Elasticity and Its

Applications

Copyright © 2004 South-Western

ELASTICITY . . .
 … allows us to analyze supply and demand with
greater precision.

 … is a measure of how much buyers and sellers

respond to changes in market conditions
THE ELASTICITY OF DEMAND
 Price elasticity of demand is a measure of how
much the quantity demanded of a good responds
to a change in the price of that good.

 Price elasticity of demand is the percentage

change in quantity demanded given a percent
change in the price.
THE PRICE ELASTICITY OF DEMAND
AND ITS DETERMINANTS

 Availability of Close Substitutes

 Necessities versus Luxuries

 Definition of the Market

 Time Horizon
THE PRICE ELASTICITY OF DEMAND
AND ITS DETERMINANTS

 Demand tends to be more elastic :

 the larger the number of close substitutes.
 if the good is a luxury.
 the more narrowly defined the market.
 the longer the time period.
COMPUTING THE PRICE ELASTICITY OF
DEMAND
 The price elasticity of demand is computed as the
percentage change in the quantity demanded
divided by the percentage change in price.

Percentage change in quantity demanded

Price elasticity of demand =
Percentage change in price
COMPUTING THE PRICE ELASTICITY OF
DEMAND
Percentage change in quantity demanded
Price elasticity of demand =
Percentage change in price
 Example: If the price of an ice cream cone
increases from $2.00 to $2.20 and the amount
you buy falls from 10 to 8 cones, then your
elasticity of demand would be calculated as:

(10  8)
 100 20%
10  2
(2.20  2.00)
 100 10%
2.00
THE MIDPOINT METHOD: A BETTER WAY
TO CALCULATE PERCENTAGE CHANGES AND
ELASTICITIES
 The midpoint formula is preferable when
calculating the price elasticity of demand because
it gives the same answer regardless of the
direction of the change.

(Q2  Q1 ) / [(Q2  Q1 ) / 2]
Price elasticity of demand =
(P2  P1 ) / [(P2  P1 ) / 2]
THE MIDPOINT METHOD: A BETTER WAY
TO CALCULATE PERCENTAGE CHANGES AND
ELASTICITIES
 Example: If the price of an ice cream cone
increases from $2.00 to $2.20 and the amount
you buy falls from 10 to 8 cones, then your
elasticity of demand, using the midpoint formula,
would be calculated as:

(10  8)
(10  8) / 2 22%
  2.32
(2.20  2.00) 9.5%
(2.00  2.20) / 2
THE VARIETY OF DEMAND CURVES
 Inelastic Demand
 Quantity demanded does not respond strongly to
price changes.
 Price elasticity of demand is less than one.

 Elastic Demand
 Quantity demanded responds strongly to changes in
price.
 Price elasticity of demand is greater than one.
COMPUTING THE PRICE ELASTICITY OF
DEMAND
(100 - 50)
(100  50)/2
ED 
Price (4.00 - 5.00)
(4.00  5.00)/2
$5
4
Demand 67 percent
  -3
- 22 percent

0 50 100 Quantity
Demand is price elastic
THE VARIETY OF DEMAND CURVES
 Perfectly Inelastic
 Quantity demanded does not respond to price
changes.
 Perfectly Elastic
 Quantity demanded changes infinitely with any
change in price.
 Unit Elastic
 Quantity demanded changes by the same percentage
as the price.
THE VARIETY OF DEMAND CURVES
 Because the price elasticity of demand measures
how much quantity demanded responds to the
price, it is closely related to the slope of the
demand curve.
FIGURE 1 THE PRICE ELASTICITY OF DEMAND

(a) Perfectly Inelastic Demand: Elasticity Equals 0

Price
Demand

$5

4
1. An
increase
in price . . .

0 100 Quantity

2. . . . leaves the quantity demanded unchanged.

Copyright©2003 Southwestern/Thomson Learning

 FIGURE 1 THE PRICE ELASTICITY OF DEMAND

(b) Inelastic Demand: Elasticity Is Less Than 1

Price

$5

4
1. A 22% Demand
increase
in price . . .

0 90 100 Quantity

2. . . . leads to an 11% decrease in quantity demanded.

