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Chapter 4: Elasticity
Price elasticity of demand –
– The percentage change in quantity demanded in response to
one percent change in price;
– Measure of sensitivity of quantity demanded to changes in
price.
An Example:
– When the price of gasoline increases by 1%, the quantity
demanded of gasoline decreases by 0.5%. Therefore, the
price elasticity of demand of gasoline is –0.5.
– To what extent would a tax on gasoline help reduce
environmental pollution?
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Price Elasticity of Demand
Calculate price elasticity of demand –
ε=
Percentage change in quantity demanded
Percentage change in price
• Price elasticity of demand is always negative;
• In practice, we take the absolute value of .
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Price Elasticity of Demand
Demand
>1
Elastic
=1
Unit elastic
<1
Inelastic
An example: Demand for season ski passes
Old
New
% Change
Price
$400
$380
5%
Quantity
10,000
12,000
20%
ε=
20%
5%
=4
Demand is elastic
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Determinants of Price Elasticity of Demand
• Substitution options: more options, more elastic;
• Budget share: higher the share, more elastic;
• Time horizon: longer the time, more elastic;
• Necessity: more necessary, more elastic;
• Breadth of definition: broader, less elastic.
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Price Elasticity of Demand
Green peas
Restaurant meals
Beer
Coffee
2.80
1.63
1.19
0.25
Automobiles
Foreign air travel
1.35
0.77
Movies
0.87
Theater, opera
0.18
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Price Elasticity: A Graphical View
ε=
ΔP / P
P
x
Q
Price
ε=
ΔQ / Q
ΔQ
P
ΔP
P–ΔP
A
ΔP
ΔQ
D
ε=
P
Q
x
1
slope
Q Q+ΔQ
Quantity
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Price Elasticity on A Straight-Line Demand Curve
ε=
P
Q
x
1
slope
• The slope is the same at each point;
• P/Q increases along the demand curve since when price
increases, quantity demanded decreases;
• As a result,  is different at each point.
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Price Elasticity on A Straight-Line Demand Curve
Price
a
 1
 1
 1
a/2
b/2
Quantity
b
• At high price, quantity demanded is elastic;
• At low price, quantity demanded is inelastic.
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Two Special Cases of Price Elasticity
Perfectly Elastic
Demand
• Infinite price elasticity of
demand
Price
Perfectly Inelastic Demand
• Zero price elasticity of
demand
Price
Price
D
D
D
Quantity
Quantity
Quantity
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Elasticity and Total Revenue
R=PxQ
• Since price and quantity demanded change in opposite
directions, whether revenue increases/decreases when
price increases/decreases depends on price elasticity.
• Intuitively speaking,
- If price elasticity is low, meaning quantity demanded is not
sensitive to a price change, revenue increases when price
increases;
- In contrast, if price elasticity is high, revenue increases when price
decreases.
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Elasticity and Total Revenue
Price
$10
$8
$6
$4
$2
$0
Quantity
0
1,000
2,000
3,000
4,000
5,000
6,000
Expenditure
$0
$1,000 $1,600 $1,800 $1,600 $1,000
Total expenditure ($/day)
$12
12
Price ($/ticket)
10
8
6
4
2
1
3
4
5
6
2
Quantity (00s of tickets/day)
$0
1,800
1,600
1,000
2
6
Price ($/ticket)
10
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Elasticity and Total Revenue
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Cross-Price Elasticity of Demand
• Definition
– Percentage change in quantity demanded of A
from a 1 percent change in the price of B
• Sign of cross-price elasticity shows
relationship between the goods
– Complements have negative cross-price
elasticity
– Substitutes have positive cross-price elasticity
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Income Elasticity of Demand
• Definition
– Percentage change in quantity
demanded from a 1 percent change in income
• Income elasticity of demand can be positive
or negative
– Positive income elasticity is a normal good
– Negative income elasticity is an inferior good
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Price Elasticity of Supply
• Definition
ε=
ε=
ΔQ / Q
Q
x
B
10
8
A
4
ΔP / P
P
S
Price
– Percentage change in
quantity supplied in
response to a 1 percent
change in price
1
slope
2
3
Quantity
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Determinants of Price Elasticity of Supply
Input Flexibility
• Uses adaptable inputs, more
elastic
• Resources move where
Mobility of Inputs
needed, more elastic
Produce
• Alternative inputs easy to find,
Substitute Inputs
more elastic
Time
• Long run, more elastic
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