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A Lecture Presentation
to accompany
Exploring Economics
3rd Edition
by Robert L. Sexton
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ISBN 0-324-26086-5
Chapter 6
Elasticities
6.1 Price Elasticity of Demand
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The law of demand establishes that
quantity demanded changes inversely
with changes in price, ceteris paribus.
But how much does quantity
demanded change?
This is very important to understand
for many economic issues.
This is what the price elasticity of
demand is designed to answer.

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The price elasticity of demand
measures how responsive quantity
demanded is to a price change.
The price elasticity of demand is
defined as the percentage change
in quantity demanded divided by
the percentage change in price.

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When economists say the price
elasticity of demand is high, it means
the quantity demanded changes by a
relatively larger amount than the price
change.
When the price elasticity of demand
is low, it means that the quantity
demanded changes by a relatively
smaller amount than the price change.
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Following the law of demand, there is
an inverse relationship between price
and quantity demanded.
For this reason, price elasticity of
demand is, in theory, always negative.
In practice, however, this quantity
is always expressed in absolute value
terms, as a positive number, for
simplicity.
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The percentage changes in the elasticity
of demand formula are measured using
the average price and average quantity.
This is so we do not get different values
for the elasticity of demand depending
on whether we moved up or down the
demand curve.
We are actually calculating the midpoint
elasticity.
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If a change in price leads to a larger
percentage change in the quantity
demanded; demand is said to be
elastic.
If a change in price leads to a smaller
percentage change in the quantity
demanded; demand is said to be
inelastic.


A demand curve or a portion of a
demand curve can be elastic, unit
elastic, or inelastic.
A segment of a demand curve is
elastic (ED > 1) if the percentage
change in quantity demanded is
greater than the percentage change
in price.

A perfectly elastic demand curve is
horizontal. The elasticity of demand
in this case is infinity because the
quantity demanded is infinitely
responsive to even a very small
percentage change in price.
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A segment of a demand curve is
inelastic (ED < 1) if the percentage
change in quantity demanded is less
than the percentage change in price.
A perfectly elastic demand curve
is vertical—the quantity demanded
is the same regardless of price.

A segment of a demand curve is unit
elastic demand (ED = 1) if the
percentage change in quantity
demanded equals the percentage
change in the price.
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When the demand curve is relatively
steep, ceteris paribus, its price
elasticity of demand is relatively low
(more inelastic).
When the demand curve is relatively
flat, ceteris paribus, its price elasticity
of demand is relatively high (more
elastic).

The price elasticity of demand
depends on the availability of close
substitutes, the proportion of income
spent on the good, and the amount
of time people have to adapt to a
price change.
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Goods with close substitutes tend to
have more elastic demand.
Goods without close substitutes tend
to have less elastic demand.
Example: the elasticity of demand for
a Ford, Toyota, or a Honda is more
elastic than the demand for a car
because there are more and better
substitutes for a certain type of car
than for a car itself.

The degree of substitutability can
also depend on whether the good
is a luxury or a necessity. Good
that are necessities , like food,
have no ready substitutes and
thus tend to have lower elasticities
than do luxury items like jewelry.
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The fewer the number of close
substitutes, the less elastic the demand
curve.
Examples: insulin for diabetics, heroin for
an addict, and emergency medical care
have few, if any, close substitutes.
The smaller the proportion of income
spent on a good, the lower its elasticity
of demand.
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If the amount spent on a good relative to
income is small (Example: salt), then the
impact of a change in its price on one's
budget will also be small.
Consumers will respond less to price
changes for these goods than for similar
percentage changes in large-ticket items,
like an automobile, where a price change
could have a potentially large impact on
the consumer's budget.
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The more time that people have to adapt
to a new price change, the greater the
elasticity of demand.
The more time that passes, the more time
consumers have to find or develop suitable
substitutes and to plan and implement
changes in their patterns of consumption.
Hence, the short-run demand curve is
generally less elastic than the long-run
demand curve.
6.2 Total Revenue and Price
Elasticity of Demand
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When demand is relatively price
elastic (ED > 1), total revenues will
rise as the price declines.
This occurs because the percentage
increase in the quantity demanded is
greater than the percentage reduction
in price.
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If the price rises and the quantity
demanded falls, then total revenue
falls.
This occurs because the percentage
decrease in the quantity demanded is
greater than the percentage increase
in price.
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When demand is relatively price
inelastic (ED < 1), total revenues will
fall as the price declines.
Total revenues fall because the
percentage increase in the quantity
demanded is less than the percentage
reduction in price.
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If the price rises and the quantity
demanded falls, then total revenue
rises.
Total revenue rises because the
percentage decrease in the quantity
demanded is less than the percentage
increase in price.
Total Revenue and
Inelastic Demand

