Elasticity and its Application

CHAPTER 5 ELASTICITY AND ITS APPLICATION 1

This chapter looks at the following:
 The elasticity of demand
 The elasticity of supply
 Applications of supply, demand and elasticity

CHAPTER 5 ELASTICITY AND ITS APPLICATION 2

 Elasticity
 Elasticity is a measure of the responsiveness of
quantity demanded or quantity supplied to a
change in one of its determinants.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 3

 Price Elasticity of Demand
• The law of demand states that a fall in the price of a good raises
the quantity demanded. The price elasticity of demand
measures how much the quantity demanded responds to a change
in price. The price elasticity of demand for any good measures the price-
sensitivity of buyers’ demand.

• Demand for a good is said to be elastic if the quantity demanded responds

substantially to changes in the price. Demand is said to be inelastic if the
quantity demanded responds only slightly to changes in the price.

Numerically,

Price elasticity Percentage change in Qd

of demand =
Percentage change in P

CHAPTER 5 ELASTICITY AND ITS APPLICATION 4

Factors influencing price elasticity of
demand
 Availability of Close Substitutes: Goods with
close substitutes tend to have more elastic
demand because it is easier for consumers to
switch from that good to others.
 Necessities versus Luxuries:Necessities tend
to have inelastic demands, whereas luxuries
have elastic demands. Whether a good is a
necessity or a luxury depends not on the intrinsic
properties of the good but on the preferences of
the buyer.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 5

 Factors influencing price elasticity of
demand

 Definition of the Market :The elasticity of demand in

any market depends on how we draw the boundaries of
the market. Narrowly defined markets tend to have more
elastic demand than broadly defined markets because it
is easier to find close substitutes for narrowly defined
goods. For example, food, a broad category, has a fairly
inelastic demand because there are no good substitutes
for food. Ice cream, a narrower category, has a more
elastic demand because it is easy to substitute other
desserts for ice cream.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 6

Factors influencing price elasticity of
demand
 Time Horizon: Goods tend to have more elastic demand
over longer time horizons as people get more time to
adjust to the price change. New substitutes come in, or
habits change over time.
 Multiple usage: A good with multiple uses has an elastic
demand, as the quantity demanded can be cut down on
unnecessary /unessential usage, restricting the demand
only to necessary use.
 Proportion of income spent: If the buyers spend a
small proportion of their income on a good, then they would
not considerably decrease their purchase of the good as its
price increases, hence it has inelastic demand.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 7

 Calculating Percentage Changes
Standard method
of computing the
Demand for percentage (%) change:
your websites
P end value – start value
x 100%
start value
B
$250
A Going from A to B,
$200
the % change in P equals
D
($250–$200)/$200 = 25%
Q
8 12

CHAPTER 5 ELASTICITY AND ITS APPLICATION 8

 Calculating Percentage Changes
Problem:
The standard method gives
Demand for different answers depending
your websites on where you start.
P
From A to B,
B P rises 25%, Q falls 33%,
$250
A elasticity = 33/25 = 1.33
$200
From B to A,
D
P falls 20%, Q rises 50%,
Q elasticity = 50/20 = 2.50
8 12

CHAPTER 5 ELASTICITY AND ITS APPLICATION 9

 Calculating Percentage Changes
 So, we instead use the midpoint method:
end value – start value
x 100%
midpoint
 Price elasticity of demand =(Q2 - Q1) / [(Q2 + Q1) / 2]
(P2 2 P1) / [(P2 1 P1) / 2]

 It doesn’t matter which value you use as the “start”

and which as the “end” – you get the same answer
either way!

CHAPTER 5 ELASTICITY AND ITS APPLICATION 10

 Calculating Percentage Changes
 Using the midpoint method, the % change
in P equals
$250 – $200
x 100% = 22.2%
$225
 The % change in Q equals
12 – 8
x 100% = 40.0%
10
 The price elasticity of demand equals
40/22.2 = 1.8

CHAPTER 5 ELASTICITY AND ITS APPLICATION 11

 The Variety of Demand Curves
 Economists classify demand curves according to
their elasticity.
 The price elasticity of demand is closely related
to the slope of the demand curve.
 Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 12

“Perfectly inelastic demand” (one extreme case)
Price elasticity % change in Q 0%
= = =0
% change in P 10%
of demand
D curve: P
It is vertical. Any change in prices leads
D
to no change in quantity demanded

P1

P2

P falls Q
by 10% Q1
Q changes
by 0%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 13
“Inelastic demand”
Price elasticity % change in Q < 10%
= = <1
% change in P 10%
of demand
D curve: P
is relatively steeper - change in prices is
proportionately higher than the change in quantity
demanded.

