Elasticity: Learning Objectives

First Pages
chapter 4
Elasticity
LEARNING OBJECTIVES
LO 4.1
Calculate price elasticity of demand using the mid-point method.
LO 4.2
Explain how the determinants of price elasticity of demand affect the

degree of elasticity.
LO 4.3
Calculate price elasticity of supply using the mid-point method.
LO 4.4
Explain how the determinants of price elasticity of supply affect the

degree of elasticity.
LO 4.5
Calculate cross-price elasticity of demand, and interpret the sign of

the elasticity.
LO 4.6
Calculate income elasticity of demand, and interpret the sign of the

elasticity.
COFFEE BECOMES CHIC

In the 1990s, a coffeehouse craze rippled through middle-class communities in the
United States, as a strong economy bolstered sales of high-priced espresso drinks.
Soon Americans were making daily pilgrimages to a place called Starbucks, where a
cup of coffee had been transformed into the Starbucks experience, complete with
soundtrack, mints, and charity-themed water bottles. For 15 years the Starbucks
business model was highly successful. From 1992 through 2007, the company expanded
by over 15,000 stores.
When the U.S. economy stumbled in 2008, however, Starbuckss growth rate dropped
to an all-time low. Competitors and customers began to ask, How much is too much
for a cup of coffee? Presumably, Starbucks executives had asked themselves that very
question over the course of more than a decade. Given the companys phenomenal rate
of expansion, they must have had the right answerat least until the economy started
having problems.
How do businesses like Starbucks make pricing decisions? How do they anticipate and
react to changing circumstances? We learned in the last chapter that if Starbucks raises
the price of their lattesperhaps due to a coffee supply shortage caused by poor weather
in Ethiopiathis would reduce the quantity demanded by consumers. Elasticity allows
us to determine how much this change in prices will affect consumers.
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PART 2
Supply and Demand
Li
Like
the market for cell phones, the market for gourmet coffee is not perfectly
competitive. Managers of a big company like Starbucks have some ability to set
co
prices, and they try to choose those specific prices that will earn the largest profits.
They also try to respond to changing market conditions: How much will sales
fall if the price of coffee beans drives up the cost of a latte? How much will people
decrease their coffee consumption during a recession? How many customers
will be lost if competitors like Dunkin Donuts and McDonalds offer less-expensive
coffee? Even in perfectly competitive markets, producers want to predict how
their earnings will change in response to economic conditions and changes in the
market price.
Similarly, airlines want to calibrate the price of each flight to each destination so as
to m
maximize their profits. Even nonprofit service providers, such as some hospitals, need
to think about this, as they try to set the price of care so as to cover their costs without
driving away too many patients. The ability to answer questions like these is critical
for any public or private organization. Understanding how to price a Starbucks latte
requires the same kind of thinking as figuring out whether to give away or to charge for
anti-malaria treatments in poor countries, or whether to raise entrance fees to national
parks to cover the costs of maintaining the wilderness. Solving these challenges relies
on a tool called elasticity, a measure of how much supply and demand will respond to
changes in price and income.
In this chapter, you will learn how to calculate the effect of a price change on
the quantity supplied or demanded. You will become familiar with some rules
that businesses and policy-makers follow when they cannot measure elasticity
exactly. Using what you know about supply and demand, you will be able to
categorize different types of goods by noting whether their elasticities are positive or negative. You will also learn how to use a rough approximation of price
elasticity to tell whether raising prices will raise or lower an organizations total
revenue.
What Is Elasticity?
elasticitya
measure of how
much consumers and
producers will respond
to a change in market
conditions
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If Starbucks raises the price of a latte, we can expect the quantity of lattes
demanded to fall. But by how much? Although we saw in Chapter 3 that price
increases cause the quantity demanded to fall in a competitive market, we have
not yet been able to say how big that movement will be. That question is the subject
of this chapter.
Elasticity is a measure of how much consumers and producers will respond to a
change in market conditions. The concept can be applied to supply or demand, and
it can be used to measure responses to a change in the price of a good, a change in
the price of a related good, or a change in income.
The concept of elasticity allows economic decision makers to anticipate how others will respond to changes in market conditions. Whether you are a business owner
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111
trying to sell cars or a public official trying to set sales taxes, you need to know how
much a change in prices will affect consumers willingness to buy.
The most commonly used measures of elasticity are price elasticity of demand
and price elasticity of supply. These two concepts describe how much the quantity demanded and the quantity supplied change when the price of a good
changes. The cross-price elasticity of demand describes what happens to the quantity demanded of one good when the price of another good changes. Another
helpful measure, income elasticity of demand, measures how much the quantity
demanded reacts to changes in consumers incomes. Lets begin with price elasticity of demand.
Price Elasticity of Demand

Price elasticity of demand describes the size of the change in the quantity demanded
of a good or service when its price changes. As weve mentioned, quantity demanded
generally decreases when the price increases, but so far we have not been able to say
how much it decreases. Price elasticity of demand fills this gap in our understanding
of supply and demand.
Another way to think about price elasticity of demand is as a measure of consumers sensitivity to price changes. When consumers buying decisions are highly
influenced by price, we say that their demand curve is more elastic, meaning that a
small change in price causes a large change in the quantity demanded. When consumers are not very sensitive to price changesthat is, when they will buy approximately the same quantity, regardless of the pricewe say that their demand curve
is less elastic.
price elasticity
of demandthe size
of the change in the
quantity demanded
of a good or service
when its price changes
Calculating price elasticity of demand

LO 4.1 Calculate price elasticity of demand using the mid-point method.
Consider the challenge Starbucks faced in shoring up falling sales during the
recession. One tactic that a business might try in this situation is to lower its prices
by offering a sale. But would a sale work? How much could Starbuckss managers expect purchases to increase as a result of the sale? In other words, How will
customers respond to a sale? The ability to answer this question is a critical tool
for businesses. To do so, we need to know the price elasticity of demand for Starbucks coffee.
Lets say that Starbucks usually charges $2 for a cup of coffee. What might
happen if Starbucks offered a special sale price of $1.50? Suppose that before the
sale, Starbucks sold 10 million cups of coffee in the United States each day. Now,
say that consumers react to the sale by increasing the quantity demanded to
15 million cups per day. Figure 4-1 shows the quantity demanded before and
after the sale as two points on the demand curve for coffee. Based on the results
of this sale, what can we say about consumers sensitivity to the price of coffee
at Starbucks?
Mathematically, price elasticity is the percentage change in the quantity of a good
that is demanded in response to a given percentage change in price. The formula
looks like this:
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FIGURE 4-1
Elasticity of the demand for coffee
Price ($)
3
2.5
A
2
1. When price
decreases by
25%
1.5
D
1
2. quantity
demanded
increases
by 50%.
0.5
10
15
20
Quantity of coffee (millions of cups)

When the price of coffee is $2 a cup, consumers demand
10 million cups. If the price falls to $1.50 per cup, the
quantity demanded increases to 15 million cups.
Equation 4-1
% change in Q demanded
Price elasticity of demand 5 _______________________
% change in P
If we plug the original and sale quantities and prices into Equation 4-1, what
do we find? The price was cut by 25 percent, and the quantity demanded rose by
50 percent. That tells us that the price elasticity of demand is 22.0.
(15 million 2 10 million)
[
]
10 million
2
2 2.00)
[ (1.502.00
]
______________________
________________________
____________
50% 5 22.0
5 ______
225%
HINT
A percentage change is the difference between the starting and ending levels divided by
the starting level, expressed as a percentage. So a percentage change in quantity would
be expressed as:
(Q2 2 Q1)
3 100
Percentage change in quantity 5 _________
Q1
Similarly, a percentage change in price would be expressed as:
(P2 2 P1)
Percentage change in price 5 ________
3 100
P1
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POTENTIALLY CONFUSING
Some books print the negative sign of elasticity estimates; others do not. Another way
to think of an elasticity measure is as an absolute value. The absolute value of a number
is its distance from zero, or its numerical value without regard to its sign. For example,
the absolute values of 4 and 24 are both 4. Thus, the absolute value of an elasticity
measure is always positive.
Note that the price elasticity of demand will always be a negative number. Why?
Because price and quantity demanded move in opposite directions. That is, a positive change in price will cause a negative change in the quantity demanded, and
vice versa. However, be aware that economists often drop the negative sign and
express the price elasticity of demand as a positive number, just for the sake of convenience. Dont be fooled! Under normal circumstances, price elasticity of demand
is always negative, whether or not the negative sign is printed.
You might be wondering why we work with percentages in calculating elasticity.
Why not just compare the change in the quantity demanded to the change in price?
The answer is that percentages allow us to avoid some practical problems. Think
about what would happen if one person measured coffee in 12-ounce cups, while
another measured it by the pot or the gallon. Without percentages, we would have
several different measures of price elasticity, depending on which unit of measurement we used. To avoid this problem, economists use the percentage change in quantity rather than the absolute change in quantity. That way, the elasticity of demand for
coffee is the same whether we measure the quantity in cups, pots, or gallons.
Using the mid-point method

