Elasticity

CASE STUDY
 
HOW MUCH TUITION FOR COLLEGE
STUDENTS?
The board of trustees of a leading private college is faced with a critical financial
problem. At present tuition rates, the college is losing Rs. 75 lakhs per year. The
chairman of the college, a well-known biologist, urges that tuition be raised by Rs.
750 over the present Rs. 3,000 rate- a 25 percent increase. Based on the 10,000
students now attending the school, he projects that this increase would cover the Rs.
75 lakhs shortfall in revenues.
 
Student leaders protest that they cannot afford a tuition hike, but the chairman
responds that the only alternative is to cut back significantly on programs and
faculty. The faculty supports the tuition increase as a means of preserving their jobs.
 
The students quickly realize that any appeal that involves compassion for their plight
is likely to fall on deaf ears. Their only hope is to demonstrate that the tuition hike is
not in the best interest of the college. What can they do?
 Solution
The college administration sees a tuition increase as a means of
increasing total revenue. The board of trustees is likely to reject
the administration’s proposal only if the students can demonstrate
that it would not achieve this purpose.
 
As part of a term paper, an economics honors student discovers a journal
article that discusses the price elasticity of demand for a college education.
The author of the article estimates that the elasticity for enrollment at the
college is – 1.3 with respect to tuition changes. That is, a 1 percent increase
in tuition fees would decrease enrollments by 1.3 percent. The data are
current and the paper was written by a highly respected scholar.
 
Based on the elasticity estimate from the paper, the students calculate that
the proposed tuition hike of 25 percent would decrease enrollment by 32.5
percent, or nearly 3,300 students. This would result in a decrease in total
revenue from Rs. 3 crores at present (i.e., Rs. 3,000 x 10,000) to about Rs.
2.5 crores after the tuition increase (i.e. Rs. 3,750 x 6,700).
 
Faced with this startling information, the board of
trustees asks the college chairman if the cost savings
from fewer students would compensate for the revenue
drop. The chairman replies that most of the college’s
costs are independent of enrollment and, hence, there
would not be a significant cost saving. By a unanimous
vote, the board of trustees rejects the tuition increase and
orders the chairman to find some other way to meet the
revenue deficiency.
 Elasticity
• The law of demand tells you that quantity demanded will increase as
price falls, or conversely, that quantity demanded will decrease as
price rises. So, the law of demand says there is an inverse
relationship between price and quantity demanded.
• By contrast, the price elasticity of demand tells you “how much”
quantity demanded changes when price changes. It shows the
responsiveness of a change in quantity demanded to a change in
price.
• elasticity Percentage change in one variable resulting from a 1
percent change (increase/decrease) in another.
 Price Elasticity of Demand
• Measures buyers’ responsiveness to price changes
• Elastic demand
• Sensitive to price changes
• Large change in quantity to a given change in price
• Inelastic demand
• Insensitive to price changes
• Small change in quantity to a given change in price.

LO1 4-8
 Price Elasticity of Demand Formula

• Formula for price elasticity of demand

Ed = Percentage Change in Quantity Demanded of Product X

Percentage Change in Price of Product X

Q / Q PQ
Ep  
P / P QP

LO1 4-9
 Arc Price Elasticity of Demand

• Use the midpoint formula

• Ensures consistent results

Change in quantity Change in price

Sum of quantities/2 Sum of prices/2
Ed = ÷

LO1 4-10
 Price Elasticity of Demand Formula

• Use percentages
• Unit free measure
• Compare responsiveness across
products
• Eliminate the minus sign
• Easier to compare elasticities

LO1 4-11
 Interpretation of Elasticity of Demand

• Ed > 1 demand is elastic

• Ed = 1 demand is unit elastic
• Ed < 1 demand is inelastic
• Extreme cases
• Perfectly inelastic
• Perfectly elastic

LO1 4-12
LINEAR DEMAND CURVE
● linear demand curve Demand curve that is a straight line.

