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Elasticity
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MC
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Elasticity

What do you think?

Could reducing the supply of illegal drugs
cause an increase in drug-related
burglaries?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 2
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The Effect of Extra Border
Patrols on the Market for Illicit Drugs
Total Expenditure = P x Q
S
$2500
= $50 x 50
S’
$3200
= $80 x 40
S’
P($/ounce)
80
S
50
D
40
50
Q(1,000s of ounces/day)
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 3
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Price Elasticity of Demand

Elasticity

A measure of the extent to which quantity
demanded and quantity supplied respond
to variations in price, income, and other
factors.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 4
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Price Elasticity of Demand

Defined

Generally
A
measure of the responsiveness of the
quantity demanded of a good to a change in
the price of that good

Formally
 The
percentage change in the quantity
demanded that results from a 1 percent change
in its price
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 5
MB MC
Price Elasticity of Demand

Measuring Price Elasticity of Demand
Percentage Change in Quantity Demanded
Percentage Change in Price
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 6
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Price Elasticity of Demand

Assume

The price of pork falls by 2% and the
quantity demanded increases by 6%
 Then
the price elasticity of demand for pork is
6%
 3
 2%
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 7
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Price Elasticity of Demand

Measuring Price Elasticity of Demand
Percentage Change in Quantity Demanded
Percentage Change in Price

Observations
 Price elasticity of demand will always be
negative (i.e., an inverse relationship
between price and quantity)
 For convenience we drop the negative sign
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 8
MB MC
Price Elasticity of Demand

Measuring Price Elasticity of Demand
> 1: elastic
When
Percentage Change in Quantity Demanded
Percentage Change in Price
is < 1: inelastic
= 1: unit elastic
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 9
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Elastic and Inelastic Demand
Unit elastic
Inelastic
0
Elastic
1
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
2
3
Chapter 4: Elasticity
Price elasticity
of demand
Slide 10
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Price Elasticity of Demand

What is the elasticity of demand for pizza?

Originally
 Price
= $1/slice
 Quantity demanded = 400 slices/day

New
 Price
= $0.97/slice
 Quantity demanded = 404 slices/day, then
% Change in Quantity 1
 : Inelastic
% Change in Price
3
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 11
MB MC
Price Elasticity of Demand

What is the elasticity of season ski passes?

Originally
 Price
= $400
 Quantity demanded = 10,000 passes/year

New
 Price
= $380
 Quantity demanded = 12,000 passes/year, then
% Change in Quantity 20

: Elastic
% Change in Price
5
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 12
MB MC
Price Elasticity of Demand

Determinants of Price Elasticity of
Demand
Substitution possibilities
 Budget share
 Time

Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 13
MB MC
Price Elasticity
Estimates for Selected Products
Good or service
Price elasticity
Green peas
2.80
Restaurant meals
1.63
Automobiles
1.35
Electricity
1.20
Beer
1.19
Movies
0.87
Air travel (foreign)
0.77
Shoes
0.70
Coffee
0.25
Theater, opera
0.18
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 14
MB MC
Price Elasticity of Demand

What do you think?

Why is the price elasticity of demand more
than 14 times larger for green peas than
for theater and opera performances?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 15
MB MC
Price Elasticity of Demand

Economic Naturalist
Will higher taxes on cigarettes curb
teenage smoking?
 Why was the luxury tax on yachts such a
disaster?

Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 16
MB MC

A Graphical Interpretation
of Price Elasticity
For small changes in price
ΔQ Q
Price elasticity   
ΔP P
Where Q is the original quantity and P is the original
price
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 17
A Graphical Interpretation
of Price Elasticity of Demand
MB MC
 P  1 

Pr ice elasticity at A   
 Q  slope 
A
Price
P
P
P-
P
Q
D
Q
Q+
Q
Quantity
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 18
MB MC

A Graphical Interpretation
of Price Elasticity
Example

Originally
 Price
(P) = $100
 Quantity (Q) = 20

New
 Price
(P) = $105
 Quantity (Q) = 15
5 20 25


 5 : Elastic
5 100 5
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 19
MB MC
Calculating Price Elasticity of Demand
20
vertical intercept
20
slope 

4
horizontal intercept
5
D
16
8 1 8 2
A  x 

3 4 12 3
Price
12
A
8
4
1
2
3
4
5
Quantity
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 20
MB MC
Calculating Price Elasticity of Demand
20
D
Question
What is the price elasticity
of demand when P = $4?
16
Price
12
A
8
4
1
2
3
4
5
Quantity
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 21
MB MC
Price Elasticity and the
Steepness of the Demand Curve
12
What is the price elasticity of
Demand for D1 & D2 when P = $4?


