Elasticity . . .

(1) …is a measure of how much buyers and sellers

respond to changes in market conditions. . .
Elasticity and Its (2) …allows us to analyze supply and demand with
Applications greater precision.

(3) …unlike slope, is a unit-free measure; no

matter what units price and quantity are
measured in, elasticity won’t change, but
slope will change as units change

Elasticity: A General Definition: Four Types of Elasticities. . .

Price
Elasticity is a ratio of proportional changes.
u Price Elasticity of
The elasticity of X with respect to Y is: Demand
u Income Elasticity
% X
u Price Elasticity of
----------
% Y Supply
u Cross Elasticity of
Demand
Elasticity could also be said to be the %
change in X for every 1% change in Y

Quantity

Price Elasticity of Demand Ranges of Elasticity . . .

Demand
The percentage u Perfectly Inelastic
P Consumers are “completely
change in the unresponsive” to price changes.
quantity demanded
u Perfectly Elastic Consumers are “infinitely responsive”
A for every. . .
to price changes.
. . . one percent
B change in the price. u Unit Elastic Consumer’s response is “proportionally equal
to” the change in price.

Q
 Elasticity of Demand Illustrated Elasticity of Demand Illustrated
Perfectly elastic. If
Perfectly inelastic, or price increases any
totally unresponsive amount, quantity
to changes in price demanded drops to
P2 zero.
P1

P1

Determinants of Market and general vs. firm specific

Price Elasticity of Demand demand curves
n Why is one consumer’s demand curve for rice
Demand tends to be more elastic: in general in Vietnam relatively inelastic and
n if the good is a luxury; downward sloping (and by logic, the market
n the longer the time period; curve also), but the demand curve for one
n the greater the number of close substitutes; and seller’s rice is nearly perfectly elastic, or
n the more narrowly defined the market.
horizontal?

n Answer: The availability of substitutes

Computing the Elasticity of Demand

Coefficient Ranges of Elasticity
Percentage Change in u Perfectly Elastic infinite
Price Elasticity Quantity Demanded u Elastic >1
=
of Demand Percentage Change
u Unitary or Unit =1
in Price u Inelastic <1
u Perfectly Inelastic =0
P.E.D. using Q / Avg. Q
the mid-point = Note: Elasticity of demand will always be negative
P / Avg. P (because P and Q go in opposite directions),
method therefore we use its absolute value (drop the
negative sign).
Computing Elasticity Coefficient Computing Elasticity Coefficient

Demand for Demand for

Ice Cream ED = Ice Cream ED =

2.10
(9 - 11) ÷ 10 2.10
(20%)

1.90 ($2.10 - $1.90) ÷ $2.00 1.90 (10%)

9 11 9 11

Computing Elasticity Coefficient Elasticity and Total Revenue

Demand for Over the Elastic Range of
Ice Cream
prices and quantity
price and total revenue are
2.10
ED = 2 NEGATIVELY CORRELATED
1.90
Demand is Elastic
Why?
9 11

Changing elasticity along a linear

Elasticity and Total Revenue demand curve
Over the Inelastic Range of prices
and quantity P Elastic range; TR as P ;
elasticity approaches 1 as P
price and total revenue are
At the mid-point ED = 1;
POSITIVELY CORRELATED unitary; TR maximum

Inelastic range; TR as P ;
elasticity approaches 1 as P

Q
 What happens to net revenue when What happens to net revenue when price
price changes? changes?

Price of Chocolate
Price of Chocolate

Net revenue effect: Net revenue effect:

$2 price increase $144 million ¯ $2 price increase $54 million
30 30

20 Elastic Demand 20 Inelastic Demand

Revenue rises Revenue falls by Revenue rises

10 10 Revenue falls
by $96 million $240 million by $114 million
by $60 million
0 10 20 30 40 50 60 70 0 10 20 30 40 50 60 70
Quantity Demanded Quantity Demanded
Fig 4.6a Fig 4.6b

Income Elasticity of Demand Computing Income Elasticity

Percentage Change in
The percentage change in the equilibrium Income Elasticity Equilibrium QD
quantity demanded =
of Demand Percentage Change
given a one percent change in income.
in Income
% Q D

----------
% Income
The sign of the income elasticity tells us what
kind of good it is...

