BUI DUY HUNG NINTH EDITION

MICROECONOMICS

CHAPTER

Elasticity and Its Application

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Interactive PowerPoint Slides by:
V. Andreea Chiritescu
Eastern Illinois University

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IN THIS CHAPTER
• What is elasticity?
• What kinds of issues can elasticity help us understand?
• What is the price elasticity of demand?
How is it related to the demand curve?
How is it related to revenue and expenditure?
• What is the price elasticity of supply?
How is it related to the supply curve?
• What are the income and cross-price elasticities of demand?

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IN THIS CHAPTER

1.The Elasticity of Demand

2.The Elasticity of Supply
3.Three Applications of Supply, Demand, and Elasticity

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 Our scenario

• You maintain the social media accounts for local businesses

– You charge $2,000 per business, and currently maintain the social media
accounts for 12 businesses per year.
• Your costs are rising (including the opportunity cost of your time).
– You consider raising the price to $2,500.
• The law of demand: if you raise your price, you will not have as many accounts
to maintain.
– How many fewer accounts?
– How much will your revenue fall, or might it increase?

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 THE ELASTICITY

Elasticity is a measure of how much buyers and sellers

respond to changes in market conditions.

• Elasticity of demand • Elasticity of supply

– Measure of the – Measure of the
responsiveness of Qd responsiveness of Qs
to a change in one of to a change in one of
its determinants. its determinants.

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 I THE ELASTICITY OF DEMAND

Elasticity of demand: Measure of the responsiveness of Qd to a change in one of

its determinants.

• Price Price elasticity of demand

• Income Income elasticity of demand

• Related goods Cross-price elasticity of demand

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I THE ELASTICITY OF DEMAND: THE PRICE ELASTICITY OF DEMAND

• Price elasticity of demand (Ep)

– How much the quantity demanded of a good responds to a change in the
price of that good
• Loosely speaking, it measures the price-sensitivity of buyers’ demand

Percentage change in Qd
Ed =
Percentage change in P

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 I THE ELASTICITY OF DEMAND: THE PRICE ELASTICITY OF DEMAND

Computing
P Price elasticity of demand is

P rises P2 15%
by 10% P1 Ed = = 1.5
10%
D
Q
Q2 Q1
Along a D curve, P and Q move in
Q falls opposite directions, which would
by 15% make price elasticity negative.
We will drop the minus sign and report all price elasticities as positive numbers
(absolute values).
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 Calculating percentage changes
Demand for maintaining Standard method of computing
social media accounts the percentage (%) change:
P
B
$2500 end value  start value
$2000
A  100%
start value
D
Q Going from A to B:
8 12 • the % change in P = 25%
Going from B to A: • the % change in Q = - 33%
• % change in P = - 20% Price elasticity = 33/25 = 1.33
• % change in Q = 50%
Price elasticity =50/20 = 2.5 We get different values!
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 I THE ELASTICITY OF DEMAND: THE PRICE ELASTICITY OF DEMAND

Computing
• Midpoint method
– The midpoint is the number halfway between the start and end values
• The average of those values

end value  start value

percentage change   100%
midpoint
(Q2  Q1 ) / [(Q2  Q1 ) / 2 ]
Price elasticity of demand 
(P2  P1 ) / [(P2  P1 ) / 2 ]

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 Our scenario: calculating percentage changes
Demand for maintaining Using the midpoint method
Computing
social media accounts of computing % changes:
P
B
$2500
A 40%
$2000
Price elasticity =  1.8
D 22.2%
Q
8 12
$2500  $2000
% change in P =  100%  22.2%
$2250
12  8
% change in Q =  100%  40%
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Active Learning 1: Calculate an elasticity

Computing

Use the following information to calculate the

price elasticity of demand for iPhones:
• if P = $400, Qd = 10,600
• if P = $600, Qd = 8,400
A. Use the midpoint method to calculate percentage change in price
B. Use the midpoint method to calculate percentage change in quantity
C. Calculate the price elasticity of demand

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Active Learning 1: Answers

Using the midpoint method to calculate percentage changes:

A. % change in P = [($600 - $400)/$500] ×100 = 40%
B. % change in Qd = [(10,600 – 8,400)/9,500] ×100 = 23.16%
C. Price elasticity of demand = % change in Qd / % change in P
= 23.16/40 = 0.58

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 I THE ELASTICITY OF DEMAND: THE PRICE ELASTICITY OF DEMAND

Determinants of price elasticity of demand

We look at a series of examples comparing two common goods.
• In each example:
– Suppose prices of both goods rise by 20%
– Which good has the highest price elasticity of demand? Why?
– What lesson we learn about the determinants of price elasticity of demand?

