Chapter 5 Elasticity and Its Application
Learn the meaning of the elasticity of demand
Examine what determines the elasticity of demand
Learn the meaning of the elasticity of supply
Examine what determines the elasticity of supply
Apply the concept of elasticity in two very different markets.
Gas prices rise: consumers buy less. But, by HOW MUCH did the consumption of gas fall?
Elasticity: Measure of how much buyers a2nd sellers respond to changes in market conditions. Studying
an event or policy affecting a market: we can discuss direction and magnitude of the curve.
Gas prices response: QD responds more in the long run than in the short run. About half of long run
reduction in QD arises because people drive less and half because they switch to more fuel efficient cars.
Elasticity of Demand
Elasticity: a measure of the responsiveness of quantity demanded or QS to one of its determinants.
Price of Elasticity of Demand and its determinants
Law of demand: Fall price in good raises Qd.
Price elasticity: A measure of how much the Qd of a good responds to a change in QD divided by the
percentage change in price.
Demand of good is ELASTIC if Qd responds substantially to changes in price.
Demand of good is INELASTIC if Qd responds only slightly to changes in price.
Price elasticity of demand for any good, measure HOW WILLING consumers are to move away from the
good as its prices rises.
reflects the economic, social, psychological forces that shape consumer tastes.
General Rules about Price Elasticity of Demand
1. Availability of Close Substitutes:
Goods with close substitutes have more elastic demand b/c it is easier for consumers to switch from that good to others. Ex: Butter and Margarine.
Butter price slightly rises, Margarine stays fixed= decrease in consumption for butter.
Eggs are food without substitute the demand for eggs is less elastic than the demand for butter.
2. Necessities versus Luxuries
Necessities have inelastic demands whereas luxuries have elastic demands.
dentists: necessity, Sailboats: Luxury.
3. Definition of the Market
Elasticity of demand in any market depends on how we draw the boundaries of the market.
Narrowly defined markets have more elastic demand than broadly defined markets because
it is easier to find close subs for narrowly defines goods.
ex: food: broad category: Inelastic demand because there are no good subs for food.
4. Time Horizons
Goods have more elastic demand over longer time horizons.
When price of gas rises, quantity of demanded falls only slightly in first few months.
Over time, people buy more fuel efficient cars, take oc transpo, move closer to work.
Quantity of gas demanded FALLS SUBSTANTIALLY.
Computing the Price Elasticity Of Demand
Price Elasticity of Demand= % Qd/ %P
Percentage change in quantity demanded / Percentage change in price
10% increase in price of ice cream cone causes the amount of ice cream you buy to decrease by 20%.
Elasticity of Demand: 20% / 10% = 2
It means that change in quantity demanded is proportionally TWICE as large as change in Price.
Quantity of a good is NEGATIVELY related to its price:
Percentage Change in QUANTITY will always have an opposite sign as Percent Change in PRICE.
percentage change in Price is POSITIVE 10 PERCENT= INCREASE,
percentage change in Quantity is NEGATIVE 20 PERCENT = DECREASE.
Therefore PED can be negative. But we can take absolute values of prices: larger price elasticity implies
greater responsiveness of a quantity demanded to price.
Midpoint Method: A better way to Calculate Percentage Changes and Elasticities
• Trying to calculate PED between two points on demand curve : The elasticity of point A to point
B is different than vice versa • To avoid this problem we use midpoint method for calculating elasticities.
• Change/ Initial
• computes percentage change by dividing change by the midpoint (average) of the initial and final
• ex: midpoint of 4 and 6 is 5 dollars.
=(64)/5 X 100= 40.
change from 4 to 6 is 40% increase.
change from 6 to 4 is 40% fall. ( does not matter direction of change).
In both directions PED equals 1.
• PED: (Q2Q1)/ [(Q2+Q1)/2]
• To calculate elasticities.
The Variety Of Demand Curves
• PED<1 (absolute value) Inelastic: Cigarettes, gas: Inelastic goods increase in price, increase
• PED >1 (absolute Value) Elastic: Movie Tickets, Cheesburgers, Candy: Price increases,
• PED=1 (absolute Value) Unit Elasticity: equal change
PED: measure show much quantity demanded responds to changes in its price, its closely related
to the slope of demand curve.
FLATTER DEMAND CURVE THAT PASSES THRU GIVEN POINT= > THE PED
STEEPER DEMAND CURVE THAT PASSES THRU GIVEN POINT= 1) Price and TR move in opposite directions.
Unit Elastic Demand (PED=1) TR remains constant when price changes.
Elasticity And Total Revenue Along a Linear Demand Curve
Demand curves don't always have the same PED along the entire curve (STRAIGHT LINE).
Linear Demand has a constant Slope. (rise= price/ run= quantity)
EX: FOR EVERY 1$ INCREASE IN PRICE = QD DECREASES BY 2 UNITS.
Even though the slope of the linear demand curve is constant, the elasticity IS NOT.
Slope is the RATIO OF CHANGES IN 2 VARIABLES
Elasticity: RATIO OF PERCENTAGE CHANGES IN 2 VARIABLES. Other Demand Elasticities
We use other elasticities to describe the behaviour of buyers in market:
The Income Elasticity Of Demand
Measures how the quantity demanded changes as consumer income changes. It is calculated as
• %change in quantity demanded/ % change in Income
o Most goods are normal goods. Higher income raises Qd.
o Qd and income move in same direction, normal goods have positive income elasticities.
o ex: Bus rides are inferior goods.
o Higher income lowers Qd because Qd and income move in opposite directions, inferior
goods have negative income i