CHAPTE

R 5
Elasticity and its
Application
Premium PowerPoint Slides
by Ron Cronovich
Edited by Amal Hili

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In this chapter,
look for the answers to these
questions:
 What is elasticity? What kinds of issues can
elasticity help us understand?
 What is the price elasticity of demand?
How is it related to the demand curve?
How is it related to revenue & expenditure?
 What is the price elasticity of supply?
How is it related to the supply curve?
 What are the income and cross-price elasticities of
demand?
2
 A scenario…
You
You design
design websites
websites for
for local
local businesses.
businesses.
You
You charge
charge $200
$200 per
per website,
website,
and
and currently
currently sell
sell 12
12 websites
websites per per month.
month.
Your
Your costs
costs are
are rising
rising
(including
(including the
the opportunity
opportunity cost
cost of
of your
your time),
time),
so
so you
you consider
consider raising
raising the
the price
price to
to $250.
$250.
The
The law
law of
of demand
demand says
says that that you
you won’t
won’t sell
sell as
as
many
many websites
websites ifif you
you raise
raise your
your price.
price.
How
How many
many fewer
fewer websites?
websites? How How much
much will
will your
your
revenue
revenue fall,
fall, or
or might
might itit increase?
increase?
3
 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 websites will fall if you raise
your price.
 Definition:
Elasticity is a numerical measure of the
responsiveness of Qd or Qs to one of its
determinants.

ELASTICITY AND ITS APPLICATION 4

 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.

ELASTICITY AND ITS APPLICATION 5

 Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
P
Example:
P rises
Price elasticity P2
by 10%
P1
of demand D
equals
-15% Q
= -1.5 Q2 Q1
10%
Q falls
by 15%
ELASTICITY AND ITS APPLICATION 6
 Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
P
Along
Along aa DD curve,
curve, PP and
and QQ
move
move in in opposite
opposite directions,
directions, P2
which
which would
would makemake price
price
elasticity P1
elasticity negative.
negative.
We D
We can
can drop
drop the the minus
minus sign
sign
and
and report
report all all price
price Q
elasticities Q2 Q1
elasticities using
using absolute
absolute
value
value butbut itit has
has toto be
be
mentioned.
mentioned.
ELASTICITY AND ITS APPLICATION 7
 Calculating Percentage
Changes
Standard method
of computing the
Demand for percentage (%) change:
your websites
P end value – start value
x 100%
start value
B
$250
A Going from A to B,
$200
the % change in P equals
D
($250–$200)/$200 = 25%
Q
8 12

ELASTICITY AND ITS APPLICATION 8

 Calculating Percentage
Changes
Problem:
The standard method gives
Demand for different answers depending
your websites on where you start.
P From A to B,
B P rises 25%, Q falls 33%,
$250 elasticity = -33/25 = -1.33 or |
A
$200 elasticity|= 1.33
D
From B to A,
Q P falls 20%, Q rises 50%,
8 12
elasticity = 50/-20 = - 2.50

ELASTICITY AND ITS APPLICATIONor |elasticity|= 2.50 9

 Calculating Percentage
Changes
 So, we instead use the midpoint method:
end value – start value
x 100%
midpoint
 The midpoint is the number halfway between
the start & end values, 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 in absolute value!

ELASTICITY AND ITS APPLICATION 10

 Calculating Percentage
Changes
 Using the midpoint method, the % change
in P equals
$250 – $200
x 100% = 22.2%
$225
 The % change in Q equals
8 – 12
x 100% = -40.0%
10
 The price elasticity of demand equals
-40/22.2 = -1.8

ELASTICITY AND ITS APPLICATION 11

ACTIVE LEARNING 1
Calculate an elasticity
Use the following
information to
calculate the
price elasticity
of demand
for hotel rooms:

if P = $70, Qd = 5000

if P = $90, Qd = 3000

12
ACTIVE LEARNING 1
Answers
Use midpoint method to calculate
% change in Qd
(5000 – 3000)/4000 = 50%

% change in P
($70 – $90)/$80 = -25%

The price elasticity of demand equals

50%
= -2.0
-25%
13
 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 (i.e, this good is
said to be more elastic or its demand is more elastic).
Which good is it? Why?
 What lesson does the example teach us about the
determinants of the price elasticity of demand?

