Elasticity: A Measure of Responsiveness

C H A P T E R

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Prepared by: Fernando and Yvonn Quijano

© 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin

Elasticity: A Measureof Responsiveness

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© 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 2 of 24

The Price Elasticity of Demand

• The price elasticity of demand (Ed) measures the responsiveness of consumers to changes in price.

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The Price Elasticity of Demand

• For example, if the price of milk increases by 10% (from $2 to $2.20) and the quantity demanded decreases by 15% (from 100 to 85), the price elasticity of demand is:

• We compute the price elasticity of demand as follows:

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Price Elasticity andthe Demand Curve

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• When demand is perfectly inelastic, the quantity demanded is the same at every price, so the price elasticity of demand is zero.

• When demand is perfectly elastic, the quantity demanded is infinitely responsive to changes in price, so the price elasticity of demand is infinite.

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What Determines thePrice Elasticity of Demand?

• The price elasticity of demand for a particular product depends on the availability of substitutes.

• Products with relatively inelastic demand have few good substitutes.

• The demand for a specific brand of a product is typically elastic.

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What Determines thePrice Elasticity of Demand?

• The short-run price elasticity of demand is typically smaller than the long-run elasticity.

• Elasticity is larger for goods that take a relatively large part of a consumer’s budget.

• The price elasticity of demand for some products varies with the age of the consumer.

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Computing Price Elasticity:Initial Value versus Midpoint

Table 5.1: Computing Percentage Changes and Elasticity

Old New Initial Value Method Midpoint value method

Price $2.00 $2.20 Percent change: 10% = $0.20 / $2.00 Percent change: 9.52% = 0.20 / 2.10

Quantity 100 85 Percent change: 15% = 15 / 100 Percent change: 16.22% = 15 / 92.5

Elasticity: 1.5 = 15% / 10% Elasticity: 1.70 = 16.22% / 9.52%

The midpoint method measures the percentage changes more precisely, so we get a more precise measure of price elasticity.

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Elasticity Along aLinear Demand Curve

• The price elasticity of demand decreases as we move downward along a linear demand curve.

• Demand is elastic on the upper half of the demand curve and inelastic on the lower half.

Percentagedecrease in price

Percentage increase in quantity Elasticity

Point r to point s 4 / 80 = 5% 2 / 10 = 20% 20% / 5% = 4.0Point t to point u 4 / 50 = 8% 2 / 25 = 8% 8% / 8% = 1.0Point v to point w 4 / 20 = 20% 2 / 40 = 5% 5% / 20% = 0.25

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Using the Price Elasticityof Demand to Make Predictions

• Predicting changes in quantity demanded:• We can rearrange the elasticity formula to

predict changes in quantity demanded as a result of price changes.

• For example:

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Predicting Changes in Total Revenue

Table 5.2 Price and Total Revenue with Elastic Demand

Price Quantity of Tickets Sold Total Revenue4.00 100 $4004.40 80 $352

• An increase in the ticket price brings good news and bad news:• Good news. You get more money for

each ticket sold.• Bad news. You sell fewer tickets.

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Table 5.3 Elasticity and Total Revenue

Type of Demand

Value of PriceElasticityof Demand

Change inQuantity VersusChange in Price

Effect of HigherPrice on Total Revenue

Effect of LowerPrice on Total Revenue

Elastic Greater than 1.0 Larger percentage change in quantity

Decreases Increases

Inelastic Less than 1.0 Smaller percentage change in quantity

Increases Decreases

Unitary elastic

1.0 Same percentage changes in quantity and price

Does not change Does not change

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• Total revenue reaches its maximum at the midpoint of the demand curve, where demand is unitary elastic.

• Demand is elastic along the upper half of a linear demand curve, so an increase in quantity increases total revenue.

• Demand is inelastic along the lower half of a linear demand curve, so a decrease in price decreases total revenue.

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Other Elasticities of Demand

• The income elasticity of demand measures of the responsiveness of demand to changes in income, indicating how much more or less of a particular product is purchased as income changes.

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Other Elasticities of Demand

• The cross elasticity of demand measures the responsiveness of demand to changes in the price of other goods.

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The Price Elasticity of Supply

• The price elasticity of supply measures the responsiveness of producers to changes in price.

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The Price Elasticity of Supply

• A 10% increase in the price of milk (from $2 to $2.20) increases the quantity supplied by 20% (from 100 million gallons to 120 million), so the price elasticity of supply is 2.0 = 20%/10%.

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Predicting Changesin Quantity Supplied

• Predicting changes in quantity supplied:• We can rearrange the elasticity formula to

predict changes in quantity supplied as a result of price changes.

• For example:

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Extreme Cases: Perfectly Inelastic Supply and Perfectly Elastic Supply

• When supply is perfectly elastic, the quantity supplied is infinitely responsive to changes in price, so the price elasticity of supply is infinite.

• When supply is perfectly inelastic, the quantity supplied is the same at every price, so the price elasticity of supply is zero.

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Predicting Changes in PriceUsing Supply and Demand Elasticities

• The price-change formula shows the percentage change in equilibrium price resulting from a change in demand or supply, given values for the price elasticity of supply and price elasticity of demand.

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Predicting Changes in PriceUsing Supply and Demand Elasticities

• In this example, an increase in demand shifts the demand curve to the right, increasing the equilibrium price. In this case, a 35% increase in demand increases the price by 10%.

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The Price Effects ofa Change in Supply

• A slight variation of the price-change formula is used to predict the change in price resulting from a change in supply.

• For example, when the price elasticities of demand and supply are 0.6 and 1.4 respectively, an increase in the supply of milk by 10% will decrease equilibrium price by 5%.

Elasticity: A Measure of Responsiveness

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