ECON 100 Lecture 12

November 8/9
Lecture starts …
 Elasticity and Its
Applications

Copyright © 2004 South-Western

 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.
A decrease in supply 
P
the equilibrium price S2 S1
increases
the equilibrium quantity
decreases
P2
P1

D
Q
Q2 Q1
Same decrease in supply, but with a different demand
curve
P D
The equilibrium price S2 S1
increases a lot
the equilibrium quantity
decreases a little
P2

P1

Q
Q2
Q1
Same decrease in supply, with yet another demand
curve
P
The equilibrium price S2 S1
increases a little
the equilibrium quantity
decreases a lot
P2
P1
D

Q
Q2 Q1
“As the price of a good falls, the quantity demanded increases. ”

But how much will it increase?

A little or a lot?
How responsive is quantity demanded to changes in the price?
 The price elasticity of demand

Price elasticity of demand is a “measure” of how responsive the

quantity demanded is to a change in price.
 Elasticity is a very general concept!

Elasticity is a measure of the responsiveness of the quantity

demanded or the quantity supplied to a change in one of their
determinants.

EXAMPLES:
Income elasticity of demand
Cross-price elasticity of demand
Price elasticity of supply
Let’s focus on the price elasticity of demand.
 Case 1
Price
Demand

$5.00

$4.00

The increase
in price…

0 100 Quantity
…has no effect on the quantity
demanded.
 Case 2
Price

$4.25
$4

Demand

a small
increase in
price…

0 50 100 Quantity

leads to a large decrease in quantity

demanded.
 Case 1: Case 2:
“Demand is inelastic” “Demand is elastic .”
 What makes the demand more price-elastic?

Demand tends to be more elastic if, …

narrow broad
• there are close substitutes.
• the market is more narrowly defined (milk versus food).
• more time is allowed after the price change.
• the good is a luxury. (Necessities have inelastic demand.)
Demand will be more elastic if there are close substitutes

The patent expires on a brand-name drug and

five generic drugs come on the market.
As a result, the demand for the original brand-
name drug becomes…
a) more price elastic
b) less price elastic

ANSWER: A
The demand for the original drug becomes more
price elastic because the generic drugs are
perfect substitutes.
 Demand for food v. demand for lettuce

The more general the classification, the fewer substitutes there

are and this makes demand less elastic.
Demand for food is less price elastic than demand for lettuce.

vs
.
 Time is on our side…

More time to adjust means higher elasticity!

Over time consumers can adjust their behavior by finding substitutes. (This
makes their demand more price elastic in the long run.)
 Luxuries vs. necessities

Demand for necessities is price inelastic.

Demand for luxuries is price elastic.

How do we measure / quantify
the price elasticity of demand?
 The Price Elasticity of Demand, EP

The degree of responsiveness of quantity demanded to a change

in price is quantified in a single number: EP
EP is computed as follows:
The percentage change in quantity demanded
divided by
the percentage change in price.

P ercen tag e ch an g e in q u an tity d em an d ed

P rice elasticity o f d em an d =
P ercen tag e ch an g e in p rice
 How to calculate a percentage change in 3 easy steps:

Step 1: Calculate the change (the new value minus the initial
value)
Step 2: Divide the change by the initial value
Step 3: Multiply by 100 and add the "%" sign
EXAMPLE
Compute the Price Elasticity of Demand EP at P = ₺2.00
the initial values of P and Q

When P = ₺2.00,  QD = 10 % change in QD

EP 
% change in P

When P = ₺2.20,  QD = 8

the new values of P and Q

Compute the Price Elasticity of Demand EP at P = ₺2.00

When P = ₺2.00,  QD = 10 % change in QD

EP 
When P = ₺2.20,  QD = 8 % change in P

1. Calculate the change in QD (ΔQD): (8 – 10) = –2 (units: cone of ice-cream)

2. Divide the change by the initial value: (–2/10) = –0.2
3. Multiply by 100, add the % sign: –20 % (unitless)

4. Calculate the change in P (ΔP): (2.20 – 2.00) = +0.20 (units: TL)

5. Divide the change by the initial value: (0.20/2) = +0.10
6. Multiply by 100, add the % sign: +10 % (unitless)

7. EP = {% change in QD}/{% change in P}

8. EP = –20/10 = –2
 Please note that

Because price and quantity are negatively related (price↑, QD↓,

and price ↓, QD↑), the price elasticity EP is always a negative
number.

