The Elasticity of Demand

Chapter 7

The Concept of Elasticity

• Elasticity is a measure of the responsiveness of one variable to another.

• The greater the elasticity, the greater the responsiveness.

Laugher Curve

Q. What’s the difference between an economist and a befuddled old man with Alzheimer’s?

A. The economist is the one with a calculator.

The Concept of Elasticity

• Elasticity is a measure of the responsiveness of one variable to another.

• The greater the elasticity, the greater the responsiveness.

Price Elasticity

• The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price.

Sign of Price Elasticity• According to the law of demand, whenever

the price rises, the quantity demanded falls. Thus the price elasticity of demand is always negative.

• Because it is always negative, economists usually state the value without the sign.

What Information Price Elasticity Provides

• Price elasticity of demand and supply gives the exact quantity response to a change in price.

Classifying Demand and Supply as Elastic or Inelastic

• Demand is elastic if the percentage change in quantity is greater than the percentage change in price.

E > 1

Classifying Demand and Supply as Elastic or Inelastic

• Demand is inelastic if the percentage change in quantity is less than the percentage change in price.

E < 1

Elastic Demand

• Elastic Demand means that quantity changes by a greater percentage than the percentage change in price.

Inelastic Demand

• Inelastic Demand means that quantity doesn't change much with a change in price.

Defining elasticities• When price elasticity is between zero and

-1 we say demand is inelastic.

• When price elasticity is between -1 and - infinity, we say demand is elastic.

• When price elasticity is -1, we say demand is unit elastic.

Elasticity Is Independent of Units

• Percentages allow us to have a measure of responsiveness that is independent of units.

• This makes comparisons of responsiveness of different goods easier.

Calculating Elasticities

• To determine elasticity divide the percentage change in quantity by the percentage change in price.

The End-Point Problem

• The end-point problem – the percentage change differs depending on whether you view the change as a rise or a decline in price.

The End-Point Problem

• Economists use the average of the end points to calculate the percentage change.

Graphs of ElasticitiesP

rice

Quantity of software (in hundred thousands)

$26242220181614

0

D

B

A

10 12 14

C (midpoint)

Elasticity of demand between A and B = 1.27

Calculating Elasticities: Price elasticity of Demand

D

P

Q

What is the price elasticity of demand between A and B?

$20

10

$26

14

MidpointB

A

ED = %ΔQ%ΔP

Q2–Q1

½(Q2+Q1)P2–P1

½(P2+P1)

=

C

12

$23

=

10–14½(10+14)

26–20½(26+20)

-.33.26 = 1.27 =

7-18

Price Elasticity: Supply• Price elasticity of supply is the

percentage change in quantity supplied divided by the percentage change in

• This tells us exactly how quantity supplied responds to a change in price

ES =

• Elasticity is independent of units

% change in Quantity Supplied% change in Price

7-19

Price Elasticity: Supply

• Supply is elastic if the percentage change in quantity is greater than the percentage change in price Elastic supply is when ES > 1

• Supply is inelastic if the percentage change in quantity is less than the percentage change in price

Inelastic supply is when ES < 1

7-20

Calculating Elasticities: Price elasticity of Supply

P

Q

What is the price elasticity of supply between A and B?

$4.50

476

$5.00

485

B

A

ES = %ΔQ%ΔP

Q2–Q1

½(Q2+Q1)P2–P1

½(P2+P1)

=

=

485–476½(485+476)

5–4.50½(5+4.50)

Midpoint

C

480.5

$4.750.01870.105 = 0.18 =

S

7-21

Graphs of Elasticities

Elasticity of supply between A and B = 0.18

Wag

e pe

r ho

ur

Quantity of workers

$6.005.505.004.504.003.503.00

0

CB

A

470

(midpoint)

480 490

Calculating Elasticity

)PP(PP

)QQ(QQ

P%

Q% E

2121

12

2121

12

Calculating Elasticity of Demand Between Two Points

27.126.

33.

