ELASTICITY

Microeconomics
ELASTICITY
is a measure of how much buyers and sellers
respond to changes in market conditions
THE ELASTICITY OF DEMAND
Price elasticity of demand is a measure of how
much the quantity demanded of a good responds to
a change in the price of that good.

Price elasticity of demand is the percentage change
in quantity demanded given a percent change in the
price.

DETERMINANTS OF PRICE ELASTICITY
OF DEMAND
Availability of Close Substitutes:
More close substitutes=More elastic
Example: Butter vs Egg

Necessities versus Luxuries:
inelastic versus elastic
Example: visit a doctor vs sailboat
DETERMINANTS OF PRICE ELASTICITY
OF DEMAND
Definition of the Market:
Narrowly defined market more elastic
Broadly defined market less elastic
Example: Food vs Ice Cream

Time Horizon
Longer time horizon more elastic
Shorter time horizon less elastic

SUMMARY
Demand tends to be more elastic :
the larger the number of close substitutes.
if the good is a luxury.
the more narrowly defined the market.
the longer the time period.

The (own) price elasticity of demand is computed
as the percentage change in the quantity
demanded divided by the percentage change in
price.
Price elasticity of demand =
Percentage change in quantity demanded
Percentage change in price
CALCULATING ELASTICITY
1.1
1.0
1.44 1.5
CALCULATING ELASTICITY: POINT
ELASTICITY
Point Elasticity={[Q2-Q1]/Q1}/{[P2-P1]/P1}

Case 1: Price rises from 1 to 1.1

% change in qty = (1.44-1.5)/1.5= -4%
% change in price = (1.10-1)/1= 10%
Elasticity=-4%/10%=-0.4

CALCULATING ELASTICITY: POINT
APPROACH

Case 2: Price falls from 1.1 to 1.

% change in qty = (1.5-1.44)/1.44= 4.16%
% change in price = (1-1.10)/1.10= -9.09%
Elasticity=4.16%/-9.09%=-0.457

POTENTIAL PROBLEM OF POINT
ELASTICITY
(Point) Elasticity level in case 1 is different from
(point) elasticity level in case 2
MIDPOINT METHOD (ARC ELASTICITY
The midpoint formula is preferable when calculating
the price elasticity of demand because it gives the
same answer regardless of the direction of the
change.

MIDPOINT METHOD FORMULA
Price elasticity of demand =
( ) / [( ) / ]
( ) / [( ) / ]
Q Q Q Q
P P P P
2 1 2 1
2 1 2 1
2
2


ARC ELASTICITY
(MIDPOINT METHOD)
Case 1: Price rises from 1 to 1.1.
% change in qty = (1.44-1.5)/1.47 = -4.1%
% change in price = (1.10-1)/1.05 = 9.5%
Elasticity=-4.1%/9.5%
=-0.432
Case 2: Price falls from 1.1 to 1.
% change in qty = (1.5-1.44)/1.47 = 4.1%
% change in price = (1-1.10)/1.05 = -9.5%
Elasticity=4.1%/-9.5%
=-0.432


ELASTIC OR INELASTIC?
Inelastic Demand
Quantity demanded does not respond strongly to price
changes.
Price elasticity of demand is less than one.
Elastic Demand
Quantity demanded responds strongly to changes in
price.
Price elasticity of demand is greater than one.

OTHER TYPES
Perfectly Inelastic
Quantity demanded does not respond to price
changes.
Perfectly Elastic
Quantity demanded changes infinitely with any
change in price.
Unit Elastic
Quantity demanded changes by the same
percentage as the price.

SUMMARY
|E|=0, perfectly inelastic
0<|E|<1, inelastic
|E|=1, unit elastic
|E|>1, elastic
|E|=infinity, perfectly elastic

Product Market Elasticity
Automobiles
Chevette U.S. -3.2
Civic U.S. -4
Consumer products
music CDs Aus -1.83
cigarettes U.S. -0.3
liquor U.S. -0.2
football games U.S. -0.275
Utilities
electricity (residential) Quebec -0.7
telephone service Spain -0.1
water (residential) U.S. -0.25
water (industrial) U.S. -0.85
OWN-PRICE ELASTICITIES
SLOPE AND ELASTICITY
Because the price elasticity of demand measures
how much quantity demanded responds to the price,
it is closely related to the slope of the demand
curve.
Higher slope, lower elasticity

Copyright2003 Southwestern/Thomson Learning
(a) Perfectly Inelastic Demand: Elasticity Equals 0
5
4
Quantity
Demand
100 0
1. An
increase
in price . . .
2. . . . leaves the quantity demanded unchanged.
Price
(b) Inelastic Demand: Elasticity Is Less Than 1
Quantity 0
5
90
Demand
1. A 22%
increase
in price . . .
Price
2. . . . leads to an 11% decrease in quantity demanded.
4
100
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2. . . . leads to a 22% decrease in quantity demanded.
(c) Unit Elastic Demand: Elasticity Equals 1
Quantity
4
100 0
Price
5
80
1. A 22%
increase
in price . . .
Demand
(d) Elastic Demand: Elasticity Is Greater Than 1
Demand
Quantity
4
100 0
Price
5
50
1. A 22%
increase
in price . . .
2. . . . leads to a 67% decrease in quantity demanded.
(e) Perfectly Elastic Demand: Elasticity Equals Infinity
Quantity 0
Price
4 Demand
2. At exactly P4,
consumers will
buy any quantity.
1. At any price
above P4, quantity
demanded is zero.
3. At a price below P4,
quantity demanded is infinite.
LINEAR DEMAND CURVE
Vertical intercept: perfectly elastic
Upper segment: elastic
Middle: Unit elastic
Lower segment: inelastic
Horizontal intercept: perfectly inelastic
TOTAL REVENUE AND ELASTICITY
Total revenue is the amount paid by buyers and
received by sellers of a good.
Computed as the price of the good times the
quantity sold.

