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Describing Demand Describing Demand ElasticitiesElasticities

Chapter 3Chapter 3

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The Concept of The Concept of Elasticity Elasticity Elasticity is a measure of the

responsiveness of one variable to a change in another.

The most commonly used elasticity concept is price elasticity of demand.

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Price Elasticity Price Elasticity

The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price.

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Things to Note About Things to Note About ElasticityElasticity Price elasticity of demand is always

negative because price and quantity demanded are inversely related—when price rises, quantity demanded falls, and vice versa.

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Things to Note About Things to Note About ElasticityElasticity Economists have developed a

convention and talk about price elasticity of demand as an absolute value of the number.

Thus, price elasticity of demand is reported as if it were positive.

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Classifying Demand as Classifying Demand as Elastic or InelasticElastic or Inelastic It is helpful to classify demand by

relative responsiveness as elastic or inelastic.

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Elastic DemandElastic Demand

For elastic points on curves, the percentage change in quantity is greater than the percentage change in price, in absolute value.

D > 1

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Elastic DemandElastic Demand

Common sense tells us that an elastic demand means that quantity changes by a greater percentage than the percentage change in price, in absolute value.

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Inelastic Demand Inelastic Demand

For inelastic points on curves, the percentage change in quantity is less than the percentage change in price, in absolute value.

D < 1

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Inelastic DemandInelastic Demand

Common sense tells us that an inelastic demand means that the percent change in quantity is less than the percentage change in price, in absolute value.

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Elasticity Is Elasticity Is Independent of UnitsIndependent of Units Elasticity is calculated as a ratio of

percentages. Percentages allow us to have a

measure of responsiveness that is independent of units.

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Elasticity Is Elasticity Is Independent of UnitsIndependent of Units Having a measure of responsiveness

that is independent of units makes comparisons of responsiveness of different goods easier.

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Calculating ElasticitiesCalculating Elasticities

To determine elasticity, divide the percentage change in quantity by the percentage change in price.

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The Mid-point Formula The Mid-point Formula

Using the mid-point formula, the average of the two end points are used when calculating percentage change.

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Graph of Price Elasticity Graph of Price Elasticity of Demandof Demand

Elasticity of demand = 1.3

Pric

e

Quantity of software (in thousands)

$26

23

20

0

D

B

A

5 7 9

C (midpoint)

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Graph of Price Elasticity Graph of Price Elasticity of Demandof Demand

Pric

e

Quantity

$10987654321

C

D

B

A

D = 0.54

D = 4

5 10 15 20 25 30 35 40 45 50 55b) Some examples

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Calculating Elasticity at Calculating Elasticity at a Pointa Point Let us now turn to a method of

calculating the elasticity at a specific point, rather than over a range.

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Calculating Elasticity at Calculating Elasticity at a Pointa Point To calculate elasticity at a point,

determine a range around that point and calculate the elasticity using the mid-point formula.

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Calculating Elasticity at Calculating Elasticity at a Pointa Point

Pric

e

Quantity

$10 9 8 7 6 5 4 3 2 1

C

BA

24 402820

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Calculating Elasticity at Calculating Elasticity at a Pointa Point

6 12 18 30 36 42 48

Pric

e

Quantity

87654321

$109

A

24 6054

B

D= 2.33

D = 0.11

Demand

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Elasticity and Demand Elasticity and Demand CurvesCurves Two important points to consider:

Elasticity is related to (but is not the same as) slope.

Elasticity changes along a straight-line demand curve.

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Elasticity Is Not the Elasticity Is Not the Same as SlopeSame as Slope The relationship between elasticity and

slope means that the steeper the curve, the less elastic is demand.

There are two limiting examples of this.

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Elasticity Is Not the Elasticity Is Not the Same as SlopeSame as Slope When the curve is horizontal, it is

perfectly elastic. Perfectly elastic demand is a horizontal

line in which quantity changes enormously in response to any change in price (D = ).

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Elasticity Is Not the Elasticity Is Not the Same as SlopeSame as Slope When the curve is vertical, we call the

demand perfectly inelastic. Perfectly inelastic demand is a vertical

line in which quantity does not change at all in response to a change in price (D = 0).

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Perfectly inelastic demand curve

0Quantity

Perfectly Inelastic Perfectly Inelastic Demand CurveDemand Curve

Price

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Perfectly elastic demand curve

0Quantity

Perfectly Elastic Perfectly Elastic Demand Curve Demand Curve

Price

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Elasticity Changes Elasticity Changes Along Straight-Line Along Straight-Line CurvesCurves Elasticity is not the same as slope. Elasticity changes along the straight line

supply and demand curves—slope does not.

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Elasticity Changes Elasticity Changes Along Straight-Line Along Straight-Line CurvesCurves A demand curve is perfectly elastic ( D

= ) at the vertical (price) intercept.

