Chapter 5Elasticity and its

Application

Measure of the responsiveness of quantity demanded or quantity supplied to one of its determinants

What is Elasticity?

Measure of how much quantity demanded responds to a change in price

Can be computed as % change in quantity demanded divided by % change in price

Price Elasticity of Demand

1. Availability of Close Substitutes: More substitutes available, more elastic demand is

2. Necessities vs. Luxuries: Necessities are less elastic

3. Definition of the market: Narrowly defined are more elastic than broadly defined ones

4. Time Horizon: Goods tend to be more elastic over longer time periods

Determinants of Price Elasticity of Demand

Put the following into its likely order from most elastic to least elastic:

BeefSaltEuropean VacationSteakNew Honda AccordDijon mustard

Let’s practice:

1. European Vacation2. New Honda Accord3. Steak4. Dijon Mustard5. Beef6. Salt

Answers

Formula is:Price Elasticity of Demand =

% Change in Quantity Demanded% Change in Price

So… if the price of of ice cream rises by 10% and quantity demanded falls by 20%

Price elasticity of demand = 2

Computing Price Elasticity of Demand

Of the following, what will have the greatest elastic effect on demand?

1 2 3 4 5

9%

82%

0%

9%

0%

1. Good A, which has few if any substitutes

2. Good A, which has many substitutes

3. Good A, which is seen as a necessity

4. Good A, which is defined very broadly (like market for soap)

5. None of the above

A 5 percent decrease in the price of good X leads to a 20 percent increase in the quantity demanded of Good X. The elasticity coefficient of demand is:

1 2 3. 4. 5

0%

92%

0%4%4%

1. 242. 43. .254. 2.255. 1

Put the following in order from most elastic to least elastic:

Eggs Rice Beef Mountain Dew Healthcare Housing Restaurant Meals

Midpoint Method The elasticity is calculated by going from

one point to another on demand curve, which will be different at different parts on curve

So, you get around it using midpoint method

Price Elasticity of Demand =(Q2 – Q1)/{(Q1+Q2)/2}(P2 – P1)/{(P1+P2)/2}

Rarely, need to use this – big idea is that you use it to counteract differences in elasticities

Midpoint Method Example:Calculate Price Elasticity of Demand if the

price rises from $4 to $6 and the resulting quantity demanded falls from 120 to 80

Answer = 1

Variety of Demand Curves

Demand is elastic if elasticity is greater than 1

Demand is inelastic if elasticity is less than 1

Demand is unit elastic if elasticity is exactly 1

Rule of Thumb for Elasticity

Flatter the demand curve, the greater the price elasticity of demand

The steeper the curve, the smaller the price elasticity of demand

Special Cases Perfectly Elastic Perfectly Inelastic

Of the following, which is not a factor that will determine elasticity of a good?1. Percent of income

spent on a good2. How the market is

defined3. Time in which the

market is viewed4. Number of

substitutes available5. Change in income

If any change in price leads to no change in quantity demanded, then demand for this good:

1 2 3 4 5

0% 0% 0%0%0%

1. Is relatively elastic2. Is perfectly inelastic3. Is relatively inelastic4. Is perfectly elastic5. The answer cannot

be determined based on the information given

A good that may be perfectly inelastic is:

1 2 3 4 5

0% 0% 0%0%0%

1. Toothpaste2. Bottled Water3. Pencils4. Insulin5. Granny Smith

apples

Total Revenue Total Revenue = Amount paid by buyers and

received by sellers of the good (P x Q) Rules about TR as it relates to Elasticity

1. When demand is inelastic, price & total revenue move in the same direction

2. When demand is elastic, price & total revenue move in opposite directions

3. If demand is unit elastic, total revenue remains constant as price changes

Linear Demand Curves Slope is constant, but elasticity isn’t

Income Elasticity of Demand

Income Elasticity Demand =% Change in Quantity Demanded % Change in Income

Normal = positive income elasticityInferior = negative income elasticity

Necessities = small income elasticityLuxuries = large income elasticity

Cross-Price Elasticity of Demand

Shows if goods are substitutes or complements

% Change in Quantity Demanded of Good 1% Change in Price of Good 2

Substitutes = Positive Cross-Price ElasticityComplements = Negative Cross-Price

Price Elasticity of Supply

% Change in Quantity Supplied% Change in Price

Depends on flexibility of sellers to change the amount of the good they produce

Time period is key determinant (more elastic in long run)

Variety of Supply Curves Flat supply curves show more elasticity;

more vertical supply curve is more inelastic Perfectly Inelastic = Vertical;

Perfectly Elastic = Horizontal