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Elasticity . . allows us to analyze supply and demand with greater precision. is a measure of how much buyers and sellers respond to changes in market conditions
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THE ELASTICITY OF DEMAND
The price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good. When we talk about elasticity, that responsiveness is always measured in percentage terms. Specifically, the price elasticity of demand is the percentage change in quantity demanded due to a percentage change in the price.
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The Price Elasticity of Demand and Its Determinants Availability of Close Substitutes Necessities versus Luxuries Definition of the Market Time Horizon
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The Price Elasticity of Demand and Its Determinants Demand tends to be more elastic:
the larger the number of close substitutes. if the good is a luxury. the more narrowly defined the market. the longer the time period.
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Computing the Price Elasticity of Demand The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price.
P ric e e la s tic ity o f d e m a n d = P e rc e n ta g e c h a n g e in q u a n tity d e m a n d e d P e rc e n ta g e c h a n g e in p ric e
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Computing the Price Elasticity of Demand Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as:
P ric e e la s tic ity o f d e m a n d = P e rc e n ta g e c h a n g e in q u a n tity d e m a n d e d P e rc e n ta g e c h a n g e in p ric e
(1 0 8 ) 100 20% 10 = = 2 ( 2 .2 0 2 .0 0 ) 100 10% 2 .0 0
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The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities
The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the price change.
Price elasticity of demand = (Q2 Q1 ) /[(Q2 + Q1 ) / 2] ( P2 P ) /[( P2 + P ) / 2] 1 1
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The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities
Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as:
(10 8) 22% (10 + 8) / 2 = = 2.32 (2.20 2.00) 9.5% (2.00 + 2.20) / 2
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The Variety of Demand Curves Inelastic Demand
Quantity demanded does not respond strongly to price changes. Price elasticity of demand is less than one.
Elastic Demand
Quantity demanded responds strongly to changes in price. Price elasticity of demand is greater than one.
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Computing the Price Elasticity of Demand
(100 50) ED =
Price $5 4 Demand
(4.00 5.00)
(100 + 50)/2 (4.00 + 5.00)/2
67 percent = = 3 22 percent
0
50
100 Quantity
Demand is price elastic.
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The Variety of Demand Curves Perfectly Inelastic
Quantity demanded does not respond to price changes.
Perfectly Elastic
Quantity demanded changes infinitely with any change in price.
Unit Elastic
Quantity demanded changes by the same percentage as the price.
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The Variety of Demand Curves Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve. But it is not the same thing as the slope!
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Figure 1 The Price Elasticity of Demand
(a) Perfectly Inelastic Demand: Elasticity Equals 0 Price Demand $5 4 1. An increase in price . . .
0
100
Quantity
2. . . . leaves the quantity demanded unchanged.
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Figure 1 The Price Elasticity of Demand
(b) Inelastic Demand: Elasticity Is Less Than 1 Price
$5 4 1. A 22% increase in price . . . Demand
0
90
100
Quantity
2. . . . leads to an 11% decrease in quantity demanded.
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Figure 1 The Price Elasticity of Demand
(c) Unit Elastic Demand: Elasticity Equals 1 Price
$5 4 1. A 22% increase in price . . . Demand
0
80
100
Quantity
2. . . . leads to a 22% decrease in quantity demanded.
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Figure 1 The Price Elasticity of Demand
(d) Elastic Demand: Elasticity Is Greater Than 1 Price
$5 4 1. A 22% increase in price . . . Demand
0
50
100
Quantity
2. . . . leads to a 67% decrease in quantity demanded.
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Figure 1 The Price Elasticity of Demand
(e) Perfectly Elastic Demand: Elasticity Equals Infinity Price 1. At any price above $4, quantity demanded is zero. $4 2. At exactly $4, consumers will buy any quantity. Demand
0 3. At a price below $4, quantity demanded is infinite.
Quantity
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Total Revenue and the Price Elasticity of Demand
Total revenue is the amount paid by buyers and received by sellers of a good. Computed as the price of the good times the quantity sold.
TR = P Q
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Figure 2 Total Revenue
Price
When the price is $4, consumers will demand 100 units, and spend $400 on this good.
$4
P
P Q = $400 (revenue)
Demand
0 Q
100
Quantity
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Elasticity and Total Revenue along a Linear Demand Curve With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases.
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Figure 3 How Total Revenue Changes When Price Changes: Inelastic Demand
Price An Increase in price from $1 to $3 Price leads to an Increase in total revenue from $100 to $240
$3
Revenue = $240 $1 Revenue = $100 0 100 Demand Quantity 0 80 Demand Quantity
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Elasticity and Total Revenue along a Linear Demand Curve
With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases.
