1. 4 Prepared by: Fernando Quijano and Yvonn Quijano © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair Elasticity

2. C H A P T E R 4: The Price System, Demand and Supply, and Elasticity © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 2 of 42 Elasticity Elasticity is a general concept that can be used to quantify the response in one variable when another variable changes.

3. C H A P T E R 4: The Price System, Demand and Supply, and Elasticity © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 3 of 42 Price Elasticity of Demand A popular measure of elasticity is price elasticity of demand measures how responsive consumers are to changes in the price of a product.A popular measure of elasticity is price elasticity of demand measures how responsive consumers are to changes in the price of a product. The value of demand elasticity is always negative, but it is stated in absolute terms.

4. C H A P T E R 4: The Price System, Demand and Supply, and Elasticity © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 4 of 42 Types of Elasticity Hypothetical Demand Elasticities for Four Products PRODUCT % CHANGE IN PRICE (%  P) % CHANGE IN QUANTITY DEMANDED (%  Q D ) ELASTICITY (%  Q D d %  P) Insulin+10%0%0.0Perfectly inelastic Basic telephone service+10%-1%-0.1Inelastic Beef+10%-10%Unitarily elastic Bananas+10%-30%-3.0Elastic When the percentage change in quantity demanded is smaller than the percentage change in price, demand for that product is inelastic. When the percentage change in quantity demanded is larger than the percentage change in price, demand for that product is elastic.

5. C H A P T E R 4: The Price System, Demand and Supply, and Elasticity © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 5 of 42 Perfectly Elastic and Perfectly Inelastic Demand Curves When demand does not respond at all to a change in price, demand is perfectly inelastic. Demand is perfectly elastic when quantity demanded drops to zero at the slightest increase in price.

6. C H A P T E R 4: The Price System, Demand and Supply, and Elasticity © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 6 of 42 Calculating Elasticities Calculating percentage changes:

7. C H A P T E R 4: The Price System, Demand and Supply, and Elasticity © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 7 of 42 Calculating Elasticities Elasticity is a ratio of percentages. Using the values on the graph to compute elasticity, using percentage changes yields the following result:

8. C H A P T E R 4: The Price System, Demand and Supply, and Elasticity © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 8 of 42 Calculating Elasticities A more accurate way of computing elasticity than percentage changes is the midpoint formula:

9. C H A P T E R 4: The Price System, Demand and Supply, and Elasticity © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 9 of 42 Calculating Elasticities Here is how to interpret two different values of elasticity: When  = 0.2, a 10% increase in price leads to a 2% decrease in quantity demanded. When  = 2.0, a 10% increase in price leads to a 20% decrease in quantity demanded.

10. C H A P T E R 4: The Price System, Demand and Supply, and Elasticity © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 10 of 42 Elasticity and Total Revenue When demand is inelastic, price and total revenues are directly related. Price increases generate higher revenues. When demand is elastic, price and total revenues are indirectly related. Price increases generate lower revenues. Type of demandValue of E d Change in quantity versus change in price Effect of an increase in price on total revenue Effect of a decrease in price on total revenue ElasticGreater than 1.0 Larger percentage change in quantity Total revenue decreases Total revenue increases InelasticLess than 1.0Smaller percentage change in quantity Total revenue increases Total revenue decreases Unitary elastic Equal to 1.0Same percentage change in quantity and price Total revenue does not change

11. C H A P T E R 4: The Price System, Demand and Supply, and Elasticity © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 11 of 42 Other Important Elasticities Income elasticity of demand – measures the responsiveness of demand to changes in income. Income elasticity of demand is positive for normal goods and negative for inferior goods.

12. C H A P T E R 4: The Price System, Demand and Supply, and Elasticity © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 12 of 42 Other Important Elasticities Cross-price elasticity of demand: A measure of the response of the quantity of one good demanded to a change in the price of another good. Cross-price elasticity of demand is positive for substitutes and negative for complements.

13. C H A P T E R 4: The Price System, Demand and Supply, and Elasticity © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 13 of 42 Other Important Elasticities Elasticity of supply: A measure of the response of quantity of a good supplied to a change in price of that good. Likely to be positive in output markets.