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Lecture 4
Working with Supply and Demand:
Elasticities
Elasticities
• Elasticity: A measure of responsiveness of economic
actors to changes in conditions
• Price elasticity of demand: What happens to the
quantity demanded when the price of a good changes?
What happens to the revenue?
Sales of Braeburn Publishing’s Poetry Book
Location A
Price = $5
Quantity = 5
Revenue = $5 × 5 = $25
Location B
Price = $8
Quantity = 4
Revenue = $8 × 4 = $32
Question: How will the firm
best set the price for its product?
The firm may try to test two different
prices at two different locations with
similar tastes and income levels
Location A: P=5; Q=5
Location B: P=8; Q=4
The firm can then look at price elasticity
of demand in order to find out how a
price change affects its revenues.
Price inelastic demand
• Demand for a good is price inelastic if the effect of a price
change on the quantity demanded is rather small
• In this case, revenues to the seller move in the same
direction as the price
• Three reasons why demand might be inelastic:
– There are few good, close substitutes for the good or
service.
– The good or service is something that people feel they
need, rather than just want.
– The good or service is a very small part of a buyer’s
budget.
Sales of Braeburn Publishing’s Poetry Book
Location A
Price = $5
Quantity = 5
Revenue = $5 × 5 = $25
Location B
Price = $8
Quantity = 4
Revenue = $8 × 4 = $32
Price elastic demand
• The demand for a good is price elastic if the effect of a
price change on the quantity demanded is rather large
• In this case, revenues to the seller move inversely with
price.
• Three reasons why demand may be elastic:
– There are a number of good, close substitutes for the
good
– The good is merely wanted, rather than needed
– The good makes up a large part of the budget of the
buyer
Sales of Braeburn Publishing’s Mystery Novel
Location A
Price = $5
Quantity = 5
Revenue = $5 × 5 = $25
Location B
Price = $8
Quantity = 2
Revenue = $8 × 2 = $16
Elasticity and slope
• When you compare movements along demand curves
that go through a specific point on graphs with the same
scale:
– The flatter curve represents the relatively more
elastic demand
– The steeper curve represents the relatively less elastic
demand
• Note that: The curves that you are comparing must be
on the same scale and go through one common point!
Elasticity and slope
Location B
9
8
Price ($)
7
6
Demand for
Mystery Novel
(relatively elastic)
Demand for
Poetry Book
(relatively inelastic)
Location A
5
4
3
2
1
0
1
2
3
4
5
6
Quantity of Books
7
8
9
9
Location B
9
8
8
6
Demand for
Mystery Novel
(relatively elastic)
7
Price ($)
Price ($)
7
Demand for
Poetry Book
(relatively inelastic)
Location A
5
4
6
5
4
3
3
2
2
1
1
0
1
2
3
4
5
6
Quantity of Books
7
8
9
Demand for
Mystery Novel
0 123456789
Quantity of Books
BUT: Elasticity is not just the same thing as slope!
A relatively elastic demand curve can be made to look «steep» just
by changing the scale of the graph!!
Elasticity and Slope
• Elasticity is not just the same thing as slope!
• Elasticity varies at different points along a
straight-line curve.
2 extreme cases
Perfectly inelastic
demand curve:
Perfectly Inelastic
Price
A demand curve that is vertical,
i.e. quantity demanded does not
respond at all to price
Perfectly Elastic
Perfectly elastic
demand curve:
A demand curve that is
horizontal, i.e. quantity
demanded is extremely
sensitive to price
Quantity
Price-taker: a seller that faces
perfectly elastic demand for its
good
Elasticity and change in
revenue
Relationships of Price Elasticity to Quantity and Revenue Change
If Price Elasticity of
Demand Is:
0
greater than 0,
less than 1
1
greater than 1
Then Quantity Response
to Price Is:
Perfectly inelastic
(no change)
And Revenue Response to
Price Change Is:
inelastic (little change)
in same direction
unit elastic
(same percentage change)
elastic (big change)
very big, in same direction
no change
in opposite direction
A Few Estimated Price Elasticities
Good or Service
Cigarettes
Day care center services
Beef
Clothing
Ford compact automobile
Estimated Price
Elasticity
0.20
0.28
0.61
1.1
2.8
Price elasticity of supply
The more inelastic the supply curve is,
the more the buyer will have to push up
the price to make suppliers respond,
and
the more she will end up paying.
Income elasticity of demand
Income elasticity of demand
Cross-price elasticity of demand
Income and substitution effects
of a price change
• Price changes have two effects:
– income effect (IE): the tendency of a price increase
to reduce the quantity demanded of normal goods
and to increase the quantity demanded of any inferior
goods
– substitution effect (SE): the tendency of a price
increase for a particular good to reduce the quantity
demanded of that good, as buyers turn to cheaper
substitutes
Income and substitution effects
of a price change
• These two effects act together when there is a price change:
– If the good is normal and its price rises, both IE and SE will
tend to lead to a reduction in the quantity demanded of the
good.
– If the good is inferior and its price rises, the IE will increase
quantity demanded, at the same time, SE decreases the
quantity demanded. In general, SE is stronger than IE for
inferior goods, i.e., quantity demanded will fall.
[The exception is the case of Giffen goods: as price rises,
quantity demanded rises for Giffen goods]
Short-run vs. long-run
elasticities
Short-run elasticity:
A measure of the relatively immediate
responsiveness to a price change
Long-run elasticity:
A measure of the response to a price
change after economic actors have had
time to make adjustments