Elasticity and Its Application

Principles of Economics

CHAPTER 5 ELASTICITY AND ITS APPLICATION 0

In this chapter, look for the answers to
these questions:
 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 & 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?

CHAPTER 5 ELASTICITY AND ITS APPLICATION 1

 A scenario…
You design websites for local businesses.
You charge $200 per website, and currently sell
12 websites per month.
Your costs are rising (including the opp. cost of
your time), so you’re thinking of raising the price
to $250.
The law of demand says that you do not sell as
many websites if you raise your price. How many
fewer websites? How much will your revenue fall,
or might it increase?

CHAPTER 5 ELASTICITY AND ITS APPLICATION 2

 Elasticity
 Basic idea: Elasticity measures how much
one variable responds to changes in another
variable.
• One type of elasticity measures how much
demand for your websites will fall if you raise
your price.
 Definition:
Elasticity is a numerical measure of the
responsiveness of Qd or Qs to one of its
determinants.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 3

 Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P

 Price elasticity of demand measures how

much Qd responds to a change in P.

 Loosely speaking, it measures the price-

sensitivity of buyers’ demand.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 4

 Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
P
Example:
P rises
Price by 10%
P2
elasticity P1
of demand D
equals
Q
15% Q2 Q1
= 1.5 Q falls
10%
by 15%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 5
 Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
P
Along a D curve, P and Q
move in opposite directions, P2
which would make price
elasticity negative. P1

We will drop the minus sign D

and report Q
all price elasticities Q2 Q1
as positive numbers.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 6

 Calculating Percentage Changes
Standard method
of computing the
Demand for percentage (%) change:
your websites
P end value – start value
x 100%
start value
B
$250
A Going from A to B,
$200 the % change in P equals
D
($250–$200)/$200 = 25%
Q
8 12

CHAPTER 5 ELASTICITY AND ITS APPLICATION 7

 Calculating Percentage Changes
Problem:
The standard method gives
Demand for different answers depending
your websites on where you start.
P
From A to B,
B P rises 25%, Q falls 33%,
$250
A elasticity = 33/25 = 1.33
$200
From B to A,
D
P falls 20%, Q rises 50%,
Q elasticity = 50/20 = 2.50
8 12

CHAPTER 5 ELASTICITY AND ITS APPLICATION 8

 Calculating Percentage Changes
 So, we instead use the midpoint method:
end value – start value
x 100%
midpoint
 The midpoint is the number halfway between
the start & end values, also the average of
those values.
 It doesn’t matter which value you use as the
“start” and which as the “end” – you get the
same answer either way!

CHAPTER 5 ELASTICITY AND ITS APPLICATION 9

 Calculating Percentage Changes
 Using the midpoint method, the % change
in P equals
$250 – $200
x 100% = 22.2%
$225
 The % change in Q equals
12 – 8
x 100% = 40.0%
10
 The price elasticity of demand equals
40/22.2 = 1.8

CHAPTER 5 ELASTICITY AND ITS APPLICATION 10

ACTIVE LEARNING 1:
Calculate an elasticity
Use the following
information to
calculate the
price elasticity
of demand
for hotel rooms:
if P = $70, Qd = 5000
if P = $90, Qd = 3000

11
ACTIVE LEARNING 1:
Answers
Use midpoint method to calculate
% change in Qd
(5000 – 3000)/4000 = 50%

% change in P
($90 – $70)/$80 = 25%

The price elasticity of demand equals

50%
= 2.0
25%

12
 What determines price elasticity?
To learn the determinants of price elasticity,
we look at a series of examples.
Each compares two common goods.
In each example:
• Suppose the prices of both goods rise by 20%.
• The good for which Qd falls the most (in percent)
has the highest price elasticity of demand.
Which good is it? Why?
• What lesson does the example teach us about the
determinants of the price elasticity of demand?

