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Chapter 19
Demand and
Supply Elasticity
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
Introduction
Economists have estimated that if the price of satellite
delivered TV services decreases by a certain
percentage, the demand for cable TV falls by about the
same percentage, but a given percentage decline in the
price of cable TV causes less than half of the
percentage decrease in the demand for satellite TV.
What does this tell us about how consumers perceive
consumption of cable TV versus satellite TV?
This chapter will help you understand this question
through the concept called the cross price elasticity of
demand.
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
19-2
Learning Objectives
• Express and calculate price elasticity of
demand
• Understand the relationship between the
price elasticity of demand and total
revenues
• Discuss the factors that determine the
price elasticity of demand
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
19-3
Learning Objectives (cont'd)
• Describe the cross price elasticity of
demand and how it may be used to
indicate whether two goods are substitutes
or complements
• Explain the income elasticity of demand
• Classify supply elasticities and explain how
the length of time for adjustment affects
the price elasticity of supply
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
19-4
Chapter Outline
•
•
•
•
Price Elasticity
Price Elasticity Ranges
Elasticity and Total Revenues
Determinants of the Price Elasticity of
Demand
• Cross Price Elasticity of Demand
• Income Elasticity of Demand
• Price Elasticity of Supply
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
19-5
Did You Know That ...
• Economists have estimated that when bank debitcard transaction fees increase by 10 percent, the
number of debit-card transactions that people
wish to utilize declines by nearly 67 percent?
• A special name for quantity responsiveness is
elasticity, which is one of the topics in this
chapter.
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
19-6
Price Elasticity
• Price Elasticity of Demand (Ep)
– The responsiveness of quantity demanded of a
commodity to changes in its price
– Defined as the percentage change in quantity
demanded divided by the percentage change in
price
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19-7
Price Elasticity (cont'd)
• Price Elasticity of Demand (Ep)
Ep =
Percentage change in quantity demanded
Percentage change in price
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19-8
Price Elasticity (cont'd)
• Example
– Price of oil increases 10%
– Quantity demanded decreases 1%
–1%
Ep =
= –.1
+10%
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
19-9
Price Elasticity (cont'd)
• Question
– How would you interpret an elasticity of –0.1?
• Answer
– A 10% increase in the price of oil will lead to a
1% decrease in quantity demanded.
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
19-10
Price Elasticity (cont'd)
• Relative quantities only
– Elasticity is measuring the change in quantity
relative to the change in price
• Always negative
– An increase in price decreases the quantity
demanded, ceteris paribus
– By convention, the minus sign is ignored
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19-11
Price Elasticity (cont’d)
• Calculating Elasticity
Ep =
change in Q
change in P
sum of quantities/2
sum of prices/2
or
Ep =
 in Q
(Q1 + Q2)/2
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 in P
(P1 + P2)/2
19-12
Example: The Price Elasticity of Demand for
Natural Gas
• During a recent three-month period, the price of
natural gas decreased from $4.81 per 1,000 cubic
feet to $4.44 per 1,000 cubic feet.
• During this period the total quantity of natural
gas consumed in the United States increased from
62.21 billion cubic feet per day to 62.64 billion
cubic feet per day.
• What is the price elasticity of demand?
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
19-13
Example: The Price Elasticity of Demand for
Natural Gas (cont'd)
•
Use the elasticity formula:
62.64 - 62.21
÷
$4.81 - $4.44
(62.64 + 62.21)/2
($4.81+$4.44)/2
= 0.43
÷ $0.37
124.85/2
$9.25/2
= 0.09
•
The price elasticity of 0.09 means that a 1%
increase in price generated a 0.09% decrease in
the quantity of oranges demanded
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19-14
Price Elasticity Ranges
• Elastic Demand
– Percentage change in quantity demanded is
larger than the percentage change in price
– Total expenditures and price are inversely
related in the elastic region of the demand
curve
– Ep > 1
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19-15
Price Elasticity Ranges (cont'd)
• Unit Elasticity of Demand
– Percentage change in quantity demanded is
equal to the percentage change in price
– Total expenditures are invariant to price
changes in the unit-elastic region of the
demand curve
– Ep = 1
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19-16
Price Elasticity Ranges (cont'd)
• Inelastic Demand
– Percentage change in quantity demanded is
smaller than the percentage change in price
– Total expenditures and price are directly
related in the inelastic region of the demand
curve
– Ep < 1
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19-17
Price Elasticity Ranges (cont'd)
• Elastic demand
– % change in Q > % change in P; Ep > 1
• Unit-elastic
– % change in Q = % change in P; Ep = 1
• Inelastic demand
– % change in Q < % change in P; Ep < 1
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19-18
Price Elasticity Ranges (cont'd)
• Extreme elasticities
– Perfectly Inelastic Demand
• A demand curve that is a vertical line
• It has only one quantity demanded for each price
• No matter what the price, quantity demanded does
not change
• A demand that exhibits zero responsiveness to price
changes
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19-19
Figure 19-1 Extreme Price Elasticities,
Panel (a)
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19-20
Price Elasticity Ranges (cont'd)
• Extreme elasticities
– Perfectly Elastic Demand
• A demand curve that is a horizontal line
• It has only one price for every quantity.
