ECON Chapter 5

Elasticity and its application

Demand is elastic

How quantity is sensitive to a change in a price

Elastic demand (PED > 1): Quantity demanded changes by a larger percentage than the price (consumers are very responsive to price changes).

Example: 

• Luxury items: Designer handbags, sports cars, or high-end electronics.

  • If the price of a luxury car increases 10%, many buyers will just not buy it → demand drops significantly.

• Fast food vs. home cooking: If the price of McDonald’s burgers rises, people can easily switch to other restaurants or cook at home.

Demand is inelastic

Inelastic demand (PED < 1): Quantity demanded changes by a smaller percentage than the price (consumers are not very responsive to price changes).

Example:

• Necessities: Gasoline, electricity, basic medicines (like insulin).

  • Even if gas prices go up 20%, most people still need to drive to work or school, so demand doesn’t drop much.

• Basic groceries: Salt, bread, milk.

  • If salt’s price doubles, people still buy nearly the same amount because they don’t use very much anyway.

Demand has unit elasticity

Unit elasticity= 1

Example:

Suppose movie tickets cost $10, and 100 tickets are sold → total revenue = $1000.

• If price rises to $11 (+10%), and ticket sales fall to 90 (–10%), total revenue = $990.

• If price falls to $9 (–10%), and sales rise to 110 (+10%), total revenue = $990.

Perfectly Inelastic

increase in price has no effect on quantity

Perfectly Elastic 

a quantity demanded or supplied changes infinitely in response to even the smallest change in price

summary

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Elasticity Rule

Slope ≠ Elasticity

• Slope of a demand curve: Measures the change in price relative to the change in quantity. It depends on the units (e.g., dollars vs. cents, gallons vs. liters).

• Elasticity: Measures percentage changes (relative responsiveness), so it’s unit-free

The rule:

• If two demand curves pass through the same point (say they both cross at the same price and quantity), the one that is flatter (less steep) is more elastic.

Why?

• A flatter curve means that for the same percentage change in price, there’s a larger percentage change in quantity demanded.

• A steeper curve means quantity doesn’t change much when price changes → more inelastic.

Formula of Price Elasticity of Demand

Midpoint Formula: 

More midpoint formula example 

Demand Determinants for Elasticity

• Price elasticity is higher when close substitutes are available (items that can replace them)

• Price elasticity is higher for narrowly defined goods than for

  broadly defined ones

• Price elasticity is higher for luxuries than for necessities.

• Price elasticity is higher in the long run.

PRICE ELASTICITY AND TOTAL REVENUE

For a price increase, if demand is elastic

▪TR decreases: the fall in Q is proportionately greater

than the rise in P.

▪ The extra revenue from selling units at a higher price is smaller than the decline in revenue from selling fewer units.

PRICE INELASTICITY AND TOTAL REVENUE

For a price increase, if demand is inelastic

▪TR increases: the fall in Q is proportionately smaller than the rise in P.

▪ The extra revenue from selling units at a higher price more than offsets the decline in revenue from selling fewer unit

PRICE UNIT ELASTIC AND TOTAL REVENUE

When demand is unit-elastic, the quantity effect equals the price effect.

– So an increase in price exactly balances the reduction in the quantity demanded.

• In this instance, total revenue doesn’t change.

Income Elasticity of Demand Formula

-Normal goods: income elasticity > 0

-Inferior goods: income elasticity < 0

Cross price elasticity of demand

How much the quantity demanded of one good responds to a change in the price of another good

1) substitutes:

cross-price elasticity of demand is positive .

An increase in the price of one brand of cookies will increase the demand for other brands.

2) complements:

cross-price elasticity of demand is negative.

An increase in the price of milk causes a decrease in demand for Oreos.

PRICE ELASTICITY OF SUPPLY

Elasticity of supply captures the sensitivity of quantity supplied to changes in price.

PRICE ELASTICITY OF SUPPLY Example

Supply unit elastic/elastic/inelastic

Supply is unit elastic

– Price elasticity of supply = 1

Supply is elastic

– Price elasticity of supply > 1

Supply is inelastic

– Price elasticity of supply <1

Supply unit elastic/elastic/inelastic determinants

Greater price elasticity of supply

– The more easily sellers can change the quantity they produce

Price elasticity of supply is greater in the long run than in the short

run

– In the long run: firms can build new factories, or new firms may

be able to enter the market