ELASTICITY

AND ITS
APPLICATION
Chapter 5

5-1
 ELASTICITY AND ITS APPLICATION
 Scenarios

 Due to an increase in the price of gasoline, the price of milk is

expected to increase by 3%. How much less milk will people buy?

 A new technology allows you to decrease the price of your products by

8%. How much more should you expect to sell? Given that you will sell
more units at a lower place, will your total revenues increase or
decrease?

5-2
 ELASTICITY AND ITS APPLICATION
 Scenarios
 Pepsi has announced a 20% decrease in the price of their products.
How much will the demand for Coke change as a result?

 How much will the demand for houses decrease if a recession will
decrease buyers’ income by 6%?

 If the price for new houses increases by 10%, how much will the
quantity supplied of new houses increase in the next 2 months (short
run)? How about next two years (long run)?

5-3
 ELASTICITY AND ITS APPLICATION
 Elasticity is a measure of how much buyers and sellers respond to
changes in market conditions.
 Practically, we look at how much the quantity demanded or supplied
responds to a change in one of the factors affecting the demand or
supply curve
 We are interested in the magnitude of changes

 Elasticity = A measure of the responsiveness of quantity demanded

or quantity supplied to one of its determinants.

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 ELASTICITY AND ITS APPLICATION
 There are many types of elasticity
 Every time a variable X changes due to a change in a related variable
Y, we can calculate an elasticity
 We will study four elasticities in this course:
o Price elasticity of demand: shows how q-ty demanded changes due to price
o Income elasticity of demand (quantity demanded and income)
o Cross-price elasticity of demand (quantity demanded of one good and the price
of another good)
o Price elasticity of supply (quantity supplied and price)

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 THE PRICE ELASTICITY OF DEMAND

 Price elasticity of demand: A measure of how much the quantity

demanded of a good responds to a change in the price of that good

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 THE PRICE ELASTICITY OF DEMAND
CALCULATING THE PRICE ELASTICITY OF DEMAND
 Example: a 10% increase in the price of an ice cream cone causes the
amount of ice cream you buy to fall by 20%.

 Interpretation: quantity demanded tends to change twice as much (2x)

as price
 This allows us to anticipate future changes in Q demanded, if we know
how much the price is expected to change
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 THE PRICE ELASTICITY OF DEMAND
THE PRICE ELASTICITY OF DEMAND (PED) – with or

without sign?
In the previous example price increased (+10%) and Q declined (-20%)
 In the elasticity calculation, we ignored the signs. Why?
 P and Q demanded always change in opposite directions (Law of Demand)
-> % change Q, % change P always have opposite signs
-> their ratio (the elasticity) will always be technically negative
 With the PED our concern is how much Q changes in response to P, not the sign
 So, for this elasticity only (PED) we will ignore the signs of the % change P, % change Q
 PED will be the ratio of these percentage changes in absolute value (i.e. ignoring any negative sign):

 Note: Greek later ‘delta’ means ‘change’; should be read as “percentage change”

5-8
 THE PRICE ELASTICITY OF DEMAND
USING THE PRICE ELASTICITY OF DEMAND
 Previous example: price elasticity of ice cream is 2
 Recall:
 Elasticity shows how much we expect Q to change if P changes by 1%
 For any other change in P, the change in Q can be calculated based
on the price elasticity of demand (E)

o If P drops by 3%, Q will increase by approximately 2 x 3% = 6%

o If P increases by 1.5%, Q decreases by approximately 2 x 1.5% = 3%

5-9
 THE PRICE ELASTICITY OF DEMAND
CALCULATING THE PRICE ELASTICITY OF DEMAND
 In most situations, however, the percentage changes will not be
provided to us
 How to calculate the percentage change of one variable?
 And why do we even need percentage changes?

 Example: variable X (X could be P, or Q demanded) is increasing by 5.

Is this increase big or small? Think for a minute. Then go to next slide.

