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ElasticityElasticity
ECONOMICS
TM 5-2Copyright © 1998 Addison Wesley Longman, Inc.
Learning Objectives
• Define and calculate the price elasticity of demand
• Use a total revenue test and an expenditure test to estimate the price elasticity of demand
• Explain the factors that influence the price elasticity of demand
TM 5-3Copyright © 1998 Addison Wesley Longman, Inc.
Learning Objectives (cont.)
• Define and calculate the cross elasticity of demand
• Define and calculate the income elasticity of demand
• Define and calculate the elasticity of supply
TM 5-4Copyright © 1998 Addison Wesley Longman, Inc.
Learning Objectives
• Define and calculate the price elasticity of demand
• Use a total revenue test and an expenditure test to estimate the price elasticity of demand
• Explain the factors that influence the price elasticity of demand
TM 5-5Copyright © 1998 Addison Wesley Longman, Inc.
The Price Elasticity of Demand
You know that when supply increases, the equilibrium price falls and the equilibrium quantity increases.
But does the price fall by a large amount and the quantity increase by a little?
Or does the price barely fall and the quantity increase by a large amount?
TM 5-6Copyright © 1998 Addison Wesley Longman, Inc.
The Price Elasticity of Demand
The price elasticity of demand is a units-free measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on buyers’ plans remain the same.
TM 5-7Copyright © 1998 Addison Wesley Longman, Inc.
S1
How a Change in Supply Changes Price and Quantity
Quantity (pizza per hour)
Pri
ce (
dolla
rs p
er p
izza
)
10.00
20.00
30.00
40.00
Da
0 255 10 15 2013
5.00
S0
An increasein supplybrings ...
… and a smallincrease in quantity...
Large price change and small quantity change
… a largefall in price...
TM 5-8Copyright © 1998 Addison Wesley Longman, Inc.
S1
How a Change in Supply Changes Price and Quantity
Quantity (pizza per hour)
Pri
ce (d
olla
rs p
er p
izza
)
10.00
20.00
30.00
40.00
Db
0 255 10 15 2017
15.00
S0
Small price change and large quantity change
An increasein supplybrings ...
… a smallfall in price...
… and a largeincrease in quantity...
TM 5-9Copyright © 1998 Addison Wesley Longman, Inc.
The Price Elasticity of Demand
Percent change in quantity demanded
Calculating Elasticity
Price elasticity of demand =Percent change in price
Express the changes in price and quantity demanded as percentages of the average price and the average quantity.
TM 5-10Copyright © 1998 Addison Wesley Longman, Inc.
The Price Elasticity of Demand
Calculating Elasticity (cont.)
The original price is $20.50 and the new price is $19.50,so the average price is $20.
The $1.00 price decrease is 5 percent of the average price.
∆P/Pavg = ($1/$20) x 100 = 5%
TM 5-11Copyright © 1998 Addison Wesley Longman, Inc.
The Price Elasticity of Demand
Calculating Elasticity (cont.)
The original quantity demanded is 9 pizzas and the newquantity demanded is 11 pizzas.
The 2 pizza increase in the quantity demanded is 20 percentof the average quantity.
∆Q/Qavg = (2/10) x 100 = 20%
TM 5-12Copyright © 1998 Addison Wesley Longman, Inc.
The Price Elasticity of Demand
Calculating Elasticity (cont.)
Price elasticity of demandP
Q
%
%
=20%
5%= 4
TM 5-13Copyright © 1998 Addison Wesley Longman, Inc.
Calculating the Elasticity of Demand
9 10 11
19.50
20.50
D
Newpoint
Pavg = $20
= $1P
= 2Q
Quantity (pizza per hour)
Pri
ce (
dolla
rs p
er p
izza
)
20.00
Elasticity = 4
Qavg = 10
Originalpoint
TM 5-14Copyright © 1998 Addison Wesley Longman, Inc.
The Price Elasticity of Demand
Average Price and Quantity
We use the average price and average quantity to avoid having two values for the elasticity of demand at a single point on the demand curve, depending whether the price falls or rises.
