Kaushalya Silva

M.Sc. in Mgt. (USJ), B.B. Mgt. (Special) Degree in Accountancy (Kel’ya), CMA Passed Finalist,
DBF (IBSL)
Lecturer
Department of Accountancy
E-mail: [email protected]
Elasticity and Its Application

BACC 11723
Microeconomics
In this chapter,
look for the answers to these questions:

• What is elasticity? What kinds of issues can elasticity help us understand?

• What is the price elasticity of demand?
How is it related to the demand curve?
How is it related to revenue & expenditure?
• What is the price elasticity of supply?
How is it related to the supply curve?
• What are the income and cross-price elasticities of demand?

3
A scenario…
You design websites for local businesses.
You charge $200 per website, and currently sell 12 websites per month.
Your costs are rising (including the opportunity cost of your time), so you
consider raising the price to $250.
The law of demand says that you won’t sell as many websites if you raise
your price.
How many fewer websites? How much will your revenue fall, or might it
increase?

4
 Elasticity
• Basic idea:
Elasticity measures how much one variable responds to changes in
another variable.
• One type of elasticity measures how much demand for your websites will fall if you
raise your price.
• Definition:
Elasticity is a numerical measure of the responsiveness of Qd or Qs to
one of its determinants.

5
 Price Elasticity of Demand

Price elasticity Percentage change in Qd

=
of demand Percentage change in P

• Price elasticity of demand measures how much Qd responds to a

change in P.

▪ Loosely speaking, it measures the price-sensitivity of buyers’

demand.

6
 Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P

P
Example:
P rises
Price elasticity P2
by 10%
of demand P1
equals
D
15%
= 1.5 Q
10% Q2 Q1
Q falls
by 15%
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 Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
P
Along a D curve, P and Q move
in opposite directions, which P2
would make price elasticity
negative. P1

We will drop the minus sign D

and report all price elasticities Q
as positive numbers. Q2 Q1

8
 Calculating Percentage Changes
Standard method of computing the
percentage (%) change:
Demand for
your websites
P end value – start value
x 100%
start value
B
$250
A Going from A to B, the % change in
$200 P equals
D
($250–$200) x 100% = 25%
Q
8 12 $200

9
 Calculating Percentage Changes
Problem:
The standard method gives different
Demand for answers depending on where you start.
your websites
P
From A to B,
B P rises 25%, Q falls 33%,
$250
A elasticity = 33/25 = 1.33
$200
From B to A,
D
P falls 20%, Q rises 50%,
Q elasticity = 50/20 = 2.50
8 12

10
 Calculating Percentage Changes
• So, we instead use the midpoint method:

end value – start value

x 100%
midpoint

▪ The midpoint is the number halfway between the start & end
values, the average of those values.
▪ It doesn’t matter which value you use as the “start” and which
as the “end” – you get the same answer either way!

11
 Calculating Percentage Changes
• Using the midpoint method, the % change in P equals

$250 – $200
x 100% = 22.2%
$225
▪ The % change in Q equals
12 – 8
x 100% = 40.0%
10
▪ The price elasticity of demand equals
40/22.2 = 1.8

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 The Determinants of Price Elasticity of Demand:

The price elasticity of demand depends on:

• the extent to which close substitutes are available
• whether the good is a necessity or a luxury
• how broadly or narrowly the good is defined
• the time horizon – elasticity is higher in the long run than the short
run

13
 What determines Price Elasticity of Demand?
To learn the determinants of price elasticity, we look at a series of examples.
Each compares two common goods.
In each example:
• Suppose the prices of both goods rise by 20%.
• The good for which Qd falls the most (in percent) has the highest price elasticity of
demand.
Which good is it? Why?
• What lesson does the example teach us about the determinants of the price elasticity
of demand?

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EXAMPLE 1:
Breakfast cereal vs. Sunscreen

• The prices of both of these goods rise by 20%. For which good does Qd
drop the most? Why?
• Breakfast cereal has close substitutes (e.g., pancakes, Eggo waffles, leftover
pizza), so buyers can easily switch if the price rises.
• Sunscreen has no close substitutes, so consumers would probably not buy
much less if its price rises.
• Lesson: Price elasticity is higher when close substitutes are available.

15
EXAMPLE 2:
“Blue Jeans” vs. “Clothing”

• The prices of both goods rise by 20%.

