04
Elasticity
McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Price Elasticity of Demand
• Measures buyers’ responsiveness to
price changes
• Elastic demand
• Sensitive to price changes
• Large change in quantity
• Inelastic demand
• Insensitive to price changes
• Small change in quantity
LO1 4-2
Price Elasticity of Demand
Formula
• Formula for price elasticity of demand
Percentage Change in Quantity
Demanded of Product X
Ed =
Percentage Change in Price
of Product X
LO1 4-3
Price Elasticity of Demand
Formula
• Use the midpoint formula
• Ensures consistent results
Change in quantity Change in price
Sum of quantities/2 Sum of prices/2
Ed = ÷
LO1 4-4
Price Elasticity of Demand
Formula
• Use percentages
• Unit free measure
• Compare responsiveness across
products
• Eliminate the minus sign
• Easier to compare elasticities
LO1 4-5
Interpretation of Elasticity of
Demand
• Ed > 1 demand is elastic
• Ed = 1 demand is unit elastic
• Ed < 1 demand is inelastic
• Extreme cases
• Perfectly inelastic
• Perfectly elastic
LO1 4-6
Extreme Cases
P D1
Perfectly
inelastic
demand
(Ed = 0)
Perfectly inelastic demand
LO1 4-7
Extreme Cases
D2
Perfectly
elastic
demand
(Ed = ∞)
Perfectly elastic demand
LO1 4-8
Total Revenue Test
• Total Revenue = Price X Quantity
• Inelastic demand
• P and TR move in the same direction
• Elastic demand
• P and TR move in opposite directions
LO2 4-9
Total Revenue Test
• Lower price and elastic demand
• Blue gain exceeds orange loss
P
$3
a
2
b
1 D1
0 10 20 30 40 Q
LO2 4-10
Total Revenue Test
• Lower price and inelastic demand
• Orange loss exceeds blue gain
P
$4 c
d
1
D2
0 10 20 Q
LO2 4-11
Total Revenue Test
• Lower price and unit elastic demand
• Blue gain equals orange loss
P
$3 e
f
1
D3
0 10 20 30 Q
LO2 4-12
Total Revenue Test
Price Elasticity of Demand for Movie Tickets as Measured by the Elasticity
Coefficient and the Total-Revenue Test
(1) (3) (4) (5)
Total Quantity of Elasticity Total Total
Tickets Demanded per (2) Coefficient Revenue Revenue
Week, Thousands Price per Ticket (Ed) (1) X (2) Test
1 $8 $8,000
2 7 5.00 14,000 Elastic
3 6 2.60 18,000 Elastic
4 5 1.57 20,000 Elastic
5 4 1.00 20,000 Unit Elastic
6 3 0.64 18,000 Inelastic
7 2 0.38 14,000 Inelastic
8 1 0.20 8,000 Inelastic
LO2 4-13
Elasticity and Total Revenue
$8 Elastic
7 a Ed > 1
6 b
5 c Unit Elastic
Price
4 d Ed = 1
3 e Inelastic
2 f Ed < 1
1 g
h D
0 1 2 3 4 5 6 7 8
Quantity Demanded
(Thousands of Dollars)
$20
18
Total Revenue
16
14
12
10
8
6 TR
4
2
0 1 2 3 4 5 6 7 8
Quantity Demanded
LO2 4-14
Summary of Price Elasticity of
Demand
Price Elasticity of Demand: A Summary
Absolute Impact on Total Revenue of a:
Value of
Elasticity
Coefficient Demand Is: Description Price Increase Price Decrease
Greater than 1 Elastic or Qd changes by a Total Revenue Total Revenue
(Ed > 1) relatively larger decreases increases
elastic percentage than
does price
Equal to 1 Unit or unitary Qd changes by Total revenue Total revenue
(Ed = 1) elastic the same is unchanged is unchanged
percentage as
does price
Less than 1 Inelastic or Qd changes by a Total revenue Total revenue
(Ed < 1) relatively smaller increases decreases
inelastic percentage than
does price
LO2 4-15
Determinants of Elasticity of
Demand
• Substitutability
• More substitutes, demand is more elastic
• Proportion of Income
• Higher proportion of income, demand is more
elastic
• Luxuries vs. Necessities
• Luxury goods, demand is more elastic
• Time
