Chapter 4 Notes

Equations

Price Elasticity of Demand = % change in Q demanded / % change in Price

Price Elasticity of Demand = (Q2 – Q1) / [(Q1 +Q2) / 2] / P2 – P1) / [(P1 +P2) / 2]

Midpoint Method (quantity changed) = Q2 – Q1

Midpoint Average (for quantity) = Q1 + Q2 / 2
** The percentage change in quantity is therefore the change divided by the midpoint, or..
Q2 – Q1 / ((Q1 + Q2) / 2) (refer to slide 11) **

Percentage Change = Change in variable / Level of variable

Midpoint (for price) = P1 + P2 / 2

Elasticity = % change in quantity / % change in price

% change in quantity = change in Q / average of Q

Also shown as Q2 – Q1 / ((Q1 +Q2) / 2)

% change in price = Change in P / Average of P

Also shown as P2 – P1 / ((P1 + P2) / 2)

Revenue = Price you pay for product per unit x Number of units you purchase

Price Elasticity of Supply = % change in quantity supplied / % change in price

Calculating Price Elasticity (Midpoint Method) = ((Q2 – Q1) / [(Q1 + Q2) / 2]) / (P2 -P1) / [(P1 +
P2) / 2] (slide 44)

Income Elasticity of Demand = % change in quantity demanded / % change in income

% Change in Quantity Demanded = [(Q2 - Q1) / ((Q2 + Q1) / 2)] * 100

% Change in Income = [(Income in Year 2 - Income in Year 1) / ((Income in Year 2 + Income in

Year 1) / 2)] * 100

Cost Price Elasticity of good A in response to a change in price of good B = % change in

quantity of A demanded / % change in price of B
Definitions

Elasticity: is a measure of how much consumers and producers will respond to a change in
market conditions

Total Revenue: is the amount that a firm receives from the sale of goods and services,
calculated as the quantity sold multiplied by the price paid for each unit

Price Elasticity of Supply: is the size of the change in the quantity supplied of a good or service
when its price changes

Cross-price elasticity of demand: describes how the quantity of one good changes when the
price of a different good changes

Income Elasticity of Demand: describes how the quantity of one good changes when a
consumers income changes

- Elasticity can apply to supply or demand

- Can be used to measure responses to
o A change in the price of a good (or service)
o A change in the price of a related good or service
o A change in income
- Helps decision makers anticipate answers to: How will others respond?

Two Main Elasticities and Two Related Elasticities

 The most commonly used measures of elasticity are the own-price elasticities.
o price elasticity of demand and
o price elasticity of supply
 These describe how much the quantity demanded or supplied will change when the
price of the good changes.
 A related and important price elasticity is
o cross-price elasticity of demand
 This describes how much the quantity demanded will change when the price of a related
good changes. The related good might be a substitute or a complement.
 Lastly, but also very important is
o income elasticity of demand
 This describes how much the quantity demanded will change when income changes.
 NOTE: because the own-price elasticity is the most commonly used, if you see the term
‘elasticity of demand’ or ‘elasticity of supply’, this refers to the own- price elasticity.
Price Elasticity of Deman

The price elasticity of demand measures consumers’ sensitivity to price changes:

 When consumers buying decisions are highly influenced by price, we say that
o Demand is more elastic or very elastic
o A small change in price causes a large change in quantity demanded
 When consumers buying decisions are not much influenced by price, we say that
o Demand is less elastic
o A small change in price causes a very small or almost no change in quantity
demanded

Example:

Tim Horton’s price of coffee is $2.00.

Tim’s has a sale. Coffee is now $1.50.
We can measure this in percentages. In our example,
 Coffee price decreases by 25%
 Quantity increases by 50%.
 Quantity change is large relative to price change (in percent).

For elasticity, the level is measured as the midpoint or average of the start level and end levels.

Examples for Equations

Elasticity – Midpoint Method

In our example, price falls from $2 to $1.50, and quantity increases from 10 million to 15 million
cups of coffee.

𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒗𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝒍𝒆𝒗𝒆𝒍 𝒐𝒇 𝒗𝒂𝒓𝒊𝒂𝒃𝒍𝒆

The change in quantity is 15 – 10 = 5 The change in price is $1.50 - $2 = -0.50.

