Welcome to “Economics Today”

By
TANVEER ALI
 Elasticity
• Basic idea: Elasticity measures how much
one variable responds to changes in another
variable.
– One type of elasticity measures how much
demand for your product will fall if you raise your
price.
• Definition:
Elasticity is a numerical measure of the
responsiveness (reaction) of Qd or Qs to one
of its determinants.
CHAPTER 5 ELASTICITY AND ITS
APPLICATION
 Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P

• Price elasticity of demand measures how

much Qd responds to a change in P.
▪ Loosely speaking, it measures the price-sensitivity of
buyers’ demand.

CHAPTER 5 ELASTICITY AND ITS

APPLICATION
 Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
P
Example:
P rises
Price by 10%
P2
elasticity P1
of demand
D
equals
Q
15% Q2 Q1
= 1.5 Q falls
10%
by 15%
CHAPTER 5 ELASTICITY AND ITS
APPLICATION
 Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
P
Along a D curve, P and Q move in
opposite directions, which would P2
make price elasticity negative.
P1
We will drop the minus sign and
report all price elasticity's D
as positive numbers. Q
Q2 Q1

CHAPTER 5 ELASTICITY AND ITS

APPLICATION
 Calculating Percentage Changes
• we use the midpoint method:

end value – start value

x 100%
midpoint

▪ The midpoint is the number halfway between the

start & end values, also the average of those
values.
▪ It doesn’t matter which value you use as the
“start” and which as the “end” – you get the same
answer either way!

CHAPTER 5 ELASTICITY AND ITS

APPLICATION
 Calculating Percentage Changes
• Using the midpoint method, the % change
in P equals
Rs250 – Rs200
x 100% = 22.2%
Rs225
▪ The % change in Q equals
12 – 8
x 100% = 40.0%
10

▪ The price elasticity of demand equals

40/22.2 = 1.8
CHAPTER 5 ELASTICITY AND ITS
APPLICATION
ACTIVE LEARNING 1:
Calculate an elasticity
Use the following
information to
calculate the
price elasticity
of demand
for hotel rooms:
if P = Rs70, Qd = 5000
if P = Rs90, Qd = 3000

8
ACTIVE LEARNING 1:
Answers
Use midpoint method to calculate
% change in Qd
(5000 – 3000)/4000 = 50%
% change in P
(Rs90 – Rs70)/Rs80 = 25%
The price elasticity of demand equals
50%
= 2.0
25%
9
What determines price elasticity?
To learn the determinants of price elasticity,
we look at a series of examples.
Each compares two common goods.
In each example:
– Suppose the prices of both goods rise by 20%.
– The good for which Qd falls the most (in percent) has
the highest price elasticity of demand.
Which good is it? Why?
– What lesson does the example teach us about the
determinants of the price elasticity of demand?
EXAMPLE 1:
Rice Krispies vs. Sunscreen
• The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
– Rice Krispies has lots of close substitutes
(e.g., Cap’n Crunch, Count Chocula),
so buyers can easily switch if the price rises.
– Sunscreen has no close substitutes,
so consumers would probably not
buy much less if its price rises.
• Lesson: Price elasticity is higher when close
substitutes are available.
EXAMPLE 2:
“Blue Jeans” vs. “Clothing”
• The prices of both goods rise by 20%.
For which good does Qd drop the most? Why?
– For a narrowly defined good such as
blue jeans, there are many substitutes
(khakis, shorts).
– There are fewer substitutes available for broadly
defined goods.
(Can you think of a substitute for clothing)
• Lesson: Price elasticity is higher for narrowly defined
goods than broadly defined ones.
EXAMPLE 3:
Insulin vs. Caribbean Cruises
• The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
– To millions of diabetics, insulin is a necessity.
A rise in its price would cause little or no decrease
in demand.
– A cruise is a luxury. If the price rises,
some people will forego it.
• Lesson: Price elasticity is higher for luxuries than for
necessities.
EXAMPLE 4:
Gasoline in the Short Run vs. Gasoline in the Long
Run
• The price of gasoline rises 20%. Does Qd drop more in
the short run or the long run? Why?
– There’s not much people can do in the
short run, other than ride the bus or carpool.
– In the long run, people can buy smaller cars
or live closer to where they work.
• Lesson: Price elasticity is higher in the
long run than the short run.
 The Determinants of Price Elasticity:
A Summary

