YMANECON / 2nd SEMESTER – MIDTERMS / 2ND YR BSA

ELASTICITY AND ITS

APPLICATION
Elasticity
 Measure of the responsiveness of quantity demanded or quantity
supplied
 To a change in one of its determinants
The price elasticity of demand determines whether the
THE ELASTICITY OF DEMAND demand curve is steep or flat.
Note that all percentage changes are calculated using the
Price elasticity of demand midpoint method.
 How much the quantity demanded of a good responds to a
change in the price of that good The Price Elasticity of Demand (c)
 Percentage change in quantity demanded divided by the
percentage change in price
Elastic demand
 Quantity demanded responds substantially to changes in price
Inelastic demand
 Quantity demanded responds only slightly to changes in price

Determinants of price elasticity of demand

1. Availability of close substitutes
 Goods with close substitutes: more elastic demand
2. Necessities versus luxuries
 Necessities: inelastic demand
 Luxuries: elastic demand
3. Definition of the market
 Narrowly defined markets: more elastic demand
4. Time horizon
 Demand is more elastic over longer time horizons

Computing the price elasticity of demand The Price Elasticity of Demand (d, e)
 Percentage change in quantity demanded divided by percentage
change in price
 Use absolute value (drop the minus sign)
Midpoint method
 Two points: (Q1, P1) and (Q2, P2)

Variety of demand curves

a. Demand is elastic
 Price elasticity of demand > 1
b. Demand is inelastic
 Price elasticity of demand < 1
c. Demand has unit elasticity
 Price elasticity of demand = 1 Total revenue, TR
d. Demand is perfectly inelastic  Amount paid by buyers and received by sellers of a good
 Price elasticity of demand = 0  Price of the good times the quantity sold (P × Q)
 Demand curve is vertical
e. Demand is perfectly elastic For a price increase
 Price elasticity of demand = infinity  If demand is inelastic, TR increases
 Demand curve is horizontal  If demand is elastic, TR decreases
Figure 2 Total Revenue
The flatter the demand curve
The greater the price elasticity of demand

Figure 1
The Price Elasticity of Demand (a, b)
 a. Constant slope
 Rise over run
b. Different price elasticities
 Inelastic demand: points with low price and high
quantity
The total amount paid by buyers, and received as revenue  Elastic demand: points with high price and low quantity
by sellers, equals the area of the box under the demand curve, P × Q.
Here, at a price of $4, the quantity demanded is 100, and Figure 4 Elasticity along a Linear Demand Curve
total revenue is $400.

Figure 3
How Total Revenue Changes When Price Changes (a)

The slope of a linear demand curve is constant, but its elasticity is

The impact of a price change on total revenue (the product
of price and quantity) depends on the elasticity of demand. In panel
(a), the demand curve is inelastic.
In this case, an increase in the price leads to a decrease in
quantity demanded that is proportionately smaller, so total revenue
increases. Here an increase in the price from $4 to $5 causes the
quantity demanded to fall from 100 to 90. Total revenue rises from
$400 to $450.
not. The price elasticity of demand is calculated using the demand
schedule in the table and the midpoint method.
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.

How Total Revenue Changes When Price Changes (b)

The impact of a price change on total revenue (the product

of price and quantity) depends on the elasticity of demand. In panel
(b), the demand curve is elastic.
In this case, an increase in the price leads to a decrease in
quantity demanded that is proportionately larger, so total revenue
decreases. Here an increase in the price from $4 to $5 causes the
quantity demanded to fall from 100 to 70. Total revenue falls from
$400 to $350.

