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ECN1A Week 2
Ch. 3 Supply and Demand
Ch. 6 Elasticity
What Determines the Price of a Smartphone?
Demand for smartphones
• How many smartphones do consumers want to buy?
• Affected by price of the smartphones
• Affected by other factors, including prices of other goods
Supply of smartphones
• How many smartphones are producers willing to sell?
• Affected by price of the smartphones
• Affected by other factors, including prices of other goods
We will analyze these in a perfectly competitive market: a
market with (1) many buyers and sellers, (2) all firms selling
identical products, and (3) no barriers to new firms entering the
market.
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The Demand Side of the Market
3.1 LEARNING OBJECTIVE
Discuss the variables that influence demand.
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Demand Schedules and Quantity Demanded
Demand schedule: A table that shows the relationship between
the price of a product and the quantity of the product demanded.
Quantity demanded: The amount of a good or service that a
consumer is willing and able to purchase at a given price.
Figure 3.1
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A demand schedule
and a demand curve
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Demand Curve and Market Demand
Demand curve: A curve that shows the relationship between the
price of a product and the quantity of the product demanded.
Market demand: the demand by all the consumers of a given good
or service.
Figure 3.1
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A demand schedule
and a demand curve
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Ceteris Paribus
When drawing the demand curve, we assume ceteris paribus.
Ceteris paribus (“all else equal”) condition: The requirement
that when analyzing the relationship between two variables—such
as price and quantity demanded—other variables must be held
constant.
Figure 3.1
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A demand schedule
and a demand curve
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The Law of Demand
Law of demand: The rule that, holding everything else constant,
when the price of a product falls, the quantity demanded of the
product will increase, and when the price of a product rises, the
quantity demanded of the product will decrease.
Implication: Demand curve slopes downward
Figure 3.1
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A demand schedule
and a demand curve
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What Explains the Law of Demand?
When the price of a product falls, two effects cause consumers to
purchase more of it:
• The product has become cheaper relative to other goods, so
consumers substitute toward it. This is the substitution effect.
• The consumer now has greater purchasing power, and elects to
purchase more goods overall. This is income effect.
Substitution effect: The change in the quantity demanded of a good
that results from a change in price making the good more or less
expensive relative to other goods that are substitutes.
Income effect: The change in the quantity demanded of a good that
results from the effect of a change in the good’s price on consumers’
purchasing power.
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Increase and Decrease in Demand
A change in something
other than price that
affects demand
causes the entire
demand curve to shift.
A shift to the right (D1
to D2) is an increase
in demand.
A shift to the left (D1 to
D3) is a decrease in
demand.
Figure 3.2
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Shifting the demand curve
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Shifts of the Demand Curve
As the demand curve
shifts, the quantity
demanded will change,
even if the price
doesn’t change.
The quantity
demanded changes at
every possible price.
P1
Q2
Figure 3.2
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Q1
Q3
Shifting the demand curve
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What Factors Influence Market Demand?
Income of consumers
Increase in income increases demand if product is normal,
decreases demand if product is inferior.
Prices of related goods
Increase in price of related good increases demand if products
are substitutes, decreases demand if products are
complements
Tastes
Population and demographics
Expected future prices
We will discuss how each of these affects demand.
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Change in Income of consumers
Normal good:
A good for which the demand increases as
income rises, and decreases as income falls.
Examples:
Clothing
Restaurant meals
Vacations
Effect of increase in income,
if good is normal
Inferior good:
A good for which the demand decreases as
income rises, and increases as income falls.
Examples:
Second-hand clothing
Ramen noodles
Effect of increase in income,
if good is inferior
Are smartphones normal or inferior goods?
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Change in the Price of Related Goods
Substitutes:
Goods and services that can be used for
the same purpose.
Examples:
Big Mac and Whopper
Ford F-150 and Dodge Ram
Jeans and Khakis
Effect on demand for Big
Macs, if price of Whopper
increases
Complements:
Goods and services that are used together.
Examples:
Big Mac and McDonald’s fries
Hot dogs and hot dog buns
Left shoes and right shoes
Effect on demand for Big
Macs, if price of McDonald’s
fries increases
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Change in Tastes or Population/demographics
Tastes
If consumers’ tastes change, they may buy
more or less of the product.
Example:
If consumers become more concerned about
eating healthily, they might decrease their
demand for fast food.
Population and demographics
Increases in the number of people buying
something will increase the amount
demanded.
