Elasticity and Its Application: Chapter 5 P.

A Scenario…

Suppose you are the owner/manager of a kiosk selling hotdogs. You estimate the following
weekly demand for your product:

Price Quantity Total Revenue

(P) (Q) (TR)
1 180 180 You are free to set the price as you wish.
2 160 320
3 140 420 Would you want to set the price as
4 120 480 high as possible?
5 100 500
6 80 480 What price might help you reap the most benefit?
7 60 420
8 40 320
9 20 180

To answer, we need considering the total revenue (TR = PxQ ).

A higher price cannot ensure higher TR because Q falls as P rises .

Therefore, to develop successful business strategy, we have to examine the

% change in Q in response to the % change in P .

In this chapter, we will focus on the sensitiveness of Qd against a change in P – called the
price elasticity of demand. This number is important as it affects our
decision on whether to cut or raise the price in order to maximize revenue.

1. Price Elasticity of Demand

Price elasticity of demand measures how the Quantity Demanded (Qd) of a good changes in
response to a change in its Price (P). Mathematically,

% change in Qd
Price elasticity of demand =
% change in P

= (Qd2 – Qd1) / Qd1 ∆Qd / Qd1

or =
(P2 – P1) / P1 ∆P / P1

© 2024 by Sunny HA
Elasticity and Its Application: Chapter 5 P. 2

Suppose that P changes from $6.0 (A) to $8.0 (B):

∆Qd / QdA
Price Elasticity of Demand =
∆P / PA
–40 / 80
= = –1.5
+2 / 6

But put another way, if P changes from $8.0 (B) to $6.0 (A):

∆Qd / QdB
Price Elasticity of Demand =
∆P / PB
+40 / 40
= = –4.0
–2 / 8

Fig. 1 P

10.0
(–25%) Ed = –1.5 (–4.0)
PB 8.0 Ed = 2.33
B
PA 6.0
+33.3% A
4.0

2.0
Demand curve

0 40 80 120 160 200 Qd

QdB QdA
–50%
(+100%)

So depending on where you start, the standard method in calculating % change would
give you different answers for elasticity.

In economic studies, to avoid assigning different elasticity values to the same interval of
a demand curve, we may use the midpoint method to calculate a % change:

∆Qd / (QdA+QdB)/2
Price Elasticity of Demand =
∆P / (PA+PB)/2
–40 / 60
= = –2.33
+2 / 7

Under the midpoint method, the calculated elasticity number would refer to the elasticity
over an interval on demand curve.

Note that the calculated price elasticity of demand is always a [ positive / negative ] number,
because P and Qd are inversely related. For ease of communication and to avoid confusion,
it’s customary to drop the minus sign, so having a price elasticity of demand of –4 is
considered [ greater / smaller ] than price elasticity of –1.5.
© 2024 by Sunny HA
Elasticity and Its Application: Chapter 5 P. 3

Inelastic Demand
When demand is inelastic (for example, P 10% => Qd 5% ), the calculated
price elasticity of demand is [ >1 / =1 / <1 ]. Graphically, an inelastic demand is usually
described by a steep demand curve (Fig. 2).

Perfectly Inelastic Demand

When Qd is totally irresponsive to change in price (for example, P 10% => Qd 0% ),
the calculated price elasticity of demand is [ zero / infinity ]. Graphically, the perfectly
inelastic demand is described by a vertical demand curve (Fig. 3).

P Fig. 2: Inelastic demand P Fig. 3: Perfectly inelastic demand

D

$7 $7
55% 55%

$4 $4

90 120 Qd 120 Qd
29% 0%

Elastic Demand
When demand is elastic (for example, P 10% => Qd 20% ), the calculated
price elasticity of demand is [ >1 / =1 / <1 ]. Graphically, an elastic demand is usually
described by a relatively flat demand curve (Fig. 4).

Perfectly Elastic Demand

When Qd is extremely sensitive to change in price (for example, P 0.1% => Qd falls to zero
and P  0.1% => Qd rises to infinity , the calculated price elasticity of demand is
[ zero / infinity ]. Graphically, a perfectly elastic demand is described by a horizontal
demand curve (Fig. 5).

