1. MODULE 47 & 48 : INTERPRETING PRICE ELASTICITY OF DEMAND
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2. Student learning objectives:
The difference between elastic and inelastic demand. The relationship between elasticity and total revenue. Changes in the price elasticity of demand along a demand curve. The factors that determine price elasticity of demand.
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3. Key Economic Concepts For This Module
A price elasticity greater than one is considered elastic; a price elasticity less than one is considered inelastic. A vertical demand curve is perfectly inelastic and the price elasticity is equal to zero. A horizontal demand curve is perfectly elastic and the price elasticity is infinitely large. Total revenue is the product of price and quantity demanded. If total revenue rises when price rises, the price elasticity is inelastic. If total revenue falls when price rises, the price elasticity is elastic. Along a linear demand curve, demand is elastic above the midpoint of that demand curve and inelastic below the midpoint. In general, goods are more price elastic if they have many substitutes, if they are luxuries rather than necessities, if they account for a large share of consumer income, and if consumers have more time to adjust to price changes.
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4. Presentation Format
I. Interpreting the Price Elasticity of Demand A. How Elastic is Elastic? B. Total Revenue and Elasticity C. Elasticity Along the Demand Curve D. What Factors Determine the Price Elasticity of Demand? 1. Whether Close Substitutes are Available 2. Whether the Good is a Luxury or a Necessity 3. Share of Income Spent on the Good 4. Time
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5. I. Interpreting the Price Elasticity of Demand
A price elasticity is a numerical measure, but what does it really tell us? A. How Elastic is Elastic? Responsiveness to price change is what elasticity is. If we are not responsive at all our demand in INELASTIC—Looks like an I
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6. I. Interpreting the Price Elasticity of Demand
What would be the largest response to a price decrease? Consumers immediately increase consumption to an infinitely large amount. If the price increased 1%, and there was an enormous change to quantity demanded, %ΔQd = ∞, so Ed = ∞. This is an extreme case described as “perfectly elastic”. For whatever reason, consumers have an infinitely large response to higher or lower prices. E
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7. I. Interpreting the Price Elasticity of Demand
Some curves will be closer to elastic—relatively elastic
Some curves will be closer to inelastic—relatively inelastic
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8. Duffka School of Economics
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9. Duffka School of Economics
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10. B. Total Revenue and Elasticity
When a firm sells products to consumers, the firm earns something called revenue (P X Q=TR). TR = Price*Quantity Demanded= P*Qd. Suppose firms want to increase TR by increasing the price. What will happen? Quantity demanded will fall. A rising price and a falling quantity demand have competing influences on total revenue. Will TR go up, go down, or stay the same?
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11. B. Total Revenue & Elasticity
Will TR go up, go down, or stay the same? It depends upon which effect, the higher price or the lower quantity, is relatively stronger. We can describe these as a price effect and a quantity effect. o A price effect. After a price increase, each unit sold sells at a higher price, which tends to raise revenue. o A quantity effect. After a price increase, fewer units are sold, which tends to lower revenue. Example Suppose P increases 1%, Qd decreases 5%, a very elastic response. TR will fall, because the downward quantity effect is stronger than the upward price effect. Example Suppose P increases 10%, Qd decreases 5%, an inelastic response. TR will rise, because the downward quantity effect is weaker than the upward price effect. Example Suppose P increases 10%, Qd decreases 10%, a unit elastic response. TR will not change, because the downward quantity effect is equal to the upward price effect
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12. B. Total Revenue & Elasticity
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13. B. Total Revenue & Elasticity
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14. B. Total Revenue & Elasticity
Graphical Example The competing effects on total revenue can also be seen in a graph of the demand for pizza slices at a local pizzeria. Suppose the initial price of pizza slices is equal to $2 and 50 slices are sold every day. This is point A on the demand curve below. TR = P*Qd = $2*50 = $100 and is seen as the TR area of the rectangle below the demand curve.
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15. B. Total Revenue & Elasticity
Now the pizzeria wishes to increase the price of a slice to $3 and estimates that 40 slices will be sold each day. This is point B on the demand curve below. TR = $3*40 = $120 The gain of $20 can be seen through the price and quantity effects. The area labeled L is revenue lost due to the decreased quantity. Ten slices were lost, at $2 each, so area L represents $20 of lost revenue. The area labeled G is revenue gained due to the increased price. Forty slices were sold, at a price $1 higher than before, so area G represents $40 of gained revenue. Area G – Area L = $40 - $20 = $20 total increase from the higher price. If the upward price effect is stronger than the downward quantity effect, demand must be inelastic.
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16. B. Total Revenue & Elasticity
P TR = INELASTIC
P TR = ELASTIC
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17. B. Total Revenue & Elasticity
P TR = INELASTIC
P TR = ELASTIC
As the price rises, initially total revenue rises because of the inelastic response in quantity demand. However, further price increases eventually cause total revenue to decline because of a larger elastic response.
Price elasticity is inelastic at low prices & more elastic at higher prices.
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18. B. Total Revenue & Elasticity
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19. D. What Factors Determine the Price Elasticity of Demand?
1. Substitutes for the product: Generally, the more substitutes, the more elastic the demand. If a product has many substitutes, and the price rises, consumers will have an elastic response because they can easily find alternative products. 2. Whether the product is a luxury or a necessity: Generally, the less necessary the item, the more elastic the demand. In the case of a luxury, if the price increases, consumers will just do without and have an elastic response. 3. Share of income spent on the good: Generally, the larger the expenditure relative to one’s budget, the more elastic the demand, because buyers notice the change in price more. 4. The amount of time involved: Generally, the longer the time period involved, the more elastic the demand becomes.
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20. APE U2 L4 A18 The Determinants of Elasticity of Demand Substitute B No
Suppose we don’t know the precise demand schedule for electricity and there is a 20% increase in the price of KWH of electricity. We know that quantity demanded will decrease, but will it be by less than 20% (inelastic demand), exactly 20% (unit elastic) or more than 20% (elastic demand)?
PART A:
Consider the following representative households in our market for electricity:
HHA: Uses electricity for lighting, appliances and heating.
HHB: Uses electricity for lighting, appliances and heating. Has a heating system that can, with one day’s labor, be switched to burn natural gas.
1. HH _________ will have more elastic demand because of the presence of a _________ good.
2. Because HHA has no available substitutes, should we assume that the quantity demanded of electricity will remain unchanged given the increase in price? __________
Do you think HHA’s response will be elastic or inelastic? __________
3. The least price elastic to the most…Explain
_____ Demand for insulin
_____ Demand for Granny Smith Apples
_____ Demand for running shoes
Rationale: The smaller the # of sub goods, less elastic. Insulin has no sub. Granny Smith apples have more subs than running shoes.
4. To summarize: Demand is (more/less) elastic for goods with many available substitutes. B
Substitute No
Inelastic 1 3 2

