Chapter 3.

Elasticity and its application

Chapter 3
Elasticity and its application

Van Tran, 2024

Principles of Economics, Van Tran, 2024 1

Chapter 3. Elasticity and its application

Content
1. The Elasticity of Demand
2. The Elasticity of Supply
3. Application

Principles of Economics, Van Tran, 2024 2

Chapter 3. Elasticity and its application

References
Mankiw, N.G., 2018, Priciples of economics, Cengate Learning.
Chapter 5

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Chapter 3. Elasticity and its application @ 1. The elasticity of demand

1. The Elasticity of Demand

• Elasticity
– Measure of the responsiveness of quantity demanded or quantity
supplied to a change in one of its determinants

• Price elasticity of demand

– How much the change in quantity demanded of a good responds
to a change in the price of that good

Principles of Economics, Van Tran, 2024 4

Chapter 3. Elasticity and its application @ 1. The elasticity of demand

1.1. The price elasticity of demand

• Computing the price elasticity of demand
– Percentage change in quantity demanded divided by percentage
change in price
%Q dQ Q
ED = =
%P dP P

– Use absolute value (drop the minus sign)

• Midpoint method
– Two points: (Q1, P1) and (Q2, P2)
(Q2 − Q1 )/[(Q2 + Q1 )/ 2 ]
ED =
(P2 − P1 )/[(P2 + P1 )/ 2 ]
Principles of Economics, Van Tran, 2024 5

Chapter 3. Elasticity and its application @ 1. The elasticity of demand

1.1. The price elasticity of demand

• Variety of demand curves
– Demand is elastic
• Price elasticity of demand > 1
• Quantity demanded responds substantially to changes in price

– Demand is inelastic
• Price elasticity of demand < 1
• Quantity demanded responds only slightly to changes in price

– Demand has unit elasticity

• Price elasticity of demand = 1

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 Chapter 3. Elasticity and its application @ 1. The elasticity of demand

1.1. The price elasticity of demand

• Variety of demand curves
– Demand is elastic
• Price elasticity of demand > 1
• Quantity demanded responds substantially to changes in price

– Demand is inelastic
• Price elasticity of demand < 1
• Quantity demanded responds only slightly to changes in price

– Demand has unit elasticity

• Price elasticity of demand = 1

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Figure 1
The Price Elasticity of Demand (a, b)
(a) Perfectly Inelastic Demand: (b) Inelastic Demand: Elasticity Is
Elasticity Equals 0 Less Than 1

Price Price
1. An Demand 1. A 22% 2. … leads
increase in increase to an 11%
price… decrease in
in price… quantity
$5 $5 demanded
4 4
2. …leaves
the quantity Demand
demanded
unchanged
0 100 0 90 100
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.
Principles of Economics, Van Tran, 2024 8

Figure 1
The Price Elasticity of Demand (c)

(c) Unit Elastic Demand: Elasticity Equals 1

Price
Demand

$5
1. A 22%
4
increase
in price…
2. … leads to a 22%
decrease in quantity
demanded
0 80 100
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.
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 Figure 1
The Price Elasticity of Demand (d, e)
(d) Elastic demand: (e) Perfectly elastic demand:
Elasticity > 1 Elasticity equals infinity

Price Price 1. At any price

A 22% above $4, quantity
increase demanded is zero 2. At exactly $4,
in price… consumers will
$5 buy any quantity
4 Demand $4
Demand
2. … leads to a 3. At a price
67% decrease
below $4, quantity
in quantity
demanded demanded is infinite

0 50 100 0
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.
Principles of Economics, Van Tran, 2024 10

Chapter 3. Elasticity and its application @ 1. The elasticity of demand

1.1. The price elasticity of demand

• Determinants of 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
• Demand is more elastic over longer time horizons

– Budget
• Smaller budget more elastic demand

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Chapter 3. Elasticity and its application @ 1. The elasticity of demand

1.1. The price elasticity of demand

• Elasticity of a Linear Demand Curve

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 Elasticity of a Linear Demand Curve
Price

$7
6

5
4 1. an
3
2
Demand
1

0 2 4 6 8 10 12 14 Quantity
❖ Calculate price elasticity of demand between price levels
• $6 and $5
• $5 and $4 • $3 and $2
• $4 and $3 • $2 and $1
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Figure 4
Elasticity of a Linear Demand Curve (schedule)

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.

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Figure 4
Elasticity of a Linear Demand Curve (graph)
Price

$7 Elasticity is larger
than 1
6

5
4 1. an
Elasticity is
3 smaller than 1
2
Demand
1

0 2 4 6 8 10 12 14 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.
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 Chapter 3. Elasticity and its application @ 1. The elasticity of demand

1.1. The price elasticity of demand

• Elasticity of a Linear Demand Curve
– A linear demand curve has
• Constant slope
• Different price elasticities
– Points with low price and high quantity
• Inelastic demand
– Points with high price and low quantity
• Elastic demand

Principles of Economics, Van Tran, 2024 16

Chapter 3. Elasticity and its application @ 1. The elasticity of demand

1.2. Price elasticity of demand and revenue

• Total revenue, TR
– Amount paid by buyers and received by sellers of a good
– Price of the good times the quantity sold (P ˣ Q)
Price

$4

P ˣ Q=$400
P (revenue)
Demand

0 100 Quantity

Principles of Economics, Van Tran, 2024 Q 17

Figure 3
How Total Revenue Changes When Price Changes (a)

(a) The Case of Inelastic Demand

Price
1. When the demand
curve is inelastic . . .

