Handout Two-Elasticity-Chapter Four

Q-1: Draw a graph by using data of above table and also explain why the choice between 1, 2,
3, 4, 5, 6, 7, and 8 “units,” or 1000, 2000, 3000, 4000, 5000, 6000, 7000, and 8000 movie tickets,
makes no difference in determining elasticity.

Price elasticity of demand is determined by comparing the percentage change in price and the percentage
change in quantity demanded. The percentage change in quantity will remain the same regardless of
whether the difference is between 1 unit and 2 units or 1000 units and 2000 units.
To see this note that the percentage change between 1 and 2 equals ((2-1)/1) x 100 = 100%. The
percentage change between 1000 and 2000 equals ((2000-1000)/1000) x 100=100%. Since these are the
same for a given percentage change in price the elasticities will be the same.
Q-2: Graph the accompanying demand data, and then use the midpoint formula for Ed to
determine price elasticity of demand for each of the four possible Rs.1 price changes. What can
you conclude about the relationship between the slope of a curve and its elasticity? Explain in a
nontechnical way why demand is elastic in the northwest segment of the demand curve and
inelastic in the southeast segment. Also calculate total-revenue and draw its graph below your
demand curve. Generalize about the relationship between price elasticity and total revenue.

Product Price Rs. 4 3 2 1

5
Quantity 1 2 3 4 5
Demanded

This demand curve has a constant slope of -1 (= -1/1), but elasticity declines as we move down the
curve. When the initial price is high and initial quantity is low, a unit change in price is a low percentage
while a unit change in quantity is a high percentage change.
Q-3: What are the major determinants of price elasticity of demand? Use those determinants
and your own reasoning in judging whether demand for each of the following products is
probably elastic or inelastic: (a) bottled water; (b) toothpaste, (c) Crest toothpaste, (d) ketchup,
(e) diamond bracelets, (f) Microsoft’s Windows operating system.

(a) bottled water. This good is likely elastic because there are a number of substitutes (water
fountains, cans of soda, etc...)

(b) toothpaste. This good is likely inelastic because there aren't many substitutes and it is a necessity
(in economic terms).

(c) Crest toothpaste. This specific brand of the good is likely elastic. There are a number of
substitutes for this specific brand of the good.

(d) ketchup. This good is likely inelastic. There aren't many substitutes for ketchup (for people who
like ketchup) and it makes up a small percentage of income.

(e) diamond bracelets. This good is likely elastic because it is a luxury good and may make up a
large fraction of income (more than ketchup).

(f) Microsoft's Windows operating system. This good is likely inelastic because there aren't many
substitutes for this good and it has become a necessity in a number of workplaces.
Q-4: How would the following changes in price affect total revenue? That is, would total
revenue increase, decrease, or remain unchanged?

A. Price falls and demand is inelastic.

 Example: Imagine a life-saving drug with few substitutes. The price drops from $100 to $90, a
10% decrease.
 Since demand is inelastic, patients need this drug regardless of the price, so quantity demanded
only increases by, say, 2%.
 Effect on Total Revenue: Total revenue decreases because the small increase in quantity
demanded doesn’t compensate for the drop in price. Even though more units are sold, the lower
price leads to less overall revenue.

B. Price rises and demand is elastic.

 Example: Consider a luxury brand bag, where buyers are very sensitive to price. The price rises
from $1,000 to $1,200, a 20% increase.
 Because demand is elastic, fewer people are willing to buy at the higher price, so quantity
demanded falls significantly—say, by 30%.
 Effect on Total Revenue: Total revenue decreases because the sharp drop in quantity demanded
outweighs the benefit of the higher price.

C. Price rises and supply is elastic.

D. Price rises and supply is inelastic.

E. Price rises and demand is inelastic.

Example: Think of a necessary utility like electricity. If the price per kilowatt-hour rises from
$0.10 to $0.12, a 20% increase, people still need electricity, so quantity demanded only decreases
by a small amount, say 5%.
Effect on Total Revenue: Total revenue increases because the higher price more than
compensates for the small drop in quantity demanded.

F. Price falls and demand is elastic.

Example: Suppose a popular brand of smartphone reduces its price from $1,000 to $800 (a 20%
decrease). Demand for the phone is elastic, so a lot more people decide to buy it; quantity
demanded might increase by 30%.
Effect on Total Revenue: Total revenue increases because the significant increase in quantity
sold outweighs the effect of the lower price.