P1

P2
D
P falls Q
by 10% Q1 Q2

Q rises less
than 10%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 14
“Unit elastic demand”
Price elasticity % change in Q 10%
= = =1
% change in P 10%
of demand
P
D curve
change in prices is equal to
the change in quantity P1
demanded.
P2
D

P falls Q
by 10% Q1 Q2

Q rises by 10%

CHAPTER 5 ELASTICITY AND ITS APPLICATION 15

“Elastic demand”
Price elasticity % change in Q > 10%
= = >1
% change in P 10%
of demand
D curve: P
is relatively flatter - change in quantity demanded
is proportionately higher than the change in prices.

P1

P2 D

P falls Q
by 10% Q1 Q2
Q rises more
than 10%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 16
“Perfectly elastic demand” (the other extreme)
Price elasticity % change in Q any %
= = = infinity
% change in P 0%
of demand
D curve: P
horizontal
P2 = P1 D

P changes Q
by 0% Q1 Q2

Q changes
by any %
CHAPTER 5 ELASTICITY AND ITS APPLICATION 17
Elasticity of a Linear Demand Curve

P The slope
200% of a linear
$30 E = = 5.0 (Elastic)
40% demand
67% curve is
20 E = = 1.0 (Unit
constant,
67% elastic)
but its
40%
10 E = = 0.2 elasticity
200%
(Inelastic)
is not.
$0 Q
0 20 40 60

CHAPTER 5 ELASTICITY AND ITS APPLICATION 18

 Price Elasticity and Total Revenue
 If you raise your price, would your revenue rise or
fall?
Revenue = P x Q
 A price increase has two effects on revenue:
• Higher P means more revenue on each unit
you sell.
• But you sell fewer units (lower Q), due to
Law of Demand, which reduces the revenue.
 What will be the net effect on TR, or which of these
two effects is bigger?
It depends on the price elasticity of demand.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 19
 Price Elasticity and Total Revenue
Revenue = P x Q

 If demand is elastic, then

% change in Q > % change in P
 The fall in revenue from lower Q is greater
than the increase in revenue from higher P,
so revenue falls.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 20

 Price Elasticity and Total Revenue
Elastic demand increased
(elasticity = 1.8) P revenue due lost
to higher P
revenue
If P = $200,
due to
Q = 12 and $250 lower Q
revenue = $2400.
$200
If P = $250, D
Q = 8 and
revenue = $2000.
When D is elastic, Q
8 12
a price increase
causes revenue to fall.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 21
 Price Elasticity and Total Revenue

 If demand is inelastic, then

% change in Q < % change in P
 The fall in revenue from lower Q is smaller
than the increase in revenue from higher P,
so revenue rises.
 In our example, suppose that Q only falls to 10
(instead of 8) when you raise your price to $250.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 22

 Price Elasticity and Total Revenue
Now, demand is increased
inelastic: revenue due
elasticity = 0.82 P to higher P lost
If P = $200, revenue
due to
Q = 12 and
$250 lower Q
revenue = $2400.
$200
If P = $250,
Q = 10 and D
revenue = $2500.
When D is inelastic, Q
a price increase 10 12
causes revenue to rise.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 23
 Other Elasticities
 The income elasticity of demand measures the
response of Qd to a change in consumer income.

Income elasticity Percent change in Qd

=
of demand Percent change in income

 As, an increase in income causes an increase in

demand for a normal good.
 Hence, for normal goods, income elasticity > 0.
 For inferior goods, income elasticity < 0.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 24

 Other Elasticities
 The cross-price elasticity of demand measures
the response of demand for one good to changes
in the price of another good.