Example:
An increase in the elderly
population increases the
demand for medical care.
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Effect on demand for fast food,
if consumers want to eat healthy
Effect on demand for medical
care, as the population ages
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Change in Expectations about Future Prices
Consumers decide which products to buy
and when to buy them.
• Future products are substitutes for
current products
• An expected increase in the price
tomorrow increases demand today.
• An expected decrease in the price
tomorrow decreases demand today.
Effect on today’s gasoline
demand, if price will rise tomorrow
Example:
If you found out the price of gasoline would
go up tomorrow, you would increase your
demand today.
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Change in Demand vs. Change in Quantity Demanded
A change in the price
of the product being
examined causes a
movement along the
demand curve.
• This is a change in
quantity demanded.
Any other change
affecting demand
causes the entire
demand curve to shift.
• This is a change in
demand.
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Figure 3.3
A change in demand
versus a change in
quantity demanded
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Supply Schedules and Supply Curves
Supply schedule: A table that shows the relationship between the
price of a product and the quantity of the product supplied.
Quantity supplied: The amount of a good or service that a firm is
willing and able to supply at a given price.
Supply curve: A curve that shows the relationship between the price
of a product and the quantity of the product supplied.
Figure 3.4
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A supply schedule
and a supply curve
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The Law of Supply
The law of supply: The rule that, holding everything else constant,
increases in price cause increases in the quantity supplied, and
decreases in price cause decreases in the quantity supplied.
Implication: supply curves slope upward.
Figure 3.4
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A supply schedule
and a supply curve
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Increase and Decrease in Supply
A change in something
other than price that
affects supply causes
the entire supply curve
to shift.
• A shift to the right
(S1 to S3) is an
increase in supply.
• A shift to the left (S1
to S2) is a decrease
in supply.
Figure 3.5
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Shifting the supply curve
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Shifts of the Supply Curve
As the supply curve
shifts, the quantity
supplied will change,
even if the price
doesn’t change.
The quantity supplied
changes at every
possible price.
P1
Q2
Figure 3.5
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Q1
Q3
Shifting the supply curve
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Variables that Shift Market Supply
Prices of inputs
Technological change
Prices of substitutes in production
Number of firms in the market
Expected future prices
We will discuss how each of these affects supply.
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Changes in Prices of Inputs
Inputs are things used in the production of a
good or service.
Examples of inputs for smartphones:
Computer processor
Plastic housing
Labor
Effect of an increase in the
price of input goods
An increase in the price of an input
decreases the profitability of selling the good,
causing a decrease in supply.
A decrease in the price of an input
increases the profitability of selling the good,
causing an increase in supply.
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Effect of a decrease in the
price of input goods
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Technological Change
A firm may experience a positive or negative
change in its ability to produce a given level of
output with a given quantity of inputs. This is a
technological change.
Changes raise or lower firms’ costs, hence
their supply of the good.
Examples:
A new, more productive variety of wheat would
increase the supply of wheat.
Governmental restrictions on land use for
agriculture might decrease the supply of wheat.
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Effect of a positive change
in technology
Effect of a negative change
in technology
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Prices of Substitutes, and Number of Firms
Many firms can produce and sell more than
one product.
Example:
An Illinois farmer can plant corn or soybeans. If
the price of soybeans rises, he will plant
(supply) less corn.
Effect on the supply of corn,
of an increase in the price of
soybeans
More firms in the market will result in more
product available at a given price (greater
supply).
Fewer firms → supply decreases.
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Effect of a increase in the
number of firms
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Change in Expected Future Prices
If a firm anticipates that the price of its
product will be higher in the future, it
might decrease its supply today in order
to increase it in the future.
What types of products could be “stored”
like this?
Perishable products, or
Non-perishable products
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Effect of an increase in
future expected price of a
good
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Change in Supply vs. Change in Quantity Supplied
A change in the price
of the product being
examined causes a
movement along the
supply curve.
• This is a change in
quantity supplied.
Any other change
affecting supply
causes the entire
supply curve to shift.
• This is a change in
supply.
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Figure 3.6
A change in supply
versus a change in
quantity supplied
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Market Equilibrium: Putting Demand and Supply
Together
3.3 LEARNING OBJECTIVE
Use a graph to illustrate market equilibrium.
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Market Equilibrium
At a price of $200,
• consumers want to buy 10
million smartphones, and
• producers want to sell 10
million smartphones.
This is a market equilibrium:
a situation in which quantity
demanded equals quantity
supplied.