P Fig .4: Elastic demand P Fig. 5: Perfectly elastic demand

This happens to the demand for individual

firms’ product in a “perfectly competitive
market” (Chapter 14).
$5
22% $4 $4 D

D The demand curve above indicates that, at

the given price of $4, buyers can buy any
quantity of the good they want.

60 120 Qd Qd
66%
© 2024 by Sunny HA
Elasticity and Its Application: Chapter 5 P. 4

Unit Elastic Demand

When demand is unitarily elastic (for P Fig. 6: Unit elastic demand
example, P 10% => Qd 10%), the
calculated price elasticity of demand is
[ >1 / =1 / <1 ]. Graphically, a unit elastic
demand is represented by a rectangular $6
hyperbola (Fig. 6).
66.7%
$3
D
$2

60 120 180 Qd
66.7%

2. Price Elasticity of Demand and Total Revenue

It is most important to master the relationship between price elasticity and total revenue
(TR). Note the following situations:

If, for example, Elasticity over this range of the Raising the price over this range
demand curve is: would cause:
P +10% and Q –5% Inelastic TR to rise
P +10% and Q –20% Elastic TR to fall
P +10% and Q –10% Unit elastic TR unchanged

If, for example, Lowering the price would cause:

P –10% and Q +5% Inelastic TR to fall
P –10% and Q +20% Elastic TR to rise
P –10% and Q +10% Unit elastic TR unchanged

In summary, as a seller, the way to increase TR is to:

 raise price if demand is [ elastic / inelastic ] (because a price increase leads only a smaller
percentage drop in Qd).
 lower price if demand is [ elastic / inelastic ] (because a price decrease leads to a bigger
percentage increase in Qd).

3. Point Elasticity of Demand

When demand curve is a straight line, its slope is a constant. But its price
elasticity is NOT a constant along the demand curve (even this is a straight line).
 In general, demand tends to more [ elastic / inelastic ] over the upper portion of the
demand curve and more [ elastic / inelastic ] over the lower portion.

© 2024 by Sunny HA
Elasticity and Its Application: Chapter 5 P. 5

To illustrate this, we can calculate the point elasticity of demand (not covered in our
textbook). Recall figure 1 (the data from page 1):

10.0
9 Elastic (Ed > 1)
8.0 4
B 2.33
6.0 1.5
A 1
4.0 0.66 Inelastic (Ed < 1)
0.43
2.0 0.25
0.11

0 40 80 120 160 200 Qd

To calculate the elasticity value of different points (Px, Qdx) on a demand curve, we start
with the same equation:

% change in Qd
Price elasticity of demand =
% change in P
= ∆Qd / Qdx
∆P / Px
= ∆Qd Px
x
∆P Qdx
= 1 Px
x
slope Qdx

Because slope (of a straight line) is a constant, the reciprocal of a slope (1/slope) is also a
constant. In other words, the elasticity of a point (PA, QdA) on the demand curve is just the
ratio PA to QdA times a constant.

In the above demand curve, that constant (1/slope or ∆Qd / ∆P) is equal to 20 .
So, for example, the point elasticity of demand of Point A is:
20 x 6/80 = 1.5

And then the point elasticity of demand of Point B would be:

20 x 8/40 = 4

Continuing these calculations will help us determine the point elasticity of all points on the
demand curve and for which part is elastic and which part is inelastic.

© 2024 by Sunny HA
Elasticity and Its Application: Chapter 5 P. 6

4. Determinants of Price Elasticity of Demand

(1) The fast rule is to see how important the good is to the buyer – the higher
the importance, the more [ elastic / inelastic ] it is (e.g. MTR service); conversely, the
lower the importance, the more [ elastic / inelastic ] it is (e.g. hamburgers).
 Note: The definition of “importance” is highly subjective, implying that the price
elasticity of a good is contingent upon the perspective of the decision maker. For
instance, the MTR service may be deemed important (inelastic) by students, but less
important (elastic) to other individuals.
 Note: Points (2) and (3) below give you some idea on how “importance” may be
judged by individuals.

