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Learn the meaning of the elasticity of

demand.
Examine what determines the elasticity of
demand.
Learn the meaning of the elasticity of
supply.
Examine what determines the elasticity of
supply.


In this lecture you will
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Elasticities are tools you can use to quantify
the impact of changes in prices, income, and
advertising on sales and revenues.

is a measure of how much buyers and sellers
respond to changes in market conditions
THE ELASTICITY OF DEMAND
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Elasticity the concept
The responsiveness of one variable to
changes in another
When price rises, what happens
to demand?
Demand falls
BUT!
How much does demand fall?

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Elasticity the concept
If price rises by 10% - what happens to
demand?
We know demand will fall
By more than 10%?
By less than 10%?
Elasticity measures the extent to which
demand will change

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Elasticity
4 basic types used:
Price elasticity of demand
Income elasticity of demand
Cross elasticity
Price elasticity of supply


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Price elasticity of demand is a measure of
how much the quantity demanded of a
good responds to a change in the price of
that good.

Price elasticity of demand is the
percentage change in quantity demanded
given a percent change in the price.

Price Elasticity of Demand
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Availability of Close Substitutes
Necessities versus Luxuries
Definition of the Market
Time Horizon
The Price Elasticity of Demand and Its
Determinants
8
Demand tends to be more elastic:
the larger the number of close substitutes.
if the good is a luxury.
the more narrowly defined the market.
The longer the time period.
The Price Elasticity of Demand and Its
Determinants
9
The price elasticity of demand is computed
as the percentage change in the quantity
demanded divided by the percentage
change in price.
Computing the Price Elasticity of
Demand
P r i c e e l a s t i c i t y o f d e m a n d =
P e r c e n t a g e c h a n g e i n q u a n t i t y d e m a n d e d
P e r c e n t a g e c h a n g e i n p r i c e
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Inelastic Demand
Quantity demanded does not respond
strongly to price changes.
Price elasticity of demand is less than one.
Elastic Demand
Quantity demanded responds strongly to
changes in price.
Price elasticity of demand is greater than
one.
A Variety of Demand Curves
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Perfectly Inelastic
Quantity demanded does not respond to
price changes.
Perfectly Elastic
Quantity demanded changes infinitely with
any change in price.
Unit Elastic
Quantity demanded changes by the same
percentage as the price.
A Variety of Demand Curves
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How Elastic Is Elastic?
Demand is elastic if the price elasticity of
demand is greater than 1, inelastic if the
price elasticity of demand is less than 1,
and unit-elastic if the price elasticity of
demand is exactly 1.

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E = 0
0 Quantity
Price
Demand
100
1. An increase
in price
$4.00
$5.00
2. leaves the quantity demanded unchanged.
Figure 5-1 a): Perfectly Inelastic
Demand
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E < 1
0
Quantity
Price
100
1. A 22%
increase in
price
$5.00
2. Leads to a 11% decrease in quantity demanded.
Demand
$4.00
90
Figure 5-1 b): Inelastic Demand
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E = 1
0
Quantity
Price
100
1. A 22%
increase in
price
$5.00
2. Leads to a 22% decrease in quantity demanded.
Demand
$4.00
80
Figure 5-1 c): Unit Elastic Demand
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E > 1
0
Quantity
Price
100
1. A 22%
increase in
price
$5.00
2. Leads to a 67% decrease in quantity demanded.
Demand
$4.00
50
Figure 5-1 d): Elastic Demand
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E =
0
Quantity
Price
2. At exactly $4, consumers will buy any quantity.
$4.00
Demand
1. At any price above $4, quantity
demanded is zero.
3. At any price below $4, quantity demanded is
infinite.
Figure 5-1 e): Perfectly Elastic Demand
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Example

Point Formula for Price Elasticity of Demand or
Measurement of elasticity at apoint on the demand
curve
The exact formula for calculating an
elasticity at the point A on the demand
curve.
Note: well take absolute value
atA
P
X
X
P
elasticity
D
A
A
|
|
.
|

