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Principles of Microeconomics
R. Larry Reynolds
 Elasticity
Elasticity is a concept borrowed from physics
Elasticity is a measure of how responsive a
dependent variable is to a small change in an
independent variable(s)
Elasticity is defined as a ratio of the percentage
change in the dependent variable to the
percentage change in the independent variable
Elasticity can be computed for any two related
variables

Fall '97 Economics 205Principles of Microeconomics Slide 2

 Elasticity [cont. . . ]
Elasticity can be computed to show the effects of:
a change in price on the quantity demanded [ a change in
quantity demanded is a movement on a demand function]
a change in income on the demand function for a good
a change in the price of a related good on the demand
function for a good
a change in the price on the quantity supplied
a change of any independent variable on a dependent
variable

Fall '97 Economics 205Principles of Microeconomics Slide 3

 Own Price Elasticity
Sometimes called price elasticity
can be computed at a point on a demand
function or as an average [arc] between two
points on a demand function

ep, h,e are common symbols used to represent

price elasticity
Price elasticity [ep] is related to revenue
How will a change in price effect the total
revenue? is an important question.

Fall '97 Economics 205Principles of Microeconomics Slide 4

 Elasticity as a measure of
responsiveness
The law of demand tells us that as the
price of a good increases the quantity that
will be bought decreases but does not tell
us by how much.
ep [ownprice elasticity] is a measure of
that information]
If you change price by 5%, by what
percent will the quantity purchased
change?
Fall '97 Economics 205Principles of Microeconomics Slide 5
 % change in quantity demanded
ep

% change in price
% DQ At a point on a demand function this can be
or, ep calculated by:
% DP
Q
Q22 -
-QQ11 = DQ DQ
Q1 Q1
ep = =
P2 P-2 P
-1 P=1 DP DP
P1 P1

Fall '97 Economics 205Principles of Microeconomics Slide 6

 +2
DQ
[2/3 = .66667]
31
ep =
Q % DQ = 67%
DP
-2 =
% DP = -28.5%
= -2.3 [rounded]

P71 [-2/7=-.28571] The own price elasticity of demand

at a price of $7 is -2.3
Price decreases from $7 to $5
This is point price elasticity. It is calculated at a point
Px on a demand function. It is not influenced by the direction
or magnitude of the price change.
A
P1 = $7 P2- P1 = 5 - 7 = DP = -2
DP = -2
B Q2 - Q1 = 5 - 3 = DQ = +2
P2 = $5 There is a problem! If the
price changes from $5 to
D $7 the coefficient of
DQ = +2 elasticity is different!

Q1 = 3 Q2 = 5 Qx/ut
Fall '97 Economics 205Principles of Microeconomics Slide 7
.
 -2
DQ [-2/5 = -.4]
% DQ = -40%
ep = 5Q1 =
% DP = 40%
= -1 [this is called unitary elasticity]
+2
DP
P51 [+2/5 = .4]
When the price increases from $5 to $7, the ep = -1 [unitary]
In the previous slide, when the price decreased from $7 to $5, ep = -2.3

The point price elasticity is Px

different at every point! ep = -2.3
A
P2 = $7 ep = -1
DP = +2 B
There is an P1 = $5
easier way!
D
DQ = -2
Q2= 3 Q1= 5 Qx/ut
Fall '97 Economics 205Principles of Microeconomics Slide 8
 An easier way! By rearranging terms
DQ this is a point on
DQ P1 DQ P1 the demand
ep = Q1
Q1
DP
=
Q1 * D P
= * function
DP Q1
P1 this is the
slope of the
Given that when: demand function
P1 = $7, Q1 = 3
DQ P71
P2 = $5, Q2= 5 ep = -1
DP
* Q
31
= -2.33
P2- P1 = 5 - 7 = DP = -2
P1 = $7, Q1 = 3
Q2 - Q1 = 5 - 3 = DQ = +2
On linear demand functions the
Then, slope remains constant so you
DQ +2 just put in P and Q
= = -1
DP -2
This is the slope of the demand Q = f(P)
Fall '97 Economics 205Principles of Microeconomics Slide 9
The following information was Px Q = f (P)
given
P1 = $7, Q1 = 3 A
$7
P2 = $5, Q2= 5 What is the Q
B intercept?
$5
Q2 - Q1 = 5 - 3 = DQ = +2
P2- P1 = 5 - 7 = DP = -2 Px must decrease
The slope of the demand function
by 5. D
Q increases by 5
[Q = f(P)] is DQ +2
DP
=
-2
= -1 3 5 Q
The slope [-1] indicates that for every
/
Q=x 10ut
1 unit increase in Q, Px will decrease by 1.
Since Px must decrease by 5, Q must
The equation for the demand increase by 5
function we have been using is Q = 10 when Px = 0
Q = 10 - 1P. A table can be The slope-intercept form
constructed. Q = a10+ -m1 P