Unfortunately, even when we use percentages, we still have a measurement
problem: The answer changes depending on which direction we move along the
demand curve. We saw that when the price dropped from $2 to $1.50, the elasticity
of demand was 22.0:

______________________
10 million
________________________
2 2.00)
[ (1.502.00
]
____________
50% 5 22.0
5 ______
225%
What happens if we calculate the price elasticity from the other direction? Suppose that Starbucks ends the sale and puts the price of coffee back up from $1.50 to
$2. This action causes the quantity demanded to fall from 15 million cups back down
to 10 million. Note that while dropping from $2 to $1.50 was a 25 percent reduc$0.50
525 Percent , increasing from $1.50 to $2 is a 33 percent increase
tion in price ____
$2.00
$0.50
____
5
33
Percent
. Similarly, going from a quantity of 15 million to 10 million is a
$1.50
33 Percent decrease, whereas going from 10 million to 15 million is a 50 percent
increase. Plugging these figures into our equation, we find that the elasticity of
demand now seems to be 21.0:
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______________________
15 million
________________________
2 1.50)
[ (2.001.50
]
____________
33%
5 2____ 5 21.0
33%
mid-point
methodmethod that
measures percentage
change in demand (or
supply) relative to a
point midway between
two points on a curve;
used to estimate
elasticity
This is a headache. Were moving between the same two points on the demand
curve, with the same change in price and quantity ($0.50 and 5 million cups), but
in one direction we find an elasticity of demand of 2.0 and in the other direction
its 21.0. Wed like to have a consistent way to estimate the elasticity of demand
between two points on the demand curve, regardless of the direction of the
movement.
The mid-point method solves our problem: It measures the percentage change
relative to a point midway between the two points. Using the mid-point method, we
find the percentage change in quantity by dividing the change in quantity by the
average of (that is, the mid-point between) the old and new quantities:
Equation 4-2
Change in Q
% change in Q 5 ____________
Average of Q
In the denominator of this expression, the mid-point (average) quantity is equal

to the sum of the two quantities divided by 2. We can find the mid-point price in
the same way:
(Q1 1 Q2)
Mid-point of Q 5 _________
2
(P1 1 P2)
Mid-point of P 5 ________
2
In our example, the demand for coffee went from 10 million cups at $2 to 15 million cups at $1.50. So the average (mid-point) quantity was 12.5 million, and the
average (mid-point) price was $1.75.
The formula for the price elasticity of demand using the mid-point method is
shown in Equation 4-3.
Equation 4-3
Price elasticity of demand
[[
[[
]
]]
(Q2 2 Q1)
___________
(Q1 1 Q2)
_________
2
____________
5
(P2 2 P1)
__________
(P1 1 P2)
________
2
Using Equation 4-3, we find that the price elasticity of demand is the same
whether we move from a lower price to a higher one or vice versa. For a price
decrease, the elasticity is:
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115

______________________
12.5 million
________________________
2 2.00)
[ (1.501.75
]
____________
40% 5 21.38
5 ______
229%
For a price increase, the elasticity is:

2 15 million)
[ (10 million
]
12.5 million
(2.00 2 1.50)
[ 1.75 ]
______________________
________________________
____________
240% 5 21.38
5 ______
29%
Our measure for the price elasticity of demand is now consistent.
Determinants of price elasticity of demand

LO 4.2 Explain how the determinants of price elasticity of demand affect the degree
of elasticity.
How would your quantity demanded of lattes (or your drink of choice) change if
the price fell from $3 to $1.50? Now, how much would your quantity demanded of
cotton socks change if the price fell from $10 per pack to $5? Although both represent a 50 percent price reduction, we suspect that the former might change your
buying habits more than the latter. Socks are socks, and $5 savings probably wont
make you rush out and buy twice as many.
The underlying idea here is that consumers are more sensitive to price changes
for some goods and services than for others. Why isnt price elasticity of demand the
same for all goods and services? Many factors determine consumers responsiveness to price changes. The availability of substitutes, relative need and relative cost,
and the time needed to adjust to price changes all affect price elasticity of demand.
Availability of substitutes. Recall from Chapter 3 that substitutes are

goods that are distinguishable from one another, but have similar uses. When
the price of a good with a close substitute increases, consumers will buy the
substitute instead. If close substitutes are available for a particular good, then
the demand for that good will be more elastic than if only distant substitutes are
available. For example, the price elasticity of demand for orange juice is likely
to be relatively elastic; if the price gets too high, many consumers may switch to
grapefruit juice.
Degree of necessity. When a good is a basic necessity, people will buy it even if
prices rise. The demand for socks probably is not very elastic, nor is the demand for
home heating during the winter. Although people may not like it when the prices
of these goods rise, they will buy them to maintain a basic level of comfort. And
when prices fall, they probably wont buy vastly more socks or make their homes
a lot hotter.
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In comparison, the demand for luxuries like vacations, expensive cars, and
jewelry is likely to be much more elastic. Most people can easily do without these
goods when their prices rise. Note, however, that the definition of a necessity
depends on your standards and circumstances. In Florida, air conditioning may
be a necessity and heating a luxury; the opposite is likely to be true in Alaska.
Cost relative to income. All else held equal, if consumers spend a very
small share of their incomes on a good, their demand for the good will be less
elastic than otherwise. For instance, most people can get a years supply of salt
for just a few dollars. Even if the price doubled, a years supply would still
cost less than $10, so consumers probably would not bother to adjust their salt
consumption.
The opposite is also true: If a good costs a very large proportion of a persons
income, like going on a luxury three-week vacation to the beach, the demand
for the good will be more elastic. If the price of rooms at high-end beach-front
hotels doubles, then a lot of people will decide to do something else with their
vacations.
Adjustment time. Goods often have much more elastic demand over the long run
than over the short run. Often, adjusting to price changes takes some time. Consider
how you might react to an increase in the price of gasoline. In the short run, you
might cancel a weekend road-trip, but you would still have to do the same amount
of driving as usual to school, work, or the grocery store. Over a year, however, you
could consider other choices that would further reduce your consumption of gas,
such as buying a bus pass or a bicycle, getting a more fuel-efficient car, or moving
closer to work or school.
perfectly elastic
demanddemand
for which the demand
curve is horizontal, in a
way such that demand
could be any quantity
at the given price, but
drops to zero if the
price increases
perfectly inelastic
demanddemand
for which the demand
curve is vertical, in a
way such that that the
quantity demanded is
always the same no
matter what the price
kar11498_ch04_109-140.indd 116
Scope of the market. A major caveat to the determinants just described is that
each depends on how you define the market for a good or service. The price elasticity of demand for bananas might be high, but the price elasticity of demand for
fruit could still be low, because there are more substitutes for bananas than for the
broader category of fruit. Similarly, although water might have a very low price
elasticity of demand as a basic necessity, the demand for bottled water could be
extremely elastic.
Using price elasticity of demand

When we make decisions in the real world, we often dont know the exact price
elasticity of demand. But we dont always need to estimate elasticity precisely to
know that consumers will react differently to price changes for lattes than for socks.
Instead, businesses and other decision makers often know something general about
the shape of the demand curve they are facing. Being able to place goods into several broad categories of elasticity can facilitate real pricing decisions in situations
without full information.
At the extremes, demand can be perfectly elastic or perfectly inelastic. When
demand is perfectly elastic, the demand curve is horizontal, as shown in panel A of
Figure4-2. This graph indicates that consumers are very sensitive to price, because
demand drops to zero when the price increases even a minuscule amount. When
demand is perfectly inelastic, the demand curve is vertical, as shown in panel B of
Figure4-2. In this case, the quantity demanded is the same no matter what the price.
These two extremes rarely occur in real life.
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FIGURE 4-2
Perfectly elastic and perfectly inelastic demand
(A) Perfectly elastic demand Elasticity 5 infinite
Consumers
will buy any
quantity at a
price of $5.
(B) Perfectly inelastic demand Elasticity 5 0
Price ($)
Price ($)
10
10
At prices
higher than $5,
the quantity
demanded is 0.
5
Quantity
10
When demand is perfectly elastic, the

demand curve is horizontal. At prices
above $5, consumers will not buy any
quantity of the good.
At any
price, the
quantity
demanded
is the
same.
5
Quantity
10
When demand is perfectly inelastic, the

