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Microeconomics 1
Dali Laxton
Elasticity and its Application
Masaryk University
Lecture
3

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•What factors affect buyers’ demand for goods?
•What factors affect sellers’ supply of goods?
•How do supply and demand determine the price of a good and the quantity sold?
•How do changes in the factors that affect demand or supply affect the market price and quantity of
a good?
Last Lecture

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Lecture Today

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or in part, except for use as permitted in a license distributed with a certain product or service
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Lecture Today
•What is elasticity?  What kinds of issues can elasticity help us understand?
•What is the price elasticity of demand?
How is it related to the demand curve?
How is it related to revenue & expenditure?
•What is the price elasticity of supply?
How is it related to the supply curve?
•The concept of elasticity in three different markets (wheat, oil and illegal drugs)

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‹#›
§
§You design websites for local businesses.
You charge 7,000 CZK per website,
and currently sell 12 websites per month.
§Your costs are rising
(including the opportunity cost of your time),
so you consider raising the price to 8,750 CZK.
§The law of demand says that you won’t sell as many websites if you raise your price.
How many fewer websites?  How much will your revenue fall, or might it increase?
A scenario…
[USEMAP]
0
4

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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
‹#›
Elasticity
§Basic idea:
Elasticity measures how much one variable responds to changes in another variable.
§One type of elasticity measures how much quantity demanded for your websites will fall if you
raise your price.
§Definition:
Elasticity is a numerical measure of the responsiveness of  Qd  or  Qs  to one of its
determinants.
[USEMAP]
0

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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
‹#›
Price Elasticity of Demand
§Price elasticity of demand measures how much Qd responds to a change in P.
Price elasticity of demand
=
Percentage change in Qd
Percentage change in P
§Loosely speaking, it measures the price-sensitivity of buyers’ demand.
[USEMAP]
0

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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
‹#›
Price Elasticity of Demand
§Price elasticity
of demand equals
[USEMAP]
0
P
Q
D
Q2
P2
P1
Q1
P  rises by 10%
Q  falls by 15%
15%
10%
=  1.5
Price elasticity of demand
=
Percentage change in Qd
Percentage change in P
Example:

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‹#›
Price Elasticity of Demand
§Along a D curve, P and Q move in opposite directions, which would make price elasticity negative.
§We will drop the minus sign and report all price elasticities as
non-negative numbers.
[USEMAP]
0
P
Q
D
Q2
P2
P1
Q1
Price elasticity of demand
=
Percentage change in Qd
Percentage change in P

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or otherwise on a password-protected website for classroom use.
‹#›
Calculating Percentage Changes
[USEMAP]
0
P
Q
D
8,750 CZK
8
B
7,000 CZK
12
A
Demand for your websites
Standard method
of computing the percentage (%) change:
end value – start value
start value
x 100%
Going from A to B,
the % change in P equals
(8,750CZK-7,000CZK)/7,000CZK = 25%

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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
‹#›
Calculating Percentage Changes
[USEMAP]
0
P
Q
D
8,750 CZK
8
B
7,000 CZK
12
A
Demand for your websites
Problem:
The standard method gives different answers depending on where you start.
From A to B,
P rises 25%, Q falls 33%,
elasticity = 33/25= 1.33
From B to A,
P falls 20%, Q rises 50%, elasticity = 50/20 = 2.50

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‹#›
Calculating Percentage Changes
§So, we instead use the midpoint method:
[USEMAP]
0
end value – start value
midpoint
x 100%
§The midpoint is the number halfway between the start and end values, the average of those values.
§It doesn’t matter which value you use as the start and which as the end—you get the same answer
either way!

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or otherwise on a password-protected website for classroom use.
‹#›
Calculating Percentage Changes
§Using the midpoint method, the % change
in P equals
[USEMAP]
0
8,750– 7,000
7,875
x 100%
=  22.2%
§The % change in Q equals
12 – 8
10
x 100%
=  40.0%
§The price elasticity of demand equals
40/22.2  =  1.8

ACTIVE LEARNING   1
Calculate an elasticity
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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
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§Use the following
information to
calculate the
price elasticity
of demand
for hotel rooms:
§if P = $135,  Qd = 8600
§if P = $165,  Qd = 7400
©stefanolunardi/Shutterstock.com