For which good does Qd drop the most? Why?
• For a narrowly defined good such as blue jeans, there are many substitutes
(khakis, shorts, Speedos).
• There are fewer substitutes available for broadly defined goods.
(There aren’t too many substitutes for clothing, other than living in a nudist
colony.)
• Lesson: Price elasticity is higher for narrowly defined goods than
broadly defined ones.

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EXAMPLE 3:
Insulin vs. Caribbean Cruises

• The prices of both of these goods rise by 20%. For which good does
Qd drop the most? Why?
• To millions of diabetics, insulin is a necessity.
A rise in its price would cause little or no decrease in demand.
• A cruise is a luxury. If the price rises, some people will forego it.
• Lesson: Price elasticity is higher for luxuries than for necessities.

17
EXAMPLE 4:
Gasoline in the Short Run vs. Gasoline in the Long Run

• The price of gasoline rises 20%. Does Qd drop more in the short run or
the long run? Why?
• There’s not much people can do in the short run, other than ride the bus or
carpool.
• In the long run, people can buy smaller cars or live closer to where they work.
• Lesson: Price elasticity is higher in the long run than the short run.

18
 The Variety of Demand Curves

• The price elasticity of demand is closely related to the slope of the

demand curve.
• Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
• Five different classifications of D curves.…

19
 “Perfectly Inelastic Demand” (one extreme case)
Price elasticity % change in Qd 0%
= = =0
of demand % change in P 10%

D curve: P
D This is a situation
vertical where no change in
quantity demanded,
P1
Consumers’ though there is a
change in price.
price sensitivity: P2 Ex: demand for salt.
none
P falls Q
Elasticity: by 10% Q1
0 Q changes
by 0%

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 “Inelastic Demand”
Price elasticity % change in Qd < 10%
= = =<1
of demand % change in P 10%
This is a situation where
D curve: percentage change in
P
relatively steep quantity demanded, less
than the percentage
change in price
Consumers’ P1 Ex: demand for necessary
price sensitivity: goods
P2
relatively low
P falls D
Elasticity: by 10%
Q
<1 Q1 Q2

Q rises less than 10%

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 “Unit Elastic Demand”
Price elasticity % change in Qd 10%
= = =1
of demand % change in P 10%
This is a situation where
D curve: P percentage change in
intermediate slope quantity demanded, is
equal to the percentage
P1 change in price
Consumers’
price sensitivity: P2
intermediate D

P falls Q
Elasticity: by 10% Q1 Q2
1
Q rises by 10%

22
 “Elastic Demand”

Price elasticity % change in Qd

= = > 10% =>1
of demand % change in P 10% This is a situation
D curve: where percentage
relatively flat P change in quantity
demanded, higher
than the percentage
Consumers’ change in price
P1 Ex: luxury goods
price sensitivity:
relatively high P2 D
Elasticity:
>1 P falls Q
by 10% Q1 Q2
Q rises more than 10%

23
 “Perfectly Elastic Demand” (the other extreme)
Price elasticity % change in Qd any %
= = = infinity (∞)
of demand % change in P 0%
This is a
D curve: P situation where
horizontal there is a
change in
P2 = P1 D quantity
Consumers’ demanded ,
price sensitivity: though there is
no change in
extreme price.

Elasticity: P changes Q
by 0% Q1 Q2
infinity
Q changes by any %

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Summary : Types of Price Elasticity of Demand

25
Summary : Types of Price Elasticity of Demand

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 Elasticity of a Linear Demand Curve

P
200% The slope of a linear
$30 E = = 5.0 demand curve is
40%
constant, but its
67% elasticity is not.
20 E = = 1.0
67%
40%
10 E = = 0.2
200%

$0 Q
0 20 40 60

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 Price Elasticity and Total Revenue
• Continuing our scenario, if you raise your price from $200 to $250, would your
revenue rise or fall?
Revenue = P x Q
• A price increase has two effects on revenue:
• Higher P means more revenue on each unit you sell.
• But you sell fewer units (lower Q), due to Law of Demand.
• Which of these two effects is bigger?
It depends on the price elasticity of demand.

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 Price Elasticity and Total Revenue
Price Elasticity Percentage change in Qd
=
of Demand PercentageQchange in P

Revenue = P x Q
• If demand is elastic, then
price elast. of demand > 1
% change in Qd > % change in P
• The fall in revenue from lower Q is greater than the increase in
revenue from higher P, so revenue falls.