A market equilibrium with
many buyers and sellers is a
competitive market
equilibrium.
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Figure 3.7
Market equilibrium
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Market Equilibrium Price and Quantity
In this market:
• The equilibrium price of a
smartphone is $200, and
• The equilibrium quantity of
a smartphone is 10 million
smartphones per week.
Since buyers and sellers
want to trade the same
quantity at the price of $200,
we do not expect the price to
change.
Figure 3.7
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Market equilibrium
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A Surplus in the Market for Smartphones
At a price of $250,
• consumers want to
buy 9 million
smartphones, while
• producers want to
sell 11 million.
This gives a surplus of 2
million smartphones: a
situation in which quantity
supplied is greater than
quantity demanded.
Prediction: sellers will compete
amongst themselves, driving
the price down.
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Figure 3.8
The effect of surpluses and
shortages on the market price
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A Shortage in the Market for Smartphones
At a price of $100,
• consumers want to
buy 12 million
smartphones, while
• producers want to
sell 8 million.
This gives a shortage of 4
million smartphones: a
situation in which quantity
demanded is greater than
quantity supplied.
Prediction: sellers will realize
they can increase the price
and still sell as many
smartphones, so the price will
rise.
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Figure 3.8
The effect of surpluses and
shortages on the market price
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Demand and Supply Both Count
Price is determined by the interaction of buyers and sellers.
Neither group can dictate price in a competitive market (i.e. one with
many buyers and sellers).
However changes in supply and/or demand will affect the price and
quantity traded.
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The Effect of Demand and Supply Shifts on Equilibrium
3.4 LEARNING OBJECTIVE
Use demand and supply graphs to predict changes in prices and quantities.
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The Usefulness of the Demand and Supply Model
Predictions about price and quantity in our model require us to know
supply and demand curves.
Typically, we know price and quantity, but do not know the curves
that generate them.
The power of the demand and supply model is in its ability to predict
directional changes in price and quantity traded.
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The Effect of Shifts in Supply on Equilibrium
Suppose Amazon enters
the smartphone market:
More smartphones are
supplied at any given
price—an increase in
supply from S1 to S2.
Equilibrium price falls from
P1 to P2.
Equilibrium quantity rises
from Q1 to.
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Figure 3.9
The effect of an
increase in supply on
equilibrium
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How Much Will Price and Quantity Change?
By how much will price
fall? By how much will
quantity rise?
We cannot say, without
knowing more information.
For now, we can only
predict that price will fall
and quantity traded will
rise.
Figure 3.9
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The effect of an
increase in supply on
equilibrium
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The Effect of Shifts in Demand on Equilibrium
Suppose incomes increase.
What happens to the
equilibrium in the
smartphone market?
Smartphones are a normal
good, so as income rises,
demand shifts to the right
(D1 to D2).
Equilibrium price rises (P1
to P2).
Equilibrium quantity rises
(Q1 to Q2).
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Figure 3.10
The effect of an
increase in demand on
equilibrium
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Shifts in Demand and Supply over Time
Over time, it is likely that both
demand and supply will
change.
For example, as new firms
enter the market for
smartphones and incomes
increase, we expect
• The supply of smartphones
will shift to the right, and
• The demand for
smartphones will shift to
the right.
Figure 3.11a
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Shifts in demand and
supply over time:
demand shifting more
than supply
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Demand Shifting More Than Supply
What does our model predict?
S↑  ( P↓ and Q↑ )
D↑  ( P↑ and Q↑ )
So we can be sure equilibrium
quantity will rise; but the effect
on equilibrium price is not
clear.
This panel shows demand
shifting more than supply:
equilibrium price and quantity
both rise.
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Figure 3.11a
Shifts in demand and
supply over time:
demand shifting more
than supply
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Supply Shifting More Than Demand
This panel shows supply
shifting more than demand:
quantity rises, but equilibrium
price falls.
Without knowing the relative
size of the changes, the effect
on equilibrium price is
ambiguous.
It is possible, but unlikely, that
the equilibrium price will
remain unchanged.
Figure 3.11b
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Shifts in demand and
supply over time:
supply shifting more
than demand
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Effect of Changes in Demand or Supply—redux
We can now fill in the rest of Table 3.3.
The cell in red is the example that we just did.