(2) Availability of substitutes :

A good tends to become less important if it has many close substitutes. Therefore, the more
the substitutes available, the more [ elastic / inelastic ] the demand for the good would be.
For example, Giordano’s clothes have many close substitutes. If Giordano raises the price
for its clothes, its Qd tends to decrease by a relatively [ large / small ] amount, indicating
[ elastic / inelastic ] demand.

(3) Perception of necessities versus luxuries:

Necessities (such as medicines, bus service and foodstuff) tend to have [ elastic / inelastic ]
demand (as people can’t avoid or reduce the Qd by much for a price increase).
Luxuries (such as diamonds, sailboats and a tour to South Pole) tend to have more
[ elastic / inelastic ] demand.
 Note: The distinction between necessity and luxury is again very personal and
therefore never stable. For example, while Apple iPhone may be a necessity which is
important to you, it could be regarded as a luxury to other people.

(4) Breadth of the market:

Narrowly defined markets have more elastic demand than broadly defined markets. For
example, while demand for hotdogs and Giordano’s clothes may be [ elastic / inelastic ],
the demand for food and clothing tend to be more [ elastic / inelastic ].

(5) Time horizon:

There is a postulation that demand for a good tends to be more elastic over longer time
horizons. For example, when the price of gasoline rises, the Qd may fall only slightly in
in the first few months ( less substitutes = inelastic in short run ).
But over time, people may more fuel-efficient cars, switch to public transportation, and
even move closer to where they work. Therefore, demand for a good tends to be
more elastic in long run (because people manage to find more substitute).
 Note: Known as the “second law of demand” though, you may find lots of our life
experience contradictory to this postulation. Because in long run, many “other
things” change rather than remain constant, leading to an uncertain change in Qd
(rather than as predicted). For instance,
 Taxi service: P  10%  Qd  8% (inelastic in short run)
 Qd  28% (elastic in long run) – would this happen?
© 2024 by Sunny HA
Elasticity and Its Application: Chapter 5 P. 7

5. Other Demand Elasticities

In addition to the price elasticity of demand, economists also study the responsiveness of Qd
to a change in (i) income, and (ii) price of related goods

% change in Qd
(i) Income elasticity of demand =
% change in Income

In most situations, Qd for a good increases as consumers’ income increases. Thus, a

normal good would have a [ positive / negative ] income elasticity.

Note that among normal goods, income elasticities could vary greatly. For necessities,
their income elasticity tends to be [ smaller / larger ] (e.g. +10% in income => +8% in Qd;
so it’s calculated +0.8 for this necessity). For luxuries (also called “superior goods”) their
income elasticity tends to be [ smaller / larger ] (e.g. +10% in income => +33% in Qd;
so it’s calculated +3.3 for this luxury).

Conversely, an inferior good (Qd drops when income increases) would have a
[ positive / negative ] income elasticity (e.g. +10% in income => –25% in Qd; so
it’s calculated –2.5 for this inferior good).

Example: John’s income rises from $20,000 to $22,000 and the quantity of hamburger he
buys each week falls from 2 pounds to 1 pound.

–1 / 1.5
Income elasticity of demand = = –7.0
+2,000 / 21,000

The negative income elasticity indicates that hamburgers are an inferior good
for John.

% change in Qd of one good

(ii) Cross-price elasticity of demand =
% change in P of another good

Example: The price of apples rises from $1.0 per pound to $1.5 per pound. As a result, the
quantity of oranges demanded rises from 8,000 to 9,500 per week.

+1,500 / 8,750
Cross price elasticity of demand = = +0.43
+0.5 / 1.25

If the quantity demanded of one good increases as the price of another good increases
(a positive cross-price elasticity), then the two goods may be substitute
to each other.

If the quantity demanded of one good increases as the price of another good decreases
(a negative cross-price elasticity), then the two goods may be complement
to each other.

