Elasticity

C HAPT E R O U T LI N E

Price Elasticity of Demand

Slope and Elasticity
Types of Elasticity
Calculating Elasticities
Calculating Percentage Changes
Elasticity Is a Ratio of Percentages
The Midpoint Formula
Elasticity Changes Along a Straight-Line
Demand Curve
Elasticity and Total Revenue
The Determinants of Demand Elasticity
Availability of Substitutes
The Importance of Being Unimportant
The Time Dimension
Other Important Elasticities
Income Elasticity of Demand
Cross-Price Elasticity of Demand
Elasticity of Supply
The model of supply and demand we have just introduced tells us a good deal about how a
change in the price of a good affects behavior.

When McDonalds lowers the price of its hamburgers, you should understand why the volume
they sell increases. Many universities want to fill up their football stadiums. You should see
why low ticket prices for football games might help them to do this. If the government wants
to cut the smoking rate in a country, you should see why raising prices through taxation might
be advantageous.

But in many situations, knowing the direction of a change is not enough. What we really need
to know to help us make the right decisions is how big market reactions are.

How many more fans would come to a football game if the price were lowered?
For profit-making firms, knowing the quantity that would be sold at a lowered price is key to
their ability to increase profits. Should McDonald’s lower the price of its Big Mac? For
McDonald’s, the answer depends on how many more hamburgers will be sold at the lower
prices.

How many potential new smokers will be deterred from smoking by higher cigarette prices the
government tax has induced?
Questions such as these lie at the core of economics. To answer these questions, we need to
know the magnitude of market responses. general concept used to quantify the response in one
variable when another variable changes.
Economists commonly measure market responsiveness using the concept of 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
Price Elasticity of Demand
Slope and Elasticity

Slope Is Not a Useful Measure of Responsiveness

Changing the unit of measure from pounds to ounces changes the numerical value of the demand
slope dramatically, but the behavior of buyers in the two diagrams is identical.
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
quantity demanded to changes in price.

% change in quantity demanded

price elasticity of demand =
% change in price

Percentage changes should always carry the sign (plus or minus) of the change.
Positive changes, or increases, take a (+). Negative changes, or decreases, take a (-).
The law of demand implies that price elasticity of demand is nearly always a negative
number: Price increases (+) will lead to decreases in quantity demanded (-), and vice
versa. Thus, the numerator and denominator should have opposite signs, resulting in a
negative ratio.
Types of Elasticity

perfectly inelastic demand Demand in which quantity demanded does not respond at
all to a change in price.

perfectly elastic demand Demand in which quantity drops to zero at the slightest
increase in price.
Perfectly Inelastic and Perfectly Elastic Demand Curves
Left panel shows a perfectly inelastic demand curve for insulin.
Price elasticity of demand is zero.
Quantity demanded is fixed; it does not change at all when price changes.
Right panel shows a perfectly elastic demand curve facing a wheat farmer.
A tiny price increase drives the quantity demanded to zero.
In essence, perfectly elastic demand implies that individual producers can sell all they want at the
going market price but cannot charge a higher price.
A good way to remember the difference between the two perfect elasticities is
elastic demand A demand relationship in which the percentage change in quantity
demanded is larger than the percentage change in price in absolute value (a demand
elasticity with an absolute value greater than 1).

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.

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).

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.
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

% change in quantity demanded = 100%
Q1
Q2 − Q1
= 100%
Q1
We can calculate the percentage change in price in a similar way. Once again, let us use
the initial value of P—that is, P1—as the base for calculating the percentage. By using
P1 as the base, the formula for calculating the percentage of change in P is

change in price
% change in price = 100%
P1
P2 − P1
= 100%
P1
Elasticity Is a Ratio of Percentages

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

% change in quantity demanded

price elasticity of demand =
% change in price
Refering to the figure below, find the price elasticity of demand
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.
Point Elasticity

point elasticity A measure of elasticity that uses the slope measurement.

We have defined elasticity as the percentage change in quantity demanded divided by

the percentage change in price. We can write this as

Q
Q1
P
P1

Where ∆ denotes a small change and Q1 and P1 refer to the original price and quantity
demanded.
This can be rearranged and written as

Q P1

P Q1

Notice that ∆Q/∆P is the reciprocal of the slope.

