Econ 201 (02):

Principles of Microeconomics

Lecture 8
Associated Text Chapter 5
October 3, 2023
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Roadmap for today’s lecture
• Announcements
• Chapter 5
• Elasticity
• Price elasticity
• Determinants of elasticity

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Announcement
• Reminder: Midterm is a week from today.
• On Thursday I’ll give more details
• Held during lecture
• No Zoom link, open book
• No collaborating

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Chapter 5 – Elasticity
• Now we’re looking at adding another dimension to our supply and
demand model
• Elasticity
• Elasticity adds more complexity – but also more richness – to our
economic model
• It is a measure of the responsiveness of quantity demanded or
quantity supplied to one of its determinants
• In other words – so far we have looked at the direction of the change
in quantity demanded or suppled
• Now, we will look at the size of the change as well

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Market responses
• If we play the role of policy advisor, it is important to know the
direction and the magnitude of a change in quantity demanded
• This is easily done if we know the entire demand curve, but this is something
rare in reality
• We want to measure how buyers and sellers might respond to
changes in market conditions

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Illustrative example
• Consider cigarettes
• Taxed to reduce consumption (health implications)
• Problematic among young consumers (addiction issues)
• What type of things affect the responsiveness of consumers to that
price increase (i.e., a new tax)?
• Addicted or not
• Income level
• Price of related goods
• Availability of substitutes
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Price Elasticity of Demand
• Our first elasticity is the price elasticity of demand
• This measures how much the quantity demanded of a good responds
to a change in the price of that good
• It’s computed as the percentage change in quantity demanded
divided by the percentage change in price
• Determinants of elasticity (responsiveness)
• Availability of close substitutes
• Necessity vs. luxury
• Time horizon (short run vs. long run)
• Definition of the market (specific vs. nonspecific)
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Determinants of elasticity
• Availability of close substitutes
• Goods with close substitutes tend to have more elastic demand
• Quantity demanded is more responsive to price changes
• It is easier for consumers to switch from that good to others
• Example: butter and margarine
• Increase in price of butter causes a relatively large drop in quantity demanded
because margarine is a close substitute (assuming price of margarine does not
change)
• Another example: eggs
• Not many close substitutes for eggs. Increase in price of eggs will cause a
relatively small drop in quantity demanded of eggs. Not much available to
substitute away to

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Determinants of elasticity
• Necessities vs. Luxuries
• Necessities tend to have inelastic demands
• Price changes tend to change quantity demanded by very little, if at all
• Example: insulin
• Price changes in insulin do not drastically change the quantity demanded of
insulin – it is a necessity to many
• Another example: boats
• Boats are an example of a luxury (for many). Price increases in boats will
cause a relatively large drop in quantity demanded of boats.
• Whether a good is a luxury depends on the individual consumer and their
preferences

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Determinants of elasticity
• Time horizon
• Goods tend to have more elastic demand over longer time horizons.
• Example: gasoline
• When the price of gasoline rises, quantity demanded of gasoline falls only
slightly in the immediate future as people still need to get around
• But over time, more consumers may move toward electric vehicles meaning a
more drastic response to the price change over the long run

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Determinants of elasticity
• Market definition
• How do we define the market?
• The elasticity of demand depends on how we draw the boundaries of the
market
• Narrowly defined markets tend to have more elastic demands, where broader
markets have less elastic demands
• Example: food
• If we define the market as food, we observe a very inelastic demand as there
are no close substitutes for food
• If we define the market as ice cream, the demand becomes more elastic as
there are indeed close substitutes for ice cream (for many people)

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 Computing Price Elasticity of Demand
percentage change in quantity demanded
Price elasticity of demand =
percentage change in price

• Consider the example of a 10% increase resulting in the decrease in quantity

demanded of 20%

20%
Price elasticity of demand = =2
10%

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Credit goes to Jordan Bartsch for this slide
The “midpoint method”
• In this class, we use the midpoint method to calculate percentage changes
and elasticity
• Consider the following example:
Point Price Quantity
A $4 120
B $6 80

• The midpoint of the price is $5

midpoint
• The midpoint of the quantity is 100
𝑄2 + 𝑄1
(𝑄2 − 𝑄1 )/[ ]
Price elasticity of demand = 2
𝑃2 + 𝑃1
(𝑃2 − 𝑃1 )/[ ]
2 midpoint
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Elasticity of Demand
• Demand curves are often grouped according to elasticity
• Demand is elastic when the absolute value of elasticity is greater
than 1
• Quantity moves proportionately more than price
• Demand is inelastic when the absolute value of elasticity is less than
1
• Quantity moves proportionately less than the price
• If the absolute value of elasticity is equal to 1 (quantity moves
proportionately with price) then demand is unit elastic

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Perfectly Inelastic Demand
Inelastic Demand
Unit Elastic Demand
Elastic Demand
Perfectly Elastic Demand

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Elasticity of a linear demand curve
• The slope of a linear demand curve
is constant, but its elasticity is not
• At points with a low price and high
quantity, the demand curve is
inelastic
• At points with a high price and low
quantity, the demand curve is
elastic
• This has to do with the nature of
percentage change
• If consumption is relatively low, it is
easier to have a significant percentage
change
• If consumption is relatively high, it is
relatively difficult
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Revenue implications
• Total revenue in a market is the price times the quantity sold
• TR = P × Q

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Revenue implications
• How does total revenue change as one moves along the demand
curve?
• It depends on the price elasticity of demand!

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Revenue implications
• When demand is inelastic (elasticity less than 1), a price increase
leads to a smaller quantity decrease, and total revenue rises!
• When demand is elastic (greater than 1), a price increase leads to a
larger quantity decrease, and total revenue falls!
• If demand is unit elastic (elasticity is equal to 1), a price increase
leads to a same-percentage-size quantity decrease and total revenue
remans constant

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Revenue implications
• Let’s think about a real-world example to drive this home…
• How does a drug dealer operate?
• New users have very elastic demand curves
• Therefore, charge low prices to new consumers
• Free samples, low cost to consumers of trying
• Frequent users have very inelastic demand curves
• Therefore, charge higher prices to these existing consumers
• Higher direct price and imposition of costs related to dealing

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 Other demand elasticities
• Income elasticity of demand measures how much quantity demanded
responds to a change in consumers’ income
percentage change in quantity demanded
Income elasticity of demand =
percentage change in income

• Cross-price elasticity of demand measures how much quantity demanded of

good 1 responds to change in price of good 2
percentage change in quantity demanded good 1
Cross − price elasticity of demand =
percentage change in price of good 2

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