© 2024 by Sunny HA
Elasticity and Its Application: Chapter 5 P. 8

6. Elasticity of Supply

Price elasticity of supply (Es) measures how the Quantity Supplied (Qs) of a good changes in
response to a change in its Price (P). Mathematically,

% change in Qs
Price elasticity of supply (Es) =
% change in P

= (Qs2 – Qs1) / Qsmid ∆Qs / Qsmid

or =
(P2 – P1) / Pmid ∆P / Pmid

Example: The P of milk increases from $2.85 to $3.15 per gallon and the Qs rises from 9,000 to
11,000 gallons per month.

When the midpoint method is used:

+2,000 / 10,000
Es = = +2.0
+0.3 / 3

According to the law of supply (as there’s a positive relationship between P and Qs), the
calculated Es should always be positive.

Similar to the case of demand, five types of price elasticity of supply can be identified:

Inelastic Supply
If supply is inelastic (for example, P 10% => Qs6% ), then the calculated Es < 1 .
Graphically, an inelastic supply is usually described by a [ steep / relatively flat ] supply curve
with a positive horizontal intercept (Fig. 7).

Perfectly Inelastic Supply

If supply is perfectly inelastic (for example, P 10% => Qs0% ), then the calculated
Es = 0 . Supply is fixed at a particular quantity, irrespective of the price; so graphically,
it would be represented by a [ vertical / horizontal ] line (Fig. 8).

P Fig. 7: Inelastic supply P Fig. 8: Perfectly inelastic supply

S S

+10% +10%

6% Qs +0% Qs

© 2024 by Sunny HA
Elasticity and Its Application: Chapter 5 P. 9

Elastic Supply
If supply is elastic (for example, P 5% => Qs20% ), then the calculated Es > 1 .
Graphically, an elastic supply is usually described by a [ steep / relatively flat ] supply curve
with a positive vertical intercept (Fig. 9).

Perfectly elastic Supply

If supply is perfectly elastic, then the Es is equal to infinity. That means at a given price, the
seller is willing to supply any quantity. Graphically, a perfectly elastic supply is described by a
horizontal line (Fig. 10).

P Fig. 9: Elastic supply P Fig. 10: Perfectly elastic supply

The horizontal supply curve is used to describe a

unique situation that the seller has planned to fix
S the price of its product at a particular level (e.g.
due to government regulation).

+5% $5 S

The above supply curve means that, at a

given price of $5, the seller is prepared to
sell any quantity.

+20% Qs Qs

Unit Elastic Supply

If supply is unitarily elastic (for example, P 10% => Qs10% ), then the calculated
Es = 1 . Graphically, it is described by a supply curve that starts from the origin
(Fig. 11).

P Fig .11: Unit elastic supply P Fig. 12: Supply curve with
varying elasticities

S S
Es<1

+10%

Es>1

+10% Qs Qs

Supply curve with varying elasticities

When describing the typical business environment, a supply curve with varying elasticities
(Fig. 12) may be considered. In general, supply is [ elastic / inelastic ] over the lower portion of
the supply curve and [ elastic / inelastic ] over the upper portion.

© 2024 by Sunny HA
Elasticity and Its Application: Chapter 5 P. 10

The consideration behind is that: when output level is low, it would be relatively easy for
firms to increase output as they have excess capacity (supply tends to be elastic).
However, when the output becomes high, it becomes increasingly costly for firms to increase
output further (e.g. workers are paid extra for working overtime ; machines
require extra repairs for over-utilization). Therefore, it takes a much large price
increase to make firms willing to increase output further (supply tends to be inelastic).

7. Determinants of Price Elasticity of Supply

(1) The fundamental rule is to see how flexible the sellers are in providing or
producing the good – the greater the flexibility, the more [ elastic / inelastic ] it is (e.g.
manufactured goods such as books, cars, and televisions); conversely, the lower the
flexibility, the more [ elastic / inelastic ] it is (e.g. beachfront property that is quite
limited in supply).

(2) Time horizon: Supply is usually more [ elastic / inelastic ] in the long run than in the short
run. The general reason is that, in short run, the Qs is not very responsive to P because
firms cannot easily adjust the size of their factory to make more of
a good. But over longer term, firms can build new factories or close old ones, making
output more responsive to price changes, indicating more elastic supply.