CHAPTER 5 ELASTICITY AND ITS APPLICATION 13

EXAMPLE 1:
Rice Krispies vs. Sunscreen
 The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
• Rice Krispies has lots of close substitutes
(e.g., Cap’n Crunch, Count Chocula),
so buyers can easily switch if the price rises.
• Sunscreen has no close substitutes,
so consumers would probably not
buy much less if its price rises.
 Lesson: Price elasticity is higher when close
substitutes are available.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 14
EXAMPLE 2:
“Blue Jeans” vs. “Clothing”
 The prices of both goods rise by 20%.
For which good does Qd drop the most? Why?
• For a narrowly defined good such as
blue jeans, there are many substitutes
(khakis, shorts, Speedos).
• There are fewer substitutes available for
broadly defined goods.
(Can you think of a substitute for clothing,
other than living in a nudist colony?)
 Lesson: Price elasticity is higher for narrowly
defined goods than broadly defined ones.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 15
EXAMPLE 3:
Insulin vs. Caribbean Cruises
 The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
• To millions of diabetics, insulin is a necessity.
A rise in its price would cause little or no
decrease in demand.
• A cruise is a luxury.If the price rises,
some people will forego it.
 Lesson: Price elasticity is higher for luxuries
than for necessities.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 16

EXAMPLE 4:
Gasoline in the Short Run vs. Gasoline in
the 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 where they work.
 Lesson: Price elasticity is higher in the
long run than the short run.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 17

 The Determinants of Price Elasticity:
A Summary

The price elasticity of demand depends on:

 the extent to which close substitutes are
available
 whether the good is a necessity or a luxury
 how broadly or narrowly the good is defined
 the time horizon: elasticity is higher in the
long run than the short run.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 18

 The Variety of Demand Curves
 Economists classify demand curves according to
their elasticity.
 The price elasticity of demand is closely related
to the slope of the demand curve.
 Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
 The next 5 slides present the different
classifications, from least to most elastic.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 19

“Perfectly inelastic demand” (one extreme case)
Price elasticity % change in Qd 0%
= = =0
of demand % change in P 10%

D curve: P
D
vertical
P1
Consumers’
price sensitivity: P2
0
P falls Q
Elasticity: by 10% Q1
0 Q changes
by 0%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 20
“Inelastic demand”
Price elasticity % change in Qd < 10%
= = <1
of demand % change in P 10%

D curve: P
relatively steep
P1
Consumers’
price sensitivity: P2
relatively low D
P falls Q
Elasticity: < 1 by 10% Q1 Q 2

Q rises less
than 10%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 21
“Unit elastic demand”
Price elasticity % change in Qd 10%
= = =1
of demand % change in P 10%

D curve: P
intermediate slope
P1
Consumers’
price sensitivity: P2
intermediate D

P falls Q
Elasticity: by 10% Q1 Q2
1
Q rises by 10%

CHAPTER 5 ELASTICITY AND ITS APPLICATION 22

“Elastic demand”
Price elasticity % change in Qd > 10%
= = >1
of demand % change in P 10%

D curve: P
relatively flat
P1
Consumers’
price sensitivity: P2 D
relatively high
P falls Q
Elasticity: by 10% Q1 Q2
>1
Q rises more
than 10%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 23
“Perfectly elastic demand” (the other extreme)
Price elasticity % change in Qd any %
= = = infinity
of demand % change in P 0%

D curve: P
horizontal
P2 = P1 D
Consumers’
price sensitivity:
extreme
P changes Q
Elasticity: by 0% Q1 Q2
infinity
Q changes
by any %
CHAPTER 5 ELASTICITY AND ITS APPLICATION 24
Elasticity of a Linear Demand Curve

P The slope
200% of a linear
$30 E = = 5.0
40% demand
67% curve is
20 E = = 1.0 constant,
67%
but its
40%
10 E = = 0.2 elasticity
200%
is not.
$0 Q
0 20 40 60

CHAPTER 5 ELASTICITY AND ITS APPLICATION 25

 Price Elasticity and Total Revenue
 Continue our scenario, if you raise your price
from $200 to $250, would your revenue rise or fall?
Revenue = P x Q
 A price increase has two effects on revenue:
• Higher P means more revenue on each unit
you sell.
• But you sell few units (lower Q), due to
Law of Demand.
 Which of these two effects is bigger?
It depends on the price elasticity of demand.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 26

 Price Elasticity and Total Revenue
Price elasticity Percentage change in Q
=
of demand Percentage change in P

Revenue = P x Q
 If demand is elastic,
then price elasticity. of demand > 1
% change in Q > % change in P
 The fall in revenue from lower Q is greater
than the increase in revenue from higher P,
so revenue falls.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 27
 Price Elasticity and Total Revenue
Demand for your
Elastic demand websites increased
(elasticity = 1.8) P revenue due lost
to higher P revenue
If P = $200,
due to
Q = 12 and lower Q
$250
revenue = $2400.
$200
If P = $250, D
Q = 8 and
revenue = $2000.
When D is elastic, Q
8 12
a price increase
causes revenue to fall.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 28
 Price Elasticity and Total Revenue
Price elasticity Percentage change in Q
=
of demand Percentage change in P

