Elasticity and Its Applications

Elasticity . . .
… allows us to analyze supply and demand with greater precision.
… is a measure of how much buyers and sellers respond to changes in market conditions

THE ELASTICITY OF DEMAND
Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good.
Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price.

The Price Elasticity of Demand and Its Determinants
Availability of Close Substitutes
Necessities versus Luxuries
Definition of the Market
Time Horizon

The Price Elasticity of Demand and Its Determinants
Demand tends to be more elastic :
the larger the number of close substitutes.
if the good is a luxury.
the more narrowly defined the market.
the longer the time period.

Computing the Price Elasticity of Demand
The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price.

Computing the Price Elasticity of Demand
Example: If the price of a cup of coffee increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cups (per week), then your elasticity of demand would be calculated as:

The Variety of Demand Curves
Inelastic Demand
Quantity demanded does not respond strongly to price changes.
Price elasticity of demand is less than one.
Elastic Demand
Quantity demanded responds strongly to changes in price.
Price elasticity of demand is greater than one.

The Variety of Demand Curves
Perfectly Inelastic
Quantity demanded does not respond to price changes.
Perfectly Elastic
Quantity demanded changes infinitely with any change in price.
Unit Elastic
Quantity demanded changes by the same percentage as the price.

The Variety of Demand Curves
Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve.

The Price Elasticity of Demand
(a) Perfectly Inelastic Demand: Elasticity Equals 0
Quantity
0
Price

The Price Elasticity of Demand
(b) Inelastic Demand: Elasticity Is Less Than 1
Quantity
0
Price

The Price Elasticity of Demand
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(c) Unit Elastic Demand: Elasticity Equals 1
Quantity
0
Price

The Price Elasticity of Demand
(d) Elastic Demand: Elasticity Is Greater Than 1
Quantity
0
Price

The Price Elasticity of Demand
(e) Perfectly Elastic Demand: Elasticity Equals Infinity
Quantity
0
Price

Total Revenue and the Price Elasticity of Demand
Total revenue is the amount paid by buyers and received by sellers of a good.
Computed as the price of the good times the quantity sold.
TR = P x Q

Total Revenue
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Quantity
0
Price

Elasticity and Total Revenue along a Linear Demand Curve
With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases.

How Total Revenue Changes When Price Changes: Inelastic Demand
Quantity
0
Price
Quantity
0
Price
An Increase in price from $1
to $3 …
… leads to an Increase in total revenue from $100 to $240

Elasticity and Total Revenue along a Linear Demand Curve
With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases.

How Total Revenue Changes When Price Changes: Elastic Demand
Quantity
0
Price
Quantity
0
Price
An Increase in price from $4
to $5 …
… leads to an decrease in total revenue from $200 to $100

Income Elasticity of Demand
Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income.
It is computed as the percentage change in the quantity demanded divided by the percentage change in income.

Computing Income Elasticity

Income Elasticity
Types of Goods
Normal Goods
Inferior Goods
Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods.

Income Elasticity
Goods consumers regard as necessities tend to be income inelastic
Examples include food, fuel, clothing, utilities, and medical services.
Goods consumers regard as luxuries tend to be income elastic.
Examples include sports cars, furs, and expensive foods.

THE ELASTICITY OF SUPPLY
Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good.
Price elasticity of supply is the percentage change in quantity supplied resulting from a percent change in price.

The Price Elasticity of Supply
Copyright©2003 Southwestern/Thomson Learning
(a) Perfectly Inelastic Supply: Elasticity Equals 0
Quantity
100
0
Price

The Price Elasticity of Supply
(b) Inelastic Supply: Elasticity Is Less Than 1
Quantity
0
Price

The Price Elasticity of Supply
(c) Unit Elastic Supply: Elasticity Equals 1
Quantity
0
Price

The Price Elasticity of Supply
(d) Elastic Supply: Elasticity Is Greater Than 1
Quantity
0
Price

The Price Elasticity of Supply
(e) Perfectly Elastic Supply: Elasticity Equals Infinity
Quantity
0
Price

Determinants of Elasticity of Supply
Ability of sellers to change the amount of the good they produce.
Real estate by beach is inelastic.
Books, cars, or manufactured goods are elastic.
Time period.
Supply is more elastic in the long run.

Computing the Price Elasticity of Supply
The price elasticity of supply is computed as the percentage change in the quantity supplied divided by the percentage change in price.

Summary
Price elasticity of demand measures how much the quantity demanded responds to changes in the price.
Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price.
If a demand curve is elastic, total revenue falls when the price rises.
If it is inelastic, total revenue rises as the price rises.

Summary
The income elasticity of demand measures how much the quantity demanded responds to changes in consumers’ income.
The price elasticity of supply measures how much the quantity supplied responds to changes in the price.