TM 5-15Copyright © 1998 Addison Wesley Longman, Inc.
The Price Elasticity of Demand
Percentages and Proportions
Elasticity is the ratio of the percentage change in the quantity demanded to the percentage change in the price.
Equivalently, the proportionate change in the quantity demanded divided by the proportionate change in price.
TM 5-16Copyright © 1998 Addison Wesley Longman, Inc.
The Price Elasticity of Demand
A Units-Free Measure
Elasticity is a units-free measure because the percentage change in each variable is independent of the units in which the variable is measured.
And the ratio of the two percentages is a number without units.
TM 5-17Copyright © 1998 Addison Wesley Longman, Inc.
The Price Elasticity of Demand
Minus Sign and Elasticity
The price elasticity of demand is a negative number.
But, it is the magnitude, or absolute value, of the price elasticity of demand that tells us how elastic demand is.
We use the magnitude and ignore the minus sign.
TM 5-18Copyright © 1998 Addison Wesley Longman, Inc.
The Price Elasticity of Demand
Inelastic and Elastic Demand
Perfectly inelastic demand Implies that quantity demanded remains constant when price changes occur.
Price elasticity of demand = 0
TM 5-19Copyright © 1998 Addison Wesley Longman, Inc.
The Price Elasticity of Demand
Inelastic and Elastic Demand (cont.)
Unit elastic demand Implies that the percentage change in quantity demanded equals the percentage change in price.
Price elasticity of demand = 1
TM 5-20Copyright © 1998 Addison Wesley Longman, Inc.
Inelastic and Elastic Demand
Inelastic and Elastic Demand (cont.)
Perfectly elastic demand
Implies that if price changes by any percentage, quantity demanded will fall to 0.
Price elasticity of demand =
TM 5-21Copyright © 1998 Addison Wesley Longman, Inc.
Inelastic and Elastic Demand
Inelastic and Elastic Demand (cont.)
Inelastic demand Implies the percentage change in quantity demanded is less than the percentage change in price.
Price elasticity of demand > 0 and < 1.
TM 5-22Copyright © 1998 Addison Wesley Longman, Inc.
Inelastic and Elastic Demand
Inelastic and Elastic Demand (cont.)
Elastic demand Implies the percentage change in quantity demanded is greater than the percentage change in price.
Price elasticity of demand > 1.
TM 5-23Copyright © 1998 Addison Wesley Longman, Inc.
Inelastic and Elastic Demand
6
12
Pri
ce
Quantity
D1
Elasticity = 0
Perfectly inelastic demand
0
TM 5-24Copyright © 1998 Addison Wesley Longman, Inc.
Inelastic and Elastic Demand
6
12
Pri
ce
Quantity
D2
1 2 3
Elasticity = 1
Unit elastic demand
0
TM 5-25Copyright © 1998 Addison Wesley Longman, Inc.
Inelastic and Elastic Demand
6
12
Pri
ce
Quantity
D3
Elasticity =
Perfectly elastic demand
0
TM 5-26Copyright © 1998 Addison Wesley Longman, Inc.
Inelastic and Elastic Demand
Elasticity Along a Straight-Line Demand Curve
Along a straight-line demand curve, the elasticity varies.
At high prices and small quantities, the elasticity is large and at low prices and large quantities, the elasticity is small.
TM 5-27Copyright © 1998 Addison Wesley Longman, Inc.
Elasticity Along a Straight-Line Demand Curve
0 10 20 25 30 40 50
12.50
5.00
10.00
15.00
20.00
25.00
Quantity (pizza per hour)
Pri
ce (
dolla
rs p
er p
izza
)
Elasticity = 1/4
Elastic
Inelastic
Elasticity = 1
Elasticity = 4
TM 5-28Copyright © 1998 Addison Wesley Longman, Inc.
Learning Objectives
• Define and calculate the price elasticity of demand
• Use a total revenue test and an expenditure test to estimate the price elasticity of demand
• Explain the factors that influence the price elasticity of demand
TM 5-29Copyright © 1998 Addison Wesley Longman, Inc.