LINEAR DEMAND CURVE Q  a  bP

The price elasticity of
demand depends not only on
the slope of the demand
curve but also on the price
and quantity.
The elasticity, therefore,
varies along the curve as
price and quantity change.
Slope is constant for this
linear demand curve.
Near the top, because price is
high and quantity is small,
the elasticity is large in
magnitude.
The elasticity becomes
smaller as we move down the
curve.
 Price elasticity varies along the linear demand curve (use point elasticity
formula)

Quantity Price
A 0 6
B 100 5
C 200 4
D 300 3
E 400 2
F 500 1
G 600 0
LINEAR DEMAND CURVE

(a) INFINITELY ELASTIC

DEMAND
(a) For a horizontal
demand curve, ∆Q/∆P is
infinite. Because a tiny
change in price leads to
an enormous change in
demand, the elasticity of
demand is infinite.

● infinitely elastic demand Principle that consumers will buy as much of

a good as they can get at a single price, but for any higher price the
quantity demanded drops to zero, while for any lower price the quantity
demanded increases without limit.
LINEAR DEMAND CURVE

(b) COMPLETELY INELASTIC

DEMAND

(b) For a vertical demand

curve, ∆Q/ ∆P is zero.
Because the quantity
demanded is the same no
matter what the price, the
elasticity of demand is zero.

● completely inelastic demand Principle that consumers will buy a fixed

quantity of a good regardless of its price.
 Determinants of Elasticity of Demand
• Substitutability
• More substitutes, demand is more elastic
• Proportion of Income
• Higher proportion of income, demand is more elastic
• Luxuries vs. Necessities
• Luxury goods, demand is more elastic
• Time
• More time available, demand is more elastic

LO1 4-17
 Short-Run versus Long-Run
Elasticities
Demand

(a) GASOLINE: SHORT-RUN AND

LONG-RUN DEMAND CURVES
(a) In the short run, an increase
in price has only a small effect
on the quantity of gasoline
demanded. Motorists may drive
less, but they will not change
the kinds of cars they are
driving overnight.
In the longer run, however,
because they will shift to
smaller and more fuel-efficient
cars, the effect of the price
increase will be larger. Demand,
therefore, is more elastic in the
long run than in the short run.
DEMAND AND DURABILITY

(b) AUTOMOBILES: SHORT-RUN

AND LONG-RUN DEMAND
CURVES
(b) The opposite is true for
automobile demand. If price
increases, consumers initially
defer buying new cars; thus
annual quantity demanded
falls sharply.
In the longer run, however,
old cars wear out and must be
replaced; thus annual quantity
demanded picks up. Demand,
therefore, is less elastic in the
long run than in the short run.
What are the major determinants of price elasticity of
demand? Use those determinants and your own
reasoning in judging whether demand for each of the
following products is probably elastic or inelastic:
•(a) bottled water;
•(b) toothpaste;
•(c) Colgate toothpaste;
•(d) ketchup;
•(e) diamond bracelets;
•(f) Microsoft’s Windows operating system.
Answer:The key determinants of price elasticity are substitutability, proportion
of income; luxury versus necessity, and time.

(a) bottled water. This good is likely elastic because there are a number of
substitutes (water fountains, cans of soda, etc...)

 (b) toothpaste. This good is likely inelastic because there aren't many
substitutes and it is a necessity (in economic terms).

(c) Colgate toothpaste. This specific brand of the good is likely elastic. There are
a number of substitutes for this specific brand of the good.

(d) ketchup. This good is likely inelastic. There aren't many substitutes for
ketchup (for people who like ketchup) and it makes up a small percentage of
income.

(e) diamond bracelets. This good is likely elastic because it is a luxury good and
may make up a large fraction of income (more than ketchup).

(f) Microsoft's Windows operating system. This good is likely inelastic because
there aren't many substitutes for this good and it has become a necessity in a
number of workplaces.
What effect would a rule stating
that university students must live
in university dormitories have on
the price elasticity of demand for
dormitory space? What impact
might this in turn have on room
rates?
Answer: The ruling would make the price
elasticity of demand more inelastic than
if there were no such rule, assuming
that there is not another equivalent
university nearby to which students
could transfer. Although universities
are nonprofit organizations, the rule
would certainly allow them to raise
rates without worrying so much about
students moving out to live elsewhere.
 Total Revenue Test

• Total Revenue = Price X Quantity

• Inelastic demand
• P and TR move in the same direction
• Elastic demand
• P and TR move in opposite directions