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 THE PRICE ELASTICITY OF DEMAND
CALCULATING THE PRICE ELASTICITY OF DEMAND
 Example: variable X is increasing by 5. Is this increase big or small?
 Like most things in life…it depends
o If X is the price of a pizza, a $5 increase is significant
o If X is the price of a car, the same $5 increase is insignificant
 To judge if the change in X (5) is big /small we need to compare it to
something
 Usually we compare it to what the value of X used to be
 Say X was 20 initially and now it is 25.
 Then, the most usual way to calculate the percentage change in X is:
% change X = (X2 – X1)/X1 = (25 – 20) / 20 = 0.25 = 25% 5-11
 CALCULATNG THE PRICE ELASTICITY OF DEMAND
Percentage Changes: 1. THE ARC METHOD
Percentage Change = (End value – Start value)/Start value
% change X = (X2 – X1)/X1
 The arch method is the most used method of calculating percentage changes outside of this class
 This is how we calculate inflation rates, growth rates, etc.
 This method is intuitive, simple, but problematic
 Why?
o The percentage change in X (whether X is price or quantity) will be different when X increases or X decreases
o Example: if X decreased from 25 to 20, then % change X = (X2 – X1)/X1 = (20 – 25) / 25 = - 0.20 = -20%
o The denominator is always the starting point; if the change happens in reverse the starting point changes
o The same change in X amounts to +25% when X increases and -20% when X decreases
=> For the same set of prices and quantities, the elasticity will be different when the price changes from P1 to P2 then if it
changes from P2 to P1
o That means, the elasticity value will be unreliable
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CALCULATING THE ELASTICITY OF DEMAND
1. THE ARC METHOD – Another Example
 Example: Consider we know these two points on the demand curve.
Let’s calculate the elasticity when moving from A to B and viceversa.
Point A: Price = $4 Quantity = 120
Point B: Price = $6 Quantity = 90
 Moving from A to B: P increases (from 4 to 6) and Q declines (from 120 to 90)
 % change P = (6 - 4) /4 = 50%
 % change Q = (90 - 120) /120 = -25%
 E = |% change Q| / |% change P| = 25% / 50% = 0.5 (moving from A to B)
 Moving from B to A: P decreases (from 6 to 4) and Q increases (from 90 to 120)
 % change Q = (120 – 90) /90 = 33%
 % change P = (4 - 6) /6 = -33%
 E = |% change Q| / |% change P| = 33% / 33% = 1 (moving from B to A)
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 THE PRICE ELASTICITY OF DEMAND
Percentage Changes: 2. THE MIDPOINT METHOD

Percentage change of X = (End value – Start value)/Average value

% change X = (X2 – X1) / [(X1+X2)/2]

 X can be price, quantity, or any other variable that may enter the elasticity calculations
 It may seem complicated but it is not
 The midpoint method is the default method used in this course.
 If you are not requested specifically to use the arc method, you must use the midpoint method
 We will, again, ignore the negative sign and just focus on the magnitude
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 THE PRICE ELASTICITY OF DEMAND
Percentage Changes: 2. THE MIDPOINT METHOD
P

The intuition
 What changes is how we calculate the percentage change () of Q and P
 Once we calculate these, the elasticity is still = % change Q/ % change P
 With the midpoint method, the percentage change compares the change in a
variable to the average (mid) value of that variable, which is the same whether the
variables increases or decreases
 Sometimes that average value is obvious, other times is not, so we can calculate it
as (X1 + X2) /2

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 THE PRICE ELASTICITY OF DEMAND
Percentage Changes: 2. THE MIDPOINT METHOD
P

 Previous example: moving from A to B

o P increases from 4 to 6, Q declines from 120 to 90.
o % change in P = (4 – 6) /5 = 40%
o % change in Q = (90 – 120) /[(90 + 120) /2 ] = (90 – 120)/105 = -28.6%
o Elasticity = |-28.6%| / 40% = 0.715
• Note that the average P between 4 and 6 is obvious, so it’s written directly as 5
• The average between 90 and 120 may be less obvious, so we calculate it first as (90 + 120)/2 = 105
• Feel free to write the average directly or calculate it, as you feel comfortable
 If instead we looked at the reverse change (B to A) the values would be the same,
only signs would change.
 Since we ignore the signs in the final step, the elasticity is the same moving from A
to B or B to A. 5-16
 THE ELASTICITY OF DEMAND
Percentage Changes: 2. THE MIDPOINT METHOD
 Recap: With the midpoint method:
Mid price = $5 Mid Quantity = 105
 Moving from A to B:
 P rises by 40% (=(6-4)/5) and QD falls by 28.6% (=(90-120)/105)

 Moving from B to A:
 P falls by 40% ( = (4-6)/5) and QD rises by 28.6% (= (120-90)/105)