\
|
A
A
=
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Example: Elasticity Calculation
at A
Slope =
(40-32)/(10-14)=-2
1/slope = -1/2
P/X = 36/12 = 3 at
point A
P/X x 1/slope
= -1.5
Elasticity of
demand = -1.5
Absolute value of
the elasticity = 1.5
Linear Demand Curve
30
31
32
33
34
35
36
37
38
39
40
41
42
10 11 12 13 14
Quantity
P
r
i
c
e
A
20
Exercise -- Linear Demand
Compute the elasticity
at the point indicated
in red on the table
(X=18,P=24).
Slope = -2
1/Slope = -1/2
P/X = 24/18 = 4/3
Elasticity = -2/3
Quantity Price
10 40
11 38
12 36
13 34
14 32
15 30
16 28
17 26
18 24
19 22
20 20
21
22
Price
Quantity
2
4
6 8 10
12
0
6
5
4
3
2
1
7
14
Elasticity
is larger
than 1.
Elasticity
is smaller
than 1.
Figure 5-5: A Linear Demand Curve
Elasticities and Linear Demand
The elasticity varies along a linear demand (or supply) curve.
This is illustrated in the linear demand curve table above.
Note: Usually we would report last column as absolute value
Linear Demand
Quantity Price Slope 1/Slope
Exact
Elasticity
10 40
11 38 -2 -0.5 -1.7273
12 36 -2 -0.5 -1.5000
13 34 -2 -0.5 -1.3077
14 32 -2 -0.5 -1.1429
15 30 -2 -0.5 -1.0000
16 28 -2 -0.5 -0.8750
17 26 -2 -0.5 -0.7647
18 24 -2 -0.5 -0.6667
19 22 -2 -0.5 -0.5789
20 20
23
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Because the price elasticity of demand
measures how much quantity demanded
responds to the price, it is closely related
to the slope of the demand curve.
Slope of the Demand Curve
AP is the
change in
price. (AP<0)
Price
Quantity
Demand
X X + AX
AX
P
P+ AP
AP
AX is the
change in
quantity.
slope =
AP/ AX
X
P
A
A
= slope
1/slope =
AX/ AP
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Slope Compared to Elasticity
The slope measures the rate of change of
one variable (P, say) in terms of another
(X, say).
The elasticity measures the percentage
change of one variable (X, say) in terms of
another (P, say).
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Arc Formula for Elasticity -
General
Although the exact formula for calculating
an elasticity is useful for theory, in
practice economists usually calculate an
approximation called the arc elasticity.
You are really approximating the elasticity
between two points.
Need two points to perform the
calculation.
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Arc Formula for Own Price
Elasticity of Demand
Get two points of the demand curve:
Points A and B.
Consider P
A
and X
A
and P
B
and X
B
from
the demand relationship.
Note: well take absolute value
Pavg P P
Xavg X X
elasticity
B A
B A
/ ) (
/ ) (

=
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Using the Midpoint Method to
Calculate Elasticities
The midpoint method is a technique for
calculating the percent change. In this
approach, we calculate changes in a
variable compared with the average, or
midpoint, of the starting and final values.


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The midpoint formula is preferable when
calculating the price elasticity of demand
because it gives the same answer
regardless of the direction of the change.
point Method: A Better Way to Calculate Percentage
Changes and Elasticities
The Midpoint Method: A Better Way to
Calculate Percentage Changes and
Elasticities
(Q
2
- Q
1
)

/ [(Q
2
+ Q
1
)

/ 2]
(P
2
- P
1
)

/ [(P
2
+ P
1
)

/ 2]
Price elasticity of demand =
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Using the Midpoint Method to Calculate
Elasticities
100 x
of value Average
in Change
in change %
X
X
X =
2 / )
2 / )
2 1
1 2
2 1
1 2
(
-
(
-
demand of elasticity Price
P P
P P
Q Q
Q Q
+
+
=
Average value of X =
Starting value of X + final value of X
2
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From Point A to Point B: Price rise = 50% and Quantity fall = 33%
From Point B to Point A: Price fall = 33% and Quantity rise = 50%
(80 - 120) / [(80 + 120)/ 2]
(6 - 4)

