2 ELASTICITY

Elasticity of Demand:
Price Elasticity Along a Straight-Line Demand Curve:

Along a straight-line demand curve, ed, can be calculated as the ratio of two
line segments separated by the point of interest.

V V V
F
F

F
H H H

ed = FH / FV > 1 ed = FH / FV = 1 ed = FH / FV < 1
At F, demand is At F, demand is unit At F, demand is
elastic. elastic. inelastic.
Elasticity of Demand:
Price Elasticity Along a Straight-Line Demand Curve:
So, the ranges of ed along a straight-line demand curve are:

Recall, the ratio ed = FH / FV

P
V If F is the point V, then ed =
(Demand is perfectly elastic at V)
M
If F is the point H, then ed = 0
(Demand is perfectly inelastic at H)
H
Q If F is the point M, then ed = 1
(Demand is unit elastic at the midpoint of a straight-
line demand curve)

If F falls between V and M then ed > 1 and demand is elastic at the point of interest, F.
If F falls between M and H then ed < 1 and demand is inelastic at the point of interest, F.
Elasticity of Demand:
Why is demand more elastic at higher prices than at lower prices?
P

V
12
A
10 -2
+2
8
6
B
4 -2
+2
2
H
0 2 4 6 8 10 12 Q

At a price like P1 = 8, a $2 increase in price (to P1 = 10) results in a 50% drop

in quantity demanded (from 4 units to 2 units).
At such high prices, the consumer finds that more and more substitutes are
affordable.
Elasticity of Demand:
Why is demand more elastic at higher prices than at lower prices?
P

V
12
A
10 -2
+2
8
6
B
4 -2
+2
2
H
0 2 4 6 8 10 12 Q

However, at a price like P2 = 2, a $2 increase in price (to P2 = 4) results in

only a 20% reduction in quantity demanded (from 10 units to 8 units).
At lower prices there are fewer affordable substitutes.
Elasticity of Demand:
Why is demand more elastic at higher prices than at lower prices?
P

V
12
A
10 -2
+2
8
6
B
4 -2
+2
2
H
0 2 4 6 8 10 12 Q

What are the 2 price elasticities in this example (i.e. at point A and point B)?

At point A: ed = AH / AV ed = 10 / 2 ed = - 5
At point B: ed = BH / BV ed = 4 / 8 ed = -
Elasticity of Demand:
Shifts in Demand and Price Elasticity:
A parallel shift in demand to the right (raises / lowers) the price elasticity at any given price
level.
P
V

- -
A + B +
P1

Q
H H

Clearly, AH / AV > BH / BV. This means that on the new demand curve the same price
increase causes a smaller (percentage) decrease in the quantity demanded. Said differently,
the price elasticity at any given price has fallen. We should remember that the price elasticity
depends upon the slope of the demand curve and ALSO upon P and Q.
Income Elasticity:
Income Elasticity of Demand
Definition:
eM = % in Q
% in M
the percentage change in quantity demanded as a result of a percentage change in the
consumers income.
This is the income elasticity of demand.

We can write eM as eM= Q/Q = Q . M

M/M M Q

If eM > 0 then we have a normal good. eM > 1 means a luxury good.

eM < 1 means a necessity.

If eM < 0 then we have an inferior good.

Income Elasticity:
Engel Curves:
An Engel curve relates changes in income to changes in quantity demanded. For a normal
good, as income increases so too does quantity demanded. On the other hand, for an
inferior good, as income increases the quantity demanded of the good decreases.
Q Q

+
+
+ -

Income (M) Income (M)

Mq (Normal goods) Mq (Inferior goods)

eM = % in Q = + = + eM = % in Q = - = -
% in M + % in M +
Income Elasticity:
Engel Curves:
Engel Law states that, as income increases, the percentage of income spent
on certain foods declines.
In general, it has been empirically observed that as income rises, some goods
that were normal can become inferior in a different range of income.
For example, dusty noodles might be a normal good in the income range
from $0 to $1,000 per month but becomes an inferior good in the income
range of over $1,000 per month.
Cross Price Elasticity of Demand:

Definition:
eXY = % in QX
% in PY

the percentage change in quantity demanded of good X as a result of a

percentage change in the price of good Y.
This is the cross price elasticity of demand.

