Objectives

After studying this chapter, you will be able to

 Define, calculate, and explain the factors that influence
the price elasticity of demand
 Define, calculate, and explain the factors that influence
the cross elasticity of demand and the income elasticity
of demand
 Define, calculate, and explain the factors that influence
the elasticity of supply
Tough Times in the Recording Industry

More and more people are illegally downloading music

rather than paying $12 for a CD.
CD producers are loosing revenue and some of them are
trying to combat the problem by slashing the price of a CD.
Will this strategy work?
Can lower priced CDs beat illegal downloads, bring
greater revenue to the recording industry and artists, and
help to promote the social interest?
The concept of elasticity helps to answer these questions.
Price Elasticity of Demand

In Figure 4.1a, a change in

supply brings a small
increase in the quantity
demanded and a large fall
in price.
Price Elasticity of Demand

In Figure 4.1b, a change in

supply brings a large
increase in the quantity
demanded and a small fall
in price.
Price Elasticity of Demand

The contrast between the

two outcomes in Figure 4.1
highlights the need for a
measure of the
responsiveness of the
quantity demanded to a
price change.
Price Elasticity of Demand

The price elasticity of demand is a units-free measure

of the responsiveness of the quantity demanded of a
good to a change in its price when all other influences
on buyers’ plans remain the same.
Calculating Elasticity
The price elasticity of demand is calculated by using the
formula:
Percentage change in quantity demanded
Percentage change in price
Price Elasticity of Demand

To calculate the price elasticity of demand:

We express the change in price as a percentage of the
average price—the average of the initial and new price,
and we express the change in the quantity demanded as a
percentage of the average quantity demanded—the
average of the initial and new quantity.
Price Elasticity of Demand

Figure 4.2 calculates the

price elasticity of demand
for pizza.
The price initially is $20.50
and the quantity
demanded is 9 pizzas an
hour.
Price Elasticity of Demand

The price falls to $19.50

and the quantity
demanded increases to 11
pizzas an hour.

The price falls by $1 and

the quantity demanded
increases by 2 pizzas an
hour.
Price Elasticity of Demand

The average price is $20

and the average quantity
demanded is 10 pizzas an
hour.
Price Elasticity of Demand

The percentage change in

quantity demanded, %Q,
is calculated as Q/Qave,
which is 2/10 = 1/5.
The percentage change in
price, %P, is calculated
as P/Pave, which is
$1/$20 = 1/20.
Price Elasticity of Demand

The price elasticity of

demand is (1/5)/(1/20) =
20/5 = 4.
Price Elasticity of Demand

By using the average price and average quantity, we get

the same elasticity value regardless of whether the price
rises or falls.
The ratio of two proportionate changes is the same as the
ratio of two percentage changes.
The measure is units free because it is a ratio of two
percentage changes and the percentages cancel out.
Changing the units of measurement of price or quantity
leave the elasticity value the same.
Price Elasticity of Demand

The formula yields a negative value, because price and

quantity move in opposite directions. But it is the
magnitude, or absolute value, of the measure that reveals
how responsive the quantity change has been to a price
change.
Price Elasticity of Demand

Inelastic and Elastic Demand

Demand can be inelastic, unit elastic, or elastic, and can
range from zero to infinity.
If the quantity demanded doesn’t change when the price
changes, the price elasticity of demand is zero and the
good as a perfectly inelastic demand.
Price Elasticity of Demand

Figure 4.3a illustrates the

case of a good that has a
perfectly inelastic demand
and that has a vertical
demand curve.
Price Elasticity of Demand

If the percentage change

in the quantity demanded
equals the percentage
change in price, the price
elasticity of demand
equals 1 and the good has
unit elastic demand.
Figure 4.3b illustrates this
case—a demand curve
with ever declining slope.
(Note that the demand
curve is not linear.)
Price Elasticity of Demand

Between the two previous cases, the percentage change

in the quantity demanded is smaller than the percentage
change in price so that the price elasticity of demand is
less than 1 and the good has inelastic demand.
If the percentage change in the quantity demanded is
infinitely large when the price barely changes, the price
elasticity of demand is infinite and the good has perfectly
elastic demand.
Price Elasticity of Demand

