Chapter 5

PowerPoint Slides prepared by:
Andreea CHIRITESCU
Eastern Illinois University
PowerPoint Slides prepared by:
Andreea CHIRITESCU
Eastern Illinois University
Elasticity
CHAPTER
1© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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Price Elasticity of Demand
• Elasticity
–Sensitivity of one market variable to
another
• Slope = ΔP/ΔQD
–Not a measure of price sensitivity of
demand
• Depends on the arbitrary units of
measurement
• Doesn’t tell us the significance of ΔP or ΔQD
2
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as

• Price elasticity of demand (ED)
–Sensitivity of quantity demanded to price
–Percentage change in quantity demanded
caused by a 1 percent change in price
–The greater the elasticity value the more
sensitive quantity demanded is to price
3
%
%
%
%
D
D
Q
E
P



Change in Quantity Demanded
Elasticity of Demand =
Change in Price

• Midpoint formula, percentage change in a
variable
• Change in the variable divided by the average
of the old and new values
• When calculating elasticity values from data
on prices and quantities
4
 
 
 
 
1 0
1 0
1 0
1 0
%
2
%
2
Change in Price =
Change in Quantity Demanded =
P P
P P
Q Q
Q Q

 
 
 

 
 
 

Figure
Using the Midpoint Formula for Elasticity
5
1
Quantity of
Avocados per Week
Price per
Avocado
$1.00
$1.50
4,500 5,500
D
A
B
1. Using the midpoint
formula, the
percentage drop in
price is $0.50/$1.25 =
0.40 or 40% …
2. and the percentage rise in quantity
is 1,000 / 5,000 = 0.2 or 20%.
3. Elasticity of demand for
the move from A to B is
20% / 40% = 0.5

Categorizing Demand
• Inelastic demand
–ED between 0 and 1
–Quantity demanded is relatively insensitive
to price changes
• Elastic demand: ED > 1
–Quantity demanded is relatively sensitive
to price changes
• Unit elastic demand: ED = 1
–Quantity demanded changes by the same
percentage as the price
6

Categorizing Demand
• Perfectly inelastic demand
–ED = 0
–Vertical demand curve
• Perfectly (infinitely) elastic demand
–ED approaching infinity
–Horizontal demand curve
7

Figure
Categories of Demand Behavior (a, b)
8
2
(a) Inelastic Demand (ED < 1) (b) Elastic Demand (ED > 1)
Q
P
95 105
Price rises by 20%
D
Quantity falls
by less than 20%
$11
9
Q
P
Price rises by 20%
D
85 115
Quantity falls
by more than 20%
$11
9

Figure
Categories of Demand Behavior (c, d, e)
9
2
(c) Unit-Elastic
Demand (ED = 1)
(e) Perfectly Elastic
Demand (ED = ∞)
Q
P
90 110
Price rises by 20%
D
Quantity falls by 20%
$11
9
(d) Perfectly Inelastic
Demand (ED = 0)
Q
P
9
$11
D
100
Price rises
Quantity doesn’t change
Q
P
Consumers will buy
any quantity at $9,
none at a higher
price
D
$9

Straight-Line Demand Curves
• Straight-line demand curve
–Demand becomes less elastic (ED gets
smaller)
• As we move downward and rightward
–Slope of demand is constant
10

Figure
How Elasticity Changes along a Straight-Line Demand Curve
11
3
Quantity of
Laptops
Price
1,500
$2,000
5,000 15,000
Each time P
drops by
another $500,
the percentage
drop is larger.
Each time Q rises by another 10,000, the
percentage rise is smaller.
D
A
1,000
35,00025,000
C
B
Elasticity falls as we
move rightward along a
straight-line demand
curve.

