3 ELASTICITY

Introduction

Question 1: How does the recent conflict between Israel and

Palestine affect the price of gasoline in global market?
Introduction

Question 1: How does the recent conflict between Israel and

Palestine affect the price of gasoline in global market?

v The supply ↓ as the war disrupts the world supply of oil

v If the conflict is expected to last for some period, consumers

would expect to the future oil supply decrease, which leads
an increase in the current demand; If the conflict is expected
to end soon, the current demand would not be affected.

v Anyway, the oil price would increase for sure.

Introduction
Recall Principle 4 “People respond to incentives”

Question 2: how would consumers in China respond to the

increase in gasoline price?

v If the current demand is unchanged, according to Law of

demand, the quantity demanded by consumers would
decrease.

v If the current demand increases, it is unclear whether the

quantity demanded by consumers would increase or decrease.
 Introduction

Question 3: how much would the consumption of gasoline

decrease ?

v It depends on sensitivity of consumers and suppliers to the

price change.
 Introduction

Question 4: how to measure that sensitivity ?

Elasticity

Definition: Elasticity is a measure of the responsiveness of quantity

demand or quantity supplied to a change in one of its determinants,
 Introduction

Recall
v Determinants of quantity demanded include
price
income
price of related goods
…

v Determinants of quantity supplied include

price
price of production factors
….
In this chapter, we will learn

v Four kinds of elasticities about demand and supply

v Price elasticity of demand
v Income elasticity of demand
v Cross-price elasticity of demand
v Price elasticity of supply

v Determinants of these elasticities

v How to use these elasticities to analyze some real

life situations
Price Elasticity of
Demand
Price Elasticity of Demand

Definition：Price elasticity of demand measures how much the

quantity demanded of a good responds to a change in the price
of that good.

v If the quantity demanded responds substantially to the price

change, then the demand is elastic;

v If the quantity demanded responds slightly to the price

change, then the demand is inelastic.
Price Elasticity of Demand
Example:

(1)Does your quantity demanded of apples respond substantially

/slightly to the a price change of it?
(2) Does your quantity demanded of salt respond substantially
/slightly to the a price change of it?
Determinants of Price Elasticity of Demand

The price elasticity of demand for a good depends on:

v Availability of Close Substitutes
v Necessities versus Luxuries
v Time horizon
v Definition of the Market: Narrowly or Broadly defined
category
Availability of Close Substitutes

Goods with close substitutes tend to have more elastic demand.

e.g. Apples & Salt

Necessities versus Luxuries

Necessities generally have inelastic demand.

e.g. Salt, medicine, water ...

Luxuries generally have elastic demand.

e.g. Protein powder, sailboats, ...

Whether a good is a necessity or a luxury depends not on the

intrinsic properties of the good but on the preferences of the
buyer.
Determinants of Price Elasticity of Demand
Time horizon
Goods tend to have more elastic demand over longer time
horizons.
e.g., gasoline...

Narrowly or Broadly defined category

Narrowly defined markets tend to have more elastic demand
than broadly defined markets.
e.g. Food v.s. Ice cream
Computing Price Elasticity of Demand

The price elasticity of demand is calculated by using the formula:

v By Law of demand, the above ratio must be negative.

v But it is a common practice to take the absolute value of the
above ratio as the price elasticity of demand.
Computing Price Elasticity of Demand
Scenario 1: The given information is percentage changes in price
and quantity.

Example 1: P
Price elasticity of demand is
!"%
P 上升 = 1.5
P2 !%%
10%
P1
D
Q
Q2 Q1
Q 下降
15%
Computing Price Elasticity of Demand
Scenario 2: The given information is prices and quantities before
change and after change.
P
B A: P1= 4 , Q1 = 120
Example 2: P2
A B: P2 =6, Q2 = 80
P1
D
Q
Q2 Q1

How to calculate the price elasticity of demand?

