Describing demand and supply: Elasticity

Describing demand and supply: Elasticity

1. © 2003 McGraw-Hill Ryerson Limited
Describing Demand and Describing Demand and
Supply: ElasticitiesSupply: Elasticities
Chapter 6Chapter 6

2. © 2003 McGraw-Hill Ryerson Limited.
6 - 2
The Concept of Elasticity The Concept of Elasticity
Elasticity is a measure of the
responsiveness of one variable to a
change in another.
The most commonly used elasticity
concept is price elasticity of demand.

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6 - 3
Price Elasticity Price Elasticity
The price elasticity of demand is the
percentage change in quantity
demanded divided by the percentage
change in price.

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6 - 4
Things to Note About Things to Note About
ElasticityElasticity
Price elasticity of demand is always
negative because price and quantity
demanded are inversely related—when
price rises, quantity demanded falls,
and vice versa.

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6 - 5
Things to Note About Things to Note About
ElasticityElasticity
Economists have developed a
convention and talk about price elasticity
of demand as an absolute value of the
number.
Thus, price elasticity of demand is
reported as if it were positive.

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Classifying Demand as Classifying Demand as
Elastic or InelasticElastic or Inelastic
It is helpful to classify demand by
relative responsiveness as elastic or
inelastic.

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Elastic DemandElastic Demand
For elastic points on curves, the
percentage change in quantity is greater
than the percentage change in price, in
absolute value.

D
> 1

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Elastic DemandElastic Demand
Common sense tells us that an elastic
demand means that quantity changes
by a greater percentage than the
percentage change in price, in absolute
value.

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Inelastic Demand Inelastic Demand
For inelastic points on curves, the
percentage change in quantity is less
than the percentage change in price, in
absolute value.

D
< 1

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Inelastic DemandInelastic Demand
Common sense tells us that an inelastic
demand means that the percent change
in quantity is less than the percentage
change in price, in absolute value.

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Elasticity Is Independent of Elasticity Is Independent of
UnitsUnits
Elasticity is calculated as a ratio of
percentages.
Percentages allow us to have a
measure of responsiveness that is
independent of units.

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Elasticity Is Independent of Elasticity Is Independent of
UnitsUnits
Having a measure of responsiveness
that is independent of units makes
comparisons of responsiveness of
different goods easier.

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Calculating ElasticitiesCalculating Elasticities
To determine elasticity, divide the
percentage change in quantity by the
percentage change in price.

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The Mid-point Formula The Mid-point Formula
Using the mid-point formula, the
average of the two end points are used
when calculating percentage change.

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Graph of Price Elasticity of Graph of Price Elasticity of
Demand,Demand, Fig.6-1a, p 136Fig.6-1a, p 136
Elasticity of demand = 1.3
P
r
ic
e
Quantity of software (in thousands)
$26
23
20
0
D
B
A
5 7 9
C (midpoint)

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Graph of Price Elasticity of Graph of Price Elasticity of
DemandDemand, , Fig.6-1b, p 136Fig.6-1b, p 136
P
r
ic
e
Quantity
$10
9
8
7
6
5
4
3
2
1

C
D
B
A

D
= 0.54

D
= 4
5 10 15 20 25 30 35 40 45 50 55
b) Some examples

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Calculating Elasticity at a Calculating Elasticity at a
PointPoint
Let us now turn to a method of
calculating the elasticity at a specific
point, rather than over a range.

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Calculating Elasticity at a Calculating Elasticity at a
PointPoint
To calculate elasticity at a point,
determine a range around that point and
calculate the elasticity using the mid-
point formula.

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Calculating Elasticity at a Calculating Elasticity at a
Point, Point, Fig a) p 138Fig a) p 138
P
r
ic
e
Quantity
$10
9
8
7
6
5
4
3
2
1

C
B
A
24 402820

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Calculating Elasticity at a Calculating Elasticity at a
Point Point Fig b) p 138Fig b) p 138
61218 3036 4248
P
r
ic
e
Quantity
8
7
6
5
4
3
2
1
$10
9
A
24 6054
B

D
= 2.33

D
= 0.11
Demand

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Elasticity and Demand Elasticity and Demand
CurvesCurves
Two important points to consider:
Elasticity is related to (but is not the same
as) slope.
Elasticity changes along a straight-line
demand curve.