/ [(6 + 4)/ 2]
Price elasticity of demand =
Point A: Price = $4 Quantity = 120
Point B: Price = $6 Quantity = 80
= 1
Mid point method
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Estimating Elasticities
TABLE 5-1
Some Estimated Price
Elasticities of Demand

Good
Price elasticity
of demand
Inelastic demand
Eggs 0.1
Beef 0.4
Stationery 0.5
Gasoline 0.5
Elastic demand
Housing 1.2
Restaurant meals 2.3
Airline travel 2.4
Foreign travel 4.1
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Elasticity and Total Revenue
The total revenue is the total value of sales
of a good or service. It is equal to the price
multiplied by the quantity sold.



(5-6)
sold quantity Price revenue Total =
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Total revenue is the amount paid by
buyers and received by sellers of a good.
Computed as the price of the good times
the quantity sold.

TR = P x Q
Total Revenue and the Price Elasticity
of Demand
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When price elasticity of demand is equal
to unity, the total expenditure remains the
same with the fall or rise in price.
When price elasticity of demand is greater
than one, the total expenditure will
increase with the fall in price and will
decrease with the rise in price.
When price elasticity of demand is lesser
than one, the total expenditure will
decrease with the fall in price and will
increase with the rise in price.


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Table 5-1. Elasticity and Total Revenue
along a Linear Demand Curve
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Income elasticity of demand measures
how much the quantity demanded of a
good responds to a change in consumers
income.
It is computed as the percentage change
in the quantity demanded divided by the
percentage change in income.
Other Demand Elasticities
Income elasticity of demand =
Percentage change
in quantity demanded
Percentage change
in income
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Types of Goods
Normal Goods
Inferior Goods
Higher income raises the quantity
demanded for normal goods but lowers
the quantity demanded for inferior goods.
Other Demand Elasticities
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Goods consumers regard as necessities
tend to be income inelastic
Examples include food, fuel, clothing, utilities,
and medical services.
Goods consumers regard as luxuries tend
to be income elastic.
Examples include sports cars, furs, and
expensive foods.
Other Demand Elasticities
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Cross-Price elasticity of demand
measures how much the quantity
demanded of a good responds to a
change in the price of another good.
It is computed as the percentage
change in the quantity demanded
divided by the percentage change in the
price of the second good.
Other Demand Elasticities
c o e l a s t i c i t y o f d e m a n d =
P e r c e n t a g e c h a n g e
i n q u a n t i t y d e m a n d e d
P e r c e n t a g e c h a n g e
i n the price of
good 2.
Cross
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Cross elasticity of substitutes is positive and large.
The higher the coefficient, the better substitutes the
goods are
If coefficient of elasticity is more than one, then
goods are close substitutes, if less than one-----
poor substitutes and if infinite than perfect
substitutes.
For complementary goods the cross elasticity of
demand is negative.

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Price elasticity of supply is a measure of
how much the quantity supplied of a good
responds to a change in the price of that
good.

Price elasticity of supply is the percentage
change in quantity supplied given a
percent change in the price.

