CHAPTER Elasticity and Its

5 Application

© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning
1
management system 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

2
 The Elasticity of Demand
• Price elasticity of demand
– Percentage change in quantity demanded
divided by the percentage change in price
• Elastic demand
– Quantity demanded responds
substantially to changes in price
• Inelastic demand
– Quantity demanded responds only slightly
to changes in price
3
 The Elasticity of Demand
• Determinants of price elasticity of demand
– Availability of close substitutes
• Goods with close substitutes: more elastic
demand
– Necessities versus luxuries
• Necessities: inelastic demand
• Luxuries: elastic demand

4
 The Elasticity of Demand
• Determinants of price elasticity of demand
– Definition of the market
• Narrowly defined markets: more elastic
demand
– Time horizon
• Demand is more elastic over longer time
horizons

5
 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 ]

6
 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

7
 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

8
Figure 1 The Price Elasticity of Demand (a, b)
(a) Perfectly Inelastic Demand: (b) Inelastic Demand: Elasticity
Elasticity Equals 0 Is Less Than 1
Price Price
1. An Demand 1. A 22% 2. … leads
increase in increase to an 11%
price… in price… decrease in
quantity
$5 $5 demanded
4 4
2. …leaves
the quantity
demanded Demand
unchanged

0 100 0 90 100
Quantity Quantity

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.

9
Figure 1 The Price Elasticity of Demand (c)
(c) Unit Elastic Demand: Elasticity Equals 1

Price
Demand

$5
1. A 22%
increase 4
in price…
2. … leads to a 22%
decrease in quantity
demanded
0 80 100
Quantity

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.

10
 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
buy any quantity
$5
4 Demand $4
Demand
2. … leads to a 3. At a price
67% decrease below $4, quantity
in quantity demanded is infinite
demanded
0 50 100 0
Quantity Quantity

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.

11
 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 × Q)
• For a price increase
– If demand is inelastic, TR increases
– If demand is elastic, TR decreases

12
Figure 2 Total Revenue

Price

$4

P × Q=$400
P (revenue)
Demand

0 100 Quantity

Q
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.

13
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
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.

14
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
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.

15
 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
16
 The Elasticity of Demand
• Linear demand curve
– Constant slope
• Rise over run
– Different price elasticities
• Inelastic demand: points with low price and
high quantity
• Elastic demand: points with high price and
low quantity

17
Figure 4 Elasticity along a Linear Demand Curve
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

The slope of a linear demand curve is constant, but its elasticity is not. The price elasticity of
demand is calculated using the demand schedule in the table and 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.

18
Figure 4 Elasticity along a Linear Demand Curve

The slope of a linear demand curve is constant, but its elasticity is not. The price elasticity of
demand is calculated using the demand schedule in the table and 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.

19
 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

20
 The Elasticity of Demand
• Normal goods
– Positive income elasticity
– Necessities
• Smaller income elasticities
– Luxuries
• Large income elasticities
• Inferior goods
– Negative income elasticities

21
 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

22
 The Elasticity of Demand
• Substitutes
– Goods typically used in place of one
another
– Positive cross-price elasticity
• Complements
– Goods that are typically used together
– Negative cross-price elasticity

23
 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

24
 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 the long run

25
 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 ]

26
 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

27
 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

28
Figure 5 The Price Elasticity of Supply (a, b)
(a) Perfectly Inelastic Supply: (b) Inelastic Supply: Elasticity
Elasticity Equals 0 Is Less Than 1
Price Price
1. An Supply 1. A 22% Supply
increase increase
in price… in price…

$5 $5 2. … leads to
a 10% increase
4 2. …leaves 4
in quantity
the quantity
supplied
supplied
unchanged

0 100 0 100 110

Quantity Quantity

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.

29
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
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.

30
Figure 5 The Price Elasticity of Supply (d, e)
(d) Elastic Supply: Elasticity (e) Perfectly Elastic Supply:
Is 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 supply any quantity
$5
4 2. … leads to $4
Supply
a 67% increase 3. At any price
in quantity below $4, quantity
supplied supplied is zero

0 100 200 0
Quantity Quantity

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.

31
 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

32
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

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.
Here an increase in price from $3 to $4 increases the quantity supplied from 100 to 200.
Because the 67 percent increase in quantity supplied (computed using the midpoint method) is
larger than the 29 percent increase in price, the supply curve is elastic in this range.
By contrast, when the price rises from $12 to $15, the quantity supplied rises only from 500 to
525. Because the 5 percent increase in quantity supplied is smaller than the 22 percent increase
in price, the supply curve is inelastic in this range.

33
 Two Applications
1. Can Good News for Farming Be Bad
News for Farmers?
– New hybrid of wheat – increase
production per acre by 20%
• Supply curve shifts to the right
• Higher quantity and lower price
• Demand is inelastic: total revenue falls

34
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
to a large fall $3
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

When an advance in farm technology increases the supply of wheat from S 1 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).

35
 Two Applications
1. Can Good News for Farming Be Bad
News for Farmers?
– Paradox of public policy
• Induce farmers not to plant crops

36
 Two Applications
2. 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

37
 Two Applications
2. 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

38
 Figure 9 Policies to Reduce the Use of Illegal Drugs
(a) Drug Interdiction (b) Drug Education
1. Drug education
2. … which 1. Drug interdiction 2. . . . which reduces the demand
Price raises the reduces the supply Price reduces the for drugs . . .
price . . . of drugs. . . price . . .
S2 S1
Supply

P2
P1
3. … and
reduces the P2
P1
quantity sold
3. … and
reduces the
Demand D1
quantity sold D2

0 Q2 Q1 Quantity 0 Q2 Q1 Quantity
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.
39