ACTIVE LEARNING   1
Applying the principles
§Use midpoint method to calculate
% change in Qd
§ (8600 – 7400)/8000 = 15%
§% change in P
§ ($165 – $135)/$150 = 20%
§The price elasticity of demand equals
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15%
20%
=  0.75

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or otherwise on a password-protected website for classroom use.
‹#›
What determines price elasticity?
§To learn the determinants of price elasticity,
we look at a series of examples.
Each compares two common goods.
[USEMAP]
0

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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
‹#›
Examples
§In the following examples suppose the prices of both goods rise by 20%.
§The good for which Qd falls the most (in percent) has the highest price elasticity of demand.
Which good is it?  Why?
§What lesson does the example teach us about the determinants of the price elasticity of demand?
1)Breakfast Cereal  vs.  Sunscreen
2)“Slim Jeans”  vs.  “Clothing”
3)Insulin  vs.  Caribbean Cruises
4)Gasoline in the Short Run vs.
Gasoline in the Long Run
5)
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‹#›
EXAMPLE 1
Breakfast Cereal  vs.  Sunscreen
§The prices of both of these goods rise by 20%.
For which good does Qd drop the most?  Why?
§Breakfast cereal has close substitutes
(e.g., pancakes, sandwiches, leftover pizza),
so buyers can easily switch if the price rises.
§Sunscreen has no close substitutes,
so a price increase would not affect demand very much.
§Lesson:  Price elasticity is higher when close substitutes are available.
[USEMAP]
0

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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
‹#›
EXAMPLE 2
“Slim Jeans”  vs.  “Clothing”
§The prices of both goods rise by 20%.
For which good does Qd drop the most?  Why?
§For a narrowly defined good such as
blue jeans, there are many substitutes
(khakis, shorts, Speedos).
§There are fewer substitutes available for broadly defined goods.
(Are there any substitutes for clothing?)
§Lesson:  Price elasticity is higher for narrowly defined goods than for broadly defined ones.
[USEMAP]
0

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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
‹#›
EXAMPLE 3
Insulin  vs.  Caribbean Cruises
§The prices of both of these goods rise by 20%.
For which good does Qd drop the most?  Why?
§To millions of diabetics, insulin is a necessity.
A rise in its price would cause little or no decrease in demand.
§A cruise is a luxury.  If the price rises,
some people will forego it.
§Lesson:  Price elasticity is higher for luxuries than for necessities.
[USEMAP]
0

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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
‹#›
EXAMPLE 4
Gasoline in the Short Run vs.
Gasoline in the Long Run
§The price of gasoline rises 20%.  Does Qd drop more in the short run or the long run?  Why?
§There’s not much people can do in the
short run, other than ride the bus or carpool.
§In the long run, people can buy smaller cars
or live closer to work.
§Lesson:  Price elasticity is higher in the
long run than the short run.
[USEMAP]
0

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‹#›
The Determinants of Price Elasticity:
A Summary
§The price elasticity of demand depends on:
§the extent to which close substitutes are available
§whether the good is a necessity or a luxury
§how broadly or narrowly the good is defined
§the time horizon—elasticity is higher in the long run than the short run
[USEMAP]
0

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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
‹#›
The Variety of Demand Curves
§The price elasticity of demand is closely related to the slope of the demand curve.
§Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
§Five different classifications of D curves.…
[USEMAP]
0

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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
‹#›
Q1
P1
D
“Perfectly inelastic demand”  (one extreme case)
P
Q
P2
P  falls by 10%
Q  changes
by  0%
[USEMAP]
0
0%
10%
= 0
Price elasticity
of demand
=
% change in Q
% change in P
=
Consumers’
price sensitivity:
D curve:
Elasticity:
vertical
none
0

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‹#›
D
“Inelastic demand”
P
Q
Q1
P1
Q2
P2
Q  rises less than 10%
[USEMAP]
0
< 10%
10%
< 1
Price elasticity
of demand
=
% change in Q
% change in P
=
P  falls by 10%
Consumers’
price sensitivity:
D curve:
Elasticity:
relatively steep
relatively low
< 1

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‹#›
D
“Unit elastic demand”
P
Q
Q1
P1
Q2
P2
Q rises by 10%
[USEMAP]
0
10%
10%
= 1
Price elasticity
of demand
=
% change in Q
% change in P
=
P  falls by 10%
Consumers’
price sensitivity:
Elasticity:
intermediate
1
D curve:
intermediate slope

