Chapter 4:

Elasticity
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Learning Objectives
1. Define price elasticity of demand
Explain

its determinants

2. Calculate price elasticity of demand

3. Understand how changes in price affect
total revenue
Relate

to price elasticity of demand

4. Define cross-price elasticity and income

elasticity
5. Define price elasticity of supply
Explain

what determines this elasticity

6. Calculate price elasticity of supply

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Drug Enforcement and Local Theft

Hypothesis
Drug

users steal to buy drugs

Increasing drug enforcement will decrease
theft

Analysis
Increased

enforcement reduces supply of

drugs

Price of drugs increases

Quantity demanded decreases

Is

this policy successful in decreasing the

prevalence of theft?
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Drug Enforcement and Local Theft

Theft

goes down ONLY IF total expenditures on

drugs decreases

Meaning the amount of crime that drug users

commit depends not on the quantity of drugs they
consume but rather on their total expenditures
How responsive is quantity demanded to price?

Total
expenditures on
drugs increased
rather than
decreased!
Expect more
crime
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Elasticity
It is a measure of responsiveness
of one variable to a change in an
another variable
Slope

measures a form of
responsiveness
But if a different unit is used then the
value of the slope is different which
biases the magnitude of the response

Elasticity corrects for this issue

Unit

choice does not change the value

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Price Elasticity of Demand

Price elasticity of demand
Percentage

change in quantity
demanded from a 1% change in price
Measure of responsiveness of quantity
demanded to change in price

Example:

Price

of beef decreases 1%
Quantity of beef demanded
increases 2%
Price elasticity of demand is 2
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Calculate Price Elasticity of Demand

Symbol for elasticity is
Lower

case Greek letter epsilon

For small percentage changes in

pricePercentage change in quantity demanded
=

Percentage change in price

Price elasticity of demand is always negative

Ignore the sign
Focus on the value
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Elastic Demand
Price Elasticity of Demand
Unit elastic

Elastic

Inelastic

If price elasticity is greater than 1, demand

is elastic
Percentage

change in quantity demanded is

greater than percentage change in price
Quantity demanded is responsive to price
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Inelastic Demand
Price Elasticity of Demand
Unit elastic

Elastic

Inelastic

If price elasticity is less than 1, demand is

inelastic
Percentage

change in quantity demanded is less

than percentage change in price
Quantity demanded is not very responsive to price
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Unit Elastic Demand

Price Elasticity of Demand
Unit elastic

Elastic

Inelastic

If price elasticity is 1, demand is unit

elastic
Price

and quantity demanded change by

the same percentage
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Example: Demand for Pizza

Old

New

% Change

Price

$1.00

$0.97

3%

Quantity

400

404

1%

=
=

Percentage change in quantity demanded

Percentage change in price
1%
3%

= 0.33

Demand is inelastic

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11

Determinants of Price Elasticity of

Demand

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12

Examples of Elasticities
Green peas
Restaurant
meals
Shoes
Coffee

2.80

Automobiles
Foreign air
travel

1.35

Movies
Theater, opera

0.87
0.18

1.63
0.70
0.25

0.77

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13

Price Elasticity Notation

Percentage change in quantity demanded

Percentage change in price

Q is the change in quantity

Q

/ Q is percentage change in
quantity

P is change in price
P

/ P is percentage
in price
Q / change
Q
=
P / P

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14

Price Elasticity: Graphical View

=
=
=

P / P
Q
Q
P
Q
P
Q

x
x
x

Price

Q / Q

P
Q

P
P
PP

Q
D

P
1
slope

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Q Q+Q
Quantity

15

Price Elasticity: Graphical View

1
slope

At point A
P = 28
Q=3
Slope = 20 / 5 = 4

28
3

1
4

Price

28
P
8

= 2.33

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Q
D

Quantity

16

Price Elasticity and Slope

When two demand
curves cross

At

P / Q is same for
both curves
(1 / slope) is
smaller for the
steeper curve

the common
point demand
is less elastic
for the steeper
curve

12
D1
Price

Less Elastic
More Elastic

6
4

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D2

6
Quantity

12

17

Price Elasticity on a Straight-Line

Demand Curve
Price elasticity is different at each
point
P
1
=

Slope

slope

is the same for the demand

curve
P/Q decreases as price goes down
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quantity
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18

Price Elasticity Pattern

Price elasticity changes systematically as
price goes down
At high P and low Q, P /
Q is large
Demand is elastic

At the midpoint,
demand is unit elastic
At low P and high Q,
P / Q is small

Price

1
1

a/2

Demand is
inelastic
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b/2
Quantity

19

Two Special Cases

Perfectly Elastic Demand
Infinite price elasticity of
demand
Price

Perfectly Inelastic
Demand
Zero price elasticity of
demand
Price
D

Quantity
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Quantity
20

The Midpoint Formula for Elasticity

of Demand
Elasticity is different at
each point on the demand
curve
Compare 2 points
Answer

depends on which
point is the starting point

Start at A and elasticity is 2

Start at B and elasticity is 1

more stable solution is

needed

4
3

Use the midpoint formula

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A
B

P
Q

Q
21

The Midpoint Formula for Elasticity

of Demand
Midpoint formula
Use

average quantity in the numerator

Use average price in the denominator

=
=

Q / [(QA + QB)/2]
P / [(PA + PB)/2]