 4  1  1
D1   


12
 2
 4 
 6
D1
Price
6
4
D2
4
6


 4  1 
D2   
2

6

 4 
 12 
12
Quantity
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 22
MB MC
Price Elasticity and the
Steepness of the Demand Curve
For D2 when P = $1
12
Price
6


 1  1  1
D2   


 10  6  5
 12 
D1
4
D2
1
4
6
10
12
Quantity
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 23
MB MC
Price Elasticity and the
Steepness of the Demand Curve
Observation
12
Price
6
If two demand curves have a
point in common, the steeper
curve must be less elastic with
respect to price at that point
D1
4
D2
1
4
6
10
12
Quantity
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 24
Price Elasticity Regions along
a Straight-Line Demand Curve
MB MC
Observation
Price elasticity varies at
every point along a straightline demand curve
Price
a
 1
 1
 1
a/2
b/2
b
Quantity
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 25
MB MC
Perfectly Elastic Demand Curve
Perfectly elastic
Price
demand (elasticity   )
Quantity
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 26
MB MC
Perfectly Inelastic Demand Curve
Price
Perfectly inelastic
demand (elasticity  0)
Quantity
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 27
MB MC
Elasticity and Total Expenditure

Total Expenditure = P x Q


Market demand measures the quantity (Q)
at each price (P)
Total Expenditure = Total Revenue
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 28
MB MC
The Demand Curve for Movie Tickets
12
D
Price ($/ticket)
10
Total Expenditure
= $1,000/day
8
6
4
A
2
0
1
2
3
4
5
6
Quantity (100s of tickets/day)
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 29
MB MC
The Demand Curve for Movie Tickets
12
D
Price ($/ticket)
10
Total Expenditure
= $1,600/day
8
6
B
4
2
0
1
2
3
4
5
6
Quantity (100s of tickets/day)
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 30
MB MC
Elasticity and Total Expenditure

What do you think?

Will increasing the market price always
increase total revenue?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 31
MB MC
The Demand Curve for Movie Tickets
12
Total Expenditure
= $1,600/day
D
Price ($/ticket)
10
8
6
4
2
0
1
2
3
4
5
6
Quantity (100s of tickets/day)
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 32
MB MC
The Demand Curve for Movie Tickets
Total Expenditure
= $1,000/day
12
Price ($/ticket)
10
8
6
4
D
2
0
1
2
3
4
5
6
Quantity (100s of tickets/day)
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 33
MB MC
Elasticity and Total Expenditure

General Rule

A price increase will increase total revenue
when the % change in P is greater than the
% change in Q.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 34
MB MC
The Demand Curve for Movie Tickets
12
Price ($/ticket)
10
8
6
4
2
0
1
2
3
4
5
6
Quantity (100s of tickets/day)
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 35
MB MC
Total Expenditure
as a Function of Price
Price ($/ticket)
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Total expenditure ($/day)
12
0
10
1,000
8
1,600
6
1,800
4
1,600
2
1,000
0
0
Chapter 4: Elasticity
Slide 36
Total Expenditure
as a Function of Price
MB MC
Total revenue is at a maximum at the
midpoint on a straight-line demand curve
12
1,800
1,600
Total expenditure ($/day)
Price ($/ticket)
10
8
6
4
2
0
1
2
3
4
5
6
1,000
0
Quantity (100s of tickets/day)
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
2
4
6
8
Price ($/ticket)
Chapter 4: Elasticity
Slide 37
10
12
MB MC
Elasticity and Total Expenditure

What do you think?


Should a rock band raise or lower its price
to increase total revenue?
Assume
P  $20
Q  5,000
 3
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 38
MB MC
Elasticity and Total Expenditure

What do you think?


