Chapter 4:
Elasticity
McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia
Objectives
After studying this chapter, you will be able to:
§ Define, calculate, and explain the factors that influence the
price elasticity of demand
§ Define, calculate, and explain the factors that influence the
cross elasticity of demand and the income elasticity of demand
§ Define, calculate, and explain the factors that influence the
elasticity of supply
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Squeezing Out Revenue
§ To predict the quantitative effects of changes in demand and
supply on prices, quantities and total revenue, we need to
know how responsive demand and supply are to price and
other influences on buying plans and selling plans.
§ This chapter explains how we measure the response of
demand and supply to price and other influences on buying
plans and selling plans using the concept of elasticity.
§ It explains how we calculate, interpret, and use elasticity.
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4-3
Price Elasticity of Demand
When supply increases, the equilibrium price falls and
the equilibrium quantity increases
§
But does the price fall by a larger amount and the quantity
increase by a little? (Figure 4.1(a))
§
Or does the price barely fall and the quantity increase by a
large amount? (Figure 4.1 (b))
§
The answer depends on the responsiveness of the quantity
demanded to a change in price.
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Price (dollars per smoothie)
Impact of a Change in Supply
4.00
S0 An increase
in supply brings ...
… a large
fall in
price...
S1
3.00
2.00
… and a small
increase in quantity
1.00
DA
Figure 4.1 (a)
0
5
10
15
20
25
Quantity (smoothies per hour)
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4-5
Price (dollars per smoothie)
Impact of a Change in Supply
4.00
S0 An increase
in supply brings ...
S1
… a small
fall in
price...
3.00
2.00
DA
1.00
… and a large
increase in quantity
Figure 4.1 (b)
0
5
10
15
20
25
Quantity (smoothies per hour)
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4-6
Price Elasticity of Demand
§ The price elasticity of demand 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
buyers’ plans remain the same.
§ Calculating Elasticity
§ The price elasticity of demand is calculated by using the
formula:
Percentage change in quantity demanded
Percentage change in price
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4-7
Price Elasticity of Demand
To calculate the price elasticity of demand:
§ We express the change in price as a percentage of the
average price—the average of the initial and new price,
§ and we express the change in the quantity demanded as a
percentage of the average quantity demanded—the average
of the initial and new quantity.
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4-8
Price (dollars per smoothie)
Calculating the
Elasticity of Demand
Figure 4.2
Original
point
3.10
Elasticity = 3
3.00
Pave =
$3.00
∆ P
= $0.20
New
point
Qave = 10
2.90
D
9
∆Q = 2
10
11
Quantity (millions of smoothies per hour)
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4-9
Price Elasticity of Demand
§ By using the average price and average quantity, we get the
same elasticity value regardless of whether the price rises or
falls.
§ The ratio of two proportionate changes is the same as the
ratio of two percentage changes.
§ The measure is units free because it is a ratio of two
percentage changes and the percentages cancel out.
§ Changing the units of measurement of price or quantity
leaves the elasticity value the same.
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Price Elasticity of Demand
§ The formula yields a negative value because price and
quantity move in opposite directions.
§ But it is the magnitude, or absolute value, of the measure
that reveals how responsive the quantity change has been to
a price change.
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Price Elasticity of Demand
§ Inelastic and elastic demand
§ Demand can be inelastic, unit elastic, or elastic, and can
range from zero to infinity.
§ If the quantity demanded doesn’t change when the price
changes, the price elasticity of demand is zero and the good
has a perfectly inelastic demand.
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Price Elasticity of Demand
§ Between the two previous cases, the percentage change in
the quantity demanded is smaller than the percentage
change in price, so the price elasticity of demand is less
than 1 and the good has inelastic demand.
§ If the percentage change in the quantity demanded is
infinitely large when the price barely changes, the price
elasticity of demand is infinite and the good has perfectly
elastic demand.
