Elasticity

1
 A scenario:
• You design websites for local businesses.
– You charge $200 per website, and currently sell 12
websites per month.
• Your costs are rising (including the opportunity
cost of your time)
– You consider raising the price to $250.
• The law of demand: you won’t sell as many
websites if you raise your price.
– How many fewer websites?
– How much will your revenue fall, or might it increase?

2
 What is elasticity?
• A measure of the responsiveness of the
Quantity Demanded or Supplied to a change
in one of it’s determinants, such as
– Price (price elasticity)
– Income (income elasticity)
– Price of another good (cross price elasticity)

3
 Price Elasticity of Demand
– How much the quantity demanded of a good
responds to a change in the price of that good
• Loosely speaking, it measures the price-sensitivity of
buyers’ demand

4
 Price Elasticity of Demand
• Elastic demand
– Quantity demanded responds substantially to
changes in price
• Inelastic demand
– Quantity demanded responds only slightly to
changes in price

5
Elasticity – Visualization Exercise
– Think of a rubber band
• If a rubber band is very elastic, you will be able to make
it big when you pull.
– Similarly, if a good is very elastic (high price elasticity of
demand) it means that the quantity demanded of that good
responded a lot to a change in price
• If a rubber band is not very elastic, or inelastic, that
same pull will only stretch it out a little.
– Similarly, if a good is inelastic (low price elasticity of demand),
it means that the quantity demanded responded little to that
same change in price.

6
 Computing Elasticity
• Computing the price elasticity of demand
– Percentage change in quantity demanded divided
by percentage change in price
– Price elasticity of demand is negative due to the
Law of Demand.*

*Some texts drop the negative to make elasticity comparisons easier. We will
keep the negative and look at absolute value when needed for comparison.

7
 Computing Elasticity
• Midpoint method
– Two points: (Q1, P1) and (Q2, P2)
(Q2  Q1 )/[(Q2  Q1 )/ 2 ]
Price elasticity of demand 
(P2  P1 )/[(P2  P1 )/ 2 ]

Note: If you calculate elasticity without using the midpoints, you will get
a different number going from P1 to P2 than from P2 to P1. The difference
will be greater the farther apart the start and end prices are.

8
 Calculating Price Elasticity of Demand
Demand for your websites
P
B
$250 Using the midpoint method of
A computing % changes:
$200
D
Q
8 12
$250  $200
% change in P =  100%  22.2%
$225
8
8 -12
12
% change in Q =  100% -40%
10
- 40% -
Price elasticity =  1.8
22.2%
9
Active Learning 1 Calculate an elasticity

Use the following information to calculate the

price elasticity of demand for iPhones:
• if P = $400, Qd = 10,600
• if P = $600, Qd = 8,400
• Use the midpoint method to calculate
percentage changes.

10
Active Learning 1 Answers

Using the midpoint method to calculate percentage

changes:
• % change in P =
[($600 - $400)/$500] ×100 = 40%
• % change in Qd =
[(8,400 – 10,600)/9,500] ×100 = -23.16%
• Price elasticity of demand =
= % change in Qd / % change in P
= -23.16/40 = -0.58

11
 Price Elasticity of Demand
• Determinants of price elasticity of demand
– We’ll look at a series of examples comparing two
common goods
• In each example:
– Suppose prices of both goods rise by 20%
– Which good has the highest price elasticity of
demand? Why?
– What lesson do we learn about the determinants of
price elasticity of demand?

12
 Price Elasticity of Demand
Example 1: Breakfast cereal vs. Sunscreen
– Prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?

• Breakfast cereal has close substitutes, so buyers can easily

switch if the price rises
• Sunscreen has no close substitutes, so a price increase
would not affect demand very much

Price elasticity is higher when close substitutes

are available
13
 Price Elasticity of Demand
Example 2: Blue Jeans vs. Clothing
– Prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
• For a narrowly defined good, blue jeans, there are many
substitutes
There are fewer substitutes available for broadly defined
goods (clothing)

Price elasticity is higher for narrowly defined

goods than for broadly defined ones.

