Elasticity

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Elasticity and its Application

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eStudy.us Price Elasticity of Demand

Price elasticity of demand measures how much
quantity demand responds to a change in price

measures the price sensitivity of consumers
measures how willing consumers are to buy less of the
good as its price rises

Percentage change in Qd %∆Qd
Ed = =
Percentage change in P %∆P


P

P rises by 10%
P2
%∆Qd 20%
= = 2 P1
%∆P 10% D

Q2 Q1 Q
Q falls by 20%

P

P rises by 10%
P2
%∆Qd 5%
= = .5 P1
%∆P 10%
D
Q2 Q1 Q
Q falls by 5%


eStudy.us Price elasticity of demand
Elastic demand - Quantity demanded responds
substantially to changes in the price
Ed 1 Ed 2 is Elastic

Inelastic demand - Quantity demanded responds
only slightly to changes in the price
Ed 1 Ed .5 is Inelastic

Unit elastics - Quantity demanded responds by the
same as the change in the price
Ed 1

eStudy.us Midpoint Formula

Midpoint is the number halfway between the start
& end values or the mean of those values

Use the following information to calculate the price
elasticity of demand for hotel rooms:
if P = $7, Qd = 50
if P = $9, Qd = 30


eStudy.us Midpoint Formula
Use the following information to calculate the price
elasticity of demand for hotel rooms:
if P = $7, Qd = 50 then changes to P = $9, Qd = 30

q0 q1 50 30
q0 q1 50 30 20
% Qd 2 2 40 .50
Ed 2
% P $2 .25
p0 p1 $7 $9 $8
p0 p1 $7 $9
2 2


eStudy.us Determinants
Determinants of price elasticity of demand
– Availability of close substitutes: goods with close
substitutes are more elastic demand
– Necessities vs. luxuries
• Necessities are more inelastic demand
• Luxuries are more elastic demand
– Definition of the market
• Narrowly defined markets are more elastic
• Broadly defined market are more inelastic
– Time horizon
• More elastic over longer time horizons
• More inelastic over shorter time horizons


eStudy.us Determinants
Determinants of price elasticity of demand
– Availability of close substitutes
½ ton pick-up trucks (GM, Ford, Chrysler) + Toyota
– Necessities vs. luxuries (Toyota vs. Mercedes)
– Definition of the market (Transportation vs. Automobiles)
– Time horizon (running car vs. broken car)


eStudy.us Elasticity of Gasoline
Short Run vs. Long Run elasticity of Gasoline
When price doubles:
– Tomorrow you will:

Increasingly Elasticity
Purchase about the same amount
– With in the next few months you will:
• Purchase a more fuel efficient car
• Car pool
– Over the next few years you may:
• Move closer to work
• Find a job closer to home


eStudy.us Elasticity of Gasoline
Available Gasoline Substitutes
When price doubles:
– and you live in the country:

Increasingly Elasticity
Purchase about the same amount
– or you live in a small city:
• Ride a bike
• Car pool
– or you live in a large city:
• Car pool (HOV)
• Train
• Bus

Price elasticity of demand is closely related to the
slope of the demand curve
– the flatter the demand curve, the greater the elasticity
– the steeper the demand curve, the lower the elasticity

more elastic more inelastic
P P

P rises by 10%
P rises by 10%

P2 P2

P1 P1

D D

Q2 Q1 Q Q2 Q1 Q
Q falls by 20% Q falls by 5%


eStudy.us Other Demand Elasticities
Price Demand
― Demand is perfectly inelastic
• Elasticity = 0 P1
1. an
P0
• Demand curve – vertical
• Increase in price leaves the
quantity demanded unchanged 0 Q Quantity

― Demand is perfectly elastic Price
• Elasticity = infinity
• Demand curve – horizontal
P0 1. an
• At P0 consumers will buy any quantity Demand

0 Quantity

eStudy.us Total revenue
Total revenue (TR) - price of the good times the
quantity sold The total amount paid by buyers, and received
as revenue by sellers, equals the area of the
Price
box under the demand curve, P × Q.
At price equal $8, the quantity demanded is
100, and total revenue is $800.

$8 TR P Q
1. an

Demand
$800 $8 100
P $800

0 100
Quantity
Q

eStudy.us Demand Curve
Elasticity of a linear demand curve
Price

$7 Elastic
E>1
6

5
4 1. an
Inelastic
3 E<1
2
Demand
1

0 2 4 6 8 10 12 14 Quantity


Percentage Percentage
Total revenue Change Change in
Price Quantity (Price ˣ Quantity) in Price Quantity Elasticity Description

$7 0 $0 200% 15% = 13.0 Elastic
6 2 12 67% 18% 3.7 Elastic
5 4 20 40% 22% 1.8 Elastic
4 6 24 29% 29% 1.0 Unit elastic
3 8 24 22% 40% 0.6 Inelastic
2 10 20 18% 67% 0.3 Inelastic
1 12 12 15% 200% 0.1 Inelastic
0 14 0


