HE9091

Principles of Economics
Lecture 2
Elasticity and Consumer
Behaviour
Tan Khay Boon
Email: khayboon@ntu.edu.sg
Office: HSS-04-25

Topics

Price Elasticity of Demand

Income Elasticity of Demand
Cross-Price Elasticity of Demand
Price Elasticity of Supply
Total Utility and Marginal Utility
The Rational Spending Rule
Demand and Consumer Surplus
Supply and Producer Surplus
Reference: FBLC, chapters 4, 5 & 6

Price Elasticity of Demand

Price elasticity of demand is defined as the
percentage change in quantity demanded from a
1% change in price
Measure of responsiveness of quantity demanded
to changes in price

Example:
Price of beef decreases 1%
Quantity of beef demanded
increases 2%
Price elasticity of demand is 2

Calculate Price Elasticity

Symbol for elasticity is
Lower case Greek letter epsilon

For small percentage changes in price

=

Percentage change in quantity demanded

Percentage change in price

Price elasticity of demand is always negative

Ignore the sign and consider the absolute value when
interpreting price elasticity of demand

Elastic Demand
Price Elasticity of Demand
Unit elastic

Elastic

Inelastic

If price elasticity is greater than 1, demand is

elastic
Percentage change in quantity is greater than
percentage change in price
Demand is responsive to price

Inelastic Demand
Price Elasticity of Demand
Unit elastic

Elastic

Inelastic

If price elasticity is less than 1, demand is

inelastic
Percentage change in quantity is less than
percentage change in price
Quantity demanded is not very responsive to price

Unit Elastic Demand

Price Elasticity of Demand
Unit elastic

Elastic

Inelastic

If price elasticity is 1, demand is unit elastic

Price and quantity change by the same percentage

Example: Demand for Pizza

Price
Quantity
=
=

Old
$1.00
400

New
$0.97
404

% Change
3%
1%

Percentage change in quantity demanded

Percentage change in price
1%
3%

= 0.33

Demand is inelastic

Determinants of Price Elasticity

of Demand
Substitution
Options

More options, more

elastic

Budget Share

Large share, more

elastic

Time

Long time to adjust,

more elastic

Price Elasticity Notation

=

Percentage change in quantity demanded

Percentage change in price

Q is the change in quantity

Q / Q is percentage change in quantity

P is change in price
P / P is percentage change in price

Q / Q
P / P

Price Elasticity: Graphical View

=
=

P / P
Q

Q
P

Q
P

slope

Price

Q / Q

P
PP

Q
D

Q Q+Q
Quantity

Price Elasticity: Graphical View

P=8
Q=3
Slope = 20 / 5 = 4

8
3

Price

At point A
A

P
P
PP

Q
D

slope

1
4

= 0.67

Q Q+Q
Quantity

Price Elasticity and Slope

When two demand curves cross

At the common
point demand
is less price elastic
for the steeper
curve

Price

P / Q is same for both curves

(1 / slope) is
12
smaller for the
steeper curve
D1
Less Elastic
More Elastic

6
4

D2

6
Quantity

12

Price Elasticity on a StraightLine Demand Curve

Price elasticity is different at each point

P
Q

1
slope

Slope is the same for the demand curve

P/Q decreases as price goes down and quantity
goes up

Price Elasticity Pattern

Price elasticity changes systematically as price goes
down
At high P and low Q, P / Q is large
Demand is elastic

Demand is
inelastic

Price

At the midpoint,
demand is unit elastic
At low P and high Q,
P / Q is small

a/2

b/2
Quantity

Two Special Cases

Perfectly Elastic
Demand

Perfectly Inelastic
Demand

Infinite price elasticity of

demand

Zero price elasticity of

demand

Price

Price
D

Quantity

Quantity

Elasticity and Total Expenditure

When price increases, total expenditure can
increase, decrease or remain the same
The change in expenditure depends on elasticity

Terminology: total expenditure = total

revenue
Calculate as P Q
Graphing idea: total
expenditure is the area
of a rectangle with height P
and width Q
Example: P = 2 and
Q=4
x

Price
Expenditure = 8

2
D

Quantity

Price Elasticity and Total

Expenditure
Movie ticket price increases from $2 to $4
A and B are both below the midpoint of the curve
Inelastic portion of the demand curve

Total revenue increases when price increases

D

12

Expenditure =
$1,000/day

Price ($/ticket)

Price ($/ticket)

12

2
5

Quantity (00s of tickets/day)