Average Q = 15 million+10 million / 2 = 12.5 million

Average P = 2.00+1.50 / 2 = 1.75

In our example = [(15 million −10 million) / (12.5 million)] / (1.50−2.00)/(1.75) = 40% / -29% =
−1.38 (refer to slide 14)

What does it mean for the elasticity of demand to be -1.38?

 - A measure of -1.38 means that a 1 percent increase in the price of coffee will cause the
number of cups purchased to fall by 1.38% (since percent is negative)
- Alternatively, a 1 percent decrease in the price of coffee will cause the number of cups
purchased to increase by 1.38 percent

** PRICE ELASTICITY OF DEMAND IS ALWAYS NEGATIVE **

Why is Price Elasticity always negative?

 Because price and quantity demanded move in opposite directions:

o A positive change in price will cause a negative change in the quantity demanded
o A negative change in price will cause a positive change in the quantity demanded

Two Ways Elasticity of Demand can be Confusing

1. We sometimes drop the negative sign in general speech (and some textbooks) because
it is ALWAYS negative.
- Because this elasticity is ALWAYS NEGATIVE, we often refer to it based on its absolute
value or size.

Example a) An economist might report that the elasticity of demand is 0.4. They mean
MINUS 0.4. (and they mean own-price elasticity of demand)

Example b) A demand price elasticity less than 1 refers to its absolute value or SIZE. For
example, −0.3 = 0.3 < 1.

Sample Question #2: Using Percentages

1. a) A 30% increase in price leads to a 60% decrease in quantity demanded. What is the
price elasticity of demand?

Answer: -60%/30% = -2. the price elasticity of demand is -2.

2. b) Bo’s elasticity of demand for milk is 0.4. Milk costs $2 per litre. If milk price increases
by 2 % how does Bo’s demand change?

Answer: elasticity = % change in Q/% change in p.

-0.4 = % change in Q/2. % change in Q = -0.4 * 2 = -0.8%
If milk increases by 2%, then Bo’s demand will fall by 0.8%.

Determinants of Price Elasticity of Demand

- our reaction to a price change depends on the good and how we consume it
 - we might increase our consumption of some goods in response to a price drop, but for
others, our reaction is small

Factors that Affect Elasticity (Substitutes and Necessity)

Availability of Substitutes
 if there are close substitutes available, then we expect the demand for a good to be
more elastic than if there are no close substitutes.
 You might switch easily between one juice and another.
Degree of Necessity
 When a good is a necessity, people will buy it even if prices rise. Necessities tend to be
not very elastic. In winter, if the price of home heating falls, your demand does not
increase a lot.
 In contrast, if prices rise, people will substitute away from luxuries. That exotic vacation
might be replaced by camping nearby.

Factors that Affect Elasticity (Cost Relative to Income)

Cost relative to income:

 All else equal, if consumers spend a very small share of their incomes on a good, their
demand for the good will be less elastic. For example, if you buy a box of salt for $2 or
$4, you might not even notice the price difference, since you might buy it once a year (or
every several years) and it is a small part of your spending.
 Again, that luxury vacation is more price elastic. If there is a sale, you might move your
vacation to take advantage of the lower price. Since it is a big purchase, a small change
in price matters.

Factors that Affect Elasticity (Adjustment Time and Market Scope)

Adjustment time
• Goods often have much more elastic demand in the long run than in the short run. Consider
your reaction to gasoline prices. In the short-run, you might try to drive a little less. In the long-
run, you might move closer to school or work, or get a 2nd hand electric vehicle. (maybe one of
those new bikes)
Scope of the market
 The wider the scope of the market, the lower the elasticity of demand.
 The price elasticity of demand for bananas might be high, but the price elasticity of
demand for fruit would be lower.
 The price elasticity of demand for a brand of tea might be high, but the price elasticity of
demand for tea in general would be lower.

- When we make decisions, we often don’t know the exact price elasticity of demand. But
we don’t always need to know this.
 - Placing into a broad category of elasticity, that is enough to predict the effect of a price
change

Elastic demand describes an elasticity greater than 1 in size. This means that the percent
change in quantity is larger than the percent change in price.

o This is common for goods with close substitutes, luxuries, and goods whose
purchase requires a big part of your income.

o inelastic demand describes an elasticity smaller than 1 in size. This means that
the percent change in quantity is smaller than the percent change in price.

o This is common for goods without close substitutes, necessities, and goods
whose cost is small relative to income.