Revenue = P x Q
 If demand is inelastic, then
price elasticity of demand < 1
% change in Q < % change in P
 The fall in revenue from lower Q is smaller
than the increase in revenue from higher P,
so revenue rises.
 In our example, suppose that Q only falls 12 to10
& price raise $200 to $250. Then
CHAPTER 5 ELASTICITY AND ITS APPLICATION 29
 Price Elasticity and Total Revenue
Now, demand is Demand for your
inelastic:
websites increased
revenue due
elasticity = 0.82 P lost in
to higher P
If P = $200, revenue
Q = 12 and due to
$250 lower Q
revenue = $2400.
If P = $250, $200
Q = 10 and D
revenue = $2500.
When D is inelastic, Q
a price increase 10 12
causes revenue to rise.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 30
ACTIVE LEARNING 2:
Elasticity and expenditure/revenue
A. Pharmacies raise the price of insulin by 10%.
Does total expenditure on insulin rise or fall?
B. As a result of a farewar, the price of a luxury
cruise falls 20%.
Does luxury cruise companies’ total revenue
rise or fall?

31
ACTIVE LEARNING 2:
Answers
A. Pharmacies raise the price of insulin by 10%.
Does total expenditure on insulin rise or fall?
Expenditure = P x Q
Since demand is inelastic, Q will fall less
than 10%, so expenditure rises.

32
ACTIVE LEARNING 2:
Answers
B. As a result of a fare war, the price of a luxury
cruise falls 20%.
Does luxury cruise companies’ total revenue
rise or fall?
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.
33
APPLICATION: Does Drug Interdiction
Increase or Decrease Drug-Related Crime?
 To discourage the use of illegal drugs, the U.S. government devotes
billions of dollars each year to reducing the flow of drugs into the
country. Let’s use the tools of supply and demand to examine this policy
of drug interdiction.
 Suppose the government increases the number of federal agents
devoted to the war on drugs.
 What happens in the market for illegal drugs? As usual, we answer this
question in three steps. First, we consider whether the supply or
demand curve shifts. Second, we consider the direction of the shift.
Third, we see how the shift affects the equilibrium price and quantity.
 Although the purpose of drug interdiction is to reduce drug use, its
direct impact is on the sellers of drugs rather than on the buyers. When
the government stops some drugs from entering the country and arrests
more smugglers, it raises the cost of selling drugs and, therefore,
reduces the quantity of drugs supplied at any given price.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 34
 Policy 1: Interdiction
Interdiction new value of drug-
reduces Price of related crime
the supply Drugs S2
D1
of drugs. S1
Since demand P2
for drugs is
inelastic, initial value
P1
P rises propor- of drug-
tionally more related
than Q falls. crime

Result: an increase in Q2 Q 1 Quantity

total spending on drugs, of Drugs
and in drug-related crime
CHAPTER 5 ELASTICITY AND ITS APPLICATION 35
 Policy 2: Education
new value of drug-
Education Price of related crime
reduces the Drugs
demand for D2 D1
drugs. S

P and Q fall.
P1 initial value
Result: of drug-
A decrease in P2 related
total spending crime
on drugs, and
in drug-related Q2 Q 1 Quantity
crime. of Drugs

CHAPTER 5 ELASTICITY AND ITS APPLICATION 36

 Price Elasticity of Supply
Price elasticity Percentage change in Qs
=
of supply Percentage change in P

 Price elasticity of supply measures how much

Qs responds to a change in P.
 Loosely speaking, it measures the price-
sensitivity of sellers’ supply.
 Again, use the midpoint method to compute the
percentage changes.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 37

 Price Elasticity of Supply
Price elasticity Percentage change in Qs
=
of supply Percentage change in P
P
Example: S
P rises
Price P2
by 8%
elasticity P1
of supply
equals
Q
16% Q1 Q2
= 2.0
8% Q rises
by 16%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 38
 The Variety of Supply Curves
 Economists classify supply curves according to
their elasticity.
 The slope of the supply curve is closely related
to price elasticity of supply.
 Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
 The next 5 slides present the different
classifications, from least to most elastic.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 39

“Perfectly inelastic” (one extreme)
Price elasticity % change in Q 0%
= = =0
of supply % change in P 10%