Should a rock band raise or lower its price to
increase total revenue?
Then
Total revenue = $20 x 5,000 =
$100,000/week
 If P is increased 10%, Q will decrease 30%

 Total

revenue = $22 x 3,500 = $77,000/week
If P is lowered 10%, Q will increase 30%
 Total
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
revenue = $18 x 6,500 = $177,000/week
Chapter 4: Elasticity
Slide 39
MB MC
Elasticity and Total Expenditure

Rule
When price elasticity is greater than 1,
changes in price and changes in total
expenditures always move in opposite
directions.
 When price elasticity is less than 1, changes
in price and changes in total expenditures
always move in the same direction.

Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 40
MB MC
Elasticity and the Effect of a Price
Change on Total Expenditure
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 41
MB MC
Elasticity and Total Expenditure

Cross-Price Elasticity of Demand

The percentage by which quantity demanded
of the first good changes in response to a 1
percent change in the price of the second
good
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 42
MB MC
Elasticity and Total Expenditure

Cross-Price Elasticity of Demand

Substitute Goods
 When
the cross-price elasticity of demand is
positive

Complement Goods
 When
the cross-price elasticity of demand is
negative
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 43
MB MC
Elasticity and Total Expenditure

Income Elasticity of Demand

The percentage by which quantity
demanded changes in response to a 1
percent change in income
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 44
MB MC
Elasticity and Total Expenditure

Income Elasticity of Demand

Normal Goods
 Income

elasticity is positive
Inferior Goods
 Income
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
elasticity is negative
Chapter 4: Elasticity
Slide 45
MB MC
The Price Elasticity of Supply

Price Elasticity of Supply

The percentage change in the quantity
supplied that occurs in response to a 1
percent change in price
Q Q
Price elasticity of supply 
P P
 P  1 

Price elasticity of supply   
 Q  slope 
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 46
MB MC
A Supply Curve for Which Price
Elasticity Declines as Quantity Rises
A  8 21 2  2
S
B
10
A
Price
8
5
B  10 31 2 
3
4
0
2
3
Quantity
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 47
MB MC
Calculating the Price
Elasticity of Supply Graphically
A  8 22  1
S
B
5
Q
Price
4
P
A
B  5 1515 5  1
0
12
15
Quantity
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 48
MB MC
The Price Elasticity of Supply

Observation

The price elasticity of supply will always
equal 1 at any point along a straight-line
supply curve that passes through the
origin.
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 49
MB MC
A Perfectly Inelastic Supply Curve
What is the price elasticity of supply of land
within the borough limits of Manhattan?
Price ($/acre)
S
Elasticity = 0 at every
point along a vertical
supply curve
0
Quantity of land in Manhattan
(1,000s of acres)
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 50
MB MC
A Perfectly Elastic Supply Curve
Price (cents/cup)
What is the price elasticity of supply of lemonade?
If MC is constant, then the
price elasticity of supply at every point
along a horizontal supply curve is infinite
S
14
0
Quantity of lemonade
(cups/day)
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 51
MB MC
The Price Elasticity of Supply

Determinants of Supply Elasticity
Flexibility of inputs
 Mobility of inputs
 Ability to produce substitute inputs
 Time

Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 52
MB MC
The Price Elasticity of Supply

Economic Naturalist

Why are gasoline prices so much more
volatile than car prices?
 Differences
in markets
o Demand for gasoline is more inelastic
o Gasoline market has larger and more frequent
supply shifts
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 53
MB MC
Greater Volatility in
Gasoline Prices than in Car Prices
S’
Gasoline
Price ($/gallon)
S
1.69
1.02
D
0
6 7.2
Quantity
(millions of gallons/day)
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 54
MB MC
Greater Volatility in
Gasoline Prices than in Car Prices
Cars
Price ($1,000s/car)
S’
S
17
16.4
D
11 12
Quantity
(1,000s of cars/day)
Cars
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 55
MB MC
The Price Elasticity of Supply

What do you think?

How would elasticity of supply and
fluctuating demand impact price volatility?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 56
MB MC
The Price Elasticity of Supply

Unique and Essential Inputs: The
Ultimate Supply Bottleneck

Why does Shaquille O’Neal get paid over
$120 million over a seven-year contract?
Copyright c 2007 by The McGraw-Hill
Companies, Inc. All rights reserved.
Chapter 4: Elasticity
Slide 57
End of
Chapter
MB
MC