Elasticity

Chapter 4
Elasticity

1
 Example 4.1

 Will the China’s trade balance (export – import)

deteriorate if RMB appreciates (say, from
1USD=8.1RMB to 1USD=7.8RMB)?

1. China’s imports become less expensive.

Quantity demanded for import may increase.
2. China’s Exports become more expensive.
Quantity demanded for export may decrease.

 The impact of RMB appreciation on the trade

balance depends on the responsiveness of import
demand and export demand to the appreciation.

2
 Price Elasticity of Demand

 The Price Elasticity of Demand is a measure of

the responsiveness of the quantity demanded of
a good to a change in the price of that good.

 Formally, it is the percentage change in the

quantity demanded that results from a 1 percent
change in its price.
Percentage change in quantity
demanded
Percentage change in price

3
 Elasticity

 Generally, elasticity is a measure of the

responsiveness of the quantity demanded of a
good to a change in the price of that good

4
 Example 4.2

 The price of pork falls by 2% and the quantity

demanded increases by 6%
 Then the price elasticity of demand for pork is

6%
= -3
-2%

Percentage change in quantity

demanded
Percentage change in price
5
 Example 4.3.

 If a 1 percent rise in the price of shelter caused a

2 percent reduction in the quantity of shelter
demanded, the price elasticity of demand for
shelter would be

-2%
= -2
1%

6
 Price Elasticity of Demand
 Measuring Price Elasticity of Demand
Percentage change in quantity demanded
Percentage change in price

 Observations
 Price elasticity of demand will always be negative
(i.e., an inverse relationship between price and
quantity).
 For convenience sometimes we drop the negative
sign.

7
Price Elasticity of Demand

Percentage Change in Quantity Demanded

Percentage Change in Price

Unit elastic

Elastic inelastic

Price elasticity
-3 -2 -1 0 of demand

8
 Example 4.4.
What is the elasticity of demand for sushi?
 Originally
 Price = $10/piece
 Quantity demanded = 400 pieces/day
 New
 Price = $9.7/piece
 Quantity demanded = 404 pieces/day, then

(404 - 400)/400 1% -1
= =
(9.7 - 10)/10 -3% 3

Inelastic!

9
 Example 4.5. What is the elasticity of
Hong Kong Disney passes?
 Originally
 Price = $1600
 Quantity demanded = 10,000 passes/year
 New
 Price = $1520
 Quantity demanded = 12,000 passes/year, then

(12000 - 10000)/10000 20%

= = -4
(1520 - 1600)/1600 -5%

Elastic!
10
 Determinants of Price Elasticity of
Demand

1. Availability of substitutes - the higher the number of substitutes, the

more responsive people are to price changes. Elasticity increases with
availability of substitutes.
2. Proportion of income used to buy the good - the higher the fraction of
income spent on a good, the higher is elasticity.
3. Temporary versus permanent change in price - if the price change is
temporary people react more to it. Suppose there is a one-day sale - the
response of quantity demanded that day will be much greater than the
response to quantity when prices are expected to decrease
permanently.
4. Short run versus long run - elasticity increases over time. If there is a
sudden price increase, individuals will take some time to find other
substitutes and make suitable changes. So quantity will not respond
much in the short run.

11
 Example 4.6.
Price Elasticity Estimates for Selected
Products
Good or service Price elasticity
Green peas -2.80
Restaurant meals -1.63
Automobiles -1.35
Electricity -1.20
Beer -1.19
Movies -0.87
Air travel (foreign) -0.77
Shoes -0.70
Coffee -0.25
Theater, opera -0.18

Why is the price elasticity of demand more than 14 times

larger for green peas than for theater and opera
performances? 12
 A Graphical Interpretation
of Price Elasticity

 For small changes in price

ΔQ Q
Price elasticity = ∈ = = ( ΔQ / ΔP )( P / Q)
ΔP P

Where Q is the original quantity and P is the original

price.

13
 A Graphical Interpretation
of Price Elasticity

ΔQ Q
 For small changes in pricePrice elasticity =∈=
ΔP P

 P  1 
Pr ice elasticity at A =   
A Q
  slope 
P
Price

P- P
Q

Q Q+ Q
Quantity 14
 Example 4.7. Calculating Price Elasticity of
Demand

vertical intercept − 20
slope = = = −4
20 horizontal intercept 5
D

16

8 −1 8 2
12 ∈A = x =− =−
3 4 12 3
Price

A
8
Question:
4 What is the price elasticity
of demand when P = $8?

1 2 3 4 5

Quantity
15
 Example 4.8. Price Elasticity and the
Steepness of the Demand Curve
What is the price elasticity of Demand for D1 & D2 when P = $4?
 
12  4  1  1
∈D1 =   − =−
4  12  2
D1  6

  Observation
 4  1 
6 ∈D2 =   − = −2 If two demand curves
4  6 
 12  have a point in
Price

4 common, the steeper

curve must be less
D2
elastic with respect to
price at that point.

