S121 ECO504 BUSINESS ECONOMICS
roy robin 
Session-03-handouts.pdf
1
Elasticity and Its Application
The Elasticity of Supply
• Elastic supply
– Quantity supplied responds substantially
to changes in the price
• Inelastic supply
– Quantity supplied responds only slightly to
changes in the price
The Elasticity of Supply
Determinant of price elasticity of supply
• Time period
• Productive capacity
• The size of the firm/industry
• Mobility of factors of production
• Ease of storing stock/inventory
2
The Elasticity of Supply
• Computing price elasticity of supply
– Percentage change in quantity supplied
divided by percentage change in price
– Always positive
• Midpoint method
– Two points: (Q1, P1) and (Q2, P2)
2 1 2 1
2 1 2 1
2
2 Price elasticity of supply
(Q Q ) / [(Q Q ) / ]
(P P ) / [(P P ) / ]
The Price Elasticity of Supply (a, b)
(a) Perfectly Inelastic Supply:
Elasticity Equals 0
Price
Quantity 0
Supply
100
$5
4
1. An
increase
in price…
2. …leaves
the quantity
supplied
unchanged
(b) Inelastic Supply: Elasticity Is
Less Than 1
Price
Quantity 0
$5
4
1. A 22%
increase
in price…
2. … leads to
a 10% increase
in quantity
supplied
100 110
The price elasticity of supply determines whether the supply curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
Supply
The Price Elasticity of Supply (c)
(c) Unit Elastic Supply: Elasticity Equals 1
Price
Quantity 0
$5
4
1. A 22%
increase
in price…
2. … leads to
a 22% increase
in quantity
supplied
100 125
The price elasticity of supply determines whether the supply curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
Supply
3
The Price Elasticity of Supply (d, e)
The price elasticity of supply determines whether the supply curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
(d) Elastic Supply: Elasticity Is
Greater Than 1
Price
Quantity 0
$5
4
1. A 22%
increase
in price…
2. … leads to
a 67% increase
in quantity
supplied
100 50
(e) Perfectly Elastic Supply:
Elasticity Equals Infinity
Price
Quantity 0
Supply $4
1. At any
price above
$4, quantity
supplied is
infinite
2. At exactly $4,
producers will
supply any quantity
3. At any price
below $4, quantity
supplied is zero
Supply
The Elasticity of Supply
• Supply curve
– Different price elasticities
• Points with low price and low quantity
– Elastic supply
– Capacity for production not being used
• Points with high price and high quantity
– Inelastic supply
How the Price Elasticity of Supply Can Vary
Price
Quantity 0
$15
12
Supply
100 525
Because firms often have a maximum capacity for production, the elasticity of supply may be very
high at low levels of quantity supplied and very low at high levels of quantity supplied. Here an
increase in price from $3 to $4 increases the quantity supplied from 100 to 200. Because the 67%
increase in quantity supplied (computed using the midpoint method) is larger than the 29%
increase in price, the supply curve is elastic in this range. By contrast, when the price rises from
$12 to $15, the quantity supplied rises only from 500 to 525. Because the 5% increase in quantity
supplied is smaller than the 22% increase in price, the supply curve is inelastic in this range.
500 200
4 3
Elasticity is small
(less than 1).
Elasticity is large
(greater than 1).
4
•For use with Business Economics 1e
•By N. Gregory Mankiw, Mark P. Taylor, and Andrew Ashwin
•ISBN: 978-1-4080-6981-3
•© Cengage Learning •10 of 17 •Chapter 5
The total revenue (TR) received by sellers is P x Q, the price
of the good times the quantity of the good sold
The change in TR as one moves along the supply curve
depends on the elasticity of a supply
• If supply is inelastic, then an increase in
the price causes an increase in TR that
is proportionately less than the price
change
• If the supply is elastic, then an increase
in price leads to a much greater
increase in TR
The Elasticity of Demand
• Elasticity
– Measure of the responsiveness of quantity
demanded or quantity supplied
– To a change in one of its determinants
• Price elasticity of demand
– How much the quantity demanded of a
good responds to a change in the price of
that good
The Elasticity of Demand
• Price elasticity of demand
– Percentage change in quantity demanded
divided by the percentage change in price
• Elastic demand
– Quantity demanded responds
substantially to changes in price
• Inelastic demand
– Quantity demanded responds only slightly
to changes in price
5
The Elasticity of Demand
• Determinants of price elasticity of demand
– Availability of close substitutes
• Goods with close substitutes: more elastic
demand
– Necessities vs. luxuries
• Necessities: inelastic demand
• Luxuries: elastic demand
The Elasticity of Demand
• Determinants of price elasticity of demand
– Definition of the market
• Narrowly defined markets: more elastic
demand
– Time horizon
• Demand is more elastic over longer time
horizons
– Proportion of income devoted to the
product
• Demand is more elastic for goods that take
up a higher proportion of our income
The Elasticity of Demand
• Computing the price elasticity of demand
– Percentage change in quantity demanded
divided by percentage change in price
– Use absolute value (drop the minus sign)
• Midpoint method
– Two points: (Q1, P1) and (Q2, P2)
])/P)/[(PP(P
])/Q)/[(QQ(Q
2
2
1212
1212
demand of elasticity Price
6
The Price Elasticity of Demand (a, b)
(a) Perfectly Inelastic Demand:
Elasticity Equals 0
Price
Quantity 0
Demand
100
$5
4
1. An
increase in
price…
2. …leaves
the quantity
demanded
unchanged
(b) Inelastic Demand: Elasticity Is
Less Than 1
Price
Quantity 0
$5
4
1. A 22%
increase
in price…
2. … leads
to an 11%
decrease in
quantity
demanded
Demand
100 90
The price elasticity of demand determines whether the demand curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
The Price Elasticity of Demand (c)
(c) Unit Elastic Demand: Elasticity Equals 1
Price
Quantity 0
$5
4 1. A 22%
increase
in price… 2. … leads to a 22%
decrease in quantity
demanded
Demand
100 80
The price elasticity of demand determines whether the demand curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
The Price Elasticity of Demand (d, e)
(d) Elastic demand:
Elasticity > 1
Price
Quantity 0
$5
4
A 22%
increase
in price…
2. … leads to a
67% decrease
in quantity
demanded
Demand
100 50
The price elasticity of demand determines whether the demand curve is steep or flat.