 In both directions, E = 28.6% / 40% = 0.72

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 THE ELASTICITY OF DEMAND
THE VARIETY OF DEMAND CURVES
 Elastic Demand:
o price elasticity > 1
o quantity changes proportionately more than price; very responsive to price changes
o D looks flat
o Perfectly elastic demand: Q changes infinitely more than P (Q drops to zero if P increases a
tiny amount, Q increases to infinity if P drops a tiny amount ); only exists in theory
 Inelastic Demand:
o Price elasticity < 1
o quantity changes proportionately less than the price; D looks steep
o Perfectly inelastic demand: Q does not change at all as P changes; PED = 0; mostly in theory
 Unit Elastic Demand:
o Price elasticity = 1
o quantity changes proportionately same as price; D looks neither flat nor steep (symmetrically
curved) 5-18
FIGURE 5.1 The Price Elasticity of
Demand

5-19
FIGURE 5.1 (cont.) The Price Elasticity
of Demand

5-20
FIGURE 5.1 (cont.) The Price Elasticity
of Demand

5-21
 THE ELASTICITY OF DEMAND
THE PRICE ELASTICITY OF DEMAND AND
 ITS and
Intuition: Buyers don’t like when P increases DETERMINANTS
will try to buy less of that good. The question is – for which goods can they
easily reduce their Q demanded and for which goods they can’t? Goods for which Q can drop easily when P increases have
elastic demand. Goods for which Q is hard to change have inelastic demand. What makes the difference between them?

 Availability of substitutes
o Elasticity is higher when close substitutes are available
 If mozzarela becomes more expensive, I can easily buy less (and replace it with cheddar cheese, Gouda, etc.)
 If my heart prescription becomes more expensive, I still have to buy about the same Q (no substitutes)
 Necessities versus luxuries
o Elasticity is higher for luxuries than necessities
 If concerts and toilet paper become more expensive, it is easier to give up the first but not the second
 Definition of the market
o Elasticity is higher for narrowly defined goods than broadly defined ones
 2% milk vs. milk in general; if 2% milk becomes more expensive (but not other types of milk), I can buy another kind; if all milk
becomes more expensive, there are fewer/no substitutes for it
 Time horizon
o Elasticity is larger in the long run than short run (more time to adjust in long run)
 Gasoline, cigarettes, drugs, etc. have an inelastic demand in the short-run (hard to change habits fast when P increases), but in the
5-22
longer term people can adapt, change habits and reduce their Q demanded more in response to higher prices
 Total Revenue and the Price Elasticity of Demand

 Total revenue (in a market): The amount paid by buyers and received by sellers
of a good
 Often called ”sales” in practice
 Computed as the price of the good times the quantity sold (and bought)

TR = P x Q
 Since the elasticity determines the relationship between P and Q, it will impact the
size of TR
 If the price of good increases and the quantity demanded drops as a result, will

TR ↑↓ = P↑ x Q↓
TR increase or decrease? It depends on the elasticity of the demand curve.
5-23
FIGURE 5.2 Total Revenue

5-24
 Total Revenue and the Price Elasticity of Demand

 Moving along the demand curve, as the price increases the quantity
demanded drops and viceversa
 How does total revenue (TR = P X Q) change as one moves along the
demand curve?
 The answer depends on the price elasticity of demand (how much Q
changes when P changes)

5-25
 Total Revenue and the Price Elasticity of Demand
 Inelastic demand:
 Q changes less than P does, so P has a larger impact on TR than Q
 TR will change in the same direction as P:
o If P increases, Q drops (but not too much) and TR increases (like P)
o If P decreases, Q increases (but not much) and TR decreases (like P)
 Elastic demand:
 Q changes more than P does, so Q has a larger impact on TR
 TR will change in the same direction as Q:
o If P increases, Q drops even more than P and TR drops as well (like Q)
o If P decreases, Q increases even more than P and TR increases (like Q)
 Unit elastic demand:
 Q and P changes are equal
 TR remains the same regardless of how much P (and Q) change 5-26
FIGURE 5.3 How Total Revenue Changes When
Price Changes

5-27
 How Total Revenue Changes When Price Changes

 The examples in Figure 5.3 illustrate some general rules:

 Inelastic demand (E<1)
o price and total revenue move in the same direction.
 Elastic demand (E>1):
o price and total revenue move in opposite directions.
 Unit-elastic demand (E=1)
o total revenue remains constant when the price changes.

