AEC02: PRINCIPLES OF ECONOMICS

Elasticity
Engr. Czarina Catherine L. San Miguel
(Instructor)
The Elasticity of
Demand
 By how much would
ELASTICITY
Russia-Ukraine Crisis

consumption of gasoline fall?

Oil price hike

Decrease in Demand
 Elasticity
It is a measure of the responsiveness of quantity demanded or quantity
supplied to a change in one of its determinants.
 The Price Elasticity of Demand
and Its Determinants
• Price elasticity of demand
 A measure of how much the quantity demanded of a good responds to a
change in the price of that good, computed as the percentage change in
quantity demanded divided by the percentage change in price.
 The Price Elasticity of Demand
and Its Determinants
• Price elasticity of demand
 Demand for a good is said to be elastic if the quantity demanded responds
substantially to changes in the price.
 Demand is said to be inelastic if the quantity demanded responds only
slightly to changes in the price.
 The Price Elasticity of Demand
and Its Determinants
1. Availability of Close Substitutes
 Goods with close substitutes tend to have more elastic demand because it is easier for
consumers to switch from that good to others.
 Example:
 Butter and margarine are easily substitutable. A small increase in the price of butter, assuming
the price of margarine is held fixed, causes the quantity of butter sold to fall by a large amount.
 By contrast, because eggs are a food without a close substitute, the demand for eggs is less
elastic than the demand for butter. A small increase in the price of eggs does not cause a
sizable drop in the quantity of eggs sold.
 The Price Elasticity of Demand
and Its Determinants
2. Necessities versus Luxuries
 Necessities tend to have inelastic demands, whereas luxuries have elastic demands.
 When the price of a doctor’s visit rises, people do not dramatically reduce the number of times
they go to the doctor, although they might go somewhat less often. By contrast, when the price of
sailboats rises, the quantity of sailboats demanded falls substantially. The reason is that most
people view doctor visits as a necessity and sailboats as a luxury.
 Whether a good is a necessity or a luxury depends not on the intrinsic properties of the good but
on the preferences of the buyer. For avid sailors with little concern about their health, sailboats
might be a necessity with inelastic demand and doctor visits a luxury with elastic demand.
 The Price Elasticity of Demand
and Its Determinants
3. Definition of the Market
 The elasticity of demand in any market depends on how we draw the boundaries of the
market. Narrowly defined markets tend to have more elastic demand than broadly defined
markets because it is easier to find close substitutes for narrowly defined goods.
 Example:

Food, a broad category, has a fairly inelastic demand because there are no good substitutes
for food. Ice cream, a narrower category, has a more elastic demand because it is easy to
substitute other desserts for ice cream. Vanilla ice cream, a very narrow category, has a very
elastic demand because other flavors of ice cream are almost perfect substitutes for vanilla.
 The Price Elasticity of Demand
and Its Determinants
4. Time Horizon
 Goods tend to have more elastic demand over longer time horizons.
 When the price of gasoline rises, the quantity of gasoline demanded falls only slightly
in the first few months. Over time, however, people buy more fuel-efficient cars, switch
to public transportation, and move closer to where they work. Within several years, the
quantity of gasoline demanded falls more substantially.
 Computing the Price Elasticity of
Demand
• Economists compute the price elasticity of demand as the percentage change in the
quantity demanded divided by the percentage change in the price.

• For example, suppose that a 10 percent increase in the price of an ice-cream cone causes
the amount of ice cream you buy to fall by 20 percent.
Computing the Price Elasticity of
Demand
A larger price elasticity implies a greater responsiveness of
quantity demanded to changes in price.
 The Midpoint Method: A Better Way to Calculate
Percentage Changes and Elasticities
Example: Point A: price = $4 quantity = 120
Point B: price=$6 quantity = 80
• From Point A to point B: the price rises by 50 percent and the quantity falls by 33 percent,
indicating that the price elasticity of demand is 33/50, or 0.66.
• Going from point B to point A: the price falls by 33 percent and the quantity rises by 50
percent, indicating that the price elasticity of demand is 50/33, or 1.5.
• This difference arises because the percentage changes are calculated from a different base.
• One way to avoid this problem is to use the midpoint method for calculating elasticities.
 The Midpoint Method: A Better Way to Calculate
Percentage Changes and Elasticities
• The standard procedure for computing a percentage change is to divide the change by the
initial level. By contrast, the midpoint method computes a percentage change by dividing the
change by the midpoint (or average) of the initial and final levels.
• Example:
Midpoint between $4 and $6 = $5
Change from $4 to $6 =
Change from $6 to $4 =
 The Midpoint Method: A Better Way to Calculate
Percentage Changes and Elasticities
• Because the midpoint method gives the same answer regardless of the direction of change, it
is often used when calculating the price elasticity of demand between two points.