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 Price Elasticity and Total Revenue
Demand for your websites
Elastic demand increased
(elasticity = 1.8) revenue due
P lost
to higher P revenue
If P = $200,
due to
Q = 12 and lower Q
$250
revenue = $2400.
$200
If P = $250, D
Q = 8 and
revenue = $2000.
When D is elastic, Q
8 12
a price increase
causes revenue to fall.
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 Price Elasticity and Total Revenue
Price Elasticity Percentage change in Qd
=
of Demand Percentage change in P

Revenue = P x Q

• If demand is inelastic, then

price elast. of demand < 1
% change in Qd < % change in P
• The fall in revenue from lower Q is smaller than the increase in
revenue from higher P, so revenue rises.
• In our example, suppose that Q only falls to 10 (instead of 8) when
you raise your price to $250.
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 Price Elasticity and Total Revenue
Demand for your websites
Now, demand is
inelastic: increased
revenue due
elasticity = 0.82 P lost
to higher P
If P = $200, revenue
Q = 12 and due to
$250 lower Q
revenue = $2400.
If P = $250, $200
Q = 10 and D
revenue = $2500.
When D is inelastic, Q
10 12
a price increase
causes revenue to rise.
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ACTIVE LEARNING 2
Elasticity and expenditure/revenue

A. Pharmacies raise the price of insulin by 10%. Does total expenditure

on insulin rise or fall?
B. As a result of a fare war, the price of a luxury cruise falls 20%. Does
luxury cruise companies’ total revenue rise or fall?

33
 ACTIVE LEARNING 2
Answers

A. Pharmacies raise the price of insulin by 10%. Does total expenditure

on insulin rise or fall?
Expenditure = P x Q
Since demand is inelastic, Q will fall less than 10%, so expenditure
rises.

34
ACTIVE LEARNING 2
Answers
B. As a result of a fare war, the price of a luxury cruise falls 20%.
Does luxury cruise companies’ total revenue rise or fall?
Revenue = P x Q
The fall in P reduces revenue, but Q increases, which increases
revenue. Which effect is bigger?
Since demand is elastic, Q will increase more than 20%, so revenue
rises.

35 35
 Other Demand Elasticities
• Income Elasticity of Demand: measures the response of Qd to a change in
consumer income.

Income Elasticity Percent change in Qd

=
of Demand Percent change in income

▪ Recall from Chapter 4: An increase in income causes an increase

in demand for a normal good.
▪ Hence, for normal goods, income elasticity > 0.
▪ For inferior goods, income elasticity < 0.
36
 Other Demand Elasticities
• Cross-price Elasticity of Demand:
measures the response of demand for one good to changes in the price
of another good.
Cross-price Elast. % change in Qd for good 1
=
of Demand % change in price of good 2

▪ For substitutes, cross-price elasticity > 0

(e.g., an increase in price of beef causes an increase in demand for
chicken)
▪ For complements, cross-price elasticity < 0
(e.g., an increase in price of computers causes decrease in demand
for software)
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 Price Elasticity of Supply
Price Elasticity Percentage change in Qs
=
of Supply Percentage change in P

• Price Elasticity of Supply measures how much Qs responds to a

change in P.

▪ Loosely speaking, it measures sellers’ price-sensitivity.

▪ Again, use the midpoint method to compute the percentage
changes.

38
 Price Elasticity of Supply
Price Elasticity Percentage change in Qs
=
of Supply Percentage change in P
P
Example: S
Price P rises
P2
elasticity by 8%
P1
of supply
equals
Q
16% Q1 Q2
= 2.0
8% Q rises
by 16%
39
 The Variety of Supply Curves
• The slope of the supply curve is closely related to price elasticity of
supply.
• Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
• Five different classifications.…

40
 “Perfectly Inelastic” (one extreme)
Price elasticity % change in Qs 0%
= = =0
of supply % change in P 10%

S curve: P This is a situation

S
vertical where no change in
quantity supplied,
P2 though there is a
Sellers’ change in price.
price sensitivity: P1
none
P rises Q
Elasticity: by 10% Q1
0 Q changes
by 0%
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 “Inelastic”
Price elasticity % change in Qs < 10%
= = =<1
of supply % change in P 10%

