Chapter 4

Elasticity

03/10/1
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1999 South-Western College Publishing
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 What is Elasticity?
A term economists use to
describe sensitivity

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 How do we measure the
Price Elasticity of Demand?
The percentage change in
quantity demanded
divided by the percentage
change in price
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Price Elasticity of
Demand
Ed = % change in Q
% change in P
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 Notes on Ed

Ed negative, but ignore

negative
use of % change-not
affected by units of
measurement 5
 Classifying Ed

Ed = 1 Unitary elasticity
Ed > 1 Elastic demand
Ed < 1 Inelastic demand
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 Extreme elasticities

Ed = 0 Perfectly inelastic
(vertical demand curve)
Ed = Perfectly elastic
(horizontal demand curve)
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 Perfectly inelastic Perfectly elastic
demand demand
P

P
D

Q Q
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When consumers are very
sensitive to a price change
what does the demand
curve look like?
Very horizontal

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 When consumers are less
sensitive to a price change
what does the demand
curve look like?
Very vertical

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 Problem - When we
move along a demand curve
between two points, we get
different answers to elasticity
depending if we are moving
up or down the demand curve
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 If there is an increase
from 3 units to 5, what is
the percentage increase?
2/3 = 66%
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If there is a decrease from
5 units to 3, what is the
percentage decrease?
2/5 = 40%
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 If we go from 3 to 5,
the percentage change is
2/3 , but if we go from 5
to 3, the percentage
change is 2/5 , so the
elasticities are different
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 The answer to this
problem is to work with
averages ...

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Price elasticity equals the
change in quantity demanded
sum of quantities/2
divided by
change in price
sum of prices/2 16
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 Quantity Price
Bananas 200 $20
240 $18
Oranges 400 $40
280 $70

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What is the Price Elasticity of Demand
for bananas?

40 2
220 19
=
40 X 19 760
220 2 = 440
= 1.727
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What is the Price Elasticity
of Demand for oranges?
120 30
340 55
=
120 X 55 6,600
340 30 = 10,200
= .647
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Practice: calculating Ed
You usually buy 4 cds per
month at a price of $14, but
when the price rises to $18,
you purchase only 3 per
month. What is your
elasticity of demand for cds
over this range of prices?
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 Elasticity and Total
Revenue (TR)
TR = PQ, price times
quantity
Ed = % change in Q
% change in P
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 When price increases,
what two things happen?
more money per unit
fewer units are sold

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If total revenue does
not change when
price increases, the
demand curve is
unitary elastic,
value equals 1
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If price increases and
the revenue gained is
less than the revenue
lost, the demand curve
is price elastic, > 1
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If price increases and the
revenue gained is greater
than the revenue lost, the
demand curve is price
inelastic, < 1
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Summary, elasticity, price changes,
and total revenue
Price Price
increase Decrease
Ed = 1 Total
revenue
Total
revenue
same same

Ed > 1 Total
revenue
Total
revenue
falls rises

Ed < 1 Total Total

revenue revenue
rises falls 26
What factors influence Demand
Sensitivity (elasticity)?
Number and
closeness of
Substitute goods
% of income a good
makes up
Basic goods or
needs
Time to adjust
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What do substitutes have to
do with sensitivity?
The more substitutes a
good has, the more
sensitive consumers are to
a price change
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P A P B

D D
0 Q 0 Q
Which demand curve is for
spark plugs and which for Coca-
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Cola? 29
What does % of income a good makes
up have with sensitivity?

The lower the % of ones

budget a good is, the less
sensitive consumers are to a
price change
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What do basic goods have
to do with sensitivity?
The greater the need a good
has to the consumer, the less
sensitive the consumer is to
a price change

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What does time have to
do with sensitivity?
The more time to adjust, the
more sensitive consumers
are to a price change

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If a college raises tuition,
what happens to revenue?
If demand is elastic -
revenue goes down
If demand is inelastic -
revenue goes up
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What strategies do Coca-
Cola and Pepsi use to
make the demand for their
products less elastic?
http://www.cocacola.com
http://www.pepsi.com
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What is Cross Elasticity
of Demand?
The percentage change in
the quantity demanded of
one commodity resulting
from a 1 percent change in
price of another commodity
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E c = % Quantity of X

% Price of Y

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If negative - complements (steak &
steak sauce)
If positive - substitutes (butter &
margarine)
Unrelated goods should have a cross
elasticity close to zero

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 What is Income
Elasticity of Demand?
The ratio of the percentage
change in quantity
demanded to the percentage
change in income
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 E i = % Quantity
% Income
E i > 0 Normal goods
E i < 0 Inferior goods
E i > 1 Luxury goods
0 < E i < 1 Necessities
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When does a good face
an income elastic
demand curve?
A 1% change in income
generates a greater than
1% change quantity
demanded
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When does a good face
an income inelastic
demand curve?
A 1% change in income
generates a less than
1% change quantity
demanded
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 What is an
Inferior Good?
Something that people
will buy less of as
their incomes increase

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 What is a
Normal Good?
Something that people
will buy more of as their
incomes increase

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 What is Price Elasticity
of Supply?
The ratio of the percentage
change in quantity
supplied to the percentage
change in price
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 E s = % Q supplied
% Price
E s = 1 Unitary
E s > 1 Elastic
E s < 1 Inelastic
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 Extreme cases of E s

E s = 0, perfectly inelastic
(vertical supply curve
E s = , perfectly elastic
(horizontal supply curve)
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Does time effect Supply
Elasticities?
Yes! The more time,
the more elastic the
supply curve

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Applications of Elasticity

The farm problem

Illegal drugs
The volunteer army
Tax incidence
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 The Farm Problem

Inelastic demand for

many farm goods
Low income elasticity of
demand also
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 P S

S1
P1

P2

Q
Q1 Q2
Since farmers face volatile supply, with inelastic
demand, % change in Price is greater than %
change in quantity, making for more fluctuating
of incomes
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Recall with inelastic demand, lower prices
do not increase quantity by the same %,
leading to lower revenue, yet costs are
higher due to increased quantity, resulting
in lower farm profits.

Low income elasticity means that farming is

not a growth industry, as our incomes
rise we tend to allocate that income to other
goods, not as much to food products.
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P S (illegal)

S1 (legal)
P1

P2

D inelastic

Q
Q1 Q2

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 Which type of good
would be best to tax to
raise the most revenue?
Goods that face a price
inelastic demand curve will
generate the most revenue
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 What factors influence Demand
Sensitivity?
What is Elasticity?
How do we measure the Price
Elasticity of Demand?
What is Cross Elasticity of
Demand?
What is Income Elasticity of
Demand?
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END
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