Two Extreme Cases (Perfectly Elastic & Perfectly Inelastic)

Demand for a good is perfectly elastic when a small change in price leads to an extreme
reaction.

 Imagine you are one of 50 firms selling a good along a sidewalk. All prices are visible.
 You decide to increase the price of your magnets by 20%. Your competitors do not
change their prices.
 Your demand drops to zero.
 That is perfectly elastic demand.
 If you decrease your price, you attract ALL the customers – that is also perfectly elastic.
 Since a small change in price leads to an extreme change in behaviour, the elasticity is
infinite.

• When we say a firm is a price-taker, we imagine it faces a perfectly elastic demand curve

The second extreme case if perfectly inelastic demand.

• In this case, the same amount is demanded no matter the price.

• These two extreme cases rarely occur in real life.

Refer to Slide 29 for Perfectly Elastic and Inelastic Demand Graphs

 For example, imagine the price of a good falls by 40%.

 If demand is elastic, the quantity demanded increases more than proportionately. In our
example, it increases more than 40%.
 If demand is inelastic, the quantity demanded increases less than proportionately. In
our example, the quantity demanded increases less than 40%.
 If demand is unit elastic, the quantity demanded increase by the same percentage.
Review Slide 31 for Graphs for above Example

Total Revenue for Suppliers

For example, if you buy 5 apples at $2 each the supplier gets

 5 ×$2=10

Similarly, if you buy 4 apples at $3 each, the supplier gets

 4 × $3 = 12

Effect of Price Change on Total Revenue – Two Effects

An increase in price affects the total revenue in two ways:

1. It causes a quantity effect, or a decrease in revenue from selling fewer units of the
good.
2. It causes a price effect, an increase in revenue from receiving a higher price for each unit
sold.

 If 1 is bigger than 2, then the increase in price causes total revenue to fall

 If 2 is bigger than 1, then the increase in price causes total revenue to increase

Refer to Slide 35 for graph explaining the above on Effect of Price Change on Total Revenue

Effect of a Price Change on Total Revenue - Elasticity

If the quantity effect of a price change is bigger than the price effect, then
o demand is elastic
o If price increased, the quantity effect is negative and total revenue falls.
o If price decreased the quantity effect is positive and total revenue increases.
If the quantity effect of a price change is smaller than the price effect, then
o demand is inelastic
o if price increased, total revenue increases
o if price decreased, total revenue falls.

Finally, if the quantity effect is equal to the price effect, then

o elasticity equals one
o the effects offset each other perfectly and total revenue does not change.
For graphs in relation to Elasticity and Changes in Total Revenue (Elastic and Inelastic) refer to
Slide 37.
One final point:

- The elasticity tends to be different depending on the initial price. More specifically,
along a demand curve, demand is often more elastic at higher prices.

Elasticity Along a Linear Demand Curve

If a demand curve is actually a straight line, it will always have an elastic part at the top and an
inelastic part at the bottom.
 at some point along the curve the elasticity will equal -1

Refer Slide 40 for Graphs

Elasticity and Pricing for a Monopolist

- For a seller who can control price (like a monopolist), the elasticity of demand affects
their pricing decision
o If price is near the bottom of the demand curve, increasing price increases
revenue
o If the price is near the top of the demand curve, increasing price lowers revenue
o The price choice will PARTLY depend on cost – and a monopolist can set price
well above cost, but the price will always be in the elastic portion of the curve
o In the inelastic portion, the monopolist always makes more profit by increasing
price

Price Elasticity of Supply

- We can predict, based on the law of supply, that coffee growers will increase production
in response to an increase in price – but by how much?
Price elasticity of supply measures producers’ responsiveness to a change in price.

Calculating the Price Elasticity of Supply

Like all elasticities, the price elasticity of supply is measured as the percentage change in
quantity from a percentage change in the key variable – in this case price

Example Question & Answer

Price rises from $1 to $1.20. Quantity increases from 90 to 100 million pounds.