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 Elasticity and Total Revenue
along a Linear Demand Curve
 Even though the slope of a linear demand curve is constant, the
elasticity is not constant along the linear demand curve
 Straight line = constant slope
 The elasticity is related to the slope but it’s more than the slope
 The slope is the ratio of changes in the two variables
oS =
 The elasticity is the ratio of percentage changes in the two variables
o E=
o Note that subscript “a” stands for average
o If we calculate the elasticity between any two points on the D curve, the slope is the same, but the average P and Q are changing, and
thus the elasticity, will change depending on where we are on the demand curve.
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FIGURE 5.4
Elasticity of a Linear Demand Curve
Elasticity along the linear demand curve
 Recall: E = (1/slope)* (Pa/Qa)
 Slope = 7/14 = 0.5; 1/slope = 1/0.5 = 2
 Moving from A to B: E = 1/slope*5.5/3 =2*1.83 =3.66
 From B to C: E = 1/slope*4.5/5 = 2*0.9 =1.8
 From C to D: E = 1/slope*3.5/7 = 2*0.5 =1
Top half of the D curve: D is elastic
 From D to E: E = 1/slope*2.5/9 = 2*0.27 =0.55
• To increase TR firms should lower P
• When P is large, a lower P leads to a  From E to F: E = 1/slope*1.5/11 = 2*0.13 =0.26
substantial increase in Q, such that TR  The elasticity declines as we move down along the
increases demand curve!
A Elasticity = 1 (middle of the linear D curve)
The elasticity of the D curve is:
B Bottom half of the D curve: D Greater than 1 on the top half of the D curve
C is inelastic  Firms can earn more TR by lowering P
• To increase TR firms Lower than 1 on the bottom half of the D curve
D should increase P
 Firms can earn more TR by increasing P
• When P is small, a higher
E P leads to only a small  Equal to 1 exactly at the middle of the D curve
F reduction in Q, such that (between C and D)
TR increases  TR will not increase whether P increase or
decrease a little; meaning, TR is maximized at
this point

5-30
 OTHER DEMAND ELASTICITIES

 In addition to the price elasticity of demand,

economists also use other elasticities to describe the
behaviour of buyers in a market.

5-31
 INCOME ELASTICITY OF DEMAND
 Income elasticity of demand: A measure of how much the
quantity demanded of a good responds to a change in
consumers’ income

 Sign very important here!

 Normal goods: positive income elasticity of demand
 Inferior goods: negative income elasticity of demand
 Note: still using the midpoint formula
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 CROSS-PRICE ELASTICITY OF
DEMAND
 Cross-price elasticity of demand: A measure of how much the
quantity demanded of one good responds to a change in the price
of another good
Cross price elasticity of demand

 Sign very important here!

 Substitute goods: positive cross-price elasticity of demand
o Example: price of Coke increases (good 2) -> people buy less Coke (good 2) ->
people buy more Pepsi (good 1)
 Complement goods: negative cross-price elasticity of demand
o Example: price of cream cheese decreases (good 2)-> people buy more cream
cheese (good 2) -> people buy more bagels (good 1)
5-33
 THE PRICE ELASTICITY OF SUPPLY
 Price elasticity of supply: A measure of how much the quantity
supplied of a good responds to a change in the price of that good
 Supply is
o elastic if the quantity supplied responds substantially to
changes in the price.
o inelastic if the quantity supplied responds only slightly to
changes in the price.
 Supply is usually more elastic in the long run than in the short run
 Other determinants: the ability to find the inputs and change
production as necessary

5-34
Active Learning
Elasticity and Changes in Equilibrium

 The supply of beachfront property is inelastic.

The supply of new cars is elastic.
 Suppose population growth causes demand for both goods to double
(at each price, QD doubles).
 For which product will P change the most?
 For which product will Q change the most?

5-35
Active Learning
Answers
Beachfront property
 When supply is inelastic,
(inelastic supply):
an increase in demand has a P
bigger impact on price than on
quantity. D1 D2 S
 Since Q cannot change much, P
will change more P2 B
 This also explains why properties in
desirable inner city neighborhoods
(less ability to built) tend to appreciate P1 A
faster than in suburbs (more ability to
spread) Q
Q1 Q2
5-36
Active Learning
Answers
New cars
When supply is elastic, (elastic supply):
P
an increase in demand has
a bigger impact on quantity D1 D2
than on price.
S
Since producers can easily
B
produce more, the price P2
A
will not increase much P1

Q
Q1 Q2
5-37
 THE ELASTICITY OF SUPPLY
COMPUTING THE PRICE ELASTICITY OF
SUPPLY

 For example, suppose an increase in the price of milk from $2.85 to $3.15
per 4 L container raises the amount that dairy farmers produce from 9000 to
11 000 L per month.
 Using the midpoint method, we calculate the percentage change in price as:
Percentage change in price = (3.15 ̶ 2.85) / 3.00 × 100 = 10%