Total Revenue and Elasticity
When a price changes, the change in producers’ total revenue depends on the elasticity of demand.
TM 5-30Copyright © 1998 Addison Wesley Longman, Inc.
Total Revenue and Elasticity
Elastic demand: a 1 percent price cut increases the quantity sold by more than 1 percent and total revenue increases.
Unit elastic demand: a 1 percent price cut increases the quantity sold by 1 percent and so total revenue does not change.
Inelastic demand: a 1 percent price cut increases the quantity sold by less than 1 percent and total revenue decreases.
TM 5-31Copyright © 1998 Addison Wesley Longman, Inc.
Total Revenue and Elasticity
Total Revenue Test
Price elasticity of demand can be
estimated by observing the change in
total revenue that results from a price
change (ceteris paribus).
TM 5-32Copyright © 1998 Addison Wesley Longman, Inc.
Total Revenue and Elasticity
Total Revenue Test
If a price cut increases total revenue, demand is elastic.
If a price cut decreases total revenue, demand is inelastic.
If a price cut leaves total revenue unchanged, demand is unit elastic.
TM 5-33Copyright © 1998 Addison Wesley Longman, Inc.
Elasticity and Total Revenue
TM 5-34Copyright © 1998 Addison Wesley Longman, Inc.
350.00 25 50
12.50
5.00
10.00
20.00
25.00
0 25 50
150.00
200.00
250.00
312.50
Tot
al R
even
ue (
bill
ions
of
doll
ars)
Maximum total revenue
When demandis inelastic, price cut decreasestotal revenue
Unitelastic
Elasticdemand
Quantity (pizza per hour)
Pric
e (d
olla
rs p
er p
izza
)
15.00
Inelastic demand
300.00
100.00
50.00
0
When demandis elastic, price cut increasestotal revenue
TM 5-35Copyright © 1998 Addison Wesley Longman, Inc.
Total Revenue and Elasticity
Your Expenditure and Your Elasticity
If your demand is elastic, a 1 percent price cut increases the quantity you buy by more than 1 percent and your expenditure on the item increases.
TM 5-36Copyright © 1998 Addison Wesley Longman, Inc.
Total Revenue and Elasticity
Your Expenditure and Your Elasticity (cont.)
If your demand is unit elastic, a 1 percent price cut increases your quantity bought by 1 percent and so your expenditure on the item does not change.
TM 5-37Copyright © 1998 Addison Wesley Longman, Inc.
Total Revenue and Elasticity
Your Expenditure and your Elasticity (cont.)
If your demand is inelastic, a 1 percent price cut increases your quantity bought by less than 1 percent and so your expenditure on the item decreases.
TM 5-38Copyright © 1998 Addison Wesley Longman, Inc.
Some Real-World Price Elasticities of Demand
Good or Service ElasticityElastic Demand
Metals 1.52Electrical engineering products 1.30Mechanical engineering products 1.30Furniture 1.26Motor vehicles 1.14Instrument engineering products 1.10Professional services 1.09Transportation services 1.03
Inelastic DemandGas, electricity, and water 0.92Oil 0.91Chemicals 0.89Beverages (all types) 0.78Clothing 0.64Tobacco 0.61Banking and insurance services 0.56Housing services 0.55Agricultural and fish products 0.42Books, magazines, and newspapers 0.34Food 0.12
TM 5-39Copyright © 1998 Addison Wesley Longman, Inc.
Learning Objectives
• Define and calculate the price elasticity of demand
• Use a total revenue test and an expenditure test to estimate the price elasticity of demand
• Explain the factors that influence the price elasticity of demand
TM 5-40Copyright © 1998 Addison Wesley Longman, Inc.
Factors That Influence Elasticity the Elasticity of Demand
Closeness of Substitutes.
The closer the substitutes, the more elastic the demand.
• necessities
• luxuries
TM 5-41Copyright © 1998 Addison Wesley Longman, Inc.
Factors That Influence Elasticity the Elasticity of Demand
Proportion of Income Spent on the GoodThe greater the proportion of income spent on food, the more elastic the demand.
Time Elapsed Since Price Change
The longer the time, the more elastic the demand.
