Demand & Utility

What is Utility?

Satisfaction, happiness, benefit

 Cardinal Utility vs. Ordinal Utility

Cardinal Utility: Assigning numerical

values to the amount of satisfaction
Ordinal Utility: Not assigning numerical
values to the amount of satisfaction but
indicating the order of preferences, that is,
what is preferred to what
 Util

A unit of measure of utility

 Total Utility
The amount of satisfaction obtained by
consuming specified amounts of a product
per period of time.
Example: TU(X) = U(X) = 16 X – X2
where X is the amount a good that is
consumed in a given period of time.

5 units of the product per period of time

yields 55 utils of satisfaction
 Marginal Utility

The change in total utility (TU) resulting from

a one unit change in consumption (X).
MU = TU/ X
 Diminishing Marginal Utility

Each additional unit of a product contributes

less extra utility than the previous unit.
When the changes in consumption are
infinitesimally small, marginal utility is the
derivative of total utility.

MU = dTU/dX
Calculating MU from a TU Function
Example: TU(X) = 16 X – X2

MU = dTU/dX = 16-2X
In general, the derivative of a total function
is the marginal function.

The marginal function is the slope of the

total function.
 Graphs of Total Utility
Total
TU
& Marginal Utility
Utility
X1 is where marginal utility
reaches its maximum.
This is where we encounter
diminishing marginal utility.
The slope of TU has reached its
maximum; TU has an inflection
X1 X2 X point here.
Marginal
Utility X2 is where total utility reaches
its maximum.
MU MU is zero.
This is the saturation point or
satiation point.
After that point, TU falls and
MU is negative.
X1 X2 X
 Example: If TU = 15 X + 7X2 – (1/3) X3,
find (a) the MU function,
(b) the point of diminishing marginal utility,
& (c) the satiation point.
a. MU = dTU/dX = 15 +14X – X2
b. Diminishing MU is where MU has a maximum, or the
derivative of MU is zero.
0 = dMU/dx = 14 – 2X
 X=7
c. Satiation is where TU reaches a maximum or its
derivative (which is MU) is zero.
How do we determine where MU = 15 +14X – X2 = 0 ?
Apply Quadratic Formula to –X2 + 14 X + 15 = 0 .

b  b  4ac 2
14  (14) 2  4(1)(15)
X 
2a 2(1)

14  256 14  16

 
2 2
2 30
So either X   1 or X   15
2 2

Since a negative amount of a product makes no sense,

X must equal 15.
If the previous example were about eating
free cookies at a party, you’d eat 15 of them.

That is where you become satiated.

After 15 cookies, you begin to feel a bit bloated.
 When you have more than one product,
the marginal utility is a partial derivative.
Calculating partial derivatives is no more difficult than calculating
other derivatives.
You just treat all variables as constants, except the one with
which you are taking the derivative.
We denote the partial derivative of Z with respect to X as Z/X
instead of dZ/dX.
Example: Z = X2 +3XY + 5Y3
To take the partial derivative with respect to X, pretend Y is a
constant (like 4). Then,
Z/X = 2X + 3Y .
Similarly, to take the partial derivative with respect to Y,
pretend X is a constant (like 4). So,
Z/Y = 3X + 15Y2 .
 Indifference Curve

A set of combinations of goods that are

viewed as equally satisfactory by the
consumer.
 Indifference Map

A collection of indifference curves

 Assumptions

1. The consumer can rank all bundles of

commodities.
2. If bundle A is preferred to bundle B and
B is preferred to C, then A is preferred to
C. (This property is called transitivity.)
3. More is better.
Characteristics of indifference curves
 Indifference curves slope down from left to right.
Consider 2 points A & B on the
same indifference curve.
At point B, you have more food
clothing than at point A.
If the amount of clothing you had
at point B was the same as or
more than at point A (like at
A C point C), you would not be
indifferent between A and B
(since more is better).
B So A & B could not be on the
same indifference curve, which
goes against our initial statement
that they are.
So you must have less clothing
food at B, which means than B lies
below A and the indifference
curve slopes downward.
 Indifference curves to the northeast are preferred.
Point E is preferred to
point A because it has
clothing
more food & more
clothing.
E
Since you are indifferent
between A & all points
on IC1, E must be
A IC2 preferred to all points on
IC1.
Since you are indifferent
IC1
between E and all
points on IC2, all points
on IC2 must be
food preferred to all points on
IC1.
 Indifference curves can not intersect.
Suppose indifference curves could intersect.
Let the intersection of IC1 & IC2 be D.
Then you must be indifferent between D &
any other point A on IC1.
clothing
Similarly, you must be indifferent between D
& any other point B on IC2.
By transitivity, you must be
indifferent between A & B.
But A & B are not on the same
D
indifference curve, which they
B IC2 should be if you are indifferent
between them.
IC1
Then, our initial supposition that
A indifference curves could
intersect must be wrong.
food
 Indifference curves are convex
[the slopes of IC’s fall as we move from left to right, or
we have a diminishing marginal rate of substitution (MRS)]