Elasticity and Total Revenue
• Total revenue (TR = P ˣ Q)
–Price per unit (P) times quantity (Q)
–The area of a rectangle with height equal
to price and width equal to quantity
demanded
• A price increase
–Inelastic demand, ED < 1, then TR ↑
–Elastic demand, ED > 1, then TR ↓
–Unit elastic demand, ED = 1, then TR
doesn’t change
12

Figure
In panel (a), demand is inelastic, so a rise in price causes total revenue to increase. Specifically,
at a price of $9 (point A), total revenue is $9 × 105 = $945. When price rises to $11 (point B),
total revenue increases to $11 × 95 = $1,045. In panel (b), demand is elastic, so a rise in price
causes total revenue to decrease. Specifically, at a price of $9 (point A), total revenue is $9 ×
115 = $1,035. When price rises to $11 (point B), total revenue falls to $11 × 85 = $935.
Elasticity and Total Revenue
13
4
Q
P
D
Q
P
D
B
95 105
$11
9
$11
85 115
9A A
B
(a) Inelastic Demand (b) Elastic Demand

Table
Effects of Price Changes on Revenue
14
1

Determinants of Elasticity
• Availability of substitutes
–Close substitutes are available for a
product
–More elastic demand
• Necessities versus luxuries
–Necessities tend to have less elastic
demand than luxuries
• Importance in buyers’ budgets
–Larger proportion of families’ budgets
–More elastic demand
15

Table
Some Short-Run Price Elasticities of Demand
16
2

Determinants of Elasticity
• Time horizon
–The longer the time horizon, the more
elastic the demand
• Short-run elasticity
–Measured just a short time after a price
change
• Long-run elasticity
–Measured a year or more after a price
change
–Larger than short-run elasticity
17

Table
Short-Run versus Long-Run Elasticities
18
3

Table
Adjustments After a Rise in the Price of Gasoline
19
4

Figure
When the price of gasoline rises by $1, the decrease in quantity demanded (and the price
elasticity of demand) depends on how long we wait before measuring buyers’ response. If we
waited just a few months after the price change, we’d move along demand curve DSR, from point
A to point B. If we waited a year or longer, we’d move from point A to point E along demand
curve DLR, with quantity demanded falling even more.
Short-Run versus Long-Run Price Elasticity of Demand
20
5
Quantity of Gasoline (millions of
gallons per day)
Price per
gallon
2.00
$3.00
320 400
DSR
B
DLR
A
360
E

Elasticity and Mass Transit
• Elasticity and mass transit
–Inelastic demand
• Both short and long run
–A rise in fares would likely raise mass-
transit revenue for a city
–Why cities don’t raise fares:
• Elasticity estimates come from past data
• Want to provide affordable transportation,
reduce traffic congestion on city streets, and
limit pollution
21

Price Elasticity of Supply
• Price elasticity of supply
–Percentage change in quantity supplied
caused by a 1 percent change in its price
–Sensitivity of quantity supplied to price
changes
• As we move along the supply curve
22
%
%
%
%
S
Q
P


Change in Quantity Supplied
Elasticity of Supply =
Change in Price
Elasticity of Supply =

Determinants of Supply Elasticity
• Easier to find alternatives in production
–The more elastic the supply
• The narrow the market definition
• The longer the time horizon
• Long-run supply elasticities are greater
than short-run supply elasticities
23

Figure
When the price of corn rises from $4.50 to $5.50 per bushel, the increase in quantity supplied (and the
price elasticity of supply) depends on how long we wait before measuring the response. If we wait just
a few months after the price change, we’d move along supply curve SSR, from point A to point B. If we
wait a year or longer, we’d move along supply curve SLR, from point A to point C. The same rise in
price causes a greater increase in quantity supplied after a year or longer, because farmers can make
further adjustments in quantity supplied if given more time.
Short-Run versus Long-Run Price Elasticity of Supply
24
6
Quantity (millions of bushels per week)
Price per
bushel
4.50
$5.50
190
SSR
210 230
B
SLR
A
C

Income Elasticity of Demand
• Income elasticity of demand
–The percentage change in quantity
demanded caused by a 1 percent change
in income
–Relative shift in the demand curve
–Is > 0 for normal goods
–Is < 0 for inferior goods
25
%
%
Change in Quantity Demanded
Income elasticity =
Change in Income

Cross-Price Elasticity of Demand
• Cross-price elasticity of demand
–The percentage change in the quantity
demanded of one good (X)
• Caused by a 1 percent change in the price of
another good (Z)
–If > 0 → substitutes
–If < 0 → complements
26
%
%
Change in Quantity Demanded of X
Change in Price of Z

The war on drugs:
should we fight supply or demand?
• Every year, the U.S. government
–Sends about $10 billion intervening in the
market for illegal drugs
• Most of this money is spent on efforts to
restrict the supply of drugs
27

