Elasticity

More Precious than a Bexsero January 2017,

Meningitis B. 1-100,000
Flu Shot
The U.S. supply of the flu vaccine for the 2004–2005 flu
season was suddenly cut in half
As news of it spread, there was a rush to get the shots.
Some pharmaceutical distributers detected a profit - making
opportunity in the frenzy.
Consumers of the vaccine were relatively unresponsive to
price;
 that is, the large increase in the price of the vaccine
left the quantity demanded by consumers relatively
unchanged.
In this chapter we will show how the price elasticity of
demand is calculated and why it is the best measure of how
the quantity demanded responds to changes in price.
Chapter Objectives

1. What is elasticity?
A. Price elasticity of demand
B. Cross-price elasticity of demand
C. Income elasticity of demand
D. Price elasticity of supply
2. The effects of taxes on supply and demand
3. What determines who bears the burden of a tax
4. The costs and benefits of taxes, and why taxes impose
a cost that is larger than the tax revenue they raise
Defining and Measuring Elasticity
The price elasticity of demand is the ratio of the
percent change in the quantity demanded to the
percent change in the price as we move along the
demand curve
%∆Q
%∆P
Drop the minus sign - Price elasticity of demand
is always negative because of the inverse
relationship between price and quantity demanded-
so drop the minus sign and use Absolute Value
The Price Elasticity of Demand
 Demand for Vaccinations
Price of vaccination
When price rises to $21 per
dose, demand falls to 9.9
million doses per day (point
B
$21 B).

A
20

0 9.9 10.0
Quantity of vaccinations (millions)
 Calculating the Price Elasticity of Demand

1)

2)

3)
The Midpoint Method

 Percentage change can vary depending on which variables

are used to measure. To alleviate this problem:
 The midpoint method is a technique for calculating the percent
change using averages of starting and final values (midpoints).
Midpoint Method
Using the Midpoint Method
Estimating Elasticities
 Assumption: It’s easy to estimate price elasticities of demand
from real-world data

 Fact: Changes in price aren’t the only thing affecting changes in

the quantity demanded. Other factors include:
changes in income
changes in population
changes in the prices of other goods

 To estimate price elasticities of demand, economists must use

careful statistical analysis to separate the influence of these
different factors, holding other things equal.
 Some Estimated Price Elasticities of Demand
Good Price elasticity
Inelastic demand
• Eggs 0.1 Price elasticity of
demand<1
• Beef 0.4
• Stationery 0.5
• Gasoline 0.5

Elastic demand
• Housing 1.2
• Restaurant meals 2.3 Price elasticity of
• Airline travel 2.4 demand>1
• Foreign travel 4.1
Interpreting Price Elasticity of Demand

Extreme Cases of Price Elasticity of Demand:

• Demand is perfectly inelastic when the

quantity demanded does not respond at all to
changes in the price
• demand curve is a vertical line.

• Demand is perfectly elastic when any price

increase will cause the quantity demanded to
drop to zero.
• demand curve is a horizontal line.
Interpreting Price Elasticity of Demand
(continued)
Demand is elastic if the price elasticity of demand
is greater than 1
Price Elasticity of Demand > 1
Demand is inelastic if the price elasticity of
demand is less than 1
Price Elasticity of Demand < 1
Demand is unit-elastic if the price elasticity of
demand is exactly 1
Price Elasticity of Demand = 1
 Two Extreme Cases of Price Elasticity of Demand

Perfectly Inelastic Demand: Price Elasticity of Demand = 0

Price of shoelaces
(per pair) D
1

$3
An increase in
price…
$2
… leaves the
quantity
demanded
unchanged.

0 1
Quantity of shoelaces (billions of pairs per year)
 Two Extreme Cases of Price Elasticity of Demand

Price Elastic Demand: Price Elasticity of Demand = ∞

Price of pink tennis balls

(per dozen)

At any price above $5, At exactly $5,

quantity demanded is consumers will
zero buy any
quantity
$5 D
2

At any price below $5,

quantity demanded is
infinite

0 Quantity of tennis balls (dozens per year)

Unit-Elastic Demand, Inelastic Demand, and Elastic Demand

Demand is unit-elastic if the price elasticity of demand is exactly 1

Price of crossing
Unit-Elastic Demand:
Price Elasticity of Demand = 1

B
A 20% $1.10
A
increase in the
0.90
price . . .

