CHAPTER 4
ELASTICTY
© 2011 Cengage South-Western
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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© 2007 ThomsonSouth-Western
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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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2007 Thomson South-Western
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The Price Elasticity of Demand and Its
Determinants
• Availability of Close Substitutes
• Necessities versus Luxuries
• Definition of the Market
• Time Horizon
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The Price Elasticity of Demand and Its
Determinants
• 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.
P ercen tag e ch an g e in q u an tity d em an d ed
P rice elasticity o f d em an d =
P ercen tag e ch an g e in p rice
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© 2007 ThomsonSouth-Western
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Computing the Price Elasticity of Demand
• Example: You design websites for local
businesses. You charge RM200 per website,
and currently sell 12 websites per month. Your
costs are rising (including the opportunity cost
of your time), so you consider raising the price
to RM250 and new sell is 8.
P ercen tag e ch an g e in q u an tity d em an d ed
P rice elasticity o f d em an d =
P ercen tag e ch an g e in p rice
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© 2007 ThomsonSouth-Western
South-Western
© 2007 Thomson South-Western
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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Point elasticity: measures the price elasticity at a
particular point on dd curve.
% Qdd
Ep
% P
(Q1 Q0 )
x100
Q0
( P1 P0 )
x100
P0
= (ΔQ/Qo) ÷ (ΔP/Po)
= (ΔQ/ ΔP) x (Po/Qo)
© 2007 Thomson South-Western
Computing the Price Elasticity of Demand
(100 50)
(100 50)/2
ED
(4.00 5.00)
Price (4.00 5.00)/2
RM5
67 percent
4 3
Demand 22 percent
0 50 100 Quantity
Demand is price inelastic.
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© 2007 ThomsonSouth-Western
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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
• Perfectly Inelastic
• Quantity demanded does not respond to price
changes.
• Perfectly Elastic
• Quantity demanded changes infinitely with any
change in price.
• Unit Elastic
• Quantity demanded changes by the same percentage
as the price.
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The Variety of Demand Curves
• Because the price elasticity of demand
measures how much quantity demanded
responds to the price, it is closely related to the
slope of the demand curve.
• But it is not the same thing as the slope!
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Figure 1 The Price Elasticity of Demand
(a) Perfectly Inelastic Demand: Elasticity Equals 0
Price
Demand
4
1. An
increase
in price . . .
0 100 Quantity
2. . . . leaves the quantity demanded unchanged.
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© 2007 ThomsonSouth-Western
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Figure 1 The Price Elasticity of Demand
(b) Inelastic Demand: Elasticity Is Less Than 1
Price
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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Figure 1 The Price Elasticity of Demand
(c) Unit Elastic Demand: Elasticity Equals 1
Price
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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© 2007 ThomsonSouth-Western
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Figure 1 The Price Elasticity of Demand
(d) Elastic Demand: Elasticity Is Greater Than 1
Price
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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© 2007 ThomsonSouth-Western
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Figure 1 The Price Elasticity of Demand
(e) Perfectly Elastic Demand: Elasticity Equals Infinity
Price
1. At any price
above RM4, quantity
demanded is zero.
4 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 4 Elasticity of a Linear Demand Curve
Demand is elastic; When price increases from
Price demand is responsive to RM4 to RM5, TR declines
7 changes in price. from RM24 to RM20.
6
Elasticity is > 1 in this range.
4 Elasticity is < 1 in this range.
Demand is inelastic; demand is
3
not very responsive to changes
2 in price.
When price increases from
1 RM2 to RM3, TR increases
from RM20 to RM24.
0 2 4 6 8 10 12 14
Quantity
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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
P ercen tag e ch an g e
in q u an tity d em an d ed
In co m e elasticity o f d em an d =
P ercen tag e ch an g e
in in co m e
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
• Income Elasticity
• Goods consumers regard as necessities tend to be
income inelastic
• Examples include food, fuel, clothing, utilities, and
medical services.
• Goods consumers regard as luxuries tend to be
income elastic.
• Examples include sports cars, furs, and expensive foods.
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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.
©© 2011 Cengage
2007 Thomson South-Western
South-Western
Figure 5 The Price Elasticity of Supply
(a) Perfectly Inelastic Supply: Elasticity Equals 0
Price
Supply
4
1. An
increase
in price . . .
0 100 Quantity
2. . . . leaves the quantity supplied unchanged.
© 2011 Cengage
© 2007 ThomsonSouth-Western
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Figure 5 The Price Elasticity of Supply
(b) Inelastic Supply: Elasticity Is Less Than 1
Price
Supply
5
4
1. A 22%
increase
in price . . .
0 100 110 Quantity
2. . . . leads to a 10% increase in quantity supplied.
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© 2007 ThomsonSouth-Western
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Figure 5 The Price Elasticity of Supply
(c) Unit Elastic Supply: Elasticity Equals 1
Price
Supply
5
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.
© 2011 Cengage
© 2007 ThomsonSouth-Western
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Figure 5 The Price Elasticity of Supply
(d) Elastic Supply: Elasticity Is Greater Than 1
Price
Supply
4
1. A 22%
increase
in price . . .
0 100 200 Quantity
2. . . . leads to a 67% increase in quantity supplied.
© 2011 Cengage
© 2007 ThomsonSouth-Western
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Figure 5 The Price Elasticity of Supply
(e) Perfectly Elastic Supply: Elasticity Equals Infinity
Price
1. At any price
above RM4, quantity
supplied is infinite.
4 Supply
2. At exactly RM4,
producers will
supply any quantity.
0 Quantity
3. At a price below RM4,
quantity supplied is zero.
© 2007 Thomson South-Western
The Price Elasticity of Supply and Its
Determinants
• Ability of sellers to change the amount of the
good they produce.
• Beach-front land is inelastic.
• Books, cars, or manufactured goods are elastic.
• Time period
• Supply is more elastic in the long run.
© 2011 Cengage
© 2007 ThomsonSouth-Western
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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.
P ercen tag e ch an g e
in q u an tity su p p lied
P rice elasticity o f su p p ly =
P ercen tag e ch an g e in p rice
© 2011 Cengage
© 2007 ThomsonSouth-Western
South-Western
Figure 7 An Increase in Supply in the Market for Rice
Price of
Rice 1. When demand is inelastic,
2. . . . leads an increase in supply . . .
to a large fall S1
in price . . . S2
Demand
0 100 110 Quantity of
Rice
3. . . . and a proportionately smaller
increase in quantity sold. As a result,
revenue falls from RM300 to RM220.
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© 2007 ThomsonSouth-Western
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Compute the Price Elasticity of Demand When There Is a
Change in Supply
1 0 0 11 0
( 1 0 0 11 0 ) / 2
ED
3 .0 0 2 .0 0
( 3 .0 0 2 .0 0 ) / 2
0 .0 9 5
0 .2 4
0 .4
Demand is inelastic.
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© 2007 ThomsonSouth-Western
South-Western