Computing Price Elasticity of Demand

(Example 2 continued)
Method 1: calculate percentage change using the following formula:
New point – Original point
x 100%
Original point

If the change is from point A to point B, then

(1) price increases 50%
(2) quantity demanded decreases 33.33%
--- Price elasticity of demand = 33.33% / 50% = 0.667
Computing Price Elasticity of Demand

(Example 2 continued)
In Example 2, if the change is from B to A, then
(1) price ↓ 33.33%
(2) quantity demanded ↑ 50%
--- Price elasticity of demand = 50% / 33.33% = 1.5

Problem of Method 1: Different direction of change will lead to

different price elasticity of demand.

So Method 1 should not adopted.

Computing Price Elasticity of Demand

Method 2: calculate percentage change using the following formula:

New point – Original point

x 100%
Middle point
In Example 2, no matter the change is from A to B or from B to A,
(1) the percentage changes in price is always 40%
(2) the percentage changes in quantity demanded is always 40%
--- Price elasticity of demand = 40% /40% =1

Method 2 is adopted when calculating the percentage change for

Scenario 2
Calculate Price Elasticity of Demand
Scenario 3: The given information is demand function 𝑄 𝑝 .
Find the price elasticity of demand at a given price or quantity.

Calculate the price elasticity of demand using the following

formula:

Example 3: Suppose that the demand function of apple is

𝑄 𝑝 = 12 − 4𝑝
Please calculate the price elasticity of demand for apple for price
𝑝 = 1.
Features of Price Elasticity of Demand

v A Units-Free Measure
Elasticity is a ratio of percentage changes, so change the units of
measurement of price or quantity does not affect the value of
elasticity.

v Positive value
The value of price elasticity of demand is positive, that is, we take
the absolute value of the ratio of percentage changes. (Sometimes,
you may meet negatively valued price elasticity, it is also correct.
It emphasizes the opposite direction of price change and quantity
change.)
Unit-free Measure
Recall example 2:

If we use the absolute change instead of percentage change

price change = 2RMB
quantity demanded change = -40 kg / -40,000g

Is the price elasticity of demand = 40/2 or 40,000/2 ?

Using the absolute change instead of percentage change would

lead to unit-dependent elasticity. That is, the elasticity changes
with the unit measure. So absolute change is not used when
computing elasticity.
Elastic and Inelastic Demand

v Demand can be inelastic, unit elastic, or elastic.

v Price elasticity of demand can range from 0 to infinity.

Perfectly Inelastic Demand

If the quantity demanded

doesn’t change when the price
changes,
v the price elasticity of demand
is zero
v the good has a perfectly
inelastic demand.
v the demand curve is vertical.
Unit Elastic Demand

If the percentage change in the

quantity demanded equals the
percentage change in price,
v price elasticity of demand =1
v the good has unit elastic
demand
v The demand curve has a
declining slope.
Perfectly Elastic of Demand

If the percentage change in the

quantity demanded is infinitely
large when the price barely
changes,
v the price elasticity of demand
is infinite
v the good has a perfectly
elastic demand.
v demand curve is horizontal.
Inelastic and Elastic Demand

If the percentage change in the quantity demanded is

smaller than the percentage change in price,
▪ the price elasticity of demand is less than 1
▪ the good has inelastic demand.

If the percentage change in the quantity demanded is

greater than the percentage change in price,
▪ price elasticity of demand is greater than 1
▪ the good has elastic demand.
Price Elasticity of Demand along
Demand Curve
Elasticity varies along a
linear demand curve.
At the mid-point of the demand
curve, demand is unit elastic.

At prices above the mid-point of

the demand curve, demand is
elastic.

At prices below the mid-point of

the demand curve, demand is
inelastic.
Total Revenue and Elasticity

Total revenue : the amount paid by buyers and received by

sellers of a good, computed as the price of the good times by the
quantity sold.
v When the price changes, total revenue also changes.
v But does a rise in price always increase the total revenue?
 Total Revenue and Elasticity

The change in total revenue due to a price change depends on

the price elasticity of demand:
v If demand is elastic, a 1 percent price cut increases the quantity
sold by more than 1 percent, and total revenue increases.
v If demand is inelastic, a 1 percent price cut increases the quantity
sold by less than 1 percent, and total revenues decreases.
v If demand is unit elastic, a 1 percent price cut increases the
quantity sold by 1 percent, and total revenue remains unchanged.
Total Revenue and Elasticity