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Price
Inelastic and Elastic Demand
Figure 4.3(a)
D1
Elasticity = 0
12
Perfectly Inelastic
6
Quantity
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4-14
Inelastic and Elastic Demand
Price
Figure 4.3(b)
Elasticity = 1
12
Unit Elasticity
6
D2
1
2
3
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Quantity
4-15
Inelastic and Elastic Demand
Price
Figure 4.3(c)
Elasticity = ∞
12
6
D3
Perfectly Elastic
Quantity
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Price Elasticity of Demand
§ Elasticity along a linear demand curve
§ Figure 4.4 shows how demand becomes less elastic as the
price falls along a linear demand curve.
§ At prices above the mid-point of the demand curve,
demand is elastic.
§ At prices below the mid-point of the demand curve,
demand is inelastic
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Price Elasticity of Demand
§ For example, if the price falls from $5 to $3, the quantity
demanded increases from 0 to 10 smoothies an hour.
§ The average price is $4 and the average quantity is 5.
§ The price elasticity of demand is (10/5)/(2/4), which
equals 4.
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Elasticity Along a Linear
Demand Curve
Price (dollars per smoothie)
5.00
4.00
Elastic
Elasticity = 1
3.00
2.50
Inelastic
2.00
Elasticity 1/4
1.00
0
Figure 4.4
Elasticity =4
5
10 12.5 15 20
25
Quantity (smoothies per hour)
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4-19
Price Elasticity of Demand
§ Total revenue and elasticity
§ The total revenue from the sale of a good or service equals
the price of the good multiplied by the quantity sold.
§ When the price changes, total revenue also changes.
§ But a rise in price doesn’t always increase total revenue.
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4-20
Price Elasticity of Demand
§ The change in total revenue due to a change in price
depends on the 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 inelastic, a 1 percent price cut decreases the
quantity sold by more than 1 percent, and total revenues
decreases.
§
If demand is unit elastic, a 1 percent price cut increases
the quantity sold by 1 percent, and total revenue
remains unchanged.
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Price Elasticity of Demand
§ The total revenue test is a method of estimating the price
elasticity of demand by observing the change in total revenue
that results from a price change (when all other influences on
the quantity sold remain the same).
§ If a price cut increases total revenue, demand is elastic.
§ If a price cut decreases total revenue, demand is inelastic.
§ If a price cut leaves total revenue unchanged, demand is unit
elastic.
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4-22
Price (dollars per smoothie)
Figure 4.5
5.00
Elastic demand
4.00
Unit
elastic
3.00
2.50
2.00
Inelastic
demand
1.00
0
31.25
6
12
Maximum
total revenue
Total Revenue (dollars)
When demand
is elastic, a
price cut
increases
total revenue
Elasticity and
Total Revenue
When demand
is inelastic, a
price cut decreases
total revenue
0
12.5
Copyright © 2007 Pearson Education Australia Pty Limited
25
Quantity (smoothies per hour)
23
Price Elasticity of Demand
§ Your expenditure and your elasticity
§ If your demand is elastic, a 1 percent price cut increases the
quantity you buy by more than 1 percent, and your
expenditure on the item increases.
§ If your demand is inelastic, a 1 percent price cut increases the
quantity you buy by less than 1 percent, and your expenditure
on the item decreases.
§ If your demand is unit elastic, a 1 percent price cut increases
the quantity you buy by 1 percent, and your expenditure on
the item does not change.
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4-24
Price Elasticity of Demand
§ The factors that influence the elasticity of demand
§ The elasticity of demand for a good depends on:
§ The closeness of substitutes
§ The proportion of income spent on the good
§ The time elapsed since a price change
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4-25
Price Elasticity of Demand
§ The closeness of substitutes
§ The closer the substitutes for a good or service, the more
elastic is the demand for it.
§ Necessities, such as food or housing, generally have
inelastic demand.
§ Luxuries, such as exotic vacations, generally have elastic
demand.
§ The proportion of income spent on the good
§ The greater the proportion of income consumers spent on a
good, the larger is its elasticity of demand.
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4-26
Price Elasticity of Demand
§ The time elapsed since a price change
§ The more time consumers have to adjust to a price
change, or the longer that a good can be stored without
losing its value, the more elastic is the demand for that
good.
