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Chapter 5

Elasticity and its


Applications

2002 by Nelson, a division of Thomson Canada Limited

In this chapter you will


Learn
Learn the
the meaning
meaning of
of the
the elasticity
elasticity of
of
demand.
demand.
Examine
Examine what
what determines
determines the
the elasticity
elasticity of
of
demand.
demand.
Learn
Learn the
the meaning
meaning of
of the
the elasticity
elasticity of
of
supply.
supply.
Examine
Examine what
what determines
determines the
the elasticity
elasticity of
of
supply.
supply.
Apply
Apply the
the concept
concept of
of elasticity
elasticity in
in three
three
different
different markets.
markets.

THE ELASTICITY OF DEMAND



allows
allows us
us to
to analyze
analyze supply
supply and
and
demand
demand with
with greater
greater precision.
precision.

is
is aa measure
measure of
of how
how much
much buyers
buyers and
and
sellers
sellers respond
respond to
to changes
changes in
in market
market
conditions
conditions

Price Elasticity of Demand


Price
Price elasticity
elasticity of
of demand
demand is
is aa measure
measure of
of
how
how much
much the
the quantity
quantity demanded
demanded of
of aa
good
good responds
responds to
to aa change
change in
in the
the price
price of
of
that
that good.
good.
Price
Price elasticity
elasticity of
of demand
demand is
is the
the
percentage
percentage change
change in
in quantity
quantity demanded
demanded
given
given aa percent
percent change
change in
in the
the price.
price.

The Price Elasticity of Demand and Its


Determinants

Availability
Availability of
of Close
Close Substitutes
Substitutes
Necessities
Necessities versus
versus Luxuries
Luxuries
Definition
Definition of
of the
the Market
Market
Time
Time Horizon
Horizon

The Price Elasticity of Demand and Its


Determinants
Demand
Demand tends
tends to
to be
be more
more elastic:
elastic:
the
the larger
larger the
the number
number of
of close
close
substitutes.
substitutes.
ifif the
the good
good is
is aa luxury.
luxury.
the
the more
more narrowly
narrowly defined
defined the
the market.
market.
the
the longer
longer the
the time
time period.
period.

Computing the Price Elasticity of Demand


The
The price
price elasticity
elasticity of
of demand
demand is
is
computed
computed as
as the
the percentage
percentage change
change in
in the
the
quantity
quantity demanded
demanded divided
divided by
by the
the
percentage
percentage change
change in
in price.
price.

Price elasticity of demand =

Percentage change in quantity demanded


Percentage change in price

The Midpoint Method: A Better Way to


Calculate Percentage Changes and Elasticities
The
The midpoint
midpoint formula
formula is
is preferable
preferable when
when
calculating
calculating the
the price
price elasticity
elasticity of
of demand
demand
because
because itit gives
gives the
the same
same answer
answer
regardless
regardless of
of the
the direction
direction of
of the
the change.
change.
point
pointMethod:
Method:AABetter
BetterWay
Wayto
toCalculate
CalculatePercentage
Percentage
Changes
Changesand
andElasticities
Elasticities

Price elasticity of demand =

(Q2 - Q1) / [(Q2 + Q1) / 2]


(P2 - P1) / [(P2 + P1) / 2]

The Midpoint Method: A Better Way to


Calculate Percentage Changes and Elasticities
Point
PointA:
A:
Point
PointB:
B:

Price
Price==$4
$4
Price
Price==$6
$6

Quantity
Quantity==120
120
Quantity
Quantity==80
80

From
FromPoint
PointAAto
toPoint
PointB:
B:Price
Pricerise
rise==50%
50%and
andQuantity
Quantityfall
fall==33%
33%
From
FromPoint
PointBBto
toPoint
PointA:
A:Price
Pricefall
fall==33%
33%and
andQuantity
Quantityrise
rise==50%
50%

Price elasticity of demand =


Mid point method

(80 - 120) / [(80 + 120)/ 2]


(6 - 4) / [(6 + 4)/ 2]
=

A Variety of Demand Curves


Inelastic
Inelastic Demand
Demand
Quantity
Quantity demanded
demanded does
does not
not respond
respond
strongly
strongly to
to price
price changes.
changes.
Price
Price elasticity
elasticity of
of demand
demand is
is less
less than
than
one.
one.
Elastic
Elastic Demand
Demand
Quantity
Quantity demanded
demanded responds
responds strongly
strongly
to
to changes
changes in
in price.
price.
Price
Price elasticity
elasticity of
of demand
demand is
is greater
greater
than
than one.
one.