Elasticity Changes Along a Straight-Line Demand Curve
Demand Schedule for Office Dining Demand Curve for Lunch at the Office Dining Room
Room Lunches

Price Quantity
(per Demanded
Lunch) (Lunches per Month)
$11 0
10 2
9 4
8 6
7 8
6 10
5 12
4 14
3 16
2 18
1 20
0 22

To calculate price elasticity of demand between points A and B on the demand curve, first calculate
the percentage change in quantity demanded:
4−2 2
% change in quantity demanded = 100% = 100% = 66.7%
(2 + 4) / 2 3
Elasticity Changes Along a Straight-Line Demand Curve
Demand Schedule for Office Dining Demand Curve for Lunch at the Office Dining Room
Room Lunches

Price Quantity
(per Demanded
Lunch) (Lunches per Month)
$11 0
10 2
9 4
8 6
7 8
6 10
5 12
4 14
3 16
2 18
1 20
0 22

Next, calculate the percentage change in price:

9 − 10 −1
% change in price = 100% = 100% = −10.5%
(10 + 9) / 2 9.5
Elasticity Changes Along a Straight-Line Demand Curve
Demand Schedule for Office Dining Demand Curve for Lunch at the Office Dining Room
Room Lunches

Price Quantity
(per Demanded
Lunch) (Lunches per Month)
$11 0
10 2
9 4
8 6
7 8
6 10
5 12
4 14
3 16
2 18
1 20
0 22

Finally, calculate elasticity:

66.7%
elasticity of demand = = −6.33
− 10.5%
Elasticity Changes Along a Straight-Line Demand Curve
Demand Schedule for Office Dining Demand Curve for Lunch at the Office Dining Room
Room Lunches

Price Quantity
(per Demanded
Lunch) (Lunches per Month)
$11 0
10 2
9 4
8 6
7 8
6 10
5 12
4 14
3 16
2 18
1 20
0 22

Between points A and B, demand is quite elastic at −6.33.

Between points C and D, demand is quite inelastic at −.294. (You can work this number out for
yourself using the midpoint formula.)
 Point Elasticity Changes Along a Demand Curve

Again, it is useful to keep in mind the underlying economics as well as the mathematics. At high prices
and low quantities, it is easy to make a big impact on the level of sales. At low prices, appreciably
increasing restaurant volumes is much harder. For businesses, this is an important point to keep in mind.
Elasticity and Total Revenue

In any market, P × Q is total revenue (TR) received by producers:

TR = P × Q
total revenue = price × quantity

When price (P) declines, quantity demanded (QD) increases. The two factors, P and QD,
move in opposite directions:

effects of price changes P → QD 

on quantity demanded: and
P → QD 
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.

effect of price increase on

a product with inelastic demand:  P  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.

effect of price increase on

a product with elastic demand:  P  QD  = TR 
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  QD  = TR 

When demand is inelastic, a cut in price reduces total revenues:

effect of price cut on a product

with inelastic demand:  P  QD  = TR 
 The Determinants of Demand Elasticity

We have begun to see how important elasticity is to decision making, but what
determines elasticity? Why do you think the demand for oil is inelastic and the demand
for bananas elastic?

Availability of Substitutes
Perhaps the most obvious factor affecting demand elasticity is the availability of
substitutes. For example, the demand for oil is inelastic in large measure because of
the lack of substitutes. Most automobiles, millions of homes, and most industries use
petroleum products.

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. For example, if you pick up a pack of mints once in a while, you
might not notice an increase in price from 25 cents to 35 cents. Yet this is a 40 percent
increase in price (33.3 percent using the midpoint formula).
The Determinants of Demand Elasticity

Luxuries versus Necessities

Luxury goods, like yachts, tend to have relatively elastic demand, while necessities,
like food, have inelastic demand. It is easy to give up owning a yacht (at least for most
people) when the price rises, but few of us can give up food.

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.
Who Are the Elastic Smokers?

Many people would argue that because more young people are new smokers and
because they have less money than adults, their demand for cigarettes would be more
elastic.
On the other hand, if peer pressure favors smoking, this could lower demand elasticity
for youths.

THINKING PRACTICALLY
1. Cigarette taxes help discourage smoking and also raise revenue for states.
How does elasticity affect each of these?
Other Important Elasticities

Income Elasticity of Demand

income elasticity of demand A measure of the responsiveness of demand to changes

in income.

% change in quantity demanded

income elasticity of demand =
% change in income

Inferior goods: E < 0

Normal goods: E > 0
Luxury goods: E > 1
Other Important Elasticities

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.

% change in quantity of Y demanded

cross - price elasticity of demand =
% change in price of X

Complementary goods: E < 0

Substitute goods: E > 0
No relationship: E = 0
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

elasticity of labor supply A measure of the response of labor supplied to a change in

the price of labor.

% change in quantity of labor supplied

elasticity of labor supply =
% change in the wage rate