• The slightest increase in price leads to zero quantity
demanded.
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19-21
Figure 20-1 Extreme Price Elasticities,
Panel (b)
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19-22
Elasticity and Total Revenues
• When demand is elastic, a negative relationship
exists between changes in price and changes in
total revenues
• When demand is unit-elastic, changes in price do
not change total revenues
• When demand is inelastic, a positive relationship
exists between changes in price and total
revenues
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
19-23
Figure 19-2 The Relationship Between Price
Elasticity of Demand and Total Revenues for Cellular
Phone Service, Panel (a)
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19-24
Figure 19-2 The Relationship Between Price
Elasticity of Demand and Total Revenues for Cellular
Phone Service, Panel (b)
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19-25
Figure 19-2 The Relationship Between Price
Elasticity of Demand and Total Revenues for Cellular
Phone Service, Panel (c)
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19-26
Elasticity and Total Revenues
(cont'd)
• Elasticity-revenue relationship
– Total revenues are the product of price times
units sold.
– The law of demand states along a given curve,
price is inverse to quantity.
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19-27
Elasticity and Total Revenues
(cont'd)
• What happens to the product of price times
quantity depends on which of the opposing forces
exerts a greater force on total revenues
• This is what price elasticity of demand is designed
to measure: responsiveness of quantity
demanded to a change in price
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
19-28
Table 19-1 Relationship Between Price
Elasticity of Demand and Total Revenues
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19-29
Determinants of the Price Elasticity
of Demand
• Existence of substitutes
– The closer the substitutes and the more
substitutes there are, the more elastic is
demand
• Share of the budget
– The greater the share of the consumer’s total
budget spent on a good, the greater is the
price elasticity
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19-30
Determinants of the Price Elasticity
of Demand (cont'd)
• The length of time allowed for adjustment
– The longer any price change persists, the
greater is the elasticity of demand
– Price elasticity is greater in the long run than in
the short run
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19-31
Figure 19-3 Short-Run and Long-Run
Price Elasticity of Demand
With more time for
adjustment the
demand curve
becomes more
elastic and quantity
demanded falls by
a greater amount
In the short run, quantity
demanded falls slightly
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19-32
Why Not … always raise prices when demand is
inelastic?
• Even if the market demand is inelastic, you have
competitors.
• If you increase the price of your product, but your
competitors do not raise the prices of their
products, your competitors will pick off your
customers.
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19-33
Determinants of the Price Elasticity
of Demand (cont'd)
• How to define the short run and the long
run
– The short run is a time period too short for
consumers to fully adjust to a price change
– The long run is a time period long enough for
consumers to fully adjust to a change in price,
other things constant
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19-34
Example: What Do Real-World Price Elasticities
of Demand Look Like?
• Economists have found that estimated elasticities
of demand are greater in the long run than in the
short run.
• Remember that even though we are leaving off
the negative sign, there is an inverse relationship
between price and quantity demanded.
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19-35
Table 19-2 Price Elasticities of Demand
for Selected Goods
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19-36
Cross Price Elasticity of Demand
• Cross Price Elasticity of Demand (Exy)
– The percentage change in the demand for one
good (holding its price constant) divided by the
percentage change in the price of a related
good
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19-37
Cross Price Elasticity of Demand
(cont'd)
• Formula for computing cross price
elasticity of demand between good X and
good Y
Exy =
% change in amount of good X demanded
% change in price of good Y
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19-38
Cross Price Elasticity of Demand
(cont'd)
• Substitutes
– Exy would be positive
• An increase in the price of X would increase the
quantity of Y demanded at each price.
• Complements
– Exy would be negative
• An increase in the price of X would decrease the
quantity of Y demanded at each price.
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19-39
Income Elasticity of Demand
• Income Elasticity of Demand (Ei)
– The percentage change in demand for any
good, holding its price constant, divided by the
percentage change in income
– The responsiveness of demand to changes in
income, holding the good’s relative price
constant
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19-40
Income Elasticity of Demand
(cont'd)
Ei =
Percentage change in demand
Percentage change in income
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19-41
Income Elasticity of Demand
(cont'd)
• Calculating the income elasticity of
demand
Ei = Change in quantity
income
Average quantity
÷
Change in
Average income
– The income elasticity of demand can be either
negative or positive.
– Remember that in calculating the income
elasticity of demand, the price of the good is
assumed to be constant.
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19-42
Table 19-3 How Income Affects
Quantity of Blu-Ray Discs Demanded
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19-43
Income Elasticity of Demand
(cont'd)
• From Table 19-3, income elasticity of
demand for Blu-ray discs:
Ei =
=
2/[(6+8)/2]
= 2/7
$2000/[($4000+$60000)/2]
2/5
0.71
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19-44
Example: The Income Elasticity of Demand for
Dental Services
• During a few weeks in the depths of the Great
Recession of the late 2000s, U.S. household
income declined by 1 percent, while the amount
of dental services that people purchased
nationwide fell by 5.8 percent.
