Lecture 3

Elasticity and its Application

Reading
• Mankiw, Chapter 5

1
 Elasticity . . .

. . . is a measure of how much buyers and

sellers respond to changes in market
conditions. . .
. . . allows us to analyze supply and demand
with greater precision.

2
 Types of Elasticities

• Price elasticity of demand

• Income elasticity of demand
• Cross elasticity of demand
• Price elasticity of supply

3
 Price Elasticity of Demand

• Price elasticity of demand is the percentage

change in quantity demanded given a one
percent change in the price.

4
 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.

Price elasticity of % change in quantity demanded

=
demand % change in price

5
Computing the Price Elasticity of Demand
Example: price of ice cream rises by 10 % and quantity
demanded falls by 20%.

Price elasticity of demand = (20%)/(10%) = 2

Because there is an inverse relationship between price

and quantity demanded (the price of ice cream rose by
10% and the quantity demanded fell by 20%), the price
elasticity of demand is sometimes reported as a negative
number. We generally ignore the minus sign and
concentrate on the absolute value of the elasticity.
6
 Computing the Price Elasticity of Demand

(Q2 - Q1) / Q1 X 100

Price ED =
(P2 - P1) / P1 X 100
A
$5
B
4 Demand (100 - 50) X 100
ED  50
(4.00 - 5.00) X 100
5.00
100 percent
  -5
-20 percent
0 50 100 Quantity

7
 Computing the Price Elasticity of Demand

(Q2 - Q1) / Q1 X 100

Price ED =
(P2 - P1) / P1 X 100
A
$5
B
4 Demand (50 - 100) X 100
ED  100
(5.00 - 4.00) X 100
4.00
- 50 percent
  -2
25 percent
0 50 100 Quantity

8
 Computing the Price Elasticity of Demand
The elasticity calculated by going from point A to point
B on a demand curve will be different than an elasticity
calculated by going from point B to point A.

The Midpoint Method is preferable when calculating the

price elasticity of demand because it gives the same
answer regardless of the direction of the change.

Midpoint price elasticity (Q2 - Q1) / [(Q1 + Q2) / 2]

=
of demand (P2 - P1) / [(P1 + P2) / 2]

9
 Computing the Price Elasticity of Demand
Midpoint Price elasticity
Price of demand
(Q2 - Q1) / [(Q1 + Q2) / 2]
A =
$5 (P2 - P1) / [(P1 + P2) / 2]
B
4 Demand
(100 - 50) / [(50 + 100) / 2]
=
(4 - 5) / [(5 + 4) / 2]

0.6667
= = -3
0 50 100 Quantity -0.2222

10
 Determinants of
Price Elasticity of Demand
• Demand tends to be more elastic . . .
. . . if the good is a luxury.
. . . the longer the time period.
. . . the larger the number of close substitutes.
. . . the more narrowly defined the market
(i.e. The market for vanilla ice cream is more
narrowly defined than the ice cream market in
general).
11
 Determinants of
Price Elasticity of Demand
• Demand tends to be more inelastic . . .
. . . if the good is a necessity.
. . . the shorter the time period.
. . . the fewer the number of close substitutes.
. . . the more broadly defined the market.

12
 Price Elasticity of Demand
Elasticity of demand > 1 : Elastic
(Quantity demanded responds strongly to changes in
price)

Elasticity of demand < 1 : Inelastic

(Quantity demanded does not respond strongly to
changes in price)

Elasticity of demand = 1 : Unit Elastic

(Quantity demanded changes by the same percentage
as the price)

(using the absolute value) 13

 The Price Elasticity of Demand:
Elastic Demand
Price

$5
4 Demand
1. A 22%
increase
in price...

0 50 100 Quantity
2. ...leads to a 67% decrease in quantity demanded.
14
 The Price Elasticity of Demand:
Inelastic Demand
Price

$5
4
1. A 22% Demand
increase
in price...

0 90 100 Quantity
2. ...leads to an 10.53% decrease in quantity demanded.
15
 The Price Elasticity of Demand:
Unit Elastic
Price

$5
4
1. A 22% Demand
increase
in price...

0 80 100 Quantity
2. ...leads to a 22% decrease in quantity demanded.
16
 Price Elasticity of Demand
Price $7
Ela
6
stic
5 Unit Elastic (mid point of
4
the demand curve)
3 Ine
las
2
tic
1 Demand
0
2 4 6 8 10 12 14
Quantity
17
 Price Elasticity of Demand
Price Quantity % change % change Elasticity Description
in price in quantity

$7 0
15 200 13.0 Elastic
6 2 Elastic
18 67 3.7
5 4
22 40 1.8 Elastic
4 6
29 29 1.0 Unit Elastic
3 8
40 22 0.6 Inelastic
2 10
67 18 0.3 Inelastic
1 12
200 15 0.1 Inelastic
0 14
18
 The Price Elasticity of Demand:
Perfectly Inelastic
Price
Demand

$5
4
1. An
increase
in price...