Income Elasticity... Types Income Elasticity

u As with ED, when classifying consumer
response to income changes as inelastic,
YD > 0 Normal Goods elastic, or unitary, we take the absolute
value (drop the sign)
YD < 0 Inferior Goods
YD = 0 Income-neutral Goods u Goods consumers regard as “necessities”
tend to be income inelastic...( Y < 1)
n Examples include: food, fuel, clothing, utilities,
& medical services.
 Determinants of
Income Elasticity... Types
Elasticity of Supply
u Goods consumers regard as “luxuries” tend (1) Flexibility or ability of sellers to
to be income elastic... ( Y > 1) change the amount of the good they
n Examples: Sports cars, furs, and produce.
n expensive foods. Forget
n The nature of the good: Beachfront land
about that vs. books, cars, manufactured goods, etc.
sailboat my
dear, our n Time: More elastic in the long run.
income has
gone down
(2) Expectations: is the price change
likely to be permanent?
If yes, firms will be more responsive, if no,
less responsive

Elastic or inelastic supply? If linear, it

Computing Elasticity Coefficient
depends on which axis it crosses.
Percentage Change in Always elastic, approaches 1
Elasticity Quantity Supplied P as P & Q increase
=
of Supply Percentage Change Always unitary Always
in Price inelastic,
approaches 1
as P & Q
Notes: increase
(a) since P and Q move in the same direction for supply, there is
no need to take the absolute value before classifying it as
elastic, inelastic, or unitary.
(b) Since P and Q move in the same direction, there is no
meaningful relationship between ES and total revenue.
Q

Applications of Elasticity Apply Comparative Statics

“Can Good News for Farming Be Bad News Examine whether the supply or demand
For Farmers?” curve shifts.
What happens to wheat farmers and the ‚Consider the direction the curve shifts.
market for wheat when the weather is ƒUse supply-and-demand diagrams to see
especially good? how the market equilibrium changes.
Consider the state of elasticity.
Examine whether the supply or demand Consider which direction the curve shifts.
curve shifts.

Price Expected Note: once the

Price SExp.
crop is put in SActual
Mkt. Supply the ground, the
supply curve
becomes
$4.00 perfectly
$4.00 Good weather
inelastic and its
location causes an
depends on
weather, increase
insects,
disease, etc.
in supply.

DA DA
2000 Quantity 2000 Quantity

Use Supply-and-Demand diagram to see

how the market changes. Compute Elasticity
Price SExp. SActual
(2400 - 2000) / (2200)
Because demand
for food is
ED =
$4.00 inelastic (why?) ($2.60 - $4.00) / ($3.30)
small changes in
$2.60 supply cause
proportionally
large changes in
ED = 0.46 (Inelastic)
equilibrium price
DA
2000 2400 Quantity

Observe the Change in Total

Revenue Applications of Elasticity
Price SExp. SActual “Why did OPEC fail to keep the price of oil
TRExp. = $8,000 high in the long run?”
While the OPEC cartel has been successful in
$4.00 achieving short run bursts in oil prices, over
TRActual = $5,760 the long run these high oil prices have not
$2.60 Because costs been maintained.
wouldn’t
change, farm
DA profit will fall
when TR falls
2000 2400 Quantity
Apply economic reasoning Apply economic reasoning…

OPEC’s cartel policy consists of restricting • In the long run, the demand for oil and the supply of
the supply of oil. oil becomes more elastic. This will tend to restrain oil
‚The supply for oil will decrease. prices.
ƒThe price of oil will increase. • Why is oil elasticity different in the short run vs. long
„In the short run, the demand for oil is run?
inelastic. A higher price for oil will increase
• oil is a necessity for industrial societies
the total revenue of OPEC.
• adding to the supply of oil is difficult
• But…over time elasticity increases due to conservation,
alternate energy sources

Graph the demand curve for a

OPEC and Elasticity product that:
• OPEC wants oil prices high enough to
partly exploit short-run inelasticity, but a) is unitary elastic at every point
not so high that it causes oil-buying
countries to invest heavily in alternative b) when price is $1, Total Revenue =
energy sources (nuclear, solar, 100
hydroelectric…).
Hint: remember the rule about unitary
elasticity and total revenue

Quick quick on income elasticity Calculate the following (using the previous
chart):

Price Quantity Quantity

Demanded Demanded
(Income = (Income = a) Using the mid-point method calculate your price elasticity of
$10,000) $12,000) demand as the price of meals increases from $8 to $10 if
$8 40 50 (i.) your income is $10,000, and (ii.) your income is
$12,000.
b) Interpret your answers in (a); i.e. elastic, unit elastic, or
10 32 45 inelastic.
12 24 30 c) Calculate your income elasticity of demand (mid-point) as
14 16 20 your income increases from $10,000 to $12,000 if (i.) your
16 8 12 price is $12, and (ii.) your price is $16.
d) Interpret your answers in (c). [i.e. normal good or inferior
good.]