Chapter PPT 05

Chapter
5
Elasticity
Prepared by:
Fernando & Yvonn Quijano
2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair
ELASTICITY
CHAPTER 5: Elasticity
elasticity A general concept used to

quantify the response in one variable
when another variable changes.
%A
elasticity of A with respect to B
%B
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PRICE ELASTICITY OF DEMAND
SLOPE AND ELASTICITY
FIGURE 5.1 Slope Is Not a Useful Measure of Responsiveness

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price elasticity of demand The ratio

of the percentage of change in quantity
demanded to the percentage of change
in price; measures the responsiveness
of demand to changes in price.
price elasticity of demand
% change in quantity demanded

% change in price
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TYPES OF ELASTICITY
TABLE 5.1 Hypothetical Demand Elasticities for Four Products

% CHANGE
INPRICE
(% P)
+10%
% CHANGE
IN QUANTITY
DEMANDED
(% QD)
0%
Basic telephone service
+10%
-1%
-0.1
Inelastic
Beef
+10%
-10%
-1.0
Unitarily elastic
Bananas
+10%
-30%
-3.0
Elastic
Insulin
PRODUCT
ELASTICITY
(% QD %P)
0.0
Perfectly inelastic
perfectly inelastic demand Demand

in which quantity demanded does not
respond at all to a change in price.
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FIGURE 5.2 Perfectly Elastic and Perfectly Inelastic Demand

Curves
inelastic demand Demand that responds

somewhat, but not a great deal, to changes
in price. Inelastic demand always has a
numerical value between zero and -1.
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A warning: You must be very careful about signs. Because it is generally understood
that demand elasticities are negative (demand curves have a negative slope), they are
often reported and discussed without the negative sign. For example, a technical paper
might report that the demand for housing appears to be inelastic with respect to price,
or less than 1 (0.6). What the writer means is that the estimated elasticity is -.6, which
is between zero and -1. Its absolute value is less than 1.
unitary elasticity A demand

relationship in which the percentage
change in quantity of a product
demanded is the same as the
percentage change in price in absolute
value (a demand elasticity of -1).
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elastic demand A demand
relationship in which the percentage
change in quantity demanded is larger
in absolute value than the percentage
change in price (a demand elasticity
with an absolute value greater than 1).
perfectly elastic demand Demand in
which quantity drops to zero at the
slightest increase in price.
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A good way to remember the difference between

the two perfect elasticities is:
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CALCULATING ELASTICITIES
CALCULATING PERCENTAGE CHANGES
To calculate percentage change in quantity demanded

using the initial value as the base, the following formula is
used:
change in quantity demanded

x 100%
Q1
Q2 - Q1
x 100%
Q1
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We can calculate the percentage change in price in a

similar way. Once again, let us use the initial value of P
that is, P1as the base for calculating the percentage. By
using P1 as the base, the formula for calculating the
percentage of change in P is simply:
change in price
% change in price
x 100%
P1
P2 - P1
x 100%
P1
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ELASTICITY IS A RATIO OF PERCENTAGES

Once all the changes in quantity demanded and price
have been converted into percentages, calculating
elasticity is a matter of simple division. Recall the formal
definition of elasticity:
price elasticity of demand

% change in price
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THE MIDPOINT FORMULA

midpoint formula A more precise way of
calculating percentages using the value
halfway between P1 and P2 for the base in
calculating the percentage change in price,
and the value halfway between Q1 and Q2 as
the base for calculating the percentage
change in quantity demanded.

x 100%
(Q1 Q2 ) / 2
Q2 - Q1
x 100%
(Q1 Q2 ) / 2
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Using the point halfway between P1 and P2 as the base for

calculating the percentage change in price, we get
change in price
% change in price
x 100%
( P1 P2 ) / 2
P2 - P1
x 100%
( P1 P2 ) / 2
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TABLE 5.2 Calculating Price Elasticity with the Midpoint Formula
First, Calculate Percentage Change in Quantity Demanded (% QD):

Q2 - Q1
x 100%
x 100%
(Q1 Q2 ) / 2
(Q1 Q2 ) / 2
By substituting the numbers from Figure 5.1(a):

10 5
5
x 100%
x 100% 66.7%
(5 10) / 2
7.5
Next, Calculate Percentage Change in Price (% P):

change in price
P2 - P1
% change in price
x 100%
x 100%
( P1 P2 ) / 2
( P1 P2 ) / 2
By substituting the numbers from Figure 5.1(a):

% change in price
PRICE ELASTICITY COMPARES THE

PERCENTAGE CHANGE IN QUANTITY
DEMANDED AND THE PERCENTAGE
CHANGE
IN
PRICE:
%Q
66.7%
D
%P
- 40.0%
1.67
DEMAND IS ELASTIC
23
-1
x 100%
x 100% - 40.0%
(3 2) / 2
2.5
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ELASTICITY CHANGES ALONG A STRAIGHTLINE DEMAND CURVE

TABLE 5.3 Demand Schedule for Office
Dining Room Lunches
PRICE
QUANTITY DEMANDED
(PER LUNCH) (LUNCHES PER MONTH)
$11
10
9
2
4
10
12
14
16
18
20
22
FIGURE 5.3 Demand Curve for Lunch at

the Office Dining Room
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ELASTICITY AND TOTAL REVENUE
In any market, P x Q is total revenue (TR) received by

producers:
TR = P x Q
total revenue = price x quantity
When price (P) declines, quantity demanded (QD)

increases. The two factors, P and QD, move in opposite
directions:
Effects of price changes
on quantity demanded:
P QD
and
P QD
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Because total revenue is the product of P and Q, whether