% 𝑐h𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑 = (100 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 − 90 𝑚𝑖𝑙𝑙𝑖𝑜𝑛) / 95 Million = 11%

% 𝑐h𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒= 1.2−1 / 1.1=18%
𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑠𝑢𝑝𝑝𝑙𝑦 = 11%/18% = 0.6
Classification of Price Elasticity of Supply

1. Elastic, if it has an absolute value greater than 1

2. Inelastic, if it has an absolute value less than 1
3. Unit-elastic, if it has an absolute value of exactly 1

Supply is perfectly elastic if the quantity supplied could be anything at a given price and is zero
at any other price (demanders face this perfectly elastic supply curve when they are PRICE
TAKERS)

At the other extreme, supply is perfectly inelastic if the quantity supplied stays the same,
regardless of price. In the above example the number 0.6 tells us supply is inelastic.

Elasticity of demand is calculated by dividing a positive number by a negative number, or by

dividing a negative number by a positive number, so the answer is always negative.
o For demand, price and quantity move in opposite directions.

Elasticity of supply, on the other hand, is calculated by dividing either a positive number by
another positive number or a negative number by another negative number. In either case, the
answer is always positive.
o For supply, price and quantity move in the same direction.

3 Main Determinants of Price Elasticity of Supply

1. Availability of Inputs – the production of some goods can be expanded easily, others are
more difficult
Example: a bakery can buy more flour and yeast to produce more bread, possibly at the same
price as smaller quantities.
o this results in an elastic supply of bread.
Example: an engineering firm might struggle to find more engineers, so that supply of
engineering services cannot increase a lot in response to a small increase in price.

2. Flexibility of the production process - easiest way for producers to adjust the quantity
supplied of a particular good is to draw production capacity away from other goods
when prices rise, or to reassign capacity to other goods when prices fall.
Example: if you own sewing equipment to make t-shirts, you can quickly switch to producing
cloth masks when their price rises, then switch to other clothing when price of masks falls,
resulting in elastic supply of masks and t-shirts.
o if production equipment is very specialized, then switching its use is difficult or
costly, leading to inelastic supply.

3. Adjustment time – supply is more elastic over long periods than over short periods
 Suppliers can adjust more in the long-run than in the short-run.
o The number of hotel rooms at a resort is fixed in the short-run.
 o In the long-run, a hotel can be expanded in response to higher prices caused by
increased demand.
o By definition (of the short-run), in the short-run, the number of firms is fixed.
o In the long-run, new firms can enter the business and increase supply.

Other Elasticities

In addition to own-price elasticity of demand and own-price elasticity of supply, there are two
other elasticities commonly used.

1. Cross-price elasticity of demand

 Is measured as:
Cost Price Elasticity of good A in response to a change in price of good B = % change in quantity
of A demanded / % change in price of B

Example: If the price of Tim’s coffee increases, then people will buy more of their coffee from
Starbucks.
• Tim’s and Starbucks coffees are substitutes.
• The cross-price elasticity is positive.
• For substitutes, the price of one good and the quantity demanded of the other good move in
the same direction.

Complements

If the price of Tim’s coffee increases, then the quantity demanded of cream will fall.

• Cream and coffee are complements.

• The cross-price elasticity is negative.

• For complements, the price of one good and the quantity demanded of the other good move
in opposite directions.

2. Income elasticity of demand

 Is measured as:

Income Elasticity of Demand = % change in quantity demanded / % change in income

- For most goods, demand increases when income increases

o If the income elasticity is positive, then a good is normal
Example: for a coffee drinker, an increase in income might cause a small increase in coffee
demand.
- if the income elasticity is positive, but less than one, the good is called a necessity.
 - On the other hand, you might increase your demand for Frappucinos or other fancy
drinks a lot.
- if the income elasticity is positive, and greater than one, the good is called a luxury

Inferior Goods – Income Elasticity

 If the quantity demanded and income move in opposite directions for a good.
 Quantity demanded increases when income falls
 Quantity demanded decreases when income rises
 Then the good is called an inferior good.
Example: In 2009, Starbucks introduced a new product, VIA instant coffee. Instant coffee is
an inferior good. Most people buy less instant coffee when their income increases.

Four Measures of Elasticity – refer to slide 61