LO2 4-24
 Total Revenue Test

• Lower price and elastic demand

• Blue gain exceeds yellow loss
P
$3

a
2

b
1 D1

0 10 20 30 40 Q

LO2 4-25
 Total Revenue Test
• Lower price and inelastic demand
• Yellow loss exceeds blue gain
P
$4 c

d
1
D2
0 10 20 Q

LO2 4-26
 Total Revenue Test
• Lower price and unit elastic demand
• Blue gain equals yellow loss
P
$3 e

f
1
D3

0 10 20 30 Q

LO2 4-27
 Total Revenue Test
Price Elasticity of Demand for Movie Tickets as Measured by the Elasticity
Coefficient and the Total-Revenue Test
(1) (3) (4) (5)
Total Quantity of Elasticity Total Total
Tickets Demanded per (2) Coefficient Revenue Revenue
Week, Thousands Price per Ticket (Ed)(Arc el.) (1) X (2) Test
1 $8
2 7
3 6
4 5
5 4
6 3
7 2
8 1

LO2 4-28
 Total Revenue Test
Price Elasticity of Demand for Movie Tickets as Measured by the Elasticity
Coefficient and the Total-Revenue Test
(1) (3) (4) (5)
Total Quantity of Elasticity Total Total
Tickets Demanded per (2) Coefficient Revenue Revenue
Week, Thousands Price per Ticket (Ed)(Arc el.) (1) X (2) Test
1 $8 $8,000
2 7 5.00 14,000 Elastic
3 6 2.60 18,000 Elastic
4 5 1.57 20,000 Elastic
5 4 1.00 20,000 Unit Elastic
6 3 0.64 18,000 Inelastic
7 2 0.38 14,000 Inelastic
8 1 0.20 8,000 Inelastic

LO2 4-29
 Elasticity and Total Revenue
$8 Elastic
7 a Ed > 1
6 b
5 c Unit Elastic

Price
4 d Ed = 1
3 e Inelastic
2 f Ed < 1
1 g
h D
0 1 2 3 4 5 6 7 8
Quantity Demanded
(Thousands of Dollars)

$20
18
Total Revenue

16
14
12
10
8
6 TR
4
2
0 1 2 3 4 5 6 7 8
Quantity Demanded
LO2 4-30
Summary of Price Elasticity of Demand
Price Elasticity of Demand: A Summary
Absolute Impact on Total Revenue of a:
Value of
Elasticity
Coefficient Demand Is: Description Price Increase Price Decrease
Greater than 1 Elastic or Qd changes by a Total Revenue Total Revenue
(Ed > 1) relatively larger decreases increases
elastic percentage than
does price
Equal to 1 Unit or unitary Qd changes by Total revenue Total revenue
(Ed = 1) elastic the same is unchanged is unchanged
percentage as
does price
Less than 1 Inelastic or Qd changes by a Total revenue Total revenue
(Ed < 1) relatively smaller increases decreases
inelastic percentage than
does price

LO2 4-31
Using the demand data given, complete the following table by computing total revenue at
each of the prices. Indicate whether demand is elastic, inelastic, or unitary between each
set of prices.
  Quantity demanded Total revenue Character of
Price demand

$1000 300 $_____  

      __________
900 400 _____  
      __________
800 500 _____  
      __________
700 600 _____  
      __________
600 700 _____  
      __________
500 800 _____  
      __________
400 900 _____  
      __________
300 1000 _____  
      __________
200 1100 _____  
      __________
100 1200 _____  
   Quantity demanded Total revenue Character of
Price demand

