CHAPTER 4: ELASTICITY
PRICE ELASTICITY OF DEMAND
We know when supply decreases, the equilibrium price
rises and the equilibrium quantity decreases.
BUT does the price rise by a large amount and the
quantity decrease by a little? Or does the price barely
rise and the quantity decrease by a large amount?
ANSWER: depends on the responsiveness of the
quantity demanded of a good to a change in its price.
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PRICE ELASTICITY OF DEMAND
You may think about the responsiveness of the quantity
demanded of a good to a change in price in terms of
the slope of the demand curve.
If the demand curve is steep, the price rises by a lot, if
the demand curve is almost flat, the price barely rises.
But the slope of the demand curve depends on the
units in which we measure the price and quantity. We
can make the demand curve steep or flat.
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PRICE ELASTICITY OF DEMAND
To measure responsiveness we need a measure that is
independent of the units of measurement.
ELASTICITY is such a measure.
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 buying plans remain the same.
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PRICE ELASTICITY OF DEMAND
The price elasticity of demand is calculated as follows:
Percentage change in quantity demanded
Percentage change in price
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PRICE ELASTICITY OF DEMAND
To calculate the price elasticity of demand:
We express the change in price as a percentage of the
average price – the average of the initial and new price
AND we express the change in quantity demanded as a
percentage of the average quantity demanded – the
average of the initial and new quantity.
Let’s look at an example.
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PRICE ELASTICITY OF
DEMAND
Let’s calculate the price
elasticity of demand for
pizza.
Initially, the price of a pizza
is $20.50 and the quantity
demanded is 9 pizzas an
hour.
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PRICE ELASTICITY OF
DEMAND
The price of a pizza falls to
$19.50 and the quantity
demanded increases to 11
pizzas an hour.
The price falls by $1 and
the quantity demanded
increases by 2 pizzas an
hour.
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PRICE ELASTICITY OF
DEMAND
The average price is $20
and the average quantity
demanded is 10 pizzas an
hour.
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PRICE ELASTICITY OF
DEMAND
The percentage change in
quantity demanded, %DQ,
is calculated as:
DQ/Qave x 100, which is
(2/10) x 100 = 20%.
The percentage change
in price, %DP, is
calculated as
DP/Pave x 100, which is
($1/$20) x 100 = 5%.
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PRICE ELASTICITY OF
DEMAND
The price elasticity of
demand equals:
%DQ / %DP =
20% / 5% = 4
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PRICE ELASTICITY OF DEMAND
MINUS SIGN AND ELASTICITY
When the price of a good rises, the quantity demanded
decreases. Because a positive change in price brings a
negative change in the quantity demanded, the price
elasticity of demand is a negative number.
But it is the magnitude or absolute value that tells us
how responsive the quantity demanded is. So to
compare elasticities of demand, we use the magnitude
and ignore the minus sign.
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PRICE ELASTICITY OF DEMAND
INELASTIC AND ELASTIC DEMAND
Demand can be inelastic, unit elastic, or elastic, and can
range from zero to infinity.
If the quantity does not change when the price
changes, the price elasticity of demand is zero and the
good has a perfectly inelastic demand.
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PRICE ELASTICITY OF
DEMAND
Here is an example of a
good that has a perfectly
inelastic demand.
The demand curve is
vertical.
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PRICE ELASTICITY OF
DEMAND
If the percentage change in
the quantity demanded
equals the percentage
change in price, the price
elasticity of demand
equals 1 and the good has
a unit elastic demand.
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PRICE ELASTICITY OF DEMAND
If the percentage change in the quantity demanded is
smaller than the percentage change in price:
• The price elasticity of demand is less than 1 and the
good has inelastic demand
If the percentage change in the quantity demanded is
greater than the percentage change in price:
• The price elasticity of demand is greater than 1 and
the good has elastic demand
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PRICE ELASTICITY OF
DEMAND
If the percentage change in
the quantity demanded is
infinitely large when the
price barely changes, the
price elasticity of demand
is infinite and the good has
a perfectly elastic
demand.
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PRICE ELASTICITY OF DEMAND
FACTORS THAT INFLUENCE THE ELASTICITY OF DEMAND:
• The closeness of substitutes
• The proportion of income spent on the good
• The time elapsed since a price change
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PRICE ELASTICITY OF DEMAND
CLOSENESS OF SUBSTITUTES
The closer the substitutes for a good or service, the
more elastic the demand for the good or service.
Luxuries, such as exotic vacations, generally have elastic
demand.
Necessities, such as food or housing, generally have
inelastic demand.
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PRICE ELASTICITY OF DEMAND
PROPORTION OF INCOME SPENT ON THE GOOD
The greater the proportion of income consumers spend
on a good, the larger is the elasticity of demand for that
good.
TIME ELAPSED SINCE PRICE CHANGE
The more time consumers have to adjust to a price
change, or the longer that a good can be stored
without losing its value, the more elastic is the demand
for that good.
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PRICE ELASTICITY OF
DEMAND
ELASTICITY ALONG A
LINEAR DEMAND CURVE
The elasticity of demand
changes along a linear
demand curve.
At the mid-point of the
demand curve, demand is
unit elastic.