TR = P x Q

Copyright2003 Southwestern/Thomson Learning
Demand
Quantity
Q
P
0
Price
P Q = P400
(revenue)
4
100
TOTAL REVENUE AND ELASTICITY
With an elastic demand curve, an increase in the
price leads to a decrease in quantity demanded that
is proportionately larger. Thus, total revenue
decreases.
With an inelastic demand curve, an increase in the
price leads to a decrease in quantity demanded that
is proportionately smaller. Thus, total revenue
increases.

INCOME ELASTICITY OF DEMAND
Income elasticity of demand measures how much
the quantity demanded of a good responds to a
change in consumers income.
It is computed as the percentage change in the
quantity demanded divided by the percentage
change in income.

NORMAL OR INFERIOR?
Types of Goods
Normal Goods
Inferior Goods
Higher income raises the quantity demanded for
normal goods but lowers the quantity demanded for
inferior goods.
Normal goods: Positive income elasticity
Inferior goods: Negative income elasticity

NECESSITY OR LUXURY?
Goods consumers regard as necessities tend to be
income inelastic
Examples include food, fuel, clothing, utilities, and
medical services.
Goods consumers regard as luxuries tend to be
income elastic.
Examples include sports cars, furs, and expensive
foods.

INCOME ELASTICITY
I >0, Normal good
I <0, Inferior good
Among normal goods:
0<I<1, necessity
I>1, luxury

Item Market Elasticity
Consumer products
cigarettes U.S. 0.1
liquor U.S. 0.2
food U.S. 0.8
clothing U.S. 1
newspapers U.S. 0.9
Utilities
electricity (residential) Quebec 0.1
telephone service Spain 0.5
INCOME ELASTICITY
PRICE ELASTICITY OF SUPPLY
Price elasticity of supply is a measure of how much
the quantity supplied of a good responds to a
change in the price of that good.
Price elasticity of supply is the percentage change
in quantity supplied resulting from a percent change
in price.

FORMULA
The price elasticity of supply is computed as the
percentage change in the quantity supplied divided
by the percentage change in price.
Price elasticity of supply =
Percentage change
in quantity supplied
Percentage change in price
SUMMARY
S=0, perfectly inelastic
0<S<1, inelastic
S=1, unit elastic
S>1, elastic
S=infinity, perfectly elastic

SLOPE AND ELASTICITY
Because the price elasticity of supply measures
how much quantity supplied responds to the price,
it is closely related to the slope of the supply curve.
Higher slope, lower elasticity

Copyright2003 Southwestern/Thomson Learning
(a) Perfectly Inelastic Supply: Elasticity Equals
0
5
4
Supply
Quantity 100
0
1. An
increase
in price . . .
2. . . . leaves the quantity supplied unchanged.
Price
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(b) Inelastic Supply: Elasticity Is Less Than 1
110
5
100
4
Quantity
0
1. A 22%
increase
in price . . .
Price
2. . . . leads to a 10% increase in quantity supplied.
Supply
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(c) Unit Elastic Supply: Elasticity Equals
1
125
5
100
4
Quantity 0
Price
2. . . . leads to a 22% increase in quantity supplied.
1. A 22%
increase
in price . . .
Supply
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(d) Elastic Supply: Elasticity Is Greater Than 1
Quantity
0
Price
1. A 22%
increase
in price . . .
2. . . . leads to a 67% increase in quantity supplied.
4
100
5
200
Supply
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(e) Perfectly Elastic Supply: Elasticity Equals Infinity
Quantity 0
Price
4 Supply
3. At a price below P4,
quantity supplied is zero.
2. At exactly P4,
producers will
supply any quantity.
1. At any price
above P4, quantity
supplied is infinite.
DETERMINANTS OF PRICE ELASTICITY
OF SUPPLY
Ability of sellers to change the amount of the good
they produce.
Beach-front land is inelastic.
Books, cars, or manufactured goods are elastic.
Time period.
Supply is more elastic in the long run.

Item Horizon Price Elasticity
distillate short run 1.57
gasoline short run 1.61
pork long run 0.23
tobacco long run 7
housing long run 1.6 - 3.7
PRICE ELASTICITIES OF SUPPLY
APPLICATION OF ELASTICITY
Can good news for farming be bad news for
farmers?
What happens to wheat farmers and the market for
wheat when university agronomists discover a new
wheat hybrid that is more productive than existing
varieties?
Copyright2003 Southwestern/Thomson Learning
Quantity of
Wheat
0
Price of
Wheat
3. . . . and a proportionately smaller
increase in quantity sold. As a result,
revenue falls from P300 to P220.
Demand
S
1

S
2

2. . . . leads
to a large fall
in price . . .

1. When demand is inelastic,
an increase in supply . . .
2
110
3
100
OTHER APPLICATIONS
A reduction in supply in the world market for oil: the
response depends on the time horizon.
Policies to Reduce the Use of Illegal Drugs:
Drug interdiction
Drug education


QUIZ 1
Beachfront resorts: inelastic supply
Automobile: elastic supply
Suppose a rise in population doubles the demand
for both products.
Price? Quantity? Consumer spending?
QUIZ 2
Why? Why?
A drought around the world:
Total revenue that farmers received from sale of
grain rises. However, a drought in Kansas reduces
total revenue that Kansas farmers receive.