14
EXAMPLE 1:
Breakfast cereal vs. Sunscreen
 The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
 Breakfast cereal has close substitutes
(e.g., pancakes, Eggo waffles, leftover pizza),
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.
ELASTICITY AND ITS APPLICATION 15
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, Speedos).
 There are fewer substitutes available for
broadly defined goods.
(There aren’t too many substitutes for clothing,
other than living in a nudist colony.)
 Lesson: Price elasticity is higher for narrowly
defined goods than broadly defined ones.
ELASTICITY AND ITS APPLICATION 16
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.

ELASTICITY AND ITS APPLICATION 17

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.

ELASTICITY AND ITS APPLICATION 18

 For each of the following pairs of goods, which good
would you expect to have more elastic demand and why?
 a. required textbooks or mystery novels
 b. Beethoven recordings or classical music recordings
in general
 c. subway rides during the next six months or subway
rides during the next five years

19
 Mystery novels have more elastic demand than required textbooks, because
mystery novels have close substitutes and are a luxury good, while required
textbooks are a necessity with no close substitutes.
 Beethoven recordings have more elastic demand than classical music recordings in
general. Beethoven recordings are a narrower market than classical music
recordings, so it is easy to find close substitutes for them.

 c. Subway rides during the next five years have more elastic demand than
subway rides during the next six months. Goods have a more elastic demand over
longer time horizons. If the fare for a subway ride was to rise temporarily,
consumers could not switch to other forms of transportation without great expense
or great inconvenience. But if the fare for a subway ride was to remain high for a
long time, people would gradually switch to alternative forms of transportation. As a
result, the quantity demanded of subway rides during the next six months will be
less responsive to changes in the price than the quantity demanded of subway rides
during the next five years.

20
Subway rides during the next five years have
more elastic demand than subway rides during
the next six months. Goods have a more elastic
demand over longer time horizons.

21
 The Determinants of Price
Elasticity:
A Summary
The
The price
price elasticity
elasticity of
of demand
demand depends
depends on: on:
 the
the extent
extent to
to which
which close
close substitutes
substitutes are
are
available
available
 whether
whether the
the good
good is is aa necessity
necessity or
or aa luxury
luxury
 how
how broadly
broadly or
or narrowly
narrowly the
the good
good is
is defined
defined
 the
the time
time horizon
horizon –– elasticity
elasticity is
is higher
higher in
in the
the
long
long run
run than
than the
the short
short run
run

ELASTICITY AND ITS APPLICATION 22

 The Variety of Demand
Curves
 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.
 Five different classifications of D curves.…

ELASTICITY AND ITS APPLICATION 23

“Perfectly inelastic demand” (one
extreme case)
Price elasticity % change in Q 0%
= = =0
% change in P 10%
of demand
D curve: P
D
vertical
P1
Consumers’
price sensitivity: P2
none
P falls Q
Elasticity= by 10% Q1
0 Q changes
by 0%
ELASTICITY AND ITS APPLICATION 24
 “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
0< | Elasticity | < 1 by 10% Q1 Q2

Q rises less
than 10%
ELASTICITY AND ITS APPLICATION 25
“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
D
intermediate
P falls Q
| Elasticity | = by 10% Q1 Q2
1
Q rises by 10%

ELASTICITY AND ITS APPLICATION 26

“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%
ELASTICITY AND ITS APPLICATION 27
“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 AND ITS APPLICATION 28
 Two drivers—Tom and Jerry—each drive up to
a gas station. Before looking at the price, each
places an order. Tom says, “I’d like 10 gallons
of gas.” Jerry says, “I’d like $10 worth of gas.”
What is each driver’s price elasticity of
demand?

29
 Tom's price elasticity of demand is zero, because
he wants the same quantity regardless of the price.
His price elasticity of demand is perfectly inelastic.
 Jerry's price elasticity of demand is one, because
he spends the same amount on gas, no matter
what the price, which means his percentage
change in quantity is equal to the percentage
change in price.
His price elasticity of demand is unit elastic.

30
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
67% constant,
but its
40%
10 E = = 0.2 elasticity
200%
is not.
$0 Q
0 20 40 60
Use of “E” as an abbreviation for the absolute value of elasticity

ELASTICITY AND ITS APPLICATION 31

 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.

