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Lecture 2.

1 Chapter 4

Elasticity: The
Responsiveness of
Demand and Supply

Learning Objectives

1.

Define price elasticity of demand and understand how to measure


it.

2.

Understand the determinants of the price elasticity of demand.

3.

Understand the relationship between the price elasticity of


demand and total revenue.

4.

Define cross-price elasticity of demand and income elasticity of


demand, and understand their determinants and how they are
measured.

5.

Use price elasticity and income elasticity to analyse economic


issues.

6.

Define price elasticity of supply, and understand its main


determinants and how it is measured.

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

The Price Elasticity Of Demand


And Its Measurement
Elasticity: A measure of how much one economic
variablesuch as the quantity demanded of a product
responds to changes in another economic variable
such as the products price.
Price elasticity of demand: The responsiveness of
the quantity demanded of a good to a change in its
price.

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

Price of Coffee

Comparing Different Price Elasticities of Demand ...


Quantity demanded is very
A 10% price increase ...

sensitive to the price

30

Highly elastic
20

demand
lowers quantity

10

demanded by 20%
0

10

20

30

40

50

60

70

Quantity Demanded
4
Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

Price of Coffee

Comparing Different Price


Elasticities of Demand
Quantity demanded is not
A 10% price increase ...

very sensitive to the price

30

Demand curve with


20

low price elasticity


lowers the quantity

10

demanded by 5%
0

10

20

30

40

50

60

70

Quantity Demanded
5
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Price of Coffee

Importance of Price Elasticity of Demand


Snew

Small price

Sold

rise

30
20

More elastic demand

Supply declines by

10

20 thousand kgm per day


0

10

20

30

40

50

60

70

Quantity Demanded
6
Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

Price of Coffee

Importance of Price Elasticity


of Demand
Snew

Large price

Sold

rise

30

Less elastic
20

demand
Supply declines by

10

20 thousand kgm per day


0

10

20

30

40

50

60

70

Quantity Demanded
7
Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

The Price Elasticity Of Demand


And Its Measurement
Measuring the price elasticity of demand
Divide the percentage change in the quantity demanded
of a product by the percentage change in its price.

Note: The price elasticity of demand is not the


same as the slope of a demand curve.

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

The Price Elasticity Of Demand


And Its Measurement
Elastic demand and inelastic demand
Elastic demand: Demand is elastic when the
percentage change in quantity demanded is greater than
the percentage change in price.
| % Q |
| e |
| 1 |
| % P |
d

The price elasticity is greater than 1 in absolute


value.

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

The Price Elasticity Of Demand


And Its Measurement
Elastic demand and inelastic demand, cont.
Inelastic demand: Demand is inelastic when the
percentage change in quantity demanded is less than
the percentage change in price.
| % Q |
| e |
| 1 |
| % P |
d

The price elasticity is less than 1 in absolute


value.

10

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

The Price Elasticity Of Demand


And Its Measurement
Elastic demand and inelastic demand, cont.
Unit-elastic demand: Demand is unit-elastic when the
percentage change in quantity demanded is equal to the
percentage change in price.
| % Q |
| e |
| 1 |
| % P |
d

The price elasticity is equal to 1 in absolute value.

11

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

Elastic and inelastic demand curves: Figure 4.1


Price
D2 is inelastic
between point A
and point C.
$30

20

D2
0
12

D1 is elastic
between point A
and point B.

16

20

28

D1
Quantity

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

The Price Elasticity Of Demand


And Its Measurement
The mid-point formula
This formula is used to ensure that the value of the
price elasticity of demand between the same two points
is the same whether the price increases or decreases.
e
d

13

Q2 Q1
1
Q2 Q1
2

P2 P1
1
P2 P1
2

in absolute value

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

The Price Elasticity Of Demand


And Its Measurement
An example of calculating price elasticity
A cinema reduced the price of movie tickets from $20 to
$15, and average daily sales then increased from 5000
tickets to 7000 tickets. Calculate the price elasticity of
demand using the mid-point formula.
2000/6000
-5/17.5
= -1.17

14

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

The Price Elasticity Of Demand


And Its Measurement
Polar cases of elasticity
Perfectly inelastic demand: Demand is perfectly
inelastic when a change in price results in no change in
quantity demanded.
| e d |

| % Q |
0
| % P |

Perfectly elastic demand: Demand is perfectly elastic


when a change in price results in an infinite change in
| % Q |
d
quantity demanded.
| e |

| % P |
15

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

Summary of the price elasticities of demand: Table 4.1, cont.


If demand is unit elastic,
then the absolute value of
the price elasticity is equal
to 1.

If demand is perfectly
elastic, then the absolute
value of the price
elasticity is equal to
infinity.
16

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

Summary of the price elasticities of demand: Table 4.1, cont.

If demand is perfectly
inelastic, then the
absolute value of the price
elasticity is equal to 0.

17

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

The determinants of the price elasticity


of demand
1. Availability of close substitutes
2. The length of time involved
3. Luxuries versus necessities
4. Definition of the market
5. Share of expenditure on the good in the
consumers budget
18

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Price Elasticity &


Total Revenue

19

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

The relationship between price


elasticity and total revenue
Total revenue: The total amount of funds received
by a seller of a good or service.
Total revenue is found by multiplying price per unit
by the number of units sold.

20

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

The relationship between price


elasticity and total revenue
When demand is price inelastic:

A decrease in price leads to a decrease in total


revenue.

An increase in price leads to an increase in total


revenue.

When demand is price elastic:

21

A decrease in price leads to an increase in total


revenue.

An increase in price leads to a decrease in total


revenue.

