Elasticity of Demand

Elasticity of Demand
• A measure of the responsiveness of quantity demanded or quantity
supplied to a change in one of its determinants
• a measure of how much the quantity demanded of a good responds
to a change in the price of that good, computed as the percentage
change in quantity demanded divided by the percentage change in
price
Determinants
1. Availability of Close Substitutes
2. Necessities versus Luxuries
3. Definition of the Market
4. Time Horizon
Computing the Price Elasticity of
Demand
• Economists compute the price elasticity of demand as the percentage
change in the quantity demanded divided by the percentage change
in the price.
Mid Point Method
• Point A: Price $4 Quantity 120
• Point B: Price $6 Quantity 80
• Going from point A to point B, the price rises by 50 percent, and the
quantity falls by 33 percent, indicating that the price elasticity of
demand is 33/50, or 0.66. By contrast, going from point B to point A,
the price falls by 33 percent, and the quantity rises by 50 percent,
indicating that the price elasticity of demand is 50/33, or 1.5. This
difference arises because the percentage changes are calculated from
a different base.
Mid Point Method
• The midpoint method computes a percentage change by dividing the
change by the midpoint (or average) of the initial and final levels. For
instance, $5 is the midpoint between $4 and $6. Therefore, according
to the midpoint method, a change from $4 to $6 is considered a
40 percent rise because (6 2 4) / 5 3 100 5 40. Similarly, a change from
$6 to $4 is considered a 40 percent fall.
• Because the midpoint method gives the same answer regardless of
the direction of change, it is often used when calculating the price
elasticity of demand between two points.
The Variety of Demand Curves
• Demand is considered elastic when the elasticity is greater than 1, which means
the quantity moves proportionately more than the price.
• Demand is considered inelastic when the elasticity is less than 1, which means the
quantity moves proportionately less than the price.
• If the elasticity is exactly 1, the quantity moves the same amount proportionately
as the price, and demand is said to have unit elasticity.
• Demand is perfectly inelastic, and the demand curve is vertical. In this case,
regardless of the price, the quantity demanded stays the same
• Demand is perfectly elastic. This occurs as the price elasticity of demand
approaches infinity and the demand curve becomes horizontal, reflecting the fact
that very small changes in the price lead to huge changes in the quantity
demanded
Total Revenue and the Price
Elasticity of Demand
• Total revenue, the amount paid by buyers and received by sellers of
the good. In any market, total revenue is P 3 Q, the price of the good
times the quantity of the good sold.
Impact of a price change on TR
• The impact of a price change on total revenue (the product of price and
quantity) depends on the elasticity of demand.
• In panel (a), the demand curve is inelastic. In this case, an increase in the price
leads to a decrease in quantity demanded that is proportionately smaller, so
total revenue increases.
• Here an increase in the price from $4 to $5 causes the quantity demanded to
fall from 100 to 90. Total revenue rises from $400 to $450.
• In panel (b), the demand curve is elastic. In this case, an increase in the price
leads to a decrease in quantity demanded that is proportionately larger, so total
revenue decreases. Here an increase in the price from $4 to $5 causes the
quantity demanded to fall from 100 to 70. Total revenue falls from $400 to $350
General Rules
• When demand is inelastic (a price elasticity less than 1), price and
total revenue move in the same direction.
• When demand is elastic (a price elasticity greater than 1), price and
total revenue move in opposite directions.
• If demand is unit elastic (a price elasticity exactly equal to 1), total
revenue remains constant when the price changes
Income Elasticity of Demand
• The Income Elasticity of Demand The income elasticity of demand measures how the
quantity demanded changes as consumer income changes. It is calculated as the percentage
change in quantity demanded divided by the percentage change in income. That is

• Higher income raises the quantity demanded. Because quantity demanded and income move
in the same direction, normal goods have positive income elasticities. A few goods, such as
bus rides, are inferior goods: Higher income lowers the quantity demanded. Because quantity
demanded and income move in opposite directions, inferior goods have negative income
elasticities.
The Cross-Price Elasticity of Demand
• The cross-price elasticity of demand measures how the quantity
demanded of one good responds to a change in the price of another
good. It is calculated as the percentage change in quantity demanded of
good 1 divided by the percentage change in the price of good 2. That is,

• Whether the cross-price elasticity is a positive or negative number

depends on whether the two goods are substitutes or complements
Elasticity of Supply
• A measure of how much the quantity supplied of a good responds to
a change in the price of that good.
• In most markets, a key determinant of the price elasticity of supply is
the time period being considered. Supply is usually more elastic in the
long run than in the short run. Over short periods of time, firms
cannot easily change the size of their factories to make more or less
of a good. Thus, in the short run, the quantity supplied is not very
responsive to the price. By contrast, over longer periods, firms can
build new factories or close old ones.
Computation of Price Elasticity of
Supply
• Economists compute the price elasticity of supply as the percentage
change in the quantity supplied divided by the percentage change in
the price. That is,
The Variety of Supply Curves
Application of Supply, Demand and
Elasticity
Three Important things to be considered
• First, we examine whether the supply or demand curve shifts.
• Second, we consider in which direction the curve shifts.
• Third, we use the supply-and-demand diagram to see how the market
equilibrium changes.
1. Assess the Impact of Discovery of
Hybrid seeds of Wheat on Farmers
• The discovery of the new hybrid affects the supply curve. Because the
hybrid increases the amount of wheat that can be produced on each acre of
land.
• The supply curve shifts to the right
• The demand curve remains the same because consumers’ desire to buy
wheat products at any given price is not affected by the introduction of a
new hybrid. the demand for basic foodstuffs such as wheat is usually
inelastic
• The hybrid allows farmers to produce more wheat but now sells at lower
price.
• a decrease in price causes total revenue to fall
2. OPEC and Oil Price
• In the short run, both the supply and demand for oil are relatively inelastic.
• Supply is inelastic because the quantity of known oil reserves and the
capacity for oil extraction cannot be changed quickly.
• Demand is inelastic because buying habits do not respond immediately to
changes in price.
• Over long periods of time, producers of oil outside OPEC respond to high
prices by increasing oil exploration and by building new extraction capacity.
Consumers respond with greater conservation, such as by replacing old
inefficient cars with newer efficient ones.
• In the long-run supply and demand curves are more elastic.
Oil Market in Short run and Long
Run
3. Impact of Drug Interdiction
• Drug Interdiction may reduce the supply of Drug in the Short run
• The demand for drugs—the amount buyers want at any given price—
is not changed.
• Interdiction shifts the supply curve to the left from S1 to S2 and leaves
the demand curve the same.