A Variety of Demand Curves


Perfectly
Perfectly Inelastic
Inelastic
Quantity
Quantity demanded
demanded does
does not
not respond
respond to
to
price
price changes.
changes.
Perfectly
Perfectly Elastic
Elastic
Quantity
Quantity demanded
demanded changes
changes infinitely
infinitely
with
with any
any change
change in
in price.
price.
Unit
Unit Elastic
Elastic
Quantity
Quantity demanded
demanded changes
changes by
by the
the
same
same percentage
percentage as
as the
the price.
price.

A Variety of Demand Curves


Because
Because the
the price
price elasticity
elasticity of
of demand
demand
measures
measures how
how much
much quantity
quantity demanded
demanded
responds
responds to
to the
the price,
price, itit is
is closely
closely related
related
to
to the
the slope
slope of
of the
the demand
demand curve.
curve.

Figure 5-1 a): Perfectly Inelastic Demand


Price

Demand

E=0

$5.00

$4.00
1. An increase
in price

100
2. leaves the quantity demanded unchanged.

Quantity

Figure 5-1 b): Inelastic Demand


Price

Demand

E<1

$5.00

$4.00
1. A 22%
increase in
price

90

100

2. Leads to a 11% decrease in quantity demanded.

Quantity

Figure 5-1 c): Unit Elastic Demand


E=1

Price

Demand

$5.00

$4.00
1. A 22%
increase in
price

80

100

2. Leads to a 22% decrease in quantity demanded.

Quantity

Figure 5-1 d): Elastic Demand


E>1

Price

Demand

$5.00

$4.00
1. A 22%
increase in
price

50

100

2. Leads to a 67% decrease in quantity demanded.

Quantity

Figure 5-1 e): Perfectly Elastic Demand


E=

Price

1. At any price above $4, quantity


demanded is zero.

Demand

$4.00
2. At exactly $4, consumers will buy any quantity.

3. At any price below $4, quantity demanded is infinite.

0
Quantity

Total Revenue and the Price Elasticity of


Demand
Total
Total revenue
revenue is
is the
the amount
amount paid
paid by
by
buyers
buyers and
and received
received by
by sellers
sellers of
of aa good.
good.
Computed
Computed as
as the
the price
price of
of the
the good
good times
times
the
the quantity
quantity sold.
sold.
TR
TR == PP xx Q
Q

Figure 5-2: Total Revenue


Price

$4.00

P x Q = $400
(revenue)

Demand

100

Quantity

Figure 5-3: How Total Revenue Changes


When Prices Changes: Inelastic Demand
Price

$3.00

P x Q = $400
(revenue)
$1.00

P x Q = $100
(revenue)
0

Demand
80

100

Quantity

Figure 5-4: How Total Revenue Changes


When Prices Changes: Elastic Demand
Price

Change in Total Revenue when Price Changes

$5.00

$4.00

Demand

Revenue = $200
Revenue = $100

20

50

Quantity

Elasticity and Total Revenue along a Linear


Demand Curve
With
With an
an elastic
elastic demand
demand curve,
curve, an
an increase
increase
in
in the
the price
price leads
leads to
to aa decrease
decrease in
in quantity
quantity
demanded
demanded that
that is
is proportionately
proportionately larger.
larger.
Thus,
Thus, total
total revenue
revenue decreases.
decreases.

Table 5-1. Elasticity and Total Revenue along


a Linear Demand Curve

Figure 5-5: A Linear Demand Curve


Price

Elasticity
is larger
than 1.

7
6
5
4

Elasticity
is smaller
than 1.

3
2
1

10

12

14

Quantity

Other Demand Elasticities


Income
Income elasticity
elasticity of
of demand
demand measures
measures
how
how much
much the
the quantity
quantity demanded
demanded of
of aa
good
good responds
responds to
to aa change
change in
in consumers
consumers
income.
income.
ItIt is
is computed
computed as
as the
the percentage
percentage change
change
in
in the
the quantity
quantity demanded
demanded divided
divided by
by the
the
percentage
percentage change
change in
in income.
income.

Percentage change
in quantity demanded
Income elasticity of demand =
Percentage change
in income

Other Demand Elasticities


Types
Types of
of Goods
Goods
Normal
Normal Goods
Goods
Inferior
Inferior Goods
Goods
Higher
Higher income
income raises
raises the
the quantity
quantity
demanded
demanded for
for normal
normal goods
goods but
but lowers
lowers
the
the quantity
quantity demanded
demanded for
for inferior
inferior goods.
goods.