Expenditure =
$1,600/day
B

Quantity (00s of tickets/day)

Price Elasticity and Total

Expenditure
Movie ticket price increases from $8 to $10
Prices are both above the midpoint of the curve
Elastic portion of the demand curve

Total revenue decreases

Y Expenditure =
$1,600/day
D
2

Quantity (00s of tickets/day)

Price ($/ticket)

Price ($/ticket)

12

12
10

Z
Expenditure =
$1,000/day
D
1

Quantity (00s of tickets/day)

The Effect of a Price Change on

Total Expenditure
Price

$10

$8

$6

$4

$2

$0

Quantity

1,000

2,000

3,000

4,000

5,000

6,000

Expenditure

$0

$1,000 $1,600 $1,800 $1,600 $1,000

Total expenditure ($/day)

$12

12

Price ($/ticket)

10
8
6
4
2
1
3
4
5
6
2
Quantity (00s of tickets/day)

$0

1,800
1,600

1,000

6
Price ($/ticket)

10

Elasticity, Price Change, and

Expenditure

Cross-Price Elasticity of Demand

Substitutes and complements affect demand
Cross-price elasticity of demand is defined
as the percentage change in quantity
demanded of good A from a 1 percent change
in the price of good B
Sign of cross-price elasticity shows
relationship between the goods
Complements have negative cross-price elasticity
Substitutes have positive cross-price elasticity
Do not ignore the sign when interpreting corssprice elasticity of demand

Income Elasticity of Demand

Income elasticity of demand is defined as
the percentage change in quantity demanded
from a 1 percent change in income
Income elasticity of demand can be positive or
negative
Positive income elasticity is a normal good
Negative income elasticity is an inferior good
Do not ignore the sign when interpreting income
elasticity of demand

Calculate Income and CrossPrice Elasticity

Income elasticity of demand:
Percentage change in quantity demanded

I =

Percentage change in Income

Cross-price elasticity of demand:

Percentage change in quantity demanded of A

AB =

Percentage change in Price of B

Price Elasticity of Supply

Price elasticity of supply
Percentage change in quantity supplied from a
1 percent change in price
Q / Q
Price elasticity of supply =

Price elasticity of supply =

P
Q

P / P

1
slope

Price Elasticity of Supply

If supply curve has a
positive intercept

Price elasticity of supply

= (8 / 2) (1 / 2) = 2.00

10
8

Price

Price elasticity of supply

decreases as Q increases
Graph shows
Slope = 2
At A, P = 8 and Q = 2

At B, P = 10 and Q = 3
Price elasticity of supply
= (10 / 3) (1 / 2) = 1.67

Quantity

Price Elasticity of Supply

If supply curve has a zero
intercept
B

5
4

Price

Price elasticity of supply is

1.00
Graph shows
Slope = 1 / 3
At A, P = 4 and Q = 12

A
Q

Price elasticity of supply

= (4 / 12) (3) = 1.00

At B, P = 5 and Q = 15
Price elasticity of supply
= (5 / 15) (3) = 1.00

12

Quantity

15

Perfectly Inelastic Supply

Zero price elasticity of
supply
No response to
change in price

Example: land in
Tokyo
Supply is completely
fixed

Any one-of-a-kind
item has perfectly
inelastic supply

Price

Work of art (Mona

Lisa)
Hope Diamond
Quantity

Perfectly Elastic Supply

Infinite price elasticity of
supply
Sell all you can at a fixed
price
Price

Quantity

Inputs purchased at a
constant price
No volume discounts
Constant proportions of
production
Lemonade example
Cost of production is 14 at
all levels of Q
Marginal cost
P = 14

Determinants of Price Elasticity

of Supply
Input Flexibility

Uses adaptable inputs, more

elastic

Resources move where

Mobility of Inputs
needed, more elastic

Alternative inputs easy to find,

Produce
Substitute Inputs
more elastic
Time

Long run, more elastic

The Midpoint Formula for

Elasticity of Demand
Elasticity is different at each point on the demand
curve
Compare 2 points and get 2 answers
Depends on which point is the starting point
Start at A and elasticity is 2
Start at B and elasticity is 1

A more stable solution is

needed
Use the midpoint formula

4
3

P
Q

The Midpoint Formula for

Elasticity of Demand
Midpoint formula
Use average quantity in the numerator
Use average price in the denominator

=
=

Q / [(QA + QB)/2]
P / [(PA + PB)/2]

Q / (QA + QB)
P / (PA + PB)

Elasticity using midpoint

formula is 1.40

4
3

P
Q

Needs versus Wants

Some goods are required for subsistence
These are needs

Beyond subsistence, behavior is driven by wants

Rice or noodle
Hamburger or chicken sandwich

Wants depend on price

Unlimited wants with limited resources means
consumers have to prioritize wants when making
choices.