14
 Price Elasticity of Demand
Example 3: Insulin vs. Yachts
– Prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
• Insulin is a necessity to diabetics. A rise in price would
cause little or no decrease in demand
• A yacht is a luxury. If the price rises, some people will
forego it.

Price elasticity is higher for luxuries than for

necessities.
15
 Price Elasticity of Demand
Example 4: Gasoline in the Short Run vs.
Gasoline in the Long Run
– The price of gasoline rises 20%. Does Qd drop more in
the short run or the long run? Why?

• There’s not much people can do in the

short run, other than ride the bus or carpool.
• In the long run, people can buy smaller cars
or live closer to work.

Price elasticity is higher in the long run

16
 Price Elasticity of Demand
Example 5: A small caramel at the register vs. a
family-size bag of caramels
– Prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
• The caramels at the register typically don’t cost much, so even if
price is up 20%, it only changes by a few cents. You may not even
notice the change, and may not change Qd at all.
• A big bag will cost more, so a 20% price increase will be larger in
dollars, possibly several dollars. This bigger change will be noticed,
and the law of demand will prevail.

Price elasticity is higher the larger percentage of one’s budget

or income is spent on the good
17
 Price Elasticity of Demand
• Determinants of price elasticity of demand
– Availability of close substitutes
• Goods with close substitutes: more elastic demand
– Definition of the market
• Narrowly defined markets: more elastic demand
– Necessities versus luxuries
• Necessities: inelastic demand
• Luxuries: elastic demand
– Time horizon
• Demand is more elastic over longer time horizons
– Percentage of income spent on good
• Larger percentage of income: more elastic demand

18
 Price Elasticity of Demand

• Variety of demand curves

– Demand is elastic
• |Price elasticity of demand| > 1
– Demand is inelastic
• |Price elasticity of demand| < 1
– Demand has unit elasticity
• |Price elasticity of demand| = 1

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 Price Elasticity of Demand
• Variety of demand curves
– Demand is perfectly inelastic
• Price elasticity of demand = 0
• Demand curve is vertical
– Demand is perfectly elastic
• Price elasticity of demand = infinity
• Demand curve is horizontal
• The flatter the demand curve
– The greater the price elasticity of demand

20
 Perfectly inelastic demand
% change in Q 0%
Price elasticity =0
= = 10%
of demand % change in P
P D curve
D
Vertical
P1
Consumers’ price
P2 sensitivity:
None
P falls Q
by 10% Q1 Elasticity:
Q changes 0
by 0%
21
 Inelastic demand
Price elasticity % change in Q <10%
= = <1
of demand % change in P 10%
P
D curve
relatively steep
P1

P2 Consumers’ price
D sensitivity:
relatively low
P falls Q
by 10% Q1 Q 2
|Elasticity|:
Q rises less <1
than 10%

22
 Unit elastic demand
Price elasticity % change in Q 10%
= = =1
of demand % change in P 10%
D curve
P intermediate slope

P1 Consumers’ price
sensitivity:
P2
D intermediate

P falls Q
by 10% Q1 Q2
|Elasticity|:
Q rises
=1
by 10%

23
 Elastic demand
Price elasticity % change in Q >10%
= = >1
of demand % change in P 10%
P
D curve
relatively flat
P1

P2 D
Consumers’ price
sensitivity:
relatively high
P falls Q
by 10% Q1 Q2
|Elasticity|:
Q rises more
>1
than 10%

24
 Perfectly elastic demand
Price elasticity % change in Q any %
= = = infinity
of demand % change in P 0%
P D curve
horizontal
P2 = P1 D
P changes Consumers’ price
by 0% sensitivity:
extreme
Q
Q1 Q2
|Elasticity|:
Q changes infinity
by any %