Fall '97 Economics 205Principles of Microeconomics Slide 10

 using our formula,
The slope is -1 The intercept is 10
DQ P1
ep =
DP * Q1
For a simple demand function: Q = 10 - 1P
price quantity ep Total
Revenue the slope is -1, price is 7
0 DQ P71
ep = (-1) * Q1 = -2.3
$0 10

$1 9 -.11 DP 3
$2 8 -.25 at a price of $7, Q = 3
$3 7 -.43
$4 6 -.67 Calculate ep at P = $9
$5 5 -1. Q=1 9
ep = (-1) = -9
$6 4 -1.5 1
$7 3 -2.3 Calculate ep for all other
$8 2 -4. price and quantity
$9 1 -9 combinations.
$10 0 undefined
Fall '97 Economics 205Principles of Microeconomics Slide 11
 Notice that at higher prices
the absolute value of the price
For a simple demand function: Q = 10 - 1P elasticity of demand, ep, is
greater.
price quantity ep Total
Revenue
Total revenue is price times
$0 10 0 0 quantity; TR = PQ.
$1 9 -.11 9 Where the total revenue [TR]
16 is a maximum, ep is equal
$2 8 -.25
to 1
$3 7 -.43 21
In the range where ep < 1, [less
$4 6 -.67 24
than 1 or inelastic], TR increases as
$5 5 -1. 25 price increases, TR decreases as P
$6 4 -1.5 24 decreases.
$7 3 -2.3 21 In the range where ep > 1,
$8 2 -4. 16 [greater than 1 or elastic], TR
$9 1 -9 9 decreases as price increases, TR
$10 0 undefined 0 increases as P decreases.

Fall '97 Economics 205Principles of Microeconomics Slide 12

 To solve the problem of a point elasticity that is different for every price quantity
combination on a demand function, an arc price elasticity can be used. This arc price
elasticity is an average or midpoint elasticity between any two prices. Typically,
the two points selected would be representative of the usual range of prices in the
time frame under consideration.
The formula to calculate the average or arc price
P1 + P2 = elasticity is: DQ P1 + P2
12 ep = * Q1 + Q2
DP
P1 = $7, Q1 = 3
Q1 + Q2
Px The average or arc ep between
P2 = $5, Q2= 5 $5 and $7 is calculated,
= 8
A
Q2 - Q1 = 5 - 3 = DQ = +2 $7
Slope of demand
P2- P1 = 5 - 7 = DP = -2 DQ
$5
B = - 1
DP

DQ P1 12
+ P2 D
ep = -1
* = - 1.5
DP Q1 8+ Q2
The average ep between $5 and $7 is -1.5 3 5 Qx/ut
Fall '97 Economics 205Principles of Microeconomics Slide 13
 Given: Q = 120 - 4 P Calculate the point ep at each
price on the table.
Price Quantity
e p TR
Calculate the TR at each price
on the table.
$ 10
Calculate arc ep at between
$ 20 $10 and $20.
$ 25 Calculate arc ep at between
$ 28 $25 and $28.

Calculate arc ep at between $20 and $28.

Graph the demand function [labeling all axis and functions], identify
which ranges on the demand function are price elastic and which are
price inelastic.