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Figure 3 How Total Revenue Changes When Price Changes: Elastic Demand
Price
An Increase in price from $4 to $5
Price
leads to an decrease in total revenue from $200 to $100
$5 $4 Demand Revenue = $200 Revenue = $100 Demand
0
50
Quantity
0
20
Quantity
Note that with each price increase, the Law of Demand still holds an increase in price leads to a decrease in the quantity demanded. It is the change in TR that varies! 2007 Thomson South-Western
Elasticity of a Linear Demand Curve
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Figure 4 Elasticity of a Linear Demand Curve
Price
$7 6 5 4 3 2 1
Demand is elastic; When price increases from demand is responsive$4 to $5, TR declines from to $24 to $20. changes in price.
Elasticity is > 1 in this range.
Elasticity is is inelastic; demand is Demand < 1 in this range.
not very responsive to changes When price increases from in price. $2 to $3, TR increases from $20 to $24.
0 2 4 6 8 10 12 14
Quantity
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Other Demand Elasticities Income Elasticity of Demand
Income elasticity of demand measures how much the quantity of demanded a good responds to a change in consumers income. It is computed as the percentage change in the quantity demanded divided by the percentage change in income.
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Other Demand Elasticities Computing Income Elasticity
P e rc e n ta g e c h a n g e in q u a n tity d e m a n d e d In c o m e e la s tic ity o f d e m a n d = P e rc e n ta g e c h a n g e in in c o m e
Remember, all elasticities are measured by dividing one percentage change by another
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Other Demand Elasticities Income Elasticity
Types of Goods
Normal Goods Inferior Goods
Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods.
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Other Demand Elasticities Income Elasticity
Goods consumers regard as necessities tend to be income inelastic
Examples include food, fuel, clothing, utilities, and medical services.
Goods consumers regard as luxuries tend to be income elastic.
Examples include sports cars, furs, and expensive foods.
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Other Demand Elasticities
Cross-price elasticity of demand
A measure of how much the quantity demanded of one good responds to a change in the price of another good, computed as the percentage change in quantity demanded of the first good divided by the percentage change in the price of the second good
Cross - price elasticity of demand = %change in quantity demanded of good 1 %change in price of good 2
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THE ELASTICITY OF SUPPLY
Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good. Price elasticity of supply is the percentage change in quantity supplied resulting from a percentage change in price.
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Figure 5 The Price Elasticity of Supply
(a) Perfectly Inelastic Supply: Elasticity Equals 0 Price Supply $5 4 1. An increase in price . . .
0
100
Quantity
2. . . . leaves the quantity supplied unchanged.
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Figure 5 The Price Elasticity of Supply
(b) Inelastic Supply: Elasticity Is Less Than 1 Price Supply $5 4 1. A 22% increase in price . . .
0
100
110
Quantity
2. . . . leads to a 10% increase in quantity supplied.
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Figure 5 The Price Elasticity of Supply
(c) Unit Elastic Supply: Elasticity Equals 1 Price Supply $5 4 1. A 22% increase in price . . .
(If SUPPLY is unit elastic and linear, it will begin at the origin.)
0
100
125
Quantity
2. . . . leads to a 22% increase in quantity supplied.
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Figure 5 The Price Elasticity of Supply
(d) Elastic Supply: Elasticity Is Greater Than 1 Price Supply $5 4 1. A 22% increase in price . . .
0
100
200
Quantity
2. . . . leads to a 67% increase in quantity supplied.
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Figure 5 The Price Elasticity of Supply
(e) Perfectly Elastic Supply: Elasticity Equals Infinity Price 1. At any price above $4, quantity supplied is infinite. $4 2. At exactly $4, producers will supply any quantity. Supply
0 3. At a price below $4, quantity supplied is zero.
Quantity
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The Price Elasticity of Supply and Its Determinants Ability of sellers to change the amount of the good they produce.
Beach-front land is inelastic. Books, cars, or manufactured goods are elastic.
Time period
Supply is more elastic in the long run.
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Computing the Price Elasticity of Supply The price elasticity of supply is computed as the percentage change in the quantity supplied divided by the percentage change in price.
P e rc e n ta g e c h a n g e in q u a n tity s u p p lie d P ric e e la s tic ity o f s u p p ly = P e rc e n ta g e c h a n g e in p ric e
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THREE APPLICATIONS OF SUPPLY, DEMAND, AND ELASTICITY
Can good news for farming be bad news for farmers? What happens to wheat farmers and the market for wheat when university agronomists discover a new wheat hybrid that is more productive than existing varieties?
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Can Good News for Farming Be Bad News for Farmers? Examine whether the supply or demand curve shifts. Determine the direction of the shift of the curve. Use the supply-and-demand diagram to see how the market equilibrium changes.
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