Case Econ08 Ab - Az.ppt 05

Chapter
5
Elasticity
Prepared by:
Fernando & Yvonn Quijano
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair
Elasticity
5
Chapter Outline
Price Elasticity of Demand

Slope and Elasticity
Types of Elasticity
CHAPTER 5: Elasticity
Calculating Elasticities
Calculating Percentage Changes
Elasticity Is a Ratio of Percentages
The Midpoint Formula
Elasticity Changes along a Straight-Line
Demand Curve
Elasticity and Total Revenue
The Determinants of Demand Elasticity
Availability of Substitutes
The Importance of Being Unimportant
The Time Dimension
Other Important Elasticities
Income Elasticity of Demand
Cross-Price Elasticity of Demand
Elasticity of Supply
Looking Ahead
Appendix: Point Elasticity
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 29
ELASTICITY
elasticity A general concept used to

quantify the response in one variable
when another variable changes.
%A
elasticity of A with respect to B 
%B
PRICE ELASTICITY OF DEMAND
SLOPE AND ELASTICITY

FIGURE 5.1 Slope Is Not a Useful Measure of Responsiveness

price elasticity of demand The ratio

of the percentage of change in quantity
demanded to the percentage of change
in price; measures the responsiveness
of demand to changes in price.
% change in quantity demanded

price elasticity of demand 
% change in price
TYPES OF ELASTICITY
TABLE 5.1 Hypothetical Demand Elasticities for Four Products
% CHANGE
% CHANGE IN QUANTITY
INPRICE DEMANDED ELASTICITY
PRODUCT (% P) (% QD) (% QD ÷ %P)
Insulin +10% 0% 0.0 Perfectly inelastic

Basic telephone service +10% -1% -0.1 Inelastic
Beef +10% -10% -1.0 Unitarily elastic
Bananas +10% -30% -3.0 Elastic
perfectly inelastic demand Demand

in which quantity demanded does not
respond at all to a change in price.
FIGURE 5.2 Perfectly Elastic and Perfectly Inelastic Demand Curves
inelastic demand Demand that responds

somewhat, but not a great deal, to changes
in price. Inelastic demand always has a
numerical value between zero and -1.
A warning: You must be very careful about signs. Because it is generally understood
that demand elasticities are negative (demand curves have a negative slope), they are
often reported and discussed without the negative sign. For example, a technical paper
might report that the demand for housing “appears to be inelastic with respect to price,
or less than 1 (0.6).” What the writer means is that the estimated elasticity is -.6, which
is between zero and -1. Its absolute value is less than 1.
unitary elasticity A demand

relationship in which the percentage
change in quantity of a product
demanded is the same as the
percentage change in price in absolute
value (a demand elasticity of -1).
elastic demand A demand relationship

in which the percentage change in
quantity demanded is larger in absolute
value than the percentage
change in price (a demand elasticity
with an absolute value greater than 1).
perfectly elastic demand Demand in

which quantity drops to zero at the
slightest increase in price.
A good way to remember the difference between

the two “perfect” elasticities is:
CALCULATING ELASTICITIES
CALCULATING PERCENTAGE CHANGES
To calculate percentage change in quantity demanded

using the initial value as the base, the following formula is
used:
change in quantity demanded

% change in quantity demanded  x 100%
Q1
Q2 - Q1
 x 100%
Q1
We can calculate the percentage change in price in a

similar way. Once again, let us use the initial value of P—
that is, P1—as the base for calculating the percentage. By
using P1 as the base, the formula for calculating the
percentage of change in P is simply:
change in price
% change in price  x 100%
P1
P2 - P1
 x 100%
P1
ELASTICITY IS A RATIO OF PERCENTAGES
Once all the changes in quantity demanded and price

have been converted into percentages, calculating
elasticity is a matter of simple division. Recall the formal
definition of elasticity:

price elasticity of demand 
% change in price
THE MIDPOINT FORMULA

midpoint formula A more precise way of
calculating percentages using the value
halfway between P1 and P2 for the base in
calculating the percentage change in price,
and the value halfway between Q1 and Q2 as

the base for calculating the percentage
change in quantity demanded.
change in quantity demanded

