Chapter 5

Elasticity

In this chapter you will learn

The concept of the price elasticity of demand and

how to calculate it The factors that determine the price elasticity of demand The concept of the price elasticity of supply and how to calculate it The cross and income elasticity of demand and how to calculate them To apply the concept of elasticity to various realworld situations

Chapter 5 Topics
Price Elasticity of Demand Price Elasticity of Supply Cross Elasticity & Income Elasticity of Demand

Price Elasticity of Demand

Think About It.........

THE LAW OF DEMAND SAYS.

An increase in price causes a decrease in quantity demanded (& vice versa)

Price Elasticity of Demand

But HOW MUCH does quantity

demanded change in response to a change in price? Elasticity gives us a measure of RESPONSIVENESS

Price Elasticity of Demand

When QD responds STRONGLY

to a change in P, demand is ELASTIC When QD responds WEAKLY to a change in P, demand is INELASTIC

Price Elasticity of Demand

P
As price increases from p1 to p2 quantity demanded decreases from q1 to q2

P2 P1

D Q2 Q1 Q

Price Elasticity of Demand

P
By what percentage did price change? By what percentage did quantity change?
P2 P1

D Q2 Q1 Q

Price Elasticity of Demand

P

If the percentage price change was 4....

P2 P1

4%

D Q2 Q1 Q

Price Elasticity of Demand

P

If the percentage price change was 4....

and the percentage quantity change was 2....

P2 P1

4%

2%

D Q2 Q1 Q

Price Elasticity of Demand

P

If the percentage price change was 4....

and the percentage quantity change was 2....

P2 P1

4%

2%

Elasticity is .5

D Q2 Q1 Q

Price Elasticity of Demand

P

If the percentage price change was 4....

and the percentage quantity change was 2....

P2 P1

2%

Elasticity is .5

D Q2 Q1 Q

Price Elasticity of Demand

P The percentage change in quantity

2
P2 P1
4%

2%

D Q2 Q1 Q

Price Elasticity of Demand

P The percentage change in quantity

The percentage change in price

2
P2 P1
4%

4
2%

D Q2 Q1 Q

Price Elasticity of Demand

P The percentage change in quantity

The percentage change in price

2
P2 P1
4%

4
2%

D Elasticity is Q2 Q1 Q

.5

Price Elasticity of Demand

% change in quantity Ed % change in price
use

percentages eliminate minus sign

Demand is elastic when

Quantity is very responsive to a change in price
P
P P2
1

Ed > 1 D
Q1 Q2

Demand is inelastic when

P
P
1

Quantity is NOT very responsive to a change in price

Ed < 1

P2

D
Q1 Q2

Demand is unit elastic when

P
P
1

% change in quantity is equal to to % change in price

Ed = 1

P2

D
Q1 Q2

Extreme Cases
P D1
Perfectly _______?

Extreme Cases
P D1
Perfectly inelastic demand

Extreme Cases
P

D2
Perfectly ______?

Extreme Cases
Figure 6-1

D2
Perfectly elastic demand

Price Elasticity of Demand

Refinement: Midpoint Formula

change in quantity change in price Ed sum of quantities /2 sum of prices/2

D
9 8 7 6 5 4 3 2 1 0 0 1

Elastic

Figure 6-2

Unit Elastic
Inelastic

Price

Quantity demanded (thousands)

22 20 18 16 14 12 10 8 6 4 2 0 0 1 2 3 4 5 6 7 8 Quantity demanded (thousands)

Total revenue ($ thousands)

TR

Ed & Total Revenue

Qd
1

P
8

Ed
5.00 2.60 1.57 1.00 0.64 0.38

TR
8,000

2
3 4 5 6 7 8

7
6 5 4 3 2 1

14,000
18,000 20,000 20,000 18,000 14,000 8,000

0.20

ELASTIC DEMAND: when price decreases, total revenue increases

Ed & Total Revenue

Qd
1

P
8

Ed
5.00 2.60 1.57 1.00 0.64 0.38

TR
8,000

2
3 4 5 6 7 8

7
6 5 4 3 2 1

14,000
18,000 20,000 20,000 18,000 14,000 8,000

INELASTIC DEMAND: when price decreases, total revenue decreases

0.20

Ed & Total Revenue

Qd
1

P
8

Ed
5.00 2.60 1.57 1.00 0.64 0.38

TR
8,000

2
3 4 5 6 7 8

7
6 5 4 3 2 1

14,000
18,000 20,000 20,000 18,000 14,000 8,000

0.20

UNIT ELASTIC DEMAND: when price decreases, total revenue stays the same

Determinants of Ed
Substitutability

Determinants of Ed
Substitutability Proportion of Income

Determinants of Ed
Substitutability Proportion of Income Luxuries versus Necessities

Determinants of Ed
Substitutability Proportion of Income Luxuries versus Necessities

Time

Income Elasticity of Demand

Ei =

Percentage change in quantity demanded Percentage change in income

normal goods
positive sign

inferior goods
negative sign

Cross Elasticity of Demand

Exy =

Percentage change in quantity demanded of product X Percentage change in the price of product Y

substitute goods
positive sign

complementary goods
negative sign

independent goods
near zero

Cross Elasticity of Demand

Applications Coca-Cola vs Sprite assessing competition

Price Elasticity of Supply

Percentage change in quantity supplied of product X Percentage change in the price of product X

Es=

the main determinant of Es is the amount of time producers have for responding to a change in product price

Price Elasticity of Supply

Immediate market period P An increase in Sm demand without enough time to change supply causes.... Po

D1 Qo
2002 McGraw-Hill Ryerson Ltd
Microeconomics, Chapter 6

Q
37

Price Elasticity of Supply

Immediate market period P An increase in Sm demand without enough time to change supply Pm causes....large increase in price Po D2 D1 Qo
2002 McGraw-Hill Ryerson Ltd Microeconomics, Chapter 6

Q
38

Price Elasticity of Supply

Immediate market period P Sm

Pm
Po

inelastic supply

D2 D1 Qo
2002 McGraw-Hill Ryerson Ltd Microeconomics, Chapter 6

Q
39

Price Elasticity of Supply- Fig. 6-3

Long Run P An increase in demand in the long run allows a greater supply response.... SL

Pm
Po

D1 Qo
2002 McGraw-Hill Ryerson Ltd Microeconomics, Chapter 6

Q
40

Price Elasticity of Supply- Fig. 6-3

Long Run P D2 An increase in demand in the long run allows a greater supply response.... SL
Even more elastic response even lower price increase

Pm PL Po

D1 Qo
2002 McGraw-Hill Ryerson Ltd

QL
Microeconomics, Chapter 6

Q
41

Chapter 7
Consumer Behaviour and Utility Maximization