demand curve is vertical. Consumers will
always demand the same quantity of a
good, regardless of the price.
Between these two extremes, elasticity is commonly divided into three quantifiable categories: elastic, inelastic, and unit-elastic. When the absolute value of the
price elasticity of demand is greater than 1, we call the associated demand elastic.
With elastic demand, a given percentage change in the price of a good will cause an
even larger percentage change in the quantity demanded. For example, a 40 percent
change in price might lead to a 60 percent change in the quantity demanded. Panel A
of Figure4-3 illustrates elastic demand.
When the absolute value of the price elasticity of demand is less than 1, we say
that demand is inelastic. With inelastic demand, a given percentage change in price
will cause a smaller percentage change in the quantity demanded. For example, a
40 percent change in price might lead to a 20 percent change in the quantity
demanded. Panel B of Figure4-3 illustrates inelastic demand.
If the absolute value of elasticity is exactly 1that is, if a percentage change in
price causes the same percentage change in the quantity demandedthen we
say that demand is unit-elastic. In this case, a 40 percent change in price leads to a
40 percent change in the quantity demanded. Panel C of Figure4-3 illustrates unitelastic demand.
As well see later in this chapter, these termselastic, inelastic, and unitelasticcan be used to describe any sort of elasticity, not just the price elasticity
of demand. Although these categories may sound academic, they can have serious implications for real-world business and policy decisions. The Real Life box,
Does charging for bednets decrease malaria? describes a case in which knowing whether the price elasticity of demand is elastic or inelastic is a matter of life
and death.
Knowing whether the demand for a good is elastic or inelastic is extremely useful
in business, because it allows a manager to determine whether a price increase will
elasticdemand that
has an absolute value
of elasticity greater
than 1
inelasticdemand
that has an absolute
value of elasticity less
than 1
unit-elasticdemand
that has an absolute
value of elasticity
exactly equal to 1
To improve your
understanding of
elastic, inelastic,
and unit-elastic
demand, try
the interactive
graphing
tutorial at www.
mhhe.com/
karlanmorduch.
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FIGURE 4-3
Elastic, inelastic, and unit-elastic demand
1. After price decreases by 40% under
(A) Elastic demand
(C) Unit-elastic demand
(B) Inelastic demand
Price ($)
Price ($)
Price ($)
10
9
8
7
6
5
4
3
2
1
10
9
8
7
6
5
4
3
2
1
10
9
8
7
6
5
4
3
2
1
2.quantity
demanded
increases by 60% .
9 10
2. quantity
demanded
increases by 20%.
Quantity
9 10
2. quantity
demanded
increases by 40%.
Quantity
With an elastic demand curve, a

small change in price leads to a big
change in the quantity demanded.
As a result, the price elasticity of
demand is greater than 1.
With an inelastic demand curve,

even a large price change has a
small effect on the quantity
demanded. As a result, the price
elasticity of demand is less than 1.
9 10
Quantity
When demand is unitelastic, the

percentage change in price equals
the percentage change in quantity,
so that the price elasticity of
demand is exactly 1.
REAL LIFE
Does charging for bednets decrease malaria?
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Around the world, malaria kills millions of young people every year. There is no
vaccine to protect children from malaria. There is a way to escape the disease,
though: sleep under a bednet that has been treated with insecticide. Bednets prevent malaria by shielding people from disease-carrying mosquitoes.
Organizations that want to promote the use of bednets to fight malaria face a
practical question: Would charging a fee for bednets be more effective in reducing
the illness than handing out the nets for free?
Those who advocate charging a fee argue that people who pay for the nets will
value them more, and will probably use them more, than those who receive the
nets for free. These advocates expect that fewer nets will be wasted on people who
dont really want them and that people who do buy them will be more likely to
use them. Moreover, if people pay for their bednets, provider organizations will
be able to afford to distribute more of them. On the other hand, the law of demand
states that the higher the price, the lower the quantity demanded is likely to be.
Even if charging a fee would make some people more likely to use the nets, it
might dissuade others from getting them, thus undermining the aim of the antimalaria campaign.
To settle this question, health organizations needed to know the price elasticity of the demand for bednets. Working in Kenya, economists Jessica Cohen of
the Harvard School of Public Health and Pascaline Dupas of Stanford set up an
experiment to try both methods and to measure the price elasticity of demand for
bednets. As it turned out, charging a fee greatly reduced the quantity of the nets
demanded. In the experiment, the number of people who took bednets dropped
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by 75 percent when the price increased from zero to $0.75. Nor did people who
bought bednets at that price use them more effectively than those who received
them for free.
If profit were the goal in this campaign, a few bednets sold at $0.75 would generate more revenue than a lot of bednets given away for free. But the goal was to
protect people from malaria, not to make a profit. For organizations with a social
mission, free distribution of bednets seems more effective than charging a fee.
Source: J. Cohen and P. Dupas, Free distribution or cost sharing? Evidence from a randomized malaria prevention experiment, Quarterly Journal of Economics 125, no.1 (February 2010): 145.
cause total revenue to rise or fall. Total revenue is the quantity of a good or service
that is sold multiplied by the price paid for each unit. This number is important
for an obvious reason: It tells us how much money sellers receive when they sell
something.
An increase in price affects total revenue in two ways:
It causes a quantity effect, or a decrease in revenue that results from selling
fewer units of the good.
It causes a price effect, or an increase in revenue that results from receiving a
higher price for each unit sold.
Figure4-4 shows both the quantity effect and the price effect. When the quantity
effect outweighs the price effect, a price increase will cause a drop in revenue, as
it does in Figure4-4. When the price effect outweighs the quantity effect, a price
increase will raise total revenue.
total revenuethe
quantity of a good or
service that is sold
multiplied by the price
paid for each unit
To improve your
understanding of
the quantity and
price effects of a
price change, try
the interactive
graphing tutorial
at www
.mhhe.com/
karlanmorduch.
FIGURE 4-4
Effect of a price increase on total revenue
Price ($)
500
Price effect
2 1 3 5 total revenue
after the price change.
450
Quantity effect
400
350
300
1. As price
increases
1 1 2 5 total revenue
before the price
change.
250
200
150
100
1
2. quantity
decreases.
50
0
10
12
14
D
16
18
20
Quantity
The colored rectangles represent total revenue at two different prices.

As the price increases from $250 to $350, total revenue is affected in
two ways. The blue rectangle represents the increase in revenue received
for each unit sold (the price effect). The yellow rectangle represents the
decrease in total revenue as the number of units sold drops (the quantity
effect). The elasticity of demand determines which effect is larger. In this
case, the yellow area is larger than the blue area, meaning that the quantity
effect outweighs the price effect, and total revenue decreases.
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FIGURE 4-5
Elasticity and changes in total revenue
(A) Elastic demand
(B) Inelastic demand
Price ($)
Price ($)
Price effect
Price effect
Quantity effect
4
Quantity effect
4
When demand is
elastic, the quantity
effect outweighs the
price effect.
When demand is inelastic,

the price effect outweighs
the quantity effect.
D
0
3
4
5
6
7
Quantity (thousands)
10
In this market, demand is elastic. At a price of

$1, 5,000 units are sold for a total revenue of $5,000.
If the price increases to $2, only 1,000 units are sold
for a total revenue of only $2,000. The quantity
effect outweighs the price effect.
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kar11498_ch04_109-140.indd 120
3
4
5
6
7
Quantity (thousands)
10
In this market, demand is inelastic. At a price of

$1, 5,000 units are sold for a total revenue of
$5,000. If the price increases to $3, the number
of units sold drops by only 1,000, to 4,000 units.
Because the price effect outweighs the quantity
effect, total revenue climbs to $12,000, an
increase of $7,000.
When demand is elastic, a price increase causes total revenue to fall. We

already know that when demand is elastic, a change in price will cause a larger
percentage change in quantity demanded. Another way of saying this is that the
quantity effect outweighs the price effect. So when demand is elastic, a price
increase causes a proportionally larger decrease in the quantity demanded, and
total revenue falls.
Conversely, when demand is inelastic, the percentage change in price is larger
than the percentage change in quantity demanded. The price effect outweighs the
quantity effect, and total revenue increases. With inelastic demand, then, consumers will purchase less of a good when prices rise, but the change in the quantity
demanded will be proportionally less than the change in price. Figure4-5 shows
this trade-off between the price and quantity effects. As you can see, panel A shows
an elastic demand in which a $1 change in price causes the quantity demanded to
increase by 4,000. With the inelastic demand curve in panel B, a $2 decrease in price
increases quantity demanded by only 1,000.
There is one final point to make. So far, everything weve said has described
elasticity at a particular spot on the demand curve. For most goods, however, elasticity
varies along the curve. So when we said that the price elasticity of demand for coffee was 1.38, we meant that it was 1.38 for a price change from $1.50 to $2 a cup. If
the price changes from $2 to $2.50, the elasticity will be different.
Dont panic; the reasoning behind this fact is common sense. Imagine that the
price of lattes plummets to 10 cents, and you get into the habit of buying one
every morning. What would you do if you showed up one morning and found
that the price had doubled overnight, to 20 cents? We bet youd shrug and buy
one anyway.
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FIGURE 4-6
Changes in elasticity along the demand curve
(A) Demand and revenue schedule
(B) Price elasticity
Price
($)
Quantity
Total
revenue
($)
50
50
45
45
45
40
80
40
35
105
35
30
120
30
25
125
20
120
15
105
10
80
45
10
Price ($)
55
E
(C) Total revenue

a
Total revenue ($)

s
125
c
it
Un tic
s
ela
75
25
100
50
t
15
25
10
5
0
This table lists the data shown in the