When demand is inelastic (elasticity < 1)

 P and TR move in the same direction
 If P ↑, TR also ↑
When demand is elastic (elasticity > 1)
 P and TR move in opposite directions
 If P ↑, TR ↓
If demand is unit elastic (elasticity = 1)
 Total revenue remains constant when the price changes

Linear demand curve

 I. Income elasticity of demand e. Supply is perfectly elastic
 How much the quantity demanded of a good responds to a  Price elasticity of supply = infinity
change in consumers’ income  Supply curve is horizontal
 Percentage change in quantity demanded
 Divided by the percentage change in income Figure 5
a. Normal goods The Price Elasticity of Supply (a, b)
 Positive income elasticity
 Necessities
 Smaller income elasticities
 Luxuries
 Large income elasticities
b. Inferior goods
 Negative income elasticities

II. Cross-price elasticity of demand

 How much the quantity demanded of one good responds to
a change in the price of another good
 Percentage change in quantity demanded of the first good
 Divided by the percentage change in price of the
The price elasticity of supply determines whether the
second good
supply curve is steep or flat.
a. Substitutes
Note that all percentage changes are calculated using the
 Goods typically used in place of one another
midpoint method.
 Positive cross-price elasticity
b. Complements
The Price Elasticity of Supply (c)
 Goods that are typically used together
 Negative cross-price elasticity

THE ELASTICITY OF SUPPLY

Price elasticity of supply

 How much the quantity supplied of a good responds to a change
in the price of that good
 Percentage change in quantity supplied
 Divided by the percentage change in price
 Depends on the flexibility of sellers to change the amount of the
good they produce
Elastic supply The Price Elasticity of Supply (d, e)
 Quantity supplied responds substantially to changes in the price
Inelastic supply
 Quantity supplied responds only slightly to changes in the price

Determinant of price elasticity of supply

1. Time period
 Supply is more elastic in the long run

Computing price elasticity of supply

 Percentage change in quantity supplied divided by percentage
change in price
 Always positive
Midpoint method
 Two points: (Q1, P1) and (Q2, P2)

Variety of supply curves

a. Supply is unit elastic
 Price elasticity of supply = 1
b. Supply is elastic
 Price elasticity of supply > 1
c. Supply is inelastic
 Price elasticity of supply < 1
d. Supply is perfectly inelastic
 Price elasticity of supply = 0
 Supply curve is vertical
SUPPLY CURVE c. Long-run: supply and demand are elastic
Different price elasticities  Decrease in supply: small increase in price
1. Points with low price and low quantity
 Elastic supply Figure 8 A Reduction in Supply in the World Market for Oil
 Capacity for production not being used
2. Points with high price and high quantity
 Inelastic supply

Figure 6 How the Price Elasticity of Supply Can Vary

When the supply of oil falls, the response depends on the time horizon. In the
short run, supply and demand are relatively inelastic, as in panel (a). Thus,
when the supply curve shifts from S1 to S2, the price rises substantially.
In the long run, however, supply and demand are relatively elastic, as in panel
(b). In this case, the same size shift in the supply curve (S 1 to S2) causes a
smaller increase in the price.
Because firms often have a maximum capacity for production, the elasticity of 3. Does Drug Interdiction Increase or Decrease Drug-related
supply may be very high at low levels of quantity supplied and very low at Crime?
high levels of quantity supplied.
a. Increase the number of federal agents devoted to the war on
Here an increase in price from $3 to $4 increases the quantity supplied from
100 to 200. Because the 67 percent increase in quantity supplied (computed drugs
using the midpoint method) is larger than the 29 percent increase in price, the Illegal drugs: supply curve shifts left
supply curve is elastic in this range.  Higher price and lower quantity
By contrast, when the price rises from $12 to $15, the quantity supplied rises Amount of drug-related crimes
only from 500 to 525. Because the 5 percent increase in quantity supplied is  Inelastic demand for drugs
smaller than the 22 percent increase in price, the supply curve is inelastic in  Higher drugs price: higher total revenue
this range.  Increase drug-related crime
b. Policy of drug education
THREE APPLICATIONS
Reduce demand for illegal drugs
1. Can Good News for Farming Be Bad News for Farmers?
Left shift of demand curve
a. New hybrid of wheat – increase production per acre by
Lower quantity
20%
Lower price
Supply curve shifts to the right
Reduce drug-related crime
Higher quantity and lower price
Figure 9 Policies to Reduce the Use of Illegal Drugs
Demand is inelastic: total revenue falls

