Economics

PART I
INTRODUCTION TO ECONOMICS
Elasticity
Price Elasticity of Demand

Slope and Elasticity
CHAPTER OUTLINE
Types of Elasticity
Calculating Elasticities
Calculating Percentage Changes Elasticity Is a Ratio of Percentages The Midpoint Formula Elasticity Changes Along a Straight-Line Demand Curve Elasticity and Total Revenue
CHAPTER 5 Elasticity
The Determinants of Demand Elasticity
Availability of Substitutes The Importance of Being Unimportant The Time Dimension

Other Important Elasticities
Income Elasticity of Demand Cross-Price Elasticity of Demand Elasticity of Supply

Principles of Microeconomics 9e by Case, Fair and Oster 1 of 31
2009 Pearson Education, Inc. Publishing as Prentice Hall
Elasticity
elasticity A general concept used to quantify

the response in one variable when another variable changes.
%A elasticity of A with respect to B %B
Principles of Microeconomics 9e by Case, Fair and Oster
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FIGURE 5.1 Slope Is Not a Useful Measure of Responsiveness
Changing the unit of measure from pounds to ounces changes the numerical value of the demand slope dramatically, but the behavior of buyers in the two diagrams is identical.
price elasticity of demand The ratio of the

percentage of change in quantity demanded to the percentage of change in price; measures the responsiveness of quantity demanded to changes in price.
price elasticity of demand
% change in quantity demanded % change in price
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A good way to remember the difference between the two perfect elasticities is:
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TABLE 5.1 Hypothetical Demand Elasticities for Four Products % Change In Price (% DP) +10% +10% +10% +10% % Change In Quantity Demanded (% DQD) 0% -1% -10% -30% .0 -.1 -1.0 -3.0
Product Insulin Basic telephone service Beef Bananas CHAPTER 5 Elasticity
Elasticity (% DQD %DP) Perfectly inelastic Inelastic Unitarily elastic Elastic
perfectly inelastic demand Demand in which

quantity demanded does not respond at all to a change in price.
FIGURE 5.2 Perfectly Inelastic and Perfectly Elastic Demand Curves Figure 5.2(a) shows a perfectly inelastic demand curve for insulin. Price elasticity of demand is zero. Quantity demanded is fixed; it does not change at all when price changes. Figure 5.2(b) shows a perfectly elastic demand curve facing a wheat farmer. A tiny price increase drives the quantity demanded to zero. In essence, perfectly elastic demand implies that individual producers can sell all they want at the going market price but cannot charge a higher price.

inelastic demand Demand that responds
somewhat, but not a great deal, to changes in price. Inelastic demand always has a numerical value between zero and -1. A warning: You must be very careful about signs. Because it is generally understood that demand elasticities are negative (demand curves have a negative slope), they are often reported and discussed without the negative sign.
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unitary elasticity A demand relationship in which the
percentage change in quantity of a product demanded is the same as the percentage change in price in absolute value (a demand elasticity of -1).
elastic demand A demand relationship in which the

percentage change in quantity demanded is larger than the percentage change in price in absolute value (a demand elasticity with an absolute value greater than 1).
perfectly elastic demand Demand in which quantity drops to zero at the slightest increase in price.
A WARNING:
You must be very careful about signs. Because it is generally understood that demand elasticities are negative (demand curves have a negative slope), they are often reported and discussed without the negative sign.
To calculate percentage change in quantity demanded using the initial value as the base, the following formula is used:
change in quantity demanded x 100% Q
1
% change in quantity demanded

Q -Q x 100% Q
2 1 1
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We can calculate the percentage change in price in a similar way. Once again, let us use the initial value of Pthat is, P1as the base for calculating the percentage. By using P1 as the base, the formula for calculating the percentage of change in P is
change in price % change in price x 100% P
1
P -P x 100% P
2 1 1
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Once all the changes in quantity demanded and price have been converted to percentages, calculating elasticity is a matter of simple division. Recall the formal definition of elasticity:
price elasticity of demand
% change in quantity demanded % change in price
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midpoint formula A more precise way of calculating percentages using the value halfway between P1 and P2 for the base in calculating the percentage change in price, and the value halfway between Q1 and Q2 as the base for calculating the percentage change in quantity demanded.
% change in quantity demanded
change in quantity demanded x 100% (Q Q ) / 2

1 2
Q -Q x 100% (Q Q ) / 2
2 1 1 2
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Using the point halfway between P1 and P2 as the base for calculating the percentage change in price, we get
% change in price
change in price x 100% (P P ) / 2