When demand is elastic: the fall in revenue from lower
quantity is greater than the increase in revenue from
higher price, so revenue falls

Elastic demand: An increase in price will
decrease in total revenue

Elastic demand: A decrease in price will
increase in total revenue


When demand is inelastic, the fall in revenue from
lower quantity is smaller than the increase in
revenue from higher price, so total revenue rises

Inelastic demand: An increase in price will
increase in total revenue

Inelastic demand: A decrease in price will
decrease in total revenue


eStudy.us Drug Interdiction
The United States, Mexico, and most of South American
have been fighting the “Drug War” or several decades.
This example illustrates two different interdiction
method used during the fight.

Assume the demand for illegal drugs is perfectly
inelastic, due to addiction


eStudy.us Supply Interdiction
Interdiction Price
reduces the S1
D1
supply of drugs.
Since demand for P1 S0
drugs is perfectly
inelastic, price rises
Resulting in an P0
increase in total
spending on drugs,
and in drug-related Drug Quantity
crime


eStudy.us Demand Interdiction
Education Price
reduces the D1 D0
demand for
S0
drugs.
Both price and P0
quantity fall.
P1
Resulting in a
decrease in total
spending on
drugs, and in Q1 Q0 Drug Quantity
drug-related
crime.

eStudy.us Income elasticity of demand
Income elasticity of demand: measures the response
of Qd to a change in consumer income

%∆Qd
EI =
%∆ I

― For normal goods, income elasticity > 0
― For inferior goods, income elasticity < 0
Premium Cars
%∆Qd 40% Normal Good
EI = = = 4
%∆ I 10% Income Elastic


eStudy.us Cross-price elasticity of demand
Cross-price elasticity of demand: measures the response
of demand for one good to changes in the price of
another good
%∆Qx
Ex/y =
%∆Py

— For substitutes, cross-price elasticity > 0
(increase in price of beef causes an increase in demand for
chicken)
― For complements, cross-price elasticity < 0
(an increase in price of jelly causes decrease in demand for
peanut butter)


eStudy.us Price Elasticity of Supply
Price elasticity of supply measures how much
quantity supplied, Qs, responds to a change in price
Price elasticity of supply measures sellers’
price-sensitivity.
Percentage change in Qs %∆Qs
Es = =
Percentage change in P %∆P


eStudy.us Elasticity of Supply
Price elasticity of supply
– Elastic supply - Quantity supplied responds
substantially to changes in the price
• Elasticity >1
– Inelastic supply - Quantity supplied responds only
slightly to changes in the price
• Elasticity < 1
– Unit elastic supply - Quantity supplied responds
only equally to changes in the price
• Elasticity =1


eStudy.us Price Elasticity of Supply
P
S
P rises by 8%

P1
16%
P0 = 2.0
8%
Which is elasticity
Q
Q0 Q 1
Q rises by 16%


eStudy.us Supply Curves
The slope of the supply curve is closely related to price
elasticity of supply
• The flatter the curve, the bigger the elasticity
• The steeper the curve, the smaller the elasticity

more elastic more inelastic
P P
S S
P1 P1

P0 P0

Q0 Q1 Q Q0 Q1 Q

eStudy.us Elasticity of Supply
― Perfectly Inelastic Supply Price Supply
• Sellers’ are not price sensitive
• Es=0 P1
P0 1. an
• An increase in price leaved Qs
unchanged
0 Q0 Quantity
― Perfectly Elastic Supply
Price
• At exactly P0, producers will
supply any quantity
• Es=infinity P0 1. an
Supply
• Supply curve – horizontal
0 Quantity

eStudy.us Determinants of Supply Elasticity

— The more easily sellers can change the quantity they
produce, the greater the price elasticity of supply.
Example: Supply of beachfront property is harder to vary and
thus less elastic than supply of new cars.

— Time period: For many goods, price elasticity of
supply is greater in the long run than in the short
run, because firms can build new factories, or new
firms may be able to enter the market.
Example: Supply of classrooms are generally fixed in the short
run but school can build a new facility in time.


eStudy.us Good news for farmers?
New hybrid of corn – increase production per acre
• Supply curve shifts to the right
• Higher production quantity leads to lower price
• Demand is inelastic so total revenue falls
Price 1. When demand is inelastic,
an increase in supply. S0

S1
P0
3. A proportionately smaller
P1 increase in quantity sold. As
2. Which leads a result, revenue falls.
to a large fall
in price. Demand

0 Q0 Q1 Quantity


eStudy.us A winning football team
Your football team trades for an all pro quarterback
• Supply seats and the supply curve remain fixed
• More wins leads to higher demand (higher attendance)
• Inelastic supply leads to very high ticket prices
Price Supply

P1 1. an

P0
D1
D0

0 Q0 Quantity


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