2. . . . the extra
$5
revenue from
A
selling at a 4
higher price . . . Demand
B 3. . . . is greater than
the lost revenue from
selling fewer units.

0 90 100 Quantity
The impact of a price change on total revenue (the product of price and quantity) depends on
the elasticity of demand. In panel (a), the demand curve is inelastic. In this case, an increase in
the price leads to a decrease in quantity demanded that is proportionately smaller, so total
revenue increases. Here an increase in the price from $4 to $5 causes the quantity demanded to
fall from 100 to 90. Total revenue rises from $400 to $450.
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 Figure 3
How Total Revenue Changes When Price Changes (b)

(b) The Case of Elastic Demand

Price
1. When the demand
curve is elastic . . .
2. . . . the extra $5
revenue from A
selling at a 4
higher price . . . 3. . . . is less
Demand than the lost
B revenue from
selling fewer
units.

0 70 100 Quantity
The impact of a price change on total revenue (the product of price and quantity) depends on
the elasticity of demand. In panel (b), the demand curve is elastic. In this case, an increase in
the price leads to a decrease in quantity demanded that is proportionately larger, so total
revenue decreases. Here an increase in the price from $4 to $5 causes the quantity demanded
to fall from 100 to 70. Total revenue falls from $400 to $350.
Principles of Economics, Van Tran, 2024 19

Chapter 3. Elasticity and its application @ 1. The elasticity of demand

1.2. Price elasticity of demand and revenue

• When demand is inelastic (elasticity < 1)
– P and TR move in the same direction
• If P ↑, TR also ↑
• When demand is elastic (elasticity > 1)
– P and TR move in opposite directions
• If P ↑, TR ↓
• If demand is unit elastic (elasticity = 1)
– Total revenue remains constant when the price changes

Principles of Economics, Van Tran, 2024 20

Chapter 3. Elasticity and its application @ 1. The elasticity of demand

1.3. 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

%Q (Q2 − Q1 )/[(Q2 + Q1 )/ 2 ]

EI = =
%I (I 2 − I1 )/[(I 2 + I1 )/ 2 ]

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Chapter 3. Elasticity and its application @ 1. The elasticity of demand

1.3. Income elasticity of demand

• Normal goods
– Positive income elasticity
• Necessities
– Small income elasticities
• Luxuries
– Large income elasticities

• Inferior goods
– Negative income elasticities

Principles of Economics, Van Tran, 2024 22

Chapter 3. Elasticity and its application @ 1. The elasticity of demand

1.4. Cross price elasticity of demand

• Cross-price elasticity of demand
– How much the quantity demanded of one good responds to a
change in the price of another good
– Percentage change in quantity demanded of the first good
• Divided by the percentage change in price of the second good

%Qi (Qi 2 − Qi1 )/[(Qi 2 + Qi1 )/ 2 ]

EC = =
%Pj (Pj 2 − Pj1 )/[(Pj 2 + Pj1 )/ 2 ]

Principles of Economics, Van Tran, 2024 23

Chapter 3. Elasticity and its application @ 1. The elasticity of demand

1.4. Cross price elasticity of demand

• Substitutes
– Goods typically used in place of one another
– Positive cross-price elasticity

• Complements
– Goods that are typically used together
– Negative cross-price elasticity

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Chapter 3. Elasticity and its application @ 2. The elasticity of supply

2. The 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
• Computing price elasticity of supply
– Percentage change in quantity supplied divided by percentage
change in price
%Q dQ Q
ES = =
%P dP P
– Always positive
• Midpoint method
– Two points: (Q1, P1) and (Q2, P2)
(Q2 − Q1 )/[(Q2 + Q1 )/ 2 ]
ES =
(P2 − P1 )/[(P2 + P1 )/ 2 ]
Principles of Economics, Van Tran, 2024 25

Chapter 3. Elasticity and its application @ 2. The elasticity of supply

2. The Elasticity of Supply

• Variety of supply curves
– Supply is elastic
• Price elasticity of supply > 1
• Quantity supplied responds substantially to changes in the price
– Supply is inelastic
• Price elasticity of supply < 1
• Quantity supplied responds only slightly to changes in the price
– Supply is unit elastic
• Price elasticity of supply = 1

Principles of Economics, Van Tran, 2024 26

Chapter 3. Elasticity and its application @ 2. The elasticity of supply

2. The Elasticity of Supply

• Variety of supply curves

– 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

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 Figure 5
The Price Elasticity of Supply (a, b)
(a) Perfectly Inelastic Supply: (b) Inelastic Supply: Elasticity Is
Elasticity Equals 0 Less Than 1
Price Price
1. An Supply 1. A 22% Supply
increase increase
in price… in price…
$5 $5 2. … leads to
4 2. …leaves 4 a 10% increase
the quantity in quantity
supplied supplied
unchanged

0 100 0 100 110

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.

