McGraw-Hill/Irwin

Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 4:
Elasticity of
Demand and
Supply
Price Elasticity of Demand
According to the law of demand, when
price increases, quantity demanded falls.
By how much?
To answer this question, economists use
the concept of price elasticity of
demand.
Price elasticity of demand is a measure of the
responsiveness of the quantity of a product
demanded by consumers when the product price
changes.
LO: 4-1
4-2
Elastic and Inelastic
Demand
For some products, consumers are highly
responsive to price changes. Demand
for such products is relatively elastic or
simply elastic.
For other products, consumers
responsiveness is only slight, or in rare
cases non-existent. Demand is said to
be relatively inelastic, or simply inelastic.

LO: 4-1
4-3
Price Elasticity Coefficient
The degree of price elasticity is
measured with price elasticity
coefficient E
d



Percentage Change in Quantity
Demanded of Product X
Percentage Change in Price
of Product X
E
d
=
LO: 4-1
4-4
Interpretations of Price
Elasticity of Demand
Elastic Demand: price changes cause relatively
large changes in quantity demanded: E
d
> 1.
Inelastic Demand: price changes cause relatively
small changes in quantity demanded: E
d
< 1.
Unit Elasticity: price changes cause equal changes
in quantity demanded (in percentage terms): E
d
= 1.
Perfectly Elastic Demand: quantity demanded can
be any amount at a given price: E
d
= .
Perfectly Inelastic Demand: quantity demanded
does not depend on price: E
d
= 0.
LO: 4-1
4-5
Determinants of Price
Elasticity of Demand
Substitutability
The larger the number of substitute goods that are
available, the higher the elasticity
Proportion of Income
The higher the price of a product relative to ones
income, the higher the elasticity
Luxuries versus Necessities
The more that a good is considered to be a luxury
rather than a necessity, the higher the elasticity
Time
The longer the time period under consideration, the
higher the elasticity
LO: 4-1
4-6
The Total Revenue Test
Total Revenue = TR = PQ.
Inelastic demand:
P and TR change in same
direction.
Elastic demand:
P and TR change in opposite
directions.
LO: 4-2
4-7
Inelastic Demand and TR
Price falls from c to
d
Gold loss is larger
than blue gain
TR falls when price
falls
Therefore demand
is inelastic (E
d
< 1).
$4

3

2

1

0 10 20
Q
P
c
d
D
2
LO: 4-2
4-8
Elastic Demand and TR
Price falls from a to
b
Gold loss is
smaller than blue
gain
TR rises when
price falls
Therefore demand
is elastic (E
d
> 1)
$3

2

1

0 10 20 30 40
Q
P
a
b
D
1
LO: 4-2
4-9
Price Elasticity of Demand:
College Tuition
Share of education in total income is higher for low-
income families.
Therefore, elasticity of demand for college education
is higher for low-income families.
Colleges charge different net prices (tuition minus
financial aid) to low- and high-income families.
Tuition increases are frequently accompanied by
increases in financial aid, so that tuition hikes are
smaller for low-income families.
Such pricing strategy increases revenue while
maintaining income diversity of the student body.
LO: 4-4
4-10
Price Elasticity of Supply
The concept of price elasticity can be applied to
supply: price elasticity of supply
Price elasticity of supply is a measure of the
responsiveness of the quantity of a product supplied
by sellers when the product price changes.
Percentage Change in Quantity
Supplied of Product X
Percentage Change in Price
of Product X
E
s
=
LO: 4-3
4-11
Price Elasticity of Supply
and Time Periods
Market period
Perfectly inelastic supply
Short run
Fixed plant size, but can vary production
Supply somewhat elastic
Long run
Adjustable plant size
Firms can enter or exit
Supply more elastic
LO: 4-3
4-12
Price Elasticity of Supply:
Gold Prices
The price of gold is very volatile. Why?
The supply of gold is very inelastic due to
limited availability and the high cost of
exploration, mining, and refining.
As a result, demand shifts reflect in large
swings in prices with little effect on quantities
bought and sold.
Demand shifts for gold are common because it is
used as speculative financial investment and not
only as a commodity.
LO: 4-4
4-13
Income Elasticity of
Demand
The concept of elasticity can be applied to
income: income elasticity of demand
Income elasticity of demand is a measure of the
responsiveness of the quantity of a product
demanded by consumers to changes in consumer
income.
Percentage Change in Quantity
Demanded
Percentage Change in Income
E
i
=
LO: 4-5
4-14
Cross Elasticity of Demand
Cross elasticity of demand reflects the
relationship between products
Cross elasticity of demand is a measure of the
responsiveness of the quantity of a product demanded
to a change in the price of another product.
Percentage Change in Quantity
Demanded of product X
Percentage Change in Price
of product Y
E
xy
=
LO: 4-5
4-15