% change in quantity demanded  x 100%
(Q1  Q2 ) / 2
Q2 - Q1
 x 100%
(Q1  Q2 ) / 2
Using the point halfway between P1 and P2 as the base for

calculating the percentage change in price, we get
change in price
% change in price  x 100%
( P1  P2 ) / 2
P2 - P1
 x 100%
( P1  P2 ) / 2
TABLE 5.2 Calculating Price Elasticity with the Midpoint Formula

First, Calculate Percentage Change in Quantity Demanded (%QD):
change in quantity demanded Q2 - Q1
% change in quantity demanded  x 100%  x 100%
(Q1  Q2 ) / 2 (Q1  Q2 ) / 2
By substituting the numbers from Figure 5.1(a): PRICE ELASTICITY COMPARES THE
PERCENTAGE CHANGE IN QUANTITY
10  5 5 DEMANDED AND THE PERCENTAGE
% change in quantity demanded  x 100%  x 100%  66.7% CHANGE IN PRICE:
(5  10) / 2
7.5
%QD 66.7%

Next, Calculate Percentage Change in Price (%P): %P - 40.0%
 1.67
change in price P2 - P1  PRICE ELASTICITY OF DEMAND
% change in price  x 100%  x 100%
( P1  P2 ) / 2 ( P1  P2 ) / 2 DEMAND IS ELASTIC
By substituting the numbers from Figure 5.1(a):
23 -1
% change in price  x 100%  x 100%  - 40.0%
(3  2) / 2 2.5
ELASTICITY CHANGES ALONG A STRAIGHT-
LINE DEMAND CURVE
TABLE 5.3 Demand Schedule for Office

Dining Room Lunches
PRICE QUANTITY DEMANDED
(PER LUNCH) (LUNCHES PER MONTH)
$11 0
10 2
9 4
8 6
7 8
6 10
5 12
4 14
3 16
2 18
1 20
0 22
FIGURE 5.3 Demand Curve for Lunch at
the Office Dining Room
ELASTICITY AND TOTAL REVENUE

In any market, P x Q is total revenue (TR) received by
producers:
TR = P x Q
total revenue = price x quantity
When price (P) declines, quantity demanded (QD)

increases. The two factors, P and QD, move in opposite
directions:
Effects of price changes P  QD 

on quantity demanded: and
P  QD 
Because total revenue is the product of P and Q, whether

TR rises or falls in response to a price increase depends
on which is bigger, the percentage increase in price or the
percentage decrease in quantity demanded.
Effects of price increase on

a product with inelastic demand:  P x QD   TR 
If the percentage decline in quantity demanded following a

price increase is larger than the percentage increase in
price, total revenue will fall.
Effects of price increase on

a product with inelastic demand:  P x QD   TR 
The opposite is true for a price cut. When demand is

elastic, a cut in price increases total revenues:
effect of price cut on a product

with elastic demand:  P x QD   TR 
When demand is inelastic, a cut in price reduces total

revenues:
effect of price cut on a product

with inelastic demand:  P x QD   TR 
THE DETERMINANTS OF DEMAND ELASTICITY
AVAILABILITY OF SUBSTITUTES
Perhaps the most obvious factor affecting demand

elasticity is the availability of substitutes.
THE IMPORTANCE OF BEING UNIMPORTANT

When an item represents a relatively small part of our total

budget, we tend to pay little attention to its price.
THE TIME DIMENSION
The elasticity of demand in the short run may be very different from the elasticity of
demand in the long run. In the longer run, demand is likely to become more elastic, or
responsive, simply because households make adjustments over time and producers
develop substitute goods.
OTHER IMPORTANT ELASTICITIES
INCOME ELASTICITY OF DEMAND
income elasticity of demand Measures the

responsiveness of demand to changes in
income.