If the demand for food is inelastic
(which is generally the case), a good
harvest could result in a reduction in
total revenue for farmer’s, and a bad
harvest could result in an increase in
total revenue for farmer’s—see the
next two exhibits.
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A straight-line demand curve (having
a constant slope) will change price
elasticity continuously as you move
up or down it.
When the price falls on the upper half of
the demand curve, there is a negative
relationship between price and total
revenue.
Demand is relatively price elastic.
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When the price falls on the lower half
of the demand curve, there is a
positive relationship between price
and total revenue.
Demand is relatively price inelastic.
6.3 Price Elasticity of Supply
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According to the law of supply, there
is a positive relationship between
price and quantity supplied, ceteris
paribus.
But by how much does quantity
supplied change as price changes?
The price elasticity of supply
measures how responsive the
quantity sellers are willing to sell is
to changes in the price.
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In other words, price elasticity of
supply measures the relative change
in the quantity supplied that results
from a change in price.
The price elasticity of supply (ES) is
defined at the percentage change in
the quantity supplied divided by the
percentage change in price.
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Goods with a supply elasticity that is
greater than 1 (ES > 1 ) are relatively
elastic in supply.
With that, a 1 percent change in price
will result in a greater than 1 percent
change in quantity supplied.
The extreme case is perfectly elastic
supply, where ES = infinity.
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Goods with a supply elasticity that is
less than 1 (ES < 1) are relatively
inelastic in supply.
This means that a 1 percent change in
the price of these goods will induce a
proportionately smaller change in the
quantity supplied.
The extreme case is perfectly inelastic
supply, where ES = 0.
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Time is usually critical in supply
elasticities because it is more costly
for producers to bring forth and
release resources in shorter periods
of time.
Hence, supply tends to be more
elastic in the long run than the short
run.
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The relative elasticity of supply and
demand determines the distribution
of the tax burden for a good.
If demand has a lower elasticity than
supply in the relevant tax region, the
largest portion of the tax is paid by
the consumer.
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However, if demand is relatively more
elastic than supply in the relevant tax
region, the largest portion of the tax is
paid by the producer.
In general, the tax burden falls on the
side of the market that is less elastic,
which has nothing to do with who
actually pays the tax at the time of the
purchase.
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In 1991 Congress levied a 10 Percent
luxury tax on yachts (over $100,000)
planes (over $250,000) and some other
goods.
Congress thought it would raise $1.5
billion. However, in 1991 the tax raised
less than $30 million in taxes. Why?
People stopped buying luxury items—
the demand for new yachts was more
elastic than Congress thought.
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Government crackdowns increase the
probability of arrest and conviction for
drug dealers. This increase in risk for
suppliers shifts the supply curve to the
left.
For most drug users , addicts in
particular, the price is in the inelastic
portion of the demand curve—the seller
would therefore be abele to shift most
of the cost onto the consumer.
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That is, enforcement efforts increase
the price of illegal goods but only a
small reduction in quantity demanded
results from this price increase.
Unintended consequence—as a result of
the higher price, cash strapped buyers
search for alternative ways to fund their
expensive habit—burglary, muggings,
white collar crime and so on.
Perhaps policymakers should not just
focus on the supply side.
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If drug education leads to a
reduction in demand then the
demand curve shifts to the left
reducing the price and quantity of
illegal drugs exchanged.
This lower price for illegal drugs for
the remaining drug users may lead
to lower drug related crimes.
6.4 Other Types of Elasticities

The cross price elasticity of
demand measures both the direction
and magnitude of the impact that a
price change for one good will have
on the quantity of another good
demanded at a given price.

The cross price elasticity of demand
is defined as the percentage change
in quantity demanded of one good
at a given price divided by the
percentage change in price of another
good.
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If the cross price elasticity of demand
between two goods is positive, they
are substitutes because the price of
one good and the demand for the
other move in the same direction.
If the cross price elasticity of demand
between two goods is negative, they
are complements because the price
of one good and the demand for the
other move in opposite directions.
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The income elasticity of demand is
a measure of the relationship between
a relative change in income and the
consequent relative change in quantity
demanded, ceteris paribus.
The income elasticity of demand coefficient
expresses the degree of the connection
between the two variables, and it also
indicates whether the good in question
is normal or inferior.

The income elasticity of demand
is defined as the percentage change
in quantity demanded at a given
price divided by the percentage
change in income.
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If the income elasticity is positive, then the
good in question is a normal good because
the change in income and the change in
quantity demanded move in the same
direction.
If the income elasticity is negative, then
the good in question in an inferior good
because the change in income and the
change in quantity demanded move in
opposite directions.