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EXAMPLE 1: Bread vs. airfare

• Prices of both of these goods rise by 20%. For which good does Qd drop the
most? Why?

• Bread has many close substitutes, so buyers can easily switch if the price
rises
• Traveling by airplanes has no close substitutes, so a price increase would not
affect demand very much
Price elasticity is higher when close substitutes are available.

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EXAMPLE 2: Iphone vs. mobile phones

• Prices of both of these goods rise by 20%. For which good does Qd drop the
most? Why?

• For a narrowly defined good, iphone, there are many substitutes

• There are fewer substitutes available for broadly defined goods (mobile phone)
Price elasticity is higher for narrowly defined goods than for broadly defined ones.

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EXAMPLE 3: Gasoline vs. Rolex watches

• Prices of both of these goods rise by 20%. For which good does Qd drop the
most? Why?

• Gasoline is a necessity to diabetics. A rise in price would cause little or no

decrease in quantity demanded
• A Rolex watch is a luxury. If the price rises, some people will forego it.
Price elasticity is higher for luxuries than for necessities.

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EXAMPLE 4: Gasoline, short run vs. long run

• The price of gasoline rises 20%. Does Qd drop more in the short run or the long
run? Why?

• There’s not much people can do in the short run, other than ride the bus
or carpool.
• In the long run, people can buy smaller cars or live closer to work.
Price elasticity is higher in the long run.

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 Determinants of price elasticity of demand

• A good with close substitutes tends to have more elastic demand.

• Narrowly defined markets tend to have more elastic demand than broadly
defined markets.

• Necessities tend to have inelastic demands, whereas luxuries have

elastic demands.

• Goods tend to have more elastic demand over longer time horizons.

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 I THE ELASTICITY OF DEMAND: THE PRICE ELASTICITY OF DEMAND

The Variety of Demand Curves – 1

• Demand is elastic
– Price elasticity of demand > 1
• Demand is inelastic
– Price elasticity of demand < 1
• Demand has unit elasticity
– Price elasticity of demand = 1

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 I THE ELASTICITY OF DEMAND: THE PRICE ELASTICITY OF DEMAND

The Variety of Demand Curves – 2

• Demand is perfectly inelastic
– Price elasticity of demand = 0
– Demand curve is vertical
• Demand is perfectly elastic
– Price elasticity of demand = infinity
– Demand curve is horizontal
• The flatter the demand curve
– The greater the price elasticity of demand

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 Perfectly inelastic demand
Price elasticity % change in Q 0%
= = =0
of demand % change in P 10%

P
D
• D curve: Vertical
P1
• Consumers’ price
P2 sensitivity: None
• Elasticity: 0
P falls
by 10% Q1 Q
Q changes
by 0%
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 Inelastic demand
Price elasticity % change in Q <10%
= = <1
of demand % change in P 10%
P

P1
• D curve
relatively steep
P2
• Consumers’ price sensitivity:
D
relatively low
P falls
by 10% Q1 Q2 Q • Elasticity:
<1
Q rises less
than 10%
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Unit elastic demand
Price elasticity % change in Q 10%
= = =1
of demand % change in P 10%

P
• D curve: intermediate slope
P1 • Consumers’ price sensitivity:
intermediate
P2
D • Elasticity: =1

P falls
by 10% Q1 Q2 Q
Q rises
by 10%
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 Elastic demand
Price elasticity % change in Q >10%
= = >1
of demand % change in P 10%
P • D curve: relatively flat
• Consumers’ price sensitivity:
P1
relatively high
P2 D • Elasticity: >1

