Chapter 5 Price Elasticity of

Demand and Supply• Key Concepts• Summary• Practice Quiz• Internet Exercises

©2000 South-Western College Publishing

2

In this chapter, you will learn to solve these economic puzzles:

Can total revenue from a Steel Porcupines concert remain unchanged, regardless of

changes in the ticket price?

How sensitive is the quantity of cigarettes

demanded to changes in the price of cigarettes?

What happens to the sales of Mercedes, BMW’s and Jaguars in the U.S. if Congress prevents sales of luxury Japanese cars in

this country?

3

How is the percent increase or decrease of

two numbers calculated?Percent change is the

difference between the two numbers divided by the original number

4

Suppose the price of a rock concert increases

by 10%, what effect will this have on sales?

That all depends on the price elasticity of demand for this rock concert

5

What is Elasticity?A term economists use to

describe responsiveness, or sensitivity, to a change in price

6

What is PriceElasticity of Demand?

The ratio of the percentage change in the quantity demanded of a product to a percentage change in its price

7

% in Q demanded% in priceEd =

Price Elasticity of Demand

8

Supposing a university’s enrollment drops by 20% because tuition rises by 10%, what is the Price Elasticity of Demand?

9

Ed =-20%+10%

=-.20+.10

= 2

10

Why is Elasticity 2 in the previous example

and not -2? Economists drop the negative

sign because we know from the law of demand that quantity demanded and price are inversely related

11

If there is an increase from 3 units to 5, what is the percentage increase?

2/3 = 66%

12

If there is a decrease from 5 units to 3, what is the percentage decrease?

2/5 = 40%

13

Problem - When we move along a demand curve between two points, we get different answers to elasticity depending on whether we are moving up or down the demand curve

14

A

B2

3

P

Q

D

15

Economists can solve this problem of different base points by using the midpoints as the base points of changes in prices and quantity demanded

16

in quantity demanded

sum of quantities/2

divided by

in price

sum of prices/2

Price elasticity equals the

17

What is Elastic Demand?A condition in which the

percentage change in quantity demanded is greater than the percentage change in price

18

$40

$30

$20

$10

10 20 30 40

A

B

Elastic Demand Ed > 1P

Q

19

Why is the Demand curve in the previous

slide Elastic?The percentage change in

the quantity demanded is greater than the percentage change in price

20

Price decrease

Increase in total revenue

Elastic Demand

21

1015

= .66% change in Q =

% change in P = 1025

= .40

Ed = % change in Q% change in P

= .66.40

Ed = 1.65

22

$40$30

$20

$10

10 20 30 40

A

B

Inelastic Demand Ed < 1

23

Why is the Demand curve in the previous

slide Inelastic?The percentage change in

the quantity demanded is less than the percentage change in price

24

Price decrease

Decrease in total revenue

Inelastic Demand

25

513

= .38% change in Q =

% change in P = 1025

= .40

Ed = % change in Q% change in P =

.38

.40

26

What is a Unitary Elastic Demand Curve?The percentage change in

the quantity demanded is equal to the percentage change in price

27

$40

$30

$20

$10

10 20 30 40

EF

Unitary Elastic Demand Ed = 1

D

28

Price decrease

No change in total revenue

Unitary Elastic Demand

29

What is a Perfectly Elastic Demand Curve?

A condition in which a small percentage change in price brings about an infinite percentage change in the quantity demanded

30

$40$30

$20

$10

10 20 30 40

Perfectly Elastic Demand Ed =

8

31

Price change

Infinite change in quantity demanded

Perfectly Elastic Demand

32

What is a Perfectly Inelastic Demand Curve?

A condition in which the quantity demanded does not change as the price changes

33

$40$30

$20

$10

10 20 30 40

Perfectly Inelastic Demand Ed = 0

34

Price change

Zero change in quantity demanded

Perfectly Inelastic Demand

35

If demand is elastic - total revenue goes down

If demand is inelastic - total revenue goes up

If a college raises tuition, what happens to revenue?

