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Chapter 5 Elasticity and Its Application

The document discusses the concept of elasticity in economics, specifically price elasticity of demand. It defines elasticity as the responsiveness of quantity to a change in price. Demand is said to be elastic if quantity responds substantially to price changes, and inelastic if quantity only responds slightly. The document outlines factors that determine price elasticity, such as availability of substitutes and whether a good is a necessity. It also provides the formula for calculating price elasticity and discusses concepts like perfectly inelastic and elastic demand curves.

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0% found this document useful (0 votes)
246 views39 pages

Chapter 5 Elasticity and Its Application

The document discusses the concept of elasticity in economics, specifically price elasticity of demand. It defines elasticity as the responsiveness of quantity to a change in price. Demand is said to be elastic if quantity responds substantially to price changes, and inelastic if quantity only responds slightly. The document outlines factors that determine price elasticity, such as availability of substitutes and whether a good is a necessity. It also provides the formula for calculating price elasticity and discusses concepts like perfectly inelastic and elastic demand curves.

Uploaded by

vikash verma
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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5

Elasticity and Its Application

PowerPoint Slides prepared by:


Andreea CHIRITESCU
Eastern Illinois University

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 1
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Elasticity of Demand
• Elasticity
– Measure of the responsiveness of quantity
demanded or quantity supplied
– 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

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 2
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Elasticity of Demand
• Inelastic demand
– Quantity demanded responds only slightly
to changes in price
• Elastic demand
– Quantity demanded responds
substantially to changes in price

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 3
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Elasticity of Demand
• Determinants of price elasticity of demand
– Availability of close substitutes
• Goods with close substitutes: more elastic
demand
– Necessities vs. luxuries
• Necessities: inelastic demand
• Luxuries: elastic demand

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 4
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Elasticity of Demand
• Determinants of price elasticity of demand
– Definition of the market- narrow vs broad
• Narrowly defined markets: more elastic
demand
– Time horizon
• Demand is more elastic over longer time
horizons

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 5
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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 elasticity of demand 
(P2  P1 )/[(P2  P1 )/ 2 ]

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 6
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 7
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 8
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Figure 1
The Price Elasticity of Demand (a, b)

The price elasticity of demand determines whether the demand curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 9
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Figure 1
The Price Elasticity of Demand (c)

The price elasticity of demand determines whether the demand curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 10
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Figure 1
The Price Elasticity of Demand (d, e)

The price elasticity of demand determines whether the demand curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 11
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Elasticity of Demand
• Linear demand curve
– Constant slope
– Different price elasticities
• Points with low price and high quantity
– Inelastic demand
• Points with high price and low quantity
– Elastic demand

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 12
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Figure 4
Elasticity of a Linear Demand Curve (schedule)
Price Quantity Total Revenue Percentage Percentage Elasticity Description
(Price times Change in Price Change in
Quantity) Quantity
$7 0 $0 Empty Cell Empty Cell Empty Cell Empty Cell
$6 2 $12 15 200 13.0 Elastic
$5 4 $20 18 67 3.7 Elastic
$4 6 $24 22 40 1.8 Elastic
$3 8 $24 29 29 1.0 Unit Elastic
$2 10 $20 40 22 0.6 Inelastic
$1 12 $12 67 18 0.3 Inelastic
$0 14 $0 200 15 0.1 Inelastic

The slope of a linear demand curve is constant, but its elasticity is not. The demand
schedule in the table was used to calculate the price elasticity of demand by the
midpoint method. At points with a low price and high quantity, the demand curve is
inelastic. At points with a high price and low quantity, the demand curve is elastic.

