CHAPTER 4

Elasticity

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  Price Elasticity of Demand
 Total Revenue and Price Elasticity of
INTHISLECTURE
Demand
 Determinants of Price Elasticity of
Demand
 Cross Elasticity of Demand
 Income Elasticity of Demand
 Price Elasticity of Supply
 Taxes and Elasticity

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 LEARNING OUTCOMES
INTHISLECTURE
● To calculate and to interpret the price elasticity of
demand and the elasticity point formula.

● To explain the degree of price elasticity of demand.

● To explain the price elasticity of demand determinants.

● To calculate the cross-elasticity of demand.

● To identify the types of goods from value of cross

elasticity of demand.

● To calculate the income-elasticity of demand.

● To identify the types of goods from value of income

elasticity of demand

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 LAW OF DEMAND AND PRICE
ELASTICITY
 The law of demand states that price and
quantity demanded are inversely related,
ceteris paribus.

 But it doesn’t tell us by what percentage

the quantity demanded changes as price
changes.

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 LAW OF DEMAND AND PRICE
ELASTICITY
 Suppose price rises by 10 percent. As a
result, quantity demanded falls, but by
what percentage does it fall?

 The notion of price elasticity of demand

can help answer this question.

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 ELASTICITY

● The general concept of elasticity provides a

technique for estimating the response
of one variable to changes in another.
It has numerous applications in economics.

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 PRICE ELASTICITY OF DEMAND
(CONSUMERS)
A measure of the responsiveness of
quantity demanded to changes in price.

% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑 %∆𝑄𝐷

𝐸𝑑 = =
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒 %∆𝑃

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 ELASTICITY IS NOT SLOPE

For a linear demand

function (straight line)
slope is constant

Elasticity (Ed) changes

along the demand
curve.

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 CALCULATING PRICE ELASTICITY OF
DEMAND I

We identify two

points on a demand
curve.

At point A, price is

$12 and quantity
demanded is 50 units.
At point B, price is $10
and quantity demanded
is 100 units.

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 CALCULATING PRICE ELASTICITY OF
DEMAND II

When calculating price

elasticity of demand, we
use the average of the two
prices and the average of
the two quantities
demanded. The formula for
price elasticity of demand
is:

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 CALCULATING PRICE ELASTICITY OF
DEMAND III

For example, the

calculation is:

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 GRAPHICAL REPRESENTATION OF
PRICE ELASTIC DEMAND

The percentage change

in quantity demanded is
greater than the
percentage change in price
(∆Qd >∆P).

Quantity demanded
changes proportionately
more than price changes.

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 GRAPHICAL REPRESENTATION OF
PRICE INELASTIC DEMAND

The percentage
change in quantity
demanded is less than
the percentage change
in price (∆Qd < ∆P)

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 GRAPHICAL REPRESENTATION OF
PRICE UNITARY ELASTIC DEMAND

The percentage
change in quantity
demanded is equal
to the percentage
change in price
(∆Qd = ∆P).

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 GRAPHICAL REPRESENTATION OF
PERFECTLY ELASTIC DEMAND

A small percentage
change in price causes
an extremely large
percentage change in
quantity demanded
(from buying all to
buying nothing).

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 GRAPHICAL REPRESENTATION OF
PERFECTLY PRICE INELASTIC DEMAND

Quantity demanded
does not change
as price changes.

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 PRICE ELASTICITY OF DEMAND
SUMMARY

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 PRICE ELASTICITY AND TOTAL REVENUE

● Total revenue (TR) of a seller equals

the price of a good times the quantity of
the good sold (P x Q).

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 ELASTIC DEMAND AND TOTAL
REVENUE I
● If demand is elastic, the percentage
change in quantity demanded is greater
than the percentage change in price.

Elastic;
Ed >1;
%ΔQ >%ΔP;
P↑→TR↓
P↓→ TR↑
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 ELASTIC DEMAND AND TOTAL
REVENUE II
 Demand is elastic between points A
and B.
 A fall in price, from P1 to P2, will
increase the size of the total revenue
rectangle from 0P1AQ1 to 0P2BQ2.
 A rise in price, from P2 to P1, will
decrease the size of the total revenue
rectangle from 0P2BQ2 to 0P1AQ1.
 In other words, when demand is
elastic, price and total revenue are
inversely related

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 INELASTIC DEMAND AND TOTAL
REVENUE I
● If demand is inelastic, the percentage
change in quantity demanded is less
than the percentage change in price.

Inelastic;
Ed < 1;
%ΔQ < %ΔP;
P↓→TR↓
P↑→ TR↑
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 INELASTIC DEMAND AND TOTAL
REVENUE II
 Demand is inelastic between points A
and B.
 A fall in price, from P1 to P2, will
decrease the size of the total revenue
rectangle from 0P1AQ1 to 0P2BQ 2.
 A rise in price, from P2 to P1, will
increase the size of the total revenue
rectangle from 0P2BQ2 to 0P1AQ1.
 In other words, when demand is
inelastic, price and total revenue are
directly related.

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 UNIT ELASTIC DEMAND AND TOTAL
REVENUE
● If demand is unit elastic, the
percentage change in quantity
demanded is equal to the percentage
change in price.