Supply Curve
Unchanged
Supply Curve Shifts
to the Right
Supply Curve Shifts
to the Left
Demand Curve Unchanged
Q unchanged
P unchanged
Q increases
P decreases
Q decreases
P increases
Demand Curve Shifts to the
Right
Q increases
P increases
Q increases
P increases or
decreases
Q increases or
decreases
P increases
Demand Curve Shifts to the
Left
Q decreases
P decreases
Q increases or
decreases
P decreases
Q decreases
P increases or
decreases
Table 3.3
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How shifts in demand
and supply affect
equilibrium price (P)
and quantity (Q)
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Making
the
Connection
The Falling Price of Blu-ray Players
From 2006 to 2013, the price of Blu-ray players fell from about $800
to about $95, while the number of Blu-ray players traded increased
dramatically.
What best explains this change?
A. Increase in demand
B. Decrease in demand
C. Increase in supply
D. Decrease in supply
Can you show this change on a supply-and-demand diagram?
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Making
the
Connection
Blu-ray Players (part B)
Supply increased as additional firms started manufacturing Blu-ray
players and input costs fell.
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Shifts of a Curve vs. Movements along a Curve
Suppose an increase in supply occurs. We now know:
• Equilibrium quantity will increase, and
• Equilibrium price will decrease
It is tempting to believe the decrease in price will cause an increase in
demand. But this is incorrect.
• The decrease in price will cause a movement along with demand
curve, but not an increase in demand.
• Why? The demand curve already describes how much of the good
consumers want to buy, at any given price.
• When the price change occurs, we just look at the demand curve
to see what happens to how much consumers want to buy.
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Do People Respond to Changes in the Price of Gasoline?
Some argue that people don’t vary the quantity of gasoline they buy
as the price changes.
• Do you think this is correct?
From September 2011 to September 2012, the price of gasoline rose
by about 7% ($3.66 per gallon to $3.91 per gallon).
• Gasoline consumption fell by about 5%.
People do respond to incentives, changing their behavior as prices,
incomes, and prices of related goods change.
This chapter explores these behavioral changes.
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The Price Elasticity of Demand and Its Measurement
6.1 LEARNING OBJECTIVE
Define price elasticity of demand and understand how to measure it.
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Measuring Responsiveness to Price Changes
Although we saw consumers did change the amount of gasoline they
bought, they didn’t appear to change it by very much.
How can we come up with a sensible way to measure how much
quantity changes when price changes?
One idea is to look at the slope of the demand curve.
• But this won’t work, since the value of the slope depends on the
units used to measure on the axes.
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Price Elasticity of Demand
A better way to measure responsiveness of quantity demanded is to
think in terms of percentage changes.
• This avoids the problem with units of measurement.
Price elasticity of demand 
Percentage change in quantity demanded
Percentage change in price
Although the slope and price elasticity of demand are related, they
are not the same thing.
Since price and quantity change in opposite directions on the demand
curve, the price elasticity of demand is a negative number.
• However we often refer to “more negative” elasticities as being
“larger” or “higher”.
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Price Elasticity of Demand Terminology
A “large” value for the price elasticity of demand means that quantity
demanded changes a lot in response to a price change.
Formally, we say demand is price elastic if its price elasticity of
demand is larger (in absolute value) than 1.
• So a 10% increase in price would result in a greater than 10%
decrease in quantity demanded.
Demand is price inelastic if its price elasticity of demand is smaller
(in absolute value) than 1.
• That is, close to zero, indicating that quantity demanded changes
little in response to a price change.
Demand is unit price elastic if the price elasticity of demand is
exactly equal to (negative) 1.
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Elastic and Inelastic Demand
Along D1, cutting the price
from $4.00 to $3.70
increases the number of
gallons sold from 1,000 per
day to 1,200 per day, so
demand is elastic between
point A and point B.
Along D2, cutting the price
from $4.00 to $3.70
increases the number of
gallons sold from 1,000 per
day only to 1,050 per day, so
demand is inelastic between
point A and point C.
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Figure 6.1
Elastic and inelastic
demand
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Percentage Changes and the Midpoint formula
Percentage changes have the unfortunate characteristic that the
percentage change from A to B is not the negative of the percentage
change from B to A.
Example: On the previous slide, from point A to point B, quantity
increased from 1000 to 1200, an increase of 20%.
However from B to A, quantity decreases by 16.7%.
This would mean the elasticity from A to B was different from the
elasticity from B to A, an undesirable characteristic.
