Elasticity and Its Application

1
 The Elasticity of Demand
• Elasticity
– Measure of the responsiveness of quantity
demanded or quantity supplied
– To a change in one of its determinants
• Price elasticity of demand
– How much the quantity demanded of a
good
– Responds to a change in the price of that
good

2
 The Elasticity of Demand
• Price elasticity of demand
– Percentage change in quantity demanded
divided by the percentage change in price
• Elastic demand
– Quantity demanded responds
substantially to changes in price
• Inelastic demand
– Quantity demanded responds only slightly
to changes in price
3
 The Elasticity of Demand
• Determinants of price elasticity of demand
– Availability of close substitutes
• Goods with close substitutes – more elastic
demand
– Necessities vs. luxuries
• Necessities – inelastic demand
• Luxuries – elastic demand

4
 The Elasticity of Demand
• Determinants of price elasticity of demand
– Definition of the market
• Narrowly defined markets – more elastic
demand
– Time horizon
• Demand is more elastic over longer time
horizons

5
 The Elasticity of Demand
• Computing the price elasticity of demand
– Percentage change in quantity demanded
divided by percentage change in price
– Use absolute value (drop the minus sign)
• Midpoint method
– Two points: (Q1, P1) and (Q2, P2)

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

6
 The 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

7
 The 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

8
The Price Elasticity of Demand (a, b)
(a) Perfectly Inelastic Demand: (b) Inelastic Demand: Elasticity Is
Elasticity Equals 0 Less Than 1

Price Price
1. An Demand 1. A 22% 2. … leads
increase in increase to an 11%
price… decrease in
in price…
quantity
$5 $5 demanded
4 4
2. …leaves
the quantity
Demand
demanded
unchanged

0 100 0 90 100
Quantity Quantity

The price elasticity of demand determines whether the demand curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
9
The Price Elasticity of Demand (c)
(c) Unit Elastic Demand: Elasticity
Equals 1
Price
Demand

$5
1. A 22%
4
increase
in price…
2. … leads to a 22%
decrease in quantity
demanded
0 80 100
Quantity

The price elasticity of demand determines whether the demand curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
10
The Price Elasticity of Demand (d, e)
(d) Elastic demand: (e) Perfectly elastic demand:
Elasticity > 1 Elasticity equals infinity

Price Price 1. At any price

A 22% above $4, quantity
increase demanded is zero 2. At exactly $4,
in price… consumers will
$5 buy any quantity
4 Demand $4
Demand
2. … leads to a 3. At a price
67% decrease
below $4, quantity
in quantity
demanded demanded is infinite

0 50 100 0
Quantity Quantity

The price elasticity of demand determines whether the demand curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
11
 The Elasticity of Demand
• Total revenue, TR
– Amount paid by buyers and received by
sellers of a good
– Price of the good times the quantity sold
(P ˣ Q)
• For a price increase
– If demand is inelastic, TR increases
– If demand is elastic, TR decreases

12
Total Revenue
Price

$4

P ˣ Q=$400
P (revenue)
Demand

0 100 Quantity

The total amount paid by buyers, and received as revenue by sellers, equals the area
of the box under the demand curve, P × Q. Here, at a price of $4, the quantity
demanded is 100, and total revenue is $400.
13
How Total Revenue Changes When Price Changes

