Chapter 5

Elasticity and Its Application

Reference book-Mankiw

Sabakun Naher Shetu

Assistant Professor
Dept. of Marketing
FBS, JU
 The Elasticity Demand
• Elasticity- a measure of the responsiveness of quantity demanded or
quantity supplied to a change in one of its determinants.

• Price elasticity of demand- a measure of how much the quantity

demanded of a good responds to a change in the price of that good,
computed as the percentage change in quantity demanded divided by the
percentage change in price.

• Demand for a good is said to be elastic if the quantity demanded responds

substantially to changes in the price.
• Demand is said to be inelastic if the quantity demanded responds only
slightly to changes in the price.
 The Price Elasticity of Demand and Its Determinants

• Availability of close substitutes

• Necessities versus luxuries
• Definition of the market
• Time horizon
Continued…. Availability of Close Substitutes

• For example, butter and margarine are easily substitutable. A

small increase in the price of butter, assuming the price of
margarine is held fixed, causes the quantity of butter sold to
fall by a large amount. By contrast, because eggs are a food
without a close substitute, the demand for eggs is less elastic
than the demand for butter. A small increase in the price of
eggs does not cause a sizable drop in the quantity of eggs
sold.
 Continued…
Necessities (inelastic) versus Luxuries (elastic)

• When the price of a doctor’s visit rises, people do not

dramatically reduce the number of times they go to the doctor,
although they might go somewhat less often. By contrast, when
the price of sailboats rises, the quantity of sailboats demanded
falls substantially. The reason is that most people view doctor
visits as a necessity and sailboats as a luxury. Whether a good is
a necessity or a luxury depends not on the intrinsic properties of
the good but on the preferences of the buyer. For avid sailors
with little concern about their health, sailboats might be a
necessity with inelastic demand and doctor visits a luxury with
elastic demand.
 Continued… Definition of the market

• Narrowly defined markets tend to have more elastic demand

than broadly defined markets because it is easier to find close
substitutes for narrowly defined goods.
• For example, food, a broad category, has a fairly inelastic
demand because there are no good substitutes for food. Ice
cream, a narrower category, has a more elastic demand because
it is easy to substitute other desserts for ice cream. Vanilla ice
cream, a very narrow category, has a very elastic demand
because other flavors of ice cream are almost perfect substitutes
for vanilla.
 Continued… Time Horizon
• Goods tend to have more elastic demand over longer time
horizons. When the price of gasoline rises, the quantity of
gasoline demanded falls only slightly in the first few months.
Over time, however, people buy more fuel-efficient cars,
switch to public transportation, and move closer to where
they work. Within several years, the quantity of gasoline
demanded falls more substantially.
Computing price elasticity of demand
 SELF-STUDY
The Midpoint Method- A better way to
calculate percentage changes and
elasticities
 The Variety of demand curve
• Demand is considered elastic when the elasticity is greater
than 1, which means the quantity moves proportionately
more than the price.
• Demand is considered inelastic when the elasticity is less
than 1, which means the quantity moves proportionately less
than the price.
• If the elasticity is exactly 1, the percentage change in
quantity equals the percentage change in price, and demand
is said to have unit elasticity.
CONTINUED…. The Variety of demand curve
Continued…
Continued…
 Total revenue and the price elasticity demand

• Total revenue- the amount paid by buyers and received by sellers of a

good computed as the price of the good times the quantity sold.
 Continued….

• We can show total revenue graphically, as in Figure 2. The height of the box
under the demand curve is P, and the width is Q. The area of this box, P * Q,
equals the total revenue in this market.
• In Figure 2, where P = $4 and Q = 100, total revenue is $4 * 100, or $400. How
does total revenue change as one moves along the demand curve? The
answer depends on the price elasticity of demand. If demand is inelastic, as
in panel (a) of Figure 3, then an increase in the price causes an increase in
total revenue. Here an increase in price from $4 to $5 causes the quantity
demanded to fall from 100 to 90, so total revenue rises from $400 to $450.
An increase in price raises P * Q because the fall in Q is proportionately
smaller than the rise in P. In other words, the extra revenue from selling units
at a higher price (represented by area A in the figure) more than offsets the
decline in revenue from selling fewer units (represented by area B).
 Continued….
• When demand is inelastic (a price elasticity less than 1), price and
total revenue move in the same direction: If the price increases,
total revenue also increases.
• When demand is elastic (a price elasticity greater than 1), price
and total revenue move in opposite directions: If the price
increases, total revenue decreases.
• If demand is unit elastic (a price elasticity exactly equal to 1), total
revenue remains constant when the price changes.
Continued…
 The Income elasticity of demand
• Income elasticity of demand- a measure of how much the quantity
demanded of a good responds to a change in consumers’ income,
computed as the percentage change in quantity demanded divided by
the percentage change in income.
 CONTINUNED…
• As we discussed in Chapter 4, most goods are normal goods:
Higher income raises the quantity demanded. Because
quantity demanded and income move in the same direction,
normal goods have positive income elasticities.

• A few goods, such as bus rides, are inferior goods: Higher

income lowers the quantity demanded. Because quantity
demanded and income move in opposite directions, inferior
goods have negative income elasticities.
 CONTINUED….

• Even among normal goods, income elasticities vary

substantially in size.
• Necessities, such as food and clothing, tend to have small
income elasticities because consumers choose to buy some
of these goods even when their incomes are low.
• Luxuries, such as caviar and diamonds, tend to have large
income elasticities because consumers feel that they can do
without these goods altogether if their incomes are too low.
 The Cross Price-elasticity of demand

• Cross-price elasticity of demand- a measure of how much the quantity

demanded of one good responds to a change in the price of another good,
computed as the percentage change in quantity demanded of the first good
divided by the percentage change in price of the second good.
 CONTINUED….
• Whether the cross-price elasticity is a positive or negative
number depends on whether the two goods are substitutes or
complements.
• As we discussed in Chapter 4, substitutes are goods that are
typically used in place of one another, such as hamburgers
and hot dogs.
• An increase in hot dog prices induces people to grill
hamburgers instead. Because the price of hot dogs and the
quantity of hamburgers demanded move in the same
direction, the cross-price elasticity is positive.
 CONTINUED….

• Conversely, complements are goods that are typically

used together, such as computers and software. In this
case, the cross-price elasticity is negative, indicating that
an increase in the price of computers reduces the quantity
of software demanded.
 The Price Elasticity of Supply and Its Determinants

• Price elasticity of supply - a measure of how much the quantity

supplied of a good responds to a change in the price of that good,
computed as the percentage change in quantity supplied divided by the
percentage change in price.
• The price elasticity of supply depends on the flexibility of sellers to
change the amount of the good they produce. For example, beachfront
land has an inelastic supply because it is almost impossible to produce
more of it. Manufactured goods, such as books, cars, and televisions,
have elastic supplies because firms that produce them can run their
factories longer in response to a higher price.
 Continued…

• In most markets, a key determinant of the price elasticity of supply

is the time period being considered. Supply is usually more elastic in
the long run than in the short run.
• Over short periods of time, firms cannot easily change the size of
their factories to make more or less of a good. Thus, in the short
run, the quantity supplied is not very responsive to the price.
• Over longer periods of time, firms can build new factories or close
old ones. In addition, new firms can enter a market, and old firms
can exit. Thus, in the long run, the quantity supplied can respond
substantially to price changes.
Computing the Price Elasticity
of Supply
Continued…
The Variety of supply curves
Continued…..
Continued…
Continued…..
Any Query
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