Fall '97 Economics 205Principles of Microeconomics Slide 14

 Given: Q = 120 - 4 P Calculate the point ep at each
price on the table.
Price Quantity ep TR
Calculate the TR at each price
80 on the table. TR = PQ
$ 10 -.5 $800
Calculate arc ep at between
$ 20 40 -2 $800
$10 and $20. ep = -1
$ 25 20 -5 $500
Calculate arc ep at between
$ 28 8 -14 $224 $25 and $28. ep = -7.6
Calculate arc ep at between $20 and $28. ep = -4
Graph the demand function [labeling all axis and functions], identify
which ranges on the demand function are price elastic and which are
price inelastic. At what price will TR by maximized?
P = $15

Fall '97 Economics 205Principles of Microeconomics Slide 15

Graphing Q = 120 - 4 P, Price TR is a maximum
where ep is -1 or TRs
slope = 0
When ep is -1 TR is a maximum. The top half of the demand
When | ep | > 1 [elastic], TR and P function is elastic.
TR
move in opposite directions. (P has | ep | > 1 [elastic]
a negative slope, TR a positive slope.) 30

When | ep | < 1 [inelastic], TR and P ep = -1

move in the same direction. (P and TR 15 | ep | < 1
both have a negative slope.) inelastic
Arc or average ep is the average
elasticity between two point [or prices]
60 120 Q/ut
point ep is the elasticity at a point or price.
The bottom half of the demand
Price elasticity of demand describes function is inelastic.
how responsive buyers are to change
in the price of the good. The more elastic, the more responsive to DP.

Fall '97 Economics 205Principles of Microeconomics Slide 16

 Use of Price Elasticity
Ruffin and Gregory [Principles of Economics, Addison-
Wesley, 1997, p 101] report that:
short run |ep|of gasoline is = .15 (inelastic)
long run |ep|of gasoline is = .78 (inelastic)

short run |ep|of electricity is = . 13 (inelastic)

long run |ep|of electricity is = 1.89 (elastic)

Why is the long run elasticity greater than short
run?
What are the determinants of elasticity?
Fall '97 Economics 205Principles of Microeconomics Slide 17
 Determinants of Price
Elasticity
Availability of substitutes [greater availability of
substitutes makes a good relatively more elastic]
Portion of the expenditures on the good to the
total budget [lower portion tends to increase
relative elasticity]
Time to adjust to the price changes [longer time
period means there are more adjustment possible
and increases relative elasticity
Price elasticity for brands is tends to be more
elastic than for the category of goods

Fall '97 Economics 205Principles of Microeconomics Slide 18

 An application of price elasticity.
The price elasticity of demand for milk is estimated between -.35 and -.5.
Using -.5 as a reasonable figure, there are several important observations that
can be made.
% DQ
What effect does a
Since ep = -.5
ep
10% increase in the Pmilk % DP
have on the quantity that
individuals are willing to buy?
To solve for % DQ
% DQ
Multiply both sides by +10% -5%(-.5
(+10%)x e
) =% DQ
= p x (+10%)
A 10% increase in the price of milk would % +10%
DP
reduce the quantity demanded by about Pmilk
5%.
P2
If price were decreased by 5%, what +10%
P1
would be the effect on quantity Dmilk
demanded? A 10% increase -5%
in P reduces Q
Fall '97
by 5%
Economics 205Principles of Microeconomics Q2 Q1 Q
Slide 19 milk
 % DQ
ep The price elasticity of demand is a measure of
% DP the % DQ that will be caused by a % DP.

If the price elasticity of demand for air travel was estimated at -2.5, what
effect would a 5% decrease in price have on quantity demanded ?
% DQ
-2.5 = = +12.5% change in quantity demanded
% DP
- 5%

If the price elasticity of demand for wine was estimated at -.8, what
effect would a 6% increase in price have on quantity demanded ?