36

If price increases and the revenue gained is greater than the revenue lost, the demand curve is price inelastic, < 1

37

If price increases and the revenue gained is less than the revenue lost, the demand curve is price elastic, > 1

38

If total revenue does not change when price increases, the demand curve is unitary elastic, value equals 1

39

$20$15$10$5

5 10 15 20

$25$30$35$40

25 30 35 40 45

Price Elasticity of Demand RangesElastic

Inelastic Unitary

elastic

40

$200$150$100

$50

5 10 15 20

$250$300$350$400

25 30 35 40 45

Total Revenue Curve

Ela

stic Inelastic

Unitary Elastic

41

What factors influence Demand sensitivity?

• Availability of substitutes• Share of budget on the

product• Adjustment to a price

change over time

42

What do Substitutes have to do with a price change?

The more substitutes a product has, the more sensitive consumers are to a price change, and the more elastic the demand curve

43

P

Q0

P

Q0

A B

D D

Which demand curve is for a vital medicine and which is for candy?

44

Why is A the Demand Curve for medicine? Because medicine is a

necessity with few substitutes, and the price can change with little effect on the quantity demanded

45

Why is B the Demand curve for candy?

Because candy has many substitutes, a price change can bring about a big change in the quantity demanded

46

What does the Share of One’s Budget have to do

with a price change?The larger the purchase is to

one’s budget, the more sensitive consumers are to a price change, and the more elastic the demand curve

47

What does Time have to do with sensitivity?

The longer consumers have to adjust, the more sensitive they are to a price change, and the more elastic the demand curve

48

What are other Elasticity measures?

Income elasticity of demandCross-elasticity of demand

49

What is Income Elasticity of Demand?

The ratio of the percentage change in the quantity demanded of a good to a given percentage change in income

50

% in Q demanded% in incomeEd =

Income Elasticity of Demand

51

What is Cross-elasticity of Demand?

The ratio of the percentage change in quantity demanded of a good to a given percentage change in price of another good

52

% Q demanded of good A% price of good BEc =

Cross-elasticity of Demand

53

What is the Price Elasticity of Supply?

The ratio of the percentage change in the quantity supplied of a product to the percentage change in its price

54

% in Q supplied% in priceEs =

Price Elasticity of Supply

55

$40$30

$20

$10

10 20 30 40

Perfectly Elastic Supply =

8

56

$40

$30

$20

$10

10 20 30 40

Perfectly Inelastic Supply Es = 0

57

$40$30

$20

$10

10 20 30 40

Unit Elastic Supply Es = 1

S.5%

.5%

58

Who pays the tax levied on sellers of goods such as gasoline, cigarettes,

and alcoholic beverages?It all depends; the

corporation pays all, some, or very little of the tax

59

What decides who pays what part of the

tax increase?The more elastic the

demand, the more the corporation pays; the less elastic the demand, the more the consumer pays

60

$1.00$.75$.50$.25

5 10 15 20

$1.25$1.50$1.75$2.00

25 30 35 40 45

s1

s2

D

BuyersSellers

Partially shifted tax to buyers

61

Increase in gasoline tax

Decrease in supply

Consumers and suppliers share burden of tax

62

$1.00$.75$.50$.25

5 10 15 20

$1.25$1.50$1.75$2.00

25 3035 40 45

s1

s2

D

Buyers

Fully shifted tax to buyers

63

Increase in gasoline tax

Decrease in supply

Consumers bear full burden of tax

64

Key Concepts

65

Key Concepts• What is Elasticity?

• What is Price Elasticity of Demand?

• What is Elastic Demand?

• What is a Unitary Elastic Demand Curve?

• What is a Perfectly Elastic Demand Curve?

• What is a Perfectly Inelastic Demand Curve?

66

Key Concepts cont.

• What factors influence Demand sensitivity?

• What are other Elasticity measures?

• What is Income Elasticity of Demand?

• What is Cross-elasticity of Demand?