To avoid this, we calculate percentage changes using the midpoint
formula:
( A  B)
Percentage Change 
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 A B 


 2 
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The Midpoint Formula
The midpoint formula avoids the confusion of whether we are going
from A to B or from B to A: we use the average of A and B in the
denominator instead of choosing one of them.
Price elasticity of demand becomes:
(Q2  Q1 ) ( P2  P1 )
Price elasticity of demand 

 Q1  Q2   P1  P2 

 

 2   2 
The first term is the percentage change in quantity, using the midpoint
formula.
The second term is the percentage change in price, using the
midpoint formula.
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Calculating Price Elasticity of Demand—part 1
At your gas station, you cut
price from $3.50 per gallon to
$3.30 per gallon. Gasoline
sales went up from 2000 to
2500 gallons per day.
To calculate this price
elasticity, we first need the
average quantity and price:
Average quantity 
Average price 
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2,000  2,500
 2,250
2
$3.50  $3.30
 $3.40
2
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Calculating Price Elasticity of Demand—part 2
Now calculate the percentage
change in quantity and price:
2,500  2,000
100
2,250
 22.2%
Percentage change
in quantity demanded

Percentage change
in price

$3.30  $3.50
100
$3.40
 5.9%
Then price elasticity of
demand is the ratio of these
two:
Price elasticity
of demand
22.2%
 5.9%
 3.8

This is greater in absolute value than –1, so we say that demand in
this range is price elastic.
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Calculating Price Elasticity of Demand—part 3
What if the quantity had only
increased to 2100?
Percentage change in price
remains the same (-5.9%).
Percentage change in quantity
is now:
Percentage change
in quantity demanded
2,100  2,000
100
2,050
 4.9%

So price elasticity of demand
is now…
Price elasticity
of demand
4.9%
 5.9%
 0.8

This is smaller (in absolute value) than -1, so demand is inelastic.
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Observations About Elasticity
While slope and elasticity are not the same, they are related:
• If two demand curves go through the same point, the one with the
higher slope also has the higher (more negative) elasticity.
A vertical demand curve means that quantity demanded does not
change as price changes.
• So elasticity is zero.
• A vertical demand curve is perfectly inelastic.
A horizontal demand curve means quantity demanded is infinitely
responsive to price changes.
• Elasticity is infinite.
• A horizontal demand curve is perfectly elastic.
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Summary of Price Elasticity of Demand—part 1
If demand is…
then the absolute value
of price elasticity is…
Table 6.1
Summary of
the price
elasticity of
demand
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Summary of Price Elasticity of Demand—part 2
If demand is…
then the absolute value
of price elasticity is…
Table 6.1
Summary of
the price
elasticity of
demand
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Summary of Price Elasticity of Demand—part 3
If demand is…
then the absolute value
of price elasticity is…
Table 6.1
Summary of
the price
elasticity of
demand
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Do People Respond to Changes in the Price of Gasoline?
We can now use our knowledge to answer this question in economic
terms.
• Gasoline demand is inelastic: the quantity demanded does not
change much as the price of gasoline changes.
• It is not perfectly inelastic: it is somewhat responsive to price.
Which panel shows this?
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The Determinants of the Price Elasticity of Demand
6.2 LEARNING OBJECTIVE
Understand the determinants of the price elasticity of demand.
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What Determines the Price Elasticity of Demand?
Why do some goods have a high price elasticity of demand, while
others have a low price elasticity of demand?
There are several characteristics of the good, of the market, etc. that
determine this.
1. The availability of close substitutes
If a product has more substitutes available, it will have more elastic
demand.
Example: There are few substitutes for gasoline, so its price elasticity
of demand is low.
Example: There are many substitutes for Nikes (Reeboks, Adidas,
etc.), so their price elasticity of demand is high.
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More Determinants of the Price Elasticity of Demand
2. The passage of time
Over time, people can adjust their buying habits more easily.
Elasticity is higher in the long run than the short run.
Example: If the price of gasoline rises, it takes a while for people to
adjust their gasoline consumption. How might they do that?
• Buying a more fuel-efficient car
• Moving closer to work
3. Whether the good is a luxury or a necessity
People are more flexible with luxuries than necessities, so price
elasticity of demand is higher for luxuries.
Example: Many people consider milk and bread necessities; they will
buy them every week almost regardless of the price.
And if the price goes down, they won’t drastically increase their
consumption of bread or milk.
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Yet More Determinants of the Price Elasticity of Demand
4. The definition of the market
The more narrowly defined the market, the more substitutes are
available, and hence the more elastic is demand.