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

0 100 125
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.

Principles of Economics, Van Tran, 2024 29

Figure 5
The Price Elasticity of Supply (d, e)
(d) Elastic Supply: Elasticity Is (e) Perfectly Elastic Supply:
Greater Than 1 Elasticity Equals Infinity
Price Price 1. At any
1. A 22% price above
increase $4, quantity 2. At exactly $4,
Supply supplied is
in price… producers will
infinite
$5 supply any quantity

4 2. … leads to $4
Supply
a 67% increase 3. At any price
in quantity below $4, quantity
supplied supplied is zero

0 100 50 0
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.

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 Chapter 3. Elasticity and its application @ 2. The elasticity of supply

2. The Elasticity of Supply

• Determinants of price elasticity of supply
– The flexibility of sellers to change the amount of the good they
produce

– Time period
• Supply is more elastic in the long run

Principles of Economics, Van Tran, 2024 31

Chapter 3. Elasticity and its application @ 2. The elasticity of supply

2. The Elasticity of Supply

• Supply curve
– Different price elasticities
• Points with low price and low quantity
– Elastic supply
– Capacity for production not being used
• Points with high price and high quantity
– Inelastic supply

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Figure 6
How the Price Elasticity of Supply Can Vary
Price Elasticity is small Supply
(less than 1).
$15

12
Elasticity is large
(greater than 1).

4
3

0 100 200 500 525 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%
increase in quantity supplied (computed using the midpoint method) is larger than the 29%
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% increase in quantity
supplied is smaller than the 22% increase in price, the supply curve is inelastic in this range.

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 Chapter 3. Elasticity and its application @ 3. Application

3. Application

• Can Good News for Farming Be Bad News for Farmers?

– New hybrid of wheat – increase production per acre 20%
• Supply curve shifts to the right
• Higher quantity and lower price
• Demand is inelastic: total revenue falls

Principles of Economics, Van Tran, 2024 34

Figure 7
An Increase in Supply in the Market for Wheat
Price of 1. When demand is inelastic,
Wheat an increase in supply . . .
S1

S2
2. … leads
$3
to a large fall 3. … and a proportionately
in price. . . 2 smaller increase in quantity
sold. As a result, revenue falls
from $300 to $220.

Demand
0 100 110 Quantity of Wheat
When an advance in farm technology increases the supply of wheat from S 1 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).
Principles of Economics, Van Tran, 2024 35

Chapter 3. Elasticity and its application @ 3. Application

3. Application

• Can Good News for Farming Be Bad News for Farmers?

– Paradox of public policy
• Induce farmers not to plant crops

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 Chapter 3. Elasticity and its application @ 3. Application

3. Application

• 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

Principles of Economics, Van Tran, 2024 37

Figure 8
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 supply
demand are inelastic, a shift in supply. . . and demand are elastic, a shift
Price in supply. . .
Price
S2 2. … leads
S1 to a small
S2 S1
P2 increase in
price
2. … leads
to a large P2
P1 P1
increase in
price

Demand Demand

0 Quantity 0 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 S 1
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 (S 1 to S2)
causes a smaller increase in the price.
Principles of Economics, Van Tran, 2024 38

Chapter 3. Elasticity and its application @ 3. Application

3. Application

• 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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 Chapter 3. Elasticity and its application @ 3. Application

3. Application

• Does Drug Interdiction Increase or Decrease Drug-related

Crime?
– 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

Principles of Economics, Van Tran, 2024 40

Chapter 3. Elasticity and its application @ 3. Application

3. Application

• Does Drug Interdiction Increase or Decrease Drug-related

Crime?
– Policy of drug education
• Reduce demand for illegal drugs
• Left shift of demand curve
• Lower quantity
• Lower price
• Reduce drug-related crime

Principles of Economics, Van Tran, 2024 41

Figure 9
Policies to Reduce the Use of Illegal Drugs
(a) Drug Interdiction (b) Drug Education
1. Drug education
2. … which 1. Drug interdiction 2. . . . which reduces the demand
Price reduces the supply Price reduces the for drugs . . .
raises the
of drugs. . .
price . . . price . . .
S2 S1
Supply

P2
P1
3. … and
reduces the P2
P1
quantity sold
3. … and
reduces the
Demand D1
quantity sold D2

0 Q2 Q1 Quantity 0 Q2 Q1 Quantity
Drug interdiction reduces the supply of drugs from S 1 to S2, as in panel (a). If the demand for
drugs is inelastic, then the total amount paid by drug users rises, even as the amount of drug use
falls. By contrast, drug education reduces the demand for drugs from D 1 to D2, as in panel (b).
Because both price and quantity fall, the amount paid by drug users falls
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