graphs in panels A and B. Quantity
demanded always increases as price
falls. Total revenue rises until the price
falls to $25, then falls at lower prices.
Elastic
demand:
decreasing
price
increases
revenue
20
Price elasticity of demand varies along

the demand curve. Above a certain
price, demand is elastic; below it,
demand is inelastic.
10 D
4 5 6
Quantity
10
This graph shows total revenue along the

demand curve shown above. Total revenue
first rises, but then begins to fall as demand
moves from elastic to inelastic.
Now, imagine the price of lattes has skyrocketed to $10, and you buy them only as
occasional treats. If you arrive at the coffee shop and find the price has doubled to $20,
what will you do? Youd probably consider very carefully whether you really need that
latte. In both cases, you would be responding to a 100 percent increase in price for the
same product, but you would react very differently. This makes perfect sense: In one
case, the latte costs you only 10 more cents, but in the other, it costs an additional $10.
Your reactions to the latte illustrate a general rule: Demand tends to be more
elastic when price is high and more inelastic when price is low. This brings us to an
important caveat about the three graphs shown in Figure4-3. Although the example
of an elastic demand curve in panel A has a steeper slope than the inelastic demand
curve in panel B, we now know that slope is not the same as elasticity.
In fact, the elasticity of demand is different at different points along a linear demand
curve. The reasoning is nonintuitive, but straightforward when you think about it
graphically. Look at Figure4-6. The line in panel B has a constant slope, but the percentage changes in price and quantity are very different at either end of the curve.
For instance, going from $45 to $40 is a much smaller difference (in percentage terms)
than from $10 to $5, but the slope of the curve is the same between both sets of points.
The result is that as we move along a linear demand curve, revenue first increases
and then decreases with higher prices. Panel C graphs out the total revenue curve
associated with the demand curve in panel B, using calculations from the schedule
in Panel A. Note that when the price is high, lowering the price will increase revenue. For example, when the price decreases from $45 to $40 (see the schedule), total
revenue almost doubles, from $45 to $80. When the price is low, however, lowering
it further decreases total revenue. Moving from $10 to $5, for example, decreases
total revenue from $80 to $45.
kar11498_ch04_109-140.indd 121
Inelastic
demand:
decreasing
price
decreases
revenue
For a refresher
on slope versus
elasticity, see
Appendix C,
Math Essentials:
Calculating
Percentage
Change, Slope,
and Elasticity,
which follows this
chapter.
121
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122
PART 2
Supply and Demand
Price elasticity of demand has all sorts of real-world applications. See, for example, the issue discussed in the What Do You Think? box, Should entrance fees at
national parks be raised?
WHAT DO YOU THINK?

Should entrance fees at national parks be raised?
The National Park Service is the steward of 84 million acres of Americas most
famous natural spaces, including Yellowstone, the Grand Canyon, and the Everglades. In 2008, the Park Service proposed higher fees at some parks. Writer John
Krist argued in favor of the price increases:
A day at Disneyland costs a family of four at least $232, not counting
Mickey Mouse ears. At Six Flags Magic Mountain, the admission price
would be at least $180. A seven-day pass to enter Yellowstone National
Park costs $25 per car, which means that the same family spending a
week among bison, elk, geysers and grizzlies would pay the equivalent
of 89 cents per person, per day.
Which is why its perplexing to see such an outcry over news that the Park Service wants to raise entrance fees at 135 sites over the next two years. Their principal arguments are economic: Tourism-dependent communities fret that higher
fees will reduce visitation and cut into profits, while others argue that the increases
will keep out those of limited financial means. Its true, in theory at least, that raising the price of something should decrease demand for it.* ...
On the other hand, its absurd to expect a finite amount of parkland to accommodate a continually increasing number of people. Anyone who has driven into
Yosemite Valley on a holiday weekend is unlikely to regard a drop in park visitation as entirely a bad thing.
Slightly higher user fees are unlikely to have much effect on park use, but they
could have a significant effect on the quality of the park experience. Most of
that money will stay at individual parks, where it can be spent on upkeep and
repairsthe sort of unglamorous expenditures that typically get shortchanged in
the politically driven federal budget process. Smaller crowds and plumbing that
workswhats not to like?
* You can tell that the author of this piece hadnt read Chapter 3 of this book. If he had, he would have been careful to say that
raising the price decreases the quantity demanded, rather than that it decreases demand.
What do you think?

1. Do you agree with Krists argument that the demand for national park visits is
inelastic at current price levels, so that higher fees are unlikely to have much
effect on park use? Think about the factors that affect price elasticity, such as
the availability and price of substitutes.
2. How would you weigh the following trade-offs?
a. Should the Park Service intentionally try to shrink the demand for visits in
order to reduce crowding? In order to protect parks from environmental
damage?
b. Does the Park Service have a responsibility to keep national parks accessible
to families who cannot afford to pay higher fees?
c. Should the Park Service be concerned about the economic impact of a reduced
demand for visits on surrounding communities?
Source: J. Krist, So what if park fees go up? High Country News, July 16, 2008, http://www.hcn.org/wotr/17046.
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Elasticity
CHAPTER 4
123
CONCEPT CHECK
What is the formula for calculating the price elasticity of demand? [LO 4.1]
Why should you use the mid-point method to calculate the price elasticity of
demand? [LO 4.1]
Will an increase in price increase or decrease revenue with inelastic demand?
[LO 4.2]
Price Elasticity of Supply

What happens when an increase in coffee consumption drives up the price of coffee
beans? How will the coffee market respond to the price change? We can predict based
on the law of supply that coffee growers will respond to an increase in price by
increasing their productionbut by how much?
Price elasticity of supply is the size of the change in the quantity supplied of a
good or service when its price changes. Price elasticity of supply measures producers responsiveness to a change in price, just as price elasticity of demand measures
consumers responsiveness to a change in price.
Chapter 3 showed that when prices rise, producers supply larger quantities of a
good; when prices fall, they supply smaller quantities. Just as the price elasticity of
demand for a good tells us how much the quantity demanded changes as we move
along the demand curve, the price elasticity of supply tells us how much the quantity supplied changes as we move along the supply curve.
price elasticity of
supplythe size of the
change in the quantity
supplied of a good or
service when its price
changes
Calculating price elasticity of supply

LO 4.3 Calculate price elasticity of supply, using the mid-point method.
Price elasticity of supply is measured in the same way as price elasticity of

demand: as the percentage change in quantity divided by the percentage change in
price (see Equation 4-4).
Equation 4-4
% change in quantity supplied
Price elasticity of supply 5 ____________________________
% change in price
To ensure that elasticity will be the same whether you move up or down the supply curve, you should use the mid-point method, as in Equation 4-5.
Equation 4-5
[[
]
]
(Q2 2 Q1)
___________
]
P)
(P
(P 1 P )
[ 2 ]
(Q1 1 Q2)
_________
2
____________
Price elasticity of supply 5
22 1
__________
1
2
________
Suppose that when the price of coffee beans goes from $1 to $1.20 per pound, production increases from 90 million bags of coffee beans per year to 100 million bags.
Using the mid-point method, the percentage change in quantity supplied would be:
% change in quantity supplied 5 _______________________ 5 11%
95 million
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124
PART 2
Supply and Demand
HINT
The elasticity of demand is calculated by dividing a positive number by a negative
number, or by dividing a negative number by a positive number, so the answer is
always negative.
The elasticity of supply, on the other hand, is calculated by dividing either a positive
number by another positive number, or a negative number by another negative
number. In either case, the answer is always positive.
Remembering this rule can help you to check your arithmetic.
The percentage change in price would be:

(1.2 2 1)
% change in price 5 ________ 5 18%
1.1
So the price elasticity of supply at this point on the supply curve is:
11% 5 0.6
Price elasticity of supply 5 ____
18%
An elasticity of 0.6 tells us that the supply of coffee beans is relatively inelastic,
at least in the short run. Does this result make sense? As it turns out, coffee takes a
long time to grow. Coffee plants dont produce a full yield for four to six years after
they are planted. Because coffee growers cant increase production quickly, it makes
sense that the supply of coffee would be inelastic. (Remember that if prices had
fallen from $1.20 to $1, instead of rising from $1 to $1.20, the elasticity would be the
same using the mid-point method.)
There is one important difference between the elasticities of supply and demand:
The price elasticity of demand is always negative, and the price elasticity of supply
is always positive. The reason is simple: The quantity demanded always moves in
the opposite direction from the price, but the quantity supplied moves in the same
direction as the price.
As with the price elasticity of demand, we can describe the price elasticity of supply using three categories:
Elastic, if it has an absolute value greater than 1.
Inelastic, if it has an absolute value less than 1.
Unit-elastic, if it has an absolute value of exactly 1.
In extreme cases, we can also describe supply as being perfectly elastic (if the quantity supplied could be anything at a given price, and is zero at any other price), or
perfectly inelastic (if the quantity supplied is the same, regardless of the price).
To improve your
understanding
of price elasticity,
try the interactive
graphing
tutorial at www.
mhhe.com/
karlanmorduch.
kar11498_ch04_109-140.indd 124
Determinants of price elasticity of supply