Note that all percentage changes are calculated using the midpoint method.
(e) Perfectly elastic demand:
Elasticity equals infinity
Price
Quantity 0
Demand $4
1. At any price
above $4, quantity
demanded is zero 2. At exactly $4,
consumers will
buy any quantity
3. At a price
below $4, quantity
demanded is infinite
7
The Elasticity of Demand
• Total revenue, TR
– Amount paid by buyers and received by
sellers of a good
– Price of the good times the quantity sold
(P ˣ Q)
• For a price increase
– If demand is inelastic, TR increases
– If demand is elastic, TR decreases
Total Revenue
P
Q
P ˣ Q=$400
(revenue)
Quantity 0
Demand
Price
The total amount paid by buyers, and received as revenue by sellers, equals the area
of the box under the demand curve, P × Q. Here, at a price of $4, the quantity
demanded is 100, and total revenue is $400.
100
$4
How Total Revenue Changes When Price Changes (a)
(a) The Case of Inelastic Demand
Price
Demand
100
The impact of a price change on total revenue (the product of price and quantity) depends on
the elasticity of demand. In panel (a), the demand curve is inelastic. In this case, an increase in
the price leads to a decrease in quantity demanded that is proportionately smaller, so total
revenue increases. Here an increase in the price from $4 to $5 causes the quantity demanded to
fall from 100 to 90. Total revenue rises from $400 to $450.
Quantity 0 90
4
$5 A
B
1. When the demand
curve is inelastic . . .
3. . . . is greater than
the lost revenue from
selling fewer units.
2. . . . the extra
revenue from
selling at a
higher price . . .
8
How Total Revenue Changes When Price Changes (b)
The impact of a price change on total revenue (the product of price and quantity) depends on
the elasticity of demand. In panel (b), the demand curve is elastic. In this case, an increase in
the price leads to a decrease in quantity demanded that is proportionately larger, so total
revenue decreases. Here an increase in the price from $4 to $5 causes the quantity demanded
to fall from 100 to 70. Total revenue falls from $400 to $350.
(b) The Case of Elastic Demand
Price
$5
Demand
Quantity 0 100 70
4 A
B
1. When the demand
curve is elastic . . .
3. . . . is less
than the lost
revenue from
selling fewer
units.
2. . . . the extra
revenue from
selling at a
higher price . . .
The Elasticity of Demand
• When demand is inelastic (elasticity < 1)
– P and TR move in the same direction
• If P ↑, TR also ↑
• When demand is elastic (elasticity > 1)
– P and TR move in opposite directions
• If P ↑, TR ↓
• If demand is unit elastic (elasticity = 1)
– Total revenue remains constant when the
price changes
The Elasticity of Demand
• Linear demand curve
– Constant slope
• Rise over run
– Different price elasticities
• Points with low price and high quantity
– Inelastic demand
• Points with high price and low quantity
– Elastic demand
9
Elasticity of a Linear Demand Curve (graph)
1. an
Quantity 0
Price
Demand
$7
14
6
5
4
3
2
1
2 4 6 8 10 12
Elasticity is larger
than 1
Elasticity is
smaller than 1
The slope of a linear demand curve is constant, but its elasticity is not. The demand
schedule in the table was used to calculate the price elasticity of demand by the
midpoint method. At points with a low price and high quantity, the demand curve is
inelastic. At points with a high price and low quantity, the demand curve is elastic.
Elasticity=1
The Elasticity of Demand
• Income elasticity of demand
– How much the quantity demanded of a
good responds to a change in consumers’
income
– Percentage change in quantity demanded
• Divided by the percentage change in income
The Elasticity of Demand
• Normal goods
– Positive income elasticity
– Necessities
• Smaller income elasticities
– Luxuries
• Large income elasticities
• Inferior goods
– Negative income elasticities
10
The Elasticity of Demand
• Cross-price elasticity of demand
– How much the quantity demanded of one
good responds to a change in the price of
another good
– Percentage change in quantity demanded
of the first good (Good X)
• Divided by the percentage change in price of
the second good (Good Y)
Applications
• Can Good News for Farming Be Bad
News for Farmers?
– New hybrid of wheat – increase
production per acre 20%
• Supply curve shifts to the right
• Higher quantity and lower price
• Demand is inelastic: total revenue falls
An Increase in Supply in the Market for Wheat
S1
S2
When an advance in farm technology increases the supply of wheat from S1 to S2, the
price of wheat falls. Because the demand for wheat is inelastic, the increase in the
quantity sold from 100 to 110 is proportionately smaller than the decrease in the price
from $3 to $2. As a result, farmers’ total revenue falls from $300 ($3 × 100) to $220
($2 × 110).
Price of
Wheat
Quantity of Wheat 0 110
$3
2
100
Demand
1. When demand is inelastic,
an increase in supply . . .
2. … leads
to a large fall
in price. . . 3. … and a proportionately
smaller increase in quantity
sold. As a result, revenue falls
from $300 to $220.
11
Applications
• Can Good News for Farming Be Bad
News for Farmers?
– Paradox of public policy
• Induce farmers not to plant crops