21. APE U2 L4 A18 Part B: Consider the following:
HHA: Spends $300/month on electricity. Income is $1200/month
HHB: Spends $300/month on electricity. Income is $3600/month
5. HH _________ will have the more-elastic demand, as the expenditures on this good account for a (smaller/larger) proportion of its income.
6. Illustrate the same concept identified above by placing a 1,2 or 3 by each item denoting the least elastic to the most elastic. Explain.
_______ Demand for chewing gum
_______ Demand for autos
_______ Demand for clothing
Rationale:
To summarize: Goods that command a (small/large) proportion of a consumer’s income tend to be more price elastic. A 1 3 2
Autos take the largest proportion of income, then clothing and gum.

22. APE U2 L4 A18
Part C:
We expect the price elasticity of demand will also vary with the nature of the good being considered. Is it a necessity? A durable good? Are we considering the short run or long run?
8. The price elasticity of demand for cigarettes: A product that is considered to be a necessity will have a relatively price (elastic/inelastic) demand.
9. The price elasticity of demand for autos: In the short run, consumers can postpone the purchase of durable goods, and so such goods will have a relatively price (elastic/inelastic) demand.
10. Briefly summarize how the nature of the good—necessity, durable good or luxury good—and the time frame affect the price elasticity of demand for electricity.
Goods that are necessary are less elastic than goods with many substitutes or that are luxuries. The longer the time frame, the more elastic the demand.

23. APE U2 L4 A18 Part D: Consumer incomes increase by 30%.
11. In measurements of elasticity, if income and quantity demanded move in the opposite direction—that is, if one increases while the other decreases—then the elasticity coefficient will be (positive/negative).
12. Remember that if income increases, the demand for a normal good increases. IF the good is a normal good, income elasticity will be (negative/positive). If it is an inferior good, income elasticity will be (negative/positive).