% DQ
-.8 = = -4.8% decrease in quantity demanded
%+6%
DP

Fall '97 Economics 205Principles of Microeconomics Slide 20

If the price elasticity of demand for milk were -.5, the effects
of a price change on total revenue [TR] can also be estimated.
Since , When |ep| < 1, demand is inelastic. This means that
% DQ the % DQ< % DP. Since the % price
ep % DP decrease is greater than the % increase in Q,
TR [TR = PQ] will decrease.
When |ep| < 1, a price decrease will decrease TR; a price increase will
increase TR, Price and TR move in the same direction. [inelastic demand
with respect to price]

When |ep| > 1, demand is elastic. This means that the % DQ> % DP.
When the % price decrease is less than the % increase in Q,
TR [TR = PQ] will increase.
When |ep| > 1, a price decrease will increase TR; a price increase will
decrease TR, price and TR move in opposite directions. [elastic demand
wrt price]

Fall '97 Economics 205Principles of Microeconomics Slide 21

 TR
Graphically this can be shown Price and
TR is a maximum
TR move in
TR = PQ, so the maximum TR is the opposite
rectangle 0Q1 EP1 directions

As price rises into the elastic range

the TR will decrease. Notice that
in this range the slope of demand TR
is negative, the slope of TR is P
elastic
positive
P2 at the midpoint, ep = -1
price rises +TR
E
(P2 Q2) is less
P1
than
Loss in
(P
TR1 Q1)
when
DP D
0 Q2 Q1 Q/ut

Fall '97 Economics 205Principles of Microeconomics Slide 22

 TR
When price elasticity of demand is TR is a maximum
inelastic

A price decrease will result in

a decrease in TR [PQ]. notice that
both TR and Demand have a
negative slope in the inelastic
range of the demand function. TR
Price and TR move in the same P
direction.

A price decrease will reduce at the midpoint, ep = -1

TR; a price increase will E
P1 inelastic
increase TR. Note that
TR = P1 Q1
this information is useful P0 [Maximum]
but does not provide
results in a smaller PQ D
[TR]
information about profits! 0 Q0
Q1 Q/ut

Fall '97 Economics 205Principles of Microeconomics Slide 23

 Own Price Elasticity of
Demand
ep is a measure of the responsiveness of buyers to changes
in the price of the good.
ep will be negative because the demand function is
negatively sloped.
A linear demand function will have unitary elasticity at its
midpoint. AT THIS POINT TR IS A MAXIMUM!
A linear demand function will be more elastic at higher
prices and tends to be more inelastic in the lower price
ranges

Fall '97 Economics 205Principles of Microeconomics Slide 24

 Inelastic ep
When |ep|< 1 [less than 1] the demand is
inelastic
The |%DQ|< |%DP|,buyers are not very
responsive to changes in price.
An increase in the price of the good
results in an increase in total revenue [TR],
a decrease in the price decreases TR.
Price and TR move in the same direction

Fall '97 Economics 205Principles of Microeconomics Slide 26

 P D2
D1 is a perfectly elastic perfectly
demand function. inelastic
For an infinitesimally small ep = 0
change in price, Q changes
by infinity. Buyers are very perfectly elastic
responsive to price changes. An
infinitely small change in price
|ep| = undefined D1
changes Q by infinity.

0
%
DQ
ep ==undefined
0
% DP
P 0 Q/ut
D2 is a perfectly inelastic demand function, no matter how
much the price changes the same amount is bought. Buyers
are not responsive to price changes! |ep| = 0, perfectly inelastic.

Fall '97 Economics 205Principles of Microeconomics Slide 27

.
.
 Examples
Goods that are relatively price elastic
lamb, restaurant meals, china/glassware,
jewelry, air travel [LR], new cars, Fords
in the long run, |ep|tends to be greater
Goods that are relatively price inelastic
electricity, gasoline, eggs, medical care, shoes,
milk
in the short run, |ep|tends to be less

Fall '97 Economics 205Principles of Microeconomics Slide 28

 Income Elasticity
[normal goods]

Income elasticity is a measure of the change in

demand [a shift of the demand function] that is
% DQx caused by a change in income.
ey The increase in income, DY, increases demand
% DY to D2. The increase in demand results in a
[Where Y = income] larger quantity being purchased at the
same Price [P1]..
At a price of P1 , the quantity demanded
given the demand D is Q1 . D is the P Due to increase
demand function when the income is Y1 . in income,
For a normal good an increase demand
increases
in income to Y2 will shift the
demand to the right. This is an P1 D2
increase in demand to D2.
% DY > 0; % DQ> 0; therefore,
D
ey >0 [it is positive]
Q1 Q2 Q/ut

. Fall '97 Economics 205Principles of Microeconomics Slide 29

Income Elasticity [continued. . .]
[normal goods]