When we have lots of

clothing
clothing & not much food
(as near A & B), we are
willing to give up a lot of
A clothing to get a little
B
more food.
When we have lots of
food & not much clothing
C
D
(as near C & D), we are
willing to give up very
little clothing to get a
food
little more food.
 Odd special cases that are not
consistent with the characteristics
listed previously.
 Perfect Complements
tires
You need exactly 4 tires
with 1 car body
(ignoring the spare tire).
8
IC2
Having more than 4 tires
with 1 car body doesn’t
increase utility.
IC1
4 Also having more than 1
car body with only 4
tires doesn’t increase
utility either.
1 2 Car bodies
 Perfect Substitutes
Consider two packs of paper;
Mini-packs
the mini-pack has 100 sheets &
the jumbo pack has 500 sheets.
10 No matter how many mini-packs
or jumbo packs you have, you
are always willing to trade 5
mini-packs for 1 jumbo pack.
5
Since the rate at which you’re
IC2 willing to trade is the slope of
IC1 the IC, and that rate is constant,
your IC’s have a constant slope.
1 2 Jumbo That means they are straight
packs lines.
 Goods versus Bads
production
As you get more of a
bad, you need more
of a good to
compensate you, to
keep you feeling
IC2
equally happy.
IC1
So IC of a good & a
pollution bad slopes upward.
 “Neutral” Good
Neutral good

IC1 IC2 IC3

Your utility is unaffected

by consumption of a
neutral good.

Desired
good
 Addict
Substance 1
The more substance 1
the addict has the more
he/she is willing to give
up of substance 2 to get
a little more of 1 (& vice
versa).
So the IC’s are concave
instead of convex.
Substance 2
The slope of the indifference curve is
the rate at which you are willing to
trade off one good to get another good.

It is called the marginal rate of substitution

or MRS.
 What is the MRS or slope of the IC?
Clothing C Suppose points A & B are on the same
indifference curve & therefore have the
same utility level.
IC2
IC1 Let’s break up the move from A to B
into 2 parts.
A AD: TU = C (MUC)
B DB: TU = F (MUF)
AB:
D
0 = TU = C (MUC) + F (MUF)
 C (MUC) = – F (MUF)
Food F  C/F = – MUF / MUC
So along an indifference curve, the slope or MRS is the
negative of the ratio of the marginal utilities (with the MU of the
good on the horizontal axis in the numerator).
MRS = – MUX / MUY
 For example, Suppose IC1 is the 90-util indifference
curve & IC2 is the 96-util indifference
Clothing C
curve.
Point A is 7 units of food & 6 of
IC1 =90
IC2 = 96 clothing.
B is 9 units of food & 5 of clothing.
A Since an additional unit of clothing
6 gives you 6 more utils of satisfaction,
B the MU of clothing must be 6.
5 D Since an additional 2 units of food
also give you 6 more utils of
satisfaction, the MU of food must be 3.
7 9 Food F So, MRS = – MUF / MUC = -3/6 = -0.5 .
You’d give up 2 units of food to get
1 units of clothing.
 Budget Constraint or Budget Line

This equation tells you what you can buy.

For example, suppose you have $24, & there are
two goods.
The price of the first good is $3 per unit & the price
of the second good is $4 per unit.
So, if you buy X units of the first good for $3 each,
you spend 3X on that good.
Similarly, if you buy Y units of the second good, you
spend 4Y on that good.
Your total spending is 3X+4Y.
If you spend all 24 dollars that you have, 3X+4Y=24.
That equation is your budget constraint.
 Example: Budget constraint for $24 of income,
and $3 & $4 for the prices of the two goods.

