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CHAPTER
6
E
LASTICITIES
6.1
Price Elasticity of Demand
6.3
Other Types of Demand Elasticities
6.2
Total Revenue and the Price Elasticity
of Demand
6.4
Price Elasticity of Supply
I
n the last two chapters, we introduced supply and
demand. In competitive markets, such as agricul-
tural markets, we know that the supply curve rep-
resents the behavior of many sellers and the
demand curve represents the behavior of many
buyers. And the price of the good (when there are
no price controls) brings the quantity demanded in
line with the quantity supplied. However, by adding
another concept, elasticity, we can study the impact
of supply and demand more precisely. For example, if
a rock group increases the price it charges for concert
tickets, what impact would that have on ticket sales?
More precisely, would ticket sales fall a little or a lot?
Will the group make more money by lowering the
price or by raising the price? This chapter will allow
you to answer these types of questions and more.
Some of the results in this chapter may surprise
you. A huge flood in the Midwest that destroyed
much of this year’s wheat crop would leave some
wheat farmers better off. Ideal weather that led to
a bountiful crop of wheat everywhere might leave
most wheat farmers worse off. As you will soon find
out, these issues hinge importantly on the tools of
elasticity.
In this chapter, we will also see the impor-
tance of elasticity in determining the effects of
taxes. If a tax is levied on the seller, will the seller
pay all of the taxes? If the tax were levied on the
buyer—who pays the larger share of taxes? We will
see that elasticity is critical in the determination of
tax burden. Elasticities will also help us to more
fully understand many policy issues—from illegal
drugs to luxury taxes. If Congress were to impose a
large tax on yachts, what do you think would
happen to yacht sales? What would happen to
employment in the boat industry?
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Fundamentals II
MODULE 2
SECTION
6.1
Price Elasticity of Demand
What is price elasticity of demand?
What determines the price elasticity of
demand?
How do we measure consumers’ responses
to price changes?
In learning and applying the law of demand, we have
established the basic fact that quantity demanded
changes inversely with change in price,
ceteris
paribus.
But how much does quantity demanded
change? The extent to which a change in price affects
quantity demanded may vary considerably from
product to product and
over the various price
ranges for the same
product. The
price
elasticity of demand
measures the respon-
siveness of quantity
demanded to a change
in price. Specifically,
price elasticity is defined as the percentage change in
quantity demanded divided by the percentage change
in price, or
%
%
∆
∆
Q
P
50
10
%
%
D
E
=
=
=
5
D
Demand is elastic in this case because a 10 percent
change in price led to a larger (50 percent) change in
quantity demanded.
Alternatively, if a 10 percent increase in the price
leads to a 1 percent reduction in quantity demanded, we
say that demand is
inelastic
because the quantity
demanded did not respond much to the price reduction.
price elasticity
of demand
the measure of the responsiveness
of quantity demanded to a change
in price
%
%
∆
∆
Q
P
1
10
%
%
D
E
=
=
=
.
10
D
Demand is inelastic in this case because a 10 percent
change in price led to a smaller (1 percent) change in
quantity demanded.
TYPES OF DEMAND CURVES
Economists refer to a variety of demand curves based
on the magnitude of their elasticity. A demand curve,
or a portion of a demand curve, can be elastic, inelas-
tic, or unit elastic.
Demand is
elastic
when the elasticity is greater
than 1 (
E
D
>
Percentage ch
ange in
quantity demanded
Percentage change
innprice
Price elasticity
of demand E
(
=
Note that, following the law of demand, price and
quantity demanded show an inverse relationship. For
this reason, the price elasticity of demand is, in theory,
always negative. But in practice and for simplicity,
this quantity is always expressed in absolute value
terms—that is, as a positive number.
1)—the quantity demanded changes pro-
portionally more than the price changes. In this case,
a given percentage increase in price, say 10 percent, leads
to a larger percentage change in quantity demanded, say
20 percent, as seen in
Exhibit 1(a). If the curve
is
perfectly elastic,
the
demand curve is hori-
zontal. The elasticity
coefficient is infinity
because even the slight-
est change in price will
lead to a huge change in
quantity demanded—for
example, a tiny increase
in price will cause the
quantity demanded to fall to zero. In Exhibit 1(b), a
per-
fectly elastic
demand curve (horizontal) is illustrated.