Figure 7 An Increase in Supply in the Market for Wheat

Drug interdiction reduces the supply of drugs from S 1 to S2, as in panel (a). If
the demand for drugs is inelastic, then the total amount paid by drug users
rises, even as the amount of drug use falls.
By contrast, drug education reduces the demand for drugs from D 1 to D2, as in
When an advance in farm technology increases the supply of wheat from S 1 to panel (b). Because both price and quantity fall, the amount paid by drug users
S2, the price of wheat falls. Because the demand for wheat is inelastic, the falls.
increase in the quantity sold from 100 to 110 is proportionately smaller than
the decrease in the price from $3 to $2. As a result, farmers’ total revenue falls THE THEORY OF CONSUMER
from $300 ($3 × 100) to $220 ($2 × 110).
b. Paradox of public policy CHOICE
 Induce farmers not to plant crops Introduction
 Recall one of the Ten Principles from Chapter 1:
People face tradeoffs.
2. Why Did OPEC Fail to Keep the Price of Oil High?
 Buying more of one good leaves
a. Increase in prices: 1973 – 1974, 1971 – 1981 less income to buy other goods.
b. Short-run: supply and demand are inelastic  Working more hours means more income and more
 Decrease in supply: large increase in price consumption, but less leisure time.
  Reducing saving allows more consumption today but reduces B. The price of mangos rises to
future consumption. PM = $2 per mango
 This chapter explores how consumers make choices like these.

The Budget Constraint:

What the Consumer Can Afford
Example:
Hurley divides his income between two goods:
fish and mangos.
 A “consumption bundle” is a particular combination of the goods, e.g.,
40 fish & 300 mangos.
 Budget constraint: the limit on the consumption bundles that a
consumer can afford

ACTIVE LEARNIG 1
Budget Constraint
Hurley’s income: $1200
Prices: PF = $4 per fish, PM = $1 per mango
A. If Hurley spends all his income on fish,
how many fish does he buy?
B. If Hurley spends all his income on mangos,
how many mangos does he buy?
C. If Hurley buys 100 fish, how many mangos can he buy?
D. Plot each of the bundles from parts A – C on a graph that measures
fish on the horizontal axis and mangos on the vertical, connect the
dots.

Preferences: What the Consumer Wants

The Slope of the Budget Constraint

The slope of the budget constraint equals

– the rate at which Hurley
can trade mangos for fish
– the opportunity cost of fish in terms of mangos
– the relative price of fish:

price of fish $4
  4 mangos per fish
price of mangos $1

ACTIVE LEARNIG 2
Budget Constraint, continued.
Show what happens to Hurley’s budget constraint if:
A. His income falls to $800.
 Four Properties of Indifference Curves  two goods with straight-line indifference curves,
constant MRS

Example: nickels & dimes

Consumer is always willing to
trade two nickels for one dime.

Another Extreme Case: Perfect Complements

Perfect complements
 two goods with right-angle indifference curves

Example: Left shoes, right shoes

{7 left shoes, 5 right shoes}
is just as good as
{5 left shoes, 5 right shoes}

Less Extreme Cases:

Close Substitutes and Close Complements

Optimization: What the Consumer Chooses

The Marginal Rate of Substitution

Marginal rate of substitution (MRS)
 the rate at which a consumer is willing to trade one good for
another.

Hurley’s MRS is the amount of

mangos he would substitute for
another fish.

MRS falls as you move down along

an indifference curve.

One Extreme Case: Perfect Substitutes

Perfect substitutes
The Effects of an Increase in Income

An increase in income shifts

the budget constraint
ACTIVE LEARNIG 4
outward.
The substitution effect in two cases
Do you think the substitution effect would be bigger for substitutes or
If both goods are “normal,” complements?
Hurley buys more of each.  Draw an indifference curve for Coke and Pepsi, and, on a separate
graph, one for hot dogs and hot dog buns.
 On each graph, show the effects of a relative price change (keeping the
consumer on the initial indifference curve).

ACTIVE LEARNIG 3
Inferior vs. normal goods
 An increase in income increases the quantity demanded of normal
goods and reduces the quantity demanded of inferior goods.
 Suppose fish is a normal good but mangos are an inferior good.
 Use a diagram to show the effects of an increase in income on Hurley’s
optimal bundle of fish and mangos.