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Elasticity Is Not the Same as Elasticity Is Not the Same as
SlopeSlope
The relationship between elasticity and
slope means that the steeper the curve,
the less elastic is demand.
There are two limiting examples of this.

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Elasticity Is Not the Same as Elasticity Is Not the Same as
SlopeSlope
When the curve is horizontal, it is
perfectly elastic.
Perfectly elastic demand is a horizontal
line in which quantity changes
enormously in response to any change in
price (
D
= ).

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Elasticity Is Not the Same as Elasticity Is Not the Same as
SlopeSlope
When the curve is vertical, we call the
demand perfectly inelastic.
Perfectly inelastic demand is a vertical
line in which quantity does not change
at all in response to a change in price
(
D
= 0).

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Perfectly inelastic
demand curve
0
Quantity
Perfectly Inelastic Demand Perfectly Inelastic Demand
Curve, Curve, Fig 6-2a, p 139Fig 6-2a, p 139
Price

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Perfectly elastic
demand curve
0
Quantity
Perfectly Elastic Demand Perfectly Elastic Demand
Curve Curve Fig 6-2b, p 139Fig 6-2b, p 139
Price

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Elasticity and slope, Elasticity and slope, Fig.6-3, p 140Fig.6-3, p 140
P
r
ic
e
Quantity
$10
9
8
7
6
5
4
3
2
1

10 20 30 40 50 60 70 80 90
D1
D2
Over the $3 to $4 price
interval, 
D
(D1) = 0.47
while 
D
(D2) = 4.2
A
G C

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Elasticity Changes Along Elasticity Changes Along
Straight-Line CurvesStraight-Line Curves
Elasticity is not the same as slope.
Elasticity changes along the straight line
supply and demand curves—slope does
not.

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Elasticity Changes Along Elasticity Changes Along
Straight-Line CurvesStraight-Line Curves
A demand curve is perfectly elastic (
D
= ) at the vertical (price) intercept.
Elasticity becomes smaller as you move
down the demand curve until it
becomes zero ( = ) at the horizontal
(quantity) intercept.

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P
r
ic
e
Elasticity declines along demand
curve as we move toward the
quantity axis
$10
9
8
7
6
5
4
3
2
1
0 12345678910

D
= 

D
= 1

D
= 0
Quantity
Elasticity Along a Straight Elasticity Along a Straight
Line Demand Curve Line Demand Curve Fig 6-4, p 141Fig 6-4, p 141

D
< 1

D
> 1

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Interpreting elasticitiesInterpreting elasticities
We know by the law of demand that
consumers buy less as price rises
Price elasticity of demand tells us if
whether consumers reduce their
purchases by a lot (elastic demand) or a
little (inelastic demand).

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Interpreting Price Elasticity of DemandInterpreting Price Elasticity of Demand, Table 6-1, , Table 6-1,
p 141p 141

D
Description of
demand
Interpretation

D
=
Perfectly elastic Quantity responds enormously
to changes in price

D
>1
Elastic Consumers are responsive to
price changes

D
=
Unit elastic Percent change in price and
quantity are equal

D
<1
Inelastic Consumers are unresponsive to
price changes

D
=
Perfectly inelastic Consumers are completely
unresponsive to price change

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Substitution and Price Substitution and Price
Elasticity of DemandElasticity of Demand
As a general rule, the more substitutes
a good has, the more elastic is its
demand.

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Substitution and Price Substitution and Price
Elasticity of DemandElasticity of Demand
How many substitutes a good has is
affected by many factors:
Time to Adjust
Luxuries versus Necessities
Narrow or Broad Definition
Budget Proportion

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Time to AdjustTime to Adjust
The larger the time interval considered,
or the longer the run, the more elastic is
the good’s demand curve.
There are more substitutes in the long run
than in the short run.
The long run provides more options for
change.