Demand is
inelastic
when the elasticity is less than
1; the quantity demanded changes proportionally less
than the price changes. In this case, a given percentage
elastic
when the quantity demanded is
greater than the percentage change
in price (E
D
>
IS THE DEMAND CURVE ELASTIC OR INELASTIC?
It is important to understand the basic intuition
behind elasticities, which requires a focus on the per-
centage changes in quantity demanded and price.
Think of elasticity as an elastic rubber band. If the
quantity demanded is responsive to even a small
change in price, we call it elastic. On the other hand, if
even a huge change in price results in only a small
change in quantity demanded, then the demand is said
to be inelastic. For example, if a 10 percent increase in
the price leads to a 50 percent reduction in the quantity
demanded, we say that demand is elastic because the
quantity demanded is sensitive to the price change.
1)
inelastic
when the quantity demanded is less
than the percentage change in price
(E
D
<
1)
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Elasticities
CHAPTER 6
SECTION
6.1
E
XHIBIT
1
Elastic Demand
a. Elastic Demand (
E
D
>
1)
b. Perfectly Elastic Demand (
E
D
=Ç
)
%
Q
D
.20
E
D
2
%
P
.10
P
1
Demand
P
2
10%
P
P
1
Demand
20%
Q
D
0
0
Q
2
Q
1
Quantity
Quantity
A small percentage change in price leads to a larger
percentage change in quantity demanded.
A small percentage change in price will change
quantity demanded by an infinite amount.
SECTION
6.1
E
XHIBIT
2
Inelastic Demand
a. Inelastic Demand (
E
D
<
1)
b. Perfectly Inelastic Demand (
E
D
=0
)
P
2
Demand
%
Q
D
%
P
.05
E
D
.5
P
2
10%
∆
P
.10
P
1
20%
P
P
1
5%
Demand
Q
D
0
0
Q
1
Q
2
Q
2
Q
1
Quantity
Quantity
A change in price leads to a smaller percentage
change in quantity demanded.
The quantity demanded does not change regardless
of the percentage change in price.
(for example, 10 percent) change in price is accompa-
nied by a smaller (for example, 5 percent) reduction
in quantity demanded, as seen in Exhibit 2(a). If the
demand curve is
perfectly inelastic,
the quantity
demanded is the same regardless of the price. The
elasticity coefficient is zero because the quantity
demanded does not respond to a change in price. This
relationship is illustrated in Exhibit 2(b).
Goods for which
E
D
equals one (
E
D
=
will lead to a 10 per-
cent reduction in quan-
tity demanded. This
relationship is illus-
trated in Exhibit 3.
The price elasticity
of demand is closely
related to the slope of
the demand curve. Generally speaking, the flatter the
demand curve passing through a given point, the more
elastic the demand. The steeper the demand curve pass-
ing through a given point, the less elastic the demand.
unit elastic demand
demand with a price elasticity of 1;
the percentage change in quantity
demanded is equal to the percent-
age change in price
1) are said
to have
unit elastic demand.
In this case, the quan-
tity demanded changes proportionately to price
changes. For example, a 10 percent increase in price
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Fundamentals II
MODULE 2
quantity demanded, and a higher price will reduce
quantity demanded. But what factors will influence
the magnitude of the change in quantity demanded in
response to a price change? That is, what will make
the demand curve relatively more elastic (where
Q
D
is
responsive to price changes), and what will make the
demand curve relatively less elastic (where
Q
D
is less
responsive to price changes)?
For the most part, the price elasticity of demand
depends on three factors: (1) the availability of close
substitutes, (2) the proportion of income spent on the
good, and (3) the amount of time that has elapsed
since the price change.
Availability of Close Substitutes
Goods
with
close substitutes tend to have more elas-
tic demands. Why? Because if the price of such a good
increases, consumers can easily switch to other now
relatively lower priced substitutes. In many examples,
such as one brand of root beer as opposed to another,
or different brands of gasoline, the ease of substitu-
tion will make demand quite elastic for most individ-
uals. Goods
without
close substitutes, such as insulin
for diabetics, cigarettes for chain smokers, heroin for
addicts, or emergency medical care for those with
appendicitis or broken legs, tend to have inelastic
demands. The demand for an antivenom shot after a
rattle snake bite is another example. Once bitten, that
demand curve becomes extremely inelastic.