25
A Few Demand Elasticities from the Real World
(absolute values)

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Elasticity along a Linear Demand Curve
P
-200%
$30 ε = = -5.0
40% The slope of a linear
-67% demand curve is
20 ε = = -1.0 constant, but its
67%
elasticity
-40%
10 ε = = -0.2 is not.
200%

$0 Q
0 20 40 60

27
 Price Elasticity and Total Revenue

Continuing our scenario, if you raise your price

from $200 to $250, would your revenue rise or
fall?
Total Revenue (TR) = P x Q
• A price increase has two effects on revenue:
– Higher revenue: because of the higher P
– Lower revenue: you sell fewer units (lower Q)
• Which of these two effects is bigger?
– It depends on the price elasticity of demand

28
 Price Elasticity and Total Revenue
• For a price increase, if demand is elastic
 |ε| > 1: % change in Q > % change in P
 TR decreases: the fall in revenue from lower Q >
the increase in revenue from higher P
• For a price increase, if demand is inelastic
 |ε| < 1: % change in Q < % change in P
 TR increases: the fall in revenue from lower Q <
the increase in revenue from higher P

29
 Price Elasticity and Total Revenue
Demand for your websites Elastic demand
increased (elasticity = -1.8)
P revenue
due to lost If P = $200, Q = 12, and
higher P revenue revenue = $2400
$250 due to
lower Q If P = $250, Q = 8, and
$200
D revenue = $2000

When D is elastic,
Q a price increase causes
8 12 revenue to fall.

30
 Price Elasticity and Total Revenue
Demand for your websites
Inelastic demand
increased
(elasticity = -0.82)
P revenue
due to lost If P = $200, Q = 12, and
higher P revenue revenue = $2400
$250 due to
lower Q If P = $250, Q = 10, and
$200
revenue = $2500
D
When D is inelastic,
a price increase causes
Q
10 12 revenue to rise.

31
Active Learning 2 Elasticity and revenue

A. Pharmacies raise the price of insulin by 10%.

– Does total expenditure on insulin rise or fall?

B. As a result of a fare war, the price of a luxury

cruise falls 20%.
– Does luxury cruise companies’ total revenue rise
or fall?

32
Active Learning 2 Answers

A. Pharmacies raise the price of insulin by 10%.

– Does total expenditure on insulin rise or fall?

• Expenditure = P x Q
• Since demand is inelastic, Q will fall less
than 10%, so expenditure rises.

33
Active Learning 2 Answers

B. As a result of a fare war, the price of a luxury

cruise falls 20%.
– Does luxury cruise companies’ total revenue rise or
fall?
• Revenue = P x Q
• The fall in P reduces revenue, but Q increases,
which increases revenue. Which effect is bigger?
• Since demand is elastic, Q will increase more than
20%, so revenue rises.
34
 Does Drug Interdiction Increase
or Decrease Drug-related Crime?
1. Increase the number of federal agents
devoted to the war on drugs
– Illegal drugs: supply curve shifts left
• Higher price and lower quantity
– Amount of drug-related crimes
• Inelastic demand for drugs
• Higher drugs price: higher total revenue
• Increase drug-related crime

35
 Policy 1: Interdiction
new value of drug-
Interdiction Price of related crime
reduces the Drugs S2
D1
supply of drugs. S1
P2
Demand for drugs is
inelastic: P rises initial value
P1
proportionally more of drug-
than Q falls. related
crime
Result: an increase in
total spending on drugs, Q2 Q 1 Quantity
of Drugs
and in drug-related
crime
36
 Does Drug Interdiction Increase
or Decrease Drug-related Crime?
2. Policy of drug education
– Reduce demand for illegal drugs
– Left shift of demand curve
– Lower quantity
– Lower price
– Reduce drug-related crime

37
 Policy 2: Education
new value of drug-
Price of related crime
Education reduces Drugs
the demand for D2 D1
drugs. S

P and Q fall. initial value

P1
of drug-
Result: P2 related
A decrease in total crime
spending on drugs,
and in drug-related Q2 Q 1 Quantity
of Drugs
crime.
38
 The Price Elasticity of Supply

• Price elasticity of supply

– How much the quantity supplied of a good
responds to a change in the price of that good
– Percentage change in quantity supplied
• Divided by the percentage change in price
– Loosely speaking, it measures sellers’
price-sensitivity
– Due to the Law of Supply, price and quantity
change in the same direction, hence price
elasticity of supply is positive.