P falls
by 10% Q1 Q2 Q
Q rises more
than 10%

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 Perfectly elastic demand
% change in Q any %
Price elasticity
= = 0% = infinity
of demand % change in P
P

D
• D curve: horizontal
P 2 = P1 • Consumers’ price
P changes sensitivity: extreme
by 0% • Elasticity: infinity

Q1 Q2 Q
Q changes
by any %
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A few elasticities from the real world

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 Elasticity along a linear demand curve

The slope of a linear

P demand curve is
200% constant, but its
$30 E = = 5.0
40% elasticity
is not.
67%
20 E = = 1.0
67%
40%
10 E = = 0.2
200%

$0 Q
0 20 40 60

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I THE ELASTICITY OF DEMAND: THE PRICE ELASTICITY OF DEMAND

Price Elasticity and Total Revenue

Continuing our scenario, if you raise your price from $2,000 to $2,500, would your
revenue rise or fall?
Total Revenue (TR) = P x Q
• A price increase has two effects on revenue:
– Higher revenue: because of the higher P
– Lower revenue: you maintain fewer accounts (lower Q)
• Which of these two effects is bigger?
– It depends on the price elasticity of demand

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 Our scenario: elastic demand
Demand for maintaining
social media accounts Price elasticity of demand = 1.8
increased • If P = $2,000,
P revenue due to
higher P
Q = 12, and TR = $24,000
• If P = $2,500,
lost revenue
$2500 due to lower Q Q = 8, and TR = $20,000
$2000
D When D is elastic, a price
increase causes revenue to fall.

Q
8 12

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 Our scenario: inelastic demand
Demand for maintaining
social media accounts Price elasticity of demand = 0.82
increased • If P = $2,000,
P revenue due to
higher P Q = 12, and TR = $24,000
lost revenue
• If P = $2,500,
$2500
due to lower Q Q = 10, and TR= $25,000
$2000
D When D is inelastic,
a price increase causes revenue
to rise.
Q
10 12

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 I THE ELASTICITY OF DEMAND: THE PRICE ELASTICITY OF DEMAND

Price Elasticity and Total Revenue

• For a price increase, if demand is elastic

 Ep > 1: % change in Q > % change in P
 TR decreases: the fall in revenue from lower Q > the increase in revenue from
higher P
• For a price increase, if demand is inelastic
 Ep < 1: % change in Q < % change in P
 TR increases: the fall in revenue from lower Q < the increase in revenue from
higher P

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Active Learning 2: Elasticity and total revenue

A. Vietsovpetrol raise the price of gasoline by 10%.

– Does total expenditure on gasoline rises or falls?
B. As a result of a fare war, the price of a luxury cruise falls 20%.
– Does luxury cruise companies’ total revenue rises or falls?

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Active Learning 2: Answers, A

A. Vietsovpetrol raise the price of gasoline by 10%.

– Does total expenditure on gasoline rises or falls?

• Expenditure = total revenue = P x Q

• Since demand for gasoline is inelastic, Q will fall less than 10%, so expenditure
rises.

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Active Learning 2: Answers, B

B. As a result of a fare war, the price of a luxury cruise falls 20%.

– Does luxury cruise companies’ total revenue rises or falls?

• Revenue = P x Q
• The fall in P reduces revenue, but Q increases, which increases revenue.
Which effect is bigger?
• Since demand is elastic, Q will increase more than 20%, so revenue rises.

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 I THE ELASTICITY OF DEMAND: THE PRICE ELASTICITY OF DEMAND

Does Drug Interdiction Increase or Decrease Drug-related Crime?

1. Increase the number of federal agents devoted to the war on drugs

– Illegal drugs: supply curve shifts left
• Higher price and lower quantity
– Amount of drug-related crimes
• Inelastic demand for drugs
• Higher drugs price: higher total revenue
• Increase drug-related crime

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 Policy 1: Interdiction
Price of
Interdiction reduces Drugs new value of drug-
the supply of drugs. related crime
D1 S2
• Demand for drugs S1
is inelastic: P rises P2
proportionally
more than Q falls. initial value
P1
Result: an increase of drug-
in total spending on related
crime
drugs, and in drug-
related crime. Quantity
Q2 Q1
of Drugs
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 I THE ELASTICITY OF DEMAND: THE PRICE ELASTICITY OF DEMAND

Does Drug Interdiction Increase or Decrease Drug-related Crime?