5-38
 THE ELASTICITY OF SUPPLY
COMPUTING THE PRICE ELASTICITY OF
SUPPLY
 Similarly, we calculate the percentage change in quantity supplied
as:
Percentage change in quantity supplied
= (11 000 ̶ 9000) / 10 000 × 100 = 20%

5-39
FIGURE 5.5
The Price Elasticity of Supply

5-40
FIGURE 5.5 (continued)
The Price Elasticity of Supply

5-41
FIGURE 5.5 (continued)
The Price Elasticity of Supply

5-42
FIGURE 5.6
How the Price Elasticity of Supply Can Vary

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 THREE APPLICATIONS OF SUPPLY,
DEMAND, AND ELASTICITY

1. Can good news for farming be bad news for farmers?

2. Why did the Organization of the Petroleum Exporting
Countries (OPEC) fail to keep the price of oil high?
3. Does drug interdiction increase or decrease drug-related
crime?

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 THREE APPLICATIONS OF SUPPLY,
DEMAND, AND ELASTICITY
CAN GOOD NEWS FOR FARMING BE BAD
NEWS FOR FARMERS?
 New discovery: hybrid wheat increases the amount of wheat that
can be produced on each hectare of land
=>Farmers are willing to supply more wheat at any given price; the
supply curve shifts to the right.
 Does this discovery make farmers better off?
o Depends on the price elasticity of D (how much P and Q change as S shifts)
o D for wheat is inelastic -> as P declines Q does not increase much and TR
declines overall

5-45
FIGURE 5.7
An Increase in Supply in the Market for Wheat

5-46
 THREE APPLICATIONS OF SUPPLY,
DEMAND, AND ELASTICITY
WHY DID OPEC FAIL TO KEEP THE PRICE OF OIL HIGH?
 In the 1970s and early 1980s OPEC decreased the production of oil
in order to force prices to increase
 Prices dropped again in the 1980s. Why?
 Supply and demand behave differently in the short run and in the
long run.
 Short run: both the supply and demand for oil are relatively
inelastic. A decrease in supply has a big impact on P.
 Long run: supply and demand curves are more elastic => less
impact on price
5-47
FIGURE 5.8
A Reduction in Supply in the World Market for Oil

5-48
 THREE APPLICATIONS OF SUPPLY,
DEMAND, AND ELASTICITY
DOES DRUG INTERDICTION INCREASE OR
DECREASE DRUG-RELATED CRIME?
 Consider two policies: drug interdiction (more police, harsher
penalties) vs. drug education.
 Which one will reduce drug-related crime more?
 We assume the amount of crime is proportional to the amount of
money that can be made, i.e. total revenue from selling drugs
 We can use the tools of supply and demand to examine the impact of
these policies

5-49
FIGURE 5.9
Policies to Reduce the Use of Illegal Drugs

5-50
 THREE APPLICATIONS OF SUPPLY,
DEMAND, AND ELASTICITY
DOES DRUG INTERDICTION INCREASE OR
DECREASE DRUG-RELATED CRIME?
 Drug interdiction lowers the supply => increase in price
 Demand for drugs is inelastic => total revenue from drugs increases
with price => more drug-related crime
 Education lowers the demand for drugs
=> both price and quantity decrease => total revenue decreases => less
crime

5-51
 D and S Elasticities during the COVID-19
pandemic
 Price elasticity of demand for many goods has decreased
o That means, some demand curves have become (more) inelastic
o The reason for this is that people have less inclination to go shopping and find the best price or cheaper alternatives to the goods
they need
o As a result, some producers/stores realize that they can increase their prices without losing too much Q, and thus they can
increase their TR (price gouging)
 Price elasticity of supply: in the first few weeks there were shortages of hand sanitizer, face masks, but also toilet
paper and other necessities
o That’s because, despite increases in prices for some of these goods, producers could not produce them fast enough (supply was
not elastic enough in short run)
o However, as time passed, producers adapted (switched from producing goods with lower demand to goods in high demand),
supply became more elastic, and shortages are now rare or non-existent
 Cross-price elasticity of demand: are hand sanitizer and face masks substitutes or complements?
o Some people may always use both; for them they are complements
o Some people may use one or another (they may think that if they use hand sanitizer and clean frequently, there is no reason to
wear face mask anymore); for them, these goods are substitutes
o How can we test which of this is true? Look at cross price elasticity: how the quantity demanded of masks responds to changes in
the price of hand sanitizer and viceversa 5-52