39
 Price Elasticity of Supply
s
Price elasticity percentage change in Q 16%
of supply   2
percentage change in P 8%
P
S

P rises P2
by 8% P
1
Again, we use
the midpoint
method to Q
compute the Q1 Q2
percentage Q rises
changes.
by 16%
40
 The Price Elasticity of Supply

• Variety of supply curves

– Supply is unit elastic
• Price elasticity of supply = 1
– Supply is elastic
• Price elasticity of supply > 1
– Supply is inelastic
• Price elasticity of supply < 1

41
 The Price Elasticity of Supply
• Variety of supply curves
– Supply is perfectly inelastic
• Price elasticity of supply = 0
• Supply curve is vertical
– Supply is perfectly elastic
• Price elasticity of supply = infinity
• Supply curve is horizontal
• The flatter the supply curve
– The greater the price elasticity of supply

42
Perfectly inelastic supply
Price elasticity % change in Q 0%
= = =0
of supply % change in P 10%

Supply curve: P
S
vertical
P
P rises 2
Sellers’ price
by 10% P
sensitivity: 1

none
Q
Elasticity: Q1
0 Q changes
by 0%
43
 Inelastic supply
Price elasticity % change in Q < 10%
= = <1
of supply % change in P 10%

Supply curve: P
relatively steep S

P2
P rises
Sellers’ price by 10% P
sensitivity: 1

relatively low
Q
Q1 Q 2
Elasticity:
<1 Q rises less
than 10%
44
 Unit elastic supply
Price elasticity % change in Q 10%
= = =1
of supply % change in P 10%

Supply curve: P
S
intermediate slope
P2
Sellers’ price sensitivity: P1
intermediate
P rises
by 10% Q
Elasticity: Q1 Q2
=1
Q rises
by 10%
45
 Elastic supply
Price elasticity % change in Q > 10%
= = >1
of supply % change in P 10%
S curve:
P
relatively flat
S

Sellers’ price P rises P2

sensitivity: by 10%
P1
relatively high
Q
Elasticity: Q1 Q2
>1 Q rises more
than 10%
46
 Perfectly elastic supply
Price elasticity % change in Q any %
= = = infinity
of supply % change in P 0%
S curve:
horizontal P

Sellers’ price P2 = P1 S
sensitivity: P changes
extreme by 0%

Elasticity: Q
Q1 Q2
infinity Q changes
by any %

47
 Price Elasticity of Supply
• Determinants of price elasticity of supply
– We look at examples comparing two common goods
• In each example:
– Suppose prices of both goods rise by 20%
– Which good has the highest price elasticity of supply?
Why?
– What lesson we learn about the determinants of price
elasticity of supply?

48
 Price Elasticity of Supply
Example 1: (prepared) hot dogs vs. houses
– Prices of both of these goods rise by 20%.
For which good does Qs rise the most? Why?
• To supply more hot dogs for customers to eat, a hot dog
salesperson simply buy more dogs and buns, so can respond to
price quickly and easily
• To supply more houses, one needs get permits from the city to
build on land (and get more land to build on), procure many
materials, hire builders, etc. Thus, it is more difficult to respond
to price increases.

Price elasticity of supply is higher the more easily

sellers can change the quantity they produce.
49
 Price Elasticity of Supply
Example 2: tablets/month vs. tablets/year
– Prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?