Cross-price elast. % change in Qd for good 1

=
of demand % change in price of good 2
 For substitutes, cross-price elasticity > 0
E.g., an increase in price of tea causes an
increase in demand for coffee.
 For complements, cross-price elasticity < 0
E.g., an increase in price of computers causes
decrease in demand for software.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 25
 Price Elasticity of Supply
Price elasticity Percentage change in Qs
=
of supply Percentage change in P

 Price elasticity of supply measures how much

Qs responds to a change in P.
 Loosely speaking, it measures the price-
sensitivity of sellers’ supply.
 Again, use the midpoint method to compute the
percentage changes.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 26

 The Variety of Supply Curves
 Economists classify supply curves according to
their elasticity.
 The slope of the supply curve is closely related
to price elasticity of supply.
 Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
 The next 5 slides present the different
classifications, from least to most elastic.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 27

“Perfectly inelastic” (one extreme)
Price elasticity % change in Q 0%
= = =0
% change in P 10%
of supply
S curve: P
S
vertical
P2

P1

P rises Q
by 10% Q1
Q changes
by 0%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 28
“Inelastic”
Price elasticity % change in Q < 10%
= = <1
% change in P 10%
of supply
S curve: P
S
relatively steeper
P2

P1

P rises Q
by 10% Q1 Q2
Q rises less
than 10%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 29
“Unit elastic”
Price elasticity % change in Q 10%
= = =1
% change in P 10%
of supply
S curve: P
intermediate slope S
P2

P1

P rises Q
by 10% Q1 Q2
Q rises
by 10%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 30
“Elastic”
Price elasticity % change in Q > 10%
= = >1
% change in P 10%
of supply
S curve: P
relatively flatter S
P2

P1

P rises Q
by 10% Q1 Q2
Q rises more
than 10%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 31
“Perfectly elastic” (the other extreme)
Price elasticity % change in Q any %
= = = infinity
% change in P 0%
of supply
S curve: P
horizontal
P2 = P1 S

P changes Q
by 0% Q1 Q2

Q changes
by any %
CHAPTER 5 ELASTICITY AND ITS APPLICATION 32
 The Determinants of Supply Elasticity
 The more easily sellers can change the quantity
they produce, the greater the price elasticity of
supply.
 Example: Supply of beachfront property is
harder to vary and thus less elastic than
supply of new cars.
 For many goods, price elasticity of supply is
greater in the long run than in the short run,
because firms can build new factories, or
new firms may be able to enter the market.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 33

How the Price Elasticity of Supply Can Vary

P Supply
Supply often
often
S
elasticity becomes
becomes
$15 <1 less
less elastic
elastic
as
as Q
Q rises,
rises,
12 due
due to
to
elasticity capacity
capacity
>1 limits.
limits.
4
$3
Q
100 200
500 525

CHAPTER 5 ELASTICITY AND ITS APPLICATION 34

APPLICATION: Can Good News for
Farming Be Bad News for Farmers?
 Researchers have devised a new hybrid of
wheat that raises the amount farmers can
produce from each acre of land by 20 percent.
Does this discovery makes him better off or
worse off than he was before?
 Answer such questions in three steps. First,
examine whether the supply or demand curve
shifts. Second, consider in which direction the
curve shifts. Third, use the supply-and-demand
diagram to see how the market equilibrium
changes.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 35
• In this case, the discovery of the new hybrid affects the supply curve. Because
the hybrid increases the amount of wheat that can be produced on each acre
of land, farmers are now willing to supply more wheat at any given price. In
other words, the supply curve shifts to the right. The demand curve remains
the same because consumers’ desire to buy wheat products at any given price
is not affected by the introduction of a new hybrid. This shift reduces the price
of wheat, but increases the quantity supplied.

• Does this discovery make farmers better off? To answer this question, you
need to consider what happens to the total revenue received by farmers.
Farmers’ total revenue is P * Q, the price of the wheat times the quantity sold.
The discovery affects farmers in two conflicting ways. The hybrid allows
farmers to produce more wheat (Q rises), but now each bushel of wheat sells
for less (P falls).
• Whether total revenue rises or falls depends on the elasticity of demand. In
practice, the demand for basic foodstuffs such as wheat is usually inelastic
because these items are necessity and have few good substitutes. When the
demand curve is inelastic, a decrease in price causes total revenue to fall.
Thus, the discovery of the new hybrid lowers the total revenue that farmers
receive from the sale of their crops.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 36