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

The relationship between price elasticity and total revenue:


Figure 4.2

22

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Elasticity is not constant along a linear demand curve: Figure 4.3

23

Copyright 2013 Pearson Australia (a division of Pearson Australia


Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of
Economics/2e

The relationship between price elasticity and total revenue: Table 4.2

24

If demand is

then

because

elastic

an increase in price
reduces revenue

the decrease in
quantity demanded is
proportionally greater
than the increase in
price.

elastic

a decrease in price
increases revenue

the increase in
quantity demanded is
proportionally greater
than the decrease in
price.

inelastic

an increase in price
increases revenue

the decrease in
quantity demanded is
proportionally smaller
than the increase in
price.

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e
Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

The relationship between price elasticity and total revenue: Table 4.2

25

If demand is
inelastic

then

because

a decrease in price
reduces revenue

the increase in quantity


demanded is
proportionally smaller
than the decrease in
price.

unit-elastic

an increase in price
does not affect
revenue

the decrease in quantity


demanded is
proportionally the same
as the increase in price..

unit-elastic

a decrease in price
does not affect
revenue

the increase in quantity


demanded is
proportionally the same
as the decrease in price.

Copyright
Copyright2013
2013Pearson
PearsonAustralia
Australia(a(adivision
divisionofofPearson
PearsonAustralia
AustraliaGroup
GroupPty
PtyLtd)
Ltd) 9781442558069/Hubbard
9781442558069/Hubbardand
andO'Brien/Essentials
O'Brien/EssentialsofofEconomics/2e
Economics/2e

Other Demand Elasticities


Cross-price elasticity of demand
Cross-price elasticity of demand: The percentage
change in the quantity demanded of one good divided
by the percentage change in the price of another good.

26

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

Other Demand Elasticities


Cross-price elasticity of demand, cont.
Cross-price elasticity will be positive when the two goods
are substitutes in consumption.
e QA

% QA
0
% PB

Cross-price elasticity will be negative when the two


goods are complements in consumption.
e

27

QA

% QA

0
% PB

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

Summary of cross-price elasticity of demand: Table 4.3

28

If the products
are

then the crossprice elasticity of


demand will be

Example:

substitutes

positive.

Two brands of
digital music
players

complements

negative.

Digital music
players and song
downloads from
online music
stores

unrelated

zero.

Digital music
players and peanut
butter

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

Other Demand Elasticities


Income elasticity of demand: A measure of the
responsiveness of quantity demanded to a change in
income.
It is measured by the percentage change in quantity
demanded divided by the percentage change in income
(disposable income).

29

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

Summary of income elasticity of demand: Table 4.4

30

If the income
then the good is
elasticity of demand
is

Example:

positive, but less than 1

Milk

normal and a necessity.

positive and greater than normal and a luxury.


1

Caviar

negative

High-fat mince
meat

inferior.

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

The Price Elasticity Of Supply


And Its Measurement
Price elasticity of supply: The responsiveness of the
quantity supplied to a change in price.
It is measured by dividing the percentage change in the
quantity supplied of a product by the percentage change
in the products price.

31

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

The Price Elasticity Of Supply


And Its Measurement
The elasticity of supply will always be positive, as price
and quantity supplied move in the same direction.

The primary determinant of the price elasticity of


supply is the amount by which production costs rise as
output levels rise.
Other key determinants are largely based upon this.

32

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

The Price Elasticity Of Supply


And Its Measurement
Key determinants of the price elasticity of supply

1. Length of time involved in production


2. Type of industry
3. Availability of inputs
4. Existing capacity
5. Inventories held
33

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

The Price Elasticity Of Supply


And Its Measurement
Polar cases of perfectly elastic and perfectly
inelastic supply
The perfectly elastic supply curve is a horizontal line.
The perfectly inelastic supply curve is a vertical line.

34

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

Summary of the price elasticities of supply: Table 4.5

If supply is unit-elastic,
then the value of the price
elasticity is equal to 1.

35

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

Summary of the price elasticities of supply: Table 4.5


If supply is perfectly
elastic, then the value of
the price elasticity is equal
to infinity.

If supply is perfectly
inelastic, then the value of
the price elasticity is equal
to 0.

36

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

When demand changes, the change in price


depends
onelasticity
the price elasticity
of to
supply.
Using
Price
of supply
predict

changes
in price
In panel (a), Demand

represents the typical demand for


parking spaces on a summer weekday at a beach resort.
Demandweekend represents the demand for parking spaces at the
beach resort on weekends.
weekday

Because supply is inelastic, the shift in equilibrium from point A to


point B results in a large increase in price from $2.00 per hour to
$4.00but only a small increase in the quantity suppliedfrom
1200 to 1400. In panel (b), supply is elastic.
As a result, the shift in equilibrium from point A to point B results in
a smaller increase in price and a larger increase in the quantity
supplied. An increase in price from $2.00 per hour to $2.50 is
sufficient to increase the quantity of parking supplied from 1200 to
2100.
37

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

Changes in price depend on the price elasticity of supply: Figure 4.5

38

Copyright
Copyright2013
2013Pearson
PearsonAustralia
Australia(a(adivision
divisionofofPearson
PearsonAustralia
AustraliaGroup
GroupPty
PtyLtd)
Ltd) 9781442558069/Hubbard
9781442558069/Hubbardand
andO'Brien/Essentials
O'Brien/EssentialsofofEconomics/2e
Economics/2e

Key Terms
Cross-price elasticity of
demand

Perfectly inelastic
demand

Elastic demand

Price elasticity of
demand

Elasticity
Income elasticity of
demand
Inelastic demand
Perfectly elastic
demand
39

Price elasticity of
supply
Total revenue
Unit-elastic demand

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e