• Think of a factory building tablets that may be working near

capacity. They may only be able to increase production by a little
bit as long as they are stuck with the machinery they have.
• Over a longer period, say a year, they may be able to either
expand the factory or buy/build extra equipment to help them
better respond to increases in price.
Price elasticity of supply is higher in the long run than
in the short run.
50
Active Learning 3
Elasticity and changes in equilibrium

The supply of beachfront property is inelastic.

The supply of new cars is elastic.
Suppose population growth causes demand for
both goods to double (at each price, Qd doubles).

• For which product will P change the most?

• For which product will Q change the most?

51
Active Learning 3 Answers
Beachfront property
When supply is (inelastic supply):
inelastic, an P
increase in
D1 D2 S
demand has a
bigger impact on
price than on P2 B
quantity.
P1 A

Q
Q1 Q2

52
Active Learning 3 Answers
New cars
When supply (elastic supply):
is elastic, P
an increase in D1 D2
demand has a
bigger impact on S
quantity than on B
price. P2
A
P1

Q
Q1 Q2

53
 How the Price Elasticity of Supply Can Vary

Price Elasticity is small Supply

(less than 1).
$15 Supply often
becomes less
12
elastic as Q
Elasticity is large
(greater than 1). rises, due to
capacity limits.
4
3

0 100 200 500 525 Quantity

54
 Other Elasticities of Demand
(besides price elasticity)
• Income elasticity of demand
– How much the quantity demanded of a good
responds to a change in consumers’ income
– Percentage change in quantity demanded divided
by the percentage change in income
– Normal goods: income elasticity > 0
– Inferior goods: income elasticity < 0

55
 Other Elasticities of Demand

• Cross-price elasticity of demand

– How much the QD of one good responds to a
change in the price of another good
– Percentage change in QD of the first good divided
by the percentage change in price of the second
good
– Substitutes: cross-price elasticity > 0
– Complements: cross-price elasticity < 0

56
 Cross-Price Elasticity &
Market Definition
• In order to define a market, one might wonder what
products to include together in a single market.
– Ex: ice cream market – do we include gelato, frozen yogurt, ice
milk, etc.?
– Defining a market correctly is important in legal cases where a
company has been accused of anticompetitive behavior in a
particular market. A more broadly defined market might be
argued to be more competitive (and vice versa)
• Cross-price elasticity is used to determine if goods are
substitutes. If they are, they may be in the same market
– If demand for gelato increases a lot when the price of standard
ice cream increases, this may indicate that consumers consider
them to be substitutes and the goods compete against each
other in the same market.

57
 Applications
• Can Good News for Farming Be Bad News for
Farmers?
– New hybrid of wheat – increase production per
acre 20%
• Supply curve shifts to the right
• Higher quantity and lower price
• Demand is inelastic: total revenue falls
– Paradox of public policy: induce farmers not to
plant crops

58
 An Increase in Supply in the Market for Wheat

Price of 1. When demand is inelastic,

Wheat an increase in supply . . .
S1

S2
2. … leads
to a large fall $3
3. … and a proportionately
in price. . . 2 smaller increase in quantity
sold. As a result, revenue falls
from $300 to $220.

Demand
0 100 110 Quantity of Wheat

59
 Applications
• Why Did OPEC Fail to Keep the Price of Oil High?
– Increase in prices 1973-1974, 1971-1981
– Short-run: supply and demand are inelastic
• Decrease in supply: large increase in price
• Supply: may be hard to build new oil rigs quickly. Demand:
Can’t afford a more fuel-efficient car yet.
– Long-run: supply and demand are elastic
• Decrease in supply: small increase in price
• In longer run, can get those additional rigs built and can save
up and buy a smaller car (which the car companies had time
to develop and bring to market in response to demand)

60
 A Reduction in Supply in the World Market for Oil

(a) The Oil Market in the Short Run (b) The Oil Market in the Long Run
1. In the short run, when supply and 1. In the long run, when supply
demand are inelastic, a shift in supply. . . Price and demand are elastic, a shift
Price in supply. . .
S2 2. … leads
S1 to a small
S2 S1
P2 increase in
price
2. … leads
to a large P2
P1 P1
increase in
price

Demand Demand

0 Quantity 0 Quantity

61
 Elasticity and Government Policy
• Elasticities of Demand and Supply can
determine what effect government policies
will have on market equilibrium P & Q
• They can also determine who bears more of
the economic burden of a tax.
• They can further determine how much
deadweight loss there will be from an increase
in the tax rate.