(a) The case of inelastic demand (b) The case of elastic demand
Price Price

$5 $5
A A
4 4
Demand
Demand
B B

0 90 100 Quantity 0 70 100 Quantity

The impact of a price change on total revenue (the product of price and quantity) depends on the
elasticity of demand. In panel (a), the demand curve is inelastic. In this case, an increase in the
price leads to a decrease in quantity demanded that is proportionately smaller, so total revenue
increases. Here an increase in the price from $4 to $5 causes the quantity demanded to fall from
100 to 90. Total revenue rises from $400 to $450. In panel (b), the demand curve is elastic. In this
case, an increase in the price leads to a decrease in quantity demanded that is proportionately
larger, so total revenue decreases. Here an increase in the price from $4 to $5 causes the quantity
demanded to fall from 100 to 70. Total revenue falls from $400 to $350.
14
 The Elasticity of Demand
• When demand is inelastic (elasticity < 1)
– Price and total revenue move in the same
direction
• When demand is elastic (elasticity > 1)
– Price and total revenue move in opposite
directions
• If demand is unit elastic (elasticity = 1)
– Total revenue remains constant when the
price changes
15
 The Elasticity of Demand
• Linear demand curve
– Constant slope
• Rise over run
– Different price elasticities
• Points with low price & high quantity
– Inelastic demand
• Points with high price & low quantity
– Elastic demand

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Elasticity of a Linear Demand Curve (graph)
Price

$7 Elasticity is larger
than 1
6

5
4 1. an
Elasticity is
3 smaller than 1
2
Demand
1

0 2 4 6 8 10 12 14 Quantity
The slope of a linear demand curve is constant, but its elasticity is not. The demand
schedule in the table was used to calculate the price elasticity of demand by the
midpoint method. At points with a low price and high quantity, the demand curve is
inelastic. At points with a high price and low quantity, the demand curve is elastic.
17
Elasticity of a Linear Demand Curve (schedule)

The slope of a linear demand curve is constant, but its elasticity is not. The demand
schedule in the table was used to calculate the price elasticity of demand by the
midpoint method. At points with a low price and high quantity, the demand curve is
inelastic. At points with a high price and low quantity, the demand curve is elastic.

18
 The Elasticity of Demand
• 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

19
 The Elasticity of Demand
• Normal goods
– Positive income elasticity
– Necessities
• Smaller income elasticities
– Luxuries
• Large income elasticities
• Inferior goods
– Negative income elasticities

20
 Income Elasticity of Demand
How do you rank the income elasticity of demand of the following in
developed countries?

1) Airline Travel
2) Clothing
3) Electricity
4) Food
5) Movies
6) Telephone

a) 1 > 2 > 3 > 4 > 5 > 6

b) 6 > 5 > 4 > 3 > 2 > 1
c) 1 > 5 > 6 > 2 > 3 > 4
d) 1 > 5 > 3 > 2 > 6 > 4
e) 5 > 1 > 2 > 6 > 4 > 3
21
 The Elasticity of Demand
• Cross-price elasticity of demand
– How much the quantity demanded of one
good responds to a change in the price of
another good
– Percentage change in quantity demanded
of the first good
• Divided by the percentage change in price of
the second good

22
 The Elasticity of Demand
• Substitutes
– Goods typically used in place of one
another
– Positive cross-price elasticity
• Complements
– Goods that are typically used together
– Negative cross-price elasticity

23
 長者港鐵乘車優惠延至明年
港鐵宣佈，原本昨日屆滿的長者兩元乘車優惠，將會延長多
一年至明年八月三十一日，並會增加優惠日子，由原來只有
逢周三和紅日公眾假期，擴展至每個星期六。

今日起，持有長者八達通卡的乘客，可在周三、周六及公眾
假期，以兩元乘搭港鐵。港鐵指，有關優惠深受長者歡迎，
每個星期三均有超過二十萬人次使用，有關安排是考慮本港
有不少市民都是五天工作，愈來愈多人會在周六與家人及朋
友外出聚會。

Source: Headline Daily, 1 September 2010

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 110 萬人受惠 長者殘疾人士 2 元搭巴士
由 2012 年 8 月 5 日開始，本港年滿 65 歲的長者以及合資格的殘疾人士，除了可以
用八達通以 2 元乘坐港鐵之外，亦可以乘坐巴士，預計有 98 萬名長者及 13 萬殘疾
人士受惠。勞工及福利局局長張建宗說，政府會積極爭取 2 元乘車優惠明年初推展
到渡輪及大嶼山巴士，亦會研究加入專線小巴。多間巴士公司均表示會配合政府的
計劃；長者普遍對計劃表示歡迎。

