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Elasticity and Its Application

 Overview
1. The Elasticity of Demand
 The price elasticity of demand

 The income elasticity of demand

 The cross-price elasticity of demand

2. The Elasticity of Supply

 The Elasticity
• Elasticity
– Measure of the responsiveness of quantity
demanded or quantity supplied to one of its
determinants

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 1.The Elasticity of Demand
1.1 Price elasticity of demand
1.1.1 Definition: Measure of how much quantity
demanded of a good responds to 1% change in
the price of that good
EDp = %△QD /%△P
– Measures how willing consumers are to buy
less of the good as its price rises

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 The Elasticity of Demand
• Elastic demand
• Quantity demanded responds substantially to
changes in the price
• Inelastic demand
• Quantity demanded responds only slightly to
changes in the price

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 The Elasticity of Demand
1.1.2 Determinants of price elasticity of demand
– Availability of close substitutes

– Necessities vs. luxuries

– Definition of the market

– Time horizon

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 The Elasticity of Demand
1.1.3 Computing the price elasticity of demand
Use absolute value (drop the minus sign)
– Arc-elasticity of demand: Midpoint method
• Two points: (Q1, P1) and (Q2, P2)

(Q2  Q1 )/[(Q2  Q1 )/ 2 ]
Price elasticityof demand
(P2  P1 )/[(P2  P1 )/ 2 ]

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 The Elasticity of Demand
E.g.
P
PA = 25, QA = 150
PB = 12, QB = 320 PA
A

What is the AB arc PB

B
elasticity of demand?
QA QB
Q
 The Elasticity of Demand
1.1.3 Computing the price elasticity of demand
- Point-elasticity of demand
• One points (Q*, P*)

D %Q dQ / Q dQ P P
E P     Q' ( p ) 
%P dP / P dP Q Q
E.g. Demand curve Q = 50- 3P. What is the elasticity of
demand at the point of P = 5

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 The Elasticity of Demand
1.1.4 Variety of demand curves
(a) Demand is perfectly inelastic
• Elasticity = 0
• Demand curve - vertical
(b) Demand is inelastic
• Elasticity < 1
(c) Demand has unit elasticity
• Elasticity = 1

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 The Elasticity of Demand
• Variety of demand curves
(d) Demand is elastic
• Elasticity > 1
(e) Demand is perfectly elastic
• Elasticity = infinity
• Demand curve – horizontal

The flatter the demand curve, the greater the price

elasticity of demand

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Figure 1
The price elasticity of demand (a, b)
(a) Perfectly inelastic demand: (b) Inelastic demand:
Elasticity = 0 Elasticity < 1
Price Price

1. an 1. an

0 0
Quantity Quantity

The price elasticity of demand determines whether the demand curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
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Figure 1
The price elasticity of demand (c)
(c) Unit elastic demand:
Elasticity = 1
Price

1. an

0
Quantity

The price elasticity of demand determines whether the demand curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
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Figure 1
The price elasticity of demand (d, e)
(d) Elastic demand: (e) Perfectly elastic demand:
Elasticity > 1 Elasticity equals infinity
Price Price

1. an 1. an

0 0
Quantity Quantity

The price elasticity of demand determines whether the demand curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
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 The Elasticity of Demand
1.1.5 Total revenue and price elasticity of
demand
• Total revenue - TR
– Amount paid by buyers
– Received by sellers of a good
– Computed as: price of the good times the
quantity sold
TR = P x Q

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Figure 2
Total revenue
Price

$4
1. an
P ˣ Q=$400
Demand
P (revenue)

0 100
Quantity

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 The Elasticity of Demand
1.1.5 Total revenue and price elasticity of demand

• Elastic demand: E>1

– Increase in price
• Decrease in total revenue
P2<P1 P1 |EpD| >1

TR1 = P1 x Q1 = S(a) + S(b) (b)

P2
TR2 = P2 x Q2 = S(a) + S(c)
TR2 > TR1 (a) (c)

Q Q2
1

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 The Elasticity of Demand
1.1.5 Total revenue and price elasticity of demand

• Inelastic demand
– Increase in price
P1 |EpD| <1
• Increase in total revenue
(b)
– P2<P1
P2
• TR1 = P1 x Q1 = S(a) + S(b)
• TR2 = P2 x Q2 = S(a) + S(c) (a) (c)

TR2 <TR1
Q1 Q2

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 The Elasticity of Demand
• When demand is inelastic
– Price and total revenue move in the same
direction
• When demand is elastic
– Price and total revenue move in opposite
directions
• If demand is unit elastic
– Total revenue remains constant when the
price changes
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 The Elasticity of Demand
• Elasticity and total revenue along a linear
demand curve
• Linear demand curve
– Constant slope
– Different elasticities
• Points with low price & high quantity
– Inelastic
• Points with high price & low quantity
– Elastic

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Figure 4
Elasticity of a linear demand curve (graph)
Price

$7
6

5
4 1. an
3

2
Demand
1

0 2 4 6 8 10 12 14 Quantity

The slope of a linear demand curve is constant, but its elasticity is not.