$1000 300 $300,000  

      elastic
900 400 360,000  
      elastic
800 500 400,000  
      elastic
700 600 420,000  
      unitary
600 700 420,000  
      inelastic
500 800 400,000  
      inelastic
400 900 360,000  
      inelastic
300 1000 300,000  
      inelastic
200 1100 220,000  
      inelastic
100 1200 120,000  
 Data on T- shirts
• Q=1500-200P where Q is T-shirt sales and P is Price
1. How many T-shirts could be sold at Rs. 4.50 each?
2. What price would have to be charged to sell 900 T-shirts?
3. At what price would T-shirt sales equal zero?
4. How many T-shirts could be given away?
5. Calculate the point price elasticity of demand at price of Rs. 5?
 T-shirts
1. 600 units
2. Rs. 3
3. P = rs. 7.50
4. 1500 units
5. - 2 (elastic)
 Price Elasticity of Demand
Selected Price Elasticities of Demand
Price Elasticity Price Elasticity
Product or Service of Demand (Ed) Product or Service of Demand (Ed)
Newspapers .10 Milk .63
Electricity (household) .13 Household appliances .63
Bread .15 Liquor .70
MLB Tickets .23 Movies .87
Telephone Service .26 Beer .90
Cigarettes .25 Shoes .91
Sugar .30 Motor vehicles 1.14
Medical Care .31 Beef 1.27
Eggs .32 China, glassware 1.54
Legal Services .37 Residential land 1.60
Automobile repair .40 Restaurant meals 2.27
Clothing .49 Lamb and mutton 2.65
Gasoline .60 Fresh peas 2.83
LO1 4-36
OTHER DEMAND ELASTICITIES

● income elasticity of demand Percentage change in the quantity

demanded resulting from a 1-percent increase in income.

Q / Q I Q
EI  
I / I Q I
● cross-price elasticity of demand Percentage change in the quantity
demanded of one good resulting from a 1-percent increase in the price of
another.
Qb / Qb Pm Qb
EQb Pm  
Pm / Pm Qb Pm
 Income Elasticity of Demand

• Measures responsiveness of buyers

to changes in income
• Normal goods – positive sign
• Inferior goods – negative sign

Percentage change
in quantity demanded
Ei =
Percentage change in income
LO4 4-38
 Income Elasticity Insights

• High income elasticity goods

• Most affected by a recession
• Low or negative income elasticity
goods
• Least affected by a recession

LO4 4-39
 Ex,y and Ei
Cross and Income Elasticities of Demand
Value of
Coefficient Description Type of Good(s)
Cross elasticity: Quantity demanded of W changes in same Substitutes
Positive (Ewz > 0) direction as change in price of Z

Negative (Exy < 0) Quantity demanded of X changes in Complements

opposite direction from change in price of Y

Income elasticity: Quantity demanded of the product changes Normal or superior

Positive (Ei >0) in same direction as change in income

Negative (Ei<0) Quantity demanded of the product changes Inferior

in opposite direction from change in income

LO4 4-40
 Application of price elasticity

• Elasticity and pricing power

• Charge different prices based on
price elasticity
• Examples:
• Business air travelers
• Adult vs. child

4-41
 Applications of Ed

• Large Crop Yields

• Inelastic demand, lower total revenue
• Excise Taxes on cigarettes
• Inelastic demand, more total revenue
• Decriminalization of illegal drugs
• Inelastic demand, more total revenue

LO1 4-42
 Price Elasticity of Supply

• Measures sellers’ responsiveness to price changes

• Percent change in quantity supplied to a percentage
change in price.
• Elastic supply, producers are responsive to price
changes
• Inelastic supply, producers are not responsive to price
changes

LO3 4-43
 Price Elasticity of Supply

• Formula to compute elasticity

• Es > 1 supply is elastic
• Es < 1 supply is inelastic

Percentage Change in Quantity

Supplied of Product X
Es =
Percentage Change in Price
of Product X

LO3 4-44
 Price Elasticity of Supply

• Time is primary determinant of

elasticity of supply
• Time periods considered
• Market period
• Short Run
• Long Run

LO3 4-45
Elasticity of Supply: The Market Period

• Perfectly inelastic supply

Sm

Pm

P0
D2
D1
Q0

LO3 4-46
 Elasticity of Supply: The Short Run
• Supply is more elastic than in short run period

Ss

Ps

P0
D2
D1
Q0 Qs

LO3 4-47
 Elasticity of Supply: The Long Run
• Supply is even more elastic than in the long run than in
the short run

Sl

Pl

P0
D2
D1
Q0 Ql

LO3 4-48
Supply elasticity changes
over time

COPPER: SHORT-RUN AND

LONG-RUN SUPPLY CURVES
Like that of most goods, the
supply of primary copper,
shown in part (a), is more
elastic in the long run.
If price increases, firms
would like to produce more
but are limited by capacity
constraints in the short run.
In the longer run, they can
add to capacity and produce
more.
 Applications of Elasticity of Supply