張建宗昨在一個電台節目後表示，年滿 65 歲的長者及合資格殘疾人士，在 8 月 5 日
起，可以用 2 元乘搭九巴、新巴、城巴和龍運巴士的路線，較預期提早一個月實
施；而渡輪和大嶼山巴士將會在明年初加入計劃。張建宗解釋，提早推出優惠，是
因為在八達通公司及四間專營巴士公司的配合下，已克服八達通軟件提升等技術問
題；政府亦會積極爭取在明年第一季，將 2 元乘車優惠推展到渡輪及大嶼山巴士。

多間巴士公司均表示會配合政府的計劃，九巴發言人亦表示，已經完成八達通的軟
件提升和測試，會配合政府公布的實施日期；而城巴更會保留現有優惠，讓 60 至
64 歲的長者平日半價、假日以 2 元乘車。長者普遍對計劃表示歡迎，更稱會因為計
劃，多外出探訪親戚朋友、子女孫兒等，以及多參加社交活動。

Source: Sing Pao, 22 July 2012

25
 The 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
– Depends on the flexibility of sellers to
change the amount of the good they
produce

26
 The Elasticity of Supply
• Elastic supply
– Quantity supplied responds substantially
to changes in the price
• Inelastic supply
– Quantity supplied responds only slightly to
changes in the price
• Determinant of price elasticity of supply
– Time period
• Supply is more elastic in long run

27
 The Elasticity of Supply
• Computing price elasticity of supply
– Percentage change in quantity supplied
divided by percentage change in price
– Always positive
• Midpoint method
– Two points: (Q1, P1) and (Q2, P2)

(Q2  Q1 ) / [(Q2  Q1 ) / 2 ]
Price elasticity of supply 
(P2  P1 ) / [(P2  P1 ) / 2 ]

28
 The 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

29
 The Elasticity of Supply
• Variety of supply curves
– Supply is perfectly inelastic
• Price elasticity of supply = 0
• Supply curve – vertical
– Supply is perfectly elastic
• Price elasticity of supply = infinity
• Supply curve – horizontal

30
The Price Elasticity of Supply (a, b)
(a) Perfectly Inelastic Supply: (b) Inelastic Supply: Elasticity Is
Elasticity Equals 0 Less Than 1
Price Price
1. An Supply 1. A 22% Supply
increase increase
in price… in price…
$5 $5 2. … leads to
4 2. …leaves 4 a 10% increase
the quantity in quantity
supplied supplied
unchanged

0 100 0 100 110

Quantity Quantity

The price elasticity of supply determines whether the supply curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
31
The Price Elasticity of Supply (c)

(c) Unit Elastic Supply: Elasticity Equals 1

Price
1. A 22% Supply
increase
in price…
$5
4 2. … leads to
a 22% increase
in quantity
supplied

0 100 125
Quantity

The price elasticity of supply determines whether the supply curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
32
The Price Elasticity of Supply (d, e)
(d) Elastic Supply: Elasticity Is (e) Perfectly Elastic Supply:
Greater Than 1 Elasticity Equals Infinity
Price Price 1. At any
1. A 22% price above
increase $4, quantity 2. At exactly $4,
Supply supplied is
in price… producers will
infinite
$5 supply any quantity

4 2. … leads to $4
Supply
a 67% increase 3. At any price
in quantity below $4, quantity
supplied supplied is zero

0 50 100 0
Quantity Quantity

The price elasticity of supply determines whether the supply curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
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 The Elasticity of Supply
• Supply curve
– Different price elasticities
• Points with low price & low quantity
– Elastic supply
– Capacity for production not being used
• Points with high price & high quantity
– Inelastic supply