1 2
P -P x 100% (P P ) / 2
2 1 1 2
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Example 1: Consider the market for sales of ice cream cones at a state fair. The table below gives the market quantity demand, given that all sellers at the fair charge the same price.
You can calculate the market price elasticity of demand using the information contained in the table. For example, suppose you decide to calculate the price elasticity of demand at $2.00 by examining a price decrease from $2.00 to $1.50 per cone.
Price of Ice Cream($)
Quantity Demanded (millions) 16 13 10 7 4 1
0.50 1.00 1.50 2.00 2.50 3.00
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In this case, the demand for ice cream would increase from 7 million cones to 10 million cones. You can use these figures to calculate the price elasticity of demand as follows:
This implies the following:

The price elasticity of demand for ice cream cones at a price of $2.00, according to the demand schedule provided, is 1.72.
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Example 2: You are a cement producer who has learned some points on your firm's monthly demand curve.
You wish to plot your firm's demand curve and find the price elasticity of demand at various points along the demand curve. You decide to calculate elasticity by examining the effects of price declines from $50 to $40, $40 to $30, etc. To calculate the price elasticity of demand between a price of $50 and $40 on the demand curve, divide the percentage change in quantity demanded by the percentage change in price.
Price ($ per ton)

Quantity (thousands of tons)
50 40 30 20 10
500 600 700 800 900
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Similarly, you can find the elasticity between prices of $40 and $30, $30 and $20, and $20 and $10.For example, here is what you will find when you calculate elasticity between $40 and $30:
Notice that demand becomes increasingly less elastic as prices fall. Intuitively, this makes sense; consumers can be expected to react much more dramatically to a change in price when prices are high than when they are low.
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TABLE 5.2 Demand Schedule for Office Dining Room Lunches Price (per Lunch) $11 10 9 8 7 6 5 4 3 2 1 0 Quantity Demanded (Lunches per Month) 0 2 4 6 8 10 12 14 16 18 20 22
FIGURE 5.3 Demand Curve for Lunch at the Office Dining Room
Between points A and B, demand is quite elastic at -6.4. Between points C and D, demand is quite inelastic at -.294.
In any market, P x Q is total revenue (TR) received by producers:
TR = P x Q
total revenue = price x quantity
When price (P) declines, quantity demanded (QD) increases. The two factors, P and QD move in opposite directions:
Effects of price changes on quantity demanded:
P QD and P QD
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Because total revenue is the product of P and Q, whether TR rises or falls in response to a price increase depends on which is bigger: the percentage increase in price or the percentage decrease in quantity demanded.
Effects of price increase on a product with inelastic demand:
P x QD TR
If the percentage decline in quantity demanded following a price increase is larger than the percentage increase in price, total revenue will fall.
Effects of price increase on a product with inelastic demand:
P x QD TR
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The opposite is true for a price cut. When demand is elastic, a cut in price increases total revenues:
effect of price cut on a product with elastic demand:
P x QD TR
When demand is inelastic, a cut in price reduces total revenues:

effect of price cut on a product with inelastic demand:
P x QD TR
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Perhaps the most obvious factor affecting demand elasticity is the availability of substitutes.
When an item represents a relatively small part of our total budget, we tend to pay little attention to its price.
The elasticity of demand in the short run may be very different from the elasticity of demand in the long run. In the longer run, demand is likely to become more elastic, or responsive, simply because households make adjustments over time and producers develop substitute goods.
Who Are the Elastic Smokers?

Bill aims to raise tax on cigarettes
Seattle Times
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Elasticities at a Delicatessen in the Short Run and Long Run

The graph shows the expected relationship between long-run and short-run demand for Franks sandwiches. Notice if you raise prices above the current level, the expected quantity change read off the short-run curve is less than that from the long-run curve.
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income elasticity of demand A measure of

the responsiveness of demand to changes in income.
income elasticity of demand
% change in quantity demanded % change in income
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cross-price elasticity of demand A measure of

the response of the quantity of one good demanded to a change in the price of another good.
% change in quantity of Y demanded cross - price elasticity of demand % change in price of X
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elasticity of supply A measure of the

response of quantity of a good supplied to a change in price of that good. Likely to be positive in output markets.
elasticity of supply
% change in quantity supplied % change in price
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elasticity of labor supply A measure of the

response of labor supplied to a change in the price of labor.
% change in quantity of labor supplied % change in the wage rate
elasticity of labor supply