LO 4.4 Explain how the determinants of price elasticity of supply affect the degree of
elasticity.
The price elasticity of supply can be described using the same terms as the price elasticity of demand: elastic (when it is greater than 1), inelastic (when it is less than 1), and
unit-elastic (when it exactly equals 1). Whether the supply is elastic or inelastic depends
on the suppliers ability to change the quantity produced in response to price changes.
Three factors affect a suppliers ability to expand production: the availability of inputs,
the flexibility of the production process, and the time needed to adjust to changes in
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Elasticity
CHAPTER 4
125
price. Recall that this last factortimeis also a determinant of demand. Just as consumers take time to change their habits, suppliers need time to ramp up production.
Availability of inputs. The production of some goods can be expanded easily, just
by adding extra inputs. For example, a bakery can easily buy extra flour and yeast
to produce more bread, probably at the same cost per loaf. Increasing the supply of
other goods is more difficult, however, and sometimes is impossible. If the price of
Picasso paintings goes up, there isnt much anyone can do to produce more of them,
since we cannot bring the artist back to life.
In other words, the elasticity of supply depends on the elasticity of the supply of
inputs. If producing more of a good will cost a lot more than the initial quantity did,
because the extra inputs will be harder to find, then the producer will be reluctant to
increase the quantity supplied. Higher and higher prices will be needed to convince
the producer to go to the extra trouble.
Flexibility of the production process. The easiest way for producers to adjust the
quantity supplied of a particular good is to draw production capacity away from other
goods when prices rise, or to reassign capacity to other goods when prices fall. Farmers
may find this sort of substitution relatively simple: When corn prices are high they will
plant more acres with corn; when corn prices are low they will reassign acres to more
profitable crops. Other producers have much less flexibility. If you own a company
that manufactures specialized parts for Toyota, you might need to buy new machinery
to begin making parts for Ford, let alone switch to another type of product entirely.
Adjustment time. As with demand, supply is more elastic over long periods than
over short periods. That is, producers can make more adjustments in the long run
than in the short run. In the short run, the number of hotel rooms at Disneyland is
fixed; in the medium and long run, old rooms can be renovated and new hotels can
be built. Production capacity can also increase or decrease over time as new firms
start up or old ones shut down.
CONCEPT CHECK
How would you calculate the price elasticity of supply? [LO 4.3]
What are the three determinants of the price elasticity of supply? [LO 4.4]
Other Elasticities
The quantity of a good that is demanded is sensitive to more than just the price of
the good. Because people are clever, flexible, and always on the lookout for ways to
make the most of opportunities, the quantity demanded also responds to changing
circumstances, such as the prices of other goods and the incomes consumers earn.
Lets consider two other demand elasticities, the cross-price elasticity of demand and
the income elasticity of demand.
Cross-price elasticity of demand

LO 4.5 Calculate cross-price elasticity of demand, and interpret the sign of the
elasticity.
We have noted that the substitutability of goods affects price elasticity. That is, consumers willingness to start or stop buying a good depends on the availability of
other goods that serve the same purpose. For example, we might expect a Starbucks
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126
cross-price
elasticity of
demanda measure
of how the quantity
demanded of one
good changes when
the price of a different
good changes
PART 2
Supply and Demand
latte to have relatively price-elastic demand, because some people will buy regular
coffee from Dunkin Donuts when the price of a Starbucks latte rises. Once again,
recalling the four economists questions we presented in Chapter 1, asking How
will others respond? is the key to understanding the situation.
What happens if the price of Dunkin Donuts coffee falls but the price of a Starbucks latte stays the same? Cross-price elasticity of demand describes how the quantity demanded of one good changes when the price of a different good changes.
Because lattes and regular coffee are substitutes, we expect the quantity of lattes
demanded to go down when the price of regular coffee falls, as some people switch
from lattes to coffee. The reverse also holds: If the price of a cup of Dunkin Donuts
coffee rises, while the price of a Starbucks latte doesnt, we expect the quantity of
lattes demanded to rise as some people switch from coffee to the relatively cheaper
latte. Equation 4-6 gives the formula for the cross-price elasticity of demand.
Equation 4-6
Cross-price elasticity of demand between A and B
% change in quantity of A demanded
5 _________________________________
% change in price of B
When two goods are substitutes, we expect their cross-price elasticity of demand
to be positive. That is, an increase in the price of one will cause an increase in the
quantity demanded of the other. A decrease in price, on the other hand, of one
good will cause a decrease in quantity demanded in the other. Just how elastic it
is depends on how close the two substitutes are. If they are very close substitutes,
a change in the price of one will cause a large change in the quantity demanded of
the other, so that cross-price elasticity will be high. If they are not close substitutes,
cross-price elasticity will be low.
Cross-price elasticity can also be negative. Unlike the price elasticity of demand,
which is expressed as an absolute value because it is always negative, the sign of
a cross-price elasticity tells us about the relationship between two goods. We have
seen that when two goods are substitutes, their cross-price elasticity will be positive. However, when two goods are complements (that is, when they are consumed
together), cross-price elasticity will be negative.
For example, when people drink more coffee, they want more cream to go with
it. Coffee and cream are complements, not substitutes. So when the demand for
coffee increases, the demand for cream will increase, all else held equal. When two
goods are linked in this way, their cross-price elasticity will be negative, because
an increase in the price of one good will decrease the quantity demanded of both
goods. Again, the relative size of the elasticity tells us how strongly the two goods
are linked. If the two goods are strong complements, their cross-price elasticity will
be a large negative number. If the two goods are loosely linked, their cross-price
elasticity will be negative but not far below zero.
Income elasticity of demand

LO 4.6 Calculate income elasticity of demand, and interpret the sign of the elasticity.
There are some goods that people buy in roughly the same amounts, no matter how
wealthy they are. Salt, toothpaste, and toilet paper are three examples. These are
not the sort of products people rush out to buy when they get a raise at work. Other
goods, though, are very sensitive to changes in income. If you got a raise, you might
splurge on new clothes or a meal at a fancy restaurant.
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CHAPTER 4
127
The income elasticity of demand for a good describes how much the quantity
demanded changes in response to a change in consumers incomes. As Equation
4-7 shows, it is expressed as the ratio of the percentage change in the quantity
demanded to the percentage change in income:
income elasticity
of demanda
measure of how much
the quantity demanded
changes in response
to a change in
consumers incomes
Elasticity
Equation 4-7
Income elasticity of demand
% change in quantity demanded
5 ______________________________
% change in income
Recall from Chapter 3 that increases in income raise the demand for normal goods
and lower the demand for inferior goods. Income elasticity tells us how much the
demand for these goods changes.
For example, a Starbucks Frappuccino is a normal good that might be fairly
responsive to changes in income. When people become wealthier, they will buy
more of a small luxury item like this. Therefore, we would guess that the income
elasticity of demand for fancy iced coffee drinks is positive (because the drink is
a normal good) and relatively large (because the drink is a nonnecessity that has
many cheaper substitutes).
Regular coffee is also generally a normal good, so its income elasticity should
be positive. However, we might guess that it will be less elastic than a Frappuccinos. Many people consider their standard cup of coffee every day before work
to be more of a necessity than a luxury and will buy it regardless of their incomes.
Another way to put it is that the demand for Frappuccinos is income-elastic, while
the demand for plain coffee is relatively income-inelastic. For normal goods like
these, income elasticity is positive, because the quantity that is demanded increases
as incomes rise. Both necessities and luxuries are normal goods. If the good is a
necessity, income elasticity of demand will be positive but less than 1. If the good is
a luxury, income elasticity will be positive but more than 1.
As with the cross-price elasticity of demand, the income elasticity of demand
can be negative as well as positive. The income elasticity of demand is negative for
inferior goods, because the quantity of them that is demanded decreases as incomes
increase. Remember the instant noodles example from Chapter 3an inferior good
for people who buy it when their incomes are low but abandon it in favor of luxury
food items when their incomes increase.
In 2008 Starbucks introduced a new retail product, Via Ready instant coffee.
Although some coffee enthusiasts sneered, others thought it was a shrewd move
at a time of economic hardship. Instant coffee mix may be an inferior good in some
places: As incomes increase, people will drink more expensive beverages and
decrease their consumption of instant coffee. During a recession, however, budgets
tighten, and people may increase their consumption of instant coffee as they cut
back on more expensive drinks. At least, that is what Starbucks was hoping. In this
scenario, the income elasticity of instant coffee would be small and negative. A lessappealing inferior good that people quickly abandon as they grow richer would
have a large, negative income elasticity.
Once again, the sign and size of a goods elasticity tell us a lot about the good.
Table4-1 summarizes what we have learned about the four types of elasticity.
If you find this discussion particularly interesting, you might want to consider
work as a pricing analyst. Pricing analysts use their knowledge of elasticity and
markets to help businesses determine the right price to charge for their products. You can read more about this in the Where Can It Take You? box, Pricing
analyst.
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TABLE 4-1 Four measures of elasticity

Measure
Equation
Negative
Positive
More elastic
Less elastic
Never
Over time, for

substitutable
goods and
luxury items
In the short
run, for unique
and necessary
items
In the short
run, with
production
constraints
Price
Elasticity of
Demand

__________________________
% change in price
Price
Elasticity of
Supply
% change in quantity supplied

_________________________
% change in price
Never
Always
Over time,
with flexible
production
Cross-Price
Elasticity
% change in quantity demanded of A

______________________________
% change in price of B
For
complements
For
substitutes
For near-perfect
substitutes
and strong
complements
For loosely
related goods
Income
Elasticity

__________________________
For inferior
goods
For normal
goods
For luxury items

with close
substitutes
For unique
and necessary
items
% change in income
Always
WHERE CAN IT TAKE YOU?