Elasticity becomes smaller as you move down the demand curve until it becomes zero ( = ) at the horizontal (quantity) intercept.

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Pric

e

Elasticity declines along demand curve as we move toward the

quantity axis$10

987654321

0 1 2 3 4 5 6 7 8 9 10

D =

D = 1

D = 0

Quantity

Elasticity Along a Elasticity Along a Straight Line Demand Straight Line Demand Curve Curve

D < 1

D > 1

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Interpreting elasticitiesInterpreting elasticities

We know by the law of demand that consumers buy less as price rises

Price elasticity of demand tells us if whether consumers reduce their purchases by a lot (elastic demand) or a little (inelastic demand).

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Interpreting Price Elasticity of Interpreting Price Elasticity of DemandDemand

D Description of demand

Interpretation

D= Perfectly elastic Quantity responds enormously to changes in price

D>1 Elastic Consumers are responsive to price changes

D= Unit elastic Percent change in price and quantity are equal

D<1 Inelastic Consumers are unresponsive to price changes

D= Perfectly inelastic Consumers are completely unresponsive to price change

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Substitution and Price Substitution and Price Elasticity of DemandElasticity of Demand As a general rule, the more substitutes

a good has, the more elastic is its demand.

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Substitution and Price Substitution and Price Elasticity of DemandElasticity of Demand How many substitutes a good has is

affected by many factors: Time to Adjust Luxuries versus Necessities Narrow or Broad Definition Budget Proportion

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Time to AdjustTime to Adjust

The larger the time interval considered, or the longer the run, the more elastic is the good’s demand curve. There are more substitutes in the

long run than in the short run. The long run provides more options

for change.

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Luxuries versus Luxuries versus NecessitiesNecessities The less a good is a necessity, the

more elastic its demand curve. Necessities tend to have fewer

substitutes than do luxuries, so their demand is less elastic.

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Narrow or Broad Narrow or Broad DefinitionDefinition As the definition of a good becomes

more specific, demand becomes more elastic. If the good is broadly defined—for

example, transportation—there are not many substitutes and demand will be inelastic.

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Narrow or Broad Narrow or Broad DefinitionDefinition As the definition of a good becomes

more specific, demand becomes more elastic. If the definition of a good is narrowed

—to travel by bus, for example—there are more substitutes.

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Budget ProportionBudget Proportion

Demand for goods that represent a large proportion of one's budget are more elastic than demand for goods that represent a small proportion of one's budget.

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Budget ProportionBudget Proportion

Most people shop around for the lowest price on expensive items – the demand elasticity is large for those goods.

It is not worth spending the time looking for substitutes for goods which do not take much out of one’s income.

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Empirical Estimates of Empirical Estimates of ElasticitiesElasticities The following table provides short- and

long-term estimates of elasticities for a number of goods.

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Empirical Estimates of Empirical Estimates of ElasticitiesElasticities

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Price Elasticity of Price Elasticity of Demand and Total Demand and Total RevenueRevenue Total revenue is the total amount of money a

firm receives from selling its product. Revenue equals total quantity sold multiplied

by the price of good. Knowing the elasticity of demand is useful to

firms because from it they can tell what happens to total revenue when they raise or lower their prices.

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Price Elasticity of Price Elasticity of Demand and Total Demand and Total RevenueRevenue If demand is elastic ( D > 1), a rise in

price lowers total revenue. Price and total revenue move in

opposite directions.

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Price Elasticity of Price Elasticity of Demand and Total Demand and Total RevenueRevenue If demand is unit elastic ( D = 1), a rise

in price leaves total revenue unchanged.

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Price Elasticity of Price Elasticity of Demand and Total Demand and Total RevenueRevenue If demand is inelastic ( D < 1), a rise in

price increases total revenue. Price and total revenue move in the

same direction.

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A

Pric

e

Elastic Demand D > 1

Quantity

$10

8

6

4

2

0 1 2 3 4 5 6 7 8 9

Elasticity and Total Elasticity and Total RevenueRevenue

C

B

FE

Lost revenue

Gained revenue

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A

Pric

e

Inelastic Demand D < 1

Quantity

$10

8

6

4

2

0 1 2 3 4 5 6 7 8 9

Elasticity and Total Elasticity and Total Revenue Revenue

C

H

BG

Lost revenue

Gained revenue

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A

Unit Elastic Demand D = 1

Elasticity and Total Elasticity and Total Revenue Revenue

C

0 6

Pric

e

Quantity

$10

8

6

4

2

1 2 3 4 5 7 8 9

J

K

B

Lost revenue

Gained revenue

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Total Revenue Along a Total Revenue Along a Demand CurveDemand Curve Demand is elastic at prices above the

middle point where demand is unit elastic – a rise in price in that range lowers total revenue.

Demand is inelastic at prices below the middle point where demand is unit elastic – a rise in price in that range increases total revenue.

