Chapter

Elasticity and Its Application

5

Types of Elasticities• Generally 3 categories we are concerned about

– Price elasticity• Own-price:

– How quantity demanded changes with the (own) price • Cross-price

– How quantity demanded changes with another (cross) good’s price changes

– Income• How quantity demanded changes with a change in your income

– Supply elasticity• How quantity supplied changes with a change in (own/market) price

Table 4.1 Factors That Shift the Demand Curve

Own-Price (Demand) Elasiticity

• Economist use the (own) price elasticity of demand to summarize how responsive quantity demanded is to price

• Demand curves are not always linear; and responsiveness can change with price

%

%dchangein Q

elasticitychangein price

The own-price elasticity of demand (d, e)

1

5

(d) Elastic demand: Elasticity > 1

1. an

Price

Quantity 0

$5

4

1. A 22%increasein price…

2. … leads toa 67% decreasein quantitydemanded

Demand

10050

The price elasticity of demand determines whether the demand curve is steep or flat.Note that all percentage changes are calculated using the midpoint method.

(e) Perfectly elastic demand: Elasticity equals infinity

1. an

Price

Quantity 0

Demand $4

1. At any priceabove $4, quantitydemanded is zero 2. At exactly $4,

consumers willbuy any quantity

3. At any pricebelow $4, quantitydemanded is infinite

The (own-price) Elasticity of Demand

• Determinants of (own) price elasticity of demand– Availability of close substitutes

• Goods with close substitutes– More elastic demand

– Necessities vs. luxuries• Necessities – inelastic demand• Luxuries – elastic demand

– Definition of the market• Narrowly defined markets – more elastic demand

– Time horizon– More elastic over longer time horizons

6

The (own-price) Elasticity of Demand

• Variety of demand curves: own-price (absolute value)– Demand is elastic

• Elasticity > 1 => ΔQ/Q > ΔP/Praise price => ΔTot Rev < 0

– Demand is inelastic• Elasticity < 1 => ΔQ/Q < ΔP/P

raise price => ΔTot Rev > 0

– Demand has unit elasticity• Elasticity = 1 => ΔQ/Q = ΔP/P => ΔTot Rev = 0

7

The Elasticity of Demand• Cigarettes (US)[41]

– -0.3 to -0.6 (General) – -0.6 to -0.7 (Youth) – proportion of income?

• Soft drinks – -0.8 to -1.0 (general)[51] (broadly defined)– -3.8 (Coca-Cola)[52] (narrow)– -4.4 (Mountain Dew)[52] (narrow)

• Car fuel[45] – -0.25 (Short run) (same car – reduce trips)– -0.64 (Long run) (new car?)

8

The Elasticity of Demand

• Total revenue – Amount paid by buyers– Received by sellers of a good– Computed as: price of the good times the

quantity sold (P ˣ Q)

9

Figure

Total revenue

2

10

1. an

P

Q

P ˣ Q=$400(revenue)

Quantity 0

Demand

Price

The total amount paid by buyers, and received as revenue by sellers, equals the area of the box under the demand curve, P × Q. Here, at a price of $4, the quantity demanded is 100, and total revenue is $400.

100

$4

The Elasticity of Demand

• When demand is inelastic– Price and total revenue move in the same

direction• When demand is elastic

– Price and total revenue move in opposite directions

• If demand is unit elastic– Total revenue remains constant when the

price changes

11

The Elasticity of Demand

• Elasticity and total revenue along a linear demand curve

• Linear demand curve– Constant slope– Different elasticities

• Points with low price & high quantity– Inelastic

• Points with high price & low quantity– Elastic

12

Figure

Elasticity of a linear demand curve (graph)

4

13

1. an

Quantity 0

Price

Demand

$7

14

6

5

4

3

2

1

2 4 6 8 10 12

Elasticityis largerthan 1

Elasticityis smallerthan 1

The slope of a linear demand curve is constant, but its elasticity is not. The demand schedule in the table was used to calculate the price elasticity of demand by the midpoint method. At points with a low price and high quantity, the demand curve is inelastic. At points with a high price and low quantity, the demand curve is elastic.

Figure

Elasticity of a linear demand curve (schedule)

4

14

The slope of a linear demand curve is constant, but its elasticity is not. The demand schedule in the table was used to calculate the price elasticity of demand by the midpoint method. At points with a low price and high quantity, the demand curve is inelastic. At points with a high price and low quantity, the demand curve is elastic.

Price Quantity Total revenue

(Price ˣ Quantity)

PercentageChangein Price

Percentage Change inQuantity Elasticity Description

$76543210

O2468

101214

$01220242420120

151822294067

200

200674029221815

13.03.71.81.00.60.30.1

ElasticElasticElasticUnit elasticInelasticInelasticInelastic

Figure The Elasticity of Demand• Income elasticity of demand

– Measure of how much the quantity demanded of a good responds

• To a change in consumers’ income– Percentage change in quantity demanded

• Divided by the percentage change in income– Normal goods: positive income elasticity

• Necessities: smaller income elasticities (~0, <1)• Luxuries: large income elasticities ( > 1)

– Inferior goods: negative income elasticities (<0)

15

Figure The Elasticity of Demand

• Cross-price elasticity of demand – Measure of how much the quantity demanded of one good

responds• To a change in the price of another/different good

– [∆Qx/Qx] / [∆Py/Py ]– Sign matters -> tells whether substitute or complement

• Magnitude (<1 or >1) -> how “good” a substitute/essential a complement

– Substitutes: Positive cross-price elasticity• >1 -> “close” or good substitute as big shift with small price change

– Complements: Negative cross-price elasticity• >1 -> “essential” to be used/consumed together (cars and gas)

16

FigureTable 4.2

Factors That Shift the Supply Curve