• Short-run demand
• Long-run demand
TM 5-42Copyright © 1998 Addison Wesley Longman, Inc.
Price Elasticities in 20 Countries
TM 5-43Copyright © 1998 Addison Wesley Longman, Inc.
Learning Objectives
• Define and calculate the cross elasticity of demand
• Define and calculate the income elasticity of demand
• Define and calculate the elasticity of supply
TM 5-44Copyright © 1998 Addison Wesley Longman, Inc.
More Elasticities of Demand
Cross elasticity of demand
Measures the responsiveness of the demand for a good to a change in the price of a substitute or complement good.
Cross elasticity of demand =
Percentage changein quantity demanded
Percentage change in price of a substitute or complement
TM 5-45Copyright © 1998 Addison Wesley Longman, Inc.
Cross Elasticity of DemandP
rice
of
pizz
as
Quantity of pizzas
Price of soda, a complement, falls. Negativecross elasticity.
D2
Price of a burger, a substitute, falls.Positive cross elasticity. D0
D1
0
TM 5-46Copyright © 1998 Addison Wesley Longman, Inc.
Learning Objectives
• Define and calculate the cross elasticity of demand
• Define and calculate the income elasticity of demand
• Define and calculate the elasticity of supply
TM 5-47Copyright © 1998 Addison Wesley Longman, Inc.
Income Elasticity of Demand
Income elasticity
Measures the responsiveness of the demand to a change in income.
Income elasticity of demand =
Percentage changein quantity demanded
Percentage change in income
TM 5-48Copyright © 1998 Addison Wesley Longman, Inc.
Income Elasticity of Demand
Income elasticity can be:
1 ) Greater than 1 (normal good, income elastic)
2 ) Between zero and 1 (normal good, income inelastic)
3 ) Less than zero (inferior good)
TM 5-49Copyright © 1998 Addison Wesley Longman, Inc.
Income Elasticity of Demand
Income Income Income
Qua
ntit
y de
man
ded
Qua
ntit
y de
man
ded
Income
Qua
ntit
y de
man
ded
m
Income inelastic
Income elastic
Positiveincome elasticity
Negativeincome elasticity
Elasticity greaterthan 1
Elasticity betweenzero and 1
Elasticity less than 1and becomes negative
TM 5-50Copyright © 1998 Addison Wesley Longman, Inc.
Some Real-World IncomeElasticities of Demand
Elastic DemandAirline Travel 5.82Movies 3.41Foreign Travel 3.08Electricity 1.94Restaurant meals 1.61Local buses and trains 1.38Haircutting 1.36Cars 1.07
Inelastic DemandTobacco 0.86Alcoholic beverages 0.62Furniture 0.53Clothing 0.51Newspapers and magazines 0.38Telephone 0.32Food 0.14
TM 5-51Copyright © 1998 Addison Wesley Longman, Inc.
Income Elasticities in 15 Countries
TM 5-52Copyright © 1998 Addison Wesley Longman, Inc.
Learning Objectives
• Define and calculate the cross elasticity of demand
• Define and calculate the income elasticity of demand
• Define and calculate the elasticity of supply
TM 5-53Copyright © 1998 Addison Wesley Longman, Inc.
Elasticity of Supply
Elasticity of supply measures the responsiveness of quantity supplied to a change in price.
Elasticityof supply =
Percentage change in quantity supplied
Percentage change in price
TM 5-54Copyright © 1998 Addison Wesley Longman, Inc.
How a Change in Demand Changes Price and Quantity
Quantity (pizza per hour)
Pri
ce (
dolla
rs p
er p
izza
)
10.00
30.00
40.00
D0
0 255 10 15 2013
Sa
… a largeprice rise...
Large price change and small quantity change
20.00
D1
An increasein demandbrings ...
… and a smallquantity increase...
TM 5-55Copyright © 1998 Addison Wesley Longman, Inc.
How a Change in Demand Changes Price and Quantity
Quantity (pizza per hour)
Pri
ce (
dolla
rs p
er p
izza
)
10.00
30.00
40.00
D0
0 255 10 15 20
Sb
… a smallprice rise...