4 6 12

Quantity 16
 Example 4.9. Price Elasticity Regions along
a Straight-Line Demand Curve

When P = $4 When P = $1
12
 
 4  1   
∈D =   − = −2  1  1  1
4  6  ∈D =   − =−
 12   10  6  5
 12 
6
Price

4 Observation
Price elasticity varies at every
D
point along a straight-line
1 demand curve

4 6 10 12

Quantity

17
 Price Elasticity Regions along
a Straight-Line Demand Curve

Observation
Price elasticity varies at
every point along a straight-
line demand curve

a ε < −1
ε = −1
Price

a/2 ε > −1

b/2 b
Quantity 18
 Perfectly Elastic Demand Curve

Perfectly elastic
demand (elasticity = - ∞)
Price

Quantity

If the price increases a little, the quantity demanded will drop

to zero. If the price drops a little, the quantity demanded will
increase a lot.
19
 Perfectly Inelastic Demand Curve

Perfectly inelastic
demand (elasticity = 0)
Price

Quantity

The quantity demanded is not responsive to any change in

price.

20
 Elasticity and Total Expenditure

 Total Expenditure = P x Q
 Market demand measures the quantity (Q) at
each price (P)
 Total Expenditure = Total Revenue

21
 Example 4.10. The Demand Curve for Movie
Tickets
Price ($/ticket) Total expenditure ($/day)
12
12 0
10 1000
10
8 1600
8 6 1800
Price ($/ticket)

4 1600
6 2 1000
0 0
4

0 1 2 3 4 5 6
Quantity (100s of tickets/day)

22
 Total Expenditure as a Function of Price
Total revenue is at a maximum at the midpoint
on a straight-line demand curve.

12
1,800

10 1,600

Total expenditure ($/day)

8
Price ($/ticket)

1,000
6

0 1 2 3 4 5 6 0 2 4 6 8 10 12
Quantity (100s of tickets/day) Price ($/ticket)

23
 Example 4.11.

 What happens to total expenditure on shelter

when the price is reduced from $12/sq yd to
$10/sq yd? When price goes
Price ($/sq yd)
down, total
expenditure will rise
16 Reduction in expenditure from [fall] if the gain from
14 sale at a lower price sale of additional
12 E units is larger
10 Increase in expenditure from [smaller] than the
8 loss from the sale of
additional sales
6 existing units at the
4 F G lower price.
2
Quantity (sq yds/wk)
0 2 4 6 8 10 1214 16

24
 Example 4.12. Elasticity and Total Expenditure

 Should a rock band raise or lower its price to increase total

revenue?
 Assume P=$20, Q=5,000, and ε =-3.
 Total revenue = $20 x 5,000 = $100,000/week

 If P is increased 10%,
 Q will decrease 30%
 Total revenue = $22 x 3,500 = $77,000/week
 If P is lowered 10%,
 Q will increase 30%
 Total revenue = $18 x 6,500 = $177,000/week

Note: Cost does not change with Q. Maximizing total

revenue is the same as maximizing total profit. 25
Elasticity and Total Expenditure

If demand is... A price increase will... A price reduction will...

reduce total increase total

expenditure expenditure
elastic
(ε > 1)
P x Q = P Q P x Q = P Q

increase total reduce total

expenditure expenditure
inelastic
(ε < 1)
P x Q = P Q P x Q = P Q

26
 A demand curve with constant elasticity

Unitary elastic: PxQ=k

Q 27
 Example 4.13.

 A director of a big bus company said, "For each 1 percent

fare hike, we lose 0.2 percent of our riders." We can
conclude that:
a. a fare increase will increase total revenue.
b. demand for bus service will go up as fares increase.
c. demand is price elastic.
d. a 10 percent fare hike will produce a 20 percent reduction
in riders.
e. the price elasticity is -5.
 We are told that when ∆ P/P = 1%, ∆ Q/Q = -0.2%.
 Elasticity = (∆ Q/Q)/(∆ P/P) = -0.2. (inelastic)
So answer a is correct. A fare increase will increase total revenue.

28
 Cross-Price Elasticity of Demand

 The percentage by which quantity demanded of

the first good changes in response to a 1 percent
change in the price of the second good
 Substitute Goods
When the cross-price elasticity of demand is
positive
 Complement Goods
When the cross-price elasticity of demand is
negative

29
 Income Elasticity of Demand

 The percentage by which quantity demanded

changes in response to a 1 percent change in
income
 Normal Goods
Income elasticity is
positive
 Inferior Goods
Income elasticity is
negative

30
 The Price Elasticity of Supply

 Price Elasticity of Supply

 The percentage change in the quantity
supplied that occurs in response to a 1
percent change in price
∆Q Q
Price elasticity of supply =
∆P P

 P  1 
Price elasticity of supply =   
 Q  slope 

31
 Example 4.14. A Supply Curve for Which Price
Elasticity Declines as Quantity Rises

A = ( 8 2)(1 2 ) = 2 5
S
B = (10 3)(1 2 ) =
3
B
10
A
88
Observations:
Price

1. Elasticity >0
2. Elasticity >1 for linear supply
4 curve that has a positive Y-
intercept.
3. Elasticity decreases as
quantity increases.