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Elastic range

D > 1

D = 1

Inelastic range

D < 1

Q0 Quantity(a)

0 0Quantity

(b)

How Total Revenue How Total Revenue Changes Along a Demand Changes Along a Demand CurveCurve

Q0

P TR

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Elasticity of Individual Elasticity of Individual and Market Demandand Market Demand Market demand elasticity is influenced

both by: How many people reduce their

quantity to zero when price increases. How much an existing consumer

marginally changes his or her quantity demanded.

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Elasticity of Individual Elasticity of Individual and Market Demandand Market Demand Price discrimination occurs when a

firm separates the people with less elastic demand from those with more elastic demand.

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Elasticity of Individual Elasticity of Individual and Market Demandand Market Demand Firms that price discriminate can charge

more to the individuals with inelastic demand and less to individuals with elastic demand.

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Elasticity of Individual Elasticity of Individual and Market Demandand Market Demand Examples of price discrimination

include: Airlines’ Saturday stay-over specials. Selling new cars at a discount. The almost-continual-sale

phenomenon.

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Other Elasticities of Other Elasticities of DemandDemand Two other demand elasticities are

important in describing consumer behaviour: Income elasticity of demand. Cross-price elasticity of demand.

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Income Elasticity of Income Elasticity of DemandDemand Income elasticity of demand is

defined as the percentage change in demand divided by the percentage change in income.

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Income Elasticity of Income Elasticity of DemandDemand Income elasticity of demand tells us

how demand responds to changes in income.

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Income Elasticity of Income Elasticity of DemandDemand An increase in income generally

increases one’s consumption of almost all goods, although the increase may be greater for some goods than for others.

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Income Elasticity of Income Elasticity of DemandDemand Normal goods are those goods whose

consumption increases with an increase in income.

They have income elasticities greater than zero (positive).

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Income Elasticity of Income Elasticity of DemandDemand Normal goods are usually divided into

two categories: luxuries and necessities.

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Income Elasticity of Income Elasticity of DemandDemand Luxuries are goods that have an

income elasticity greater than 1. Their percentage increase in quantity

demanded is greater than the percentage increase in income.

They are an “income elastic normal good”.

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Income Elasticity of Income Elasticity of DemandDemand Shoes are a necessity—a good that

has an income elasticity less than 1, but still positive (shoes are an “income inelastic normal good”).

The consumption of a necessity rises by a smaller proportion than the rise in income.

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Income Elasticity of Income Elasticity of DemandDemand Inferior goods are those whose

consumption decreases when income increases.

Inferior goods have income elasticities less than zero (negative).

Generic (store-brand) cereals are one example of inferior goods.

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Income Elasticities of Income Elasticities of Selected GoodsSelected Goods

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Coefficient

Interpretation

Description

Normal good

I Qd

Two cases of normal good:

Income inelastic normal good (“necessity”)

Income elastic normal good (“superior” good)

Inferior good

I Qd

0

10

1

Interpreting Income Interpreting Income Elasticity of DemandElasticity of Demand

0

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Cross-Price Elasticity of Cross-Price Elasticity of DemandDemand Cross-price elasticity of demand is

computed by dividing the percentage change in quantity demand by the percentage change in the price of another good.

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Cross-Price Elasticity of Cross-Price Elasticity of DemandDemand Cross-price elasticity of demand tells us

the responsiveness of demand to changes in prices of other goods.

Cross-price elasticity measures both how and how strongly consumers respond to changes in the price of related products.

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Cross-Price Elasticity of Cross-Price Elasticity of DemandDemand Depending on how consumers respond

to changes in the price of related products, goods can be classified as Substitutes or Complements

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Complements and Complements and SubstitutesSubstitutes Substitutes are goods that can be used

in place of one another. When the price of a good goes up, the

demand for the substitute good also goes up.

Cross-price elasticity of substitutes is positive

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Complements and Complements and SubstitutesSubstitutes Complements are goods that are used

in conjunction with other goods.

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Complements and Complements and SubstitutesSubstitutes A rise in the price of a good will

decrease the demand for its complement, and a fall in the price of a good will increase the demand for its complement.

The cross-price elasticity of complements is negative.

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Interpretation of Cross-Interpretation of Cross-Price ElasticityPrice Elasticity

Coefficient Interpretation Ratio

XY > 0 Substitute

Goods

PYQX

XY < 0 Complementary

Goods

PY QX

XY = 0 Unrelated Goods PY QX=0

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P0

D0 D1

P0

18 Quantity25

Shift due to rise in income

Calculating Income and Calculating Income and Cross-Price ElasticitiesCross-Price Elasticities

Price

=6.5

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Calculating Income and Calculating Income and Cross-Price ElasticitiesCross-Price Elasticities

P0 P0

3 Quantity of ketchup4

Shift due to rise in priceof hot dogs

D1

D0

Price of ketchup

XY= -0.7

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