Chapter 4

Elasticities

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All

Learning Objectives
What is price elasticity of demand?
What are categories of demand elasticity and
what factors influence them?
What is the relationship between demand
elasticity and total revenue?
What is income elasticity of demand?
What is cross elasticity of demand?
What is price elasticity of supply?
What are categories of supply elasticity and
what factors influence them?
4-2
2

Price Elasticity of Demand

Price elasticity of demand
Percentage change in quantity demanded

Percentage change in price

Price elasticity of demand measures
consumers responsiveness to price
changes.
How much quantity demanded will change
if price changes.
Ignore the negative sign since its always
there.

4-3
3

Categories of Demand Elasticity

If price elasticity of demand >1:

% change in quantity demanded > % change in price
Elastic demand

If price elasticity of demand <1:

% change in quantity demanded < % change in price
Inelastic demand

If price elasticity of demand =1:

% change in quantity demanded = % change in price
Unit elastic demand
4-4
4

Elastic Demand Curve

A small percentage
change in price:
A large percentage
change in quantity.
The price elasticity of
demand between
Point A and Point B is
high.
Price elasticity of
demand > 1.

Price

Point A

Point B

$8
$7

Demand

100

220

Quantity

4-5
5

Inelastic Demand Curve

A large percentage
change in price:
A small percentage
change in quantity.
The price elasticity of
demand between
Point A and Point B is
low.
Price elasticity of
demand < 1.

Price
Point A
$10

Point B
$4

100

110

Quantity

4-6
6

Perfectly Inelastic Demand Curve

Quantity demanded is
constant and does not
respond to price
changes.
Price elasticity of
demand = 0.
This demand curve
violates the Law of
Demand.
Unrealistic demand
curve.

Price

Quantity

4-7
7

Perfectly Elastic Demand Curve

Quantity demanded is
extremely responsive
to price changes.
The smallest price
change causes infinite
change in quantity
demanded.
Price elasticity of
demand = infinity.

Price

$4

Quantity

20

4-8
8

Unit Elastic Demand Curve

Any percentage
change in price
causes the same
percentage change in
quantity demanded.
Price elasticity of
demand = 1.
Elasticity is the same
but not the slope
along the demand
curve.
4-9
9

Elasticity Along a Straight Line Demand Curve

At the top of demand curve:

When the quantity is near zero a
small absolute increase in
quantity demanded means a
huge percentage increase in
quantity demanded.
The price elasticity of demand is
huge.
At the bottom of demand curve:
When price is near zero a small
absolute increase in price
means a huge. percentage
increase in price.
The price elasticity of demand is
tiny.

Price

Elasticity =infinity

Demand
Quantity = 0

Elasticity =0

Price = 0
Quantity

4-10
10

Do You Know?
If a 10% price increase causes 60% fall in
quantity demanded then what is the price
elasticity of demand?
Is it elastic, inelastic or unit elastic demand?
Price elasticity of demand
60%

10%
6

It is elastic demand.
4-11
11

Price Elasticity of Demand and Total

Revenue
Total revenue = Price X sales.
Law of demand: As price increases,
quantity demanded falls and as price
decreases, quantity demanded rises.
Should you increase or decrease price to
increase total revenue?

4-12
12

Elastic Demand and Total Revenue

Elastic demand
= Quantity demanded is
very responsive to price
change.
Lower price
= Gain of huge number of
customers.
= Increase in total revenue
Price and total revenue
move in the opposite
direction.

$Price

We are here on
the demand
curve.

We are here on
the demand
curve.

8
7.50
Total revenue
= ($8)(100)
=$800 andTotal
is revenue=($7.50)(1,000)
=$7,500 and is represented by
represented
this box.
.
by this box.

100

Quantity

1,000

4-13
13

Inelastic Demand and Total Revenue

Inelastic demand
= Quantity demanded is not
responsive to price
change
Lower price
= Gain of very few number
of customers
= Decrease in total revenue
Price and total revenue
move in the same
direction

Price

We are here on the

demand curve.

$10

Total revenue
=($10)(500)
= $5,000 and is
represented
by this box.
$2
Total revenue =($2)(600)
= $1,200 and is represented
by this box.
500 600

We are here on
the demand
curve.

Quantity

4-14
14

Price Elasticity of Demand and Total

Revenue
Price Elasticity of Effect of a
Demand
Price Increase

Effect of a
Price Decrease

Elastic

Decrease in total
revenue

Increase in total
revenue

Unit elastic

No change in total No change in total

revenue
revenue

Inelastic

Increase in total
revenue

Decrease in total
revenue
4-15
15

Factors That Influence

Demand Elasticity
Substitutes:
The greater the availability of substitutes
for a good, the higher the goods price
elasticity of demand.
Complements:
Strong complements reduce a goods
price elasticity of demand.
4-16
16

Factors That Influence

Demand Elasticity
Product definition:
The more broadly defined a product, the
less elastic the products demand.
Broadly defined products have less
substitutes whereas narrowly defined
products have more substitutes.
4-17
17

Factors That Influence

Demand Elasticity
Necessities:
= Goods that are considered a must have.
Necessities do not have good substitutes.
Necessities have less elastic demand.
Luxuries:
Luxury goods have more elastic demand.
4-18
18

Factors That Influence

Demand Elasticity
Time:
Consumers are more flexible in the long run than
in the short term.
The price elasticity of demand is higher the more
time consumers have to adjust to price changes.
Share of income spent on good:
The greater the percentage of income spent on
a good, the more price elasticity of demand for
that good.
4-19
19

Factors That Influence

Demand Elasticity
Addiction:
Fear of being addicted to a good can
result in high price elasticity of demand.
However, for a consumer already addicted
to the good, price elasticity of demand will
be low.

