Chapter 6/Demand and Elasticity
CHAPTER 6
DEMAND AND ELASTICITY
The principal subject of the chapter is the price elasticity of demand, introduced first by
considering a problem: Will taxing cigarettes make teenagers stop smoking? By the end of the
chapter this problem turns out to be understandable. Elasticity is defined and calculated, and the
determinants of elasticity are discussed.
CHAPTER OUTLINE
ELASTICITY: THE MEASURE OF RESPONSIVENESS
The price elasticity of demand is the percentage change in quantity divided by the percentage
change in price.
The percentages are calculated in terms of the averages of the prices and quantities, and the
minus sign is dropped.
Price Elasticity of Demand and the Shapes of Demand Curves
A horizontal curve has infinite elasticity (e.g., perfectly elastic).
PRICE ELASTICITY OF DEMAND: ITS EFFECT ON TOTAL REVENUE
AND TOTAL EXPENDITURE
When the demand curve is inelastic, a price increase will yield an increase in revenue.
WHAT DETERMINES DEMAND ELASTICITY?
Elasticity is influenced by:
1. the nature of the good (necessity vs. luxury)
2. the availability of close substitutes (narrowly vs. broadly defined commodities)
Chapter 6/Demand and Elasticity
ELASTICITY AS A GENERAL CONCEPT
Elasticity can be used to measure the responsiveness of any economic variable to another
economic variable.
The income elasticity of demand is the ratio of the percentage change in quantity demanded
to the percentage change in income.
THE TIME PERIOD OF THE DEMAND CURVE AND DECISION
MAKING
The demand curve shows the quantity bought at different hypothetical prices, during the
same time period, not the quantity actually bought at different prices at different times.
REAL-WORLD APPLICATION: POLAROID VERSUS KODAK
In the 1989 case of Polaroid versus Kodak, both price elasticity of demand and cross price
elasticity of demand played crucial roles in determining the damages that Kodak would pay
to Polaroid.
The court used price elasticity of demand to determine to what degree the growth in instant
APPENDIX: HOW CAN WE FIND A LEGITIMATE DEMAND CURVE
FROM HISTORICAL STATISTICS?
Because we usually only observe historical price-quantity combinations in the real world, it
is often difficult to distinguish between movement along a demand curve and shifting demand
curves.
Prices and quantities observed in the real world, at different times, may result from shifting
Chapter 6/Demand and Elasticity
MARGIN DEFINITIONS
(Price) Elasticity of Demand: the ratio of the percentage change in quantity demanded to the
percentage change in price.
Elastic Demand: a given percentage change in price leads to a larger percentage change in
quantity demanded.
Inelastic Demand: a given percentage change in price leads to a smaller percentage change in
quantity demanded.
Unit-Elastic Demand: a given percentage change in price leads to the same percentage change
in quantity demanded.
MAJOR IDEAS
1. The price elasticity of demand is the percentage change in quantity divided by the
percentage change in price.
2. The effect of a price change on revenue depends upon the price elasticity of demand.
ON TEACHING THE CHAPTER
This material can easily get abstract and technical, and the students may drift off. So it is useful
to think of ways of making the subject immediate.
One might begin the discussion of elasticity, for example, without any numbers, formulas, or
diagrams, but with just the idea of responsiveness. Elasticity is simply a measure of
Chapter 6/Demand and Elasticity
change in energy prices and conservation. In fact, throughout the presentation of all the topics in
this chapter, it is fun—and almost essential—to use examples.
There are many examples to which students can easily relate. One example is to observe
people’s behavior at an all-you-can-eat buffet. Because of the low marginal cost (each trip is
essentially free after the “admission fee” has been paid) people often overeat, sometimes to the
point of being uncomfortable. Another similar example is the “Happy Hour” promotion at many
PROBLEMS
1. The demand and supply schedules for simple calculators and for T-shirts are as follows:
Calculators T-shirts
Price Demand Supply Demand Supply
$16 600 800 400 800
15 625 775 475 775
14 650 750 550 750
13 675 725 625 725
12 700 700 700 700
11 725 675 775 675
10 750 650 850 650
9 775 625 925 625
8 800 600 1000 600
a) What are the equilibrium prices and quantities in the two markets? Draw supply and
demand curve diagrams showing this.
b) How does revenue change in the two markets, as the price rises in $1 increments from
$8 to $16?
c) What do you learn about the price elasticity of demand in the two markets from your
calculations in b)? Confirm this by calculating and comparing the elasticities in the
two markets for two different price changes of $1 each.