We can write eXY as eXY = QX/QX = QX . PY

PY/PY PY QX

If eXY > 0, then good X and good Y are substitutes.

eXY < 0, then good X and good Y are complements.
eXY = 0, then good X and good Y are entirely unrelated.
Cross Price Elasticity of Demand:
Example:
Substitute: Water skis (Y) Pskis Qboards , so

eXY = % in Qboards = _+_ = +

% in Pskis +
Wakeboards (X)
Complement: Life Jackets (Y) Pjacket Qboards , so
eXY = % in Qboards = _-_ = -
% in Pjackets +

The magnitude of the cross price elasticity

measures the degree of substitutability (+) or
complementarity (-). This is often quite useful
when conducting market studies or when
analyzing certain policy effects.
Revenue:
Derivation of Total Revenue (TR) and Marginal Revenue (MR):

TOP DIAGRAM:
At A the price is so high that nothing is sold (TR = 0). At B, the
price is zero so TR = 0. (Total Revenue = price x quantity OR TR
= PQ)

Total revenue at any price-quantity combination can be

represented as a rectangle under the demand curve. This
reaches a maximum (in terms of area) at the midpoint of a
straight-line demand curve.
Revenue:
Derivation of Total Revenue (TR) and Marginal Revenue (MR):

SECOND GRAPH:
The total revenue curve thus rises from zero to some maximum
(at the midpoint of the straight-line demand curve) and then
returns back to zero.

THIRD & FOURTH GRAPHS:

Marginal revenue (MR) is the change in Total revenue as a
result of a change in the quantity sold.

MR = TR / Q = the slope of the TR curve.

As quantity increases, the slope of the TR curve (MR) gets flatter

(i.e. MR is falling) until it flattens completely where TR is
maximized and then turns downward sloping (i.e. MR becomes
negative).
Thus, MR crosses the Q-axis where TR is maximized.
Revenue:
These are the relationships that we have developed so far
TR = 0
P

TR is maximized.

MR is zero.
ed is one.

TR = 0

In this graph, we are representing the case where price is falling and quantity demanded is rising.

If price were to rise instead we would be moving from right to left along the demand curve and the
direction of change in TR and MR would be the opposite (but everything else would remain the same).
Revenue:

Analytical Relationship between Price, MR and ed:

MR = P 1 - _1_
ed

Logically, this implies that (if P > 0 and it is for most goods)
ed > 1 MR > 0
ed = 1 MR = 0
ed < 1 MR < 0

For example: Lets consider an equal shift in two identical supply curves that have two
different demand structures; one is relatively demand elastic and the other is relatively
demand inelastic. It will be important to recall that Total Revenue (TR) is represented as the
rectangle under each equilibrium point.

Lets see what these situations look like using a couple of graphs on the next slide
Revenue:
P P

S S
S S

A A
B
B D

D
Q
Q
Demand Inelastic (steeper) Demand Elastic (flatter)

ed = % in Q < 1 ed = % in Q > 1
% in P % in P

(% in Q) < (% in P) (% in Q) > (% in P)

From A to B, TR = PQ falls since: From A to B, TR = PQ increases (or

does not fall by as much) since:

P and Q
P and Q
Deriving Market Demand:

Horizontal Summation
Assume that there are just two consumers for a good, Ricky and Lucy. At P1, add their
quantity demanded and we get a point for the market demand at P1. At P2, we add their
quantity demanded and get a point for the market demand at P2. We can repeat this
horizontal summation for all possible prices and trace out the market demand curve for the
good. Of course, this procedure can easily be generalized to markets with more than two
consumers.
Ricky Lucy Market
P P P
dR D
dL

P2

P1

Q Q Q
QRicky2 QRicky1 QLucy2 QLucy1 Q2 Q1

Note that: Q1 = qRicky1 + qLucy1 Q2 = qRicky2 + qLucy2

Lecture #2: Homework Questions

1. Suppose that we know that a demand curve is defined as: QD = 2000 6P.

a) What is the elasticity of demand at the point where P = 150 using the FH/FV method?
b) What is the elasticity of demand at the point where P = 300 using the FH/FV method?

2. Suppose that when the price of skates goes up by 10% the demand for hockey sticks falls by 5%.

a) What is the cross-price elasticity?

b) Are these goods substitutes or complements?

3. Given a demand function QD = 17 6P, find the elasticity of demand at P = $2. Is demand elastic or
inelastic at P = $2? Suppose P = $1, find the elasticity of demand. Is demand elastic or inelastic at P =
$1?

4. Given a demand function QD = 69 4P + 0.1 M, find the income elasticity when income is $110 and
price is $7. Is this a normal or inferior good?