Hall and Lieberman, 3rd edition, Thomson South-Western, Chapter 4

2
Overview
Elasticity calculation and interpretation
Difference between elastic, inelastic, and unitary
elastic demand/supply
Prediction on revenue change in response to a
change in price
Elasticity varies as one moves along a straight-line
demand curve
Determinants of price elasticity of demand/supply
Income elasticity
Cross price elasticity of demand

3
Motivation to Study Elasticity
The Problem with Rate Change
-- is not a good measure of price
sensitivity
Doesnt tell whether a change in price or a change in
quantity demanded is a relatively large or relatively
small change
Relative means compared to value of price or quantity before
change
One extreme example:
100 more Big Mac purchased per week after every $1
decrease in Ames
100 more Ipod Nano purchased per week after every $1
decrease in Ames
P Q A A /
4
Elasticity - Concept
Elasticity approach improves on the problems with rate of change
By comparing percentage change in quantity demanded with percentage
change in price
Price elasticity of demand ( ) for a good is percentage change in
quantity demanded divided by percentage change in price



P %
Q %
D
D
A
A
=
q
always be a negative number
Arc elasticity

Price elasticity of demand tells us percentage change in quantity
demanded caused by a 1% rise in price as we move along a demand
curve from one point to another
q
D
5
Part 1: Price Elasticity of Demand
- Calculation
Base value for percentage changes in price or quantity is always
midway between initial value and new value
Denominator
- Define the percentage change in price from any value P
0
to any other
value P
1
as
2
) (
) (
Price in Change %
P P
P P
0 1
0 1
+

=
Numerator:
When quantity demanded changes from Q
0
to Q
1
,
percentage change is calculated as
(
(

+
=
2
) _ (
Demanded Quantity in Change %
0 1
0 1
Q Q
Q Q
6
( )
( )
( )
%
%
1
D
Q
Q
Q
E
P P
P
Q
P
P
Q
P
slope
Q
| |
A
|
A
\ .
= =
A A
| |
A
= -
|
A
\ .
| |
= -
|
\ .
(Own) Price Elasticity of Demand
Or written as
7
Figure 1: Calculating Price Elasticity of Demand
-- laptop computer demand
Quantity of
Laptops
C
Price per
Laptop
100,000 200,000 300,000 400,000 500,000 600,000
$3,500
3,000
2,500
2,000
1,500
1,000
B
A
D
D
8
Calculating Price Elasticity of Demand
-- An Example
Now lets calculate an elasticity of demand for laptop
computers using data in Figure 1 from point A to point B
% 2 . 18 or , 182 . 0
000 , 550
000 , 100
2
) 000 , 600 000 , 500 (
) 000 , 600 000 , 500 (
Q % =

=
(

= A
Use percentage changes for price and quantity to
calculate price elasticity of demand ( )
% 40.0 or , 400 . 0
250 , 1 $
500 $
2
) 000 , 1 $ 500 , 1 ($
) 000 , 1 $ 500 , 1 ($
P % = =
(

= A
46 . 0
400 . 0
182 . 0
D
=

=
q
q
D
9
Price Elasticity of Demand
-- Categorize Goods
Inelastic Demand
Price elasticity of demand between 0 and -1
1.0
P %
Q %
Demand Inelastic <
A
A

|% Change in Quantity Demanded| < |% Change in Price|

Extreme Case: Perfectly Inelastic Demand
Price elasticity of demand equal to 0
10
Categorizing Goods by Elasticity
Elastic Demand
Price elasticity of demand with absolute value > 1
|% Change in Quantity Demanded| > |% Change in Price|
Extreme Case: Perfectly (infinitely) Elastic Demand
Price elasticity of demand approaching minus infinity
Another Special Case: Unitary Elastic Demand
Price elasticity of demand equal to -1
1
P %
Q %
Demand Elastic >
A
A

11
Figure 2: Extreme Cases of Demand
D
Perfectly Inelastic
Demand
(a)
Quantity
Price
per
Unit
1
2
3
$4
20 40 60 80 100
(b)
D
Quantity
20 40 60 80 100
1
2
3
$4
Price
per
Unit
Perfectly Elastic
Demand
12
Figure 3: Relationship between demand
slope and elasticity

Elasticity = |(1/slope)*(P/Q)|
Quantity
PRICE
Perfectly elastic
Perfectly inelastic
Relatively Inelastic Demand
Relatively Elastic Demand
13
Elasticity and Total Revenue
Total revenue (TR) of all firms is defined as
TR = P x Q
Rule: when two numbers are both changing, percentage
change in their product is (approximately) the sum of
their individual percentage changes
Applying this to total revenue

Example: assume demand is unitary elastic and Q rises
by 10%
% Change in TR = 10% + (-10%) = 0

P Q TR A + A = A % % %
14
Figure 4(a): When does it pay to raise the price?

