978-1305971509 Chapter 5 Lecture Notes

WHAT’S NEW IN THE EIGHTH EDITION:

A new question has been added to the Problems and Applications section.

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.

80

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5ELASTICITY AND ITS

APPLICATION

81 ❖ Chapter 5/Elasticity and Its Application

 the concept of elasticity in three very di4erent markets (the market for wheat, the

market for oil, and the market for illegal drugs).

CONTEXT AND PURPOSE:

Chapter 5 is the second chapter of a three-chapter sequence that deals with supply and

demand and how markets work. Chapter 4 introduced supply and demand. Chapter 5 shows

how much buyers and sellers respond to changes in market conditions. Chapter 6 will

address the impact of government policies on 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:

 The price elasticity of demand measures how much the quantity demanded responds to

changes in the price. Demand tends to be more elastic if close substitutes are available,

if the good is a luxury rather than a necessity, if the market is narrowly de;ned, 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 proportionately more than the price,

then the elasticity is greater than one, and demand is said to be 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.

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Chapter 5/Elasticity and Its Application ❖ 82

 The income elasticity of demand measures how much the quantity demanded responds

to changes in consumers’ income. The cross-price elasticity of demand measures how

much the quantity demanded of one good responds to the price of another good.

 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.

 The price elasticity of supply is calculated as the percentage change in quantity supplied

divided by the percentage change in price. If quantity supplied moves proportionately

less than the price, then the elasticity is less than one, and supply is said to be inelastic.

If quantity supplied moves proportionately more than the price, then the elasticity is

greater than one, and supply is said to be elastic.

 The tools of supply and demand can be applied in many di4erent 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

A. De;nition of elasticity: a measure of the responsiveness of quantity

demanded or quantity supplied to one of its determinants.

B. The Price Elasticity of Demand and Its Determinants

1. De;nition of price elasticity of demand: a measure of how much the

quantity demanded of a good responds to a change in the price of that

good, computed as the percentage change in quantity demanded

divided by the percentage change in price.

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83 ❖ Chapter 5/Elasticity and Its Application

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.

c. De;nition of the market: narrowly de;ned markets (ice cream) have more

elastic demand than broadly de;ned 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

% change in quantity demanded

Price elasticity of demand = % change in price

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 diCcult for some students.

Working through a few simple examples will help to alleviate some of the

2. Example: the price of ice cream rises by 10% and quantity demanded falls by

20%.

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Chapter 5/Elasticity and Its Application ❖ 84

Price elasticity of demand = (20%)/(10%) = 2

3. Because there is an inverse relationship between price and quantity demanded

(the price of ice cream rose by 10% and the quantity demanded fell by 20%), the

price elasticity of demand is sometimes reported as a negative number. We will

ignore the minus sign and concentrate on the absolute value of the elasticity.

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.

D. The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities

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 di4erent from an elasticity calculated by going from the second point to

the ;rst. This di4erence arises because the percentage changes are calculated

using a di4erent base.

a. A way around this problem is to use the midpoint method.

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 ;nal levels rather than by the initial level

itself.

c. Example: the price rises from $4 to $6 and quantity demanded falls from 120

to 80.

% change in price = (6 − 4)/5 × 100 = 40%

% change in quantity demanded = (120 − 80)/100 x 100 = 40%

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85 ❖ Chapter 5/Elasticity and Its Application

price elasticity of demand = 40/40 = 1

( – ) /[( ) / ]

2 1 1 2

2

Price elasticity of demand = 2

+

Q Q Q Q

P P P P

E. The Variety of Demand Curves

To clearly show the di4erences between relatively elastic and relatively

inelastic demand curves, draw a graph showing a relatively Mat 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 Mat. Use the same method when

discussing the shape of the supply curve later in the chapter.

1. Classi;cation of Elasticity

a. When the price elasticity of demand is greater than one, demand is de;ned to

be elastic.

b. When the price elasticity of demand is less than one, the demand is de;ned to

be inelastic.

c. When the price elasticity of demand is equal to one, the demand is said to

have unit elasticity.

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Figure 1

Chapter 5/Elasticity and Its Application ❖ 86

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 and inelastic.

Instructions

2. In general, the Matter the demand curve that passes through a given point, the

more elastic the demand.

3. Extreme Cases

a. When the price elasticity of demand is equal to zero, the demand is perfectly

inelastic and is a vertical line.

b. When the price elasticity of demand is in;nite, the demand is perfectly elastic

and is a horizontal line.

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 ;rms are

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87 ❖ Chapter 5/Elasticity and Its Application

4. FYI: A Few Elasticities from the Real World

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

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Chapter 5/Elasticity and Its Application ❖ 88

F. Total Revenue and the Price Elasticity of Demand

Figure 2

1. De;nition of total revenue: the amount paid by buyers and received by

sellers of a good, computed as the price of the good times the quantity

sold.

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

Students ;nd the relationship between changes in total revenue and

elasticity diCcult to understand. It may take several thorough discussions

of this material before students will be able to master it.

2. If demand is inelastic, the percentage change in price will be greater than the

percentage change in quantity demanded.

Figure 3

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 will be larger than the increase in quantity demanded).

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89 ❖ Chapter 5/Elasticity and Its Application

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 price will be smaller than the decrease in quantity demanded).

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.

a. If price rises, quantity demanded falls, and total revenue will remain the same

(because the increase in price will be equal to the decrease 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).