Pricing analyst
In most industries, keeping an eye on competitors prices and responding accordingly is a major task. Large businesses hire pricing analysts to perform this critical
function.
Some businesses have especially complicated pricing problems. Think about
airlines, which charge different prices for every flight on every route, every day.
Moreover, airlines frequently charge different prices for economy, business-class,
and first-class tickets. How will air travelers respond to a change in ticket prices?
What will happen if the price of a ticket to New York goes up, while tickets to Las
Vegas go on sale? How will customers respond to a change in competitors ticket
prices? How will they respond to a booming economy or a recession?
The answers to these questions may differ for every type of ticket. To respond to
changing market conditions in the airline industry, pricing analysts need to understand all types of elasticity.
CONCEPT CHECK
Why is cross-price elasticity of demand positive for substitutes? [LO 4.5]
Why does the income-elasticity of demand depend on whether a good is normal or inferior? [LO 4.6]
Conclusion
Supply and demand may be the most common words in economics, but applying
these concepts to the real world requires a bit of elaboration. Elasticity is the first of
several concepts we will study that will help you to apply the concepts of supply
128
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and demand to business and policy questions. In this chapter we saw how elasticity can be used to set prices so as to maximize revenue. In the coming chapters we
will use elasticity to predict the effects of government intervention in the market,
and we will dig deeper into the consumer and producer choices that drive elasticity.
FP
Mobile Window on the WorldUse this QR code to find more applications of the chapter content.
Key Terms
elasticity, p. xxx
price elasticity of demand,
p. xxx
mid-point method, p. xxx
perfectly elastic demand,
p. xxx
perfectly inelastic demand,

p. xxx
elastic, p. xxx
inelastic, p. xxx
unit-elastic, p. xxx
total revenue, p. xxx
Summary
LO 4.1 Calculate price elasticity of demand using
the mid-point method.
Elasticity is a measure of consumers and producers responsiveness to a change in market conditions. Understanding the elasticity for a good
or service allows economic decision makers to
anticipate the outcome of changes in market conditions and to calibrate prices so as to maximize
revenues.
Price elasticity of demand is the size of the
change in the quantity demanded of a good or
service when its price changes. Elasticity should
be calculated as a percentage using the midpoint method to avoid problems with conflicting units of measurement and with the direction
of a change. Price elasticity of demand is almost
always negative, because the quantity demanded
falls as the price rises. It is usually represented as
an absolute value, without the negative sign.
LO 4.2 Explain how the determinants of price
elasticity of demand affect the degree of elasticity.
In general, demand is inelastic for goods that have

no close substitutes, are basic necessities, or cost a
price elasticity of supply,

p. xxx
cross-price elasticity of
demand, p. xxx
income elasticity of
demand, p. xxx
relatively small proportion of consumers income.

Demand is also inelastic over short periods and
for broadly defined markets. When demand is
elastic, a percentage change in the price of a good
will cause a larger percentage change in the quantity demanded; the absolute value of the elasticity
will be greater than 1. When demand is inelastic,
a percentage change in price will cause a smaller
percentage change in the quantity demanded; the
absolute value of the elasticity will be less than
1. When demand is unit-elastic, the percentage
changes in price and quantity will be equal, and
the elasticity will be exactly 1.
LO 4.3 Calculate price elasticity of supply using
the mid-point method.
Price elasticity of supply is the size of the change

in the quantity supplied of a good or service
when its price changes. Price elasticity of supply
is almost always positive, because the quantity
supplied increases as the price increases.
LO 4.4 Explain how the determinants of price
elasticity of supply affect the degree of elasticity.
Supply is generally inelastic when additional

inputs to the production process are difficult
to get and the production process is inflexible.
129
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Supply is also inelastic over short periods. Supply

is considered elastic when the absolute value of
its price elasticity is greater than 1; inelastic when
the absolute value is less than 1; and unit-elastic
when it is exactly 1.
LO 4.5 Calculate cross-price elasticity of demand,
and interpret the sign of the elasticity.
Cross-price elasticity of demand is the percentage

change in the quantity demanded in response to
a given percentage change in the price of a different good. The cross-price elasticity of demand
between two goods will be positive if they are
substitutes and negative if they are complements.
LO 4.6 Calculate income elasticity of demand,
and interpret the sign of the elasticity.
Income elasticity of demand is the percentage

change in the quantity of a good demanded in
response to a given percentage change in income.
Income elasticity of demand will be positive for
normal goods and negative for inferior goods.
Review Questions
1. You are advising a coffee shop manager
who wants to estimate how much sales will
change if the price of a latte rises. Explain
why he should measure elasticity in percentage terms rather than in terms of dollars
and cups. [LO 4.1]
2. Explain why the coffee shop manager
should measure elasticity using the midpoint method in his calculations. [LO 4.1]
3. You are working as a private math tutor to raise
money for a trip during spring break. First
explain why the price elasticity of demand for
math tutoring might be elastic. Then explain
why the price elasticity of demand for math
tutoring might be inelastic. [LO 4.2]
4. You are working as a private math tutor to
raise money for a trip during spring break.
You want to raise as much money as possible. Should you should increase or decrease
the price you charge? Explain. [LO 4.2]
5. You have been hired by the government
of Kenya, which produces a lot of coffee,
to examine the supply of gourmet coffee
beans. Suppose you discover that the price
elasticity of supply is 0.85. Explain this figure to the Kenyan government. [LO 4.3]
6. You have noticed that the price of tickets to
your universitys basketball games keeps
increasing but the supply of tickets remains
the same. Why might supply be unresponsive to changes in price? [LO 4.3]
7. Which will have a more price-elastic supply
over six months: real estate in downtown
Manhattan or real estate in rural Oklahoma?
Explain your reasoning. [LO 4.4]
8. Certain skilled labor, such as hair cutting,
requires licensing or certification, which
is costly and takes a long time to acquire.
Explain what would happen to the price
elasticity of supply for haircuts if this licensing requirement were removed. [LO 4.4]
9. Although we could describe both the crossprice elasticity of demand between paper
coffee cups and plastic coffee lids and the
cross-price elasticity of demand between
sugar and artificial sweeteners as highly
elastic, the first cross-price elasticity is negative and the second is positive. What is the
reason for this? [LO 4.5]
10. Name two related goods you consume
which would have a positive cross-price
elasticity. What happens to your consumption of the second good if the price of the
first good increases? [LO 4.5]
11. Name two related goods you consume
which would have a negative cross-price
elasticity. What happens to your consumption of the second good if the price of the
first good increases? [LO 4.5]
12. In France, where cheese is an important and
traditional part of peoples meals, people eat
about six times as much cheese per person
as in the United States. In which country
do you think the demand for cheese will be
more income-elastic? Why? [LO 4.6]
13. Name a good you consume for which your
income elasticity of demand is positive.
What happens when your income increases?
[LO 4.6]
14. Name a good you consume for which your

income elasticity of demand is negative.
What happens when your income increases?
[LO 4.6]
130
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First Pages
Problems and
Applications
FIGURE 4P-1
Price ($)
1. When the price of a bar of chocolate is $1,

demand is 100,000 bars. When the price rises
to $1.50, demand falls to 60,000 bars. Calculate the price elasticity of demand according
to the instructions below and express your
answer in absolute value. [LO 4.1]
a. Suppose price increases from $1 to
$1.50. Calculate the price elasticity of
demand in terms of percent change, as
described on pages 000000.
b. Suppose price decreases from $1.50
to $1. Calculate the price elasticity of
demand in terms of percent change, as
described on pages 000000.
c. Suppose the price increases from $1 to
$1.50. Calculate the price elasticity of
demand using the mid-point method.
d. Suppose the price decreases from $1.50
to $1. Calculate the price elasticity of
demand using the mid-point formula.
2. If the price elasticity of demand for used cars
priced between $3,000 and $5,000 is 21.2
(using the mid-point method), what will be
the percent change in quantity demanded
when the price of a used car falls from $5,000
to $3,000? [LO 4.1]
3. Three points are identified on the graph in
Figure 4P-1. [LO 4.2]
a. At point A, demand is
b. At point B, demand is
c. At point C, demand is
4. Which of the following has a more elastic