34
How the Price Elasticity of Supply Can Vary
Price Elasticity is small Supply
(less than 1).
$15

12
Elasticity is large
(greater than 1).

4
3

0 100 200 500 525 Quantity

Because firms often have a maximum capacity for production, the elasticity of supply may be very
high at low levels of quantity supplied and very low at high levels of quantity supplied. Here an
increase in price from $3 to $4 increases the quantity supplied from 100 to 200. Because the 67
percent increase in quantity supplied (computed using the midpoint method) is larger than the 29
percent increase in price, the supply curve is elastic in this range. By contrast, when the price
rises from $12 to $15, the quantity supplied rises only from 500 to 525. Because the 5 percent
increase in quantity supplied is smaller than the 22 percent increase in price, the supply curve is
inelastic in this range.
35
 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; lower price
• Demand – inelastic
– Total revenue falls
– Paradox of public policy
• Induce farmers not to plant crops

36
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
$3
to a large fall 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
When an advance in farm technology increases the supply of wheat from S1 to S2, the
price of wheat falls. Because the demand for wheat is inelastic, the increase in the
quantity sold from 100 to 110 is proportionately smaller than the decrease in the price
from $3 to $2. As a result, farmers’ total revenue falls from $300 ($3 × 100) to $220
($2 × 110).
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Good News Or Bad News
For Tea Farmers?

38
 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
– Long-run: supply and demand are elastic
• Decrease in supply: small increase in price

39
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 1. In the long run, when supply
and demand are inelastic, a shift and demand are elastic, a shift
Price
Price in supply. . . in supply. . .
S2 2. … leads
S1 to a small S2 S1
P2 increase in
price
2. … leads to
P2
P1 a large
P1
increase in
price
Demand Demand

0 Quantity 0 Quantity
When the supply of oil falls, the response depends on the time horizon. In the short run,
supply and demand are relatively inelastic, as in panel (a). Thus, when the supply curve
shifts from S1 to S2, the price rises substantially. By contrast, in the long run, supply and
demand are relatively elastic, as in panel (b). In this case, the same size shift in the supply
curve (S1 to S2) causes a smaller increase in the price.
40
 Applications
• Does Drug Interdiction Increase or
Decrease Drug-related Crime?
– Increase the number of federal agents
devoted to the war on drugs
• Illegal drugs - Supply curve shifts left
– Higher price; lower quantity
• Amount of drug-related crimes
– Inelastic demand for drugs
– Higher drugs price – higher total revenue
– Increase drug-related crime

41
 Applications
• Does Drug Interdiction Increase or
Decrease Drug-related Crime?
– Policy of drug education
• Reduce demand for illegal drugs
• Left shift of demand curve
• Lower quantity
• Lower price
• Reduce drug-related crime

42
Policies to Reduce the Use of Illegal Drugs
(a) Drug Interdiction (b) Drug Education
1. Drug education
2. … which 1. Drug interdiction 2. . . . which reduces the demand
Price reduces the supply Price reduces the for drugs . . .
raises the
of drugs. . .
price . . . price . . .
S2 S1
Supply

P2
P1
3. … and
reduces the P2
P1
quantity sold
3. … and
reduces the
Demand D1
quantity sold D2

0 Q2 Q1 Quantity 0 Q2 Q1 Quantity
Drug interdiction reduces the supply of drugs from S 1 to S2, as in panel (a). If the demand for
drugs is inelastic, then the total amount paid by drug users rises, even as the amount of drug use
falls. By contrast, drug education reduces the demand for drugs from D 1 to D2, as in panel (b).
Because both price and quantity fall, the amount paid by drug users falls
43
 豐田 8 車款 北美停產銷
棄短期盈利 冀重建優質形象
全球最大車廠豐田（ Toyota ）向來有口皆碑，但近期卻飽受
質量問題困擾，繼 3 個月內兩次大型回收行動後，廠方決定
即時叫停 8 款在美國生產和出售的汽車，包括高踞暢銷榜首
位的 Camry 房車。

其他停售車款包括廣受歡迎的 Corolla 及 RAV4 等，豐田去

年共售出超過 170 萬輛有關型號的汽車，佔其於美國總銷量
6 成，亦為全美輕型汽車銷量的一成，有關型號在美國及加
拿大的生產線下月 1 日起亦會暫停運作一個星期。

Source: Hong Kong Economic Times, 28 January 2010

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