Elasticity

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McGraw-Hill/Irwin Copyright 2015 by McGraw-Hill Education (Asia). All rights reserved.
 Scarcity

Cost Benefit

Incentive

Comparative
Advantage
Markets

Increasing
Supply and Demand

Opportunity Costs
The Basics

Efficiency
2

Equilibrium
 Learning Objectives
1. Define price elasticity of demand and explain what
determines whether demand is elastic or inelastic
2. Calculate the price elasticity of demand using
information from the demand curve
3. Understand how changes in the price of a good
affect total revenue and total expenditure depending
on the price elasticity of demand for the good
4. Explain the cross-price elasticity of demand and
income elasticity of demand
5. Discuss the price elasticity of supply, explain what
determines whether supply is elastic or inelastic, and
calculate the price elasticity of supply using
information from a supply curve

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Drug Enforcement and Local Theft
Hypothesis
Drug users steal to buy drugs
Increasing drug enforcement will decrease theft
Analysis
Increased enforcement reduces supply of drugs
Price of drugs increases
Quantity demanded decreases
Theft goes down ONLY IF total expenditure on
drugs decreases
How responsive is quantity demanded to price
change?

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 Price Elasticity of Demand
Price elasticity of demand is defined as the
percentage change in quantity demanded from
a 1% change in price
Measure of responsiveness of quantity demanded
to changes in price
Example: P

Price of beef decreases 1%

Quantity of beef demanded
increases 2%
Price elasticity of demand is 2 Q

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 Calculate Price Elasticity
Symbol for elasticity is
Lower case Greek letter epsilon
For small percentage changes in price

Percentage change in quantity demanded

=
Percentage change in price

Price elasticity of demand is always negative

Ignore the sign

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 Elastic Demand
Price Elasticity of Demand
Unit elastic

Inelastic Elastic

0 1 2 3

If price elasticity is greater than 1, demand is elastic

with respect to price
Percentage change in quantity is greater than
percentage change in price
Demand is responsive to price
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 Inelastic Demand
Price Elasticity of Demand
Unit elastic

Inelastic Elastic

0 1 2 3

If price elasticity is less than 1, demand is inelastic

with respect to price
Percentage change in quantity is less than percentage
change in price
Quantity demanded is not very responsive to price
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 Unit Elastic Demand
Price Elasticity of Demand
Unit elastic

Inelastic Elastic

0 1 2 3

If price elasticity is 1, demand is unit elastic

with respect to price
Price and quantity change by the same percentage
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 Example: Demand for Pizza
Old New % Change
Price $1.00 $0.97 3%
Quantity 400 404 1%

Percentage change in quantity demanded

=
Percentage change in price

1%
= = 0.33 Demand is inelastic
3%

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Determinants of Price Elasticity of
Demand
More options, more elastic
Substitution Salt
Options Mortons salt

Larger share, more elastic

Budget Share New car
Salt, Key ring

Long time to adjust, more elastic

Time Air conditioner
Gasoline

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Examples of Elasticities
Green peas 2.80
Restaurant meals 1.63
Beer 1.19
Coffee 0.25

Automobiles 1.35
Foreign air travel 0.77

Movies 0.87
Theater, opera 0.18
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 Taxes And Teen Smoking
Hypothesis:
Cigarette taxes would have little effect, as
teenagers' demand for cigarettes is driven
by peers and thus is inelastic
Analysis:
Cigarette taxes increase the price of
cigarettes
Some teens will smoke less or quit
altogether, due to limited income
These teens will influence others
to quit
Higher taxes are likely to reduce teen
smoking

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 Unintended Effects of the Yacht
Tax in the U.S.
Hypothesis
Luxury tax on yachts over $100,000 will yield
$31 million in tax revenue
Outcome:
Actual tax revenue of only $16.6 million
7,600 jobs in US boating industry lost
Lost income taxes & Increased unemployment benefits
Net loss of $7.6 million, $39 million worse than the initial
projection
tax repealed after 2 years
Analysis
Price elasticity of demand is high
People bought yachts outside US to avoid tax 14
 Price Elasticity Notation
Percentage change in quantity demanded
=
Percentage change in price

Q is the change in quantity

Q / Q is percentage change in quantity
P is change in price
P / P is percentage change in price
Q / Q
=
P / P
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Price Elasticity: Graphical View
Q / Q
=
P / P

Price
Q P A
= x P
Q P P
PP
Q
P Q
= x D
Q P

P 1 Q Q+Q
= x Quantity
Q slope
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 Price Elasticity: Graphical View
At point A
P=8

Price
Q=3 A
P
Slope = 20 / 5 = 4
P
P 1 PP
Q
= x D
Q slope

8 1 Q Q+Q
= x = 0.67
Quantity
3 4
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 Price Elasticity and Slope
When two demand curves cross
P / Q is same for both curves
(1 / slope) is
smaller for the 12
steeper curve D1

6 Less Elastic
At the common

Price
More Elastic
point demand 4
D2
is less price elastic
for the steeper
curve 4 6 12
But not so at every point! Quantity
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 Price Elasticity on a Straight-Line
Demand Curve
Price elasticity is different at each point

P 1
= x
Q slope

Slope is the same for the demand curve

P/Q decreases as price goes down and quantity
goes up

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 Price Elasticity Pattern
Price elasticity changes systematically as price goes
down
At high P and low Q, P / Q is large
Demand is elastic
At the midpoint,
demand is unit elastic a 1
1
At low P and high Q,
Price
1
P / Q is small a/
2
Demand is
inelastic b/2 b
Quantity
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 Two Special Cases
Perfectly Elastic Perfectly Inelastic
Demand Demand
Infinite price elasticity of Zero price elasticity of
demand demand
Price Price
D