income elasticity of demand 
% change in income
CROSS-PRICE ELASTICITY OF DEMAND
cross-price elasticity of demand A measure

of the response of the quantity of one good
demanded to a change in the price of another
good.
% change in quantity of Y demanded

cross - price elasticity of demand 
% change in price of X
ELASTICITY OF SUPPLY
elasticity of supply A measure of the

response of quantity of a good supplied to a
change in price of that good. Likely to be
positive in output markets.
% change in quantity supplied

elasticity of supply 
% change in price
elasticity of labor supply A measure of the

response of labor supplied to a change in the
price of labor.
% change in quantity of labor supplied

elasticity of labor supply 
% change in the wage rate
REVIEW TERMS AND CONCEPTS
cross-price elasticity inelastic demand

of demand midpoint formula
elastic demand perfectly elastic
elasticity demand
elasticity of labor perfectly inelastic
supply demand
elasticity of supply price elasticity of
income elasticity of demand
demand unitary elasticity
Appendix
POINT ELASTICITY (OPTIONAL)
FIGURE 5A.1 Elasticity at a Point

Along a Demand Curve
Consider the straight-line

demand curve in Figure 5A.1.
We can write an expression for
elasticity at point C as follows:
Q Q
 100
%Q Q Q1 Q P1
elasticity     
%P P P P Q1
 100
P P1
Appendix
Q/P is the reciprocal of the slope of the curve. To calculate

the reciprocal of the slope to plug into the electricity equation,
we take Q1B, or M1, and divide by minus the length of line
segment CQ1. Thus,
Q M 1

P CQ1
Since the length of CQ1 is equal to P1, we can write:
Q M 1

P P1
By substituting we get:
M 1 P1 M 1 P1 M1
elasticity     
P1 Q1 P1 M 2 M 2
Appendix
FIGURE 5A.2 Point Elasticity Changes

Along a Demand Curve

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Chapter

Fernando & Yvonn Quijano

Price Elasticity of Demand

elasticity A general concept used to

SLOPE AND ELASTICITY

FIGURE 5.1 Slope Is Not a Useful Measure of Responsiveness

price elasticity of demand The ratio

of demand to changes in price.

% change in quantity demanded

Insulin +10% 0% 0.0 Perfectly inelastic

perfectly inelastic demand Demand

FIGURE 5.2 Perfectly Elastic and Perfectly Inelastic Demand Curves

inelastic demand Demand that responds

unitary elasticity A demand

elastic demand A demand relationship

with an absolute value greater than 1).

perfectly elastic demand Demand in

A good way to remember the difference between

CALCULATING PERCENTAGE CHANGES

To calculate percentage change in quantity demanded

change in quantity demanded

We can calculate the percentage change in price in a

ELASTICITY IS A RATIO OF PERCENTAGES

Once all the changes in quantity demanded and price

% change in quantity demanded

THE MIDPOINT FORMULA

and the value halfway between Q1 and Q2 as

change in quantity demanded

Using the point halfway between P1 and P2 as the base for

TABLE 5.2 Calculating Price Elasticity with the Midpoint Formula

By substituting the numbers from Figure 5.1(a):

TABLE 5.3 Demand Schedule for Office

ELASTICITY AND TOTAL REVENUE

When price (P) declines, quantity demanded (QD)

Effects of price changes P  QD 

Because total revenue is the product of P and Q, whether

Effects of price increase on

If the percentage decline in quantity demanded following a

Effects of price increase on

The opposite is true for a price cut. When demand is

effect of price cut on a product

When demand is inelastic, a cut in price reduces total

effect of price cut on a product

Perhaps the most obvious factor affecting demand

THE IMPORTANCE OF BEING UNIMPORTANT

When an item represents a relatively small part of our total

THE TIME DIMENSION

INCOME ELASTICITY OF DEMAND

income elasticity of demand Measures the

% change in quantity demanded

CROSS-PRICE ELASTICITY OF DEMAND

cross-price elasticity of demand A measure

% change in quantity of Y demanded

elasticity of supply A measure of the

positive in output markets.

% change in quantity supplied

elasticity of labor supply A measure of the

% change in quantity of labor supplied

cross-price elasticity inelastic demand

POINT ELASTICITY (OPTIONAL)

FIGURE 5A.1 Elasticity at a Point

Consider the straight-line

Q/P is the reciprocal of the slope of the curve. To calculate