CHAPTER

Elasticity and its Application

Economics
PRINCIPLES OF

Dr. Nanda R. Nurdianto S.E., M.S.E.

© 2009 South-Western, a part of Cengage Learning, all rights reserved

In this chapter, look for the answers to
these questions:
▪ What is elasticity? What kinds of issues can
elasticity help us understand?
▪ What is the price elasticity of demand?
How is it related to the demand curve?
How is it related to revenue & expenditure?
▪ What is the price elasticity of supply?
How is it related to the supply curve?
▪ What are the income and cross-price elasticities of
demand?

CHAPTER 5 ELASTICITY AND ITS APPLICATION 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 opp. cost of
your time), so you’re thinking of raising the price
to $250.
The law of demand says that 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?

CHAPTER 5 ELASTICITY AND ITS APPLICATION 2

 Elasticity
▪ Basic idea: Elasticity measures how much
one variable responds to changes in another
variable.
• One type of elasticity measures how much
demand for your websites will fall if you raise
your price.
▪ Definition:
Elasticity is a numerical measure of the
responsiveness of Qd or Qs to one of its
determinants.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 3

 Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P

▪ Price elasticity of demand measures how

much Qd responds to a change in P.

▪ Loosely speaking, it measures the price-

sensitivity of buyers’ demand.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 4

 Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
P
Example:
P rises
Price by 10%
P2
elasticity P1
of demand D
equals
Q
15% Q2 Q1
= 1.5 Q falls
10%
by 15%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 5
 Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
P
Along a D curve, P and Q
move in opposite directions, P2
which would make price
elasticity negative. P1

We will drop the minus sign D

and report Q
all price elasticities Q2 Q1
as positive numbers.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 6

 Calculating Percentage Changes
Standard method
of computing the
Demand for percentage (%) change:
your websites
P end value – start value
x 100%
start value
B
$250
A Going from A to B,
$200 the % change in P equals
D
($250–$200)/$200 = 25%
Q
8 12

CHAPTER 5 ELASTICITY AND ITS APPLICATION 7

 Calculating Percentage Changes
Problem:
The standard method gives
Demand for different answers depending
your websites on where you start.
P
From A to B,
B P rises 25%, Q falls 33%,
$250
A elasticity = 33/25 = 1.33
$200
From B to A,
D
P falls 20%, Q rises 50%,
Q elasticity = 50/20 = 2.50
8 12

CHAPTER 5 ELASTICITY AND ITS APPLICATION 8

 Calculating Percentage Changes
▪ So, we instead use the midpoint method:
end value – start value
x 100%
midpoint
▪ The midpoint is the number halfway between
the start & end values, also the average of
those values.
▪ It doesn’t matter which value you use as the
“start” and which as the “end” – you get the
same answer either way!

CHAPTER 5 ELASTICITY AND ITS APPLICATION 9

 Calculating Percentage Changes
▪ Using the midpoint method, the % change
in P equals
$250 – $200
x 100% = 22.2%
$225
▪ The % change in Q equals
12 – 8
x 100% = 40.0%
10
▪ The price elasticity of demand equals
40/22.2 = 1.8

CHAPTER 5 ELASTICITY AND ITS APPLICATION 10

ACTIVE LEARNING 1:
Calculate an elasticity
Use the following
information to
calculate the
price elasticity
of demand
for hotel rooms:
if P = $70, Qd = 5000
if P = $90, Qd = 3000

11
ACTIVE LEARNING 1:
Answers
Use midpoint method to calculate
% change in Qd
(5000 – 3000)/4000 = 50%

% change in P
($90 – $70)/$80 = 25%

The price elasticity of demand equals

50%
= 2.0
25%

12
 What determines price elasticity?
To learn the determinants of price elasticity,
we look at a series of examples.
Each compares two common goods.
In each example:
• Suppose the prices of both goods rise by 20%.
• The good for which Qd falls the most (in percent)
has the highest price elasticity of demand.
Which good is it? Why?
• What lesson does the example teach us about the
determinants of the price elasticity of demand?

CHAPTER 5 ELASTICITY AND ITS APPLICATION 13

EXAMPLE 1:
Rice Krispies vs. Sunscreen
▪ The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
• Rice Krispies has lots of close substitutes
(e.g., Cap’n Crunch, Count Chocula),
so buyers can easily switch if the price rises.
• Sunscreen has no close substitutes,
so consumers would probably not
buy much less if its price rises.
▪ Lesson: Price elasticity is higher when close
substitutes are available.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 14
EXAMPLE 2:
“Blue Jeans” vs. “Clothing”
▪ The prices of both goods rise by 20%.
For which good does Qd drop the most? Why?
• For a narrowly defined good such as
blue jeans, there are many substitutes
(khakis, shorts, Speedos).
• There are fewer substitutes available for
broadly defined goods.
(Can you think of a substitute for clothing,
other than living in a nudist colony?)
▪ Lesson: Price elasticity is higher for narrowly
defined goods than broadly defined ones.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 15
EXAMPLE 3:
Insulin vs. Caribbean Cruises
▪ The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
• To millions of diabetics, insulin is a necessity.
A rise in its price would cause little or no
decrease in demand.
• A cruise is a luxury.
If the price rises,
some people will forego it.
▪ Lesson: Price elasticity is higher for luxuries
than for necessities.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 16

