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Elasticity and its Applications

Practice Questions

ECON2113 Microeconomics (L1/L7)


Tutorial Three

Jeremy TO

Department of Economics, HKUST

Jeremy TO ECON2113 Microeconomics (L1/L7)


Elasticity and its Applications
Practice Questions

Price Elasticity of Demand

In general, elasticity measures responsiveness. The price elasticity of


demand measures how responsive buyers are to a change in the price of
the good.
Mathematically, it 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 a buyer’s plans remain unchanged.
The price elasticity of demand is equal to the absolute value of

%∆ in Q D
εD,P =
%∆ in P
Expand and rearrange the equation:
∆Q D
%∆ in Q D QD ∆Q D P 1 P
εD,P = = ∆P
= × D = ∆P
×
%∆ in P P
∆P Q ∆Q D
QD

Q1D +Q2D P1 +P2


Mid-point Method: Q D = 2
and P = 2

Jeremy TO ECON2113 Microeconomics (L1/L7)


Elasticity and its Applications
Practice Questions

Inelastic and Elastic Demand

Inelastic Demand: The price elasticity of demand is less than 1.0,


which means the percent- age change in the quantity demanded is
less than the percentage change in price.
Perfectly Inelastic Demand: The price elasticity of demand is 0
and the good’s demand curve is a vertical line, which means the
quantity demanded remains constant when the price changes.
Unit Elastic Demand: The price elasticity of demand is equal to
1.0, which means the percentage change in the quantity demanded
equals the percentage change in price.
Elastic Demand: The price elasticity of demand is greater than
1.0, which means the percentage change in the quantity demanded
exceeds the percentage change in price.
Perfectly Elastic Demand: The price elasticity of demand is
infinite, which means the quantity demanded changes by an
infinitely large percentage in response to a tiny price change.

Jeremy TO ECON2113 Microeconomics (L1/L7)


Elasticity and its Applications
Practice Questions

Total Revenue and Price Elasticity of Demand


With the exception of a vertical demand curve and a
horizontal demand curve, the price elasticity of demand
changes when moving along a linear demand curve.
At points on the demand curve above the midpoint, the price
elasticity of demand is elastic while at points below the
midpoint, the price elasticity of demand is inelastic. At the
midpoint, the price elasticity of demand is unit elastic.
The total revenue (TR) from the sale of a good equals the
price of the good multiplied by the quantity sold.

TR = P × Q

Example: Given a linear demand function P = a − bQ D , find


the elasticity of demand when: P = 0, P = a, P = 2a ,
a > P > 2a and 2a > P > 0.
Jeremy TO ECON2113 Microeconomics (L1/L7)
Total Revenue and Price Elasticity of Demand
If demand is elastic, a 1 percent price cut increases the quantity
sold by more than 1 percent and total revenue increases.
If demand is unit elastic, a 1 percent price cut increases the
quantity sold by 1 percent and total revenue does not change.
If demand is inelastic, a 1 percent price cut increases the quantity
sold by less than 1 percent and total revenue decreases.
Elasticity and its Applications
Practice Questions

The Factors that Influence the Elasticity of Demand

The closeness of Substitutes: The closer and more


numerous the substitutes for a good or service, the more
elastic the demand.
Nature of the goods: Necessities tend to have inelastic
demand, whereas luxuries have elastic demands.
The amount of time elapsed since the price change: The
longer the time elapsed since the price change, the more
elastic the demand.
Definition of the market: Narrowly defined markets tend to
have more elastic demand than broadly defined markets.

Jeremy TO ECON2113 Microeconomics (L1/L7)


Elasticity and its Applications
Practice Questions

More Elasticities of Demand


Income Elasticity of Demand: It is a measure of the
responsiveness of the demand for a good to a change in the
income, other things remaining the same,
%∆ in Q D
εD,I =
%∆ in I
The income elasticity of demand is positive for normal goods
and negative for inferior goods.
Cross Elasticity of Demand: It is a measure of the
responsiveness of the demand for a good to a change in the
price of a substitute or complement, other things remaining
the same,
%∆ in QXD
εX ,PY =
%∆ in PY
The cross elasticity of demand is positive for substitutes and
negative for complements.
Jeremy TO ECON2113 Microeconomics (L1/L7)
Elasticity and its Applications
Practice Questions

Problem 1
The demand schedule for computer chips is
Price Quantity demanded
(dollars per chip) (millions of chips per year)
200 50
250 45
300 40
350 35
400 30
(1) What happens to total revenue if the price falls from $400
to $350 a chip and from $350 to $300 a chip ? At what price
is total revenue at a maximum?
(2) At an average price of $350, is the demand for chips
elastic, inelastic or unit elastic?
(3) At an average price of $250, is the demand for chips
elastic, inelastic or unit elastic?
Jeremy TO ECON2113 Microeconomics (L1/L7)
Elasticity and its Applications
Practice Questions

Problem 2

Your price elasticity of demand for bananas is 4. If the price of


bananas rises by 5 percent, what is
(1) The percentage change in the quantity of bananas you
buy?
(2)The change in your expenditure on bananas?
Now your income elasticity of demand for bananas is 12. If your
income rises by 10 percent,
(3) What is the percentage change in the quantity of bananas
you buy?
(4) Is banana a normal good or not? Explain.

Jeremy TO ECON2113 Microeconomics (L1/L7)


Elasticity and its Applications
Practice Questions

Problem 3

Recession Has Led To Spending On Food Falling By 8.5%, Say


Researchers Families in Britain, especially the ones with children,
have altered their eating habits in the face of recession. Less is
spent on fruit and vegetables and more on processed foods lacking
in nutrition.
Source: The Guardian, November 4, 2013
(1) Given the prices, is the income elasticity of demand for
fruit and vegetables positive or negative? Are fruit and
vegetables a normal good or an inferior good? Are processed
foods a normal good or inferior good?
(2) Are fruits and vegetables and processed foods substitutes?
Explain.

Jeremy TO ECON2113 Microeconomics (L1/L7)

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