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‹#›
D
“Elastic demand”
P
Q
Q1
P1
Q2
P2
Q  rises more than 10%
[USEMAP]
0
> 10%
10%
> 1
Price elasticity
of demand
=
% change in Q
% change in P
=
P  falls by 10%
Consumers’
price sensitivity:
D curve:
Elasticity:
relatively flat
relatively high
> 1

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‹#›
D
“Perfectly elastic demand”  (the other extreme)
P
Q
P1
Q1
P changes by 0%
Q  changes
by any %
[USEMAP]
0
any %
0%
= infinity
Q2
P2 =
Consumers’
price sensitivity:
D curve:
Elasticity:
infinity
horizontal
extreme
Price elasticity
of demand
=
% change in Q
% change in P
=

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‹#›
A few elasticities from the real world
Airline Travel, Long-run
Eggs
Healthcare
Rice
Housing
Beer
Chevrolet automobiles
Restaurant meals
Salt
Beef
Private Education
Fresh Tomatoes
Source: Euromonitor International’s Industry Demand Model
0.07
0.1
0.2
0.5
0.7
0.9
4.0
2.3
0.1
1.6
1.1
4.6

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‹#›
Elasticity of a Linear Demand Curve
[USEMAP]
0
§The slope
of a linear demand curve is constant,
but its elasticity
is not.
P
Q
$30
20
10
$0
0
20
40
60
200%
40%
= 5.0
E =
67%
67%
= 1.0
E =
40%
200%
= 0.2
E =

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‹#›
Price Elasticity and Total Revenue
§Continuing our scenario, if you raise your price
from 7,000 CZK to 8,750 CZK, would your revenue rise or fall?
§ Revenue = P x Q
§A price increase has two effects on revenue:
§Higher P means more revenue on each unit
you sell.
§But you sell fewer units (lower Q),
due to law of demand.
§Which of these two effects is bigger?
It depends on the price elasticity of demand.
[USEMAP]
0

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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
‹#›
Price Elasticity and Total Revenue
§If demand is elastic, then
§price elast. of demand  >  1
§            % change in Q  >  % change in P
§The fall in revenue from lower Q is greater
than the increase in revenue from higher P,
so revenue falls.
Revenue = P x Q
Price elasticity of demand
=
Percentage change in Q
Percentage change in P
[USEMAP]
0

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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
‹#›
Price Elasticity and Total Revenue
§Elastic demand
(elasticity = 1.8)
P
Q
D
7,000
12
If P = 7,000 CZK,
Q = 12 and revenue = 84,000 CZK.
When D is elastic,
a price increase
causes revenue to fall.
[USEMAP]
0
8,750
8
If P = 8,750 CZK,
Q = 8 and
revenue = 70,000 CZK.
lost revenue due to lower Q
increased revenue due to higher P
Demand for your websites

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‹#›
Price Elasticity and Total Revenue
§If demand is inelastic, then
§price elast. of demand  <  1
§            % change in Q  <  % change in P
§The fall in revenue from lower Q is smaller
than the increase in revenue from higher P,
so revenue rises.
§In our example, suppose that Q only falls to 10 (instead of 8) when you raise your price to 8,750
CZK.
Revenue = P x Q
Price elasticity of demand
=
Percentage change in Q
Percentage change in P
[USEMAP]
0

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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
‹#›
Price Elasticity and Total Revenue
§Now, demand is inelastic:
    elasticity = 0.82
P
Q
D
7,000
12
If P = 7,000,
Q = 12 and revenue = 84,000 CZK.
8,750
10
If P = 8,750,
Q = 10 and
revenue = 87,500 CZK.
When D is inelastic,
a price increase
causes revenue to rise.
[USEMAP]
0
lost revenue due to lower Q
increased revenue due to higher P
Demand for your websites