A decrease in income is associated with a decrease in

% DQx
ey the demand for a normal good.
% DY
For a decrease in income [-DY],
At income Y1, the demand D1 represents the demand decreases; i.e. shifts
the relationship between P and Q. At to the left, at the price [P1 ], a
a price [P1] the quantity [Q1] is smaller Q2 will be purchased.
demanded.
P
A decrease in income,
% DY < 0 [negative]; % DQ < 0 [negative]; decreases
so, ep > 0 [ positive] demand
P1
For either an increase or decrease in income
the ep is positive. A positive relationship D1
[positive correlation] between DY and DQ D2
is evidence of a normal good.
Q2 Q1 Q/ut
Fall '97 Economics 205Principles of Microeconomics Slide 30
When income elasticity is positive, the good is considered a normal
good. An increase in income is correlated with an increase in the
demand function. A decrease in income is associated with a
decrease in the demand function. For both increases
and decreases in

The greater the value of ey,

income, ey is positive
+- %
%%DQDQ
eeyy DQxx x
the more responsive buyers +
are to a change in their incomes. % DY
+- %%DYDY
When the value of ey is greater than 1, it is called a superior good.

The |% DQx| is greater than the |% DY|.

% DQx
Buyers are very responsive to changes in
income. Sometimes superior goods are
ey
% DY
called luxury goods.

. Fall '97
. Economics 205Principles of Microeconomics Slide 31
Income Elasticity
[inferior goods]

There is another classification of goods where changes in income

shift the demand function in the opposite direction.
An increase in income [+DY] reduces demand.
-%%DQ
DQ x

eyy
x
An increase in income reduces -e =
%+DY
DY
the amount that individuals P
are willing to buy at each price
of the good. Income elasticity
decreases
is negative: - ey demand
P1
The greater the absolute value
of - ey, the more responsive buyers D1
- %DQ x
D2
are to changes in income

Q2 Q1 Q/ut
.
. Fall '97 Economics 205Principles of Microeconomics Slide 32
Income Elasticity
[inferior goods]

Decreases in income increase the demand for inferior goods.

A decrease in income [-DY] increases demand.

+%DQ
% DQ
A decrease in income [-DY]
results in an increase in demand, P - eey y xx

% DY
the income elasticity of demand -DY
is negative

For both increases and decreases in

P1 D2
income the income elasticity is negative
for inferior goods. The greater the D1
absolute value of ey, the more responsive
+%DQ x

buyers are to changes in income

Q1 Q2 Q/ut
. . Fall '97 Economics 205Principles of Microeconomics Slide 33
 Income Elasticity
Income elasticity [ey] is a measure of the effect
of an income change on demand. [Can be calculated as
point or arc.]

ey > 0, [positive] is a normal or superior good

an increase in income increases demand, a
decrease in income decreases demand.
0< ey < 1 is a normal good
1 < ey is a superior good

ey < 0, [negative] is an inferior good

Fall '97 Economics 205Principles of Microeconomics Slide 34
 Examples of ey
normal goods, [0 < ey < 1 ], (between 0 and 1)
coffee, beef, Coca-Cola, food, Physicians
services, hamburgers, . . .

Superior goods, [ ey > 1], (greater than 1)

movie tickets, foreign travel, wine, new cars, . . .
Inferior goods, [ey < 0], (negative)
flour, lard, beans, rolled oats, . . .

Fall '97 Economics 205Principles of Microeconomics Slide 35

 Cross-Price Elasticity
Cross-price elasticity [exy] is a measure of how
responsive the demand for a good is to changes in
the prices of related goods.
Given a change in the price of good Y [Py ], what is
the effect on the demand for good X [Qy ]?
exy is defined as:
% D Q
e x
xy
% D P y

Fall '97 Economics 205Principles of Microeconomics Slide 36

Cross-price elasticity of demand , [exy]
[substitutes]

When the price of pork increases, it will tend to increase the demand
for beef. People will substitute beef, which is relatively cheaper, for
pork, which is relatively more expensive.