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 The Elasticity of Demand
1.2 Income elasticity of demand EDI
– Measure of how much the quantity
demanded of a good responds to 1% change
in consumers’ income
EDI = %△QD / %△I
– Normal goods: positive income elasticity
• Necessities: smaller income elasticities
• Luxuries: large income elasticities
– Inferior goods: negative income elasticities

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 The Elasticity of Demand
1.2 Income elasticity of demand: EDI
– Normal goods:
• Necessities:

• Luxuries:

– Inferior goods:

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 The Elasticity of Demand
1.3 Cross-price elasticity of demand
– Measure of how much the quantity
demanded of one good X responds to 1%
change in the price of another good Y
Exy = %△QDx / %△Py

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 The Elasticity of Demand
1.3 Cross-price elasticity of demand
• Substitutes:
• Complements:
• Independents:

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 2.The Price elasticity of supply
2.1 Definition:
Measure of how much the quantity supplied
of a good responds to 1% change in the
price of that good
ESp = %△QS /%△P
– Depends on the flexibility of sellers to change
the amount of the good they produce

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 The Elasticity of Supply
• Elastic supply
• Quantity supplied responds substantially to
changes in the price
• Inelastic supply
• Quantity supplied responds only slightly to
changes in the price

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 The Elasticity of Supply
2.2 Determinant of price elasticity of supply
– Time period

– Substitutions of inputs:

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 The Elasticity of Supply
2.3 Computing price elasticity of supply
Arc elasticity Point elasticity
(P1, Q1) A(P, Q)
(P2, Q2)

Q1  Q 0 S %QS
E 
P
Q1  Q 0 %P
( )
E PS  2 dQ P P
P1  P 2   Q`( P) 
P1  P 2 dP Q Q
( )
2

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 The Elasticity of Supply
2.4 Variety of supply curves
– Supply is perfectly inelastic
• Elasticity =0
• Supply curve – vertical
– Inelastic supply
• Elasticity < 1
– Unit elastic supply
• Elasticity =1
– Elastic supply
• Elasticity >1
– Supply is perfectly elastic
• Elasticity = infinity
• Supply curve – horizontal
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Figure 5
The price elasticity of supply (a, b)
(a) Perfectly inelastic supply: (b) Inelastic supply:
Elasticity = 0 Elasticity < 1
Price Price

1. an 1. an

0 0
Quantity Quantity

The price elasticity of supply determines whether the supply curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
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Figure 5
The price elasticity of supply (c)
(c) Unit elastic supply: Elasticity =1
Price

1. an

0
Quantity

The price elasticity of supply determines whether the supply curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
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Figure 5
The price elasticity of supply (d, e)
(d) Elastic supply: (e) Perfectly elastic supply:
Elasticity > 1 Elasticity equals infinity
Price Price

1. an 1. an

0 0
Quantity Quantity

The price elasticity of supply determines whether the supply curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
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Figure 6
How the price elasticity of supply can vary
Price

1. an

0 Quantity

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Applications of Supply, Demand, & Elasticity

• Why did OPEC fail to keep the price of oil

high?
– 1970s: OPEC reduced supply of oil
• Increase in prices 1973-1974 and 1971-1981
• Short-run: supply is inelastic
– Decrease in supply: large increase in price
– 1982-1990 – price of oil decreased
• Long-run: supply is elastic
– Decrease in supply: small increase in price
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 Figure 8
A reduction in supply in the world market for oil
(a) The Oil Market in the Short Run (b) The Oil Market in the Long Run
Price 1. In the short run, when supply and Price
demand are inelastic, a shift in supply. . . 1. In the long run, when supply and
demand are elastic, a shift in supply. . .
S2
S1 S2 S1
P2

2. … leads to
1. an a P2 1. an
P1 large increase P1
in price

2. … leads to
Demand a Demand
small increase
in price
0 Quantity 0 Quantity

When the supply of oil falls, the response depends on the time horizon. In the short run,
supply and demand are relatively inelastic, as in panel (a). Thus, when the supply curve
shifts from S1 to S2, the price rises substantially. By contrast, in the long run, supply and
demand are relatively elastic, as in panel (b). In this case, the same size shift in the supply
curve (S1 to S2) causes a smaller increase in the price. 36