• What is the Price Elasticity of Supply?

67

Summary

68

Price elasticity of demand is a measure of the responsiveness of the quantity demanded to a change in price. Specifically, price elasticity of demand is the ratio of the percentage change in quantity demanded to the percentage change in price.

69

% in Q demanded% in priceEd =

Price Elasticity of Demand

70

What is the midpoint formula for the price elasticity of demand?

71

in quantity demanded

sum of quantities/2

divided by

in price

sum of prices/2

Price elasticity equals the

72

Elastic demand is a change of more than one percent in quantity demanded in response to a one percent change in price. Demand is elastic when the elasticity coefficient is greater than one and total revenue (price time quantity) varies inversely with the direction of the price change.

73

$40$30

$20

$10

10 20 30 40

Elastic Demand

74

Inelastic demand is a change of less than one percent in quantity demanded in response to a one percent change in price. Demand is inelastic when the elasticity coefficient is less than one and total revenue varies directly with the direction of the price change.

75

$40$30

$20

$10

10 20 30 40

Inelastic Demand

76

Unitary elastic demand is a one percent change in quantity demanded in response to a one percent change in price. Demand is unitary elastic when the elasticity coefficient equals one and total revenue remains constant as the price changes.

77

$40$30

$20

$10

10 20 30 40

Unitary elastic Demand

78

Perfectly elastic demand is a decline in quantity demanded to zero for even the slightest rise or fall in price. This is an extreme case in which the demand curve is horizontal and the elasticity coefficient equals infinity.

79

$40$30

$20

$10

10 20 30 40

Perfectly Elastic Supply =

8

80

Perfectly inelastic demand is no change quantity demanded in response to price changes. This is an extreme case in which the the demand curve is vertical and the elasticity coefficient equals zero.

81

$40

$30

$20

$10

10 20 30 40

Perfectly Inelastic Supply Es = 0

82

Determinants of price elasticity of demand include (a) the availability of substitutes, (b) the percentage of budget spent on the product, and (c) the length of time allowed for adjustment. Each of these factors is directly related to the elasticity coefficient.

83

Income elasticity of demand is the percentage change in quantity demanded divided by the percentage change in income. For a normal good or service, income elasticity of demand is positive. For an inferior good or service, income elasticity of demand is negative.

84

Cross elasticity of demand is the percentage change in the quantity demanded of one product caused by a change in the price of another product. When the cross-elasticity of demand is negative, the two products are complements.

85

Price elasticity of supply is a measure of the responsiveness of the quantity demanded to a change in price. Price elasticity of supply is the ratio of the percentage change in quantity supplied to the percentage change in price.

86

Tax incidence is the share of a tax ultimately paid by buyers and sellers. Facing a downward-sloping demand curve and an upward-sloping supply curve, sellers cannot raise the price by the full amount of the tax. If the demand curve is vertical, sellers will raise the price by the full amount of a tax.

87

$1.00$.75$.50$.25

5 10 15 20

$1.25$1.50$1.75$2.00

25 3035 40 45

s1

s2

D

Buyers

Fully shifted tax to buyers

88

$1.00$.75$.50$.25

5 10 15 20

$1.25$1.50$1.75$2.00

25 30 35 40 45

s1

s2

D

BuyersSellers

Partially shifted tax to buyers

89

Chapter 5 Quiz

©2000 South-Western College Publishing

90

1. If an increase in bus fares in Charlotte, North Carolina reduces total revenue of the public transit system, this is evidence that demand is a. price elastic.b. price inelasticc. unitary elasticd. perfectly elastic

A. When price increases and the total revenue decreases, by definition, this represents an elastic demand curve. The revenue lost from selling fewer units is not offset by the revenue gained by charging a higher price.

91

2. Which of the following is the result of an increase in total revenue? a. Price increases when demand is elastic.b. Price decreases when demand is elastic.c. Price increases when demand is unitary

elastic.d. Price decreases when demand is inelastic.

