Lecture 3

Elasticity

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Elasticity
• … allows us to analyze supply and
demand with greater precision.

• … is a measure of how much buyers and

sellers respond to changes in market
conditions

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THE ELASTICITY OF DEMAND
• The 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.
• When we talk about elasticity, that
responsiveness is always measured in
percentage terms.
• Specifically, the price elasticity of demand is the
percentage change in quantity demanded due to
a percentage change in the price.

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 The Price Elasticity of Demand and Its
Determinants

a) Availability of Close Substitutes

b) Necessities versus Luxuries
c) Definition of the Market
d) Time Horizon

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 The Price Elasticity of Demand and Its
Determinants

a) Availability of Close Substitutes

The more possible substitutes there are for a given good or service, the greater the
elasticity. When several close substitutes are available, consumers can easily switch from
one good to another even if there is only a small change in price. Conversely, if no
substitutes are available, demand for a good is more likely to be inelastic.

b) Necessities versus Luxuries

The greater the necessity for a good, the lower the elasticity. Consumers will attempt to
buy necessary products (e.g. critical medications like insulin) regardless of the price.
Luxury products, on the other hand, tend to have greater elasticity. However, some goods
that initially have a low degree of necessity are habit-forming and can become
“necessities” to consumers (e.g. coffee or cigarettes).

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 The Price Elasticity of Demand and Its
Determinants

c) Definition of the Market

Demand for Fords is more elastic than demand for cars in general. Why? There are more substitutes for
Fords than for cars in general. If the price of a Ford goes up, you can just buy some other kind of car. If
the price of all cars goes up, maybe you can buy a truck or a motorcycle instead, but that’s not really the
same as a car. This is why the elasticity of demand for Fords will be higher than that of all cars in
general. The way you define the market affects how the elasticity will turn out. In general, the broader
the market, the lower the elasticity of demand

d) Time Horizon
Elasticity tends to be greater over the long-run than the short-run. In the short-term it may be difficult
for consumers to find substitutes in response to a price change, but, over a longer time period,
consumers can adjust their behavior. For example, if there is a sudden increase in gasoline prices,
consumers may continue to fuel their cars with gas in the short-run, but may lower their demand for
gas by switching to public transportation, carpooling, or buying more fuel-efficient vehicles over a
longer period of time.

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 The Price Elasticity of Demand and Its
Determinants

In 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.

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Computing the Price Elasticity of Demand

• The price elasticity of demand is computed

as the percentage change in the quantity
demanded divided by the percentage
change in price.
Percentage change in quantity demanded
Price elasticity of demand =
Percentage change in price

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 Computing the Price Elasticity of Demand
• Example: If the price of an ice cream cone
increases from RM2 to RM2.20 and the amount
you buy falls from 10 to 8 cones, then your
elasticity of demand would be calculated as:

Percentage change in quantity demanded

Price elasticity of demand =
Percentage change in price

(10  8)
 100 20%
10  2
(2.20  2.00)
 100 10%
2.00
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The Midpoint Method: A Better Way to Calculate
Percentage Changes and Elasticities
• The midpoint formula is preferable when
calculating the price elasticity of demand because
it gives the same answer regardless of the
direction of the price change.

(Q2  Q1 ) /[(Q2  Q1 ) / 2]
Price elasticity of demand =
( P2  P1 ) /[( P2  P1 ) / 2]

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The Midpoint Method: A Better Way to Calculate
Percentage Changes and Elasticities
• Example: If the price of an ice cream cone
increases from RM2 to RM2.20 and the amount
you buy falls from 10 to 8 cones, then your
elasticity of demand, using the midpoint formula,
would be calculated as:

(10  8)
(10  8) / 2 22%
  2.32
(2.20  2.00) 9.5%
(2.00  2.20) / 2

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The Variety of Demand Curves

• 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.

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The Variety of Demand Curves

a) Perfectly Inelastic
– Quantity demanded does not respond to price changes.
b) Perfectly Elastic
– Quantity demanded changes infinitely with any change in price.
c) Unit Elastic
– Quantity demanded changes by the same percentage as the
price.
d) Elastic
– Quantity demanded changes more than change in price.
e) Inelastic
– Quantity demanded changes less than the change in price.

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Figure 1 The Price Elasticity of Demand

(a) Perfectly Inelastic Demand: Elasticity Equals 0

Price
Demand

RM5

4
1. An
increase
in price . . .

0 100 Quantity

2. . . . leaves the quantity demanded unchanged.

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Figure 1 The Price Elasticity of Demand

(b) Perfectly Elastic Demand: Elasticity Equals Infinity

Price

1. At any price
above RM4, quantity
demanded is zero.
RM4 Demand

2. At exactly RM4,
consumers will
buy any quantity.

0 Quantity
3. At a price below RM4,
quantity demanded is infinite.

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Figure 1 The Price Elasticity of Demand

(c) Unit Elastic Demand: Elasticity Equals 1

Price It can be illustrated with
straight line as well
(either one)

RM5

4
1. A 22% Demand
increase
in price . . .

0 80 100 Quantity

2. . . . leads to a 22% decrease in quantity demanded.

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Figure 1 The Price Elasticity of Demand

(d) Elastic Demand: Elasticity Is Greater Than 1

Price

RM5

4 Demand
1. A 22%
increase
in price . . .

0 50 100 Quantity

2. . . . leads to a 67% decrease in quantity demanded.