Deriving Hurley’s Demand Curve for Fish

The Effects of a Price Change

Application 1: Giffen Goods

 Do all goods obey the Law of Demand?
 Suppose the goods are potatoes and meat, and potatoes are an
inferior good.
 If price of potatoes rises,
 substitution effect: buy less potatoes
 income effect: buy more potatoes
The Income and Substitution Effects
 If income effect > substitution effect, then potatoes are a Giffen
 A fall in the price of fish has two effects on Hurley’s
good, a good for which an increase in price raises the quantity
optimal consumption of both goods.
demanded.
1. Income effect
 A fall in PF boosts the purchasing power of Hurley’s
income, allows him to buy more mangos and more fish.
2. Substitution effect
 A fall in PF makes mangos more expensive relative to fish,
causes Hurley to buy fewer mangos & more fish.
Notice: The net effect on mangos is ambiguous.

Application 2: Wages and Labor Supply
 Budget constraint
 Shows a person’s tradeoff between consumption and
leisure.
 Depends on how much time she has to divide between
leisure and working.
 The relative price of an hour of leisure is the amount of
consumption she could buy with an hour’s wages.
 Indifference curve
 Shows “bundles” of consumption and leisure
that give her the same level of satisfaction.
An increase in the wage has two effects on the optimal quantity of
labor supplied.
1. Substitution effect (SE): A higher wage makes leisure more
expensive relative to consumption.
 The person chooses less leisure, i.e., increases quantity of
labor supplied.
2. Income effect (IE): With a higher wage, she can afford more of
both “goods.”
 She chooses more leisure, i.e., reduces quantity of labor
supplied.
Could This Happen in the Real World???
Cases where the income effect on labor supply is very strong:
 Over last 100 years, technological progress has increased labor
demand and real wages.
The average workweek fell from 6 to 5 days.
 When a person wins the lottery or receives an inheritance, his
wage is unchanged – hence no substitution effect.
But such persons are more likely to work fewer hours,
indicating a strong income effect.
Application 3: Interest Rates and Saving
 A person lives for two periods.
 Period 1: young, works, earns $100,000 consumption =
$100,000 minus amount saved
 Period 2: old, retired
consumption = saving from Period 1 plus interest earned
on saving
 The interest rate determines the relative price of consumption
when young in terms of consumption when old.
ACTIVE LEARNIG 5
Effects of a change in the interest rate
 Suppose the interest rate rises.
 Describe the income and substitution effects on current and future
consumption, and on saving.
Application 3: Interest Rates and Saving
  The theory of consumer choice can be applied in many situations. It can
explain why demand curves can potentially slope upward, why higher
wages could either increase or decrease labor supply, and why higher
interest rates could either increase or decrease saving.

CONCLUSION:
Do People Really Think This Way?
 People do not make spending decisions
by writing down their budget constraints and indifference curves.
 Yet, they try to make the choices that maximize their satisfaction given
their limited resources.
 The theory in this chapter is only intended as a metaphor for how
consumers make decisions.
 It explains consumer behavior fairly well in many situations and
provides the basis for more advanced economic analysis.

CHAPTER SUMMARY
 A consumer’s budget constraint shows the possible combinations of
different goods she can buy given her income and the prices of the
goods. The slope of the budget constraint equals the relative price of the
goods.
 An increase in income shifts the budget constraint outward. A change in
the price of one of the goods pivots the budget constraint.
 A consumer’s indifference curves represent her preferences. An
indifference curve shows all the bundles that give the consumer a certain
level of happiness. The consumer prefers points on higher indifference
curves to points on lower ones.
 The slope of an indifference curve at any point is the marginal rate of
substitution – the rate at which the consumer is willing to trade one good
for the other.
 The consumer optimizes by choosing the point on her budget constraint
that lies on the highest indifference curve. At this point, the marginal
rate of substitution equals the relative price of the two goods.
 When the price of a good falls, the impact on the consumer’s choices can
be broken down into two effects, an income effect and a substitution
effect.
 The income effect is the change in consumption that arises because a
lower price makes the consumer better off. It is represented by a
movement from a lower indifference curve to a higher one.
 The substitution effect is the change that arises because a price change
encourages greater consumption of the good that has become relatively
cheaper. It is represented by a movement along an indifference curve.