G. Price falls and demand is of unit elasticity.

 Example: Imagine a product like bottled water at a concert. The price drops from $2 to $1.80 (a
10% decrease), and quantity demanded increases by exactly 10% to match.
 Effect on Total Revenue: Total revenue remains unchanged because the increase in quantity
demanded is exactly offset by the decrease in price.
Q-5: Suppose the cross elasticity of demand for products A and B is 13.6 and for products C
and D is -25.4. What can you conclude about how products A and B are related? Products C and
D? The income elasticities of demand for movies, dental services, and clothing have been
estimated to be 13.4, 11, and 1.5, respectively. Interpret these coefficients. What does it mean if
an income elasticity coefficient is negative?

The cross elasticity relates the percentage change in quantity to the percentage change in price of a
different good. If the cross elasticity is positive this implies that and increase in the price of one good
results in an increase in the quantity purchased of another good. This implies the goods are substitutes, as
the price of one good increases substitute into the other good (purchase more).

This implies that goods A and B are substitutes and that goods C and D are compliments.
For reference, if the cross elasticity is negative this implies that and increase in the price of one good
results in a decrease in the quantity purchased of another good. This implies that the goods are
compliments; as the price of one good increases, reduce the consumption of the other good (purchase
less).
Q-6: Look at the demand curve in following Figure a. Use the midpoint formula and points a
and b to calculate the elasticity of demand for that range of the demand curve. Do the same for
the demand curves in Figures b and c using, respectively, points c and d for Figure b and points e
and f for Figure c.
Q-7: Investigate how demand elastiticities are affected by increases in demand. Shift each of
the demand curves in Figures a, b, and c to the right by 10 units. For example, point a in Figure a
would shift rightward from location (10 units, $2) to (20 units, $2), while point b would shift
rightward from location (40 units, $1) to (50 units, $1). After making these shifts, apply the
midpoint formula to calculate the demand elasticities for the shifted points. Are they larger or
smaller than the elasticities you calculated in Q-6 for the original points? In terms of the
midpoint formula, what explains the change in elasticities?
Q-8: Suppose that the total revenue received by a company selling basketballs is Rs. 6000
when the price is set at Rs. 30 per basketball and Rs. 600 when the price is set at Rs. 20 per
basketball. Without using the midpoint formula, can you tell whether demand is elastic, inelastic,
or unit-elastic over this price range?

The company is initially selling 20 basketballs at a price of $30, which results in a total revenue
of $600. The company then decreases its price to $20 a ball and still has a total revenue of $600.
This implies that the company is now selling 30 basketballs. The decrease in price of $10 on the
previous balls sold resulted in a decrease in revenue of ($200 = $10x20). However the company
sells 10 more balls at the lower price resulting in a $200 increase in revenue (= $20 x 10). Thus,
we know that that demand is unit-elastic over this range because there is no change in total
revenue.
Q-9: Imtiaz Ali is a neighborhood’s 9-year old entrepreneur. His most recent venture is selling
homemade breads that he bakes himself. At a price of Rs. 15 each, he sells 100. At a price of Rs.
10 each, he sells 300. Is demand elastic or inelastic over this price range? If demand had the
same elasticity for a price decline from Rs. 10 to Rs. 5 as it does for the decline from Rs. 15 to
Rs. 10, would cutting the price from Rs. 10 to Rs. 5 increase or decrease Imtiaz’z total revenue?

The total revenue rule implies that demand is elastic when revenue and price move in opposite directions.
In other words, a decrease in price results in an increase in total revenue. We can use this rule to answer
this question.
Consider the following values: At a price of $1.50 each, Imtiaz sells 100. At a price of $1.00 each, he
sells 300. Is demand elastic or inelastic over this price range?
Total revenue at the price $1.50 and the quantity of 100 equals $150 (= $1,50x100). Danny then decreases
his price to $1.00 and sells 300 brownies now. Total revenue at this new price equals $300 (= $1.00x300).
Since total revenue increased after Imtiaz decreased his price we know from the rule above that demand is
elastic over this range.
Q-10: What is the formula for measuring the price elasticity of supply? Suppose the price of
apples goes up from Rs. 200 to Rs. 220 a box. In direct response, Amanullah Farms supplies
1200 boxes of apples instead of 1000 boxes. Compute the coefficient of price elasticity
(midpoints approach) for Amanullah’s supply. Is its supply elastic, or is it inelastic?

The formula for measuring the elasticity of supply is the same as the formula for measuring the
elasticity of demand. Divide the percentage change in quantity by the percentage change in price.
The only difference is that we do not need to take absolute value here because the price and
quantity will move in the same direction (implying the elasticity is already positive).

Consider the following values: Suppose the price of apples goes up from $20 to $22 a box. In
direct response, Goldsboro Farms supplies 1200 boxes of apples instead of 1000 boxes. Here we
have two ordered pairs (1000,20) and (1200,22), note the form is (Q,P).

The same interpretation also applies. Supply is elastic if greater than 1, inelastic if less than 1, and is unit
elastic if the elasticity equals 1. Thus, in this case, supply is elastic.