Wants and Utility

Utility: the satisfaction people derive from
consumption
Well-being, happiness
Measured indirectly
Subjective
Observable

Cannot be compared between people

Individual goal is to maximize utility

Allocate resources accordingly

Sarah's Utility from Ice Cream

Utils/hour

Cones /
Hour
Total Utility

50

90

120 140 150 140

150
140
120
90
50

3
4
Cones/hour

Sarah's Marginal Utility from Ice

Cream
Cones /
Hour
Total Utility
Marginal Utility

50

90

120

140

150

140

50

40

30

20

10

Marginal utility: the additional utility from

consuming one more
Change in utility
Marginal utility =
Change in consumption

-10

Diminishing Marginal Utility

Law of Diminishing Marginal Utility
Tendency for additional utility gained
from consuming an additional unit of a good
to decrease as consumption increases
beyond some point

Diminishing Marginal Utility

Marginal utility can increase at low levels of
consumption
First unit stimulates your desire for more
First unit of food/drinks
Eventually marginal utility declines

Continue consuming

Apply Cost-Benefit Principle

Consume an additional unit as long as the marginal
utility (benefit) is greater than the marginal cost

 Law of Diminishing
Marginal Utility applies
As you buy more of a single
good, its marginal utility
decreases
When you buy less of that
good, its marginal utility
increases

Marginal Utility

Assume a fixed budget

Decide how much of each
good to buy

Marginal Utility

Spending on Two Goods

Budget Allocation
Maximize utility when the marginal utility per
dollar spent is the same for all goods
No Money Left On the Table Principle
Current spending has marginal utility of a dollar spent
on one good higher than the marginal utility of a
dollar spent on the other good
Take a dollar away from the good with low marginal
utility and spend it on the good with high marginal
utility
Marginal utilities per dollar begin to equalize

Sarah's Ice Cream

$400 budget
Chocolate is $2 per pint
Vanilla is $1 per pint

Buy 200 pints of vanilla

and 100 pints of
chocolate

Vanilla
Ice Cream

12

200
Pints/yr

MU (utils/ pint)

MU (utils/ pint)

Marginal utility is 12 for

vanilla, 16 for chocolate
Chocolate
Ice Cream
16

100
Pints/yr

Sarah's Next Step

Increase vanilla by 100

Vanilla
Ice Cream

MU (utils/ pint)

MU (utils/ pint)

Reduce chocolate by 50

Marginal utility of vanilla is 8

Marginal utility of chocolate
is 24

12
8
200
Pints/yr

300

24

Chocolate
Ice Cream

16

50
100
Pints/yr

Sarah's Equilibrium

Vanilla
Ice Cream

10

250

Pints/yr

Marginal utility / price is

the same for all goods
Marginal utility of vanilla
10, chocolate 20

MU (utils/ pint)

MU (utils/ pint)

Optimal combination:
highest total utility
250 pints vanilla; 75 pints
chocolate

Chocolate
Ice Cream
20

75
Pints/yr

Sarah's Choices
Scenario
1
Vanilla
Chocolate

Scenario
2
Vanilla
Chocolate
Scenario
3
Vanilla
Chocolate

Price

Quantity

$1
$2

200
100

Price

Quantity

$1
$2

300
50

Price

Quantity

$1
$2

250
75

Marginal
Utility
12
16

Marginal
Utility
8
24
Marginal
Utility
10
20

MU / $

12
8
MU / $

8
12
MU / $
10
10

Rational Spending Rule

The Rational Spending Rule

Spending should be allocated across goods so that

the marginal utility per dollar

is the same for each good

Rational Spending Rule

Rational Spending Rule can be written
algebraically
Notation

MUC is the marginal utility from chocolate

MUV is the marginal utility from vanilla
PC is the price of chocolate
PV is the price of vanilla

Rational Spending Rule

MUC / PC = MUV / PV
The marginal utility per dollar spent on chocolate
equals the marginal utility per dollar spent on
vanilla

Substitution Effect
When the price of a good goes up, substitutes for
that good are relatively more attractive
At the higher price less is demanded because some
buyers switch to the substitute good
If the price of vanilla ice cream goes up, some buyers
will buy less vanilla and more chocolate