• More time available, demand is more elastic
LO1 4-16
Price Elasticity of Demand
Selected Price Elasticities of Demand
Price Elasticity Price Elasticity
Product or Service of Demand (Ed) Product or Service of Demand (Ed)
Newspapers .10 Milk .63
Electricity (household) .13 Household appliances .63
Bread .15 Liquor .70
MLB Tickets .23 Movies .87
Telephone Service .26 Beer .90
Cigarettes .25 Shoes .91
Sugar .30 Motor vehicles 1.14
Medical Care .31 Beef 1.27
Eggs .32 China, glassware 1.54
Legal Services .37 Residential land 1.60
Automobile repair .40 Restaurant meals 2.27
Clothing .49 Lamb and mutton 2.65
Gasoline .60 Fresh peas 2.83
LO1 4-17
Applications of Ed
• Large Crop Yields
• Inelastic demand, lower total revenue
• Excise Taxes
• Inelastic demand, more total revenue
• Decriminalization of Illegal Drugs
• Inelastic demand, more total revenue
LO1 4-18
Price Elasticity of Supply
• Measures sellers’ responsiveness to
price changes
• Elastic supply, producers are
responsive to price changes
• Inelastic supply, producers are not
responsive to price changes
LO3 4-19
Price Elasticity of Supply
• Formula to compute elasticity
• Es > 1 supply is elastic
• Es < 1 supply is inelastic
Percentage Change in Quantity
Supplied of Product X
Es =
Percentage Change in Price
of Product X
LO3 4-20
Price Elasticity of Supply
• Time is primary determinant of
elasticity of supply
• Time periods considered
• Market period
• Short Run
• Long Run
LO3 4-21
Elasticity of Supply: The Market
Period
• Perfectly inelastic supply
Sm
Pm
P0
D2
D1
Q0
LO3 4-22
Elasticity of Supply: The Short
Run
• Supply is more elastic than in market
period
Ss
Ps
P0
D2
D1
Q0 Qs
LO3 4-23
Elasticity of Supply: The Long Run
• Supply is even more elastic than in
the short run
Sl
Pl
P0
D2
D1
Q0 Ql
LO3 4-24
Applications of Elasticity of
Supply
• Antiques
• Inelastic supply
• Reproductions
• More elastic supply
• Volatile gold prices
• Inelastic supply
LO3 4-25
Cross Elasticity of Demand
• Measures responsiveness of sales to
change in the price of another good
• Substitutes – positive sign
• Complements – negative sign
• Independent goods - zero
Percentage change in quantity demanded of product
X
Ex,y =
Percentage change in price of product Y
LO4 4-26
Cross Elasticity of Demand
• Application
• Change the price?
• Allow a merger?
LO4 4-27
Income Elasticity of Demand
• Measures responsiveness of buyers
to changes in income
• Normal goods – positive sign
• Inferior goods – negative sign
Percentage change
in quantity demanded
Ei =
Percentage change in income
LO4 4-28
Income Elasticity Insights
• High income elasticities
• Most affected by a recession
• Low or negative income
• Least affected by a recession
LO4 4-29
Ex,y and Ei
Cross and Income Elasticities of Demand
Value of
Coefficient Description Type of Good(s)
Cross elasticity: Quantity demanded of W changes in same Substitutes
Positive (Ewz > 0) direction as change in price of Z
Negative (Exy < 0) Quantity demanded of X changes in Complements
opposite direction from change in price of Y
Income elasticity: Quantity demanded of the product changes Normal or superior
Positive (Ei >0) in same direction as change in income
Negative (Ei<0) Quantity demanded of the product changes Inferior
in opposite direction from change in income
LO4 4-30
Elasticity and Pricing Power
• Charge different prices based on
price elasticities
• Examples:
• Business air travelers
• Adult vs. child
4-31