Other Demand Elasticities


Goods
Goods consumers
consumers regard
regard as
as necessities
necessities
tend
tend to
to be
be income
income inelastic
inelastic
Examples
Examples include
include food,
food, fuel,
fuel, clothing,
clothing,
utilities,
utilities, and
and medical
medical services.
services.
Goods
Goods consumers
consumers regard
regard as
as luxuries
luxuries tend
tend
to
to be
be income
income elastic.
elastic.
Examples
Examples include
include sports
sports cars,
cars, furs,
furs, and
and
expensive
expensive foods.
foods.

Other Demand Elasticities


Cross-Price
Cross-Price elasticity
elasticity of
of demand
demand measures
measures
how
how much
much the
the quantity
quantity demanded
demanded of
of aa
good
good responds
responds to
to aa change
change in
in the
the price
price of
of
another
another good.
good.
ItIt is
is computed
computed as
as the
the percentage
percentage change
change in
in
the
the quantity
quantity demanded
demanded divided
divided by
by the
the
percentage
percentage change
change in
in the
the price
price of
of the
the
second
second good.
good.
Percentage change
in quantity demanded
Income elasticity of demand =
Percentage change
in the price of
good 2.

PRICE ELASTICITY OF SUPPLY


Price
Price elasticity
elasticity of
of supply
supply is
is aa measure
measure of
of
how
how much
much the
the quantity
quantity supplied
supplied of
of aa good
good
responds
responds to
to aa change
change in
in the
the price
price of
of that
that
good.
good.
Price
Price elasticity
elasticity of
of supply
supply is
is the
the percentage
percentage
change
change in
in quantity
quantity supplied
supplied given
given aa
percent
percent change
change in
in the
the price.
price.

The Price Elasticity of Supply and Its


Determinants
Ability
Ability of
of sellers
sellers to
to change
change the
the amount
amount of
of
the
the good
good they
they produce.
produce.
Beach-front
Beach-front land
land is
is inelastic.
inelastic.
Books,
Books, cars,
cars, or
or manufactured
manufactured goods
goods are
are
elastic.
elastic.
Time
Time period.
period.
Supply
Supply is
is more
more elastic
elastic in
in the
the long
long run.
run.

Computing the Price Elasticity of Supply


The
The price
price elasticity
elasticity of
of supply
supply is
is computed
computed
as
as the
the percentage
percentage change
change in
in the
the quantity
quantity
supplied
supplied divided
divided by
by the
the percentage
percentage
change
change in
in price.
price.

Percentage change
in quantity supplied
Price elasticity of supply =
Percentage change in price

Computing the Price Elasticity of Supply


Suppose
Supposean
anincrease
increasein
inthe
theprice
priceof
ofmilk
milkfrom
from$1.90
$1.90to
to$2.10
$2.10aalitre
litreraises
raises
the
amount
that
dairy
farmers
produce
from
9000
to
11
000
L
per
month
the amount that dairy farmers produce from 9000 to 11 000 L per month


using
usingthe
themidpoint
midpointmethod,
method,we
wecalculate
calculatethe
thepercent
percentchange
changein
in
the
price
as
(2.10
1.90)
/
2.00
x
100
=
10%
the price as (2.10 - 1.90) / 2.00 x 100 = 10%
Similarly,
Similarly,we
wecalculate
calculatethe
thepercent
percentchange
changein
inthe
thequantity
quantitysupplied
supplied
as
(11
000
9000)
/
10
000
x
100
=
20%
as (11 000 - 9000) / 10 000 x 100 = 20%

Price elasticity of supply =

20%
10%

2.0

Figure 5-6 a): Perfectly Inelastic Supply


Price

Supply

E=0

$5.00

$4.00
1. An increase
in price

100
2. leaves the quantity supplied unchanged.

Quantity

Figure 5-6 b): Inelastic Supply


Price

Supply

E<0

$5.00

$4.00
1. A 22%
increase in
price

100

110

2. leads to a 10% increase in quantity


supplied.

Quantity

Figure 5-6 c): Unit Elastic Supply


E=1

Price

Supply

$5.00

$4.00
1. A 22%
increase in
price

100

125

2. leads to a 22% increase in quantity


supplied.

Quantity

Figure 5-6 d): Elastic Supply


E>1

Price

Supply
$5.00

$4.00
1. A 22%
increase in
price

100

200

2. leads to a 67% increase in quantity


supplied.

