PART I Introduction to Economics
CASE FAIR OSTER
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Prepared by: Fernando Quijano & Shelly Tefft
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PART I Introduction to Economics
Elasticity
CHAPTER OUTLINE
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
PART I Introduction to Economics
The Determinants of Demand Elasticity
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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
Appendix: Point Elasticity
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PART I Introduction to Economics
elasticity A general concept used to quantify the
response in one variable when another variable changes.
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%A
elasticityofAwithrespecttoB
%B
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Price Elasticity of Demand
PART I Introduction to Economics
Slope and Elasticity
FIGURE 5.1 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.
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Price Elasticity of Demand
Slope and Elasticity
PART I Introduction to Economics
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.
price elasticity of demand
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% change in quantity demanded
% change in price
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Price Elasticity of Demand
Types of Elasticity
perfectly inelastic demand Demand in which
quantity demanded does not respond at all to a
change in price.
PART I Introduction to Economics
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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Price Elasticity of Demand
PART I Introduction to Economics
Types of Elasticity
FIGURE
5.2 shows
Perfectly
Inelastic and
Perfectly
Elasticcurve
Demand
Figure
5.2(a)
a perfectly
inelastic
demand
for Curves
insulin. Price elasticity of demand is
zero. Quantity demanded is fixed; it does not change at all when price changes.
Figure 5.2(b) 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.
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Price Elasticity of Demand
Types of Elasticity
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).
PART I Introduction to Economics
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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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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Price Elasticity of Demand
Types of Elasticity
PART I Introduction to Economics
A warning:
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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.
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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:
% changeinquantitydemanded
changeinquantitydemanded
x100%
Q
1
Q Q
x100%
Q
2
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Calculating Elasticities
Calculating Percentage Changes
We can calculate the percentage change in price in a
similar way. Once again, let us use the initial value of
Pthat 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
changeinprice
%changeinprice
x100%
P
PART I Introduction to Economics
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P P
x100%
P
2
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Calculating Elasticities
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:
%changeinquantitydemanded
%changeinprice
PART I Introduction to Economics
priceelasticityofdemand
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Calculating Elasticities
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.
%changeinquantitydemanded
changeinquantitydemanded
x100%
(Q Q )/2
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Q Q
x100%
(Q Q )/2
2
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Calculating Elasticities
The Midpoint Formula
Using the point halfway between P1 and P2 as the base for
calculating the percentage change in price, we get
changeinprice
%changeinprice
x100%
(P P )/2
1
P P
x100%
(P P )/2
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Calculating Elasticities
PART I Introduction to Economics
The Midpoint Formula
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Calculating Elasticities
Elasticity Changes Along a Straight-Line Demand Curve
PART I Introduction to Economics
TABLE 5.2 Demand Schedule
for Office Dining
Room Lunches
Price
(per
Lunch)
Quantity
Demanded
(Lunches per Month)
$11
10
9
8
7
6
5
4
3
2
1
0
0
2
4
6
8
10
12
14
16
18
20
22
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FIGURE 5.3 Demand Curve for Lunch at the Office Dining Room
Between points A and B, demand is quite elastic at -6.4.
Between points C and D, demand is quite inelastic at -.294.
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Calculating Elasticities
Elasticity and Total Revenue
In any market, P x Q is total revenue
(TR) received by producers:
PART I Introduction to Economics
TR = P x Q
total revenue = price x quantity
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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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Calculating Elasticities
Elasticity and Total Revenue
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.
PART I Introduction to Economics
effect of price increase on
a product with inelastic demand:
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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.
effect of price increase on
a product with elastic demand:
P x QD TR
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Calculating Elasticities
Elasticity and Total Revenue
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
PART I Introduction to Economics
When demand is inelastic, a cut in price reduces total
revenues:
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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.
PART I Introduction to Economics
The Time Dimension
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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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E C O N O M I C S I N PRAC TI C E
Elasticities at a Delicatessen in the Short Run and Long Run
The graph shows the expected
relationship between long-run
and short-run demand for
Franks sandwiches.
PART I Introduction to Economics
Notice if you raise prices above
the current level, the expected
quantity change read off the
short-run curve is less than that
from the long-run curve.
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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
% change in income
PART I Introduction to Economics
income elasticity of demand
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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
% change in price of X
PART I Introduction to Economics
cross - price elasticity of demand
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Other Important Elasticities
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.
%changeinquantitysupplied
%changeinprice
PART I Introduction to Economics
elasticityofsupply
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Other Important Elasticities
Elasticity of Supply
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
% change in the wage rate
PART I Introduction to Economics
elasticity of labor supply
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CHAPTER 5 APPENDIX
Point Elasticity (Optional)
PART I Introduction to Economics
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
Q
100
%Q
Q P1
Q1
Q
elasticity
%P P 100 P P Q1
P
P1
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CHAPTER 5 APPENDIX
Point Elasticity (Optional)
Q/P is the reciprocal of the slope of the curve.
Slope in the diagram is constant along the curve, and
it is negative. To calculate the reciprocal of the slope
to plug into the previous elasticity equation, we take
Q1B, or M1, and divide by minus the length of line
segment CQ1. Thus,
Q M 1
P CQ1
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Because the length of CQ1 is equal to P1, we can write
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Q M 1
P P1
By substituting we get
M 1 P1 M 1 P1
M1
elasticity
P1 Q1 P1 M 2 M 2
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CHAPTER 5 APPENDIX
Point Elasticity (Optional)
PART I Introduction to Economics
FIGURE 5A.2 Point
Elasticity Changes Along
a Demand Curve
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