S curve: P
S This is a situation
relatively steep where percentage
change in quantity
P2
Sellers’ supplied, less than
the percentage
price sensitivity: P1 change in price.
relatively low
P rises Q
Elasticity: by 10% Q1 Q2
<1 Q rises less
than 10%
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 “Unit Elastic”
Price elasticity % change in Qs 10%
= = =1
of supply % change in P 10%

S curve: P
intermediate slope S This is a situation
where percentage
P2
Sellers’ change in quantity
supplied, is equal to the
price sensitivity: P1 percentage change in
price
intermediate
P rises Q
Elasticity: by 10% Q1 Q2
=1 Q rises
by 10%
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 “Elastic”
Price elasticity % change in Qs > 10%
= = =>1
of supply % change in P 10%
This is a
situation where
S curve: P percentage
relatively flat S change in
quantity
P2 supplied, higher
Sellers’ than the
price sensitivity: P1 percentage
change in price
relatively high
P rises Q
Elasticity: by 10% Q1 Q2
>1
Q rises more
than 10%
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 “Perfectly Elastic” (the other extreme)
Price elasticity % change in Qs any %
= = = infinity (∞)
of supply % change in P 0%
This is a
S curve: P situation
where there is
horizontal a change in
P2 = P1 S quantity
Sellers’ supplied ,
though there
price sensitivity: is no change
extreme in price.

P changes Q
Elasticity: by 0% Q1 Q2
infinity
Q changes
by any %
45
Summary : Types of Price Elasticity of Supply

46
Summary : Types of Price Elasticity of Supply

47
 The Determinants of Supply Elasticity

• The more easily sellers can change the quantity they produce, the greater the
price elasticity of supply.
• Example: Supply of beachfront property is harder to vary and thus less elastic
than supply of new cars.
• For many goods, price elasticity of supply is greater in the long run than in the
short run, because firms can build new factories, or new firms may be able to
enter the market.
• The ease and cost of factor substitution
• Easy- elastic less costly- elastic
• Difficult- inelastic High cost- inelastic

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 How the Price Elasticity of Supply Can Vary

P
S
elasticity
$15 <1 Supply often becomes
less elastic as Q rises,
12 due to capacity limits.

elasticity
>1
4
$3
Q
100 200
500 525

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APPLICATION OF SUPPLY , DEMAND & ELASTICITY: Does Drug Interdiction Increase or
Decrease Drug-Related Crime?

• One side effect of illegal drug use is crime: Users often turn to crime to
finance their habit.
• We examine two policies designed to reduce illegal drug use and see
what effects they have on drug-related crime.
• For simplicity, we assume the total dollar value of drug-related crime
equals total expenditure on drugs.
• Demand for illegal drugs is inelastic, due to addiction issues.

50
 Policy 1: Interdiction
Interdiction new value of drug-
Price of related crime
reduces S2
Drugs D1
the supply
S1
of drugs.
P2
Since demand for
drugs is inelastic, initial value
P rises proportionally P1
of drug-
more than Q falls. related
crime
Result: an increase in
total spending on drugs, Q2 Q 1 Quantity
and in drug-related crime of Drugs

51
 Policy 2: Education
new value of drug-
Education Price of related crime
reduces the Drugs
demand for D2 D1
drugs. S

P and Q fall.
P1 initial value
Result: of drug-
A decrease in P2 related
total spending crime
on drugs, and
in drug-related Q2 Q 1 Quantity
crime. of Drugs

52
 Chapter Summary

• Elasticity measures the responsiveness of Qd or Qs to one of its determinants.

• Price elasticity of demand equals percentage change in Qd divided by
percentage change in P.
When it’s less than one, demand is “inelastic.” When greater than one,
demand is “elastic.”
• When demand is inelastic, total revenue rises when price rises. When
demand is elastic, total revenue falls when price rises.
• Demand is less elastic in the short run, for necessities, for broadly defined
goods, or for goods with few close substitutes.

53
 Chapter Summary

• The income elasticity of demand measures how much quantity demanded

responds to changes in buyers’ incomes.
• The cross-price elasticity of demand measures how much demand for one
good responds to changes in the price of another good.
• Price elasticity of supply equals percentage change in Qs divided by
percentage change in P.
When it’s less than one, supply is “inelastic.” When greater than one,
supply is “elastic.”
• Price elasticity of supply is greater in the long run than in the short run.

54 54
Thank You….