Figure
Panel (a) shows the market for heroin in the absence of government intervention. Total
expenditures—and total receipts of drug dealers—are given by the area of the shaded
rectangle. Panel (b) shows the effect of a government effort to restrict supply: Price rises, but
total expenditure increases. Panel (c) shows a policy of reducing demand: Price falls, and so
does total expenditure.
The War on Drugs
28
7
Quantity
Price
per
unit
P1
(a)
D1
Quantity
Price
per
unit
(b)
D1
Quantity
Price
per
unit
P1
(c)
D1
S1
A
P1
S1
A
S2
B
P2
Q2 Q1Q1 Q1
D2
S1
C
Q3
P3
A

The war on drugs:
• No government intervention
–Equilibrium: P1, Q1
–Total revenue by sellers = Total
expenditure by buyers: P1 ˣ Q1
29

The war on drugs:
• Decreasing Supply
–Vigilant customs inspections; arrest and
stiff penalties for drug dealers; efforts to
reduce drug traffic
–Equilibrium: Higher price P2, Lower
quantity Q2
–Demand: very price inelastic
expenditure by buyers = Higher, P2 ˣ Q2
30

The war on drugs:
• Decreasing Demand
–Stiffer penalties on drug users; heavier
advertising against drug use; greater
availability of treatment centers for addicts;
more effort against drug retailers
–Equilibrium: Lower price P3, Lower
quantity Q3
expenditure by buyers = Lower, P3 ˣ Q3
31

Forecasting Price in an Oil Crisis
• Oil supply disruptions
–Increased output by other producers (due
to the rise in oil’s price or a decision by
OPEC) offset some of the lost production
• What if a major supply disruption occurred
–And only a price hike could restore the
market to equilibrium?
–Elasticity
32

Table
Oil Supply Disruptions
33
5

• Initial equilibrium
–Price = $100 per barrel
–Quantity = 90 million barrels per day
• Suppose that 9 million barrels of oil were
temporarily removed from the market
–The supply curves shift leftward
–Excess demand of 9 million barrels at the
original price
–The price will rise to restore market
equilibrium
34

• Very elastic supply and demand in the
short run (unrealistic)
–Only a relatively small price increase is
needed to increase quantity supplied and
decrease quantity demanded
• Very inelastic supply and demand in the
short run (realistic)
–A much larger price increase is needed to
restore market equilibrium
35

Figure
If either supply or demand is very elastic, only a relatively small price increase will be needed to restore
equilibrium after decrease in supply. Panel (a) illustrates the case in which both supply and demand are
very elastic. The leftward shift in the supply curve causes equilibrium price to rise from $100 to $102.50.
Panel (b) has the same leftward shift in the supply curve, but with much less elastic supply and demand. A
much larger rise in price (from $100 to $211) is needed to restore equilibrium after the decrease in supply.
A Decrease in Oil Supply: Elastic versus Inelastic Demand
36
8
Barrels per Day (millions)
Price per
Barrel
(a)
D
Barrels per Day (millions)
Price per
Barrel
(b)
D
$100.00
S1
A$102.50
90
S2
B
81
$100.00
S1
$211.00
90
S2
A
B
81

Spikes in Food Prices
• From mid-2010 to mid-2011
–Prices for wheat, corn, soybeans, sugar,
and other food crops spiked around the
world
–Increase in demand
–Decrease in supply
• Bad weather for crops in several parts of the
world
37

Spikes in Food Prices
• Demand is inelastic
–Staples like wheat or corn are commonly
regarded as necessities
–In large parts of the world only a small
percentage of income is spent on these
foods
• Supply is inelastic (in the short run)
–Farm output depends on
• Planting decisions made many months earlier
• Weather conditions while crops are growing
38

Figure
When the supply of wheat decreased from mid-2010 to mid-2011, creating an excess demand
at the original price of $4.16 per bushel, the price spiked upward. A large price rise was needed
to eliminate the excess demand because both the supply and the demand for wheat are so
inelastic in the short run.
Bad Weather and Food Prices with Inelastic Supply and
Demand
39
9
Quantity of wheat (millions
of bushels per month)
Price per
Bushel
D
$4.16
S2010
$8.16
Q1
S2011
A
B
Q2

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