demand in the short run? [LO 4.2]
a. Pomegranate juice or drinking water?
b. Cereal or Rice Krispies ?
c. Speedboats or gourmet chocolate?
5. If price increases by 10 percent and quantity
demanded decreases by 15 percent, demand
is
. [LO 4.2]
6. If price decreases by 10 percent and quantity
demanded increases by 5 percent, demand
is
. [LO 4.2]
7. If price elasticity of demand is 21.3 and price
increases by 2 percent, quantity demanded
will
by
. [LO 4.2]
45
40
35
30
25
B
20
15
10
5
0
10
20
30
Quantity
8. If price elasticity of demand is 20.3 percent

and price decreases by 2 percent, quantity
demanded will
by
. [LO 4.2]
Problems 914 refer to the demand schedule
shown in Table 4P-1. For each price change, say
whether demand is elastic, unit-elastic, or inelastic,
and say whether total revenue increases, decreases,
or stays the same.
9. Price increases from $10 to $20. Demand is
and total revenue
. [LO 4.2]
10. Price decreases from $70 to $60. Demand is
and total revenue
. [LO 4.2]
TABLE 4P-1
Price($)
Quantity demanded
80
70
50
60
100
50
150
40
200
30
250
20
300
10
350
400
131
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First Pages
FIGURE 4P-2
FIGURE 4P-3
Price ($)
Price($)
90
24
80
21
70
18
B
60
15
50
40
12
30
20
10
0
10
20
30
D
40
Quantity
3
0
10
12
14
Quantity

and total revenue
. [LO 4.2]
and total revenue
. [LO 4.2]
and total revenue
. [LO 4.2]
and total revenue
. [LO 4.2]
Problems 1518 refer to Figure 4P-2.
15. Draw the price effect and the quantity effect
for a price change from $60 to $50. Which
effect is larger? Does total revenue increase or
decrease? No calculation is necessary. [LO 4.2]
effect is larger? Does total revenue increase
or decrease? No calculation is necessary.
[LO 4.2]
19. Use the graph in Figure 4P-3 to calculate the

price elasticity of supply between points A
and B using the mid-point method. [LO 4.3]
20. If the price of a haircut is $15, the number of

haircuts provided is 100. If the price rises to
$30 per haircut, barbers will work much longer
hours, and the supply of haircuts will increase
to 300. What is the price elasticity of supply for
haircuts between $15 and $30? [LO 4.3]
21. Which of the following has a more elastic
supply in the short run? [LO 4.4]
a. Hospitals or mobile clinics?
b. Purebred dogs or pet rabbits?
c. On-campus courses or online courses?
22. If price increases by 10 percent and quantity
supplied increases by 15 percent, supply is
. [LO 4.4]
23. If price decreases by 10 percent and quantity
supplied decreases by 5 percent, supply is
. [LO 4.4]
24. If price elasticity of supply is 1.3 and price
increases by 2 percent, quantity supplied
will
by
. [LO 4.4]
25. If price elasticity of supply is 0.3 percent and
price decreases by 2 percent, quantity supplied will
by
. [LO 4.4]
26. Suppose that when the price of peanut butter
rises from $2 to $3 per jar, the quantity of jelly
purchased falls from 20 million jars to 15 million jars. What is the cross-price elasticity of
demand between peanut butter and jelly? Are
they complements or substitutes? [LO 4.5]
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First Pages
27. Suppose that when the price of peanut butter rises from $2 to $3 per jar, the quantity
of jelly purchased increases from 15 million
jars to 20 million jars. What is the crossprice elasticity of demand between peanut
butter and jelly? Are they complements or
substitutes? [LO 4.5]
28. For each of the following pairs, predict
whether the cross-price elasticity of demand
will be positive or negative: [LO 4.5]
a. Soap and hand sanitizer
b. CDs and MP3s
c. Sheets and pillowcases
29. Suppose that when the average family
income rises from $30,000 per year to $40,000
per year, the average familys purchases of
toilet paper rise from 100 rolls to 105 rolls

per year. [LO 4.6]
a. Calculate the income-elasticity of demand
for toilet paper.
b. Is toilet paper a normal or an inferior
good?
c. Is the demand for toilet paper incomeelastic or income-inelastic?
30. If income increases by 10 percent and the
quantity demanded of a good then increases
by 5 percent, the good is
and
.
[LO 4.6]
31. If income increases by 10 percent and the

quantity demanded of a good decreases by
20 percent, the good is
and
.
[LO 4.6]
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First Pages
appendix C
Math Essentials: Calculating

Percentage Change, Slope,
and Elasticity
LEARNING OBJECTIVES
LO C.1
Understand how to calculate percentage changes.
LO C.2
Use slope to calculate elasticity.
The math associated with concept of elasticity covers a wide variety of topics. In order
to be able to calculate elasticity, you need to be able to calculate percentage changes. In
order to talk about shape of a line, and its elasticity, you need to be able to understand
slope and the relationship between variables, particularly price and quantity.
Percentage Change
LO C.1 Understand how to calculate percentage changes.
In Chapter 4, we calculated elasticity in all its forms. If youre not entirely comfortable calculating percentage change, though, elasticity can be a daunting idea. Percentage changes represent the relative change in a variable from an old value to a
new one. In general, the formula can be reduced in plain English to saying, New
minus old, divided by old, times 100.
The mathematical equivalent is shown as Equation C-1. There, X1 represents the
original value of any variable X, and X2 is the new value of this variable.
Equation C-1
(X22X1)
Percentage change 5 _________
3100
X1
Overall, you can use this method to calculate the percentage change in variables of
various kinds. A percentage change in quantity, for example, would be expressed as:
(Q2 2 Q1)
Percentage change in quantity 5 _________
3 100
Q1
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kar11498_ch04_109-140.indd 134
where Q2 represents the new value of quantity demanded and Q1 the original quantity demanded.
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First Pages
Elasticity
CHAPTER 4
135
Similarly, a percentage change in price would be expressed as:
(P2 2 P1)
Percentage change in price 5 ________
3 100
P1
Lets try an example for practice: For weeks, you have been watching the price of
a new pair of shoes. They normally cost $80, but you see that the store has a sale and
now offers them for $60. You find the percentage change in the price of the shoes
by first subtracting the old price ($80) from the new one ($60) to find the change in
price, which is 2$20. To find how much of a change this is, you take this 2$20 price
change and divide it by the original cost of the shoes ($80). This gives you the decimal that you multiply by 100 to get the percentage change:
$60 2 $80
_________
520.25
$80
20.2531005225%
In this case, the $20 price reduction was a 25 percent decrease in price. Not a bad sale!
Notice that in this case, the percentage change is negative, which indicates that
the new value is less than the original. If the prices of shoes had increased instead,
the associated percentage change would be a positive value.
The best way to do get comfortable with calculating percentage changes is
through lots of practice. You can find a few extra problems to try on your own at
the end of this appendix, and you also could challenge yourself to calculate price
changes you see in your everyday life.
Slope and Elasticity

LO C.2 Use slope to calculate elasticity.
In Appendix A, Math Essentials: Understanding Graphs and Slope, we showed

that the direction of a slope tells us something meaningful about the relationship
between the two variables we are representing: When x and y move in the same
direction, they are said to have a positive relationship. Not surprisingly, this means
that the slope of the line is a positive number. When the slope of a line is positive,
we know that y increases as x increases, and y decreases as x decreases. Similarly,
when x and y move in opposite directions, they are said to have a negative relationship. The slope of the line is a negative number. When the slope of a line is negative,
we know that y decreases as x increases, and y increases as x decreases.
In Chapter 3, we saw a positive relationship between price and quantity in
the supply curve. We saw a negative relationship between price and quantity in the
demand curve. Two variables (such as price and quantity) may have more than one
relationship to each other, depending on whose choices they represent and under
what circumstances.
The steepness of a slope is also important. Numerically, the closer the number
representing the slope is to zero, the flatter the curve will be. Remember that both
positive and negative numbers can be close to zero. So, a slope of 21 is equally steep
as a slope of 1, although one slopes downward and the other upward. Correspondingly, a line with a slope of 25 is steeper than a line with a slope of 21 or one with a
slope of 1. You can tell just from looking at an equation how steep the line will be. If
this idea is still a little hazy, you might want to page back to Appendix A to refresh
your memory, as the steepness of slope is important to understanding the concept
of elasticity.
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FIGURE C-1
Measuring a change in Q in response to a change in P
(A) Steeper slope
(B) Flatter slope
7
Supply
Rise 1
5 5 0.5
Run 2
Supply
4
y 5 1
y 5 1
3
Rise 1
5 51
Run 1
x
51
2
1
x 5 2
2
1
A steeper slope means that changes in price

do not cause a large change in quantity
demanded.
A flatter slope means that quantity demanded

changes more with a change in price.
Although the ideas of slope and elasticity are related, there are two basic mathematical distinctions between them:
1. Slope describes the change in y per change in x, whereas elasticity typically
describes the change in x per change in y.
2. We usually measure elasticity in terms of percentage changes, rather than
absolute changes.
Why would we be interested in how much x changes in response to a one-unit
change in y? To get at this difference, lets look at Figure C-1. It is similar to Figure
A-1 (in Appendix A, p. xxx), but replaces the variables x and y with the quantity of
a good (Q) and its price (P).
In Chapter 4 you learned that price elasticity is a measure of the responsiveness
of supply (or demand) to changes in price. In other words, it is a measure of how
quantity (on the x-axis) responds to a change in price (on the y-axis). So this time,
lets make the change in price (vertical distance) the same and look at how much
quantity changes (horizontal distance).
Looking at Figure C-1, we can see that when price moves from P1 to P2, quantity
supplied changes by less in panel A than it does in panel B. When price increases
from P1 to P2 in panel A, quantity increases by one unit, from Q1 to Q2. In contrast,
panel B shows an increase of two units from Q1 to Q2 for the same change in P. This
means supply is less responsive to a price change in panel A compared to panel B.
X over Y, or Y over X?
y
136
kar11498_ch04_109-140.indd 136
We have noted that slope is indicated by __

