The Principles of Economics

Chapter 5

Elasticity and Its Application

Jeyhun Isgandarli
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 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
opportunity cost of your time)
– You consider raising the price to $250.
• The law of demand: you won’t sell as many
websites if you raise your price.
– How many fewer websites?
– How much will your revenue fall, or might it
increase?
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 The Elasticity of Demand
• Elasticity
– Measure of the responsiveness of Qd or Qs
• To a change in one of its determinants
• Price elasticity of demand
– How much the quantity demanded of a
good responds to a change in the price of
that good
• Loosely speaking, it measures the price-
sensitivity of buyers’ demand

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Price Elasticity of Demand
Price elasticity of demand =
P percentage change in Q d

percentage change in P
P rises P2 15%
  1.5
by 10% P1 10%
D P and Q
Along a D curve,
move in opposite directions, which would make
price elasticity
Q
negative.
Q 2 Q 1

Q falls
by 15%
We will drop the minus sign and report all price elasticities as positive
numbers.

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Calculating Percentage Changes
Standard method of computing the
Demand for your
percentage (%) change:
websites
P
end value  start value
B
  100%
$250 start value
A Going from A to B:
$200
• the % change in P = ($250–
D $200)/$200 = 25%
Q • the % change in Q = - 33%
8 12 • Price elasticity = 33/25 = 1.33
Going from B to A:
• the % change in P = - 20%
• the % change in Q = 50% We get different values!
• Price elasticity = 50/20 = 2.5
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 The Price Elasticity of Demand
• Midpoint method
– The midpoint is the number halfway
between the start and end values
• The average of those values

end value - start value

percentage change   100%
midpoint
(Q2  Q1 ) / [(Q2  Q1 ) / 2 ]
Price elasticity of demand 
(P2  P1 ) / [(P2  P1 ) / 2 ]

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Calculating Percentage Changes
Demand for your websites
P
B
$250 Using the midpoint method of
A computing % changes:
$200
D
Q
8 12
$250  $200
% change in P =  100%  22.2%
$225
12  8
% change in Q =  100%  40%
10
40%
Price elasticity =  1.8
22.2%
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Active Learning 1 Calculate an elasticity
Use the following information to calculate the
price elasticity of demand for iPhones:
• if P = $400, Qd = 10,600
• if P = $600, Qd = 8,400
• Use the midpoint method to calculate
percentage changes.

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 Active Learning 1 Answers
Using the midpoint method to calculate
percentage changes:
• % change in P =
[($600 - $400)/$500] ×100 = 40%
• % change in Qd =
[(10,600 – 8,400)/9,500] ×100 = 23.16%
• Price elasticity of demand =
= % change in Qd / % change in P
= 23.16/40 = 0.58

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 The Price Elasticity of Demand
• Determinants of price elasticity of demand
– We look at a series of examples comparing
two common goods
• In each example:
– Suppose prices of both goods rise by 20%
– Which good has the highest price elasticity
of demand? Why?
– What lesson we learn about the
determinants of price elasticity of demand?
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 The Price 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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 The Price Elasticity of Demand
Example 1: Breakfast cereal vs. Sunscreen
– Prices of both of these goods rise by 20%.
For which good does Qd drop the most?
Why?
• Breakfast cereal has close substitutes, so
buyers can easily switch if the price rises
• Sunscreen has no close substitutes, so a price
increase would not affect demand very much
• Price elasticity is higher when close
substitutes are available
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 The Price Elasticity of Demand
Example 2: Blue Jeans vs. Clothing
– Prices of both of these goods rise by 20%.
For which good does Qd drop the most?
Why?
• For a narrowly defined good, blue jeans, there
are many substitutes
There are fewer substitutes available for
broadly defined goods (clothing)
Price elasticity is higher for narrowly defined
goods than for broadly defined ones.
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 The Price Elasticity of Demand
Example 3: Insulin vs. Ships
– Prices of both of these goods rise by 20%.
For which good does Qd drop the most?
Why?
• Insulin is a necessity to diabetics. A rise in price
would cause little or no decrease in demand
• A ship is a luxury. If the price rises, some people
will forego it.
• Price elasticity is higher for luxuries than
for necessities.
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 The Price Elasticity of Demand
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 work.
• Price elasticity is higher in the long run
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 The Price 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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Perfectly inelastic demand

Price elasticity % change in Q 0%

= = =0
% change in P 10%
of demand
P
D D curve
Vertical
P1

P2 Consumers’ price
sensitivity:
P falls
None
Q
by 10% Q1
Q changes
Elasticity:
by 0% 0
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Inelastic demand

Price elasticity % change in Q <10%

= = <1
% change in P 10%
of demand
P
D curve
P1 relatively steep

P2 Consumers’ price
D sensitivity:
P falls Q relatively low
by 10% Q1 Q 2

Q rises less Elasticity:

than 10% <1
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Unit elastic demand

Price elasticity % change in Q 10%

= = =1
% change in P 10%
of demand
P D curve
intermediate slope
P1
Consumers’ price
P2 sensitivity:
D
intermediate
P falls Q
by 10% Q1 Q2 Elasticity:
Q rises =1
by 10%
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Elastic demand