Unit Elastic;
Ed =1;
%ΔQ = %ΔP;
P↑→TQ =R
P↓→TR

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 ELASTICITY, PRICE CHANGES, AND
TOTAL REVENUE

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 1. On Tuesday, price and quantity demanded
are $7 and 120 units, respectively. Ten days
later, price and quantity demanded are $6
and 150 units, respectively. What is the
SELFTEST
price elasticity of demand between the
price of $7 and the price of $6?

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 2. What does a price elasticity of
SELFTEST demand of 0.39 mean?

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 3. Identify what happens to total revenue as a
result of each of the following: (a) price rises
and demand is elastic; (b) price falls and
demand is inelastic; (c) price rises and
SELFTEST
demand is unit elastic; (d) price rises and
demand is inelastic; (e) price falls and
demand is elastic.

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 4. Alexi says, “When a seller
raises his price, his total
revenue rises.” What is Alexi
SELFTEST
implicitly assuming?
Alexi is implicitly assuming that
demand is inelastic. If, however, she
is wrong and demand is elastic, then
a rise in price will actually lower total
revenue.

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 DETERMINANTS OF PRICE ELASTICITY
OF DEMAND I
● Number of substitutes - The more
substitutes for a good, the higher the
price elasticity of demand; the fewer
substitutes for a good, the lower the
price elasticity of demand.

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 DETERMINANTS OF PRICE ELASTICITY
OF DEMAND II
● Necessities versus luxuries - Generally,
the more that a good is considered a
luxury (a good that we can do without)
rather than a necessity (a good that we
can’t do without), the higher the price
elasticity of demand.

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 DETERMINANTS OF PRICE ELASTICITY
OF DEMAND III
● Percentage of ones budget spent on the
good – The greater the percentage of
one’s budget that goes to purchase a
good, the higher the price elasticity of
demand; the smaller the percentage of
one’s budget that goes to purchase a
good, the lower the price elasticity of
demand.

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 DETERMINANTS OF PRICE ELASTICITY
OF DEMAND IV
● Time - The more time that passes (since
the price change), the higher the price
elasticity of demand for the good; the
less time that passes, the lower the
price elasticity of demand for the good.

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 CROSS ELASTICITY OF DEMAND I

● Measures the responsiveness in

quantity demanded of one good to
changes in the price of another good.

Complements
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 CROSS ELASTICITY OF DEMAND II

Ec > 0 → Goods are substitutes

Ec < 0 → Goods are complements

Substitutes
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 INCOME ELASTICITY OF DEMAND I

● Measures the responsiveness of

quantity demanded to changes in
income.

Ey > 0 Normal Good

Ey < 0 Inferior Good

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 INCOME ELASTICITY OF DEMAND II

 Income Elastic - The percentage change in

quantity demanded of a good is greater
than the percentage change in income.
 Income Inelastic - The percentage change
in quantity demanded of a good is less
than the percentage change in income.
 Income Unit Elastic - The percentage
change in quantity demanded of a good
is equal to the percentage change in
income

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 PRICE ELASTICITY OF SUPPLY

● Measures the responsiveness of

quantity supplied to changes in price.

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 GRAPHICAL REPRESENTATION OF
ELASTIC SUPPLY

The percentage
change in quantity
supplied is greater
than the percentage
change in price:
Es > 1 and supply is
elastic.

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 GRAPHICAL REPRESENTATION OF
INELASTIC SUPPLY

The percentage
change in
quantity
supplied is less
than the
percentage
change in price:
Es 1 and supply
is inelastic. .
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 GRAPHICAL REPRESENTATION OF
PERFECTLY ELASTIC SUPPLY

A small change in
price changes
quantity supplied
by an infinite
amount: Es = ∞
and supply is
perfectly elastic.

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 PRICE ELASTICITY OF SUPPLY AND TIME

 The longer the period of adjustment is to a

change in price, the higher the price elasticity
of supply will be.
 This refers to goods whose quantity supplied
can increase with time, a characteristic of
most goods. The obvious reason is that
additional production takes time.
 It does not, however, cover instances when
additional production may be impossible, say,
original Picasso paintings.

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 HOUSING PRICES AND ELASTICITY OF
SUPPLY
 S1 rep resents the supply of housing in city 1, and S2
represents the supply of housing in city 2.
 S1 has lower elasticity of supply than S2.
 Suppose the demand for housing in each city rises from
D1 to D2. As a result, the price of houses rises in both
cities, but it rises by more in city 1 than city 2. In other
words, the lower the elasticity of supply, the greater the
increase in price.

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 SUMMARY OF THE FOUR ELASTICITY
CONCEPTS

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 1. What does an income elasticity
of demand of 1.33 mean?
SELFTEST
The good in question is a normal good, and it
is income elastic; that is, as income rises, the
quantity demanded rises by a greater
percentage. In this case, quantity
demanded rises by 1.33 times the
percentage change in income. If income
rises by 10 percent, the quantity demanded
of the good will rise by 13.3 percent.

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 2. What does perfectly
inelastic supply signify?
SELFTEST

A change in price does not change

quantity supplied.

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