If you spent all $24 on the 1st good,

you could buy 8 units.
Y
If you spent all $24 on the 2nd good,
you could buy 6 units.
So we have the intercepts of the
(0,6) budget constraint.
The slope of the line connecting these
two points is
Y/X = – 6/8 = – 3/4 = – 0.75 .

0 (8,0)
X
Let’s generalize. Keep in mind that income was $24
and the prices of the goods were $3 & $4. The equation of
the budget constraint in our example was 3X + 4Y = 24.
So the budget constraint is p1X + p2Y = I
Solving for Y in terms of X, p2Y = I – p1X,
Y or Y = I /p2 – (p1/p2)X
So from our slope-intercept form, we see that
the intercept is I /p2, and the slope is –p1/p2 .
(0,6)
The intercept is income divided by the price of
the good on the vertical axis.
The slope is the negative of the ratio of
the prices, with the price of the good
on the horizontal axis in the
numerator.
0 (8,0)
X
 We have the intercept is I /p2,
& the slope is –p1/p2 .
What if income increased?
The slope would stay the same & the budget constraint
would shift out parallel to the original one.
Y
(0,9) Suppose in our example with income of 24 & prices of
3 & 4, income increased to 36.
(0,6) Our new y-intercept will be 36/4 =9
& the new X-intercept will be 36/3=12.

0 (8,0) (12,0)
X
Suppose the price of the good on the X-axis increased.
If we bought only the good whose price
increased, we could afford less of it.
If we bought only the other good, our
purchases would be unchanged.
Y
So the budget constraint would pivot inward
about the Y-intercept.
(0,6)
For example, if the price increased
from $3 to $4, our $24 would only
buy 6 units.

0 (6,0) (8,0)
X
 Similarly, if the price of the good on the Y-axis
increased, the budget constraint would pivot
in about the X-intercept.

Suppose the price of the 2nd good

Y
increased from $4 to $6. If you bought
only that good, with your $24, your $24
(0,6) would only buy 4 units of it.
(0,4)

0 (8,0)
X
 Let’s combine our indifference curves &
budget constraint to determine our utility
maximizing point.
Point A doesn’t maximize
Y
IC3 our utility & it doesn’t
IC2
IC1
spend all our income.
(It’s below the budget
constraint.)

0
X
 Points B & C spend all our
income but they don’t maximize
our utility. We can reach a
IC3
Y
IC2 higher indifference curve.
IC1

0
X
 Point D is unattainable. We
can’t reach it with our budget.
IC3
Y
IC2
IC1

0
X
 Point E is our utility-maximizing point.
We can’t do any better than at E.
Notice that our utility is maximized at
IC3 the point of tangency between the
Y
IC1
IC2 budget constraint & the indifference
curve.

0
X
Recall from Principles of Microeconomics, to maximize
your utility, you should purchase goods so that the
marginal utility per dollar is the same for all goods.
If there were just two goods, that means that MU1/P1 = MU2/P2
Multiplying both sides by P1/MU2, we have MU1/MU2 = P1/P2 .
The expression on the right is the negative of the slope of the
budget constraint.
The expression on the left is the negative of the slope of the
indifference curve.
So the slope of the indifference curve must be equal to the slope
of the budget constraint.
If at a particular point, two functions have the same slope, they
are tangent to each other.
That means your utility-maximizing consumption levels are where
your indifference curve is tangent to the budget constraint.
This is the same conclusion we reached using our graph.
Example: If TU = 10X + 24Y – 0.5 X2 – 0.5 Y2, the
prices of the two goods are 2 and 6, and we have
$44, how much should you consume of each good?

Taking the derivatives of TU we have

MU1 = 10 – X and MU2 = 24 – Y
Since MU1/MU2 = P1/P2 , we have
(10 – X) / (24 – Y) = 2 / 6 ,
or 60 – 6 X = 48 – 2Y ,
or 6X – 2Y = 12 .
This an equation with two unknowns.
Our budget constraint provides us with a 2nd equation.
Combining the two equations, we can solve for X & Y.
The budget constraint is 2X + 6Y = 44 .
 So our two equations are
6X – 2Y = 12 and 2X + 6Y = 44
Multiplying the second equation by 3 yields
6X + 18Y = 132 .
Now we have 6X + 18Y = 132
6X – 2Y = 12
--------------------
So, 20Y = 120
and Y= 6.
Plugging 6 in for Y in the 2nd equation yields 6X – 12 = 12,
or 6X = 24.
So, X= 4.
 Let’s see if all this works.
We had $44, the prices were 2 & 6, and
MU1 = 10 – X & MU2 = 24 – Y. We bought 4 units
of the 1st good & 6 of the 2nd good.
First, did we spend exactly what we had?
We spent (2)(4) + (6)(6) = 8 + 36 = 44 Good.
Is the marginal utility per dollar the same for both
goods?
For the 1st good: MU1/P1 = (10 – X)/2 = (10-4)/2 = 3
For the 2nd good: MU2/P2 = (24 – Y)/6 = (24-6)/6 = 3
So they’re equal and things look fine.
What happens to consumption when income
rises?