ACTIVE LEARNING   2
Elasticity and expenditure/revenue
§A. Pharmacies raise the price of insulin by 10%.  Does total expenditure on insulin rise or fall?
§B. As a result of a fare war, the price of a luxury cruise falls 20%.
Does luxury cruise companies’ total revenue
rise or fall?
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or otherwise on a password-protected website for classroom use.
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ACTIVE LEARNING   2
Answers
§A. Pharmacies raise the price of insulin by 10%.  Does total expenditure on insulin rise or fall?
§ Expenditure = P x Q
§ Since demand is inelastic, Q will fall less
than 10%, so expenditure rises.
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or in part, except for use as permitted in a license distributed with a certain product or service
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ACTIVE LEARNING   2
Answers
§B. As a result of a fare war, the price of a luxury cruise falls 20%.
Does luxury cruise companies’ total revenue
rise or fall?
§ Revenue = P x Q
§ The fall in P reduces revenue,
but Q increases, which increases revenue.  Which effect is bigger?
§ Since demand is elastic, Q will increase more than 20%, so revenue rises.
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or in part, except for use as permitted in a license distributed with a certain product or service
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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
‹#›
APPLICATION:  Does Drug Interdiction Increase or Decrease Drug-Related Crime?
§One side effect of illegal drug use is crime:  Users often turn to crime to finance their habit.
§We examine two policies designed to reduce illegal drug use and see what effects they have on
drug-related crime.
§For simplicity, we assume the total dollar value of drug-related crime equals total expenditure
on drugs.
§Demand for illegal drugs is inelastic, due to addiction issues.
[USEMAP]
0

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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
‹#›
D1
Policy 1:  Interdiction
[USEMAP]
0
Price of Drugs
Quantity
of Drugs
S1
S2
P1
Q1
P2
Q2
Interdiction reduces the supply of drugs.
Since demand for drugs is inelastic,
P rises propor-tionally more than Q falls.
Result: an increase in
total spending on drugs, and in drug-related crime
new value of drug-related crime
initial value of drug-related crime

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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
‹#›
Policy 2:  Education
[USEMAP]
0
Price of Drugs
Quantity
of Drugs
D1
S
P1
Q1
D2
P2
Q2
Education reduces the demand for drugs.
P and Q fall.
Result:
A decrease in total spending on drugs, and in drug-related crime.
initial value of drug-related crime
new value of drug-related crime

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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
‹#›
Price Elasticity of Supply
§Price elasticity of supply measures how much Qs responds to a change in P.
Price elasticity of supply
=
Percentage change in Qs
Percentage change in P
§Loosely speaking, it measures sellers’
price-sensitivity.
§Again, use the midpoint method to compute the percentage changes.
[USEMAP]
0

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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
‹#›
Q2
Price Elasticity of Supply
§Price
elasticity
of supply equals
[USEMAP]
0
P
Q
S
P2
Q1
P1
P  rises by 8%
Q  rises by 16%
16%
8%
=  2.0
Price elasticity of supply
=
Percentage change in Qs
Percentage change in P
Example:

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or in part, except for use as permitted in a license distributed with a certain product or service
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‹#›
The Variety of Supply Curves
§The slope of the supply curve is closely related to price elasticity of supply.
§Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
§Five different classifications…
[USEMAP]
0

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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
‹#›
S
“Perfectly inelastic” (one extreme)
P
Q
Q1
P1
P2
Q  changes
by 0%
[USEMAP]
0
0%
10%
= 0
Price elasticity
of supply
=
% change in Q
% change in P
=
P  rises by 10%
Sellers’
price sensitivity:
S curve:
Elasticity:
vertical
none
0

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‹#›
S
“Inelastic”
P
Q
Q1
P1
Q2
P2
Q  rises less than 10%
[USEMAP]
0
< 10%
10%
< 1
Price elasticity
of supply
=
% change in Q
% change in P
=
P  rises by 10%
Sellers’
price sensitivity:
S curve:
Elasticity:
relatively steep
relatively low
< 1

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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
‹#›
S
“Unit elastic”
P
Q
Q1
P1
Q2
P2
Q  rises
by 10%
[USEMAP]
0
10%
10%
= 1
Price elasticity
of supply
=
% change in Q
% change in P
=
P  rises by 10%
Sellers’
price sensitivity:
S curve:
Elasticity:
intermediate slope
intermediate
= 1

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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
‹#›
S
“Elastic”
P
Q
Q1
P1
Q2
P2
Q  rises more than 10%
[USEMAP]
0
> 10%
10%
> 1
Price elasticity
of supply
=
% change in Q
% change in P
=
P  rises by 10%
Sellers’
price sensitivity:
S curve:
Elasticity:
relatively flat
relatively high
> 1