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Luxuries versus NecessitiesLuxuries versus Necessities
The less a good is a necessity, the
more elastic its demand curve.
Necessities tend to have fewer
substitutes than do luxuries, so their
demand is less elastic.

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Narrow or Broad DefinitionNarrow or Broad Definition
As the definition of a good becomes
more specific, demand becomes more
elastic.
If the good is broadly defined—for
example, transportation—there are not
many substitutes and demand will be
inelastic.

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Narrow or Broad DefinitionNarrow or Broad Definition
As the definition of a good becomes
more specific, demand becomes more
elastic.
If the definition of a good is narrowed—to
travel by bus, for example—there are more
substitutes.

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Budget ProportionBudget Proportion
Demand for goods that represent a
large proportion of one's budget are
more elastic than demand for goods
that represent a small proportion of
one's budget.

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Budget ProportionBudget Proportion
Most people shop around for the lowest
price on expensive items – the demand
elasticity is large for those goods.
It is not worth spending the time looking
for substitutes for goods which do not
take much out of one’s income.

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Empirical Estimates of Empirical Estimates of
ElasticitiesElasticities
The following table provides short- and
long-term estimates of elasticities for a
number of goods.

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Empirical Estimates of Empirical Estimates of
Elasticities, Elasticities, Table 6-2, p 143 Table 6-2, p 143

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Price Elasticity of Demand Price Elasticity of Demand
and Total Revenueand Total Revenue
Total revenue is the total amount of money a
firm receives from selling its product.
Revenue equals total quantity sold multiplied
by the price of good.
Knowing the elasticity of demand is useful to
firms because from it they can tell what
happens to total revenue when they raise or
lower their prices.

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Price Elasticity of Demand Price Elasticity of Demand
and Total Revenueand Total Revenue
If demand is elastic (
D
> 1), a rise in
price lowers total revenue.
Price and total revenue move in
opposite directions.

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Price Elasticity of Demand Price Elasticity of Demand
and Total Revenueand Total Revenue
If demand is unit elastic (
D
= 1), a rise
in price leaves total revenue
unchanged.

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Price Elasticity of Demand Price Elasticity of Demand
and Total Revenueand Total Revenue
If demand is inelastic (
D
< 1), a rise in
price increases total revenue.
Price and total revenue move in the
same direction.

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A
P
r
ic
e
Elastic Demand

D
> 1
Quantity
$10
8
6
4
2
0
123456789
Elasticity and Total Revenue Elasticity and Total Revenue
Fig. 6-5a, p 144Fig. 6-5a, p 144
C
B
F
E
Lost
revenue
Gained
revenue

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A
P
r
ic
e
Inelastic Demand

D
< 1
Quantity
$10
8
6
4
2
0
123456789
Elasticity and Total Revenue Elasticity and Total Revenue
Fig. 6-5b, p 144Fig. 6-5b, p 144
C
H
B
G
Lost
revenue
Gained
revenue

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A
Unit Elastic
Demand

D
= 1
Elasticity and Total Revenue Elasticity and Total Revenue
Fig. 6-5c, p 144Fig. 6-5c, p 144
C
0
6
P
r
ic
e
Quantity
$10
8
6
4
2
12345 789
J
K
B
Lost
revenue
Gained revenue

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Total Revenue Along a Total Revenue Along a
Demand CurveDemand Curve
Demand is elastic at prices above the
middle point where demand is unit
elastic – a rise in price in that range
lowers total revenue.
Demand is inelastic at prices below the
middle point where demand is unit
elastic – a rise in price in that range
increases total revenue.

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Elastic range

D > 1

D = 1
Inelastic range

D < 1
Q
0 Quantity
(a)
0 0
Quantity
(b)
How Total Revenue Changes How Total Revenue Changes
Along a Demand CurveAlong a Demand Curve Fig. 6-6, p 145Fig. 6-6, p 145
Q
0
P TR

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Elasticity of Individual and Elasticity of Individual and
Market DemandMarket Demand
Market demand elasticity is influenced
both by:
How many people reduce their quantity to
zero when price increases.
How much an existing consumer
marginally changes his or her quantity
demanded.