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 where they work.
▪ Lesson: Price elasticity is higher in the
long run than the short run.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 17

 The Determinants of Price Elasticity:
A Summary

The price elasticity of demand depends on:

▪ the extent to which close substitutes are
available
▪ whether the good is a necessity or a luxury
▪ how broadly or narrowly the good is defined
▪ the time horizon: elasticity is higher in the
long run than the short run.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 18

 The Variety of Demand Curves
▪ Economists classify demand curves according to
their elasticity.
▪ The price elasticity of demand is closely related
to the slope of the demand curve.
▪ Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
▪ The next 5 slides present the different
classifications, from least to most elastic.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 19

“Perfectly inelastic demand” (one extreme case)
Price elasticity % change in Q 0%
= = =0
of demand % change in P 10%

D curve: P
D
vertical
P1
Consumers’
price sensitivity: P2
0
P falls Q
Elasticity: by 10% Q1
0 Q changes
by 0%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 20
“Inelastic demand”
Price elasticity % change in Q < 10%
= = <1
of demand % change in P 10%

D curve: P
relatively steep
P1
Consumers’
price sensitivity: P2
relatively low D
P falls Q
Elasticity: by 10% Q1 Q 2
<1
Q rises less
than 10%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 21
“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
intermediate D

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

CHAPTER 5 ELASTICITY AND ITS APPLICATION 22

“Elastic demand”
Price elasticity % change in Q > 10%
= = >1
of demand % change in P 10%

D curve: P
relatively flat
P1
Consumers’
price sensitivity: P2 D
relatively high
P falls Q
Elasticity: by 10% Q1 Q2
>1
Q rises more
than 10%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 23
“Perfectly elastic demand” (the other extreme)
Price elasticity % change in Q any %
= = = infinity
of demand % change in P 0%

D curve: P
horizontal
P2 = P1 D
Consumers’
price sensitivity:
extreme
P changes Q
Elasticity: by 0% Q1 Q2
infinity
Q changes
by any %
CHAPTER 5 ELASTICITY AND ITS APPLICATION 24
ELASTICITY AND ITS APPLICATION 25
25
Elasticity of a Linear Demand Curve

P The slope
200% of a linear
$30 E = = 5.0
40% demand
67% curve is
20 E = = 1.0 constant,
67%
but its
40%
10 E = = 0.2 elasticity
200%
is not.
$0 Q
0 20 40 60

CHAPTER 5 ELASTICITY AND ITS APPLICATION 26

 Price Elasticity and Total Revenue
▪ Continuing our scenario, if you raise your price
from $200 to $250, would your revenue rise or fall?
Revenue = P x Q
▪ A price increase has two effects on revenue:
• Higher P means more revenue on each unit
you sell.
• But you sell fewer units (lower Q), due to
Law of Demand.
▪ Which of these two effects is bigger?
It depends on the price elasticity of demand.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 27

 Price Elasticity and Total Revenue
Price elasticity Percentage change in Q
=
of demand Percentage change in P

Revenue = P x Q
▪ If demand is elastic, then
price elast. of demand > 1
% change in Q > % change in P
▪ The fall in revenue from lower Q is greater
than the increase in revenue from higher P,
so revenue falls.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 28
 Price Elasticity and Total Revenue
Elastic demand increased
Demand for
(elasticity = 1.8) P revenue due
your websiteslost
to higher P
If P = $200, revenue
due to
Q = 12 and lower Q
$250
revenue = $2400.
$200
If P = $250, D
Q = 8 and
revenue = $2000.
When D is elastic, Q
8 12
a price increase
causes revenue to fall.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 29
 Price Elasticity and Total Revenue
Price elasticity Percentage change in Q
=
of demand Percentage change in P

Revenue = P x Q
▪ If demand is inelastic, then
price elast. of demand < 1
% change in Q < % change in P
▪ The fall in revenue from lower Q is smaller
than the increase in revenue from higher P,
so revenue rises.
▪ In our example, suppose that Q only falls to 10
(instead of 8) when you raise your price to $250.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 30
 Price Elasticity and Total Revenue
Now, demand is
increased
Demand for
inelastic:
revenue due
your websites
elasticity = 0.82 P to higher P lost
If P = $200, revenue
Q = 12 and due to
$250 lower Q
revenue = $2400.
If P = $250, $200
Q = 10 and D
revenue = $2500.
When D is inelastic, Q
10 12
a price increase
causes revenue to rise.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 31
 Hubungan Elastisitas Harga dengan
Total Penerimaan (TR)

Penurunan Peningkatan
Ed Harga harga

Elastis (|Ed|>1) TR TR turun

meningkat
Inelastis (|Ed|<1) TR turun TR meningkat

Unitary Elastis) (Ed =1) TR tetap TR tetap

32
ACTIVE LEARNING 2:
Elasticity and expenditure/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?

33