• Antiques
• Inelastic supply
• Reproductions
• More elastic supply
• Volatile gold prices
• Inelastic supply

LO3 4-50
How would the following changes in price affect total
revenue? That is, would total revenue increase,
decrease, or remain unchanged?
a. Price falls and demand is inelastic.
b. Price rises and demand is elastic.
c. Price rises and supply is elastic.
d. Price rises and supply is inelastic.
e. Price rises and demand is inelastic.
f. Price falls and demand is elastic.
g. Price falls and demand is of unit elasticity.
Answer: When demand is elastic, price and total revenue move in
the opposite direction. This is because the percentage change in
quantity is greater than the percentage change in price. When
demand is inelastic, price and total revenue move in the same
direction because the percentage change in quantity is less than
the percentage change in price.
Supply is a simpler story. Since price and quantity move in the same
direction an increase in price will result in an increase in total
revenue (a higher price and selling more) and a decrease in price
will result in a decrease in total revenue (a lower price and
selling less).
Using these rules, we have the following answers.
 
(a) Total revenue decreases (As the price falls individuals purchase more
of the good. However, the decrease in price on the previous units sold
outweighs the gains from selling more units.)
(b) Total revenue decreases (As the price increases individuals purchase
less of the good reducing total revenue. However, the increase in
price on the previous units sold increases total revenue. Here the loss
in quantity sold outweighs the increase in price effect.)
(c) Total revenue increases
(d) Total revenue increases
(e) Total revenue increases
(f) Total revenue increases
(g) No change. (Here the decrease in total revenue that results from the
decrease in price is offset by the increase in total revenue from
selling more units.)
• In 2006, Willem De Kooning’s abstract painting
Woman III sold for $137.5 million. Portray this
sale in a demand and supply diagram and
comment on the elasticity of supply.
• Comedian George Carlin once mused, “If a
painting can be forged well enough to fool some
experts, why is the original so valuable?”
Provide an answer.  
• Answer: The supply is perfectly inelastic—
vertical—at a quantity of 1 unit. The $137.5
million price is determined where the downward
sloping demand curve intersected this supply
curve.
• If more than one picture were available (all
but one having to be a copy), the demand would
likely decrease enormously.
• . Suppose the cross elasticity of demand
for products A and B is +3.6 and for
products C and D is -5.4. What can you
conclude about how products A and B are
related? Products C and D?
• The cross elasticity relates the percentage change in quantity to the
percentage change in price of a different good. If the cross elasticity
is positive this implies that and increase in the price of one good
results in an increase in the quantity purchased of another good.
This implies the goods are substitutes, as the price of one good
increases substitute into the other good (purchase more).
• This implies that goods A and B are substitutes and that goods C
and D are compliments.
• For reference, if the cross elasticity is negative this implies that and
increase in the price of one good results in a decrease in the
quantity purchased of another good. This implies that the goods are
compliments; as the price of one good increases, reduce the
consumption of the other good (purchase less).
• Suppose the demand curve for a product is given by
Q = 10 - 2P + Ps, where P is the price of
the product and Ps is the price of a substitute good.
The price of the substitute good is $2.00.
1. Suppose P = $1.00. What is the price elasticity of
demand?
2. What is the cross-price elasticity
of demand?
• The income elasticities of demand for movies, dental
services, and clothing have been estimated to be +3.4,
+1, and +.5, respectively. Interpret these coefficients.
What does it mean if an income elasticity coefficient is
negative?
• All are normal goods—income and quantity demanded move in the
same direction. These coefficients reveal that a 1 percent increase
in income will increase the quantity of movies demanded by 3.4
percent, of dental services by 1 percent, and of clothing by 0.5
percent. A negative coefficient indicates an inferior good—income
and quantity demanded move in the opposite direction.
• Research has found that an increase in the price of beer would
reduce the amount of marijuana consumed. Is cross elasticity of
demand between the two products positive or negative? Are these
products substitutes or complements? What might be the logic
behind this relationship?
• Answer: If the cross elasticity is negative, this implies that an increase in
the price of one good results in a decrease in the quantity purchased of
another good. This implies that the goods are compliments; as the price of
one good increases, reduce the consumption of other good (purchase less).
The cross elasticity of the two products above is negative. Thus, the
products appear to be complementary. As one drinks beer, one also
smokes marijuana.
 EXAMPLE 2.5 THE MARKET FOR WHEAT