Small price change and large quantity change
20.00
D1
An increasein demandbrings ...
21.00
… and a largequantity increase...
TM 5-56Copyright © 1998 Addison Wesley Longman, Inc.
Elasticity of Supply
Supply elasticity depends on:
• Resource substitution possibilities
• Time frame for the supply decision
TM 5-57Copyright © 1998 Addison Wesley Longman, Inc.
Inelastic and Elastic Demand
Pri
ce
Quantity
S1
Elasticity of supply = 0
Perfectly inelastic supply
0
TM 5-58Copyright © 1998 Addison Wesley Longman, Inc.
Inelastic and Elastic Demand
Pri
ce
Quantity
S1
Elasticity of supply = 1
Unit elastic supply
0
TM 5-59Copyright © 1998 Addison Wesley Longman, Inc.
Inelastic and Elastic Demand
Pri
ce
Quantity
S3
Elasticity of supply =
Perfectly elastic supply
0
TM 5-60Copyright © 1998 Addison Wesley Longman, Inc.
Elasticity of Supply
Resource Substitution Possibilities
The more unique the resource, the more inelastic the supply.• Van Gogh painting - Van Gogh
• Wheat/corn — farmland
TM 5-61Copyright © 1998 Addison Wesley Longman, Inc.
Elasticity of Supply
Time Frame for Supply Decisions
• Momentary supply
• Long-run supply
• Short-run supply
The longer producers have to adjust to a price change, the more elastic is supply.
TM 5-62Copyright © 1998 Addison Wesley Longman, Inc.
A Compact Glossary of ElasticitiesPRICE ELASTICITIES OF DEMAND
A relationship isdescribed as
When itsmagnitude is
Which means that
Perfectly elasticor infinitely elastic
Unit elastic
In elastic
Perfectly inelasticor completely inelastic
Infinity The smallest possible increase in price causes an infinitely large decrease in quantity demanded
Less than infinitybut greater than 1
Greater than zerobut less than 1
Elastic
1
Zero
The percent decrease in the quantity demandedexceeds the percent increase in price
The percent decrease in the quantity demandedequals the percent increase in price
The percentage decrease in the quantity demandedis less than the percent increase in price.
The quantity demanded is the same at all prices
TM 5-63Copyright © 1998 Addison Wesley Longman, Inc.
A Compact Glossary of ElasticitiesCROSS ELASTICITIES OF DEMAND
A relationship isdescribed as
When itsmagnitude is
Which means that
Perfect substitutes Infinity The smallest possible increase in price of one good causes an infinitely large in the demand of the other good.
Positive, lessthan infinity
Substitutes If the price of one good increases, the quantitydemanded of the other good also increases.
Independent Zero The demand for one good remains constant,regardless of the price of the other good.
Complements Less than zero The demand for one good decreases when the price of the other good increases.
TM 5-64Copyright © 1998 Addison Wesley Longman, Inc.
A Compact Glossary of ElasticitiesINCOME ELASTICITIES OF DEMAND
A relationship isdescribed as
When itsmagnitude is
Which means that
Income elastic(normal good)
Greater than 1 The percent increase in the quantity demandedis greater than the percentage increase in income.
Less than 1 butgreater than zero
Income inelastic(normal good)
The percent increase in the quantity demandedis less than the percentage increase in income.
Negative income elastic(inferior good)
Less than zero When income increases, quantity demanded decreases.
TM 5-65Copyright © 1998 Addison Wesley Longman, Inc.
A Compact Glossary of ElasticitiesELASTICITIES OF SUPPLY
A relationship isdescribed as
When itsmagnitude is
Which means that
Perfectly elastic Infinity The smallest possible increase in price causes aninfinitely large increase in the quantity supplied.
Less than infinitybut greater than 1
Elastic The percent increase in the quantity supplied exceeds the percentage increase in the price.
Inelastic Greater than zerobut less than 1
The percentage increase in the quantity supplied is less than the percentage increase in price.
Perfectly inelastic Zero The quantity supplied is the same at all prices.
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