Price increases from P0 to P1 and quantity
demanded decreases from Q0 to Q1
Quantity
PRICE
Demand
P
1

P
0

Q
1
Q
0

15
Figure 4(b): When does it pay to raise the
price?
How about revenue change?
Quantity
PRICE
Demand
P
1

P
0

Q
1
Q
0

Change in total revenue =
P
1
Q
1
-P
0
Q
0


16
Figure 4(c): When does it pay to raise the
price?
How much is the change in total revenue?
Quantity
PRICE
Demand
P
1

P
0

Q
1
Q
0

Change in total revenue =
P
1
Q
1
-P
0
Q
0


Loss = P
0
*(Q
0
- Q
1
)
= P
0
Q
Gain = Q
1
(P
1
P
0
)
= Q
1
P
17
When does it pay to raise the price?
SUPPOSE DEMAND IS INELASTIC SO THAT THE %
CHANGE IN QUANTITY IS SMALLER THAN THE %
CHANGE IN PRICE
LOSS GAIN
( )
( )
( )
1
( )
( )
D
Q P
Q
P
E
P
Q
P Q
Q P P Q
A -
| | A
= - = <
|
A
A -
\ .
A - < A -
18
Figure 5 Effects of Price Changes on Expenditure
Where demand is: A price increase will: A price decrease will:
Inelastic ( | | < 1) increase expenditure decrease expenditure
unitary elastic ( | | = 1) cause no change in
expenditure
cause

no change in
expenditure
elastic ( | | > 1) decrease expenditure increase expenditure
19
Elasticity & Straight-Line Demand Curves
Look at percentage change in P
Look at percentage change in Q
As we move upward and leftward by equal distances,
percentage change in quantity rises
Percentage change in price falls
Elasticity of demand varies along a straight-line demand
curve
Demand becomes more elastic as we move upward
and leftward
20
Figure 4: Elasticity and Straight-
Line Demand Curves
Quantity
Price
and since equal quantity decreases
(horizontal arrows) are larger and
larger percentage decreases . . .
Since equal dollar increases (vertical
arrows) are smaller and smaller
percentage increases . . .
1
2
3
D
demand becomes more and more
elastic as we move leftward and
upward along a straight-line
demand curve.
21
0
2
4
6
8
10
0 10 20 30 40 50
PRICE
QUANTITY
( )
1
(1/ ) 5
D
P
E
slope
Q
slope fixed
| |
= -
|
\ .
= =
As P increases, Q falls,
elasticity gets bigger
| E
D
| > 1
elastic
| E
D
|

= 1
Unit elastic
| E
D
|

< 1
inelastic
25
5
22
Small Summary
Inelastic
Demand
Unitary Elastic
Demand
Elastic Demand
Definition
|ED| <1 |ED| =1

|ED| >1

Total Revenue
Same direction
as price change
Does not change
with price
change
Opposite
direction
from price

Straight Line
Demand Curve
Lower
segment
Middle point Upper segment
23
What Affects Elasticity?
-- 1. Availability of Substitutes
Demand is more elastic
If close substitutes are easy to find and buyers
can cut back on purchases of the good in
question
Demand is less elastic
If close substitutes are difficult to find and
buyers can not cut back on purchases of the
good in question

24
What Affects Elasticity?
-- 2. Narrowness of Market
More narrowly we define a good, easier it
is to find substitutes
More elastic is demand for the good
More broadly we define a good
Harder it is to find substitutes and the less
elastic is demand for the good
Different things are assumed constant
when we use a narrow definition
compared with a broader definition
25
What Affects Elasticity?
-- 3.Necessities vs. Luxuries
The more necessary we regard an item,
the harder it is to find a substitute
Expect it to be less price elastic
The less necessary (luxurious) we regard
an item, the easier it can be substituted
Expect it to be more price elastic
Example?
26
What Affects Elasticity?
-- 4. Time Horizon
Short-run elasticity
Measured a short time after a price change
Long-run elasticity
Measured a year or more after a price change
Usually easier to find substitutes for an item in
the long run than in the short run
Therefore, demand tends to be more elastic in the
long run than in the short run
27
What Affects Elasticity?
-- 5. Importance in the Buyers Budget
The more of their total budgets that
households spend on an item
The more elastic is demand for that item
The less of their total budgets that
households spend on an item
The less elastic is demand for that item
28
Figure 6 Some Short-Run Price Elasticities of
Demand
Specific Brands Narrow Categories Broad Categories
T ide Detergent 2.7 9 Transatlantic Air Travel 1.3 0 Recreation 1.09
Tourism in Thailand 1.2 0
Pepsi 2.08 Ground Beef 1.02 Clothing 0.89
Coke 1.7 1 Pork 0.7 8 Food 0.6 7
Milk 0.5 4 Imports 0.5 8
Cigarettes 0.45 Transportation 0.5 6
Electricity 0.40 to 0.5 0
Beer 0.2 6
Eggs 0.2 6
Gasoline 0.2 0
Oil 0.1 5
inelastic
elastic
29
Using Price Elasticity of Demand
-- (1) The War on Drugs
Every year U.S. Government spends about $20
billion on efforts to restrict the supply of drugs
Figure 6(a)
Market for heroin without government intervention
Figure 6(b)
Result of government efforts to restrict supply (current
policy)
Figure 6(c)
Results of an effective policy of reducing demand
30
Figure 7 The War on Drugs
Quantity
Price
per
Unit
P
1
Q
1
D
1
A
A
S
1
Quantity
Price
per
Unit
Q
1
D
1
S
1
Quantity
Price
per
Unit
P
1
Q
1
S
1
D
1
(a) (b) (c)
A
P
1
Q
2
B
S
2
P
2
Q
3
P
3
D
2
C
31
Using Price Elasticity of Demand
-- (2) Mass
Transit
Elasticity studies show that long-run
demand for mass transit is inelastic
Therefore, a rise in fare would increase revenues
Would also decrease ridership and require the city to
sacrifice other goals
To provide low-income households with affordable
transportation
To manage traffic congestion by enough ridership
To limit air pollution in the city
most cities do not raise transit fares