Quantity Quantity
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Elasticity and Total Expenditure
When price increases, total expenditure can
increase, decrease or remain the same
The change in expenditure depends on elasticity
Terminology: total expenditure = total revenue
Calculate as P x Q
Graphing idea: total
Price
expenditure is the area
of a rectangle with height P Expenditure = 8
and width Q
Example: P = 2 and
Q=4 2
D
4
Quantity
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 Price Elasticity and Total
Expenditure
Movie ticket price increases from $2 to $4
A and B are both below the midpoint of the curve
Inelastic portion of the demand curve
Total revenue increases when price increases

12 D 12 D
Expenditure = Expenditure =
Price ($/ticket)

Price ($/ticket)
$1,000/day $1,600/day

B
4
2
A

5 6 4 6
Quantity (00s of tickets/day) Quantity (00s of tickets/day)
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 Price Elasticity and Total
Expenditure
Movie ticket price increases from $8 to $10
Prices are both above the midpoint of the curve
Elastic portion of the demand curve
Total revenue decreases

12 12
Z
Price ($/ticket)

Price ($/ticket)
Y Expenditure = 10 Expenditure =
8 $1,600/day $1,000/day

D D

2 6 1 6
Quantity (00s of tickets/day) Quantity (00s of tickets/day)
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 The Effect of a Price Change on Total
Expenditure
Price $12 $10 $8 $6 $4 $2 $0
Quantity 0 1,000 2,000 3,000 4,000 5,000 6,000
Expenditure $0 $1,000 $1,600 $1,800 $1,600 $1,000 $0

Total expenditure ($/day)

12 1,800
10 1,600
Price ($/ticket)

6 1,000

1 2 3 4 5 6 2 6 10
Quantity (00s of tickets/day) Price ($/ticket)
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Elasticity, Price Change, and
Expenditure

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 Cross-Price Elasticity of
Demand
Substitutes and complements affect demand

Cross-price elasticity of demand is defined as the

percentage change in quantity demanded of good A
from a 1 percent change in the price of good B

Sign of cross-price elasticity shows relationship

between the goods
Complements have negative cross-price elasticity
Substitutes have positive cross-price elasticity

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 Income Elasticity of Demand

Income elasticity of demand is defined as

the percentage change in quantity
demanded from a 1 percent change in
income

Income elasticity of demand can be positive

or negative
Positive income elasticity is a normal good
Negative income elasticity is an inferior good

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 Price Elasticity of Supply
Price elasticity of supply
Percentage change in quantity supplied from a
1 percent change in price

Q / Q
Price elasticity of supply =
P / P

P 1
Price elasticity of supply = x
Q slope
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 Price Elasticity of Supply
If supply curve has a
positive intercept S
Price elasticity of supply 10
B
decreases as Q increases
A
Graph shows 8

Price
Slope = 2
At A, P = 8 and Q = 2 4
Price elasticity of supply
= (8 / 2) (1 / 2) = 2.00
At B, P = 10 and Q = 3
Price elasticity of supply 2 3
= (10 / 3) (1 / 2) = 1.67
Quantity

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 Price Elasticity of Supply
If supply curve has a S
zero intercept
Price elasticity of B
5
supply is 1.00 P
A
Graph shows 4
Q

Price
Slope = 1 / 3
At A, P = 4 and Q = 12
Price elasticity of supply
= (4 / 12) (3) = 1.00
At B, P = 5 and Q = 15
Price elasticity of supply
12 15
= (5 / 15) (3) = 1.00
Quantity
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 Perfectly Inelastic Supply
Zero price elasticity of Example: land in
supply Tokyo
No response to Supply is completely
change in price fixed
Price Any one-of-a-kind
S
item has perfectly
inelastic supply
Work of art (Mona
Lisa)
Hope Diamond
Quantity
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 Perfectly Elastic Supply
Infinite price elasticity of supply Inputs purchased at a
Sell all you can at a fixed constant price
price No volume discounts
Constant combination of
Price inputs
Coffee example
Cost of production is
S 14 at all levels of Q
Marginal cost
P = 14

Quantity
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Determinants of Price Elasticity of
Supply
Uses adaptable inputs, more
Input Flexibility
elastic

Resources move where

Mobility of Inputs
needed, more elastic

Produce Alternative inputs to be

Substitute Inputs produced, more elastic

Time Long run, more elastic

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 Gas Prices and Car Prices
Why the enormous differences in price volatility?

Gasoline Prices Car Prices

Short-run elasticity of Short-run elasticity of
demand is smaller demand is greater
Difficult to adjust quickly Timing of purchase can be
to changes in price adjusted to price changes
Supply fluctuates more Supply of cars is relatively
often and by larger stable
amounts Inputs are readily available
Some oil-producing Production lines yield
countries are unstable predictable, steady output
Speculation about levels
instability
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Supply Bottleneck: Unique Inputs
Over time, most producers develop alternative
production methods and a variety of input choices
The more flexible the production process, the more
elastic supply
When production relies on a single input, unique
and essential, supply is highly inelastic even in long
run
No alternatives to singular talent
Sports stars
Actors and musicians
Bill Gates, Warren Buffet, Li Ka Shing, Jerry Yang

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 Summary
Own/other-Price
elasticity of Determinants
demand

Total Price elasticity of

Revenue supply
Determinants

Income elasticity Price volatility

of demand
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