• The following formula expresses the midpoint method for calculating the price elasticity of
demand between two points, denoted (, ) and (, ):

• The numerator is the percentage change in quantity computed using the midpoint method.
• The denominator is the percentage change in price computed using the midpoint method.
 The Variety of Demand Curves
• Economists classify demand curves according to their elasticity.

• Demand is considered elastic when the elasticity is greater than 1, which means the
quantity moves proportionately more than the price.

• Demand is considered inelastic when the elasticity is less than 1, which means the
quantity moves proportionately less than the price.

• If the elasticity is exactly 1, the percentage change in quantity equals the percentage
change in price, and demand is said to have unit elasticity.
 The Variety of Demand Curves
• The flatter the demand curve that passes through a given point, the greater the price
elasticity of demand.

• The steeper the demand curve that passes through a given point, the smaller the price
elasticity of demand.
 The Variety of Demand Curves
• The steeper demand curve, D1, shows a change in
quantity demanded of 8 products (from 60 to 68)
when the price changes by one dollar (from $9 to $8).

• The flatter demand curve, D2, shows a change in

quantity demanded of 40 products (from 60 to 100)
when the price changes by $1 (from $9 to $8).

• Clearly, the flatter demand curve shows a much

greater quantity demanded response to a price
change. Therefore, it is more elastic..
The Variety of Demand Curves

In the extreme case of a zero elasticity, shown in panel (a), demand is

perfectly inelastic, and the demand curve is vertical. In this case, regardless
of the price, the quantity demanded stays the same.
The Variety of Demand Curves

As the elasticity rises, the demand curve gets flatter and. flatter, as
shown in panels (b), (c), and (d).
 The Variety of Demand Curves

. This occurs as the price

At the opposite extreme, shown in panel (e), demand is perfectly elastic.
elasticity of demand approaches infinity and the demand curve becomes horizontal, reflecting the
fact that very small changes in the price lead to huge changes in the quantity demanded.
 Total Revenue and the Price
Elasticity of Demand
• Total revenue - the amount paid by buyers and received by sellers of a good, computed
as the price of the good times the quantity sold.

The height of the box under the demand

curve is , and the width is . The area
of this box, , equals the total revenue in this
market.

𝑇 𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒=$ 4 𝑥 100=$ 400

Total Revenue and the Price
Elasticity of Demand
How Total Revenue Changes When Price Changes?

a. The Case of Inelastic Demand

• If demand is inelastic, as in panel

(a), then an increase in the price
causes an increase in total
revenue. 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.
Total Revenue and the Price
Elasticity of Demand
How Total Revenue Changes When Price Changes?

b. The Case of Elastic 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.
 Total Revenue and the Price
Elasticity of Demand
• The examples in the figure illustrate some general rules:
1. When demand is inelastic (a price elasticity less than 1), price and total revenue
move in the same direction: If the price increases, total revenue also increases.

2. When demand is elastic (a price elasticity greater than 1), price and total revenue
move in opposite directions: If the price increases, total revenue decreases.

3. If demand is unit elastic (a price elasticity exactly equal to 1), total revenue
remains constant when the price changes.
 Elasticity and Total Revenue
along a Linear Demand Curve
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.
 Elasticity and Total Revenue
along a Linear Demand Curve
Total Revenue Percentage Percentage
Price Quantity Change in Change in Elasticity Description
(Price x Quantity) Price Quantity
13.0 Elastic
$7 0 $0 15 200 3.7 Elastic
6 2 12 18 67 1.8 Elastic
5 4 20 22 40 1.0 Unit elastic
4 6 24 29 29 0.6 Inelastic
3 8 24 40 22 0.3 Inelastic
2 10 20 67 18 0.1 Inelastic
1 12 12 200 15
0 14 0
(𝑄2 −𝑄 1)/ [(𝑄2 +𝑄 1)/ 2(2− ] 0)/ [(2+ 0)/ 2]
𝑝𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑= ¿ ¿ 13
( 𝑃 2 − 𝑃 1)/ [( 𝑃 2 + 𝑃 1)/ 2(] 6 − 7)/ [(6 +7)/ 2]
 Elasticity and Total Revenue
along a Linear Demand Curve
• The table illustrates the following:
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.
 Other Demand Elasticities
The Income Elasticity of Demand
• The income elasticity of demand measures how the quantity demanded changes as
consumer income changes. It is calculated as the percentage change in quantity
demanded divided by the percentage change in income.

𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐h𝑎𝑛𝑔𝑒𝑖𝑛𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑

𝑖𝑛𝑐𝑜𝑚𝑒𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑=
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐h𝑎𝑛𝑔𝑒 𝑖𝑛𝑖𝑛𝑐𝑜𝑚𝑒
 Other Demand Elasticities
The Income Elasticity of Demand

• Most goods are normal goods: Higher income raises the quantity demanded. Because
quantity demanded and income move in the same direction, normal goods have positive
income elasticities. A few goods, such as bus rides, are inferior goods: Higher income
lowers the quantity demanded.