32
Source: ISU FACTBOOK
Figure 8 ISU Nonresident Enrollment and
Nonresident Tuition and Fees, 2002 & 2005
Year Tuition Freshmen Non Resident
2002 $12,083 1240 4255
2005 $15,707 976 4189
Change 3624 -264 -66
Mid point 13895 1108 4222
%change 0.261 -0.238 -0.016
Elasticity -0.914 -0.060
%
%
D
Q
E
P
A
=
A
33
Part 2: Income Elasticity of Demand
Percentage change in quantity demanded
divided by the percentage change in income
With all other influences on demand with the price of
the good kept constant
Y %
Q %
Income in Change %
Demanded Quantity in change %
Y
A
A
=
=
q
Interpretation: percentage increase in quantity
demanded for each 1% rise in income
34
Income Elasticity of Demand vs.
Price Elasticity of Demand
Price elasticity measures sensitivity of demand to
price as we move along a demand curve from one
point to another
Income elasticity tells us relative shift in demand
curveincrease in quantity demanded at a given
price
While a price elasticity is virtually always negative,
income elasticity can be positive or negative
Normal goods
Inferior goods
35
Income Elasticity of Demand
Economic necessity
Good with an income elasticity of demand between 0 and 1
Economic luxury
Good with an income elasticity of demand greater than 1
An implication
As income rises, proportion of income spent on economic
necessities will fall
While proportion of income spent on economic luxuries will rise
But, it is important to remember that economic
necessities and luxuries are categorized by actual
consumer behavior
Not by our judgment of a goods importance to human survival
36
Figure 9 Some Income Elasticities
Income
Elasticity
Income
Elasticity
Good or Service Good or Service
F resh F ruit 1.99 Imports 2.7 3
Computers 1.7 1
Transatlantic Air Travel 1.40 Transportation 1.7 9
College Education 0.5 5
Cigarettes 0.5 0 Recreation 1.0 7
Chicken 0.42 Clothing 1.02
Pork 0.3 4 F ood 0.60 to 0.85
Fresh Vegetables 0.2 6
Tooth Extraction 0.1 3 to 0.4 7
Ground Beef 0.2 0
Bread 0.42
Potatoes 0.8 1
Luxury (>1), Necessity (0<E
Y
<1),
Normal (>0) and Inferior (<0)
Goods defined by Income
elasticties
37
Part 3: Cross-Price Elasticity of Demand
Cross-price elasticity of demand
Percentage change in quantity demanded of one good (x)
caused by a 1% change in price of another good (z)
While all other influences on demand remain unchanged
z
x
P
Q
A
A
=
%
%
XZ
q
Sign of ?
Substitutes (+)
Complements (-)
Its size tells us how closely the two goods are related
A large absolute value for suggests that the two goods
are close substitutes or complements
xz q
xz q
38
Figure 10 Some Cross-Price Elasticities
Products Cross-Price Elasticity
Margarine with price of butter 1.5 3
Pepsi with price of Coke 0.80
Coke with price of Pepsi 0.6 1
Ground beef with price of beef table cuts 0.4 1
Ground beef with price of poultry 0.2 4
Electricity with price of natural gas 0.2 0
Theater with price of all other lively arts 0.1 2
Entertainment with price of food 0.7 2
Complements (-) vs Substitutes (+)
defined by sign of cross price elasticity
39
Part 4: Price Elasticity of Supply
Percentage change in quantity of a good
supplied that is caused by a 1% change in the
price of the good
With all other influences on supply held constant
Price in Change %
Supplied Quantity in Change %
S
=
q
40
What Affects Price Elasticity of Supply?
Supply will tend to be more elastic when
suppliers can switch to producing alternate
goods more easily
How easy? Depends on
Nature of the good itself
Narrowness of the market definitionespecially geographic
narrowness
Time horizonlonger we wait after a price change, greater
the supply response to a price change
41
Price Elasticity of Supply
Extreme cases of supply elasticity
Perfectly inelastic supply curve is a vertical
line
Many markets display almost completely inelastic
supply curves over very short periods of time
Perfectly elastic supply curve is a horizontal
line
42
Figure 10: Extreme Cases of Supply
S
(a)
Quantity per Period
Price
per
Unit
P
1
P
2
S
(b)
Quantity per Period
Price
per
Unit
Perfectly Inelastic
Supply
Perfectly Elastic
Supply