The price elasticity of demand depends on:

▪ the extent to which close substitutes are
available
▪ whether the good is a necessity or a luxury
▪ how broadly or narrowly the good is defined
▪ the time horizon: elasticity is higher in the long
run than the short run.
 The Variety of Demand Curves
• Economists classify demand curves according to
their elasticity.
• The price elasticity of demand is closely related to
the slope of the demand curve.
• Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
• The next 5 slides present the different
classifications, from least to most elastic.
“Perfectly inelastic demand” (one extreme case)
Price elasticity % change in Q 0%
= = =0
of demand % change in P 10%

D curve: P
D
vertical
P1
Consumers’
price sensitivity: P2
0
P falls Q
Elasticity: by 10% Q1
0 Q changes
by 0%
“Inelastic demand”
Price elasticity % change in Q < 10%
= = <1
of demand % change in P 10%

D curve: P
relatively steep
P1
Consumers’
price sensitivity: P2
relatively low D
P falls Q
Elasticity: by 10% Q 1 Q2
<1
Q rises less
than 10%
“Unit elastic demand”
Price elasticity % change in Q 10%
= = =1
of demand % change in P 10%

D curve: P
intermediate slope
P1
Consumers’
price sensitivity: P2
intermediate D

P falls Q
Elasticity: by 10% Q1 Q2
1
Q rises by 10%
“Elastic demand”
Price elasticity % change in Q > 10%
= = >1
of demand % change in P 10%

D curve: P
relatively flat
P1
Consumers’
price sensitivity: P2 D
relatively high
P falls Q
Elasticity: by 10% Q1 Q2
>1
Q rises more
than 10%
“Perfectly elastic demand” (the other extreme)
Price elasticity % change in Q any %
= = = infinity
of demand % change in P 0%

D curve: P
horizontal
P2 = P1 D
Consumers’
price sensitivity:
extreme
P changes Q
Elasticity: by 0% Q1 Q2
infinity
Q changes
by any %
 Elasticity of a Linear Demand Curve

P The slope
200% of a linear
$30 E= = 5.0
40% demand
67% curve is
20 E= = 1.0 constant,
67%
but its
40% elasticity
10 E= = 0.2
200% is not.

$0 Q
0 20 40 60
 Price Elasticity and Total Revenue
• Continuing our scenario, if you raise your price
from $200 to $250, would your revenue rise or fall?
Revenue = P x Q
• A price increase has two effects on revenue:
– Higher P means more revenue on each unit
you sell.
– But you sell fewer units (lower Q), due to
Law of Demand.
• Which of these two effects is bigger?
It depends on the price elasticity of demand.
 Price Elasticity and Total Revenue
Price elasticity Percentage change in Q
=
of demand Percentage change in P

Revenue = P x Q

• If demand is elastic, then

price elast. of demand > 1
% change in Q > % change in P
• The fall in revenue from lower Q is greater
than the increase in revenue from higher P,
so revenue falls.
 Price Elasticity and Total Revenue
Demand for
Elastic demand increased your websites
(elasticity = 1.8) P revenue due
lost
to higher P
revenue
If P = Rs200,
due to
Q = 12 and revenue $250 lower Q
= Rs2400.
$200
If P = Rs250, D
Q = 8 and
revenue = Rs2000.
When D is elastic, Q
8 12
a price increase
causes revenue to fall.
 Price Elasticity and Total Revenue
Price elasticity Percentage change in Q
=
of demand Percentage change in P

Revenue = P x Q
• If demand is inelastic, then
price elasticity of demand < 1
% change in Q < % change in P
• The fall in revenue from lower Q is smaller
than the increase in revenue from higher P,
so revenue rises.
• In our example, suppose that Q only falls to 10 (instead
of 8) when you raise your price to Rs250.
 Price Elasticity and Total Revenue
Now, demand is Demand for
increased your websites
inelastic:
revenue due
elasticity = 0.82 P to higher P lost
If P = Rs200, revenue
due to
Q = 12 and revenue
$250 lower Q
= Rs2400.
$200
If P = Rs250,
Q = 10 and D
revenue = Rs2500.
When D is inelastic, Q
10 12
a price increase
causes revenue to rise.