FIGURE 1 THE PRICE ELASTICITY OF DEMAND

(c) Unit Elastic Demand: Elasticity Equals 1

Price

$5

4
1. A 22% Demand
increase
in price . . .

0 80 100 Quantity

2. . . . leads to a 22% decrease in quantity demanded.

Copyright©2003 Southwestern/Thomson Learning

 FIGURE 1 THE PRICE ELASTICITY OF DEMAND

(d) Elastic Demand: Elasticity Is Greater Than 1

Price

$5

4 Demand
1. A 22%
increase
in price . . .

0 50 100 Quantity

2. . . . leads to a 67% decrease in quantity demanded.

 FIGURE 1 THE PRICE ELASTICITY OF DEMAND

(e) Perfectly Elastic Demand: Elasticity Equals Infinity

Price

1. At any price
above $4, quantity
demanded is zero.
$4 Demand

2. At exactly $4,
consumers will
buy any quantity.

0 Quantity
3. At a price below $4,
quantity demanded is infinite.
TOTAL REVENUE AND THE PRICE
ELASTICITY OF DEMAND
 Total revenue is the amount paid by buyers and
received by sellers of a good.
 Computed as the price of the good times the
quantity sold.

TR = P x Q
 FIGURE 2 TOTAL REVENUE

Price

$4

P × Q = $400
P
(revenue) Demand

0 100 Quantity

Q
Copyright©2003 Southwestern/Thomson Learning
ELASTICITY AND TOTAL REVENUE
ALONG A LINEAR DEMAND CURVE

 With an inelastic demand curve, an increase in

price leads to a decrease in quantity that is
proportionately smaller. Thus, total revenue
increases.
 FIGURE 3 HOW TOTAL REVENUE CHANGES WHEN PRICE
CHANGES: INELASTIC DEMAND

Price Price
An Increase in price from $1 … leads to an Increase in
to $3 … total revenue from $100 to
$240

$3

Revenue = $240
$1
Revenue = $100 Demand Demand

0 100 Quantity 0 80 Quantity

Copyright©2003 Southwestern/Thomson Learning

ELASTICITY AND TOTAL REVENUE
ALONG A LINEAR DEMAND CURVE

 With an elastic demand curve, an increase in the

price leads to a decrease in quantity demanded
that is proportionately larger. Thus, total revenue
decreases.
 FIGURE 4 HOW TOTAL REVENUE CHANGES WHEN PRICE
CHANGES: ELASTIC DEMAND

Price Price

An Increase in price from $4 … leads to an decrease in

to $5 … total revenue from $200 to
$100

$5

$4

Demand
Demand

Revenue = $200 Revenue = $100

0 50 Quantity 0 20 Quantity

Copyright©2003 Southwestern/Thomson Learning

ELASTICITY OF A LINEAR DEMAND CURVE
INCOME ELASTICITY OF DEMAND
 Income elasticity of demand measures how much
the quantity demanded of a good responds to a
change in consumers’ income.
 It is computed as the percentage change in the
quantity demanded divided by the percentage
change in income.
COMPUTING INCOME ELASTICITY

Percentage change
in quantity demanded
Income elasticity of demand =
Percentage change
in income
INCOME ELASTICITY
 Types of Goods
 Normal Goods
 Inferior Goods

 Higher income raises the quantity demanded for

normal goods but lowers the quantity demanded
for inferior goods.
INCOME ELASTICITY
 Goods consumers regard as necessities tend to be
income inelastic
 Examples include food, fuel, clothing, utilities, and
medical services.
 Goods consumers regard as luxuries tend to be
income elastic.
 Examples include sports cars, furs, and expensive
foods.
THE ELASTICITY OF SUPPLY
 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.
 Price elasticity of supply is the percentage
change in quantity supplied resulting from a
percent change in price.
FIGURE 6 THE PRICE ELASTICITY OF SUPPLY

(a) Perfectly Inelastic Supply: Elasticity Equals 0

Price
Supply

$5

4
1. An
increase
in price . . .

0 100 Quantity

2. . . . leaves the quantity supplied unchanged.