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Elasticity of Individual and Elasticity of Individual and
Market DemandMarket Demand
Price discrimination occurs when a
firm separates the people with less
elastic demand from those with more
elastic demand.

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Elasticity of Individual and Elasticity of Individual and
Market DemandMarket Demand
Firms that price discriminate can charge
more to the individuals with inelastic
demand and less to individuals with
elastic demand.

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Elasticity of Individual and Elasticity of Individual and
Market DemandMarket Demand
Examples of price discrimination
include:
Airlines’ Saturday stay-over specials.
Selling new cars at a discount.
The almost-continual-sale phenomenon.

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Other Elasticities of DemandOther Elasticities of Demand
Two other demand elasticities are
important in describing consumer
behaviour:
Income elasticity of demand.
Cross-price elasticity of demand.

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Income Elasticity of DemandIncome Elasticity of Demand
Income elasticity of demand is
defined as the percentage change in
demand divided by the percentage
change in income.

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Income Elasticity of DemandIncome Elasticity of Demand
Income elasticity of demand tells us
how demand responds to changes in
income.

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Income Elasticity of DemandIncome Elasticity of Demand
An increase in income generally
increases one’s consumption of almost
all goods, although the increase may be
greater for some goods than for others.

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Income Elasticity of DemandIncome Elasticity of Demand
Normal goods are those goods whose
consumption increases with an increase
in income.
They have income elasticities greater
than zero (positive).

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Income Elasticity of DemandIncome Elasticity of Demand
Normal goods are usually divided into
two categories:
luxuries and
necessities.

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Income Elasticity of DemandIncome Elasticity of Demand
Luxuries are goods that have an
income elasticity greater than 1.
Their percentage increase in quantity
demanded is greater than the percentage
increase in income.
They are an “income elastic normal good”.

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Income Elasticity of DemandIncome Elasticity of Demand
Shoes are a necessity—a good that
has an income elasticity less than 1,
but still positive (shoes are an “income
inelastic normal good”).
The consumption of a necessity rises by
a smaller proportion than the rise in
income.

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Income Elasticity of DemandIncome Elasticity of Demand
Inferior goods are those whose
consumption decreases when income
increases.
Inferior goods have income elasticities less
than zero (negative).
Generic (store-brand) cereals are one
example of inferior goods.

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Income Elasticities of Income Elasticities of
Selected Goods, Selected Goods, Table 6-3, p 148Table 6-3, p 148

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Coefficient
Interpretation
Description
Normal
good
 I   Qd
Two cases of normal good:
Income inelastic normal good
(“necessity”)
Income elastic normal good
(“superior” good)
Inferior
good
 I   Qd
0
10
1
Interpreting Income Elasticity of Interpreting Income Elasticity of
DemandDemand,,Table 6-4, p 149Table 6-4, p 149
0

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Cross-Price Elasticity of Cross-Price Elasticity of
DemandDemand
Cross-price elasticity of demand is
computed by dividing the percentage
change in quantity demand by the
percentage change in the price of
another good.

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Cross-Price Elasticity of Cross-Price Elasticity of
DemandDemand
Cross-price elasticity of demand tells us
the responsiveness of demand to
changes in prices of other goods.
Cross-price elasticity measures both
how and how strongly consumers
respond to changes in the price of
related products.

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Cross-Price Elasticity of Cross-Price Elasticity of
DemandDemand
Depending on how consumers respond
to changes in the price of related
products, goods can be classified as
Substitutes or
Complements

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Complements and Complements and
SubstitutesSubstitutes
Substitutes are goods that can be used
in place of one another.
When the price of a good goes up, the demand
for the substitute good also goes up.
Cross-price elasticity of substitutes is positive

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Complements and Complements and
SubstitutesSubstitutes
Complements are goods that are used
in conjunction with other goods.

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Complements and Complements and
SubstitutesSubstitutes
A rise in the price of a good will
decrease the demand for its
complement, and a fall in the price of a
good will increase the demand for its
complement.
The cross-price elasticity of
complements is negative.