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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
‹#›
S
“Perfectly elastic”  (the other extreme)
P
Q
P1
Q1
P changes by 0%
Q  changes
by any %
[USEMAP]
0
any %
0%
= infinity
Price elasticity
of supply
=
% change in Q
% change in P
=
Q2
P2 =
Sellers’
price sensitivity:
S curve:
Elasticity:
horizontal
extreme
infinity

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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
‹#›
The Determinants of Supply Elasticity
§The more easily sellers can change the quantity they produce, the greater the price elasticity of
supply.
§Example:  Supply of beachfront property is harder to vary and thus less elastic than
supply of new cars.
§For many goods, price elasticity of supply
is greater in the long run than in the short run,
because firms can build new factories,
or new firms may be able to enter the market.

ACTIVE LEARNING   3
Elasticity and changes in equilibrium
§The supply of beachfront property is inelastic.  The supply of new cars is elastic.
§Suppose population growth causes
demand for both goods to double
(at each price, Qd doubles).
§For which product will P change the most?
§For which product will Q change the most?
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or otherwise on a password-protected website for classroom use.
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ACTIVE LEARNING   3
Answers
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Beachfront property (inelastic supply):
P
Q
D1
S
Q1
P1
A
When supply
is inelastic,
an increase in demand has a bigger impact on price than on quantity.
D2
B
Q2
P2

ACTIVE LEARNING   3
Answers
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or in part, except for use as permitted in a license distributed with a certain product or service
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New cars
(elastic supply):
P
Q
D1
S
Q1
P1
A
When supply
is elastic,
an increase in demand has a bigger impact on quantity than on price.
D2
Q2
P2
B

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or otherwise on a password-protected website for classroom use.
‹#›
S
How the Price Elasticity of Supply Can Vary
P
Q
[USEMAP]
0
§Supply often becomes
less elastic
as Q rises,
due to capacity limits.
$15
525
12
500
$3
100
4
200
elasticity > 1
elasticity < 1

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‹#›
Other Elasticities
§Income elasticity of demand:  measures the response of Qd to a change in consumer income
Income elasticity of demand
=
Percent change in Qd
Percent change in income
§Recall from Chapter 4:  An increase in income causes an increase in demand for a normal good.
§Hence, for normal goods, income elasticity > 0.
§For inferior goods, income elasticity < 0.

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Other Elasticities
§Cross-price elasticity of demand:
measures the response of demand for one good to changes in the price of another good
Cross-price elast.
of demand
=
% change in Qd  for good 1
% change in price of good 2
§For substitutes, cross-price elasticity > 0
(e.g., an increase in price of beef causes an increase in demand for chicken)
§For complements, cross-price elasticity < 0
(e.g., an increase in price of computers causes decrease in demand for software)

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‹#›
Cross-Price Elasticities in the News
§“As Gas Costs Soar, Buyers Flock to Small Cars”
     -New York Times, 5/2/2008
§“Gas Prices Drive Students to Online Courses”
     -Chronicle of Higher Education, 7/8/2008
§“Gas prices knock bicycle sales, repairs into higher gear”
     -Associated Press, 5/11/2008
§“Camel demand soars in India”
(as a substitute for “gas-guzzling tractors”)
     -Financial Times, 5/2/2008
§“High gas prices drive farmer to switch to mules”
     -Associated Press, 5/21/2008

Summary
•Elasticity measures the responsiveness of
 Qd or Qs to one of its determinants.
•Price elasticity of demand equals percentage change in Qd divided by percentage change in P.
When it’s less than one, demand is “inelastic.”  When greater than one, demand is “elastic.”
•When demand is inelastic, total revenue rises when price rises.  When demand is elastic, total
revenue falls when price rises.
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or in part, except for use as permitted in a license distributed with a certain product or service
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Summary
•Demand is less elastic in the short run,
for necessities, for broadly defined goods,
and for goods with few close substitutes.
•Price elasticity of supply equals percentage change in Qs divided by percentage change in P.
When it’s less than one, supply is “inelastic.”  When greater than one, supply is “elastic.”
•Price elasticity of supply is greater in the long run than in the short run.
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Summary
•The income elasticity of demand measures how much quantity demanded responds to changes in buyers’
incomes.
•The cross-price elasticity of demand measures how much demand for one good responds to changes in
the price of another good.
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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
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