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PRICE ELASTICITY OF DEMAND
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PRICE ELASTICITY OF
DEMAND
At prices above the mid-
point of the demand curve,
demand is elastic.
At price below the mid-
point of the demand curve,
demand is inelastic.
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PRICE ELASTICITY OF
DEMAND
For example, if the price
falls from $25 to $15, the
quantity demanded
increases from 0 to 20
pizzas an hour.
The average price is $20
and the average quantity is
10 pizzas.
The price elasticity of
demand is (20/10) divided
by (10/20) which equals 4.
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PRICE ELASTICITY OF
DEMAND
If the price falls from $10
to $0, the quantity
demanded increases from
30 to 50 pizzas an hour.
The average price is $5 and
the average quantity is 40
pizzas.
The price elasticity of
demand is (20/40) divided
by (10/5) which equals 1/4.
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PRICE ELASTICITY OF
DEMAND
If the price falls from $15
to $10, the quantity
demanded increases from
20 to 30 pizzas an hour.
The average price is $12.50
and the average quantity is
25 pizzas.
The price elasticity of
demand is (10/25) divided
by (5/12.5) which equals 1.
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PRICE ELASTICITY OF DEMAND
TOTAL REVENUE AND ELASTICITY
The total revenue from the sale of a good or service
equals the price of the good multiplied by the quantity
sold.
When the price changes, total revenue also changes.
But a rise in the price does not always increase total
revenue.
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PRICE ELASTICITY OF DEMAND
The change in total revenue due to a change in price
depends on the elasticity of demand:
• If demand is elastic, a 1% price cut increases the
quantity sold by more than 1%, and total revenue
increases
• If demand is inelastic, a 1% price cut increases the
quantity sold by less than 1%, and total revenue
decreases
• If demand is unit elastic, a 1% cut increases the
quantity sold by 1%, and total revenue remains
unchanged
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PRICE ELASTICITY OF DEMAND
The total revenue test is a method of estimating the
price elasticity of demand by observing the change in
total revenue that results from a price change:
• 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
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ELASTICITY OF DEMAND
Recall, our demand curve.
ELASTICITY OF DEMAND
We can draw the
relationship between total
revenue and quantity
demanded.
PRICE ELASTICITY OF DEMAND
EXPENDITURE AND ELASTICITY
• If your demand is elastic, a 1% cut increases the
quantity you buy by more than 1% and your
expenditure on the item increases
• If your demand is inelastic, a 1% price cut increases
the quantity you buy by less than 1% and your
expenditure on the item decreases
• If your demand is unit elastic, a 1% price cut
increases the quantity you buy by 1% and your
expenditure on the item does not change
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MORE ELASTICITIES OF DEMAND
INCOME ELASTICITY OF DEMAND
The income elasticity of demand measures how the
quantity demanded of a good responds to a change in
income, other things remaining the same
Percentage change in quantity demanded
Percentage change in income
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MORE ELASTICITIES OF DEMAND
If the income elasticity of demand is greater than 1,
demand is income elastic and the good is a normal
good.
If the income elasticity of demand is greater than 0 but
less than 1, demand is income inelastic and the good is
a normal good.
If the income elasticity of demand is less than 0
(negative) the good is an inferior good.
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MORE ELASTICITIES OF DEMAND
CROSS ELASTICITY OF DEMAND
The cross elasticity of demand is a measure of the
responsiveness of demand for a good to a change in
the price of a substitute or a complement, other things
remaining the same.
Percentage change in quantity demanded
Percentage change in price of substitute or complement
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MORE ELASTICITIES OF DEMAND
The cross elasticity of demand for:
• A substitute is positive
• A complement is negative
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ELASTICITY OF SUPPLY
We know that when the demand for a good increases,
the equilibrium price rises and the equilibrium quantity
of the good increases.
But does the price rise by a large amount and the
quantity increase by a little? Or does the price barely
rise and the quantity increases by a large amount?
ANSWER: Depends on the responsiveness of the
quantity supplied of a good to a change in its price.
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ELASTICITY OF SUPPLY
The elasticity of supply measures the responsiveness
of the quantity supplied to a change in the price of a
good, when all other influences on selling plans remain
the same.
Percentage change in quantity supplied
Percentage change in price
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ELASTICITY OF SUPPLY
Supply is perfectly inelastic if the supply curve is
vertical and the elasticity of supply is 0.
Supply is unit elastic if the supply curve is linear and
passes through the origin (note: slope is irrelevant).
Supply is perfectly elastic if the supply curve is
horizontal and the elasticity is infinite.
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ELASTICITY OF SUPPLY
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ELASTICITY OF SUPPLY
FACTORS THAT INFLUENCE THE ELASTICITY OF SUPPLY:
• Resource substitution possibilities
• Time frame for supply decision
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ELASTICITY OF SUPPLY
RESOURE SUBSTITUTION POSSIBILITIES
The easier it is to substitute among the resources used
to produce a good or service, the greater is its elasticity
of supply.
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ELASTICITY OF SUPPLY
TIME FRAME FOR SUPPLY DECISION
The more time that passes after a price change, the
greater is the elasticity of supply.
Momentary supply is perfectly inelastic. The quantity
supplied immediately following a price change is
constant.
Short-run supply is somewhat elastic.
Long-run supply is the most elastic.
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