• Because quantity demanded and income move in opposite directions, inferior goods
have negative income elasticities..
 Other Demand Elasticities
The Cross-Price Elasticity of Demand

• The cross-price elasticity of demand measures how the quantity demanded of one good
responds to a change in the price of another good. It is calculated as the percentage
change in quantity demanded of good 1 divided by the percentage change in the price of
good 2.

𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐h𝑎𝑛𝑔𝑒𝑖𝑛𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑𝑜𝑓 𝑔𝑜𝑜𝑑 1

𝑐𝑟𝑜𝑠𝑠 −𝑝𝑟𝑖𝑐𝑒𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑=
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐h𝑎𝑛𝑔𝑒𝑖𝑛 𝑡h𝑒 𝑝𝑟𝑖𝑐𝑒𝑜𝑓 𝑔𝑜𝑜𝑑 2
 Other Demand Elasticities
The Cross-Price Elasticity of Demand

• Whether the cross-price elasticity is a positive or negative number depends on whether

the two goods are substitutes or complements.

• Substitutes are goods that are typically used in place of one another, such as
hamburgers and hot dogs. An increase in hot dog prices induces people to grill
hamburgers instead. Because the price of hot dogs and the quantity of hamburgers
demanded move in the same direction, the cross-price elasticity is positive.
 Other Demand Elasticities
The Cross-Price Elasticity of Demand

• Complements are goods that are typically used together, such as computers and
software. In this case, the cross-price elasticity is negative, indicating that an increase in
the price of computers reduces the quantity of software demanded.
The Elasticity of
Supply
 Elasticity of Supply
The Price Elasticity of Supply and Its Determinants

• Price Elasticity of Supply is a measure of how much the quantity supplied of a good
responds to a change in the price of that good, computed as the percentage change in
quantity supplied divided by the percentage change in price.

• Supply of a good is said to be elastic if the quantity supplied responds substantially to

changes in the price.

• Supply is said to be inelastic if the quantity supplied responds only slightly to changes in the
price.
 Elasticity of Supply
The Price Elasticity of Supply and Its Determinants

• The price elasticity of supply depends on the flexibility of sellers to change the amount of the
good they produce.
• Example:
Beachfront land has an inelastic supply because it is almost impossible to produce more of
it. Manufactured goods, such as books, cars, and televisions, have elastic supplies because
firms that produce them can run their factories longer in response to a higher price.
 Elasticity of Supply
The Price Elasticity of Supply and Its Determinants

• In most markets, a key determinant of the price elasticity of supply is the time period being
considered. Supply is usually more elastic in the long run than in the short run.
• Over short periods of time, firms cannot easily change the size of their factories to make
more or less of a good. Thus, in the short run, the quantity supplied is not very responsive to
the price.
• Over longer periods of time, firms can build new factories or close old ones. In addition, new
firms can enter a market, and old firms can exit. Thus, in the long run, the quantity supplied
can respond substantially to price changes.
 Elasticity of Supply
Computing the Price Elasticity of Supply
• Economists compute the price elasticity of supply as the percentage change in the quantity
supplied divided by the percentage change in the price.
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐h𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑
𝑝𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑠𝑢𝑝𝑝𝑙𝑦=
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐h𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡h𝑒 𝑝𝑟𝑖𝑐𝑒
 Elasticity of Supply
Computing the Price Elasticity of Supply
• Example:
• Suppose that an increase in the price of milk from $2.85 to $3.15 a gallon raises the
amount that dairy farmers produce from 9,000 to 11,000 gallons per month.
( 3.15 − 2.85)
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐h𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒= =10 %
(3.00 𝑥 100)

(11,000 −9,000)
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐h𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑= =20 %
(10,000 𝑥 100)
 Elasticity of Supply
Computing the Price Elasticity of Supply
• Example:
• Suppose that an increase in the price of milk from $2.85 to $3.15 a gallon raises the
amount that dairy farmers produce from 9,000 to 11,000 gallons per month.

20 %
𝑝𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑠𝑢𝑝𝑝𝑙𝑦 = =2
10 %
• In this example, the elasticity of 2 indicates that the quantity supplied changes
proportionately twice as much as the price.
 Elasticity of Supply
The Variety of Supply Curve

Supply is perfectly inelastic and the supply curve is vertical. In this

case, the quantity supplied is the same regardless of the price. As
the elasticity rises, the supply curve gets flatter, which shows that
the quantity supplied responds more to changes in the price.
 Elasticity of Supply
The Variety of Supply Curve
 Elasticity of Supply
The Variety of Supply Curve

Supply is perfectly elastic. This occurs as the price elasticity of

supply approaches infinity and the supply curve becomes
horizontal, meaning that very small changes in the price lead to
very large changes in the quantity supplied.
 Elasticity of Supply
The Variety of Supply Curve
How the Price Elasticity of Supply Can Vary
• 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% 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.

• 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.