The degree of substitutability can also depend on
whether the good is a necessity or a luxury. Goods that
are necessities, such as food, have no ready substitutes
If bus fares increase, will ridership fall a little or a lot? It all
depends on the price elasticity of demand. If the price elastic-
ity of demand is elastic, a 50-cent price increase will lead to a
relatively large reduction in bus travel as riders find viable
substitutes. If the price elasticity of demand is inelastic, a 50-
cent price increase will lead to a relatively small reduction in
bus ridership as riders are not able to find good alternatives to
bus transportation.
SECTION
6.1
E
XHIBIT
3
Unit Elastic Demand
P
2
%
Q
D
%
P
.10
E
D
1
10%
P
.10
P
1
D
10%
Q
D
0
Q
2
Q
1
Quantity
The percentage change in quantity demanded is the
same as the percentage change in price that caused
it (
E
D
=
1).
Unlike most tangible items (such as specific types of food or
cars), there are few substitutes for a physician and medical
care when you have an emergency. Because the number of
available substitutes is limited, the demand for emergency
medical care is relatively inelastic.
THE DETERMINANTS OF THE PRICE
ELASTICITY OF DEMAND
As you have learned, the elasticity of demand for a
specific good refers to movements along its demand
curve as its price changes. A lower price will increase
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Elasticities
CHAPTER 6
and thus tend to have lower elasticities than do luxury
items, such as jewelry.
When the good is broadly defined, it tends to be less
elastic than when it is narrowly defined. For example,
the elasticity of demand for food, a broad category,
tends to be inelastic because few substitutes are avail-
able for food. But for a certain type of food, such as
pizza, a narrowly defined good, it is much easier to find
a substitute—perhaps tacos, burgers, salads, burritos, or
chili fries. That is, the demand for a particular type of
food is more elastic because more and better substitutes
are available than for food as an entire category.
Short-Run and Long-Run
Demand Curves
SECTION
6.1
E
XHIBIT
4
P
2
P
1
D
LR
D
SR
0
Proportion of Income Spent on the Good
The smaller the proportion of income spent on a
good, the lower its elasticity of demand. If the amount
spent on a good relative to income is small, then the
impact of a change in its price on one’s budget will
also be small. As a result, consumers will respond less
to price changes for these goods than for similar per-
centage changes in large-ticket items, where a price
change could potentially have a large impact on the
consumer’s budget. For example, a 50 percent
increase in the price of salt will have a much smaller
impact on consumers’ behavior than a similar per-
centage increase in the price of a new automobile.
Q
LR
Q
SR
Q
1
Quantity of Gasoline
For many goods, such as gasoline, price is much more
elastic in the long run than in the short run because
buyers have more time to find suitable substitutes or
change their consumption patterns. In the short run,
the increase in price from
P
1
to
P
2
has only a small
effect on the quantity demanded for gasoline. In the
long run, the effect of the price increase will be much
larger.
in the news
Teen Smoking: Price Matters
What’s the best way to curb teen smoking? Raise taxes on cigarettes. So says
a new National Bureau of Economic Research study that explores the reasons
behind the jump in teen smoking in the 1990s. Teen smoking declined in the
1980s. But from 1991 through 1997, the rate of smoking among teenagers rose
by a third. The NBER study, by Jonathan Gruber of the economics department
of Massachusetts Institute of Technology, shows the sharp reduction in the
retail price of cigarettes in the early 1990s accounts for roughly 30 percent of
the increase in teen smoking in the years that followed.
The impact of higher prices varies by socioeconomic status. Both African
American teens and those with less-educated parents are more sensitive to
the price of cigarettes than are white youths and those with more educated
parents, according to the study.
Gruber also finds “some evidence” to indicate that limiting teen access
to cigarettes reduces smoking, but the cost of tobacco plays a greater role. In
addition, he says, no “consistent evidence” indicates that rules against smok-
ing in public places reduce the rate of teen smoking.
CONSIDER THIS:
Some studies show that a 10 percent increase in the price of cigarettes will
lead to a 7 percent reduction in youth smoking. In this price range, how-
ever, demand is still inelastic at
0.7. Of course, proponents of higher
taxes to discourage underage smoking would like to see a more elastic
demand, where a 10 percent increase in the price of cigarettes would lead
to a reduction in quantity demanded of more than 10 percent.
−
SOURCE:
Businessweek Online,
March 6, 2000, http://www.businessweek.com.
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