8. Three Applications of Supply, Demand, and Elasticity

(1) Consider the market for wheat. A new hybrid of wheat was invented so production per
acre can be increased by 20%. However, this good news for farming had turned out to be
a bad news for farmers. Explain why.

A good news for farming:

 advance in technology (lower production cost)
 supply   S curve shifts to right  P & Q

A bad news for farmers:

* because the % fall in P is likely to be associated with a [ greater / smaller ] % rise in Q.

(For example, P falls 10% but Q rises by 5% only .)

* That is to say, demand for wheat is [ elastic / inelastic ] (having a steep demand
curve). This happens because wheat belongs to basic foodstuff and a necessity
to most people.

* Hence, an increase in supply had caused farmers’ total revenue to fall

(Fig. 13).

(Paradox of public policy: induce farmers not to plant too much in order to protect their
income)

© 2024 by Sunny HA
Elasticity and Its Application: Chapter 5 P. 11

P
S1 S2

P1
–TR

P2

D1
+TR
Q1 Q2 Q
Fig. 13

(2) Consider the market for drugs (e.g. cocaine, heroin). In recent months, the government
has strengthened police force to fight against drug traffickers. However, this drug
interdiction had rather increased the overall drug-related crimes. Explain why.

Drug interdiction (fight against drug traffickers):

 higher production / transaction cost for sale
 supply   S curve shifts to left  P & Q

* Given the addictive nature of drugs, demand for drugs is likely [ elastic / inelastic ]
(having a steep demand curve). In other words, the rise in P will result in a [ bigger /
smaller ] percentage fall in Qd.

* Hence, Total Revenue (TR) will [ rise / fall ] (fig. 14); which may make drugs selling even
more profitable . On the other hand, the rise in P will make the drug
addicts more financially distressed ; so this may rather force them
to commit more crimes in order to get enough cash to support their habit.

P
S2 S1

P2
+TR

P1

–TR D1
Q2 Q1 Q
Fig. 14

© 2024 by Sunny HA
Elasticity and Its Application: Chapter 5 P. 12

(3) Consider the market for oil. In the 1970s and 1980s, OPEC (Organization of the Petroleum
Exporting Countries) reduced the amount of oil it was willing to supply to world
markets.

However, it was observed that the increase in price was much larger in the short run
than the long run. With the use of supply-and-demand diagrams, explain why.

P S2 S1 P

S2*
P2
S1*
P2*
P1 P1

D long run
D short run

Q2 Q1 Q Q2* Q1 Q
Fig. 15 Fig. 16

OPEC’s collaboration to cut oil supply

 supply   S curve shifts to left  P & Q

* In short run, demand for oil tends to be [ elastic / inelastic ] (demand curve tends to
be steeper) because consumers were hard to adjust their consumption habit. And in
short run, supply for oil is also inelastic (supply curve tends to be steep) because it
was hard to have new sellers to supply oil to the world market.

* Therefore, the decrease in supply had cause a larger increase in price (P1  P2) (Fig. 15)

* But in the long run, demand is more [ elastic / inelastic ] (demand curve becomes
flatter) because consumers can adjust to the higher price by reducing consumption or
finding other substitutes for use. Supply is also more elastic (supply curve
becomes flatter) because the higher price may attract new sellers to enter the
market.

* Therefore, even given the same amount of decrease in supply, the increase in price
may subside in the long run (P2 P2*) (Fig. 16).

------ Multiple-choice answers ------

Page 2: negative; greater
Page 3: <1; zero; >1; infinity
Page 4: =1; inelastic; elastic; elastic; inelastic
Page 6: inelastic; elastic; elastic; large; elastic; inelastic; elastic; elastic; inelastic
Page 7: positive; smaller; larger; negative
Page 8: steep; vertical
Page 9: relatively flat; elastic; inelastic
Page 10: elastic; inelastic; elastic; smaller; inelastic
Page 11: inelastic; rise
Page 12: inelastic; elastic

© 2024 by Sunny HA