Unlock document.
This document is partially blurred.
Unlock all pages and 1 million more documents.
Get Access
85
WHAT’S NEW IN THE SEVENTH EDITION:
There are no major changes to this chapter.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
the meaning of the elasticity of demand.
what determines the elasticity of demand.
the meaning of the elasticity of supply.
what determines the elasticity of supply.
the market for illegal drugs).
CONTEXT AND PURPOSE:
competitive markets.
The purpose of Chapter 5 is to add precision to the supply-and-demand model. We introduce the
concept of elasticity, which measures the responsiveness of buyers and sellers to changes in economic
variables such as prices and income. The concept of elasticity allows us to make quantitative observations
about the impact of changes in supply and demand on equilibrium prices and quantities.
KEY POINTS:
5
ELASTICITY AND ITS
APPLICATION
86 ❖ Chapter 5/Elasticity and Its Application
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
rather than a necessity, if the market is narrowly defined, or if buyers have substantial time to react
to a price change.
The price elasticity of demand is calculated as the percentage change in quantity demanded divided
by the percentage change in price. If quantity demanded moves proportionately less than the price,
then the elasticity is less than one, and demand is said to be inelastic. If quantity demanded moves
elastic.
Total revenue, the total amount paid for a good, equals the price of the good times the quantity sold.
For inelastic demand curves, total revenue moves in the same direction as the price. For elastic
demand curves, total revenue moves in the opposite direction as the price.
The price elasticity of supply measures how much the quantity supplied responds to changes in the
price. This elasticity often depends on the time horizon under consideration. In most markets, supply
is more elastic in the long run than in the short run.
elastic.
The tools of supply and demand can be applied in many different kinds of markets. This chapter uses
them to analyze the market for wheat, the market for oil, and the market for illegal drugs.
CHAPTER OUTLINE:
I. The Elasticity of Demand
B. The Price Elasticity of Demand and Its Determinants
1. Definition of price elasticity of demand: a measure of how much the quantity
price.
2. Determinants of the Price Elasticity of Demand
a. Availability of Close Substitutes: the more substitutes a good has, the more elastic its
demand.
b. Necessities versus Luxuries: necessities are more price inelastic.
Chapter 5/Elasticity and Its Application ❖ 87
c. Definition of the market: narrowly defined markets (ice cream) have more elastic
demand than broadly defined markets (food).
d. Time Horizon: goods tend to have more elastic demand over longer time horizons.
C. Computing the Price Elasticity of Demand
1. Formula
2. Example: the price of ice cream rises by 10% and quantity demanded falls by 20%.
Price elasticity of demand = (20%)/(10%) = 2
3. Because there is an inverse relationship between price and quantity demanded (the price of
1. Because we use percentage changes in calculating the price elasticity of demand, the
elasticity calculated by going from one point to another on a demand curve will be different
from an elasticity calculated by going from the second point to the first. This difference arises
because the percentage changes are calculated using a different base.
b. Using the midpoint method involves calculating the percentage change in either price or
quantity demanded by dividing the change in the variable by the midpoint between the
initial and final levels rather than by the initial level itself.
% change in price = (6 − 4)/5 × 100 = 40%
% change in quantity demanded = (120 − 80)/100 x 100 = 40%
Work through a few elasticity calculations, starting with the example in the book. For
principles of economics courses where there is no mathematical prerequisite, this
may be difficult for some students. Working through a few simple examples will help
to alleviate some of the students’ anxiety. Show every step of the algebra involved.
Students hate this! Explain that it really makes things easier and makes more sense
because larger elasticities (in absolute value) imply greater sensitivity and
responsiveness.
% change in quantity demanded
Price elasticity of demand = % change in price
88 ❖ Chapter 5/Elasticity and Its Application
price elasticity of demand = 40/40 = 1
E. The Variety of Demand Curves
1. Classification of Elasticity
a. When the price elasticity of demand is greater than one, demand is defined to be elastic.
inelastic.
c. When the price elasticity of demand is equal to one, the demand is said to have unit
elasticity.
( - ) /[( ) / ]
( - ) /[( ) / ]
2 1 1 2
2 1 1 2
2
Price elasticity of demand = 2
Q Q Q Q
P P P P
To clearly show the differences between relatively elastic and relatively inelastic
demand curves, draw a graph on the board showing a relatively flat demand curve
and one showing a relatively steep demand curve. Show that any given change in
price will result in a larger change in quantity demanded if the demand curve is
relatively flat. Use the same method when discussing the shape of the supply curve
later in the chapter.
Activity 1—How the Ball Bounces
Type: In-class demonstration
Topics: Elastic, inelastic
Materials needed: One rubber ball and one “dead” ball. The “dead” ball is made of
shock-absorbing material and doesn’t bounce. Museum stores and
magic shops carry them.
Time: 1 minute
Class limitations: Works in any size class
Purpose
This quick, but memorable, demonstration can be used to introduce the concepts of elastic
Instructions
Bring two students to the front of the class. Give each of them a ball and ask them to bounce
it off the floor and catch it. The student with the rubber ball can do this easily. The student
with the “dead” ball will not be able to bounce it high enough to catch, no matter how hard
he or she throws it.
Explain that one ball is elastic; it is responsive to change. The other ball is inelastic; it
responds very little to change. These physical properties of elastic and inelastic are analogous
to the economic concepts of elastic and inelastic.