When beef is $2, Qb beef

[price of pork]

When pork is $1.50, Qp pork

[price of beef]
is purchased. Pb is purchased.
Pp price of pork increases at Pb = $2 more
increase beef will be bought
The quantity demanded
demand to substitute for
2 of pork decreases.
2 the smaller
for an increase quantity of
1.50
in Ppork, pork.
Dp
demand for
beef increases
Db Db
-DQp

Qp Qp pork/ut Qb Qb beef/ut

Fall '97 Economics 205Principles of Microeconomics Slide 37

.
 Cross-price elasticity
In the case of beef and pork
the ebp is not the same as epb
ebp is the % change in the demand for beef with
respect to a % change in the price of pork
epb is the % change in the demand for pork with
respect to a % change in the price of beef
beef may not be a good substitute for pork
pork may not be a good substitute for beef

Fall '97 Economics 205Principles of Microeconomics Slide 38

Cross-price elasticity of demand , [exy]
[substitutes]

The cross elasticity of the demand for beef with respect to the
price of pork, ebeef-pork or ebp can be calculated:
+Q
%D DQ
ofb beef An increase in the price of pork,
+ebp
ebp = causes an increase in the demand
positive %DP+of
DPpork
p for beef.
cross elasticity is positive

%D -Q Dof
Qbeef
b A decrease in the price of pork,
+eebpbp = causes a decrease in the demand
positive %DP of pork for beef.
- DPp
If goods are substitutes, exy will be positive. The greater the
coefficient, the more likely they are good substitutes.

Fall '97 Economics 205Principles of Microeconomics Slide 39

Cross-price elasticity of demand , [exy]
[compliments]
as more crayons are
purchased, the
demand for colour
Pc a decrease in the price
Pc books increases.
increase
of crayons, demand At the same
P1 price a larger
$3 quantity will
-DPc Dp be bought
Po
Dc Dc
Q1 Q2 crayons 2000 2500 colour books
increases the quantity demanded + DQb
of crayons
DQ for compliments, the cross
- ebc %D+ Q ofbb
ebc =
negative
elasticity is negative for price
increase or decrease.
-
%DP of c
DPc

Fall '97 Economics 205Principles of Microeconomics Slide 40

 Cross-Price Elasticity
exy > 0 [positive], suggests substitutes, the
higher the coefficient the better the
substitute
exy < 0 [negative], suggests the goods are
compliments, the greater the absolute value
the more complimentary the goods are
exy = 0, suggests the goods are not related
exy can be used to define markets in legal
proceedings

Fall '97 Economics 205Principles of Microeconomics Slide 41

 Elasticity of Supply

Elasticity of supply is a measure of

how responsive sellers are to changes
in the price of the good.
Elasticity of supply [ep] is defined:
% D Quantity Supplied
e
s
% D price
Fall '97 Economics 205Principles of Microeconomics Slide 42
Elasticity of supply
%DQsupplied
es =
%DP
Given a supply function, at a price [P1], Q1 is produced and offered
for sale.
P At a higher price [P2], a larger
quantity, Q2, will be produced
and offered for sale.

P2 The increase in price [ DP ], induces

+DP a larger quantity goods [ DQ]for
P1 sale.
The more responsive sellers are to
DP, the greater the absolute value of es.
+DQ
[The supply function is flatteror
Q1 Q2 Q /ut more elastic]

Fall '97 Economics 205Principles of Microeconomics Slide 43

The supply function is a P
model of sellers behavior.
Si a perfectly inelastic
supply, es = 0
Sellers behavior is influenced by:
1. technology Se
2. prices of inputs
a perfectly
3. time for adjustment elastic supply
market period
short run
[es is undefined.]
long run
very long run
Q /ut
4. expectations
5. anything that influences costs of production
taxes
regulations, . . .

Fall '97 Economics 205Principles of Microeconomics Slide 44

 Elasticity
Price elasticity of demand [measures a move on a demand
function caused by change in price/arc or point]
elastic, inelastic or unitary elasticity

income elasticity [measures a shift of a demand function

associated with a change in income]
superior, normal, and inferior

cross elasticity
measure the shift of a demand function for a good associated
with the change in the price of a related good
[compliment/substitute]

price elasticity of supply [measures move on a supply curve]

Fall '97 Economics 205Principles of Microeconomics Slide 45