Quantity

Figure 5-6 e): Perfectly Elastic Supply


E=

Price

1. At any price above $4, quantity


supplied is infinite.

Supply

$4.00
2. At exactly $4, producers will supply any quantity.

3. At any price below $4, quantity supplied is zero.

0
Quantity

Figure 5-7: How the price elasticity of supply


can vary
Price

$15

Elasticity is less
than 1

$12

Elasticity is
greater than 1

$4
$3

100

200

500
525

Quantity

THREE APPLICATIONS OF SUPPLY,


DEMAND, AND ELASTICITY

Good
Good news
news bad
bad news
news for
for farmers
farmers
OPEC
OPEC
Drugs
Drugs and
and crime
crime

Figure 5-8: An Increase in Supply in the


Market for Wheat
Price of
Wheat

Increase in Supply
1. When demand is inelastic, an
increase in supply

S1

S2

$3

$2
2. leads
to a fall in
price

Demand
100

110

3. and a proportionately smaller increase in quantity sold. As a result revenue


falls from $300 to $220.

Quantity of Wheat

Figure 5-9: A Reduction in Supply in the


World Market for Oil
(a) Oil Market in the Short Run
Price
of Oil

(b) Oil Market in the Long Run


Price
of Oil

1. In the short run, when supply


and demand are inelastic, a shift
in supply

S2

1. In the long run, when supply


and demand are elastic, a shift in
supply

S1

S2
S1
P2

P2
P1

P1
2. leads
to a large
increase in
price

Demand

2. leads
to a small
increase in
price

Quantity of Oil

Demand

Quantity of Oil

Figure 5-10: Policies to Reduce the of Illegal


Drugs (a) Drug Interdiction
(b) Drug Education
Price of
Drugs

Price of
Drugs

1. Drug interdiction reduces the


supply of drugs

S2

1. Drug education reduces the


demand for drugs

S1

Supply

P2

P1
P2

P1

D1

2. which
reduces the
price

2. which
raises the
price

D2

Demand
Q2

Q1

Quantity of Drugs

3. and reduces the


quantity sold.

Q2

Q1 Quantity of Drugs

3. and reduces the quantity


sold.

Summary
Price
Priceelasticity
elasticityof
of demand
demandmeasures
measureshow
how much
much
the
thequantity
quantitydemanded
demandedresponds
respondsto
tochanges
changesin
in
the
theprice.
price.
Price
Priceelasticity
elasticityof
of demand
demandis
iscalculated
calculated as
as the
the
percentage
percentagechange
changein
in quantity
quantitydemanded
demandeddivided
divided
by
bythe
thepercentage
percentagechange
change in
in price.
price.
IfIf aademand
demandcurve
curveis
iselastic,
elastic, total
totalrevenue
revenuefalls
falls
when
whenthe
theprice
pricerises.
rises.
IfIf ititis
isinelastic,
inelastic, total
totalrevenue
revenuerises
risesas
asthe
theprice
price
rises.
rises.

Summary
The
Theincome
incomeelasticity
elasticityof
ofdemand
demandmeasures
measureshow
how
much
muchthe
thequantity
quantitydemanded
demandedresponds
respondsto
to
changes
changesin
in consumers
consumersincome.
income.
The
Thecross-price
cross-priceelasticity
elasticityof
of demand
demandmeasures
measures
how
how much
muchthe
thequantity
quantitydemanded
demanded of
of one
onegood
good
responds
respondsto
tothe
theprice
priceof
of another
anothergood.
good.
The
Theprice
priceelasticity
elasticityof
of supply
supplymeasures
measureshow
how
much
muchthe
thequantity
quantitysupplied
supplied responds
responds to
to changes
changes
in
inthe
theprice.
price.

Summary
In
Inmost
mostmarkets,
markets,supply
supplyis
ismore
moreelastic
elasticin
in the
the
long
longrun
runthan
thanin
inthe
the short
short run.
run.
The
Theprice
priceelasticity
elasticityof
of supply
supplyis
iscalculated
calculatedas
asthe
the
percentage
percentagechange
changein
in quantity
quantitysupplied
supplied divided
divided
by
bythe
thepercentage
percentagechange
change in
in price.
price.
The
Thetools
toolsof
ofsupply
supplyand
anddemand
demandcan
canbe
beapplied
applied in
in
many
manydifferent
differenttypes
types of
of markets.
markets.

The End

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