Income Effect
Changes in price affect the buyers' purchasing
power
Acts like a change in income

Suppose vanilla ice cream goes from $1 per pint

to $2
If Sarah spends all her income on vanilla, the amount
she can buy goes down by half
At the original prices, she could buy 100 pints of
vanilla and 150 pints of chocolate
At new price for vanilla, she buys 100 vanilla and only
100 chocolate

Rational Spending and Price

Changes
Suppose price of vanilla increases from $1 to $2
At the original equilibrium
MUC / PC = MUV / PV
With the increase in PV, MUV / PV < MUC / PC
If Sarah buys more chocolate, MUC will go down
If Sarah buys less vanilla, MUV will go up
To get to a new optimal spending point,
Buy more chocolate
Buy less vanilla
Stop when the marginal utility per dollar is the same

Chocolate Ice Cream Price

Goes Down
Originally: $400 budget, $1 per pint for vanilla,
and $2 per pint for chocolate
What if chocolate is now $1 per pint?

With the decrease in PC,

MUV / PV < MUC / PC
If Sarah buys more chocolate, MUC will go down
If Sarah buys less vanilla, MUV will go up
To get to a new optimal spending point,
Buy more chocolate
Buy less vanilla
Stop when marginal utility per dollar is the same

Market and Social Welfare

Market is the aggregation of individual consumer
demand and producer supply
Consumers and producers are able to acquire
welfare from consumption and production of
products in the market
Welfare of the society (Economic surplus) is
obtained by the sum of the consumers and
producers welfare
Economic surplus = Consumer surplus +
producer surplus

Individual and Market Demand

Curves
The market demand is the horizontal sum of
individual demand curves
At each possible price, add up the number of units
demanded by individuals to get the market demand
Smith

Jones

Market

Consumer Surplus
Consumer surplus is the difference between
the buyer's reservation price and the market
price
With multiple buyers
Find the consumer surplus for each buyer
Add up the individual surplus for each buyer

 When a product is sold in

whole units, the demand
curve is a stair-step
function
If the market supplied only
one unit, the maximum price
would be $11
For the second unit, the
price is $10, and so on
The last buyer gets no
consumer surplus

Marginal utility (utils/ pint)

Consumer Surplus on a Graph

Vanilla Ice Cream

12
11
10
9
8
7
6
5
4
3
2
1

D
2

Units/day

10

12

 Market price is $6 for all

sales
Total consumer surplus
The first sale generates $5
of consumer surplus
Reservation price of $11
minus the price of $6

Selling the second unit has

$4 of consumer surplus,
and so on

Total consumer surplus

is the area under the
demand curve and
above market price

Marginal utility (utils/ pint)

Consumer Surplus on a Graph

Vanilla Ice Cream

12
11
10
9
8
7
6
5
4
3
2
1

D
2

Units/day

10

12

Consumer Surplus for Milk

Consider the market
demand and supply of
milk
Price ($/liter)

The equilibrium price is $2

per liter
The equilibrium quantity is
4,000 liters per day
Last customer pays his
reservation price and gets
no consumer surplus

3.00

2.00
D
1.00

Quantity (000s of liters/day)

Consumer Surplus for Milk

Horizontal intercept of
demand
Market price
Market quantity
Remember: area of a right
triangle is base times
height
The area is
(4,000 liter)($1) = $2,000

Consumer
Surplus

3.00

Price ($/liter)

Price is $2 and quantity

is 4,000 liters per day
Consumer surplus is the
area of the triangle
between:

2.00
D
1.00

Quantity (000s of liter/day)

Reservation Number of
Price ()
Cans (000s)

1
1.5
2
3
6

6
10
13
15
16

Deposit (cents/can)

Individual supplier: Harry's

Supply Curve
6

3
2
1
6
10 13 16
Recycled cans
(100s of cans/day)

Individual and Market Supply

Curves
Two suppliers: Harry and Barry
Deposit (cents/can)

Harrys Supply Curve

1.5

Barrys Supply Curve

Market Supply Curve

2
1.5
1

1
10 13 16
15
Recycled cans
(00s of cans/day)
6

1.5

10 13 16
15
Recycled cans
(00s of cans/day)
6

1
0

12 20 26
Recycled cans
(00s of cans/day)

32
30

Producer Surplus
Producer surplus is the difference between the
market price and the seller's reservation price
Reservation price = Marginal cost which is on the
supply curve

Producer surplus is the area above the supply

curve and below the market price