For normal goods, consumption increases.

For inferior goods, consumption decreases.
What does this look like on our graph?
 Two Normal Goods
As income increases, the
budget constraint shifts out
& we are able to reach
Y
IC3 higher & higher IC’s.
IC2
The points of tangency are
IC1
at higher & higher levels of
C
Y3
consumption of both goods.
B
Y2
A
Y1

X1 X 2 X 3
X
 Income-Consumption Curve
The curve that traces out
these points is called the
income-consumption curve.
Y IC2
IC3
For two normal goods, the
curve slopes upward.
IC1
C
It may be convex (as drawn
Y3 here), concave, or linear.
B
Y2
A
Y1

X1 X 2 X 3
X
 One Normal Good & One Inferior Good

Suppose the good on the

horizontal axis is normal &
the one on the vertical axis
Y
is inferior.
IC1 IC2 Then X will rise & Y will fall
IC3
as income increases.

A
Y1 B
Y2 C
Y3

X1 X2 X3
X
 Income-Consumption Curve

The result is a downward sloping

income-consumption curve.
Y

IC1 IC2
IC3

A
Y1 B
Y2 C
Y3

X1 X2 X3
X
 Engel Curve

Income
The Engel Curve shows
the quantity of a good
purchased at each
income level.
C
The graph has income
I3 on the vertical axis and
B
the quantity of the good
I2
A on the horizontal.
I1
It slopes up for normal
goods & down for
X1 X2 X3 X inferior goods.
We can also look at consumption levels of two
goods when the price of one of them changes.
Suppose there is an increase in the price
of the 1st good (the good on the X-axis).
Y The budget constraint pivots inward.
Here we see X drop & Y increase.
In this case, our 2 goods are
substitutes.
Y3
Y2
Y1

X3 X2 X1
X
 If we connect the points, we have the
price consumption curve.

It shows the utility-maximizing

Y points when the price of a
good changes.

Y3
Y2
Y1

X3 X2 X1
X
If we look at the price of a good & the amount
of it consumed, we have the demand curve
for our particular individual.
P

As the price decreases the

quantity demanded increases
P1
& vice versa.
P2

P3

X1 X2 X3 X
We can separate the effect of a change in the price of
a good on its consumption level into two parts:
the income effect & the substitution effect.
Suppose the price of the
first good increases.
Y The budget constraint was
originally the blue line and
we were at A consuming
quantities XA & YA.
YB B A
After the price change, the
YA budget constraint is the red
line, and we’re at B
consuming XB & YB .

XB XA
X
We first want to capture the effect of the price change
without the effect of the change in income.
We draw a line parallel to the new budget
constraint and tangent to the old indifference
curve.
This will reflect the new relative prices, but since
Y we are tangent to the old indifference curve we
are just as well off as initially.
Under those circumstances we would be at point
H (for hypothetical).
H
YH
Since the 1st good is now relatively more
B A
expensive compared to the 2nd, we will
YB
YA substitute, increasing Y & decreasing X.

XB XH XA
X
 The movement from A to H is the
substitution effect.
As a result of the increase in the relative
price of the 1st good, we reduce our
Y consumption of it and consume more of
the other good.

H
YH
YB B A
YA

XB XH XA
X
 Now we move from H to B
Our purchasing power has been reduced by the
price change. That results in the income effect.
In our graph, we now hold the relative prices
constant at the new level, but income has
fallen. Our budget constraint has shifted
Y inward.
If both goods are normal, as a result of the
change in income, we reduce our consumption
of both goods, and X & Y fall.
H
This is the income effect of the price change.
YH
YB B A
YA

XB XH XA
X
 Total Effect of Price Increase
The total effect is to move from A to B.
X has fallen.
Both the substitution & income effects led to a
drop in X.
Y Y has increased in this case.
The substitution effect increased consumption
of the 2nd good, but the income effect reduced
it by less than the substitution effect increased
H it.
YH
YB B A
YA

XB XH XA
X
 Let’s do a price decrease.
The budget constraint moves from the blue line
to the red line.
We draw a line parallel to the new budget
constraint and tangent to the old indifference
curve.
Y
H is the tangency of the hypothetical budget
constraint with the old indifference curve.
The substitution effect is the movement from A
to H.
We substitute increasing X & decreasing Y.
B
YB

YA A H

YH

XA XH XB
X
The movement from H to B is the income effect.