Figure 4.3c illustrates the

case of perfectly elastic
demand—a horizontal
demand curve.
If the percentage change
in the quantity demanded
is greater than the
percentage change in
price, the price elasticity of
demand is greater than 1
and the good has elastic
demand.
Price Elasticity of Demand

Elasticity Along a
Straight-Line Demand
Curve
Figure 4.4 shows how
demand becomes less
elastic as the price falls
along a linear demand
curve.
Price Elasticity of Demand

At prices above the mid-

point of the demand curve,
demand is elastic.

At prices below the mid-

point of the demand curve,
demand is inelastic.
Price Elasticity of Demand

For example, if the price

falls from $25 to $15, the
quantity demanded
increases from 0 to 20
pizzas an hour.
The average price is $20
and the average quantity is
10.
The price elasticity of
demand is (20/10)/(10/20),
which equals 4.
Price Elasticity of Demand

If the price falls from $10

to $0, the quantity
demanded increases from
30 to 50 pizzas an hour.

The average price is $5

and the average quantity is
40.
The price elasticity of
demand is (20/40)/(10/5),
which equals 1/4.
Price Elasticity of Demand

If the price falls from $15

to $10, the quantity
demanded increases from
20 to 30 pizzas an hour.

The average price is

$12.50 and the average
quantity is 25.
The price elasticity of
demand is (10/25)/(5/12.5),
which equals 1.
Price Elasticity of Demand

Total Revenue and Elasticity

The total revenue from the sale of good or service equals
the price of the good multiplied by the quantity sold.
When the price changes, total revenue also changes.
But a rise in price doesn’t always increase total revenue.
Price Elasticity of Demand

The change in total revenue due to a change in price

depends n the elasticity of demand:
 If demand is elastic, a 1 percent price cut increases the
quantity sold by more than 1 percent, and total revenue
increases.
 If demand is inelastic, a 1 percent price cut decreases
the quantity sold by more than 1 percent, and total
revenues decreases.
 If demand is unitary elastic, a 1 percent price cut
increases the quantity sold by 1 percent, and total
revenue remains unchanged.
Price Elasticity of Demand

The total revenue test is a method of estimating the price

elasticity of demand by observing the change in total
revenue that results from a price change (when all other
influences on the quantity sold remain the same).
 If a price cut increases total revenue, demand is elastic.
 If a price cut decreases total revenue, demand is
inelastic.
 If a price cut leaves total revenue unchanged, demand is
unit elastic.
Price Elasticity of Demand

Figure 4.5 shows the

relationship between
elasticity of demand for
pizzas and the total
revenue from pizzas.
In part a (shown here),
as the price falls from
$25 to $12.50, demand is
elastic, and total revenue
increases.
Price Elasticity of Demand

At $12.50, demand is
unit elastic and total
revenue stops
increasing.

As the price falls from

$12.50 to zero, demand
is inelastic, and total
revenue decreases.
Price Elasticity of Demand
In part b (shown here), as
the quantity increases
from zero to 25, demand
is elastic, and total
revenue increases.
At 25, demand is unit
elastic, and total revenue is
at its maximum.
As the quantity increases
from 25 to 50, demand is
inelastic, and total
revenue decreases.
Price Elasticity of Demand

Your Expenditure and Your Elasticity

 If your demand is elastic, a 1 percent price cut increases
the quantity you buy by more than 1 percent and your
expenditure on the item increases.
 If your demand is inelastic, a 1 percent price cut
increases the quantity you buy by less than 1 percent
and your expenditure on the item decreases.
 If your demand is unit elastic, a 1 percent price cut
increases the quantity you buy by 1 percent and your
expenditure on the item does not change.
Price Elasticity of Demand

The Factors That Influence the Elasticity of Demand

The elasticity of demand for a good depends on:
 The closeness of substitutes
 The proportion of income spent on the good
 The time elapsed since a price change
Price Elasticity of Demand