TR rises or falls in response to a price increase depends
on which is bigger, the percentage increase in price or the
percentage decrease in quantity demanded.
Effects of price increase on
a product with inelastic demand:
P x QD TR
If the percentage decline in quantity demanded following a

price increase is larger than the percentage increase in
price, total revenue will fall.
Effects of price increase on
a product with inelastic demand:
P x QD TR
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The opposite is true for a price cut. When demand is
elastic, a cut in price increases total revenues:
effect of price cut on a product

with elastic demand:
P x QD TR
When demand is inelastic, a cut in price reduces total

revenues:
effect of price cut on a product
with inelastic demand:
P x QD TR
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THE DETERMINANTS OF DEMAND ELASTICITY

AVAILABILITY OF SUBSTITUTES
Perhaps the most obvious factor affecting demand

elasticity is the availability of substitutes.
THE IMPORTANCE OF BEING UNIMPORTANT

When an item represents a relatively small part of our total
budget, we tend to pay little attention to its price.
THE TIME DIMENSION

The elasticity of demand in the short run may be very different from the elasticity of
demand in the long run. In the longer run, demand is likely to become more elastic, or
responsive, simply because households make adjustments over time and producers
develop substitute goods.
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OTHER IMPORTANT ELASTICITIES

INCOME ELASTICITY OF DEMAND
income elasticity of demand Measures the

responsiveness of demand to changes in
income.
income elasticity of demand
% change in income
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CROSS-PRICE ELASTICITY OF DEMAND

cross-price elasticity of demand A measure
of the response of the quantity of one good
demanded to a change in the price of another
good.
cross - price elasticity of demand
% change in quantity of Y demanded

% change in price of X
Cross-price elasticity of demand is positive for

substitutes and negative for complements.
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ELASTICITY OF SUPPLY
elasticity of supply A measure of the
response of quantity of a good supplied to a
change in price of that good. Likely to be
positive in output markets.
% change in quantity supplied

elasticity of supply
% change in price
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elasticity of labor supply A measure of the

response of labor supplied to a change in the
price of labor.
elasticity of labor supply
% change in quantity of labor supplied

% change in the wage rate
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REVIEW TERMS AND CONCEPTS
cross-price elasticity
of demand
elastic demand
elasticity
elasticity of labor
supply
elasticity of supply
income elasticity of
demand
inelastic demand
midpoint formula
perfectly elastic
demand
perfectly inelastic
demand
price elasticity of
demand
unitary elasticity
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Appendix
POINT ELASTICITY (OPTIONAL)
FIGURE 5A.1 Elasticity at a Point

Along a Demand Curve
Consider the straight-line

demand curve in Figure 5A.1.
We can write an expression for
elasticity at point C as follows:
Q
100
%Q
Q
elasticity
P
%P
100
P
Q
Q1 Q P1
P
P Q1
P1
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Appendix
FIGURE 5A.2 Point Elasticity Changes

Along a Demand Curve
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Chapter

Fernando & Yvonn Quijano

elasticity A general concept used to

PRICE ELASTICITY OF DEMAND

SLOPE AND ELASTICITY

FIGURE 5.1 Slope Is Not a Useful Measure of Responsiveness

PRICE ELASTICITY OF DEMAND

price elasticity of demand The ratio

price elasticity of demand

% change in quantity demanded

PRICE ELASTICITY OF DEMAND

TABLE 5.1 Hypothetical Demand Elasticities for Four Products

Basic telephone service

perfectly inelastic demand Demand

PRICE ELASTICITY OF DEMAND

FIGURE 5.2 Perfectly Elastic and Perfectly Inelastic Demand

inelastic demand Demand that responds

PRICE ELASTICITY OF DEMAND

unitary elasticity A demand

PRICE ELASTICITY OF DEMAND

PRICE ELASTICITY OF DEMAND

A good way to remember the difference between

To calculate percentage change in quantity demanded

% change in quantity demanded

change in quantity demanded

We can calculate the percentage change in price in a

ELASTICITY IS A RATIO OF PERCENTAGES

price elasticity of demand

% change in quantity demanded

THE MIDPOINT FORMULA

change in quantity demanded

Using the point halfway between P1 and P2 as the base for

change in quantity demanded

By substituting the numbers from Figure 5.1(a):

Next, Calculate Percentage Change in Price (% P):

By substituting the numbers from Figure 5.1(a):

PRICE ELASTICITY COMPARES THE

ELASTICITY CHANGES ALONG A STRAIGHTLINE DEMAND CURVE

FIGURE 5.3 Demand Curve for Lunch at

In any market, P x Q is total revenue (TR) received by

When price (P) declines, quantity demanded (QD)

Because total revenue is the product of P and Q, whether

If the percentage decline in quantity demanded following a

effect of price cut on a product

When demand is inelastic, a cut in price reduces total

THE DETERMINANTS OF DEMAND ELASTICITY

Perhaps the most obvious factor affecting demand

THE IMPORTANCE OF BEING UNIMPORTANT

THE TIME DIMENSION

OTHER IMPORTANT ELASTICITIES

income elasticity of demand Measures the

OTHER IMPORTANT ELASTICITIES

CROSS-PRICE ELASTICITY OF DEMAND

% change in quantity of Y demanded

Cross-price elasticity of demand is positive for

OTHER IMPORTANT ELASTICITIES

% change in quantity supplied

OTHER IMPORTANT ELASTICITIES

elasticity of labor supply A measure of the

elasticity of labor supply

% change in quantity of labor supplied

REVIEW TERMS AND CONCEPTS

FIGURE 5A.1 Elasticity at a Point