0 100 Quantity
2. ...leaves the quantity demanded unchanged.
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The Price Elasticity of Demand:
Perfectly Elastic
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.
20
 Elasticity and Total Revenue

• 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

21
 Elasticity and Total Revenue
Price

$4

P X Q = $400
P
(total revenue) Demand

0 100 Quantity
Q

22
 Elasticity and Total Revenue:
Elastic Demand

• 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.

P x Q = TR

23
 Elasticity and Total Revenue:
Elastic Demand
Price Price

$5
$4

Demand Demand
Revenue = $200 Revenue = $100

0 50 Quantity 0 20 Quantity

24
 Elasticity and Total Revenue:
Inelastic Demand

• With an inelastic demand curve, an increase

in price leads to a decrease in quantity that
is proportionately smaller. Thus, total
revenue increases.

P x Q = TR

25
 Elasticity and Total Revenue:
Inelastic Demand
Price Price

$3

Revenue = $240
$1
Revenue = $100 Demand Demand
0 100 Quantity 0 80 Quantity

26
 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.

27
 Income Elasticity of Demand

Percentage Change in
Quantity Demanded
Income Elasticity of Demand =
Percentage Change
in Income

28
 Income Elasticity of Demand
• Higher income raises the quantity demanded for normal
goods, but lowers the quantity demanded for inferior goods.
• Normal goods have positive income elasticity, while
inferior goods have negative income elasticity.

29
 Income Elasticity of Demand
• 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.

30
 Cross-Price Elasticity of Demand
• Cross-Price Elasticity of Demand : a measure
of how much the quantity demanded of one
good responds to a change in the price of
another good.

Percentage Change in
Cross-price Quantity Demanded of good 1
Elasticity of Demand =
Percentage Change
in price of good 2

31
 Cross-Price Elasticity of Demand
• Substitutes have positive cross-price
elasticities.
• Complements have negative cross-price
elasticities

32
 Price Elasticity of Supply
• Price elasticity of supply is the percentage
change in quantity supplied resulting from a
one percent change in price.

Percentage Change in
= Quantity Supplied
Elasticity of Supply =
Percentage Change
in Price

33
 Price Elasticity of Supply:
Elastic Supply
Price
ES > 1

$5

1. A 22%
increase
in price...

100 200 Quantity

2. ...leads to a 67% increase in quantity supplied.
34
 Price Elasticity of Supply:
Inelastic Supply
Price ES < 1

$5

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

100 110 Quantity

2. ...leads to a 9.5% increase in quantity supplied.

35
 Price Elasticity of Supply:
Unit Elastic Supply
Price ES = 1

$5

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

100 125 Quantity

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

36
 Price Elasticity of Supply:
Perfectly Elastic Supply
Price ES = 
1. At any price
above $4, quantity
$5 supplied is infinite.

4
1. A 22% 2. At exactly $4,
increase producers will
in price... supply any quantity.

100 Quantity
3. At a price below $4,
quantity supplied is zero. 37
 Price Elasticity of Supply:
Perfectly inelastic Supply
Price ES =  Supply

$5

4
1. An
increase
in price...

0 100 Quantity

2. ...leaves the quantity supplied unchanged.

38
 Determinants of Elasticity of Supply
• Flexibility of Sellers.
– Ability of sellers to change the amount of the good they
produce. (i.e. Beach-front land is inelastic. Books, cars,
or manufactured goods are more elastic.)
• Time period.
– Supply is more elastic in the long run.
• Excess Capacity
– Supply is more elastic if current facilities are under-
utilized

39
 Application of Elasticity

Class Discussion:

What happens to wheat farmers and the market for

wheat when university scientists discover a more
productive method to grow wheat?

40
 Application of Elasticity
Price of
Wheat

S1

$3

Demand

0 100 Quantity of Wheat

41
 Application of Elasticity
Price of
Wheat 1. When demand is inelastic,
an increase in supply...
S1 S2
2. ...leads $3
to a large
fall in 2
price...

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.
42
 Summary

- Price elasticity of demand measures how

much the quantity demanded responds to
changes in the 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 price elasticity of supply measures

how much the quantity supplied responds
to changes in the price.
- In most markets, supply is more elastic in
the long run than in the short run.
 End of
Lecture 3

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