The closeness of substitutes

The closer the substitutes for a good or service, the more
elastic are the demand for it.
Necessities, such as food or housing, generally have
inelastic demand.
Luxuries, such as exotic vacations, generally have elastic
demand.
The proportion of income spent on the good.
The greater the proportion of income consumers spent on a
good, the larger is its elasticity of demand.
Price Elasticity of Demand

The time elapsed since a price change

The more time consumers have to adjust to a price
change, or the longer that a good can be stored without
losing its value, the more elastic is the demand for that
good.
Price Elasticity of Demand

Table 4.1 (page 87) shows

estimates of the price
elasticity of demand for
various goods and
services.
Figure 4.6 shows how the
elasticity of demand for
food varies with the
proportion of income spent
on food in different
countries.
More Elasticities of Demand

Cross Elasticity of Demand

The cross elasticity of demand is a measure of the
responsiveness of demand for a good to a change in the
price of a substitute or a compliment, other things
remaining the same.
The formula for calculating the cross elasticity is:
Percentage change in quantity demanded
Percentage change in price of substitute or complement
More Elasticities of Demand

The cross elasticity of demand for a substitute is positive.

The cross elasticity of demand for a complement is
negative.
More Elasticities of Demand

Figure 4.7 shows the

increase in the quantity of
pizza demanded when the
price of burger (a
substitute for pizza) rises.

The figure also shows the

decrease in the quantity of
pizza demanded when the
price of a soft drink (a
complement of pizza)
rises.
More Elasticities of Demand

Income Elasticity of Demand

The income elasticity of demand measures how the
quantity demanded of a good responds to a change in
income, other things equal.
The formula for calculating the income elasticity of
demand is:
Percentage change in quantity demanded
Percentage change in income
More Elasticities of Demand

If the income elasticity of demand is greater than 1,

demand is income elastic and the good is a normal good.
If the income elasticity of demand is greater than zero but
less than 1, demand is income inelastic and the good is a
normal good.
If the income elasticity of demand is less than zero
(negative) the good is an inferior good.
More Elasticities of Demand

Table 4.2 (page 91) shows

estimates of income
elasticity of demand for
various goods and
services.
Figure 4.8 shows estimates
of the income elasticity for
food in different countries.
A higher average income is
associated with a lower
income elasticity of
demand for food.
Price Elasticity of Supply

In Figure 4.9a, a change in

demand brings a small
increase in the quantity
supplied and a large rise in
price.
Price Elasticity of Supply

In Figure 4.9b, a change in

demand brings a large
increase in the quantity
supplied and a small rise
in price.
Price Elasticity of Supply

The contrast between the

two outcomes in Figure 4.9
highlights the need for a
measure of the
responsiveness of the
quantity supplied to a price
change.
Elasticity of Supply

The elasticity of supply measures the responsiveness of

the quantity supplied to a change in the price of a good
when all other influences on selling plans remain the
same.
Calculating the Elasticity of Supply
The elasticity of supply is calculated by using the formula:
Percentage change in quantity supplied
Percentage change in price
Elasticity of Supply

Figure 4.10 on the next slide shows three cases of the

elasticity of supply.
Supply is perfectly inelastic if the supply curve is vertical
and the elasticity of supply is 0.
Supply is unit elastic if the supply curve is linear and
passes through the origin. (Note that slope is irrelevant.)
Supply is perfectly elastic if the supply curve is horizontal
and the elasticity of supply is infinite.
Elasticity of Supply
Elasticity of Supply

The Factors That Influence the Elasticity of Supply

The elasticity of supply depends on
Resource substitution possibilities
The easier it is to substitute among the resources used to
produce a good or service, the greater is its elasticity of
supply.
The time frame for supply decisions
The more time that passes after a price change, the
greater is the elasticity of supply.
Elasticity of Supply

The time frame for supply decisions

The more time that passes after a price change, the
greater is the elasticity of supply.
Momentary supply is perfectly inelastic. The quantity
supplied immediately following a price change is constant.
Short-run supply is somewhat elastic.
Long-run supply is the most elastic.
Table 4.3 (page 95) provides a glossary of the all elasticity
measures.
THE END