Point out the usefulness of elasticity from a business owner’s point of

view. Students should be able to see why a ;rm’s manager would want to

know the elasticity of demand for the ;rm’s products.

G. Elasticity and Total Revenue along a Linear Demand Curve

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Chapter 5/Elasticity and Its Application ❖ 90

Figure 4

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.

b. At points with a high price and a low quantity demanded, demand is elastic.

2. Total revenue also varies at each point along the demand curve.

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.

H. Other Demand Elasticities

1. De;nition of income elasticity of demand: a measure of how much the

quantity demanded of a good responds to a change in consumers’

income, computed as the percentage change in quantity demanded

divided by the percentage change in income.

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91 ❖ Chapter 5/Elasticity and Its Application

a. Formula

% change in quantity demanded

Income elasticity of demand = % change in income

b. Normal goods have positive income elasticities, while inferior goods have

negative income elasticities.

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%

c. Necessities tend to have small income elasticities, while luxuries tend to have

large income elasticities.

2. De;nition of cross-price elasticity of demand: a measure of how much the

quantity demanded of one good responds to a change in the price of

another good, computed as the percentage change in the quantity

demanded of the 8rst good divided by the percentage change in the

price of the second good.

a. Formula

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Chapter 5/Elasticity and Its Application ❖ 92

% change in quantity demanded of good 1

Cross-price elasticity of demand = % change in price of good 2

b. Substitutes have positive cross-price elasticities, while complements have

negative cross-price elasticities.

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%

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

II. The Elasticity of Supply

A. The Price Elasticity of Supply and Its Determinants

1. De;nition 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 the percentage change in quantity supplied divided

by the percentage change in price.

2. Determinants of the Price Elasticity of Supply

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93 ❖ Chapter 5/Elasticity and Its Application

a. Flexibility of sellers: goods that are somewhat ;xed in supply (beachfront

property) have inelastic supplies.

b. Time horizon: supply is usually more inelastic in the short run than in the long

run.

B. Computing the Price Elasticity of Supply

1. Formula

% change in quantity supplied

Price elasticity of supply = % change in price

2. Example: the price of milk increases from $2.85 per gallon to $3.15 per gallon

and the quantity supplied rises from 9,000 to 11,000 gallons per month.

% change in price = (3.15 – 2.85)/3.00 × 100 = 10%

% change in quantity supplied = (11,000 – 9,000)/10,000 × 100 = 20%

Price elasticity of supply = (20%)/(10%) = 2

C. The Variety of Supply Curves

Figure 5

1. In general, the Matter the supply curve that passes through a given point, the

more elastic the supply.

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Chapter 5/Elasticity and Its Application ❖ 94

2. Extreme Cases

a. When the elasticity is equal to zero, the supply is said to be perfectly inelastic

and is a vertical line.

b. When the elasticity is in;nite, the supply is said to be perfectly elastic and is a

horizontal line.

3. Because ;rms 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.

Figure 6

Again, you may want to present several examples of goods that may have

supply curves like these.

III. Three Applications of Supply, Demand, and Elasticity

A. Can Good News for Farming Be Bad News for Farmers?

Figure 7

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95 ❖ Chapter 5/Elasticity and Its Application

1. A new hybrid of wheat is developed that is more productive than those used in

the past. What happens?

2. Supply increases, price falls, and quantity demanded rises.

3. If demand is inelastic, the fall in price is greater than the increase in quantity

demanded and total revenue falls.

4. If demand is elastic, the fall in price is smaller than the rise in quantity demanded

and total revenue rises.

5. In practice, the demand for basic foodstu4s (like wheat) is usually inelastic.

a. This means less revenue for farmers.

b. Because farmers are price takers, they still have the incentive to adopt the

new hybrid so that they can produce and sell more wheat.

c. This may help explain why the number of farms has declined so dramatically

over the past two centuries.

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Chapter 5/Elasticity and Its Application ❖ 96

d. This may also explain why some government policies encourage farmers to

decrease the amount of crops planted.

B. Why Did OPEC Fail to Keep the Price of Oil High?

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97 ❖ Chapter 5/Elasticity and Its Application

Figure 8

1. In the 1970s and 1980s, OPEC reduced the amount of oil it was willing to supply

to world markets. The decrease in supply led to an increase in the price of oil and

a decrease in quantity demanded. The increase in price was much larger in the

short run than the long run. Why?

2. The demand and supply of oil are much more inelastic in the short run than the

long run. The demand is more elastic in the long run because consumers can

adjust to the higher price of oil by carpooling or buying a vehicle that gets better

mileage. The supply is more elastic in the long run because non-OPEC producers

will respond to the higher price of oil by producing more.

C. Does Drug Interdiction Increase or Decrease Drug-Related Crime?

1. The federal government increases the number of federal agents devoted to the

war on drugs. What happens?

a. The supply of drugs decreases, which raises the price and leads to a reduction

in quantity demanded. If demand is inelastic, total expenditure on drugs

(equal to total revenue) will increase. If demand is elastic, total expenditure

will fall.

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Short

Run

Long

Run

Chapter 5/Elasticity and Its Application ❖ 98

b. Thus, because the demand for drugs is likely to be inelastic, drug-related

crime may rise.

2. What happens if the government instead pursued a policy of drug education?

a. The demand for drugs decreases, which lowers price and quantity supplied.

Total expenditure must fall (because both price and quantity fall).

b. Thus, drug education should not increase drug-related crime.

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Figure 9

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(a) Drug Interdiction (b) Drug Education