The total revenue test is a method of estimating the price

elasticity of demand by observing the change in total revenue
that results from a price change (when all other influences on the
quantity sold remain the same).
v If a price cut increases total revenue, demand is elastic.
v If a price cut decreases total revenue, demand is inelastic.
v If a price cut leaves total revenue unchanged, demand is unit
elastic.
Thinking…
If the demand is individual demand, what is the connection
between demand elasticity and your expenditure on the item?

v If the demand is elastic, a 1 percent price cut increases the quantity

you buy by more than 1 percent and your expenditure on the item
increases.
v If your demand is inelastic, a 1 percent price cut increases the
quantity you buy by less than 1 percent and your expenditure on
the item decreases.
v If your demand is unit elastic, a 1 percent price cut increases the
quantity you buy by 1 percent and your expenditure on the item
does not change.
Income Elasticity of
Demand
Income Elasticity of Demand
Definition
The income elasticity of demand measures how the quantity
demanded of a good responds to a change in income, other
things remaining the same.

The formula for calculating the income elasticity of demand is:

Income Elasticity of Demand

v If the income elasticity of demand is > 1, demand is income

elastic and the good is a normal good. (e.g., travel, luxury,...)

v If the income elasticity of demand is greater than 0 but less

than 1, demand is income inelastic and the good is a normal
good. (e.g., salt, rice)

v If the income elasticity of demand is < 0 (negative) the good

is an inferior good. (e.g., public transport,...)
Cross-price
Elasticity of
Demand
Cross-price Elasticity of Demand

Definition

The cross-price elasticity of demand measures how the

quantity demanded of a good responds to a change in the price
of a substitute or a complement.

The formula for calculating the cross elasticity is:

Percentage change in quantity demanded
Percentage change in price of substitute or complement
Cross-price Elasticity of Demand

The cross elasticity of demand for

v a substitute is positive
v a complement is negative
Price Elasticity of
Supply
Price Elasticity of Supply

Definition

The price elasticity of supply measures how the quantity

supplied of a good responds to a change in the price of a good.

The elasticity of supply is calculated by using the formula:

Percentage change in quantity supplied

Percentage change in price
Determinants of Price Elasticity of Supply

The price elasticity of supply depends on

v flexibility of seller to change the amount of good produce
e.g., beachfront land v.s. books, shoes

v time frame for supply decision

.
Determinants of Price Elasticity of Supply

Time Frame: Supply is usually more elastic in the long run

than in the short run.

v In a short period of time, firm cannot easily change the size of

factories to make more or less of a good;
v In the long run, firm can build new factories or close old one;
v In the long run, the new firms may enter and old firms can
exit.
Price Elasticity of Supply

Variety of supply curves:

v Supply is perfectly inelastic if the supply curve is vertical and
the elasticity of supply is 0.
v Supply is unit elastic if the supply curve is linear and passes
through the origin. (Note that slope is irrelevant.)
v Supply is perfectly elastic if the supply curve is horizontal
and the elasticity of supply is infinite.
Price Elasticity of Supply
Applications of
Elasticity
Applications:

1. Is good news for farming (e.g. technology improvement,

etc.) also good for farmers?

2. Can OPEC keep oil price high for very long time?

3. Drug interdiction or drug education?

Application 1:

Is good news for farming (e.g. technology improvement, etc.)

also good for farmers?
Application 2

Can OPEC keep oil price high for very long time?
Application 3

Drug interdiction or drug education?

v Drug demand is inelastic.

v In the case of drug interdiction, the total expenditure on drug
increases, which leads to more drug-related crimes.
Homework (Due on Oct 30)
(1)Chapter quick quiz on Page 107-108 of Mankiw’s book (8th edition)
(2)Questions for review & Problems and applications on Page 109-110
of Mankiw’s book (8th edition)
(3) (Open question) Please read the following news and analyze the
possible effect of the price rise on the company’s ticket revenue.