D
1

0 900 1,100
Quantity of crossings (per
day)
. . . generates a 20% decrease in the
quantity of crossings demanded.
 Unit-Elastic Demand, Inelastic Demand, and Elastic Demand
Demand is inelastic if the price elasticity of demand is less
than 1
Price of crossing
Inelastic Demand: Price Elasticity
of Demand = 0.5

B
A 20% increase in $1.10
the price . . . A
0.90

D
2
0 950 1,050 Quantity of crossings
(per day)
. . . generates a 10% decrease in the
quantity of crossings demanded.
Unit-Elastic Demand, Inelastic Demand, and Elastic Demand

Demand is elastic if the price elasticity of demand is greater

than 1
Elastic Demand: Price Elasticity of
Price of crossing
Demand = 2

B
$1.10
A
A 20%
0.90
increase in the
price . . . D
3

0 800 1,200
Quantity of crossings
(per day)
… generates a 40% decrease
in the quantity of crossings
demanded.
Why Does It Matter Whether Demand is
Unit-Elastic, Inelastic, or Elastic?

 Because this predicts how changes in the price

of a good will affect the total revenue earned by
producers from the sale of that good.

 The total revenue is defined as the total value of

sales of a good or service, i.e.

 Total Revenue = Price × Quantity Sold

Total Revenue by Area

Price of crossing Total Revenue = Price × Quantity Sold

$0.90

Total revenue = price x

quantity = $990 D

0 1,100 Quantity of crossings (per day)

Elasticity and Total Revenue
When a seller raises the price of a good, there are
two effects in action (except in the rare case of a
good with perfectly elastic or perfectly inelastic
demand):
A price effect: After a price increase, each unit sold sells at a higher
price, which tends to raise revenue.
 A quantity effect: After a price increase, fewer units are sold, which
tends to lower revenue.
Figure 5.4b Effect of a Price Increase on Total Revenue

Price of crossing Price effect of price increase:

higher price for each unit sold

Quantity effect of
$1.10 price increase: fewer
C units sold
0.90

B A D

0 900 1,100
Quantity of crossings (per day)
Elasticity and Total Revenue
 If demand for a good is elastic (the price elasticity of
demand > 1), an increase in price reduces total revenue.
The quantity effect is stronger than the price effect.

Price TR
 If demand for a good is inelastic (the price elasticity of
demand < 1), a higher price increases total revenue.
The price effect is stronger than the quantity effect.
Price TR
 If demand for a good is unit-elastic (the price elasticity of
demand = 1), an increase in price does not change total
revenue.
 The sales effect and price effect exactly offset each other.
Price Elasticity of Demand and Total Revenue
Demand Schedule and Total Revenue
Price
$10 Elastic
9 Unit-elastic
8
7
6 Inelastic
5 Demand Schedule and Total Revenue
4 for a Linear Demand Curve
3
2 Price Quantity Total
1 demanded Revenue
D $0 10 $0
0 1 2 3 4 5 6 7 8 9 10 1 9 9
Quantity 2 8 16
3 7 21
Total 4 6 24
revenue 5 5 25
$25 6 4 24
24 7 3 21
21 8 2 16
16 9 1 9
10 0 0

9
The price elasticity of demand changes
0
0 1 2 3 4 5 6 7 8 9 10
along the demand curve
Quantity

Demand is elastic: Demand is inelastic: a

a higher reduces higher price increase
total revenue total revenue
 What Factors Determine the Price Elasticity
of Demand?
Price Elasticity of Demand is determined by:

Whether Close Substitutes Are Available

Whether the Good Is a Necessity or a Luxury

Share of Income Spent on the Good

Time
How Mad?
 Responding to your tuition bill

 For years tuition has been rising faster than the overall cost of living,
but does rising tuition keep people from going to college?
 A 1988 study found that a 3% increase in tuition led to an
approximately 2% fall in the number of students enrolled at four-
year institutions, giving a price elasticity of demand of 0.67 (2%/3%)
and 0.9 for two-year institutions.
 Enrollment decision for students at two-year colleges was
significantly more responsive to price than for students at four-year
colleges. The result: students at two-year colleges are more likely to
forgo getting a degree because of tuition costs than students at four
year colleges.
 A 1999 study confirmed this pattern.
 Cross-Price Elasticity

The cross-price elasticity of demand between two goods

measures the effect of the change in one good’s price on the quantity
demanded of the other good.

