasoline or movies?
insulin injections (for diabetes patients) or music downloads (on iTunes)?
alcoholic beverages in general or Miller beer?
A 10 percent increase in gasoline prices reduces gasoline consumption by about 2.5 percent after a year and about 6 percent after five years. Why?

16. Determinants of Price Elasticity of Demand
PED of a consumer good tends to be higher…
if it has many close substitutes
if it is a luxury commodity
That is, if the good’s income elasticity of demand is high
if spending on the good is a large portion of total spending
if it is narrowly (rather than broadly) defined
if buyers are given more time to adjust to a price change

17. Income Elasticity of Demand
The income elasticity of demand is the percent increase in the quantity demanded of a commodity when there is a one percent increase in the buyers’ income
and all other factors that affect quantity demanded are unchanged

18. Computing Income Elasticity of Demand
Suppose:
income increases 10%, and
quantity demanded decreases 20%. Then
income elasticity of demand is -20/+10 = -2.
Note that IED can be positive, negative, or zero.

19. Normal Goods and Inferior Goods
Normal Goods: IED > 0
Inferior Goods: IED < 0
Higher income raises the quantity demanded for normal goods, but lowers the quantity demanded for inferior goods.
Examples

20. Necessities and Luxuries
When IED < 1, the good is called income inelastic or a necessity
Examples include food, fuel, clothing, utilities, and medical services.
When IED > 1, the good is called income elastic or a luxury
Examples include sports cars, furs, and expensive foods.

21. High Income Elasticity Implies High Price Elasticity
The effect of a change in the price of a good on its quantity demanded is the sum of:
The substitution effect, and
The income effect
See chapter 4
The higher the IED, the bigger the income effect. Therefore,
The higher the IED, the higher the PED.

22. Low IED implies low PED
Suppose the income elasticity of demand for Coke is positive, but low
2. Consumers feel richer…
3. Consumption of Coke increases, but only a little, because Coke’s IED is low
1. When the price of Coke decreases…
4. So, a decrease in the price of Coke leads to a small increase in the consumption of Coke, meaning that Coke’s PED is low
Clothes
Coke
Books
Movies
Pepsi

23. High IED implies high PED
Suppose the income elasticity of demand for Coke is positive and high
2. Consumers feel richer…
3. Consumption of Coke increases by a big amount, because Coke’s IED is high
1. When the price of Coke decreases…
4. So, a decrease in the price of Coke leads to a big increase in the consumption of Coke, meaning that Coke’s PED is high
Clothes
Coke
Books
Movies
Pepsi

24. Computing percentages

25. Computing the Percentage of a Price Change—Usual Method
Old Price
$2.00
New Price
$2.20
Increase
2.20 – 2.00 = $0.20
% Increase
[(2.20 – 2.00)/2.00] × 100 = 10%

26. Computing the Percentage of a Quantity Change—Usual Method
Old Quantity 10
New Quantity 8
Increase
8 – 10 = –2
% Increase
[(8 – 10)/10] × 100 = –20%

27. Computing the Price Elasticity of Demand: Usual Method
The price of an ice cream cone increases from $2.00 to $2.20
The amount you buy falls from 10 to 8 cones
What is your elasticity of demand?

28. Computing the Price Elasticity of Demand
But what do you do if you have to compute the PED from the demand schedule on the left?
Here you do not know whether the price increased from 2 to 4 or decreased from 4 to 2
What do you do in this case? P Q 2 10 4 8

29. Computing the Percentage Change in Price
If the price (P) goes from 2 to 4 it is a 100% increase: [(4 – 2) / 2] × 100 = 100
If P goes from 4 to 2 it is a 50% decrease: [(2 – 4) / 4] × 100 = – 50
So, in the PED formula should we use 100 or – 50 for the percentage increase in P?
After all, both answers seem logical! P Q 2 10 4 8

30. Computing the Percentage Change in Price
If the price (P) goes from 2 to 4 it is a 100% increase: [(4 – 2) / 2] × 100 = 100
If P goes from 4 to 2 it is a 50% decrease: [(2 – 4) / 4] × 100 = – 50
So, in the PED formula should we use 100 or – 50 for the percentage increase in P?
After all, both answers seem logical! P Q 2 10 4 8
An acceptable compromise may be to divide, not by 2, not by 4, but by the average of 2 and 4

31. Computing the Percentage Change in Price: Midpoint Formula
A good compromise is the midpoint formula
Denote any one of the two rows of numbers as “new” and the other as “old”
Then compute: P Q 2 10 4 8
If the (2,10)-row is “old”, the percent increase in P is (4 – 2)/3 × 100 =
On the other hand, if the (4, 8)-row is “old”, the percent increase in P is (2 – 4)/3 × 100 = –
Either way, the magnitude is the same.