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Figure 1 The Price Elasticity of Demand

(e) Inelastic Demand: Elasticity Is Less Than 1

Price

RM5

4
1. A 22% Demand
increase
in price . . .

0 90 100 Quantity

2. . . . leads to an 11% decrease in quantity demanded.

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Total Revenue and the Price Elasticity of Demand

• 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  Q

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 Figure 2 Total Revenue
Price

When the price is RM4,

consumers will demand 100 units,
and spend RM400 on this good.

RM4

P × Q = RM400
P
(revenue) Demand

0 100 Quantity

Q © 2007 Thomson South-Western

Elasticity and Total Revenue along a Linear Demand Curve

• With an inelastic demand curve, an

increase in price leads to a decrease in
quantity that is proportionately smaller.
Thus, total revenue increases.

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 Figure 3 How Total Revenue Changes When Price Changes:
Inelastic Demand

Price Price
An Increase in price from … leads to an Increase in
RM1 to RM3 … total revenue from RM100 to
RM240

Revenue = RM240
1
Demand Demand
Revenue = RM100

0 100 Quantity 0 80 Quantity

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Elasticity and Total Revenue along a Linear Demand Curve

• 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.

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 Figure 4 How Total Revenue Changes When Price Changes:
Elastic Demand

Price Price

An Increase in price from … leads to an decrease in

RM4 to RM5 … total revenue from RM200 to
RM100

RM5

RM4

Demand
Demand

Revenue = RM200 Revenue = RM100

0 50 Quantity 0 20 Quantity

Note that with each price increase, the Law of Demand still holds – an
increase in price leads to a decrease in the quantity demanded. It is the
change in TR that varies! © 2007 Thomson South-Western
 The relationship between price elasticity
and total revenue
 When demand is price inelastic:
 A decrease in price leads to a decrease in
total revenue.
 An increase in price leads to an increase in
total revenue.

 When demand is price elastic:

 A decrease in price leads to an increase in
total revenue.
 An increase in price leads to a decrease in
total revenue.

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Other Demand Elasticities

• 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.

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Other Demand Elasticities

• Computing Income Elasticity

Percentage change
in quantity demanded
Income elasticity of demand =
Percentage change
in income

Remember, all elasticities are

measured by dividing one
percentage change by another

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Other Demand Elasticities

• Income Elasticity
– Types of Goods
• Normal Goods
• Inferior Goods
– Higher income raises the quantity demanded
for normal goods but lowers the quantity
demanded for inferior goods.

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Other Demand Elasticities

• Cross-price elasticity of demand

– A measure of how much the quantity demanded of one
good responds to a change in the price of another good,
computed as the percentage change in quantity
demanded of the first good divided by the percentage
change in the price of the second good

% change in quantity demanded of good 1

Cross-price elasticity of demand = % change in price of good 2

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 THE 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
percentage change in price.

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Computing the Price Elasticity of Supply

• The price elasticity of supply is computed

as the percentage change in the quantity
supplied divided by the percentage change
in price.
Percentage change
in quantity supplied
Price elasticity of supply =
Percentage change in price

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Figure 5 The Price Elasticity of Supply

(a) Perfectly Inelastic Supply: Elasticity Equals 0

Price
Supply

RM5

4
1. An
increase
in price . . .

0 100 Quantity

2. . . . leaves the quantity supplied unchanged.

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Figure 5 The Price Elasticity of Supply

(b) Perfectly Elastic Supply: Elasticity Equals Infinity

Price

1. At any price
above RM4, quantity
supplied is infinite.

RM4 Supply

2. At exactly RM4,
producers will
supply any quantity.

0 Quantity
3. At a price below RM4,
quantity supplied is zero.

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Figure 5 The Price Elasticity of Supply

(c) Unit Elastic Supply: Elasticity Equals 1

Price

Supply
RM5

4 (If SUPPLY is unit

elastic and linear, it will
1. A 22%
increase
begin at the origin.)
in price . . .

0 100 125 Quantity

2. . . . leads to a 22% increase in quantity supplied.

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Figure 5 The Price Elasticity of Supply

(d) Elastic Supply: Elasticity Is Greater Than 1

Price

Supply
RM5

4
1. A 22%
increase
in price . . .

0 100 200 Quantity

2. . . . leads to a 67% increase in quantity supplied.

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Figure 5 The Price Elasticity of Supply

(e) Inelastic Supply: Elasticity Is Less Than 1

Price

Supply
RM5

4
1. A 22%
increase
in price . . .

0 100 110 Quantity

2. . . . leads to a 10% increase in quantity supplied.

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The Price Elasticity of Supply

• Ability of sellers to change the amount of

the good they produce.
– Example: beachfront land has an inelastic supply.
– Almost impossible to produce more

– Manufactured goods have elastic supply

e.g. books, cars, televisions
– Firms can produce more in response to a higher price.

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Determinant of the Price Elasticity of Supply

• Time period
– Time is the most significant factor which affects the
elasticity of supply.
– Supply is more elastic in the long run than in the short
run.
– Over short periods, firms cannot easily change the
size of their factories to make more or less of a good.
– By contrast, over longer periods, firms can build new
factories or close old ones. New firms can enter the
market or old ones can exit.

Quantity supplied is more elastic over a long time period.

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End of Lecture

Thank you

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