We may refer to the price elasticity of demand EP by its absolute

value (we may ignore the minus sign).
Your turn now
 the initial values of P and Q

When P = ₺5, you buy 20 units.

When P = ₺4, you buy 23 units.
the new values of P and Q

Please compute the price elasticity of demand at P = ₺5.

% change in QD
EP 
% change in P
Answers
When P = ₺5, you buy 20 units.
When P = ₺4, you buy 23 units.

1. Change in QD: (23 – 20) = 3 units

2. % change in QD is 3/20x100% = 15%

3. Change in price: (4.00 – 5.00) = ‒1.00 TL

4. % change in price: (‒ 1.00/5.00)x100% = ‒20%

5. EP = {% change in QD}/{% change in P}

6. EP = 15/(‒20) = –3/4 = –0.75
 Elastic vs. inelastic demand

When do we say “demand is inelastic”?

 Elastic vs. inelastic demand
Compute EP then take the absolute value of EP.

Unit elastic
Inelastic Elastic
│EP│
0 1 2 3 4 5 6

• Inelastic: │EP│ < 1

• Unit elastic: │EP│ = 1
• Elastic: │EP│ > 1
 Elastic vs. inelastic demand

When the price elasticity EP in absolute value is between 0 and 1, we say

that demand is inelastic.
Inelastic demand means that the quantity demanded is not very
responsive to the price.

When the price elasticity EP in absolute value is greater than 1, we say that
demand is elastic.
Elastic demand means that the quantity demanded is responsive to the
price.
 What does the EP number mean?

Suppose the price elasticity of demand for

gasoline is ‒0.2. This means:

 When the price of gasoline rises by 1%, the quantity

demanded falls by

% change in QD
EP 
% change in P
 What does the EP number mean?

Suppose the price elasticity of demand for

gasoline is ‒0.2. This means:

 When the price of gasoline rises by 1%, the quantity

demanded falls by 0.2%
 When the price of gasoline rises by 5%, the quantity
demanded falls by

% change in QD
EP 
% change in P
 What does the EP number mean?

Suppose the price elasticity of demand for

gasoline is ‒0.2. This means:

 When the price of gasoline rises by 1%, the quantity

demanded falls by 0.2%
 When the price of gasoline rises by 5%, the quantity
demanded falls by 1%

Gasoline demand is not very price sensitive.

% change in QD
EP 
% change in P
 What does the EP number mean?

Suppose the price elasticity of demand for

gold jewelry is ‒2.5. This means:

When the price of gold jewelry rises by 1%, the quantity demanded falls by
2.5%
When the price of gold jewelry rises by 5%, the quantity demanded falls by
12.5%.

Demand for gold jewelry price sensitive.

% change in QD
EP 
% change in P
Your turn now
 What does the EP number mean?

The price elasticity of demand for

gasoline is ‒0.2.

We want to reduce the gasoline consumption

by 10%. The current price is 8.40TL per liter.
What must be the new price?

% change in QD
EP 
% change in P
 Solution

Start with the price elasticity formula:

We know that EP = 0.2,
So, the price increase we need is given by this formula

 % change in P is
 We need a 50% increase in P!
 P = 8.40, 50% of 8.40 is 0.5x8.40 = 4.20, so the new price
needs to be P = 8.40 + 4.20 = 12.60
Some real price elasticity numbers
 Price
elasticity
The price elasticity of Demand for Gasoline
Water demand (urban residential, US)
 Water demand (urban residential, US)

On average, in the United States, a 10% increase in the price of

water can be expected to diminish demand in the urban
residential sector by about 3 to 4 %.

This is equivalent to saying that U.S. residential water price

?????
elasticity EP is in the range of –0.3 to –0.4.
Crude oil
Demand for oil: Price Elasticity Estimates

This is from a meta-review from

Bank of England (6/2008) on oil
price demand elasticity:

Price elasticity is close to zero in

short term.
It increases with time, but remains
low.

www.theoildrum.com/node/4397
Price Elasticity numbers, selected goods
Note that the minus sign is already dropped!
Short run vs long run price elasticity
 https://forms.gle/unSTN7Q6vR41CCrz5

TuTh 830 & 1000

End of the lecture