ELASTICITY AND ITS APPLICATION 32

 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 in abs value > 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.
ELASTICITY AND ITS APPLICATION 33
 Price Elasticity and Total
Revenue
increased
Elastic demand revenue due
to higher P
Demand for
(elasticity = 1.8) P your websiteslost
revenue
If P = $200,
due to
Q = 12 and $250 lower Q
revenue = $2400.
$200
If P = $250, D
Q = 8 and
revenue = $2000.
When D is elastic, Q
8 12
a price increase
causes revenue to fall.
ELASTICITY AND ITS APPLICATION 34
 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 elast. of demand in absolute value < 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 $250.
ELASTICITY AND ITS APPLICATION 35
 Price Elasticity and Total
Now, demand is
Revenue
inelastic: Demand for
elasticity = 0.82 your websites
P
If P = $200, lost
Q = 12 and revenue
$250 due to
revenue = $2400.
$200 lower Q
If P = $250,
Q = 10 and D
revenue = $2500.
When D is inelastic, Q
10 12
a price increase increased
causes revenue to rise. revenue due
ELASTICITY AND ITS APPLICATION to higher P 36
ACTIVE LEARNING 2
Elasticity and
expenditure/revenue
A. Pharmacies raise the price of insulin by 10%.
Does total expenditure on insulin rise or fall?

B. As a result of a fare war, the price of a luxury

cruise falls 20%.
Does luxury cruise companies’ total revenue
rise or fall?

37
ACTIVE LEARNING 2
Answers
A. Pharmacies raise the price of insulin by 10%.
Does total expenditure on insulin rise or fall?
Expenditure = P x Q
Since demand is inelastic, Q will fall less
than 10%, so expenditure rises.

38
ACTIVE LEARNING 2
Answers
B. As a result of a fare war, the price of a luxury
cruise falls 20%.
Does luxury cruise companies’ total revenue
rise or fall?
Revenue = P x Q
The fall in P reduces revenue, but Q increases,
which increases revenue. Which effect is
bigger?
Since demand is elastic, Q will increase more
than 20%, so revenue rises.
39
APPLICATION: Does Drug Interdiction
Increase or Decrease Drug-Related
Crime?
 One side effect of illegal drug use is crime:
Users often turn to crime to finance their habit.
 We examine two policies designed to reduce
illegal drug use and see what effects they have
on drug-related crime.
 For simplicity, we assume the total dollar value
of drug-related crime equals total expenditure
on drugs.
 Demand for illegal drugs is inelastic, due to
addiction issues.
ELASTICITY AND ITS APPLICATION 40
 Policy 1: Interdiction
Interdiction new value of drug-
reduces Price of related crime
the supply Drugs S2
D1
of drugs. S1
Since demand P2
for drugs is
inelastic, initial value
P1
P rises propor- of drug-
tionally more related
than Q falls. crime

Result: an increase in Q2 Q1 Quantity

total spending on drugs, of Drugs
and in drug-related crime
ELASTICITY AND ITS APPLICATION 41
 Policy 2: Education
new value of drug-
Education Price of related crime
reduces the Drugs
demand for D2 D1
drugs. S

P and Q fall.
P1 initial value
Result: of drug-
A decrease in P2 related
total spending crime
on drugs, and
in drug-related Q2 Q1 Quantity
crime. of Drugs

ELASTICITY AND ITS APPLICATION 42

 Price Elasticity of Supply
Price elasticity Percentage change in Qs
=
of supply Percentage change in P

 Price elasticity of supply measures how much

Qs responds to a change in P.
 Loosely speaking, it measures sellers’
price-sensitivity.
 Again, use the midpoint method to compute the
percentage changes.
 It is a positive value so need for abs value as for
demand elasticity.
ELASTICITY AND ITS APPLICATION 43
 Price Elasticity of Supply
Price elasticity Percentage change in Qs
=
of supply Percentage change in P
P
Example: S
P rises
Price by 8%
P2
elasticity P1
of supply
equals
Q
16% Q1 Q2
= 2.0
8% Q rises
by 16%
ELASTICITY AND ITS APPLICATION 44
 The Variety of Supply Curves
 The slope of the supply curve is closely related to
price elasticity of supply.
 Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
 Five different classifications.…