Copyright©2003 Southwestern/Thomson Learning

FIGURE 6 THE PRICE ELASTICITY OF SUPPLY

(b) Inelastic Supply: Elasticity Is Less Than 1

Price

Supply
$5

4
1. A 22%
increase
in price . . .

0 100 110 Quantity

2. . . . leads to a 10% increase in quantity supplied.

Copyright©2003 Southwestern/Thomson Learning

FIGURE 6 THE PRICE ELASTICITY OF SUPPLY

(c) Unit Elastic Supply: Elasticity Equals 1

Price

Supply
$5

4
1. A 22%
increase
in price . . .

0 100 125 Quantity

2. . . . leads to a 22% increase in quantity supplied.

Copyright©2003 Southwestern/Thomson Learning

FIGURE 6 THE PRICE ELASTICITY OF SUPPLY

(d) Elastic Supply: Elasticity Is Greater Than 1

Price

Supply

$5

4
1. A 22%
increase
in price . . .

0 100 200 Quantity

2. . . . leads to a 67% increase in quantity supplied.

Copyright©2003 Southwestern/Thomson Learning

FIGURE 6 THE PRICE ELASTICITY OF SUPPLY

(e) Perfectly Elastic Supply: Elasticity Equals Infinity

Price

1. At any price
above $4, quantity
supplied is infinite.

$4 Supply

2. At exactly $4,
producers will
supply any quantity.

0 Quantity
3. At a price below $4,
quantity supplied is zero.

Copyright©2003 Southwestern/Thomson Learning

DETERMINANTS OF ELASTICITY OF
SUPPLY
 Ability of sellers to change the amount of the
good they produce.
 Beach-front land is inelastic.
 Books, cars, or manufactured goods are elastic.

 Time period.
 Supply is more elastic in the long run.
COMPUTING THE PRICE ELASTICITY OF
SUPPLY
 The price elasticity of supply is computed as the
percentage change in the quantity supplied
divided by the percentage change in price.

Percentage change
in quantity supplied
Price elasticity of supply =
Percentage change in price
THREE APPLICATIONS OF
SUPPLY, DEMAND, AND
ELASTICITY
 Can good news for farming be bad news for
farmers?
 What happens to wheat farmers and the market
for wheat when university agronomists discover a
new wheat hybrid that is more productive than
existing varieties?
THREE APPLICATIONS OF
SUPPLY, DEMAND, AND
ELASTICITY
 Examine whether the supply or demand curve
shifts.
 Determine the direction of the shift of the curve.

 Use the supply-and-demand diagram to see how

the market equilibrium changes.
FIGURE 8 AN INCREASE IN SUPPLY IN THE MARKET FOR
WHEAT

Price of
Wheat 1. When demand is inelastic,
2. . . . leads an increase in supply . . .
to a large fall S1
in price . . . S2

$3

Demand

0 100 110 Quantity of

Wheat
3. . . . and a proportionately smaller
increase in quantity sold. As a result,
revenue falls from $300 to $220.
Copyright©2003 Southwestern/Thomson Learning
COMPUTE THE PRICE ELASTICITY OF
SUPPLY
100  110
(100  110) / 2
ED 
3.00  2.00
(3.00  2.00) / 2

0.095
  0.24
0.4 Supply is inelastic
SUMMARY
 Price elasticity of demand measures how much
the quantity demanded responds to changes in
the price.
 Price elasticity of demand is calculated as the
percentage change in quantity demanded divided
by the percentage change in price.
 If a demand curve is elastic, total revenue falls
when the price rises.
 If it is inelastic, total revenue rises as the price
rises.
SUMMARY
 The income elasticity of demand measures how
much the quantity demanded responds to
changes in consumers’ income.
 The cross-price elasticity of demand measures
how much the quantity demanded of one good
responds to the price of another good.
 The price elasticity of supply measures how much
the quantity supplied responds to changes in the
price. .
SUMMARY
 In most markets, supply is more elastic in the
long run than in the short run.
 The price elasticity of supply is calculated as the
percentage change in quantity supplied divided
by the percentage change in price.
 The tools of supply and demand can be applied in
many different types of markets.