62
 Elasticity and Price Ceilings
Rent control example P S
from the previous
module.
$800
In the short run, D &
S are moderately Price
$500
inelastic, as some ceiling
renters and landlords shortage
D
may have contractual Q
250 400
obligations.

63
 How Price Ceilings Affect Market Outcomes
P S
In the long run,
supply and demand
of rental
$800
apartments are
more price-elastic. $500
Price
ceiling
So, the shortage shortage
D
is larger. Q
150 450

64
 Elasticity and tax incidence
• We saw in the previous module that the
economic incidence of a tax is not affected by
which party the government puts the legal
burden of the tax on.
• So what, then, does determine tax incidence?
– the price elasticities of supply and demand.
• There are two cases:
– supply is more price-elastic than demand
– demand is more price-elastic than supply
 Elasticity and Tax Incidence
CASE 1: Supply is more elastic than demand

P It’s easier for

sellers than buyers
Buyers’ share PB S to leave the
of tax burden market.
Tax
Price if no tax So buyers bear
most of the burden
Sellers’ share PS
of the tax.
of tax burden
D
Q

66
 Elasticity and Tax Incidence
CASE 2: Demand is more elastic than supply

P It’s easier for

S buyers than sellers
Buyers’ share to leave the
of tax burden PB market.
Sellers bear most
Price if no tax
Tax of the burden of
Sellers’ share the tax.
of tax burden PS
D

67
 Who pays the luxury tax?

• 1990, Congress adopted a new luxury tax

– On yachts, private airplanes, furs, jewelry,
expensive cars
– Goal: to raise revenue from those who could most
easily afford to pay
– Luxury items
• Demand is quite elastic
• Supply is relatively inelastic

68
 CASE STUDY: Who Pays the Luxury Tax?
The market for yachts
Demand is
P price-elastic.
S
Buyers’ share In the short run,
of tax burden PB
supply is inelastic.
Tax
Hence,
Sellers’ share companies
of tax burden PS that build
D
yachts pay
Q most of
the tax.

69
Active Learning 3 The 2011 payroll tax cut
Prior to 2011, the Social Security payroll tax was 6.2%
taken from workers’ pay and 6.2% paid by employers
(total 12.4%). The Tax Relief Act (2010) reduced the
worker’s portion from 6.2% to 4.2% in 2011, but left the
employer’s portion at 6.2%.
• Should this change have increased the typical worker’s
take-home pay by exactly 2%, more than 2%, or less
than 2%? Do any elasticities affect your answer?
Explain.
• FOLLOW-UP QUESTION: Who gets the bigger share of
this tax cut, workers or employers? How do elasticities
determine the answer?
70
Active Learning 3 Answers
• As long as labor supply and labor demand both have
price elasticity > 0, the tax cut will be shared by
workers and employers, i.e., workers’ take-home pay
will rise less than 2%.
• The answer does NOT depend on whether labor
demand is more or less elastic than labor supply.
• Note also: the legal division of the tax (6.2% worker,
6.2% employer) is irrelevant to the economic incidence
of the tax. This means that workers’ take-home pay
depends only on the total amount of the tax (12.4%),
not on the portion that’s collected from workers vs.
employers.
71
Active Learning 3 Answers
FOLLOW-UP QUESTION :
• If labor demand is more elastic than labor supply,
workers get more of the tax cut than employers.
• If labor demand is less elastic than labor supply,
employers get the larger share of the tax cut.