During recent decades, changes in the wheat

market had major implications for both
American farmers and U.S. agricultural policy.
To understand what happened, let’s examine
the behavior of supply and demand beginning
in 1981.
Supply: QS = 1800 + 240P
Demand: QD = 3550 − 266P
By setting the quantity supplied equal to the quantity demanded, we can
determine the market-clearing price of wheat for 1981:
QS = QD
1800 + 240P = 3550 − 266P
506P = 1750
P = $3.46 per
bushel
Substituting into the supply curve equation, we get
Q = 1800 + (240)(3.46) = 2630 million bushels
 EXAMPLE 2.5 THE MARKET FOR WHEAT

We use the demand curve to find the price elasticity of demand:

Thus demand is inelastic.

We can likewise calculate the price elasticity of supply:

Because these supply and demand curves are linear, the price elasticities
will vary as we move along the curves.
• In an article about the financial problems of USA Today,
Newsweek reported that the paper was losing about $20
million a year. A Wall Street analyst said that the paper
should raise its price from 50 cents to 75 cents, which he
estimated would bring in an additional $65 million a year.
The paper’s publisher rejected the idea, saying that
circulation could drop sharply after a price increase,
citing The Wall Street Journal’s experience after it
increased its price to 75 cents. What implicit
assumptions are the publisher and the analyst making
about price elasticity?
• Solution
• The analyst believes demand is
inelastic because he believes an increase
in price will increase total revenue. The
publisher believes demand is elastic
because he believes an increase in price
will decrease total revenue.
 EXAMPLE 2.7 THE WEATHER IN BRAZIL AND THE PRICE OF
COFFEE IN NEW YORK

FIGURE 2.18 (1 of 3)
SUPPLY AND DEMAND FOR
COFFEE
(a) A freeze or drought in Brazil
causes the supply curve to shift
to the left.
In the short run, supply is
completely inelastic; only a fixed
number of coffee beans can be
harvested.
Demand is also relatively
inelastic; consumers change
their habits only slowly.
As a result, the initial effect of
the freeze is a sharp increase in
price, from P0 to P1.
 EXAMPLE 2.8 THE BEHAVIOR OF COPPER PRICES

FIGURE 2.20
COPPER PRICES, 1965–2011
Copper prices are shown in both nominal (no adjustment for inflation) and
real (inflation-adjusted) terms. In real terms, copper prices declined steeply
from the early 1970s through the mid-1980s as demand fell. In 1988–1990,
copper prices rose in response to supply disruptions caused by strikes in
Peru and Canada but later fell after the strikes ended. Prices declined
during the 1996–2002 period but then increased sharply starting in 2005.
• The R. J. Smith Corporation is a publisher of romance novels – nothing
exotic or erotic – just stories of common people falling in and out of love.
The corporation hires an economist to determine the demand for its
product. After months of hard work and submission of an exorbitant bill,
the analyst tells the company that demand for the firm’s novels (Qx) is
given by the following equation:
Qx = 12,000-5000Px+5I+500Pc

• Where Px is the price charged for the R. J. Smith novels, I is income per
capita, and Pc is the price of books from competing publishers.
• Using this information, the company’s mangers want to
1. Determine what effect a price increase would have on total revenues
2. Evaluate how sale of the novels would change during a period of rising
incomes
3. Assess the probable impact if competing publishers raise their prices
• Assume that the initial values of Px, I and Pc are $5, $10,000 and $6
respectively.
The demand for personal computers can be characterized by the
following point elasticities: price elasticity = ‑5, cross-price elasticity
with software = ‑4, and income elasticity = 2.5. Indicate whether each
of the following statements is true or false, and explain your answer.

1.A price reduction for personal computers will increase both the
number of units demanded and the total revenue of sellers.
2. The cross-price elasticity indicates that a 5% reduction in the price of
personal computers will cause a 20% increase in software demand.
3. Demand for personal computers is price elastic and computers are
cyclical normal goods.
4. Falling software prices will increase revenues received by sellers of
both computers and software.
5. A 2% price reduction would be necessary to overcome the effects of
a 1% decline in income.