5

Elasticity and Its Application

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The Elasticity of Demand

• Elasticity
– Measures the responsiveness of quantity
demanded (or quantity supplied)
– To a change in one of its determinants
• Price elasticity of demand
– Percentage change in quantity demanded
divided by the percentage change in price
– How much the quantity demanded of a
good responds to a change in the price of
that good
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 The Elasticity of Demand

• Elastic demand
– Quantity demanded responds substantially
to changes in price
• Inelastic demand
– Quantity demanded responds only slightly
to changes in price

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The Elasticity of Demand

• Determinants of price elasticity of demand
– Availability of close substitutes
• Goods with close substitutes tend to have
more elastic demand (Coke and Pepsi)
– Necessities vs. luxuries
• Necessities: inelastic demand (Bread)
• Luxuries: elastic demand (Jewelry)
– Definition of the market: Narrowly defined
markets tend to have more elastic demand (ice-
cream vs. food)
– Time horizon: Demand is more elastic over
longer time horizons (gasoline)
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 The Elasticity of Demand
• Computing the price elasticity of demand
– Percentage change in quantity demanded
divided by percentage change in price
– Use absolute value (drop the minus sign)
• Midpoint method
– Two points: (Q1, P1) and (Q2, P2)

(Q2 - Q1 )/[(Q2 + Q1 )/ 2 ]
Price elasticityof demand=
(P2 - P1 )/[(P2 + P1 )/ 2 ]

•5

The Elasticity of Demand

• Variety of demand curves

– 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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3
 The Elasticity of Demand
• Variety of demand curves
– 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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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 to an 11%
increase
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

ü The price elasticity of demand determines whether the demand curve is steep or flat.
ü Note that all percentage changes are calculated using the midpoint method.

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4
 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

ü The price elasticity of demand determines whether the demand curve is steep or flat.
ü 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

ü The price elasticity of demand determines whether the demand curve is steep or flat.
ü Note that all percentage changes are calculated using the midpoint method.
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5
 The Elasticity of Demand
• 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)
• For a price increase
– If demand is inelastic, TR increases
– If demand is elastic, TR decreases

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Figure 2
Total Revenue
Price

$4

P ˣ Q=$400
P (revenue)
Demand

0 100 Quantity

Q
ü The total amount paid by buyers, and received as revenue by sellers, equals the
area of the box under the demand curve, P × Q.
ü Here, at a price of $4, the quantity demanded is 100, and total revenue is $400.
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6
 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
ü The impact of a price change on total revenue (the product of price and quantity) depends on
the elasticity of demand.
ü 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.
ü 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
ü The impact of a price change on total revenue (the product of price and quantity) depends on
the elasticity of demand.
ü 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.
ü 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.
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7
 The Elasticity of Demand

• Linear demand curve

– Constant slope
• Rise over run
– Different price elasticities
• Points with high price and low quantity
– Elastic demand
• Points with low price and high quantity
– Inelastic demand

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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

ü The slope of a linear demand curve is constant, but its elasticity is not.
ü At points with a high price and low quantity, the demand curve is elastic.
ü At points with a low price and high quantity, the demand curve is inelastic.
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 The 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

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The Elasticity of Demand

• Normal goods (most goods)
– Positive income elasticity
– Necessities
• Smaller income elasticities
– Luxuries
• Large income elasticities
• Inferior goods (bus rides, canned goods
and frozen dinners)
– Negative income elasticities
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 The 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

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The Elasticity of Demand

• Substitutes (Coke and Pepsi)
– Goods typically used in place of one
another
– Positive cross-price elasticity
• Complements (Computer and software)
– Goods that are typically used together
– Negative cross-price elasticity

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 Elasticity and Types of Goods

• A Giffen good denotes a product that people consume more of as the

price rises violating the law of demand
• Ex. low quality staple foods à bread & potato (vs. meat), and rice (vs.
wheat)
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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
– Percentage change in quantity supplied
divided by the percentage change in price
– Depends on the flexibility of sellers to
change the amount of the good they
produce

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 The Elasticity of Supply
• Elastic supply
– Quantity supplied responds substantially
to changes in the price
• Inelastic supply
– Quantity supplied responds only slightly to
changes in the price
• Determinant of price elasticity of supply
– Time period
• Supply is more elastic in long run

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The Elasticity of Supply

• Computing price elasticity of supply
– Percentage change in quantity supplied
divided by percentage change in price
– Always positive
• Midpoint method
– Two points: (Q1, P1) and (Q2, P2)

(Q2 - Q1 ) / [(Q2 + Q1 ) / 2 ]
Price elasticity of supply =
(P2 - P1 ) / [(P2 + P1 ) / 2 ]

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 The Elasticity of Supply

• Variety of supply curves

– 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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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

ü The price elasticity of supply determines whether the supply curve is steep
or flat.
ü 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

ü The price elasticity of supply determines whether the supply curve is steep
or flat.
ü Note that all percentage changes are calculated using the midpoint method.
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 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

ü The price elasticity of supply determines whether the supply curve is steep or
flat.
ü Note that all percentage changes are calculated using the midpoint method.
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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

ü 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.
ü 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.
ü 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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Applications
• 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

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 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
ü When an advance in farm technology increases the supply of wheat from S1 to S2,
the price of wheat falls
ü 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.
ü As a result, farmers’ total revenue falls from $300 ($3 × 100) to $220 ($2 × 110).
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