Equal to the percent change in the quantity demanded of one good

divided by the percent change in the other good’s price.

The Cross-Price Elasticity of Demand between Goods A and B

Cross-Price Elasticity

Goods are substitutes when the cross-price elasticity of

demand is positive.

Goods are complements when the cross-price elasticity of

demand is negative.
Income Elasticity of Demand
The income elasticity of demand is the percent
change in the quantity of a good demanded when a
consumer’s income changes divided by the percent
change in the consumer’s income.
Normal Goods and Inferior Goods

When the income elasticity of demand is positive,

the good is a normal good
 that is, the quantity demanded at any given price increases as income
increases.

When the income elasticity of demand is negative,

the good is an inferior good
 that is, the quantity demanded at any given price decreases as income
increases.
 Where Have All the Farmers Gone?
Why do so few people now live and work on farms in
the United States?
 The income elasticity of demand for food is much less than 1—it is
income inelastic. As consumers grow richer, other things equal, spending
on food rises less than income  as the U.S. economy has grown, the
share of income it spends on food—and therefore the share of total U.S.
income earned by farmers—has fallen.
 Agriculture has been a technologically progressive sector for
approximately 150 years in the U.S., with steadily increasing yields over
time. Competition among farmers means that technological progress
leads to lower food prices. Meanwhile, the demand for food is price-
inelastic, so falling prices of agricultural goods, other things equal, reduce
the total revenue of farmers  progress in farming has been good for
consumers but bad for farmers.
Food’s Bite in World Budgets
Spending on food
(% of income)

80% Sri Lanka

60

Mexico
40
Israel United States

20

0 20 40 60 80 100%

Income (% of U.S. income per capital)

Spending It
 The Bureau of Labor Statistics captures data on
spending.
 A classic result of their surveys is that the income elasticity of demand for
‘food eaten at home’ is considerably less than 1. As a family’s income rises,
the share of income spent on food consumed at home falls, and vice a versa
as family income falls.
 In 1950, 19% of U.S. income was spent on food consumed at home
compared with 7% now. Over the same time period, the share of U.S.
income spent on food away from home has stayed constant at 5%.
 An example of an inferior good is rental housing. As family income rises
demand for rental housing decreases since higher income families are likely
to own their homes.
 Price Elasticity of Supply
The price elasticity of supply is a measure of the
responsiveness of the quantity of a good supplied to
the price of that good.
It is the ratio of the percent change in the quantity
supplied to the percent change in the price as we move
along the supply curve.
 Two Extreme Cases of Price Elasticity of Supply
Perfectly Inelastic Supply: Perfectly Elastic Supply: Price
Price Elasticity of Supply = 0 Elasticity of Supply = ∞

Price of cell phone frequency Price of pizza

S
1
At any price above At exactly $12,
$12, quantity producers will
An increase in $3,000 supplied is infinite. produce any
price… quantity
2,000 $12 S
2
… leaves the
quantity At any price
supplied below $12,
unchanged quantity
supplied is
0 100 zero. 0
Quantity of cell Quantity of pizzas
phone frequencies
Measuring the Price Elasticity of Supply

• Supply is perfectly inelastic when the price

elasticity of supply is zero. When changes in the
price have no effect on the quantity supplied
• Supply curve is a vertical line

• Supply is perfectly elastic when price elasticity

of supply is infinite. When any price change will
lead to very large changes in the quantity
supplied
• Supply curve is a horizontal line
 What Factors Determine Price Elasticity of
Supply?
The Availability of Inputs: The price elasticity of
supply tends to be large when inputs are readily
available and can be shifted into and out of production
at a relatively low cost. It tends to be small when inputs
are difficult to obtain.

Time: The price elasticity of supply tends to grow

larger as producers have more time to respond to
a price change. This means that the long-run price
elasticity of supply is often higher than the short-run
elasticity.
 European Farm Surpluses
 Imposition of a price floors to support the incomes of farmers has created
“butter mountains” and “wine lakes” in Europe.
 Were European politicians unaware that their price floors would create huge
surpluses?
 They probably knew that surpluses would arise, but underestimated the
price elasticity of agricultural supply.
 They thought big increases in production were unlikely since there was little
new land available in Europe for cultivation. However, farm production could
expand by adding other resources, especially fertilizer and pesticides, which
were readily available
 So although farm acreage didn’t increase much, farm production did!
An Elasticity Menagerie
Table 5.3 An Elasticity Menagerie (continued)