Q / (QA + QB)
P / (PA + PB)

4
3

Elasticity using midpoint

formula is 1.40
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A
B

P
Q

Q
22

Elasticity and Total Expenditure

When price increases, expenditures can
increase, decrease or remain the same
The

change in expenditures depends on elasticity

Terminology: total expenditures = total

revenue
Calculated

as P x Q

Graphing idea: total

expenditures is the area
of a rectangle with height P
and width Q
Example:

Price

Expenditures = 8

P = 2 and

Q=4
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D
4

Quantity
23

Price Elasticity and Total Expenditure

Movie ticket price increases from $2 to $4
A

and B are both below the midpoint of the

curve
Inelastic portion of the demand curve

Total

Price ($/ticket)

12

revenue increases when price increases

12

Expenditure =
$1,000/day

Price ($/ticket)

2
5

Quantity (00s of tickets/day)

Expenditure =
$1,600/day
B

Quantity (00s of tickets/day)

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Price Elasticity and Total Expenditure

Movie ticket price increases from $8 to $10
Prices

are both above the midpoint of the curve

Elastic portion of the demand curve

Total

revenue decreases when price increases

Y Expenditure =
$1,600/day
D
2

Price ($/ticket)

Price ($/ticket)

12

12
10

Quantity (00s of tickets/day)

Expenditure =
$1,000/day

Quantity (00s of tickets/day)

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Price Changes and Total Expenditure

Changes
Price
Quantity

$10

$8

$6

$4

$2

$0

1,000

2,000

3,000

4,000

5,000

6,000

$0

$10,0
00

$16,0
00

$18,0
00

$16,0
00

$10,0
00

$0

Total expenditure ($/day)

Expenditur
e

$12

12
Price ($/ticket)

10
8
6
4
2
1
2
3
4
5
6
Quantity (00s of tickets/day)

18,000
16,000

10,000

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6
Price ($/ticket)

10
26

Elasticity, Price Change, and

Expenditures

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Cross-Price Elasticity of Demand

Substitutes and complements affect
demand
Cross-price elasticity of demand
Percentage

change in quantity demanded

of good A from a 1 percent change in the
price of good B

Sign of cross-price elasticity shows

relationship between the goods:
Focus

on sign and value

Complements have negative cross-price

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28

Income Elasticity of Demand

Income elasticity of demand
Percentage

change in quantity
demanded from a 1 percent change in
income

Income elasticity of demand can

be positive or negative
Focus

on sign and value

Normal goods have a positive income

elasticity
Inferior goods have a negative income
elasticity
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29

Price Elasticity of Supply

Price elasticity of supply
Percentage

change in quantity
supplied from a
1 percent change in price
Always positive
Focus on intercept
Q / Q
Price elasticity of supply =

Price elasticity of supply =

P
Q

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P / P

1
slope
30

Price Elasticity of Supply

S
B

10
8

Price

If supply curve has a

positive intercept
Price elasticity of supply
decreases as Q
increases
Graph shows
Slope = 2
At A, P = 8 and Q = 2
Price elasticity of
supply
= (8 / 2) (1 / 2) = 2.00
At B, P = 10 and Q = 3
Price elasticity of
supply
= (10 / 3) (1 / 2) =

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Quantity
31

Price Elasticity of Supply

S
B

5
4

Price

If supply curve has a zero

intercept
Price elasticity of supply
is 1.00
Graph shows
Slope = 1 / 3
At A, P = 4 and Q = 12
Price elasticity of
supply
= (4 / 12) (3) = 1.00
At B, P = 5 and Q = 15
Price elasticity of
supply
= (5 / 15) (3) = 1.00

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A
Q

12

15

Quantity
32

Perfectly Inelastic Supply

Zero price elasticity
of supply
No response to
change in price
Price
S

Example: Land in
Cairo
Supply is
completely fixed
Any one-of-a-kind
item has perfectly
inelastic supply
Work of art (Mona
Lisa)
Hope Diamond

Quantity
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33

Perfectly Elastic Supply

Infinite price elasticity of
supply
Sell all you can at a
fixed price
Price

Inputs purchased at a
constant price
No volume discounts
Constant proportions of
production
Lemonade example
Cost of production is
14 at all levels of Q
Marginal cost
P = 14

Quantity
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Determinants of Price Elasticity of

Supply

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Supply Bottleneck: Unique Inputs

Over time, most producers develop
alternative production methods and
a variety of input choices
The

more flexible the production

process is, the more elastic supply is

When production relies on a single

input, supply is highly inelastic
No

alternatives to singular talent

Sports stars building a winning team

Actors and musicians
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36