As a result of the higher income (greater

Y
purchasing power), we consume more of both
goods, if they are normal goods.

B
YB

YA A H

YH

XA XH XB
X
 Total Effect
The total effect is to move from A to B.
X has increased.
Both the substitution & income effects led to an
increase in X.
Y Y has also increased in this case.
The substitution effect decreased consumption
of the 2nd good, but the income effect increased
it by more than the substitution effect decreased
it.
B
YB

YA A H

YH

XA XH XB
X
 Income and Substitution Effects, in words

The income effect is the result of the change in purchasing

power.
If the price of a normal good increases, you feel poorer,
and the income effect is to consume less.
If the price of a normal good decreases, you feel richer,
and the income effect is to consume more.
The substitution effect is the result of a change in relative
prices.
If the price of a good increases, the substitution effect is to
consume less of it & more of the other goods that are
now relatively cheaper.
If the price decreases, the substitution effect is to consume
more of it & less of the goods that are now relatively
more expensive.
What if the price changed of an inferior good?

The substitution effect would be the same

but the income effect would be the opposite.
 Price increase for an inferior good
Income effect:
Your purchasing power has decreased. You feel poorer.
So you consume more of the inferior good.
Substitution effect:
The good is now relatively more expensive than other goods,
so you consume less of it and more of other goods.
Notice the IE & SE are in opposite directions in this case.
If the SE is larger than the IE, you will consume less of the
good.
If the IE is larger than the SE, you will consume more of the
good.
 An inferior good for which the IE is larger
than the SE is called a Giffen good.

It is a good for which consumption rises

when the price increases, and consumption
falls when the price decreases.
 Price decrease for an inferior good
Income effect:
Your purchasing power has increased. You feel richer. So
you consume less of the inferior good.
Substitution effect:
The good is now relatively more cheaper than other goods,
so you consume more of it and less of other goods.
Again the IE & SE are in opposite directions in this case.
If the SE is larger than the IE, you will consume more of the
good.
If the IE is larger than the SE, you will consume less of the
good.
We previously looked at the demand curve
for individuals.
How do we get the market demand curve
from the demand curve for individuals?
We just horizontally sum up the individual
demand curves.
 Market Demand Curve: 3-person example
At a price of $1, person A will buy 4 units of a good, B will buy 2
units, & C will buy 3 units. So at a price of $1, the quantity
demanded by the entire 3-person market is 9 units.

P P
P P

2 2 2 2

1 1 1 1

2 4 Q 1 2 Q 1 3 Q 4 9 Q

Person A Person B Person C Market

 Market Demand Curve: 3-person example
At a price of $2, person A will buy 2 units of a good, B will buy 1
units, & C will buy 1 units. So at a price of $2, the quantity
demanded by the entire 3-person market is 4 units.

P P
P P

2 2 2 2

1 1 1 1

2 4 Q 1 2 Q 1 3 Q 4 9 Q

Person A Person B Person C Market

 Market Demand Curve: 3-person example
Continuing the process, we get the market demand curve.

P P
P P

2 2 2 2

1 1 1 1

2 4 Q 1 2 Q 1 3 Q 4 9 Q

Person A Person B Person C Market

 The Demand for a product can be
expressed as a function of

1. its price
(changes in which lead to movements along the
demand curve), and
2. other determinants such as income, prices of related
goods, & expectations (changes in which lead to shifts
of the demand curve).
So we have QDX = g(PX, Psubst, Pcomp, Inc., Expect.)
A particular demand curve QDX = g(PX) shows the
relation between the quantity demanded of a product
and its price when we hold all the factors constant.
This is also sometimes written as P= f(Q).
Total Revenue

TR = PQ
 Average Revenue

total revenue per unit of output

AR = TR / Q
= (PQ) / Q
=P

AR & P are the same function of Q.