. In contrast, elasticity is commonly meax
Q
x
___
__
sured as P , which corresponds to y . In some sense, then, elasticity is the mirror
image of slope. The easiest way to picture this is to see the difference between slope
and elasticity for vertical and horizontal lines.
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First Pages
FIGURE C-2
Slope versus elasticity of horizontal and vertical lines
(A) Horizontal lines
(B) Vertical lines
y (Price)
y (Price)
100
100
90
90
80
( y)
5
0
80
0
Slope 5
50
(x)
70
70
60
60
50
50
40
40
(% x)
Elasticity 5
5
0
30
30
20
20
10
10
Slope 5
10
20
30
40
50 60
Quantity
70
80
90 100
When a line is horizontal, the slope is zero,

and the associated elasticity is infinite. In other
words, demand or supply only occurs at a single
price.
Elasticity 5
10
20
30
40
0
50
(% y)
50 60
Quantity
70
80
90 100
When a line is vertical the slope is infinite and

the elasticity is zero. Regardless of the price,
quantity supplied or demanded is going to be
the same.
In Figure C-2, the horizontal line pictured in panel A has a slope of zero. This is
because a one-unit change in x results in zero change in y. Therefore, slope is calcu0
. Zero divided by any number is zero. If we think of the horizontal line as
lated as __
x
a demand curve mapping price to quantity demanded, however, the price elasticity
is infinity.
How can slope be zero and elasticity infinity? Remember that slope measures
how much y changes in response to a change in x. Elasticity, however, measures
the sensitivity of P (on the y-axis) to a change in Q (on the x-axis). Whereas x is
in the denominator when calculating slope, it is in the numerator when calcuQ
, since
lating elasticity. For a horizontal line, then, elasticity will be percent __
0
there is no change in P. Division by 0 is mathematically undefined, or known
as infinity.
The reverse is true when we look at a vertical line. When a graph is vertical, there
y
is zero change in x for any change in y. Therefore, slope is calculated as __
. In this
0
0
_______
case, slope is undefined (infinity). But elasticity will be percentP. Again, zero divided
by any number is zero.
Elasticity changes along lines with constant slope

The second important mathematical difference between slope and elasticity is that
we usually measure slope in terms of absolute changes, but we measure elasticity
in terms of percent changes. This means that at different points along a straight line,
slope is constant, but elasticity varies.
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TABLE C-1
Demand schedule
Price($)
Quantity
80
70
10
60
20
50
30
40
40
30
50
20
60
10
70
80
As an example, take a look at the demand schedule in Table C-1.

First, lets calculate the slope between two different sets of points. Using the first
two prices and quantities at the top of the demand schedule, we see that the slope
between these points is 21.
(0 2 10)
DP
210 5 21
Slope #1 5 ____1 5 _________ 5 ____
10
DQ1 (80 2 70)
Then, pick another two points. Using the quantities 30 and 20 and their respective prices, we can calculate that the slope is still 21.
(30 2 20)
DP2
10 5 21
Slope #2 5 ____
5 _________ 5 ____
DQ2 (50 2 60) 210
No matter what two points along the demand curve we choose, the slope is the
same. Slope is constant because the demand curve is linear.
Now lets calculate elasticity between these same two sets of points. We will use
the mid-point method described in Chapter 3 to calculate elasticity:
DQ
________
Q
midpoint
%DQ
Elasticity 5 ______ 5 ________
DP
%DP
________
Pmidpoint
Lets start with the top of the demand curve and calculate the price elasticity of
demand for a price change from 80 to 70. Using the midpoint method, we have:
DQ
________
(0 2 10)
210
________
____
Q
midpoint
5
22 5 211.8
________ 5 _________
____
5 5 5 ____
10
0.17
DP
(80 2 70)
___
________
_________
60
Pmidpoint
60
138
kar11498_ch04_109-140.indd 138
Now lets calculate the price elasticity of demand at the bottom of the demand
curve for a price change of 30 to 20.
DQ
________
(50 2 60)
10
_________
___
Q
midpoint
0.18 5 20.46
55
________
_________
____
5
5 55 5 _____
210 20.4
DP
(30 2 20) ____
________
_________
25
Pmidpoint
25
Even though both of these calculations represented a 10-unit change in quantity
in response to a $10 change in price, along a linear demand curve, elasticity changes.
Moving down along the demand curve means less elasticity. This is because the same
change in Q or P is a different percentage of the midpoint at different points on the line.
17/07/12 6:36 PM
First Pages
Problems
TABLE CP-1
1. Calculate the percentage change in each of

the following examples. [LO C.1]
a. 8 to 12
b. 16 to 14
c. 125 to 120
d. 80 to 90
2. Find the percentage change in price in these
examples [LO AC.1]
a. The price of a $4 sandwich increases
to $5.
b. A sale discounts the price of a sofa from
$750 to $500.
3. Use the demand curve in Figure CP-1 to
answer the following questions. Use the midpoint method in your calculations. [LO C.2]
a. What is the price elasticity of demand
for a price change from $10 to $20?
b. What is the price elasticity of demand
c. What is the price elasticity of demand
4. Use the demand schedule in Table CP-1 to
answer the following questions. Use the midpoint method in your calculations. [LO C.2]
FIGURE CP-1
Price ($)
100
80
60
40
20
0
Demand
20
40
80
60
Quantity
100
120
140
Price($)
Quantity
60
50
40
12
30
16
20
20
10
24
TABLE CP-2
Price($)
Quantity
56
48
42
35
28
21
14
5. Use the demand schedule in Table CP-2

to answer the following questions. Use
the mid-point method when calculating
elasticity. [LO C.2]
for a price change from $2 to $3? What
is the slope of the demand curve for a
price change from $2 to $3?
139
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Elasticity: Learning Objectives

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Elasticity: Learning Objectives

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First Pages

Calculate price elasticity of demand using the mid-point method.

Explain how the determinants of price elasticity of demand affect the

Calculate price elasticity of supply using the mid-point method.

Explain how the determinants of price elasticity of supply affect the

Calculate cross-price elasticity of demand, and interpret the sign of

Calculate income elasticity of demand, and interpret the sign of the

COFFEE BECOMES CHIC

Supply and Demand

Price Elasticity of Demand

Calculating price elasticity of demand

Quantity of coffee (millions of cups)

Using the mid-point method

(15 million 2 10 million)

Supply and Demand

(10 million 2 15 million)

In the denominator of this expression, the mid-point (average) quantity is equal

(15 million 2 10 million)

For a price increase, the elasticity is:

Our measure for the price elasticity of demand is now consistent.

Determinants of price elasticity of demand

Availability of substitutes. Recall from Chapter 3 that substitutes are

Supply and Demand

Using price elasticity of demand

(B) Perfectly inelastic demand Elasticity 5 0

When demand is perfectly elastic, the

When demand is perfectly inelastic, the

(A) Elastic demand

(C) Unit-elastic demand

(B) Inelastic demand

With an elastic demand curve, a

With an inelastic demand curve,

When demand is unitelastic, the

The colored rectangles represent total revenue at two different prices.

(B) Inelastic demand

When demand is inelastic,

In this market, demand is elastic. At a price of

In this market, demand is inelastic. At a price of

When demand is elastic, a price increase causes total revenue to fall. We

(C) Total revenue

Total revenue ($)

This table lists the data shown in the

Price elasticity of demand varies along

This graph shows total revenue along the

Supply and Demand

WHAT DO YOU THINK?

What do you think?

Price Elasticity of Supply

Calculating price elasticity of supply

Price elasticity of supply is measured in the same way as price elasticity of

Supply and Demand

The percentage change in price would be:

Determinants of price elasticity of supply

Cross-price elasticity of demand

Supply and Demand

Income elasticity of demand

TABLE 4-1 Four measures of elasticity

Over time, for

% change in quantity demanded

% change in quantity supplied

% change in quantity demanded of A

% change in quantity demanded

For luxury items