Figure 1
Chapter 5/Elasticity and Its Application ❖ 89
2. In general, the flatter the demand curve that passes through a given point, the more elastic
the demand.
3. Extreme Cases
and is a vertical line.
b. When the price elasticity of demand is infinite, the demand is perfectly elastic and is a
horizontal line.
4.
FYI: A Few Elasticities from the Real World
Make sure that you provide several examples of goods with these types of demand
curves. You may want to point out that students will see the perfectly elastic demand
curve again when competitive firms are discussed.
90 ❖ Chapter 5/Elasticity and Its Application
F. Total Revenue and the Price Elasticity of Demand
Activity 2—Ranking Elasticities
Type: In-class assignment
Topics: The determinants of price elasticity of demand
Materials needed: None
Time: 20 minutes
Class limitations: Works in any size class
Purpose
The intent of this exercise is to get students to think about varying degrees of elasticity and
the factors that determine demand elasticity.
Instructions
Give the students the following list of goods. Ask them to rank them from most to least
elastic.
1. beef
2. salt
3. European vacation
4. steak
5. new Honda Accord
6. Dijon mustard
If they have difficulty, these hints can be helpful:
1. How much would a 10% price increase for the good affect a consumer’s total
budget?
2. What substitutes are available for the good?
3. Do consumers think of this good as a necessity or a luxury?
Common Answers and Points for Discussion
A typical ranking:
1. European vacation (luxury, many other vacation destinations, expensive)
2. new Honda Accord (expensive, many substitutes including used cars)
3. steak (perceived luxury, moderate expense, other cuts of beef are close
substitutes)
4. Dijon mustard (perceived luxury, inexpensive, other types of mustard may be
close substitutes)
5. beef (moderate expense, pork and chicken are substitutes)
6. salt (inexpensive, necessity, no close substitutes)
Figure 2
Chapter 5/Elasticity and Its Application ❖ 91
2. If demand is inelastic, the percentage change in price will be greater than the percentage
change in quantity demanded.
a. If price rises, quantity demanded falls, and total revenue will rise (because the increase
in price will be larger than the decrease in quantity demanded).
b. If price falls, quantity demanded rises, and total revenue will fall (because the fall in price
3. If demand is elastic, the percentage change in quantity demanded will be greater than the
percentage change in price.
a. If price rises, quantity demanded falls, and total revenue will fall (because the increase in
b. If price falls, quantity demanded rises, and total revenue will rise (because the fall in
price will be smaller than the increase in quantity demanded).
4. If demand is unit elastic, the percentage change in price will be equal to the percentage
change in quantity demanded.
b. If price falls, quantity demanded rises, and total revenue will remain the same (because
the fall in price will be equal to the increase in quantity demanded).
Another term for price times quantity is “total expenditure.” This term is sometimes
used in questions found in the study guide and test bank. It is also important to
point this out when discussing the market for illegal drugs at the end of the chapter.
Students find the relationship between changes in total revenue and elasticity difficult
to understand. It may take several thorough discussions of this material before
students will be able to master it.
Figure 3
Point out the usefulness of elasticity from a business owner’s point of view. Students
should be able to see why a firm’s manager would want to know the elasticity of
demand for the firm’s products.
92 ❖ Chapter 5/Elasticity and Its Application
1. The slope of a linear demand curve is constant, but the elasticity is not.
a. At points with a low price and a high quantity demanded, demand is inelastic.
2. Total revenue also varies at each point along the demand curve.
H. Other Demand Elasticities
income.
a. Formula
income elasticities.
Figure 4
Note that when demand is elastic and price falls, total revenue rises. Also point out
that once demand is inelastic, any further decrease in price results in a decrease in
total revenue.
% change in quantity demanded
Income elasticity of demand = % change in income
Chapter 5/Elasticity and Its Application ❖ 93
c. Necessities tend to have small income elasticities, while luxuries tend to have large
income elasticities.
a. Formula
price elasticities.
II. The Elasticity of Supply
1. Definition of price elasticity of supply: a measure of how much the quantity
supplied of a good responds to a change in the price of that good, computed as
ALTERNATIVE CLASSROOM EXAMPLE:
John’s income rises from $20,000 to $22,000 and the quantity of hamburger he buys each
week falls from 2 pounds to 1 pound.
% change in quantity demanded = (1−2)/1.5 x 100 = -66.67%
% change in income = (22,000 −20,000)/21,000 x 100 = 9.52%
income elasticity = 66.67%/9.52% = -7.00
Point out that hamburger is an inferior good for John.
% change in quantity demanded of good 1
Cross-price elasticity of demand = % change in price of good 2
ALTERNATIVE CLASSROOM EXAMPLE:
The price of apples rises from $1.00 per pound to $1.50 per pound. As a result, the quantity
of oranges demanded rises from 8,000 per week to 9,500.
% change in quantity of oranges demanded = (9,500 − 8,000)/8,750 x 100 = 17.14%
% change in price of apples = (1.50 − 1.00)/1.25 x 100 = 40%
cross-price elasticity = 17.14%/40% = 0.43
Because the cross-price elasticity is positive, the two goods are substitutes.
Make sure that you explain to students why the signs of the income elasticity and the
cross-price elasticity matter. This will undoubtedly lead to some confusion because
we ignore the sign of the own-price elasticity of demand. You may want to put
together a table to present this distinction to students.