2. Policy of drug education

– Reduce demand for illegal drugs
– Left shift of demand curve
– Lower quantity
– Lower price
– Reduce drug-related crime

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 Policy 2: Education
new value of drug-
Price of related crime
Drugs
D2 D1
Education reduces
S
the demand for
drugs.
initial value
• P and Q fall. P1
of drug-
Result: P2 related
A decrease in total crime
spending on drugs,
and in drug-related Q2 Q1 Quantity
crime. of Drugs

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 I THE ELASTICITY OF DEMAND: INCOME ELASTICITY OF DEMAND

• Income elasticity of demand

– 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: income elasticity > 0
– Inferior goods: income elasticity < 0

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 I THE ELASTICITY OF DEMAND: CROSS-PRICE ELASTICITY OF
DEMAND

• Cross-price elasticity of demand

– How much the Qd of one good responds to a change in the price of another
good
– Percentage change in Qd of the first good
• Divided by the percentage change in price of the second good
– Substitutes: cross-price elasticity > 0
– Complements: cross-price elasticity < 0

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 II THE PRICE ELASTICITY OF SUPPLY

• Price elasticity of supply

– 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
– Loosely speaking, it measures sellers’
price-sensitivity

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 II THE PRICE ELASTICITY OF SUPPLY

Calculating Price Elasticity of Supply

s
Price elasticity percentage change in Q 16%
of supply   2 P
percentage change in P 8% S

P rises P2
Again, we use the by 8% P
midpoint method to 1
compute the
percentage changes.
Q
Q1 Q2

Q rises by 16%
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 II THE PRICE ELASTICITY OF SUPPLY

The Variety of Supply Curves – 1

• Supply is unit elastic

– Price elasticity of supply = 1
• Supply is elastic
– Price elasticity of supply > 1
• Supply is inelastic
– Price elasticity of supply < 1

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 II THE PRICE ELASTICITY OF SUPPLY

The Variety of Supply Curves – 2

• Supply is perfectly inelastic

– Price elasticity of supply = 0
– Supply curve is vertical
• Supply is perfectly elastic
– Price elasticity of supply = infinity
– Supply curve is horizontal
• The flatter the supply curve
– The greater the price elasticity of supply
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 Perfectly inelastic supply
Price elasticity % change in Q 0%
= = =0
of supply % change in P 10%

P
• S curve: vertical S
• Sellers’ price sensitivity: none
• Elasticity: 0 P
P rises 2
by 10% P
1

Q
Q1
Q changes
by 0%
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 Inelastic supply
Price elasticity % change in Q < 10%
= = <1
of supply % change in P 10%

• S curve: relatively steep P

S
• Sellers’ price sensitivity: relatively low
• Elasticity: < 1 P2
P rises
by 10% P
1

Q
Q1 Q2
Q rises less
than 10%
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 Unit elastic supply
Price elasticity % change in Q 10%
= = =1
of supply % change in P 10%

P
• S curve: intermediate slope
S
• Sellers’ price sensitivity: intermediate
• Elasticity: = 1 P2

P1
P rises
by 10% Q
Q1 Q2
Q rises
by 10%
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 Elastic supply

Price elasticity % change in Q > 10%

= = >1
of supply % change in P 10%

P
S
• S curve: relatively flat
• Sellers’ price sensitivity: relatively high P rises P2
• Elasticity: > 1 by 10%
P1

Q
Q1 Q2
Q rises more
than 10%
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 Perfectly elastic supply

Price elasticity % change in Q any %

= = = infinity
of supply % change in P 0%
P
• S curve: horizontal
• Sellers’ price sensitivity: extreme P2 = P1 S
• Elasticity: infinity P changes
by 0%

Q
Q1 Q2
Q changes
by any %
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 II THE PRICE ELASTICITY OF SUPPLY

The Determinants of Supply Elasticity

• Greater price elasticity of supply

– The more easily sellers can change the quantity they produce
• Price elasticity of supply is greater in the long run than in the short run
– In the long run: firms can build new factories, or new firms may be able to
enter the market