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4-27
Some Real-world Price
Elasticities of Demand
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4-28
Price Elasticity in 10 Countries
Figure 4.6
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More Elasticities of Demand
§ Cross elasticity of demand
§ The cross elasticity of demand is a measure of the
responsiveness of demand for a good to a change in the
price of a substitute or a compliment, other things
remaining the same.
§ The formula for calculating the cross elasticity is:
Percentage change in quantity demanded
Percentage change in price of substitute or complement
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More Elasticities of Demand
§ The cross elasticity of demand for a substitute is
positive.
§ The cross elasticity of demand for a complement is
negative.
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Cross Elasticity of Demand
Figure 4.7
Price of smoothies
Price of a sandwich,
a complement, falls.
Negative cross elasticity
D2
Price of a soft drink,
a substitute, falls,
Positive cross elasticity
D0
D1
Quantity of smoothies
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More Elasticities of Demand
§ Income Elasticity of Demand
§ The income elasticity of demand measures how the quantity
demanded of a good responds to a change in income, other
things equal.
§ The formula for calculating the income elasticity of demand
is:
Percentage change in quantity demanded
Percentage change in income
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More Elasticities of Demand
§ If the income elasticity of demand is greater than 1, demand is
income elastic and the good is a normal good.
§ If the income elasticity of demand is greater than zero but less
than 1, demand is income inelastic and the good is a normal
good.
§ If the income elasticity of demand is less than zero (negative)
the good is an inferior good.
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More Elasticities of Demand
Figure 4.8
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Elasticity of Supply
§ The elasticity of supply measures the responsiveness of the
quantity supplied to a change in the price of a good when all
other influences on selling plans remain the same.
§ Calculating the Elasticity of Supply
§ The elasticity of supply is calculated by using the formula:
Percentage change in quantity supplied
Percentage change in price
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Price (dollars per pizza)
How a Change in Demand Changes
Price and Quantity
Figure 4.9 (a)
6.00
An increase
in demand
brings ...
Large price change and small
quantity change
Sa
5.00
4.00
3.00
2.00
… a large
price rise...
1.00
D1
… and a small
quantity increase
D0
0
5
10
15
20
25
Quantity (pizzas per hour)
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4-37
Price (dollars per pizza)
How a Change in Demand Changes
Price and Quantity
Figure 4.9 (b)
6.00
An increase
in demand
brings ...
Small price change and
large quantity change
5.00
4.00
SA
3.20
3.00
2.00
… a small
1.00 price rise...
D1
… and a large
quantity increase
D0
0
5
10
15
20
25
Quantity (pizzas per hour)
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Elasticity of Supply
§ The factors that influence the elasticity of supply
§ Resource substitution possibilities
§ The easier it is to substitute among the resources used to
produce a good or service, the greater is its elasticity of
supply.
§ The time frame for supply decisions
§ The more time that passes after a price change, the
greater is the elasticity of supply.
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Elasticity of Supply
§ Supply is perfectly inelastic if the supply curve is vertical and
the elasticity of supply is 0.
§ Supply is unit elastic if the supply curve is linear and passes
through the origin. (Note that slope is irrelevant.)
§ Supply is perfectly elastic if the supply curve is horizontal and
the elasticity of supply is infinite.
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Perfectly Inelastic Supply
Price
Figure 4.10 (a)
S1
Elasticity of
supply = 0
0
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Quantity
4-41
Unit Elastic Supply
Price
Figure 4.10 (b)
S2A
Elasticity of
supply = 1
S2B
0
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Quantity
4-42
Perfectly Elastic Supply
Price
Figure 4.10 (c)
Elasticity of
supply = ∞
S3
0
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Quantity
4-43
Elasticity of Supply
§ The time frame for supply decisions
§ The more time that passes after a price change, the greater
is the elasticity of supply.
§ Momentary supply is perfectly inelastic. The quantity
supplied immediately following a price change is
constant.
§ Short-run supply is somewhat elastic.
§ Long-run supply is the most elastic.
§ Table 4.3 (p 99) provides a glossary of all the elasticity
measures.
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END
CHAPTER 4
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