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The purpose of this chapter was to convince you that measurement is important. If all we can say is that a change in one economic factor causes another to change, we cannot say whether the change is important or whether a particular policy is likely to work. The most commonly used tool of measurement is elasticity, and the term will recur as we explore economics in more depth.
We now return to the study of basic economics by looking in detail at household behavior. Recall that households demand goods and services in product markets but supply labor and savings in input or factor markets.
REVIEW TERMS AND CONCEPTS
cross-price elasticity of demand elastic demand elasticity elasticity of labor supply elasticity of supply income elasticity of demand
inelastic demand midpoint formula perfectly elastic demand perfectly inelastic demand price elasticity of demand unitary elasticity
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APPEN DIX
POINT ELASTICITY (OPTIONAL)
FIGURE 5A.1 Elasticity at a Point Along a Demand Curve
Consider the straight-line demand curve in Figure 5A.1. We can write an expression for elasticity at point C as follows:
Q 100 %Q Q elasticity %P P 100 P
Q Q1 Q P 1 P P Q1 P 1
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APPEN DIX
Q/P is the reciprocal of the slope of the curve. Slope in the diagram is constant along the curve, and it is negative. To calculate the reciprocal of the slope to plug into the previous electricity equation, we take Q1B, or M1, and divide by minus the length of line segment CQ1. Thus,
Q M 1 P CQ1
Since the length of CQ1 is equal to P1, we can write:
Q M 1 P P 1
By substituting we get:
M1 P M1 P M1 1 1 elasticity P Q1 P M2 M2 1 1
APPEN DIX
FIGURE 5A.2 Point Elasticity Changes Along a Demand Curve
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PART I

Price Elasticity of Demand

The Determinants of Demand Elasticity

Availability of Substitutes The Importance of Being Unimportant The Time Dimension

Income Elasticity of Demand Cross-Price Elasticity of Demand Elasticity of Supply

2009 Pearson Education, Inc. Publishing as Prentice Hall

elasticity A general concept used to quantify

%A elasticity of A with respect to B %B

2009 Pearson Education, Inc. Publishing as Prentice Hall

Principles of Microeconomics 9e by Case, Fair and Oster

Price Elasticity of Demand

2009 Pearson Education, Inc. Publishing as Prentice Hall

FIGURE 5.1 Slope Is Not a Useful Measure of Responsiveness

Price Elasticity of Demand

price elasticity of demand The ratio of the

price elasticity of demand

% change in quantity demanded % change in price

2009 Pearson Education, Inc. Publishing as Prentice Hall

Principles of Microeconomics 9e by Case, Fair and Oster

Price Elasticity of Demand

2009 Pearson Education, Inc. Publishing as Prentice Hall

Principles of Microeconomics 9e by Case, Fair and Oster

Price Elasticity of Demand

Product Insulin Basic telephone service Beef Bananas CHAPTER 5 Elasticity

Elasticity (% DQD %DP) Perfectly inelastic Inelastic Unitarily elastic Elastic

perfectly inelastic demand Demand in which

2009 Pearson Education, Inc. Publishing as Prentice Hall

Price Elasticity of Demand

2009 Pearson Education, Inc. Publishing as Prentice Hall

Price Elasticity of Demand

2009 Pearson Education, Inc. Publishing as Prentice Hall

Principles of Microeconomics 9e by Case, Fair and Oster

Price Elasticity of Demand

elastic demand A demand relationship in which the

2009 Pearson Education, Inc. Publishing as Prentice Hall

Price Elasticity of Demand

2009 Pearson Education, Inc. Publishing as Prentice Hall

Principles of Microeconomics 9e by Case, Fair and Oster

% change in quantity demanded

2009 Pearson Education, Inc. Publishing as Prentice Hall

Principles of Microeconomics 9e by Case, Fair and Oster

2009 Pearson Education, Inc. Publishing as Prentice Hall

Principles of Microeconomics 9e by Case, Fair and Oster

% change in quantity demanded % change in price

2009 Pearson Education, Inc. Publishing as Prentice Hall

Principles of Microeconomics 9e by Case, Fair and Oster

change in quantity demanded x 100% (Q Q ) / 2

2009 Pearson Education, Inc. Publishing as Prentice Hall

Principles of Microeconomics 9e by Case, Fair and Oster

change in price x 100% (P P ) / 2

2009 Pearson Education, Inc. Publishing as Prentice Hall

Principles of Microeconomics 9e by Case, Fair and Oster

Price of Ice Cream($)

Quantity Demanded (millions) 16 13 10 7 4 1

2009 Pearson Education, Inc. Publishing as Prentice Hall

0.50 1.00 1.50 2.00 2.50 3.00

Principles of Microeconomics 9e by Case, Fair and Oster

This implies the following:

2009 Pearson Education, Inc. Publishing as Prentice Hall

Principles of Microeconomics 9e by Case, Fair and Oster

Price ($ per ton)

Quantity (thousands of tons)

2009 Pearson Education, Inc. Publishing as Prentice Hall

Principles of Microeconomics 9e by Case, Fair and Oster