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Interpretation of Cross-Price Interpretation of Cross-Price
ElasticityElasticity Table 6-5, p 150 Table 6-5, p 150
CoefficientInterpretation Ratio

XY
> 0 Substitute
Goods
P
Y
Q
X

XY
< 0 Complementary
Goods
P
Y
Q
X

XY
= 0 Unrelated GoodsP
Y 
Q
X=0

74. © 2003 McGraw-Hill Ryerson Limited.
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P
0
D
0
D
1
P
0
18
Quantity
25
Shift due to rise
in income
Calculating Income and Calculating Income and
Cross-Price Elasticities,Cross-Price Elasticities,Fig 6-7a, p 151Fig 6-7a, p 151
Price
=6.5

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Calculating Income and Calculating Income and
Cross-Price Elasticities,Cross-Price Elasticities,Fig 6-7a, p 151Fig 6-7a, p 151


P
0
P
0
3 Quantity of ketchup4
Shift due to rise
in price
of hot dogs
D
1
D
0
Price of
ketchup

XY
= -0.7

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Price Elasticity of SupplyPrice Elasticity of Supply
Measures the responsiveness of firms
to a change in the price of their product.

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Price Elasticity of SupplyPrice Elasticity of Supply
The price elasticity of supply is
calculated as the percent change in
quantity supplied over the percent
change in price.

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Inelastic SupplyInelastic Supply
Common sense tells us that an inelastic
supply means that the percent change
in quantity is less than the percentage
change in price.

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Elastic SupplyElastic Supply
An elastic supply means that quantity
supplied changes by a larger percent
than the percent change in price.

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Substitution and SupplySubstitution and Supply
The longer the time period considered,
the more elastic the supply.

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Substitution and SupplySubstitution and Supply
The reasoning is the same as for
demand.
In the long run there are more alternatives
so it is easier (less costly) for suppliers to
change and produce other goods.

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Substitution and SupplySubstitution and Supply
Economists distinguish three time
periods relevant to supply:
The instantaneous period.
The short run.
The long run.

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Substitution and SupplySubstitution and Supply
In the instantaneous period, quantity
supplied is fixed so supply is perfectly
inelastic.
This supply is sometimes called the
momentary supply.

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Substitution and SupplySubstitution and Supply
In the short run, some substitution is
possible, so the short-run supply curve
is somewhat elastic.

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Substitution and SupplySubstitution and Supply
In the long run, significant substitution
is possible; the supply curve becomes
very elastic.

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Substitution and SupplySubstitution and Supply
An additional factor to consider in
determining elasticity of supply:
One must take into account how easy or
how difficult it is to produce more of the
same good. The easier it is to produce
additional units, the more elastic the
supply.

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Empirical Estimates of Empirical Estimates of
ElasticitiesElasticities
There are fewer empirical
measurements of elasticity of supply
than there are of demand elasticities.

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Effects of Shifts in Supply on Effects of Shifts in Supply on
Price and QuantityPrice and Quantity
An example of the importance of
elasticities of demand and supply can
be illustrated by the example of the
world market for oil

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6 - 89
Effects of Shifts in Supply on Effects of Shifts in Supply on
Price and QuantityPrice and Quantity
If oil supply decreases, the world prices
will rise sharply if the demand for oil is
inelastic
Oil prices will not be affected a lot if
demand is elastic

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6 - 90
Effects of Shifts in Supply on Effects of Shifts in Supply on
Price and Quantity,Price and Quantity, Fig 6-8a, p 154 Fig 6-8a, p 154
Inelastic Supply and Inelastic Demand
P
1
P
0
Price
Quantity
S
1S
0
Q
1Q
0
Demand

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6 - 91
Effects of Shifts in Supply on Effects of Shifts in Supply on
Price and Quantity, Price and Quantity, Fig 6-8b, p 154Fig 6-8b, p 154
Inelastic Supply and Elastic Demand
P
1
P
0
Demand
Price
Quantity
S
1
S
0
Q
1
Q
0

92. © 2003 McGraw-Hill Ryerson Limited
Describing Supply and Describing Supply and
Demand: ElasticitiesDemand: Elasticities
End of Chapter 6End of Chapter 6