ELASTICITY AND ITS APPLICATION 45

“Perfectly inelastic” (one extreme)
Price elasticity % change in Q 0%
= = =0
% change in P 10%
of supply
S curve: P
S
vertical
P2
Sellers’
price sensitivity: P1
none
P rises Q
Elasticity: by 10% Q1
0
Q changes
by 0%
ELASTICITY AND ITS APPLICATION 46
“Inelastic”
Price elasticity % change in Q < 10%
= = <1
% change in P 10%
of supply
S curve: P
S
relatively steep
P2
Sellers’
price sensitivity: P1
relatively low
P rises Q
Elasticity: by 10% Q1 Q2
<1
Q rises less
than 10%
ELASTICITY AND ITS APPLICATION 47
“Unit elastic”
Price elasticity % change in Q 10%
= = =1
% change in P 10%
of supply
S curve: P
intermediate slope S
P2
Sellers’
price sensitivity: P1
intermediate
P rises Q
Elasticity: by 10% Q1 Q2
=1
Q rises
by 10%
ELASTICITY AND ITS APPLICATION 48
“Elastic”
Price elasticity % change in Q > 10%
= = >1
% change in P 10%
of supply
S curve: P
relatively flat S
P2
Sellers’
price sensitivity: P1
relatively high
P rises Q
Elasticity: by 10% Q1 Q2
>1
Q rises more
than 10%
ELASTICITY AND ITS APPLICATION 49
“Perfectly elastic” (the other
extreme)
Price elasticity % change in Q any %
= = = infinity
% change in P 0%
of supply
S curve: P
horizontal
P2 = P1 S
Sellers’
price sensitivity:
extreme
P changes Q
Elasticity: by 0% Q1 Q2
infinity
Q changes
by any %
ELASTICITY AND ITS APPLICATION 50
 The 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.
 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.

ELASTICITY AND ITS APPLICATION 51

ACTIVE LEARNING 3
Elasticity and changes in
equilibrium
 The supply of beachfront property is inelastic.
The supply of new cars is elastic.
 Suppose population growth causes
demand for both goods to double
(at each price, Qd doubles).
 For which product will P change the most?
 For which product will Q change the most?

52
ACTIVE LEARNING 3
Answers
Beachfront property
When supply (inelastic supply):
is inelastic, P
an increase in
demand has a D1 D2 S
bigger impact
on price than P2 B
on quantity.
P1 A

Q
Q1 Q2
53
ACTIVE LEARNING 3
Answers
New cars
When supply (elastic supply):
is elastic, P
an increase in
demand has a D1 D2
bigger impact S
on quantity
than on price. B
P2
A
P1

Q
Q1 Q2
54
 How the Price Elasticity of Supply
Can Vary

P Supply
Supply often
often
S
elasticity becomes
becomes
$15 <1 less
less elastic
elastic
as
as Q
Q rises,
rises,
12
due
due to
to
elasticity capacity
capacity
>1 limits.
limits.
4
$3
Q
100 200
500 525

ELASTICITY AND ITS APPLICATION 55

 Other Elasticities
 Income elasticity of demand: measures the
response of Qd to a change in consumer income

Income elasticity Percent change in Qd

=
of demand Percent change in income

 Recall from Chapter 3: An increase in income

causes an increase in demand for a normal good.
 Hence, for normal goods, income elasticity > 0.
 For inferior goods, income elasticity < 0.

ELASTICITY AND ITS APPLICATION 56

 Other Elasticities
 Cross-price elasticity of demand:
measures the response of demand for one good to
changes in the price of another good

Cross-price elast. % change in Qd for good 1

=
of demand % change in price of good 2
 For substitutes, cross-price elasticity > 0
(e.g., an increase in price of beef causes an
increase in demand for chicken)
 For complements, cross-price elasticity < 0
(e.g., an increase in price of computers causes
decrease in demand for software)
ELASTICITY AND ITS APPLICATION 57
 Cross-Price Elasticities in the
News
“As Gas Costs Soar, Buyers Flock to Small Cars”
-New York Times
“Gas Prices Drive Students to Online Courses”
-Chronicle of Higher Education
“Gas prices knock bicycle sales, repairs into higher gear”

-Associated Press
“High gas prices drive farmer to switch to mules”
-Associated Press

ELASTICITY AND ITS APPLICATION 58

CHAPTER SUMMARY

 Elasticity measures the responsiveness of

Qd or Qs to one of its determinants.
 Price elasticity of demand equals percentage change
in Qd divided by percentage change in P. It has a
negative value. When it’s less than one in abs value,
demand is “inelastic.” When greater than one,
demand is “elastic.”
 When demand is inelastic, total revenue rises when
price rises. When demand is elastic, total revenue
falls when price rises. 59
CHAPTER SUMMARY

 Demand is less elastic in the short run,

for necessities, for broadly defined goods,
or for goods with few close substitutes.
 Price elasticity of supply equals percentage
change in Qs divided by percentage change in P. It
has a positive value. When it’s less than one,
supply is “inelastic.” When greater than one,
supply is “elastic.”
 Price elasticity of supply is greater in the long run
than in the short run. 60
CHAPTER SUMMARY

 The income elasticity of demand measures how

much quantity demanded responds to changes in
buyers’ incomes.
 The cross-price elasticity of demand measures
how much demand for one good responds to
changes in the price of another good.

61