S curve: P
S
vertical
P2
Sellers’
price sensitivity: P1
0
P rises Q
Elasticity: by 10% Q1
0
Q changes
by 0%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 40
“Inelastic”
Price elasticity % change in Q < 10%
= = <1
of supply % change in P 10%

S curve: P
S
relatively steep
P2
Sellers’
price sensitivity: P1
relatively low
P rises Q
Elasticity: by 10% Q1 Q2
<1
Q rises less
than 10%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 41
“Unit elastic”
Price elasticity % change in Q 10%
= = =1
of supply % change in P 10%

S curve: P
intermediate slope S
P2
Sellers’
price sensitivity: P1
intermediate
P rises Q
Elasticity: by 10% Q1 Q2
=1
Q rises
by 10%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 42
“Elastic”
Price elasticity % change in Q > 10%
= = >1
of supply % change in P 10%

S curve: P
relatively flat S
P2
Sellers’
price sensitivity: P1
relatively high
P rises Q
Elasticity: by 10% Q1 Q2
>1
Q rises more
than 10%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 43
“Perfectly elastic” (the other extreme)
Price elasticity % change in Q any %
= = = infinity
of supply % change in P 0%

S curve: P
horizontal
P2 = P1 S
Sellers’
price sensitivity:
extreme
P changes Q
Elasticity: by 0% Q1 Q2
infinity
Q changes
by any %
CHAPTER 5 ELASTICITY AND ITS APPLICATION 44
 The Determinants of Supply Elasticity
 The more easily sellers can change the quantity
they produce, the greater the price elasticity of
supply.
 Example: Supply of beachfront property is
harder to vary and thus less elastic than
supply of new cars.
 For many goods, price elasticity of supply is
greater in the long run than in the short run,
because firms can build new factories, or
new firms may be able to enter the market.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 45

ACTIVE LEARNING 3:
Elasticity and changes in equilibrium
 The supply of beachfront property is inelastic.
The supply of new cars 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?

46
ACTIVE LEARNING 3:
Answers
Beachfront property
When supply (inelastic supply):
is inelastic, P
an increase in
demand has a D1 D2 S
bigger impact
on price than P2 B
on quantity.
P1 A

Q
Q1 Q2

47
ACTIVE LEARNING 3:
Answers
New cars
When supply (elastic supply):
is elastic, P
an increase in
demand has a D1 D2
bigger impact S
on quantity
than on price. B
P2
A
P1

Q
Q1 Q2

48
How the Price Elasticity of Supply Can Vary

P Supply often
S
elasticity becomes
$15 <1 less elastic
as Q rises,
12 due to
elasticity capacity
>1 limits.
4
$3
Q
100 200
500 525

CHAPTER 5 ELASTICITY AND ITS APPLICATION 49

 Other Elasticities
 The income elasticity of demand measures the
response of Qd to a change in consumer income.

Income elasticity Percent change in Qd

=
of demand Percent change in income

 Recall from chap.4: An increase in income causes

an increase in demand for a normal good.
 Hence, for normal goods, income elasticity > 0.
 For inferior goods, income elasticity < 0.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 50

 Other Elasticities
 The cross-price elasticity of demand measures
the response of demand for one good to changes
in the price of another good.

Cross-price elast. % change in Qd for good 1

=
of demand % change in price of good 2
 For substitutes, cross-price elasticity > 0
E.g., an increase in price of beef causes an
increase in demand for chicken.
 For complements, cross-price elasticity < 0
E.g., an increase in price of computers causes
decrease in demand for software.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 51
CHAPTER SUMMARY
 Elasticity measures the responsiveness of
Qd or Qs to one of its determinants.
 Price elasticity of demand equals percentage
change Qd in divided by percentage change in P.
When it’s less than one, demand is “inelastic.”
When greater than one, demand is “elastic.”
 When demand is inelastic, total revenue rises
when price rises. When demand is elastic, total
revenue falls when price rises.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 52

CHAPTER SUMMARY
 Demand is less elastic in the short run,
for necessities, for broadly defined goods,
or for goods with few close substitutes.
 Price elasticity of supply equals percentage
change in Qs divided by percentage change in P.
When it’s less than one, supply is “inelastic.”
When greater than one, supply is “elastic.”
 Price elasticity of supply is greater in the long run
than in the short run.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 53

CHAPTER SUMMARY
 The income elasticity of demand measures how
much quantity demanded responds to changes in
buyers’ incomes.
 The cross-price elasticity of demand measures
how much demand for one good responds to
changes in the price of another good.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 54