0 22 3 Quantity

32
 Example 4.15. A Supply Curve for Which Price
Elasticity is unity

A = ( 4 / 12 )(12 / 4 ) = 1
S
B = ( 5 15 )(15 5) = 1
B
5
A
P The price elasticity of
4 supply will always equal 1
Q
at any point along a
Price

straight-line supply curve

that passes through the
origin.

0 12 15
Quantity
33
 A challenge

 Construct an example of supply curve so that

price elasticity increases as quantity rises.

34
 A Perfectly Inelastic Supply Curve

What is the price elasticity of supply of land within Central?

S
Price ($/acre)

Elasticity = 0 at every
point along a vertical
supply curve

0
Quantity of land in Central
(1,000s of acres)
35
A Perfectly Elastic Supply Curve

If MC is constant, then the

price elasticity of supply at every point
along a horizontal supply curve is infinite
Price (cents/cup)

14 S

0
Quantity of lemonade
(cups/day)

36
 Determinants of Supply Elasticity

1. Flexibility of inputs
2. Mobility of inputs
3. Ability to produce substitute inputs
4. Time

37
 Example 4:16. Why are gasoline prices so
much more volatile than car prices?

 Differences in markets
 Demand for gasoline is more inelastic
 Gasoline market has larger and more frequent
supply shifts

38
 Greater Volatility in
Gasoline Prices than in Car Prices
S’
Gasoline
S
Price ($/gallon)

1.69

1.02

0 6 7.2
Quantity
(millions of gallons/day)
39
 Greater Volatility in
Gasoline Prices than in Car Prices

Cars
S’
Price ($1,000s/car)

17
16.4

11 12
Quantity
(1,000s of cars/day)
Cars
40
 Example 4.17. Earnings of YAO Ming

 Why does YAO Ming earn an annual basketball

salary of some US$4.5 million?

YAO Ming is a unique and essential inputs, an

example of ultimate supply bottleneck.
41
 Other examples of unique and essential
inputs

 Dr. Joseph YAM?

 Mr Mirko Saccani?
“The fee was agreed to be $120 million for eight
years' of unlimited [Latini]dance lessons and
competitions, and Mr Saccani would be her
dancing partner and instructor by such
agreements.” (SCMP 2006-06-14, CITY3)

Who was she, the plaintiff?

Mimi Monica Wong, head of HSBC's private banking in Asia.

42
 Example 4.18. So why are the fares so
different?

If you start in Kansas City and you fly to Honolulu round-

trip, the fare is a lot lower than if you start the same trip in
Honolulu and fly to Kansas City round-trip. Passengers
travel on same planes, consuming the same fuel, the same
in-flight amenities, and so on. So why are the fares so
By Karen Hittle, a student
different? of Robert Frank.

43
 Example 4.18. So why are the fares so
different?

 If you are starting in Kansas City and going to Honolulu, you

are probably going on vacation. You could go lots of different
places. You could go to Florida, to Barbados, to Cancun.
Because vacationers have many destinations to choose from,
airlines must compete fiercely for their business. Given
economies of scale inherent in larger aircraft, carriers have a
strong incentive to fill additional seats by targeting lower
prices to the people who are more sensitive to price –
vacationers.
 But if you are starting in Honolulu on a trip to Kansas City, you
are probably not a vacationer. More likely, you either have
business or family reasons for traveling. So you are probably
not shopping for a destination if you are going to Kansas City.
 That is why the fares are so different.

44
 Example 4.19.

Other things being equal, the increase in rents that occur

after rent control are abolished is smaller when

A. the own price elasticity of demand for rental homes is

price inelastic.
B. the own price elasticity of demand for rental homes is
price elastic.
C. the own price elasticity of demand for rental homes has
unitary price elasticity.
D. rented homes and owned homes are substitutes.
E. rented homes and owned homes are complements.

45
 Example 4.19.

 Rent control is a form of PRICE CEILING.

 Price Ceiling is set at a price LOWER than the market equilibrium
price.
 Excess demand (i.e., shortage) results.

P
D S

Trading Loci

Pe

Price Ceiling

Q 46
 Example 4.19.

 And when the Price Ceiling is lifted, the market equilibrium

quantity and price should be restored eventually.
 Price (rent) should increase.

P
D S

Because supply is
upward sloping,
↑P → ↑ TR
Price Ceiling

47
Q
 Example 4.19.
Relative inelastic

P
D S

Pe

Price Ceiling

Relative elastic
Q
Hence, the increase in rents that occur AFTER abolishing rent
control is smaller when
(B) The own price elasticity of demand is elastic.
48
End

49