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Active Learning 3: Elasticity and changes in equilibrium

Assume the supply of parking spots is inelastic and the supply of wheat is elastic.
Suppose population growth causes demand for both goods to double (at each
price, Qd doubles).
• For which product will P change the most?
• For which product will Q change the most?
A. Draw a graph with the new equilibrium in the market for parking
B. Draw a graph with the new equilibrium in the market for wheat

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Active Learning 3A. Parking spots
Parking spots
When supply is (inelastic supply):
inelastic, an P S
increase in D1 D2
demand has a
P2 B
bigger impact on
price than on
P1 A
quantity.
Q
Q1 Q2

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Active Learning 3B. Wheat
Wheat
When supply (elastic supply):
P
is elastic,
an increase in D1 D2
demand has a
bigger impact on B S
quantity than on P2
A
P1
price.
Q
Q1 Q2

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 How the price elasticity of supply can vary

Price Supply
Elasticity is small
$15 (less than 1).
12

Elasticity is large
(greater than 1).
4
3

0 100 200 500 525 Quantity

• Supply often becomes less elastic as Q rises, due

to capacity limits.
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 II THE PRICE ELASTICITY OF SUPPLY

More Applications – 1

1. Can Good News for Farming Be Bad News for Farmers?

– New hybrid of wheat: 20% increased production per acre
• Supply curve shifts to the right
• Higher quantity and lower price
• Demand is inelastic: total revenue falls
– Paradox of public policy: induce farmers not to plant crops

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 An increase in supply in the market for wheat

1. When demand is inelastic,

Price of an increase in supply . . .
Wheat
S1

S2
2. … leads
$3
to a large 3. … and a proportionately
fall in 2 smaller increase in quantity
price. . . sold. As a result, revenue
falls from $300 to $220.
Demand
0 100 110 Quantity of Wheat

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 II THE PRICE ELASTICITY OF SUPPLY

More Applications – 2

2. Why Did OPEC Fail to Keep the Price of Oil High?

– Increase in prices 1973-1974, 1971-1981
– Short-run: supply and demand are inelastic
• Decrease in supply: large increase in price
– Long-run: supply and demand are elastic
• Decrease in supply: small increase in price

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 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. In the short run, when supply and 1. In the long run, when
demand are inelastic, a shift in supply and demand are
supply. . . elastic, a shift in supply. . .
Price
Price
S2 2. … leads to a
S1 S2 S
small increase 1
P2 in price

P2
P1 P1

2. … leads to a
large increase in Demand
price Demand
0 Quantity 0 Quantity

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 CHAPTER IN A NUTSHELL
• The price elasticity of demand
– Measures how much the quantity demanded responds to changes
in the price.
– Is the percentage change in quantity demanded divided by the
percentage change in price.
– If < 1, inelastic demand: quantity demanded moves proportionately
less than the price
– If > 1, elastic demand: quantity demanded moves proportionately
more than the price

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 CHAPTER IN A NUTSHELL
• Demand tends to be more elastic if
– Close substitutes are available
– The good is a luxury rather than a necessity
– The market is narrowly defined
– If buyers have substantial time to react to a price change.
• Total revenue (PxQ), total amount paid for a good
– Moves in the same direction as P (inelastic D)
– Moves in the opposite direction as P (elastic D)

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 CHAPTER IN A NUTSHELL
• The income elasticity of demand
– Measures how much the quantity demanded responds to changes
in consumers’ income
• The cross-price elasticity of demand
– Measures how much the quantity demanded of one good
responds to changes in the price of another good
• The tools of supply and demand can be applied to many different
kinds of markets. This chapter uses them to analyze the market for
wheat, the market for oil, and the market for illegal drugs.

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 CHAPTER IN A NUTSHELL
• The price elasticity of supply
– Measures how much the quantity supplied responds to changes in the
price.
– Is the percentage change in quantity supplied divided by the
percentage change in price
– If < 1, inelastic supply: quantity supplied moves proportionately less
than the price
– If > 1, elastic supply: quantity supplied moves proportionately more
than the price
– Depends on the time horizon under consideration. In most markets,
supply is more elastic in the long run than in the short run.

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