72
 Elasticity and Deadweight Loss
• We learned in the last module that taxes can
cause a deadweight loss of efficiency to society.
• Price elasticities of supply and demand determine
how much DWL
– More elastic supply curve
• Larger deadweight loss
– More elastic demand curve
• Larger deadweight loss
• The greater the elasticities of supply and demand
– The greater the deadweight loss of a tax
 DWL and the Elasticity of Supply
When supply is inelastic, P
S
it’s harder for firms to
leave the market when
the tax reduces PS.
Size
So, the tax only reduces of tax
Q a little, and DWL is
D
small.
Q

74
 DWL and the Elasticity of Supply
The more elastic is supply, P
the easier for firms to
leave the market when
the tax reduces PS, S
Size
the greater Q falls below of tax
the surplus-maximizing
quantity,
D
the greater the DWL. Q

75
DWL and the Elasticity of Demand
When demand is
P inelastic,
S
it’s harder for
Size consumers to leave the
of tax market when the tax
raises PB.

So, the tax only reduces

D
Q a little, and DWL is
Q small.

76
DWL and the Elasticity of Demand
The more elastic is
P
demand,
S the easier for buyers to
leave the market when the
tax increases PB,
Size
of tax
D
the more Q falls below the
surplus-maximizing
quantity,
Q
and the greater the DWL.

77
Active Learning 2 Elasticity and the DWL

Would the DWL of a tax be larger if the

tax were on:
A. Breakfast cereal or sunscreen?
B. Hotel rooms in the short run or hotel rooms
in the long run?
C. Groceries or meals at fancy restaurants?

78
Active Learning 2 Answers

A. Breakfast cereal or sunscreen?

From Chapter 5:
Breakfast cereal has more close substitutes than
sunscreen, so demand for breakfast cereal is
more price-elastic than demand for sunscreen.
• So, a tax on breakfast cereal would cause a
larger DWL than a tax on sunscreen.

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Active Learning 2 Answers
B. Hotel rooms in the short run or hotel rooms
in the long run?
From Chapter 5:
The price elasticities of demand and supply
for hotel rooms are larger in the long run than
in the short run.
• So, a tax on hotel rooms would cause a larger
DWL in the long run than in the short run.

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Active Learning 2 Answers

C. Groceries or meals at fancy restaurants?

From Chapter 5:
Groceries are more of a necessity and therefore
less price-elastic than meals at
fancy restaurants.
• So, a tax on restaurant meals would cause a
larger DWL than a tax on groceries.

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Active Learning 3 Discussion question
The government must raise tax revenue to pay
for schools, police, etc. To do this, it can either
tax groceries or meals at fancy restaurants.
• Which should it tax?

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 Summary
• Elasticity measures the responsiveness of
Qd or Qs to one of its determinants.
• Price elasticity of demand equals percentage
change in Qd divided by percentage change in P.
When it’s less than one, demand is “inelastic.”
When greater than one, demand is “elastic.”
• When demand is inelastic, total revenue rises
when price rises. When demand is elastic, total
revenue falls when price rises.
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 Summary
• Demand is less elastic in the short run,
for necessities, for broadly defined goods,
and for goods with few close substitutes.
• Price elasticity of supply equals percentage
change in Qs divided by percentage change in P.
When it’s less than one, supply is “inelastic.”
When greater than one, supply is “elastic.”
• Price elasticity of supply is greater in the long run
than in the short run.
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 Summary
• The income elasticity of demand measures how
much quantity demanded responds to changes in
buyers’ incomes.
• The cross-price elasticity of demand measures
how much demand for one good responds to
changes in the price of another good.
• The tools of supply and demand can be applied in
many different kinds of markets.

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 Summary
• The incidence of the tax depends on the price
elasticities of supply and demand.
• The price elasticities of demand and supply
measure how much buyers and sellers respond to
price changes. Therefore, higher elasticities
imply higher DWLs.

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