32. Computing the Percentage Change in Quantity: Midpoint Formula
The percent increase in quantity can be computed in the same way
If the (2,10)-row is “old”, the percent increase in Q is (8 – 10)/9 × 100 = – 22.22
if the (4, 8)-row is “old”, the percent increase in Q is (10 – 8)/9 × 100 = 22.22
Either way, the magnitude is the same P Q 2 10 4 8

33. Computing the Price Elasticity of DemandQ 2 10 4 8
Therefore, PED = / = 1/3

34. The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities
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.

35. Midpoint Formula: example
The price of an ice cream cone increases from $2.00 to $2.20
The amount you buy falls from 10 to 8 cones
What’s your elasticity of demand?
use the midpoint formula

36. PED and the shape of the demand curve

37. Elastic, Unit-Elastic and Inelastic Demand
Demand can be
Inelastic
Unit-elastic
Elastic
… depending on the magnitude of the PED

38. Inelastic Demand: PED < 1
Suppose:
Price changes by 10%
Quantity demanded changes by 5%.
% change in quantity is smaller than the % change in price
Here PED = 5/10 = 0.5 < 1
Demand is inelastic

39. Unit-Elastic Demand: PED = 1
Suppose:
Price changes by 10%
Quantity demanded changes by 10%.
% change in quantity is equal to the % change in price
Here PED = 10/10 = 1
Demand is unit-elastic

40. Elastic Demand: PED > 1
Suppose:
Price changes by 10%
Quantity demanded changes by 30%.
% change in quantity is greater than the % change in price
Here PED = 30/10 = 3 > 1
Demand is elastic

41. Computing the Price Elasticity of Demand: Example$5 4
Demand 50
100
Quantity
Demand is price elastic

42. Perfectly Inelastic and Perfectly Elastic Demand
Perfectly Inelastic Demand
Quantity demanded does not respond at all to price changes.
PED = 0.
Perfectly Elastic Demand
Quantity demanded changes infinitely with any change in price.
PED = infinity.

43. The Variety of Demand Curves
Because PED measures how strongly quantity demanded responds to the price, it is closely related to the slope of the demand curve.
The higher the price elasticity of demand, the flatter the demand curve.

44. Figure 1 The Price Elasticity of Demand
(a) Perfectly Inelastic Demand: Elasticity Equals 0
Price
Demand
100 $5
1. An
increase
in price . . . 4
Quantity
leaves the quantity demanded unchanged.

45. Figure 1 The Price Elasticity of Demand
(b) Inelastic Demand: Elasticity Is Less Than 1
Price
Demand $5 90
1. A 22%
increase
in price . . . 4
100
Quantity
leads to an 11% decrease in quantity demanded.

46. Figure 1 The Price Elasticity of Demand
(c) Unit Elastic Demand: Elasticity Equals 1
Price
Demand $5 80
1. A 22%
increase
in price . . . 4
100
Quantity
leads to a 22% decrease in quantity demanded.
Copyright©2003 Southwestern/Thomson Learning

47. Figure 1 The Price Elasticity of Demand
(d) Elastic Demand: Elasticity Is Greater Than 1
Price
Demand $5 50
1. A 22%
increase
in price . . . 4
100
Quantity
leads to a 67% decrease in quantity demanded.

48. Figure 1 The Price Elasticity of Demand
(e) Perfectly Elastic Demand: Elasticity Equals Infinity
Price
1. At any price
above $4, quantity
demanded is zero. $4
Demand
2. At exactly $4,
consumers will
buy any quantity.
3. At a price below $4,
quantity demanded is infinite.
Quantity

49. Ped affects the link between price and sales revenue

50. Total Revenue and the Price Elasticity of Demand
Total revenue (TR) is the amount paid by buyers (and, therefore, received by sellers) of a good.
It is computed as the price of the good times the quantity sold.
TR = P x Q

51. Figure 2 Total Revenue Price $4 P × Q = $400 P (revenue) Demand 100
Quantity Q

52. Elasticity and Total Revenue: Inelastic Demand
Suppose demand is inelastic
Specifically, suppose
Price increases by 10%, and
Quantity demanded decreases by 4%.
TR = P × Q
+6%
+10%
- 4%
Conclusion: When demand is inelastic, price and total revenue move in the same direction.

