Chapter 4 - Elasticity, in this chapter you will learn: Concept of elasticity; calculate price elasticity of demand and supply using the mid‐point method; explain how the determinants of price elasticity of demand and supply affect the degree of elasticity; calculate cross‐price and income elasticities of demand, and interpret the sign of the elasticities.
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Chapter 4
Elasticity
What will you learn in this chapter?
using the mid‐point method
elasticity of demand and supply affect the
degree of elasticity
demand, and interpret the sign of the
elasticities
a change in a market condition
What is elasticity?
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Price elasticity of demand
Quantity of coffee (millions of cups)
1 When price
Decreases by 25%
2 …quantity demanded increases
by 50%.
0
0.50
1.00
1.50
2.00
2.50
3.00
Price ($)
D
A
B
• The price elasticity of demand measures the magnitude
of change in the quantity demanded from a change in
its price. In other words, it estimates price sensitivity.
Calculating price elasticity
• The midpoint method calculates the elasticity at
the midpoint of any two points. The formula is:
%∆
where point 1 is , and point 2 is ,
• The midpoint elasticity is the differenceof any
two numbers divided by their average
Active Learning: Calculating the price
elasticity of demand
Find the price elasticity of demand using the
midpoint formula for the points along a demand
curve: ($10,350) and ($20, 150)
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for some goods and services than for others
responsiveness to price changes
– Availability of substitutes.
Determinants of price elasticity of demand
categorized based on elasticity
–Elastic: A change in price causes a relatively large
percentage change in quantity demanded.
–Inelastic: A change in price causes a relatively small
percentage change in quantity demanded.
Categorizing elasticities
0
5
10
Price ($)
At prices
higher than $5,
the quantity
demanded is 0.
D Price ($)
Quantity
0 5 10
At any price, the quantity demanded
is the same.
D
Consumers
will buy any
quantity at a
price of $5
Categorizing elasticities
At the extremes, demand can be either perfectly elastic or
perfectly inelastic.
Perfectly elastic (|ε d | = ∞) Perfectly inelastic (|ε d | = 0)
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Categorizing elasticities
10
0
1
3
5
7
9
1 2 3 4 5 6 7 8 9 10
Price ($)
Quantity
Elastic (|ε d | >1)
…quantity
demanded
increases by 60%
…quantity demanded increases by 20%.
D
Inelastic (|ε d | < 1)
0 1 3 5 7 9 10
1 2 3 4 5 6 7 8 9 10
Price ($)
Quantity D
Between these two extremes, the elasticities are divided into
three categories.
Quantity
…quantity demanded increases by 40%.
Unit‐elastic (|ε d | = 1)
0 1 3 5 7 9 10
1 2 3 4 5 6 7 8 9 10
Price ($)
D
When price declines by the same amount (say 40%)…
elastic or inelastic is extremely useful in
business
– Allows managers to determine whether a price
increase will cause total revenue to rise or fall.
receives from the sale of goods and services
– Total revenue (TR) equals price paid (P) multiplied
by quantity sold (Q), or TR = P x Q.
Using price elasticity of demand
Using price elasticity of demand
Quantity
Price ($)
1 As price
Increases…
0
50
100
150
200
250
300
350
400
450
500
2 4 6 8 10 12 14 16 18 20
2 …quantity decreases.
2+3= total revenue after the price change.
1+2= total revenue before the price change.
Price effect Quantity effect
D
1 2
3
An increase in price affects total revenue in two ways.
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Using price elasticity of demand
0
1
2
3
4
5
1 2 3 4 5 6 7 8 9 10
Price ($)
Quantity (thousands)
When demand is
elastic, the quantity
effect outweighs the
price effect.
D
Price effect
Quantity effect
0 1 2 3 4 5
1 2 3 4 5 6 7 8 9 10
Price ($)
Quantity (thousands)
When demand is inelastic, the price effect outweighs the quantity effect.
D
Price effect Quantity effect
The magnitude of the price and quantity effects
are determined by the elasticity of demand
Active Learning: Calculating the change in
total revenue
Find the change in total revenue using the following two
points along a demand curve: ($20, 150) and ($10,350).
Using price elasticity of demand
P ($) Q TR ($)
35 3 105
30 4 120
25 5 125
20 6 120
15 7 105
Inelastic demand:
decreasing price revenue
Elastic demand:
decreasing revenue price
Total revenue ($)
0 25 50 75 100 125
2
1 3 4 5 6 7 8 9 10
Quantity Quantity
0
Price ($)
5
10
15
20
25
30
35
40
45
50
1 2 3 4 5 6 7 8 9 10
D
summarized as follows
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• The concept of elasticity can also be applied to
supply
• The price elasticity of supply measures producers’
response (in quantity) to a change in price
– Uses same midpoint formula but replaces quantity
– Elasticity is always positive.
– Same interpretation:
• Elastic : εs>1.
• Inelastic: εs<1.
Price elasticity of supply
for some goods and services than for others
responsiveness to price changes
– Availability of inputs.
Determinants of price elasticity of supply
Cross‐price elasticity of demand
• The cross‐price elasticity of demand is a measure of
how the quantity demanded of one good changes when
the price of a different good changes.
• The midpoint formula calculates the elasticity between
B:
• The cross‐price elasticity of demand can be positive or
negative.
– , >0: the two goods are substitutes.
– , <0: the two goods are complements.
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Income elasticity of demand
• The income elasticity of demand is a measure of how
much the quantity demanded changes in response to a
change in consumers’ incomes.
• The midpoint formula calculates the elasticity between
income:
%∆
• The income elasticity of demand can be positive or
negative.
– >0: the good is normal If >1, then it is a luxury.
– <0: the good is inferior.
Active Learning: Calculating the income
elasticity of demand
• When consumers’ income is $100, they buy 250
units of a good. When consumers’ income
increases to $200, they buy 500. Find the income
elasticity of demand using the midpoint formula.
• Is the good inferior or normal?
• Is it a luxury good?
Four measures of elasticity
Measure Equation Negative Positive More elastic Less elastic
% change in quantity demanded
% change in price Always Never
Over time, for substitutable goods and luxury items
In the short run, for unique items
% change in quantity supplied
% change in price Always
Over time, with flexible production
In the short run, with production constraints
% change in quantity demanded of A
% change in price of B
For comple-ments
For substitutes
For near perfect substitutes complements
For loosely related goods
% change in quantity demanded
% change in income
For inferior goods For normal goods For luxury items with close substitutes
For unique and necessary items Never
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Summary
apply the concepts of supply and demand to
business and policy questions
– Indicates the sensitivity of quantity to a change in:
• Price.
• Price of a related good.
• Income.
set prices so firms can maximize revenue