24. (TR) = price (P) X quantity demanded (Qd)
APE U2 L4 A19
Elasticity and Total Revenue
(TR) = price (P) X quantity demanded (Qd)
The responsiveness of Qd to changes in price will determine whether a price increase leads to an increase or decrease in the total revenue generated.
The law of demand tells us that a price increase (or decrease) will result in a decrease (or increase) in quantity demanded: They move in opposite directions. What happens to TR when price changes is determined by the dominant effect, either the price effect or the quantity effect. In this case, knowing the price elasticity of demand solves the problem.
Ed < % in Qd < % in price The PRICE EFFECT dominates
IF PRICE IS INCREASING (Qd decreases by less), TR will increase.
IF PRICE IS DECREASING (Qd increases by less), TR will decrease.
Ed = % in Qd = % in price Neither effect dominates. TR unchanged
Ed > % in Qd > % in price THE QUANTITY EFFECT dominates.
IF PRICE IS INCREASING (Qd decreases by more), TR will decrease.
IF PRICE IS DECREASING (Qd increases by more), TR will increase.

25. APE U2 L4 A19
1. Price rises from P=$5 to P1=$6, and quantity demanded decreases from Q=15 to Q1=10.
A) The coefficient of elasticity equals ______
B) P X Q = TR
__ X __ __
C) P1 X Q1 = TR1
D) P( / ); TR ( / )
Demand is (elastic/unit elastic/inelastic)
Q 5/12.5
=.4
2.2
=2.2
P 1/5.5
=.18 5 15 75 6 10 60

26. APE U2 L4 A19
2. Price decreases from P=$10 to P1=$9, and quantity demanded increases from Q=100 to Q1=110.
A) The coefficient of elasticity equals ______
B) P X Q = TR
__ X __ __
C) P1 X Q1 = TR1
D) P( / ); TR ( / )
Demand is (elastic/unit elastic/inelastic)
Q 10/105
=.09
.91
=.9
=.10
P 1/9.5 10
100
1000 9
110
990

27. Practice Question # 1. A perfectly elastic demand curve is
a. upward sloping.
b. vertical.
c. not a straight line.
d. horizontal.
e. downward sloping.
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28. Practice Question #
2. Which of the following would cause the demand for a good to be relatively inelastic?
a. The good has a large number of close substitutes.
b. Expenditures on the good represent a large share of consumer income.
c. There is ample time to adjust to price changes.
d. The good is a necessity.
e. The price of the good is in the upper left section of a linear demand curve.
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29. Practice Question #
3. Which of the following is true if the price elasticity of demand for a good is zero?
a. The slope of the demand curve is zero.
b. The slope of the demand curve is one.
c. The demand curve is vertical.
d. The demand curve is horizontal.
e. The price of the good is high.
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30. Practice Question #
4. Which of the following is correct for a price increase? When demand is ________, total revenue will ________
Inelastic decrease
b. Elastic decrease
Unit-elastic increase
Unit-elastic decrease
e. Elastic increase
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31. Practice Question # 5. Total revenue is maximized when demand is
a. elastic.
b. inelastic.
c. unit-elastic.
d. zero.
e. infinite.
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32. Mod 48 Summary Duffka School of Economics
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33. What Factors Determine the Price Elasticity of Supply?
1. What Factors Determine the Price Elasticity of Supply? a. Availability of inputs If a firm can get inputs (labor, capital, raw materials) into and out of production quickly, the Es will be more elastic. b. The time period involved is very important in elasticity of supply • The “market period” is so short that elasticity of supply is inelastic; it could be almost perfectly inelastic or vertical. • The short-run supply elasticity is more elastic than the market period and will depend on the ability of producers to respond to price changes as to how elastic it is. • The long-run supply elasticity is the most elastic, because more adjustments can be made over time and quantity can be changed more relative to a small change in price. Example Agriculture is a great example of the importance of time.
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34. Elasticity of Supply Duffka School of Economics
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35. Main Idea Review
The difference between elastic and inelastic demand. The relationship between elasticity and total revenue. Changes in the price elasticity of demand along a demand curve. The factors that determine price elasticity of demand.
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