1. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/eO’Sullivan/Sheffrin Prepared by: Fernando Quijano and Yvonn Quijano CHAPTERCHAPTER 5 Elasticity: A Measure of Responsiveness

2. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Elasticity: A Measure of Responsiveness Price elasticity of demand: A measure of the responsiveness of the quantity demanded to changes in price; computed by dividing the percentage change in quantity demanded by the percentage change in price.Price elasticity of demand: A measure of the responsiveness of the quantity demanded to changes in price; computed by dividing the percentage change in quantity demanded by the percentage change in price.

3. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Elasticity: A Measure of Responsiveness Price elasticity of supply: A measure of the responsiveness of the quantity supplied to changes in price; computed by dividing the percentage change in quantity supplied by the percentage change in price.Price elasticity of supply: A measure of the responsiveness of the quantity supplied to changes in price; computed by dividing the percentage change in quantity supplied by the percentage change in price.

4. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Price Elasticity of Demand

5. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Market Demand Curve and Price Elasticity of Demand A 10% rise in the price of milk (from $2 to $2.20) decreases the quantity demanded by 15% (from 100 to 85), so the price elasticity of demand is 1.50 = 15%/10%.A 10% rise in the price of milk (from $2 to $2.20) decreases the quantity demanded by 15% (from 100 to 85), so the price elasticity of demand is 1.50 = 15%/10%.

6. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Price Elasticity of Demand Elastic Demand: The price elasticity is greater than one.Elastic Demand: The price elasticity is greater than one. Inelastic Demand: The price elasticity of demand is less than one.Inelastic Demand: The price elasticity of demand is less than one. Unitary Elasticity: The price elasticity of demand equals one.Unitary Elasticity: The price elasticity of demand equals one.

7. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Elasticity and Substitutes

8. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Price Elasticities of Demand for Selected Products Product Price Elasticity of Demand Salt0.1 Water0.2 Coffee0.3 Cigarettes0.3 Shoes and footwear 0.7 Housing1.0 Automobiles1.2 Foreign travel 1.8 Restaurant meals 2.3 Air travel 2.4 Motion pictures 3.7 Specific brands of coffee 5.6

9. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Other Determinants of Elasticity Time.Time. Importance in budget.Importance in budget. Necessities versus luxuries.Necessities versus luxuries.

10. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Elasticity Along a Linear Demand Curve The price elasticity of demand decreases as we move downward along a linear demand curve. Demand is elastic on the upper half of the demand curve and inelastic on the lower half.The price elasticity of demand decreases as we move downward along a linear demand curve. Demand is elastic on the upper half of the demand curve and inelastic on the lower half. Percentage decrease in price Percentage increase in quantity Elasticity Point r to point s 4/80 = 5% 2/10 = 20% 20%/5% = 4.0 Point v to point w 4/20 = 20% 2/40 = 5% 5%/20% = 0.25

11. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Extreme Cases: Perfectly Inelastic Demand and Perfectly Elastic Demand When demand is perfectly inelastic, the quantity demanded is the same at every price, so the price elasticity of demand is zero.When demand is perfectly inelastic, the quantity demanded is the same at every price, so the price elasticity of demand is zero.

12. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Extreme Cases: Perfectly Inelastic Demand and Perfectly Elastic Demand When demand is perfectly elastic, the quantity demanded is infinitely responsive to changes in price, so the price elasticity of demand is infinite.When demand is perfectly elastic, the quantity demanded is infinitely responsive to changes in price, so the price elasticity of demand is infinite.

13. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Using the Midpoint Formula to Compute Price Elasticity The percentage change in price equals the change (0.20) divided by the average price ($2.10), or 9.52%:The percentage change in price equals the change (0.20) divided by the average price ($2.10), or 9.52%:

14. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Using the Midpoint Formula to Compute Price Elasticity The percentage change in quantity equals the change (-15) divided by the average quantity (92.5), or -16.22%:The percentage change in quantity equals the change (-15) divided by the average quantity (92.5), or -16.22%:

15. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Using the Midpoint Formula to Compute Price Elasticity If we plug these percentage changes into the formula for the price elasticity of demand, the computed price elasticity is 1.70:If we plug these percentage changes into the formula for the price elasticity of demand, the computed price elasticity is 1.70:

16. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Predicting Changes in Quantity Demanded The formula for elasticity has three variables:The formula for elasticity has three variables: If we know two of the three variables in the formula for elasticity, we can compute the third. If we know two of the three variables in the formula for elasticity, we can compute the third. If the elasticity of demand is 2.0, a 15% price hike will decrease the quantity demanded by 30%: If the elasticity of demand is 2.0, a 15% price hike will decrease the quantity demanded by 30%:

17. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Predicting Changes in Total Revenue Price and Total Revenue with Elastic Demand Price Quantity of Tickets Sold Total Revenue 4.00100$400 4.4080$352

18. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Elasticity and Total Revenue Type of Demand Value of Price Elasticity of Demand Change in Quantity Versus Change in Price Effect of Higher Price on Total Revenue Effect of Lower Price on Total Revenue ElasticGreater than 1.0Larger percentage change in quantity DecreasesIncreases InelasticLess than 1.0Smaller percentage change in quantity IncreasesDecreases Unitary elastic1.0Same percentage changes in quantity and price Does not change

19. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Elasticity and Total Revenue Demand is elastic along the upper half of a linear demand curve, so a decrease in price increases total revenue.Demand is elastic along the upper half of a linear demand curve, so a decrease in price increases total revenue.

20. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Elasticity and Total Revenue Demand is inelastic along the lower half of a linear demand curve, so a decrease in price decreases total revenue.Demand is inelastic along the lower half of a linear demand curve, so a decrease in price decreases total revenue. Total revenue reaches its maximum at the midpoint of the demand curve, where demand is unitary elastic.Total revenue reaches its maximum at the midpoint of the demand curve, where demand is unitary elastic.

21. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Other Elasticities of Demand Income elasticity of demand: A measure of the responsiveness of the quantity demanded to changes in consumer income.Income elasticity of demand: A measure of the responsiveness of the quantity demanded to changes in consumer income.

22. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Other Elasticities of Demand Cross elasticity of demand: A measure of the responsiveness of the quantity demanded to changes in the price of a related good.Cross elasticity of demand: A measure of the responsiveness of the quantity demanded to changes in the price of a related good.

23. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Price Elasticity of Supply

24. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Market Supply Curve and Price Elasticity of Supply A 10% increase in the price of milk (from $2 to $2.20) increases the quantity supplied by 20% (from 100 million gallons to 120 million), so the price elasticity of supply is 2.0 = 20%/10%.A 10% increase in the price of milk (from $2 to $2.20) increases the quantity supplied by 20% (from 100 million gallons to 120 million), so the price elasticity of supply is 2.0 = 20%/10%.

25. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Extreme Cases: Perfectly Inelastic Supply and Perfectly Elastic Supply When supply is perfectly inelastic, the quantity supplied is the same at every price, so the price elasticity of supply is zero.When supply is perfectly inelastic, the quantity supplied is the same at every price, so the price elasticity of supply is zero.

26. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Extreme Cases: Perfectly Inelastic Supply and Perfectly Elastic Supply When supply is perfectly elastic, the quantity supplied is infinitely responsive to changes in price, so the price elasticity of supply is infinite.When supply is perfectly elastic, the quantity supplied is infinitely responsive to changes in price, so the price elasticity of supply is infinite.

27. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Predicting Price Changes Using Price Elasticities Price-change formula: A formula that shows the percentage change in equilibrium price resulting from a change in demand or supply, given values for the price elasticity of supply and price elasticity of demand.Price-change formula: A formula that shows the percentage change in equilibrium price resulting from a change in demand or supply, given values for the price elasticity of supply and price elasticity of demand.

28. © 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Increase in Demand Increases the Equilibrium Price An increase in demand shifts the demand curve to the right, increasing the equilibrium price. In this case, a 35% increase in demand increases the price by 10%.An increase in demand shifts the demand curve to the right, increasing the equilibrium price. In this case, a 35% increase in demand increases the price by 10%.