4-20
20

Do You Know?
How does the price elasticity of demand vary along a
straight line demand curve?
Price elasticity decreases moving along a straight line
demand curve from the top to the bottom.
How does a decrease in price affect total revenue when
demand is inelastic?
Total revenue will decrease.
How do substitutes affect price elasticity of demand?
A greater availability of substitutes makes demand more
elastic.
4-21
21

Income Elasticity of Demand

Income elasticity of demand measures how
quantity demanded responds to changes in
income.
Price elasticity of income
Percentage change in quantity demanded

Percentage change in income

Income elasticity is positive for normal goods.

Income elasticity is negative for inferior goods.
4-22
22

Cross Elasticity of Demand

Cross elasticity of demand measures how the
change in price of one good impacts the
demand for another good.
Cross elasticity of demand
Percentage change in quantity demanded of good A

Percentage change in price of good B

Cross elasticity of demand for substitutes is

positive.
Cross elasticity of demand for complements is
negative.

4-23
23

Price Elasticity of Supply

Price elasticity of supply measures
responsiveness of quantity supplied to price
changes.
Price elasticity of supply
Percentage change in quantity supplied

Percentage change in price

Due to the Law of Supply, price elasticity of

supply is always positive.
4-24
24

Categories of Supply Elasticity

Elastic supply = quantity supplied that is very responsive to

price changes.
If price elasticity of supply > 1.
% change in quantity supplied > % change in price.

Inelastic supply = quantity supplied is relatively

unresponsive to price changes.
If price elasticity of supply < 1.
% change in quantity supplied < % change in price.

Unit elastic supply.

If price elasticity of supply = 1.
% change in quantity supplied = % change in price.
4-25
25

Behind Price Elasticity of Supply

Costs:
Low costs result in relatively high price elasticity of
supply.
Capacity:
Additional productive capacity makes increases price
elasticity of supply.
Specialized inputs:
Goods that need specialized inputs for production have
lower price elasticity of supply in the short term.
4-26
26

Behind Price Elasticity of Supply

Government permission:
Need to obtain legal permission to expand
operations reduces firms price elasticity of
supply.
Ability to fire workers:
Not being able to fire workers reduces firms
price elasticity of supply.
4-27
27

Behind Price Elasticity of Supply

Time:
Price elasticity of supply is greater in the long
run than in the short term.
Longer time offers firms flexibility and possibility
of innovations.

4-28
28

Do You Know?
When is income elasticity of demand negative?
Income elasticity of demand is negative for inferior goods
i.e. Goods which consumers buy less with higher income.
What does the cross elasticity of demand measure?
Cross elasticity of demand measures how the change in
price of one good impacts the demand for another good.
What is the sign of price elasticity of supply and why does
it have this sign?
Supply elasticity is positive since as price increases,
quantity supplied rises and as price decreases, quantity
supplied falls.
4-29
29

Summary
Price elasticity of demand measures how quantity
demanded responds to price changes.
Elastic demand = consumers very responsive to price
changes.
Inelastic demand = consumers not responsive to price
changes.
Unit elastic demand = quantity demanded changes by
the same percentage as change in price.
Factors that influence demand elasticity: availability of
substitutes, product definition, share of income spent on
the good, necessities vs. luxuries, time and strong
complements.
Effect of change in price on total revenue depends on
the category of demand elasticity.
4-30
30

Summary
Price elasticity of income measures how quantity
demanded responds to income changes.
Cross elasticity of demand measures how the change in
price of one good impacts the demand for another good.
Price elasticity of supply measures responsiveness of
quantity supplied to price changes.
Elastic supply = quantity supplied very responsive to price
changes.
Inelastic demand = quantity supplied not responsive to price
changes.
Unit elastic demand = quantity supplied changes by the
same percentage as change in price.
Factors that influence supply elasticity: costs, capacity,
time, flexibility of doing business.
4-31
31

Coming up
Analyzing policies with market
forces of supply and demand.

4-32
32

Appendix: calculating demand elasticity

Price elasticity of demand
Percentage change in quantity demanded
=
Percentage change in price
=

(Q1 Q0 )
(Q1 Q0 ) / 2

( P1 P0 )
( P1 P0 ) / 2

Where Q1= new quantity, Q0= old quantity

P1= new price, P0= old price
4-33
33