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Microeconomics
ECO1IMI
Lecture 7: Elasticity and its
application
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Outline
The price elasticity of demand
Other elasticities
The elasticity of supply
Applications
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Elasticity
In general
Measures how much buyers and sellers respond to changes in
market conditions.
It allows analysis of supply and demand with greater precision.
We will talk about buyers first then talk about elasticity measures
for sellers.
Keywords
elasticity
price elasticity of demand
substitutes
complements
inferior and normal goods
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The price elasticity of demand
Price elasticity of demand measures how much the
quantity demanded of a good responds to a change in
the price of that good.
Price elasticity of demand is the percentage change in
quantity demanded divided by the percentage change in
price.
Determinants include:
availability of close substitutes
necessities versus luxuries
definition of the market
time horizon.
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The price elasticity of demand
Elasticity tends to rise
when:
many close substitutes
good is a luxury
market is defined
narrowly
the longer the time
period.
Luxury champagne has high
price elasticity of demand
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Computing the price elasticity of
demand
Calculation for the price elasticity of demand
Price elasticity of demand =
Percentage change in quantity demanded
Percentage change in price
The midpoint formula is preferable
You get same answer from identical price increases or
decreases.
(P2 P1)/[(P2 + P1)/2]
(
Q2 Q1)/[(Q2 + Q1)/2]
Price elasticity of demand =
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Computing the price elasticity of
demand
Example:
price of ice cream cones rises from $2.00 to $2.20
amount bought falls from 10 to 8
negative signs ignored.
Straight Percentage Change Midpoint Method
( )
( . . )
.
10 8
10
100
2 20 2 00
2 00
100
20%
10%
2

= =
( )
( ) /
( . . )
( . . ) /
.
.
10 8
10 8 2
2 20 2 00
2 00 2 20 2
22%
9 5%
2 32

+
= =
The variety of demand curves
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Response to price changes
Strong
Elastic
>1
Perfectly
Elastic
=
Weak
Inelastic
<1
Perfectly
Inelastic
=0
Proportionate
Unit
=1
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The price elasticity of demand
Price elasticity of demand measures
how much quantity demanded responds to the price
hence it is closely related to the slope of the demand
curve.
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The price elasticity of demand
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(a) Perfectly inelastic demand: elasticity equals 0
The price elasticity of demand
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(b) Inelastic demand: elasticity is less than 1
The price elasticity of demand
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(c) Unit elastic demand: elasticity equals 1
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The price elasticity of demand
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(d) Elastic demand: elasticity is greater than 1
The price elasticity of demand
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(e) Perfectly elastic demand: elasticity equals infinity
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Total revenue and the price elasticity
of demand
Total revenue (TR) is the total amount paid by
buyers for a good.
Calculated as price (P) times quantity sold (Q):
TR = P x Q
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Total revenue
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Elasticity and total revenue along a
linear demand curve
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With inelastic
demand curve
Increase in price
Proportionally
smaller
decrease in
quantity
Total revenue
increases
How total revenue changes:
Inelastic demand
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Elasticity and total revenue along a
linear demand curve
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With elastic
demand curve
Increase in
price
Proportionally
larger decrease
in quantity
Total revenue
decreases
How total revenue changes:
Elastic demand
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Elasticity of a linear demand
schedule
Price Quantity
Total
revenue
(price x
quantity)
Per cent
change in
price
Per cent
change in
quantity Elasticity Description
$0 14 $ 0
1 12 12 100% -15% -0.1 Inelastic
Inelastic
Inelastic
Unit elastic
Elastic
Elastic
Elastic
2 10 20 67 -18 - 0.3
3 8 24 40 - 22 -0.6
4 6 24 29 -29 -1.0
5 4 20 22 -40 -1.8
6 2 12 18 - 67 -3.7
7 0 0 15 -200 -13.0
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Elasticity of a linear demand curve
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Income elasticity of demand
Income elasticity of demand measures
how much the quantity demanded of a good responds
to a change in consumers income.
It is calculated as the percentage change in the
quantity demanded divided by the percentage change
in income.
Income elasticity of
demand =
Percentage change in quantity
demanded
Percentage change in income
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Income elasticity of demand
Income increases
Quantity demanded
increases
Good is normal
Quantity demanded
decreases
Good is inferior
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Income elasticity of demand
Goods consumers regard as necessities tend to
be income inelastic.
Examples: food, fuel, clothing, utilities and medical
services.
Goods consumers regard as luxuries tend to be
income elastic.
Examples: sports cars, furs and expensive foods.
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Income elasticity of demand
Famous result
Engels Law foods are a normal necessity.
(By Ernst Engel (1821-96) a German statistician).
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Income elasticity of demand
Income elasticities show how budget shares change as
income increases:
For luxury goods share of income spent on these
increases as income increases.
For normal (non-luxury) good share of income
decreases though amount of income spent increases.
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Summary
Price elasticity of demand measures how much the
quantity demanded responds to changes in the price.
Its calculated as the percentage change in quantity
demanded divided by the percentage change in price.
If a demand curve is elastic, total revenue falls when
the price rises but falls if the demand curve is inelastic.
The income elasticity of demand measures how much
the quantity demanded responds to changes in
consumers income.
Example presentation title Page 29
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