PRICE ELASTICITY OF
SUPPLY
44
Ability of sellers to change the amount of
the good they produce.
Beach-front land is inelastic.
Books, cars, or manufactured goods are
elastic.
Time period.
Supply is more elastic in the long run.
The Price Elasticity of Supply and Its
Determinants
45
The price elasticity of supply is computed
as the percentage change in the quantity
supplied divided by the percentage
change in price.
Computing the Price Elasticity of
Supply
Price elasticity of supply =
Percentage change
in quantity supplied
Percentage change in price
46
using the midpoint method, we calculate the percent change in
the price as (2.10 - 1.90) / 2.00 x 100 = 10%
Similarly, we calculate the percent change in the quantity supplied
as (11 000 - 9000) / 10 000 x 100 = 20%
20%
Price elasticity of supply =
Suppose an increase in the price of milk from $1.90 to $2.10 a
litre raises the amount that dairy farmers produce from 9000 to
11 000 L per month
= 2.0
Computing the Price Elasticity of
Supply
10%
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E = 0
0 Quantity
Price
Supply
1. An increase
in price
$5.00
2. leaves the quantity supplied unchanged.
100
$4.00
Figure 5-6 a): Perfectly Inelastic Supply
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E < 0
0 Quantity
Price
Supply
100
1. A 22%
increase in
price
$5.00
2. leads to a 10% increase in quantity
supplied.
$4.00
110
Figure 5-6 b): Inelastic Supply
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E = 1
0 Quantity
Price
Supply
100
1. A 22%
increase in
price
$5.00
2. leads to a 22% increase in quantity
supplied.
$4.00
125
Figure 5-6 c): Unit Elastic Supply
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E > 1
0 Quantity
Price
Supply
100
1. A 22%
increase in
price
$5.00
2. leads to a 67% increase in quantity
supplied.
$4.00
200
Figure 5-6 d): Elastic Supply
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E =
0
Quantity
Price
2. At exactly $4, producers will supply any quantity.
$4.00
Supply
1. At any price above $4, quantity
supplied is infinite.
3. At any price below $4, quantity supplied is zero.
Figure 5-6 e): Perfectly Elastic Supply
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0
Quantity
Price
$3
100
$4
200
$12
500
$15
525
Elasticity is
greater than 1
Elasticity is less
than 1
Figure 5-7: How the price elasticity of
supply can vary
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Good news bad news for farmers
OPEC
Drugs and crime

THREE APPLICATIONS OF
SUPPLY, DEMAND, AND
ELASTICITY
54
Increase in Supply
Demand
$3
Quantity of Wheat
Price of
Wheat
S
2

2. leads
to a fall in
price
3. and a proportionately smaller increase in quantity sold. As a result revenue
falls from $300 to $220.
1. When demand is inelastic, an
increase in supply
110 100
$2
Figure 5-8: An Increase in Supply in the
Market for Wheat
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Demand
Quantity of Oil
Price
of Oil
S
2

1. In the short run, when supply
and demand are inelastic, a shift
in supply
2. leads
to a large
increase in
price
P
1
P
2

Demand
Quantity of Oil
S
2

1. In the long run, when supply
and demand are elastic, a shift in
supply
2. leads
to a small
increase in
price
P
1
P
2

Price
of Oil
(a) Oil Market in the Short Run (b) Oil Market in the Long Run
Figure 5-9: A Reduction in Supply in
the World Market for Oil
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Demand
Quantity of Drugs
Price of
Drugs
S
2

1. Drug interdiction reduces the
supply of drugs
2. which
raises the
price
P
1
P
2

D
1

1. Drug education reduces the
demand for drugs
2. which
reduces the
price
(a) Drug Interdiction (b) Drug Education
Q
1
Q
2

3. and reduces the
quantity sold.
Q
2

3. and reduces the quantity
sold.
Quantity of Drugs
Price of
Drugs
D
2

P
1

Q
1

P
2
Figure 5-10: Policies to Reduce the of
Illegal Drugs
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Price elasticity of demand measures how much
the quantity demanded responds to changes in
the price.
Price elasticity of demand is calculated as the
percentage change in quantity demanded
divided by the percentage change in price.
If a demand curve is elastic, total revenue falls
when the price rises.
If it is inelastic, total revenue rises as the price
rises.

Summary
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The income elasticity of demand measures how
much the quantity demanded responds to
changes in consumers income.
The cross-price elasticity of demand measures
how much the quantity demanded of one good
responds to the price of another good.
The price elasticity of supply measures how
much the quantity supplied responds to changes
in the price.

Summary
59
In most markets, supply is more elastic in the
long run than in the short run.
The price elasticity of supply is calculated as the
percentage change in quantity supplied divided
by the percentage change in price.
The tools of supply and demand can be applied
in many different types of markets.
Summary
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The End