236

124

)2026(2026

)1014(1410

E

21

21

D

Pri

ce

Quantity of software (in hundred thousands)

$26

24

22

20

18

16

14

0

Demand

B

A

10 12 14

Cmidpoint

Elasticity of demand between A and B: P%

Q% E

Calculating Elasticity of Supply Between Two Points

P%

Q% E

Wag

e p

er h

ou

r

Quantity of workers

$6.005.505.004.504.003.503.00

0

CB

A

470 480 490

Elasticity of supply between A and B:

2.105.

021.

75.450.

48010

)50.45(50.45

)475485(475485

E

21

21

S

Calculating Elasticity at a Point

• Let us now turn to a method of calculating the elasticity at a specific point, rather than over a range or an arc.

Calculating Elasticity at a Point

• To calculate elasticity at a point, determine a range around that point and calculate the arc elasticity.

Calculating Elasticity at a PointP

rice

Quantity

$10 9 8 7 6 5 4 3 2 1

C

BA

24 402820

Calculating Elasticity at a PointP

rice

Quantity

$10 9 8 7 6 5 4 3 2 1

C

BA

24 402820

To calculate elasticity at a point determine a range around that point and calculate the arc elasticity.

66.5.

33.

42

248

)35(35

)2028(2028

E

21

21

Aat

Elasticity and Demand Curves

• Two important points to consider:– Elasticity is related (but is not the same as)

slope.– Elasticity changes along straight-line demand

and supply curves.

Calculating Elasticity at a Point

6 12 18 30 36 42 48

Pric

e

Quantity

87654321

$109

A

24 6054

D

BC

SupplyEA = 2.33

EB = 0.11

Demand

EC = 0.75

ED = 0.86

Elasticity and Demand Curves

• Two important points to consider:– Elasticity is related (but is not the same as)

slope.– Elasticity changes along straight-line demand

and supply curves.

Elasticity Is Not the Same as Slope

• The steeper the curve at a given point, the less elastic is supply or demand.

• There are two limiting examples of this.

Elasticity Is Not the Same as Slope

• When the curves are flat, we call the curves perfectly elastic.

• The quantity changes enormously in response to a proportional change in price (E = ).

Elasticity Is Not the Same as Slope

• When the curves are vertical, we call the curves perfectly inelastic.

• The quantity does not change at all in response to an enormous proportional change in price (E = 0).

Perfectly inelastic demand curve

Pric

e

0Quantity

Perfectly Inelastic Demand Curve

Perfectly elastic demand curve

Perfectly Elastic Demand CurveP

rice

0Quantity

Demand Curve Shapes and Elasticity

• Perfectly Elastic Demand Curve– The demand curve is horizontal, any change in price can and

will cause consumers to change their consumption.

• Perfectly Inelastic Demand Curve– The demand curve is vertical, the quantity demanded is totally

unresponsive to the price. Changes in price have no effect on consumer demand.

• In between the two extreme shapes of demand curves are the demand curves for most products.

Demand Curve Shapes and Elasticity

Elasticity Changes Along Straight-Line Curves

• Elasticity is not the same as slope.

• Elasticity changes along straight line supply and demand curves–slope does not.

Elasticity Along a Demand CurveP

rice

$10987654321

0 1 2 3 4 5 6 7 8 9 10 Quantity

Elasticity declines along demand curve as we move

toward the quantity axis

Ed = 1

Ed = 0

Ed < 1

Ed > 1

Ed = ∞

The Price Elasticity of Demand Along a Straight-line Demand Curve

Substitution and Elasticity

• As a general rule, the more substitutes a good has, the more elastic is its supply and demand.

Substitution and Demand

• The less a good is a necessity, the more elastic its demand curve.

• Necessities tend to have fewer substitutes than do luxuries.

Substitution and Demand

• 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.

Substitution and Demand

• Goods that cost very little relative to your total expenditures are not worth spending a lot of time figuring out if there is a good substitute.

• It is worth spending a lot of time looking for substitutes for goods that take a large portion of one’s income.

Substitution and Demand

• 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.

Determinants of the Price Elasticity of Demand

• The degree to which the price elasticity of demand is inelastic or elastic depends on:– How many substitutes there are – How well a substitute can replace the good or

service under consideration– The importance of the product in the

consumer’s total budget– The time period under consideration