B. When price decreases and the total revenue increases, the revenue gained by the increase in sales more than offsets the revenue lost from the lower price. By definition, this represents an elastic demand curve.

92

3. You are on a committee that is considering ways to raise money for your city’s symphony program. You would recommend increasing the price of symphony tickets only if you thought the demand curve for these tickets wasa. inelastic.b. elastic.c. unitary elastic.d. perfectly elastic.

A. When the demand curve is inelastic, the revenue gained from the higher price more than offsets the revenue lost from the decline in sales.

93

4. The price elasticity of demand for a horizontal demand curve is a. perfectly elastic.b. perfectly inelastic.c. unitary elastic.d. inelastic.e. elastic. A. A perfectly elastic demand curve exists

when any increase in price leads to zero sales. The only curve that would illustrate this would be a horizontal line at the beginning price.

94

5. Suppose the quantity of steak purchased by the Jones family is 110 pounds per year when the price is $2.10 per pound and 90 pounds per year when the price is $3.90 per pound. The price elasticity of demand coefficient for this family isa. 0.33.b. 0.50.c. 1.00.d. 2.00.

A. 20/100 divided by $1.80/$6.00 = .33

95

6. If a 5 percent reduction in the price of a good produces a 3 percent increase in the quantity demanded, the price elasticity of demand over this range of the demand curve isa. elastic.b. perfectly elastic.c. unitary elastic.d. inelastic.e. perfectly inelastic.

D. Since the percentage change in quantity demanded is less than the percentage change in price, this range is defined inelastic

96

7. A manufacturer of Beanie Babies hires an economist to study the price elasticity of demand for this product. The economist estimates that the price elasticity of demand coefficient for a range of prices close to the selling price is greater than 1. The relationship between changes in price and quantity demanded for this segment of the demand curve isa. elastic. e. unitary elastic.b. inelastic.c. perfectly elastic. d. perfectly inelastic.

A. Elasticity > 1 = elastic demand

97

8. A downward-sloping demand curve will have aa. higher price elasticity of demand coefficient

along the top of the demand curve.b. lower price elasticity coefficient along the

top of the demand curve.c. constant price elasticity of demand

coefficient throughout the length of the demand curve.

d. positive slope.A. The quantity demanded by consumers is

more sensitive to a price change at higher prices than at lower prices.

98

9. The price elasticity of demand coefficient for a good will be less a. if there are few or no substitutes available.b. if a small portion of the budget will be

spent on it.c. in the short run than in the long run.d. all of the above are true.

D. A low elasticity of demand means that there is a low sensitivity to a change in price. When the good has few substitutes, or the purchase represents a small portion of one’s budget, or they do not have much time to adjust to the price change, price elasticity of demand is inelastic.

99

10. The income elasticity of demand for shoes is estimated to be 1.50. We can conclude that shoes a. have a relatively steep demand curve.b. have a relatively flat demand curve.c. are a normal good.d. are an inferior good.

C. If the income elasticity coefficient is a positive number, then the good or service is a normal good.

100

11. To determine whether two goods are substitutes or complements, an economist would estimate the a. price elasticity of demand.b. income elasticity of demand.c. cross-elasticity of demand.d. price elasticity of supply.

C. Cross-elasticity of demand shows what will happen to the demand for one good if the price of a complementary good, or a good that is a substitute, changes.

101

12. If the government wanted to raise tax revenue and shift most of the tax burden to the sellers, it would impose a tax on a good with a a. steep (inelastic) demand curve and a steep

(inelastic) supply curve.b. steep (inelastic) demand curve and a flat

(elastic) supply curve.c. flat (elastic) demand curve and a steep

(inelastic) supply curve. d. flat (elastic) demand curve and a flat (elastic)

supply curve.C. An elastic demand curve would mean that a

leftward shift in the supply curve would lead to a big decrease in quantity demanded and little change in price, so the business would lose total revenue.

102

Internet ExercisesClick on the picture of the book,

choose updates by chapter for the latest internet exercises

END