53. Elasticity and Total Revenue: Elastic Demand
Suppose demand is elastic
Specifically, suppose
Price increases by 10%, and
Quantity demanded decreases by 25%.
TR = P × Q
- 15%
+10%
- 25%
Conclusion: When demand is elastic, price and total revenue move in opposite directions.

54. Elasticity and Total Revenue: Unit-elastic Demand
Suppose demand is unit-elastic
Specifically, suppose
Price increases by 10%, and
Quantity demanded decreases by 10%.
TR = P × Q
No Change
+10%
- 10%
Conclusion: When demand is unit-elastic, price has no effect on total revenue.

55. Elasticity of a Linear Demand Curve
Note that demand can change from elastic to unit-elastic to inelastic as the price changes
That is, in addition to the other factors discussed before, PED also depends on the price

56. Other important elasticities

57. Cross Price Elasticity of Demand
The cross price elasticity of demand (CPED) measures the responsiveness of the quantity demanded of one good to changes in the price of some other good.
Suppose:
The price of Coke increases 2%, and
The consumption of Pepsi increases 20%.
The CPED for Coke with respect to Pepsi is +20/+2 = +10.

58. Substitutes: CPED > 0
When the CPED for one good with respect to another is positive, the two goods are called substitutes.
In the last slide’s example, the CPED for Coke with respect to Pepsi was +10, which is positive.
This confirms our common-sense intuition that Coke and Pepsi are substitutes.

59. Complements: CPED < 0
When the CPED for one good with respect to another is negative, the two goods are called complements.
Suppose:
the price of gasoline increases 50%
the sale of cars decreases 10%
The CPED is -10/+50 = -0.2, which is negative.
This is what one would expect, given our common-sense notion that gas and cars are complements.

60. THE ELASTICITY OF SUPPLY
Price elasticity of supply is a measure of how strongly the quantity supplied of a good responds to a change in the price of that good.

61. Elasticity: examples
The price elasticity of supply is the percent increase in the quantity supplied of a commodity when there is a one percent increase in the price of the commodity
and all other factors that affect quantity supplied are unchanged

62. Figure 6 The Price Elasticity of Supply
(a) Perfectly Inelastic Supply: Elasticity Equals 0
Price
Supply $5
1. An
increase
in price . . . 4
100
Quantity
leaves the quantity supplied unchanged.

63. Figure 6 The Price Elasticity of Supply
(b) Inelastic Supply: Elasticity Is Less Than 1
Price
Supply
110 $5
1. A 22%
increase
in price . . .
100 4
Quantity
leads to a 10% increase in quantity supplied.

64. Figure 6 The Price Elasticity of Supply
(c) Unit Elastic Supply: Elasticity Equals 1
Price
Supply
125 $5
1. A 22%
increase
in price . . .
100 4
Quantity
leads to a 22% increase in quantity supplied.

65. Figure 6 The Price Elasticity of Supply
(d) Elastic Supply: Elasticity Is Greater Than 1
Price
Supply $5
200
1. A 22%
increase
in price . . . 4
100
Quantity
leads to a 67% increase in quantity supplied.

66. Figure 6 The Price Elasticity of Supply
(e) Perfectly Elastic Supply: Elasticity Equals Infinity
Price
1. At any price
above $4, quantity
supplied is infinite. $4
Supply
2. At exactly $4,
producers will
supply any quantity.
3. At a price below $4,
quantity supplied is zero.
Quantity

67. Determinants of Elasticity of Supply
The price elasticity of supply is high
if the technology enables sellers to change the amount of the good they produce.
Beach-front land has inelastic supply.
Books, cars, or manufactured goods have elastic supply.
if suppliers have time to respond to a price change
Supply is more elastic in the long run.

68. applications

69. THREE APPLICATIONS OF SUPPLY, DEMAND, AND 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?

74. Screen shot from nytimes.com