 Marginal Revenue

The additional revenue associated with

an additional unit of output

MR = dTR / dQ
 Example: Horizontal Demand Curve
(price is a constant function)
P
P = f(Q) = 10

10 AR = P = 10
D = AR =MR
TR = PQ = 10 Q
MR = dTR / dQ = 10
So D, AR, & MR are the same
Q
P horizontal function.
TR
slope = MR = 10 TR is an upward sloping line with
a constant slope.
Implications for revenue:
Every time you sell another unit of
output, revenue increases by the
Q price, which is constant.
 Example:
linear, downward-sloping Demand curve
P P = f(Q) = 8 – 3Q
8
AR = P = 8 – 3Q
TR = PQ = (8 – 3Q) Q
D = AR
= 8Q – 3Q2
MR MR = dTR / dQ = 8 – 6Q
D & MR have the same vertical
P
Q intercept. MR is twice as steep
as D. (The slope of MR is -6;
the slope of D is -3)
TR Implications for revenue:
Revenue increases more &
more slowly & then decreases
more & more quickly.
Q
 Example:
quadratic, downward-sloping Demand curve
P
20
D = AR

P = f(Q) = 20 – Q2
AR = P = 20 – Q2
MR
TR = PQ = (20 – Q2) Q
P
Q = 20Q – Q3
MR = dTR / dQ = 20 – 3Q2
MR is a quadratic; TR is a cubic.
TR

Q
 Elasticity

Responsiveness or sensitivity of one

variable to a change in another variable
(% change in X)
ε = ------------------------
(% change in Y)
 Price Elasticity of Demand

(% change in quantity demanded)

ε = ------------------------------------------------
(% change in price)
 Two methods of calculating elasticity

Arc elasticity: measures responsiveness

between 2 points
Point elasticity: measures responsiveness
at a single point for an infinitesimally small
change
 Arc Elasticity

ΔQ/(avg Q) [Q2 – Q1] / [(Q1+Q2)/2]

--------------- = --------------------------------
ΔP/(avg P) [P2 – P1] / [(P1+P2)/2]
 Arc Elasticity Example
Calculate the price elasticity of demand if in response to a increase in
price from 9 to 11 dollars, the quantity demanded decreases from
60 to 40 units.
P: 9→11 Q: 60→40

ΔQ/(avg Q) [Q2 – Q1] / [(Q1+Q2)/2]

ε = --------------- = --------------------------------
ΔP/(avg P) [P2 – P1] / [(P1+P2)/2]

[40 – 60] / [(60+40)/2] -20 / 50 -0.4

= ------------------------------ = ------------ = ------- = -2.0
[11 – 9] / [(9+11)/2] 2 / 10 0.2

The negative sign indicates that price & quantity move in opposite
directions.
The negative sign is sometimes dropped with the understanding that
price & quantity are still moving in opposite directions.
 Point Elasticity

dQ / Q dQ P
ε = ---------- = ----- ----
dP / P dP Q
 Point Elasticity Example

If the demand function is Q = 245 – 3.5 P, find the

price elasticity of demand when the price is 10.
When P = 10, Q = 245 – 3.5(10) = 210
The derivative dQ / dP = = – 3.5

dQ / Q dQ P 10
ε = ---------- = ----- --- = - 3.5 ------ = - 0.167
dP / P dP Q 210
 Categories of
Price Elasticity of Demand

Demand is elastic if |ε| > 1

Demand is inelastic if |ε| < 1
Demand is unit elastic if |ε| = 1
 What is the relationship between elasticity &
the slope of the demand curve?

dQ / Q dQ P 1 P
ε = ---------- = ----- ---- = -------- ----
dP / P dP Q dP/dQ Q
= (1/slope) (P/Q)
So, if 2 demand curves pass through the same point
(& therefore have the same values of P & Q at
that point), the flatter curve (curve with the smaller
slope) has the greater elasticity at that point.
 Example
P

D1
D2

At point E, D1 has greater elasticity than D2 .