Solution:
a) Equilibrium price and quantity supplied in the two markets are $12 and 700 units,
respectively.
Chapter 6/Demand and Elasticity
2. An excise tax of $4 per unit is now imposed on calculators and T-shirts, the markets for
which were described in Problem 1.
a) Add columns to the table, and lines to the diagrams, to show how the tax is
represented.
b) What are the new equilibrium prices and quantities in the two markets?
c) Compare the tax revenues obtained from the two markets. How does the difference in
elasticities help to explain the difference in tax revenues?
d) How is the burden of the tax shared between consumers and suppliers in the two
markets? How does the difference in elasticities help to explain this?
Solution:
a)
Calculators T-shirts
Price Demand Supply New Supply Demand Supply New Supply
$16 600 800 725 400 800 725
15 625 775 700 475 775 700
14 650 750 650 550 750 650
Chapter 6/Demand and Elasticity
b) Calculators: $14; 650 T-shirts: $12; 625
3. a) When people’s incomes rise from $18,000 to $22,000 a year, their annual purchases
of oranges rise from 78 to 82. What is the income elasticity of demand?
b) When the price of a box of herbal tea bags rises from $0.99 to $1.21, the quantity
offered for sale rises from 400,000 to 600,000. What is the price elasticity of supply?
c) When the price of wheat rises from $2.34 to $2.46, some farmers switch crops, and
the amount of barley offered on the market falls from 101 million bushels to 99
million. What is the cross elasticity of supply?
d) When the wage rate rose from $6.25 an hour to $6.75 an hour, employment in
Fastfood, Inc. fell from 5,100 to 4,900. What is the price elasticity of demand for
labor?
Solution:
a) Income elasticity of demand for oranges is 0.25
b) Price elasticity of supply is 2.0
4. When the price of cars rises, what will be the effect on the equilibrium price and quantity
of a) tires and b) bus tickets?
Solution:
a) The equilibrium price and quantity of tires will fall, as the increase in the price of cars
shifts the demand curve for tires to the left because cars and tires are complementary
Chapter 6/Demand and Elasticity
DISCUSSION QUESTIONS
1. An excise tax may be imposed on a commodity in order to raise revenue for the
government, or in order to reduce the consumption of the good.
a) Why are these goals in conflict with each other?
b) What is the relevance of the price elasticity of demand in determining which of the
goals is likely to be most fully met?
c) Why do you think excise taxes on gasoline, tobacco, and alcohol are common?
Suggested Answer: Students should discuss the concept of elasticity, different taxes and
their goals, etc. Some taxes are purely aimed at generating revenue while others are
aimed at reducing consumption (tax on alcohol, tax on tobacco) Students could also
discuss the impact of imposing tax on goods and services.
a) These goals are in conflict with each other because when tax reduces consumption,
revenue for the government will fall. To raise enough revenue, there should be no fall
b) Elasticity of demand is important for achieving the goals of a tax. If the demand for a
good is price elastic, then the imposition of tax will significantly reduce the quantity
2. Is it more usual to find relationships of complementarity or substitutability between
goods? Why?
Suggested Answer: Consumers’ demands for many products are substantially affected by
3. Explain why, when the price of a good changes, the price elasticity of demand is likely to
be higher or lower as a longer period of time elapses. Consider as an example the OPEC
oil price increases in the 1970s.
Suggested Answer: Students should discuss the importance of time in determining
elasticity. In the short term, consumers will not have many choices to select from. Price
elasticity will be low due to relatively high inflexibility in this period, e.g., a number of
Chapter 6/Demand and Elasticity
4. Will advertisers try to raise or lower the price elasticity of demand for the good they are
advertising? Why?
Suggested Answer: Through advertising, business firms try to lower the price elasticity of
demand. Many advertisements are designed to generate increased consumption of those
5. “A demand curve shows different quantities that would be bought during a period if the
price were at different levels, assuming that all other factors influencing purchases
remained constant. It is of very limited if any use, since at any one time there is only one
price, not many, and also since as prices do change over time, most of the other factors
influencing demand change, too.” Discuss.
Suggested Answer: Only people who are not familiar with economics may agree with
this. A demand curve indicates, at each possible price, the quantity of the good that is