Example: You might believe there is no good substitute for jeans, so
your demand for jeans is very inelastic.
But if you consider different brands of jeans, you might be more
sensitive to the price of a particular brand.
5. The share of a good in a consumer’s budget
If a good is a small portion of your budget, you will likely not be very
sensitive to its price.
Example: You might buy table salt once a year or less; changes in its
price will not affect very much how much you buy.
Example: Changes in the price of housing do affect where people
choose to live.
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Some Real-World Price Elasticities of Demand
Product
Estimated
Elasticity
Product
Estimated
Elasticity
Books (Barnes & Noble)
–4.00
Bread
–0.40
Books (Amazon)
–0.60
Water (residential use)
–0.38
DVDs (Amazon)
–3.10
Chicken
–0.37
Post Raisin Bran
–2.50
Cocaine
–0.28
Automobiles
–1.95
Cigarettes
–0.25
Tide (liquid detergent)
–3.92
Beer
–0.29
Coca-Cola
–1.22
Catholic school attendance
–0.19
Grapes
–1.18
Residential natural gas
–0.09
Restaurant meals
–0.67
Gasoline
–0.06
Health insurance (low-income
households)
–0.65
Milk
–0.04
Sugar
–0.04
Table 6.2
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Estimated real-world price
elasticities of demand
65
Making
the
Price Elasticity of Demand for Breakfast Cereal
Connection
What is the price elasticity of demand for breakfast cereal?
The answer depends on whether you mean:
• A particular brand of a particular breakfast cereal
• A particular category of breakfast cereal
• Breakfast cereal in general
The further down the list we go, the more broadly the market is
defined, and hence the fewer close substitutes are available.
• So we would expect the price elasticity of demand to become
smaller as we move down the list.
Price elasticity
• And so it does:
© 2015 Pearson Education, Inc.
Cereal
of demand
Post Raisin Bran
–2.5
All family breakfast cereals
–1.8
All types of breakfast cereal
–0.9
66
The Relationship between Price Elasticity of Demand
and Total Revenue
6.3 LEARNING OBJECTIVE
Understand the relationship between the price elasticity of demand and total
revenue.
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67
Elasticity and the Pricing Decision
If you are a business owner, you need to decide how to price your
product.
• “How many customers will I gain if I cut my price?”
• “What will happen to my total revenue if I cut my price?”
Total revenue: The total amount of funds received by a seller of a
good or service, calculated by multiplying the price per unit by the
number of units sold.
Knowing the price elasticity of demand for your product can help to
answer these questions.
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68
Effect of Cutting Price with Different Elasticities
Suppose demand for your product is relatively price inelastic.
• Customers are not very sensitive to the price of your product.
• As you decrease the price, you expect to gain few additional
customers.
• The few additional customers do not compensate for the lost
revenue, so overall revenue goes down.
Suppose demand for your product is relatively price elastic.
• Customers are very sensitive to the price of your product.
• As you decrease the price, you expect to gain many additional
customers.
• The many additional customers more than compensate for the lost
revenue, so overall revenue goes up.
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69
Cutting Price When Demand Is Inelastic
Revenue before price cut
(at A):
1,000 x $4.00
= $4,000
Revenue after price cut
(at B):
1,050 x $3.70
= $3,885
The decrease in price
does not generate
enough extra customers
(area E) to offset revenue
loss (area C).
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Figure 6.2a
The relationship between price
elasticity and total revenue
70
Cutting Price When Demand Is Elastic
Revenue before price cut
(at A):
1,000 x $4.00
= $4,000
Revenue after price cut
(at B):
1,200 x $3.70
= $4,440
The decrease in price
generates enough extra
customers (area E) to
more than offset revenue
loss (area C).
© 2015 Pearson Education, Inc.
Figure 6.2b
The relationship between price
elasticity and total revenue
71
Why Are Elasticity and Total Revenue Related?
The formula for price elasticity of demand is:
Percentage change in quantity demanded
Price elasticity of demand 
Percentage change in price
So if this is greater than 1 (in absolute terms) then quantity demanded
goes up by a higher percentage than price, raising the revenue.
A special case occurs when price elasticity of demand is -1: the
percentage change in quantity demanded equals the percentage
change in price, so revenue does not change.
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72
Total Revenue Along a Linear Demand Curve
Suppose we have a linear demand
curve.
What happens to total revenue as
price increases?