Elasticity on a Linear Demand Curve

Above the midpoint, |ε| > 1 (elastic)

At the midpoint, |ε| = 1 (unit elasticity)

At the midpoint, |ε| < 1 (inelastic)

Q
 Let’s show in an example that |ε| = 1
at the midpoint of a linear demand curve.
demand curve: P = 24 – 4Q
When Q = 0, P = 24. So that’s our vertical intercept.
When P = 0, Q = 6. That’s our horizontal intercept.
The midpoint then is (3,12).
The slope is dP/dQ = – 4 .
We found earlier that ε = (1/slope) (P/Q)
P
24 So ε = (1/-4) (12/3)
= (1/-4) (4)
12 |ε| = 1 = -1

MR D
3 6 Q
 Relationship between Elasticity
& Total Revenue

Price increase:
|ε| > 1: P   Q   TR
|ε| < 1: P   Q   TR 
|ε| = 1: P   Q   TR unchanged
 Relationship between Elasticity
& Total Revenue

Price decrease:
|ε| > 1: P   Q   TR 
|ε| < 1: P   Q   TR 
|ε| = 1: P   Q   TR unchanged
 The most profitable place to be is in the
elastic portion of the demand curve.

In the inelastic portion of the demand curve,

marginal revenue is negative (additional
units of output lower total revenue).
While this is true in general, we can
demonstrate it in the linear demand case.
 Recall that for a linear demand curve,
marginal revenue is twice as steep as the demand curve.

P
So MR reaches the horizontal axis when
|ε| > 1 the demand curve is only halfway there.

|ε| = 1
So when MR = 0 at the midpoint, |ε| = 1.
|ε| < 1
MR D
From the graph, we can see that above
Q the midpoint where |ε| > 1, MR > 0
P
& TR is increasing.

Below the midpoint, where |ε| < 1 ,

MR < 0 & TR is decreasing.

TR

Q
Special Elasticity Cases
 |ε| = 
Infinite Elasticity
Perfectly Elastic
P

Q
 |ε| = 0
Zero Elasticity
Perfectly Inelastic
P

Q
 |ε| = 1
Unit Elasticity
P
D

P=k/Q
where k is a constant

Q
Facts about Price Elasticity of Demand

1. The more substitutes there are for a product,

the more elastic the demand.
2. An individual firm’s product has a more elastic
demand than the entire industry’s product.
3. The longer the time period, the greater the
elasticity of demand, because the greater the
adjustments that are possible.
4. Products (like salt) that are a small part of the
budget have low elasticities of demand.
 Some examples of
estimated price elasticities of demand
Commodity Price Elasticity of Demand
wheat 0.08
cotton 0.12
potatoes 0.31
beef 0.92
haddock 2.20
movies 3.70
Notice that the demands for wheat & cotton are not very responsive to price
changes, whereas the demands for haddock and movies are very
responsive.
 So far the only elasticity that we have
discussed is price elasticity of demand.

There are other types of elasticities.

Each type can be computed as
arc elasticity or point elasticity.
 Income Elasticity of Demand

(% change in quantity demanded)

εI = ------------------------------------------------
(% change in income)
 Categories of Income Elasticity of Demand

Normal Goods:
εI > 1 income elastic
εI = 1 unit income elastic
0 < εI < 1 income inelastic
Luxury items have high income elasticities of demand,
while necessities have low income elasticities of demand.

Inferior Goods:
εI < 0
 Some examples of
estimated income elasticities of demand
Commodity Income Elasticity of Demand
flour -0.36
margarine -0.20
milk 0.07
butter 0.42
books 1.44
restaurant
1.48
consumption
Note that flour & margarine are inferior goods, milk is not very responsive
to income changes, & books & restaurant consumption are income elastic.
 Cross Elasticity of Demand

(% change in quantity demanded of Y)

εYX = ---------------------------------------------------
(% change in price of X)
Categories of Cross Elasticity of Demand
Substitutes: εYX > 0
The price of X & the quantity demanded of Y
move in opposite directions. When the price of X
increases, you consume less of X and more of the
goods that you can use in place of X.

Complements: εYX < 0

The price of X & the quantity demanded of Y
move in the same direction. When the price of X
increases, you consume less of X and less of the
goods that you use with X.
 Some examples of
estimated cross elasticities of demand
Cross Elasticity with
Commodity Cross elasticity
respect to price of
Pork Beef +0.14
Beef Pork +0.28
Butter Margarine +0.67
Margarine Butter +0.81

Notice that the cross elasticity of demand for Y with respect to

the price of X is not necessarily equal to the cross elasticity of
demand for X with respect to the price of Y.
 Price Elasticity of Supply

(% change in quantity supplied)

εS = ------------------------------------------------
(% change in price)
 Categories of
Price Elasticity of Supply

Supply is elastic if εS > 1

Supply is inelastic if εS < 1
Supply is unit elastic if εS = 1