Price elasticity % change in Q >10%

= = >1
% change in P 10%
of demand
P
D curve
P1 relatively flat

P2 D Consumers’ price
sensitivity:
P falls Q relatively high
by 10% Q1 Q2
Q rises more Elasticity:
than 10% >1
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Perfectly elastic demand

Price elasticity % change in Q any %

= = = infinity
% change in P 0%
of demand
P
D curve
horizontal
P2 = P1 D
P changes Consumers’ price
by 0%
sensitivity:
extreme
Q
Q1 Q2
Elasticity:
Q changes
by any % infinity

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A Few Elasticities from the Real World

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Elasticity along a Linear Demand Curve

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

$0 Q
0 20 40 60

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 Price Elasticity and Total Revenue
Continuing our scenario, if you raise your
price from $200 to $250, would your revenue
rise or fall?
Total Revenue (TR) = P x Q
• A price increase has two effects on revenue:
– Higher revenue: because of the higher P
– Lower revenue: you sell fewer units (lower Q)
• Which of these two effects is bigger?
– It depends on the price elasticity of demand

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 Price Elasticity and Total Revenue
• For a price increase, if demand is elastic
 E > 1: % change in Q > % change in P
 TR decreases: the fall in revenue from lower
Q > the increase in revenue from higher P
• For a price increase, if demand is
inelastic
 E < 1: % change in Q < % change in P
 TR increases: the fall in revenue from lower
Q < the increase in revenue from higher P

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 Price Elasticity and Total Revenue
Demand for your websites
Elastic demand
increased (elasticity = 1.8)
P revenue
due to lost If P = $200, Q = 12,
higher P revenue and revenue = $2400
$250 due to
lower Q
$200 If P = $250, Q = 8, and
D
revenue = $2000

Q When D is elastic,
8 12
a price increase
causes revenue to fall.
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 Price Elasticity and Total Revenue
Demand for your websites
Inelastic demand
increased (elasticity = 0.82)
P revenue
due to lost If P = $200, Q = 12,
higher P revenue and revenue = $2400
$250 due to
lower Q If P = $250, Q = 10,
$200
and revenue = $2500
D
When D is inelastic,
Q a price increase
10 12 causes revenue to
rise.
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Active Learning 2 Elasticity and revenue
A. Pharmacies raise the price of insulin by
10%.
– Does total revenue on insulin rise or fall?

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?

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 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.

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 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.
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 The Price 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
– Loosely speaking, it measures sellers’
price-sensitivity

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Price Elasticity of Supply
Price elasticity percentage change in Q s 16%
of supply    2
percentage change in P 8%

P
S

P rises P2
by 8% P
1

Again, we use the

midpoint method to
Q
compute the Q1 Q2
percentage changes. Q rises
by 16%
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 The Price 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 Price 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
• The flatter the supply curve
– The greater the price elasticity of supply

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Perfectly inelastic supply

Price elasticity % change in Q 0%

= = =0
% change in P 10%
of supply
S curve:
P
vertical S

Sellers’ price P
P rises 2
sensitivity: by 10% P
1
none
Q
Elasticity: Q1
0 Q changes
by 0%
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Inelastic supply

Price elasticity % change in Q < 10%

= = <1
% change in P 10%
of supply
S curve:
P
relatively steep S

Sellers’ price P2
P rises
sensitivity: by 10% P1
relatively low

Elasticity: Q
Q 1 Q2
<1 Q rises less
than 10%
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Unit elastic supply

Price elasticity % change in Q 10%

= = =1
% change in P 10%
of supply
S curve:
intermediate slope P
S

Sellers’ price sensitivity: P2

intermediate P1

Elasticity: P rises
by 10% Q
=1 Q1 Q2
Q rises
by 10%
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Elastic supply

Price elasticity % change in Q > 10%

= = >1
% change in P 10%
of supply
S curve:
P
relatively flat
S

Sellers’ price P rises P2

sensitivity: by 10%
P1
relatively high
Q
Elasticity: Q1 Q2
>1 Q rises more
than 10%
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Perfectly elastic supply

Price elasticity % change in Q any %

= = = infinity
% change in P 0%
of supply
S curve:
horizontal P

Sellers’ price P2 = P1 S
sensitivity: P changes
extreme by 0%

Elasticity: Q
Q1 Q2
infinity Q changes
by any %
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 The Determinants of Supply Elasticity
• Greater price elasticity of supply
– The more easily sellers can change the
quantity they produce
• Supply of beachfront property - harder to vary
and thus less elastic than supply of new cars
• Price elasticity of supply is greater in the
long run than in the short run
– In the long run: firms can build new factories,
or new firms may be able to enter the market

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How the Price Elasticity of Supply Can Vary

Price Elasticity is small Supply

(less than 1). Supply often
$15
becomes less
12 elastic as Q
Elasticity is large rises, due to
(greater than 1).
capacity limits.
4
3

0 100 200 500 525 Quantity

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 Summary
• Elasticity measures the responsiveness of
Qd or Qs to one of its determinants.
• Price elasticity of demand equals percentage
change in Qd 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.

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 Summary
• Demand is less elastic in the short run,
for necessities, for broadly defined goods,
and 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.

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 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.
• The tools of supply and demand can be applied
in many different kinds of markets. This chapter
uses them to analyze the market for wheat, the
market for oil, and the market for illegal drugs.

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