• Initially, total revenue rises,
suggesting demand is inelastic.
• But then total revenue starts to
fall, suggesting demand is
elastic!
Figure 6.3
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Elasticity is not
constant along a linear
demand curve
73
Total Revenue Along a Linear Demand Curve—cont.
The data from the table are plotted
in the graphs.
As price decreases from $8,
revenue rises—hence demand is
elastic.
As price continues to fall, revenue
eventually flattens out—demand is
unit elastic.
Then as price falls even further,
revenue begins to fall—demand is
inelastic.
Figure 6.3
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Elasticity is not
constant along a linear
demand curve
74
Price Elasticity of Demand and Revenue
If demand is…
then...
because...
elastic
an increase in price
reduces revenue
the decrease in quantity demanded is proportionally
greater than the increase in price.
elastic
a decrease in price
increases revenue
the increase in quantity demanded is proportionally
greater than the decrease in price.
inelastic
an increase in price
increases revenue
the decrease in quantity demanded is proportionally
smaller than the increase in price.
inelastic
a decrease in price
reduces revenue
the increase in quantity demanded is proportionally
smaller than the decrease in price.
unit elastic
an increase in price
does not affect
revenue
the decrease in quantity demanded is proportionally
the same as than the increase in price.
unit elastic
a decrease in price
does not affect
revenue
the increase in quantity demanded is proportionally
the same as than the decrease in price.
Table 6.3
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The relationship between
price elasticity and revenue
75
Estimating Price Elasticity of Demand
We can see that knowing the price elasticity of demand would be very
useful for a firm. But how can a firm know this information?
• For a well-established product, economists can use historical data
to estimate the demand curve.
• To calculate the price elasticity of demand for a new product, firms
often rely on market experiments.
With market experiments, firms try different prices and observe the
change in quantity demanded that results.
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76
Other Demand Elasticities
6.4 LEARNING OBJECTIVE
Define cross-price elasticity of demand and income elasticity of demand and
understand their determinants and how they are measured.
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77
Cross-Price Elasticity of Demand
When we examined demand in Chapter 3, we discussed substitutes
and complements.
Substitutes: Goods and services that can be used for the same
purpose.
Complements: Goods and services that are used together.
Cross-price elasticity of demand measures the strength of
substitute or complement relationships between goods:
Cross - price elasticity of demand 
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Percentage change in quantity demanded of one good
Percentage change in price of another good
78
Summary of the Cross-Price Elasticity of Demand
If the
products are…
then the crossprice elasticity of
demand will be…
Example
substitutes
positive
Two brands of tablet
computers
complements
negative
Tablet computers and
applications downloaded from
online stores
zero
Tablet computers and peanut
butter
unrelated
Table 6.4
© 2015 Pearson Education, Inc.
Summary of cross-price
elasticity of demand
79
Income Elasticity of Demand
When we examined demand in Chapter 3, we discussed normal and
inferior goods.
Normal goods: Goods and services for which the quantity demanded
increases as income increases
Inferior goods: Goods and services for which the quantity demanded
falls as income increases
Income elasticity of demand measures the strength of the effect of
income on quantity demanded:
Income elasticity of demand 
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Percentage change in quantity demanded
Percentage change in income
80
Summary of Income Elasticity of Demand
If the income elasticity
of demand is…
then the good is…
Example
positive but less than 1
normal and a necessity
Bread
positive and greater than 1 normal and a luxury
Caviar
negative
Ramen
noodles
inferior
Necessity: A normal good with a
quantity demanded that responds less
than proportionally to a price change.
Table 6.5
Summary of income
elasticity of demand
Luxury: A normal good with a quantity
demanded that responds more than
proportionally to a price change.
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81
Making
Elasticities of Alcoholic Beverages
the
Connection
Christopher Ruhm of the University
of Virginia and colleagues estimated
elasticities for various alcoholic
beverages. According to their study:
Price elasticity of
demand for beer
−0.30
Demand for beer is price inelastic.
Cross-price elasticity of −0.83
demand between beer
and wine
Cross-price elasticity of −0.50
demand between beer
and spirits
Income elasticity of
demand for beer
0.09
Beer and wine are complements.
Beer and spirits are also
complements, but the relationship is
not as strong.
Beer is a normal good; a necessity.
Are any of these results surprising to you?
Why or why not?
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82
The Price Elasticity of Supply and Its Measurement
6.6 LEARNING OBJECTIVE
Define price elasticity of supply and understand its main determinants and how
it is measured.
