Chapter
Demand Elasticity & its Application
PRINCIPLES OF
MICROECONOMICS
1
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.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 2
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.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 3
Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
P
Example:
P rises
Price P2
by 10%
elasticity P1
of demand D
equals
Q
15% Q2 Q1
= 1.5 Q falls
10%
by 15%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 4
Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
P
Along
Along aa DD curve,
curve, PP and
and QQ
move
move in in opposite
opposite directions,
directions, P2
which
which would
would make
make price
price
elasticity P1
elasticity negative.
negative.
We D
We will
will drop
drop the
the minus
minus sign
sign
and
and report
report Q
all Q2 Q1
all price
price elasticities
elasticities
as
as positive
positive numbers.
numbers.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 5
Calculating Percentage Changes
Standard method
of computing the
Demand for percentage (%) change:
your websites
P end value – start value
x 100%
start value
B
$250
A Going from A to B,
$200
the % change in P equals
D
($250–$200)/$200 = 25%
Q
8 12
CHAPTER 5 ELASTICITY AND ITS APPLICATION 6
Calculating Percentage Changes
Problem:
The standard method gives
Demand for different answers depending
your websites on where you start.
P
From A to B,
B P rises 25%, Q falls 33%,
$250
A elasticity = 33/25 = 1.33
$200
D From B to A,
P falls 20%, Q rises 50%,
Q
8 12 elasticity = 50/20 = 2.50
CHAPTER 5 ELASTICITY AND ITS APPLICATION 7
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, also 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!
CHAPTER 5 ELASTICITY AND ITS APPLICATION 8
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
CHAPTER 5 ELASTICITY AND ITS APPLICATION 9
A C T I V E L E A R N I N G 1:
Calculate an elasticity
Use the following
information to
calculate the
price elasticity
of demand
for hotel rooms:
if P = $70, Qd = 5000
if P = $90, Qd = 3000
10
What determines price
elasticity?
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?
CHAPTER 5 ELASTICITY AND ITS APPLICATION 11
EXAMPLE 1:
Rice Krispies vs. Sunscreen
The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
• Rice Krispies has lots of close substitutes
(e.g., Cap’n Crunch, Count Chocula),
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.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 12
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.
(Can you think of a substitute for clothing,
other than living in a nudist colony?)
Lesson: Price elasticity is higher for narrowly
defined goods than broadly defined ones.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 13
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 [Link] the price rises,
some people will forego it.
Lesson: Price elasticity is higher for luxuries
than for necessities.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 14
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.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 15
The Determinants of Price Elasticity:
A Summary
The
The price
price elasticity
elasticity of
of demand
demand depends
depends on: on:
the
the extent
extent to
to which
which close
close substitutes
substitutes are
are
available
available
whether
whether the
the good
good is is aa necessity
necessity or
or aa luxury
luxury
how
how broadly
broadly or
or narrowly
narrowly the
the good
good is
is defined
defined
the
the time
time horizon:
horizon: elasticity
elasticity is
is higher
higher in
in the
the
long
long run
run than
than the
the short
short run.
run.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 16
The Variety of Demand Curves
Economists classify demand curves according to
their elasticity.
The price elasticity of demand is closely related
to the slope of the demand curve.
Rule of thumb:
The flatter the curve, the higher the elasticity.
The steeper the curve, the smaller the elasticity.
The next 5 slides present the different
classifications, from least to most elastic.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 17
“Inelastic demand (steeper demand
curve)”
Price elasticity % change in Q < 10%
= = <1
% change in P 10%
of demand
D curve: P
relatively steep
P1
Consumers’
price sensitivity: P2
relatively low D
P increase by Q
Elasticity: 10% Q1 Q2
<1
Q decreases less
than 10%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 18
“Unit elastic demand”
Price elasticity % change in Q 10%
= = =1
% change in P 10%
of demand
D curve: P
intermediate slope
P1
Consumers’
price sensitivity: P2
D
intermediate
P falls Q
Elasticity: by 10% Q1 Q2
1
Q rises by 10%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 19
“Elastic demand (flatter demand curve)”
Price elasticity % change in Q > 10%
= = >1
% change in P 10%
of demand
D curve: P
relatively flat
P1
Consumers’
price sensitivity: P2 D
relatively high
P falls Q
Elasticity: by 10% Q1 Q2
>1
Q rises more
than 10%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 20
“Perfectly inelastic demand” (one
extreme case)
Price elasticity % change in Q 0%
= = =0
% change in P 10%
of demand
D curve: P
D
vertical
P1
Consumers’
price sensitivity: P2
0
P increases Q
Elasticity: by 10% Q1
0 Q changes
by 0%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 21
“Perfectly elastic demand” (the other
extreme)
Price elasticity % change in Q any %
= = = infinity
% change in P 0%
of demand
D curve: P
horizontal
P2 = P1 D
Consumers’
price sensitivity:
extreme
P changes Q
Elasticity: by 0% Q1 Q2
infinity
Q changes
by any %
CHAPTER 5 ELASTICITY AND ITS APPLICATION 22
Elasticity of a Linear Demand
Curve
P The slope
200% of a linear
$30 E = = 5.0
40% demand
67% curve is
20 E = = 1.0
67% constant,
but its
40%
10 E = = 0.2 elasticity
200%
is not.
$0 Q
0 20 40 60
CHAPTER 5 ELASTICITY AND ITS APPLICATION 23
Price Elasticity and Total
Revenue
Continuing our example, 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.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 24
Price Elasticity and Total
Revenue
Price elasticity Percentage change in Q
=
of demand Percentage change in P
Revenue = P x Q
If demand is elastic, then
price elast. of demand > 1
% change in Q > % change in P
Argument 1;
When D is elastic, a price increase
causes revenue to fall
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Price Elasticity and Total
Revenue
increased Demand for
Elastic demand revenue due your websites
(elasticity = 1.8) P to higher P lost
revenue
If P = $200,
due to
Q = 12 and $250 lower Q
revenue = $2400.
$200
If P = $250, D
Q = 8 and
revenue = $2000.
Q
fall in revenue is greater 8 12
than the increase in
revenue from higher P
26
Price Elasticity and Total
Revenue
Price elasticity Percentage change in Q
=
of demand Percentage change in P
Revenue = P x Q
If demand is inelastic, then
price elasticity of demand < 1
% change in Q < % change in P
Argument 2;
D is inelastic, a price increase causes revenue to rise.
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
Now, demand is increased Demand for
inelastic: revenue due your websites
elasticity = 0.82 to higher P
P lost
If P = $200, revenue
due to
Q = 12 and
$250 lower Q
revenue = $2400.
$200
If P = $250,
Q = 10 and D
revenue = $2500.
Q
A fall in revenue is smaller 10 12
than the increase in revenue
from higher P,
so revenue rises. 28
Other Elasticities of Demand
The income elasticity of demand measures the
response of Qd to a change in consumer income.
Income Percent change in Qd
=
elasticity of Percent change in
demand income
Recall from chap.4: An increase in income
causes an increase in demand for a normal
good.
Hence, for normal goods, income elasticity > 0.
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Other Elasticities
The cross-price elasticity of demand measures the
response of demand for one good to changes in the
price of another good.
Cross-price % change in Qd for good 1
=
elast. % change in price of good
of demand 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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