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 13
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Figure 4
Elasticity of a Linear Demand Curve (graph)

The slope of a linear demand curve is constant, but its elasticity is not. The demand
schedule in the table was used to calculate the price elasticity of demand by the
midpoint method. At points with a low price and high quantity, the demand curve is
inelastic. At points with a high price and low quantity, the demand curve is elastic.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 14
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 15
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Total Revenue

•The total amount paid by buyers, and received as


revenue by sellers, equals the area of the box under
the demand curve, P × Q. Here, at a price of $4, the
quantity demanded is 100, and total revenue is $400. 16
Figure 3
How Total Revenue Changes When Price Changes (a)

•The impact of a price change on total revenue (the product of price and quantity) depends on
the elasticity of demand. 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. 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.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 17
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Figure 3
How Total Revenue Changes When Price Changes (b)

•The impact of a price change on total revenue (the product of price and quantity) depends on
the elasticity of demand. 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. 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.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 18
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Elasticity of Demand
• When demand is inelastic (elasticity < 1)
– P and TR move in the same direction
• If P ↑, TR also ↑
• When demand is elastic (elasticity > 1)
– P and TR move in opposite directions
• If P ↑, TR ↓
• If demand is unit elastic (elasticity = 1)
– Total revenue remains constant when the
price changes
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 19
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 20
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Elasticity of Demand
• Normal goods
– Positive income elasticity
– Necessities
• Smaller income elasticities
– Luxuries
• Large income elasticities
• Inferior goods
– Negative income elasticities

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 21
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 22
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Elasticity of Demand, Part 14
• Substitutes
– Goods typically used in place of one
another
– Positive cross-price elasticity
• Complements
– Goods that are typically used together
– Negative cross-price elasticity

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 23
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Elasticity of Supply, Part 1
• 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

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 24
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Elasticity of Supply, Part 2
• 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

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 25
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Elasticity of Supply, Part 3
• 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 ]

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 26
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Elasticity of Supply, Part 4
• 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

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 27
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Elasticity of Supply, Part 5
• 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

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 28
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Figure 5
The Price Elasticity of Supply (a, b)

The price elasticity of supply determines whether the supply curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 29
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Figure 5
The Price Elasticity of Supply (c)

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

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 30
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Figure 5
The Price Elasticity of Supply (d, e)

The price elasticity of supply determines whether the supply curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 31
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Applications, Part 1
• 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

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 32
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Figure 7
An Increase in Supply in the Market for Wheat

When an advance in farm technology increases the supply of wheat from S1 to S2, the
price of wheat falls. 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. As a result, farmers’ total revenue falls from $300 ($3 × 100) to $220
($2 × 110).
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Applications, Part 2
• Can Good News for Farming Be Bad
News for Farmers?
– Paradox of public policy
• Induce farmers not to plant crops

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 34
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Applications, Part 3
• Why Did OPEC Fail to Keep the Price of
Oil High?
– Increase in prices 1973-1974, 1971-1981
– Short-run: supply and demand are
inelastic
• Decrease in supply: large increase in price
– Long-run: supply and demand are elastic
• Decrease in supply: small increase in price

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 35
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Figure 8
A Reduction in Supply in the World Market for Oil

When the supply of oil falls, the response depends on the time horizon. In the short run, supply
and demand are relatively inelastic, as in panel (a). Thus, when the supply curve shifts from S 1
to S2, the price rises substantially. By contrast, in the long run, supply and demand are relatively
elastic, as in panel (b). In this case, the same size shift in the supply curve (S 1 to S2) causes a
smaller increase in the price.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 36
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Applications, Part 4
• Does Drug Interdiction Increase or
Decrease Drug-related Crime?
– Increase the number of federal agents
devoted to the war on drugs
• Illegal drugs: supply curve shifts left
– Higher price and lower quantity
• Amount of drug-related crimes
– Inelastic demand for drugs
– Higher drugs price: higher total revenue
– Increase drug-related crime

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 37
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Applications, Part 5
• Does Drug Interdiction Increase or
Decrease Drug-related Crime?
– Policy of drug education
• Reduce demand for illegal drugs
• Left shift of demand curve
• Lower quantity
• Lower price
• Reduce drug-related crime

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 38
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Figure 9
Policies to Reduce the Use of Illegal Drugs

Drug interdiction reduces the supply of drugs from S 1 to S2, as in panel (a). If the demand for
drugs is inelastic, then the total amount paid by drug users rises, even as the amount of drug use
falls. By contrast, drug education reduces the demand for drugs from D 1 to D2, as in panel (b).
Because both price and quantity fall, the amount paid by drug users falls
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 39
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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