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83
Price Elasticity of Supply
Price elasticity of supply is very much analogous to price elasticity
of demand:
Price elasticity of supply 
Price elasticity of demand 
Percentage change in quantity supplied
Percentage change in price
Percentage change in quantity demanded
Percentage change in price
So the same sort of calculation methods apply (midpoint formula,
etc.)
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84
Determinants of the Price Elasticity of Supply
Price elasticity of supply depends on the ability and willingness of
firms to alter the quantity they produce as price increases.
The time period in question is critically important for determining the
price elasticity of supply.
Suppose the wholesale price of grapes doubled overnight:
• Farmers could do little to increase their quantity immediately; the
initial price elasticity of supply would be close to 0.
• Over time, farmers could plant more fields in grapes; so over the
course of several years, the price elasticity of supply would rise.
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85
Making
the
Connection
Why Are Oil Prices So Unstable?
Oil producers cannot change
output very quickly.
When demand increases
suddenly, price rises, acting
as a rationing mechanism for
the increased demand.
© 2015 Pearson Education, Inc.
On the other hand, during a
recession, demand for oil
falls.
Oil producers cannot adjust
their output quickly, so the
price falls dramatically.
86
Terminology for Price Elasticity of Supply—part 1
Much the same terminology applies to price elasticity of supply as to
price elasticity of demand: elastic, inelastic, unit-elastic, perfectly
elastic, and perfectly inelastic all have similar meanings.
If supply is…
Table 6.6
© 2015 Pearson Education, Inc.
then the value of price elasticity is…
Summary of the price
elasticity of supply
87
Terminology for Price Elasticity of Supply—part 2
If supply is…
Table 6.6
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then the value of price elasticity is…
Summary of the price
elasticity of supply
88
Terminology for Price Elasticity of Supply—part 3
If supply is…
Table 6.6
© 2015 Pearson Education, Inc.
then the value of price elasticity is…
Summary of the price
elasticity of supply
89
Why Is Knowing Price Elasticity of Supply Useful?
Knowing the price elasticity of supply can help us to predict the effect
that a change in demand will have.
When demand increases, we know equilibrium price and quantity will
increase.
But if supply is inelastic, quantity supplied cannot change much in
response to the demand change; so price will rise a lot.
If supply is elastic, price will rise much less.
The next two slides illustrate these statements.
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90
Parking on the 4th of July—Inelastic Supply
DemandTypical represents the
typical demand for parking
spaces on a summer
weekend at a beach resort.
DemandJuly 4 represents
demand on the 4th of July.
When supply is inelastic, the
price increase will be large.
Figure 6.5a
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Changes in price depend on
the price elasticity of supply
91
Parking on the 4th of July—Elastic Supply
If supply is elastic
instead, then the
resulting price
change will be
much smaller.
Figure 6.5b
© 2015 Pearson Education, Inc.
Changes in price depend on
the price elasticity of supply
92
Summary of Elasticities—part 1
Price Elasticity of Demand
Formula :
Percentage change in quantity demanded
Percentage change in price
(Q 2  Q1 ) (P 2  P1 )
Midpoint Formula :

 Q 2  Q1   P1  P2 

 

2
2

 

Absolute Value
of Price Elasticity
Effect on Total Revenue
of an Increase in Price
Elastic
Greater than 1
Total revenue falls
Inelastic
Less than 1
Total revenue rises
Unit elastic
Equal to 1
Total revenue unchanged
Table 6.7
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Summary of elasticities
93
Summary of Elasticities—part 2
Cross-Price Elasticity of Demand
Formula :
Percentage change in quantity demanded of one good
Percentage change in price of another good
Types of Products
Value of Cross-Price Elasticity
Substitutes
Positive
Complements
Negative
Unrelated
Zero
Income Elasticity of Demand
Formula :
Percentage change in quantity demanded
Percentage change in income
Types of Products
Value of Income Elasticity
Normal and a necessity
Positive but less than 1
Normal and a luxury
Positive and greater than 1
Inferior
Negative
Table 6.7
© 2015 Pearson Education, Inc.
Summary of elasticities
94
Summary of Elasticities—part 3
Price Elasticity of Supply
Formula :
Percentage change in quantity supplied
Percentage change in price
Value of Price Elasticity
Elastic
Greater than 1
Inelastic
Less than 1
Unit elastic
Equal to 1
Table 6.7
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Summary of elasticities
95