• Thus, the income elasticity of demand for U.S.
dental services was equal to 5.8 (-5.8%/-1%).
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19-45
Price Elasticity of Supply
• Price Elasticity of Supply (Es)
– The responsiveness of the quantity supplied of
a commodity to a change in its price
– The percentage change in quantity supplied
divided by the percentage change in price
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19-46
Price Elasticity of Supply (cont'd)
• Formula for computing price elasticity of
supply
ES =
Percentage change in quantity supplied
Percentage change in price
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19-47
Price Elasticity of Supply (cont'd)
• Classifying supply elasticities
– Perfectly Elastic Supply
• Quantity supplied falls to zero when there is the
slightest decrease in price
• The supply curve is horizontal at a given price
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19-48
Price Elasticity of Supply (cont'd)
• Classifying supply elasticities
– Perfectly Inelastic Supply
• Quantity supplied is constant no matter what happens
to price
• The supply curve is vertical at a given price
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19-49
Figure 19-4 The Extremes in Supply
Curves
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19-50
Price Elasticity of Supply (cont'd)
• Price elasticity of supply and length of time
for adjustment
1. The longer the time allowed for adjustment,
the more resources can flow into (out of) an
industry through expansion (contraction) of
existing firms.
2. The longer the time allowed for adjustment,
the entry (exit) of firms increases (decreases)
production in an industry.
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19-51
International Example: Price Elasticities of
Salmon Supply in Norway
• A study of prices and quantities of salmon
supplied by Norwegian salmon-farming firms
shows that a 1 percent rise in the price of salmon
induces a percentage increase in quantity
supplied that is 28 times greater in the long run
than that in the short run.
• In the long run, these firms have sufficient time
to respond to a price increase by changing
varieties and amounts of feed and capital
equipment.
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19-52
Figure 19-5 Short-Run and Long-Run
Price Elasticity of Supply
As time passes the supply
curve rotates from S1 to S2 and
quantity supplied rises to Q1
As more time passes the
supply curve rotates from S2
to S3 and quantity supplied
rises from Q1 to Q2
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19-53
You Are There: Pricing the iPad: Learning
Lessons from the iPhone
• While most industry observers anticipated that a
basic iPad would be priced at $1,000, Apple set
its initial price at only $499 in 2010.
• Apple learned a lesson from its experience with
the iPhone in mid-2007: the estimated price
elasticity of demand for smart cellphones like the
iPhone was about 1.4.
• The company set this lower price in anticipation
that the demand for the new gadget would also
be elastic, so a lower price would ultimately yield
higher revenues.
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19-54
Issues & Applications: Measuring the
Substitutability of Satellite and Cable TV
• Researchers Austan Goolsbee and Amil Petrin
estimated that the price elasticity of demand was
elastic for cable TV and satellite TV.
• They also found that their cross price elasticities
were positive, so they are substitutes.
• The cross price elasticities also suggest that
consumers of satellite TV perceive cable TV to be
less substitutable for satellite TV services than do
cable TV consumers.
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19-55
Summary Discussion of Learning
Objectives
• Expressing and calculating the price
elasticity of demand
– Percentage change in quantity demanded
divided by the percentage change in price
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19-56
Summary Discussion of Learning
Objectives (cont'd)
• The relationship between the price
elasticity of demand and total revenues
– When demand is elastic, price and total
revenue are inversely related
– When demand is inelastic, price and total
revenue are positively related
– When demand is unit-elastic, total revenue
does not change when price changes
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19-57
Summary Discussion of Learning
Objectives (cont'd)
• Factors that determine price elasticity of
demand
– Availability of substitutes
– Percentage of a person’s budget spent on the
good
– The length of time allowed for adjustment to a
price change
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19-58
Summary Discussion of Learning
Objectives (cont'd)
• The cross price elasticity of demand and
using it to determine whether two goods
are substitutes or complements
– Percentage change in the demand for one good
divided by the percentage change in the price
of a related good
– If cross elasticity is positive, the goods are
substitutes.
– If cross elasticity is negative, the goods are
complements.
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19-59
Summary Discussion of Learning
Objectives (cont'd)
• Income elasticity of demand
– Responsiveness of the demand for the good to
a change in income
– Percentage change in the demand for a good
divided by the percentage change in income.
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19-60
Summary Discussion of Learning
Objectives (cont'd)
• Classifying supply elasticities and how the length of time for
adjustment affects price elasticity of supply
– Elastic supply: price elasticity of supply is greater than 1
– Inelastic supply: price elasticity of supply is less than 1
– Unit-elastic supply: price elasticity of supply is equal to 1
– The longer the time period for adjustment, the more
elastic is supply.
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19-61