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85
WHAT’S NEW IN THE SIXTH EDITION:
There is a new
FYI
box reporting “A Few Elasticities from the Real World.”
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
➢ the meaning of the elasticity of demand.
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
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
5
ELASTICITY AND ITS
APPLICATION
86 ❖ Chapter 5/Elasticity and Its Application
rather than a necessity, if the market is narrowly defined, or if buyers have substantial time to react
to a price change.
• 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 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.
CHAPTER OUTLINE:
I. The Elasticity of Demand
A. Definition 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. Definition 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.
Chapter 5/Elasticity and Its Application ❖ 87
C. Computing the Price Elasticity of Demand
1. Formula
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 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.
a. A way around this problem is to use the midpoint method.
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
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.
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.
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
a. When the price elasticity of demand is equal to zero, the demand is perfectly inelastic
and is a vertical line.
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
90 ❖ 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
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?
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
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.
Chapter 5/Elasticity and Its Application ❖ 91
F. Total Revenue and the Price Elasticity of Demand
1. Definition 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.
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
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
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
Figure 2
Another term for price times quantity is “total expenditure.” This term is sometimes
Figure 3
92 ❖ Chapter 5/Elasticity and Its Application
G. Elasticity and Total Revenue along a Linear Demand Curve
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.
H. Other Demand Elasticities
1. Definition 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.
Figure 4
Chapter 5/Elasticity and Its Application ❖ 93
b. Normal goods have positive income elasticities, while inferior goods have negative
income elasticities.
2. Definition 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 first good
divided by the percentage change in the price of the second good.
a. Formula
b. Substitutes have positive cross-price elasticities, while complements have negative cross-
price 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.
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.
94 ❖ Chapter 5/Elasticity and Its Application
II. The Elasticity of Supply
A. The Price Elasticity of Supply and Its Determinants
1. Definition of price elasticity of supply: a measure of how much the quantity
2. Determinants of the Price Elasticity of Supply
1. Formula
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 quantity supplied
Price elasticity of supply = % change in price
Figure 5
Chapter 5/Elasticity and Its Application ❖ 95
2. Extreme Cases
3. Because firms often have a maximum capacity for production, the elasticity of supply may be
III. Three Applications of Supply, Demand, and Elasticity
A. Can Good News for Farming Be Bad News for Farmers?
Figure 7
Figure 6
96 ❖ 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?
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 foodstuffs (like wheat) is usually inelastic.
a. This means less revenue for farmers.
B. Why Did OPEC Fail to Keep the Price of Oil High?
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?
Figure 8
Chapter 5/Elasticity and Its Application ❖ 97
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
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
Figure 9
98 ❖ Chapter 5/Elasticity and Its Application
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1. The price elasticity of demand is 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
2. The price elasticity of supply is 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.
3. A drought that destroys half of all farm crops could be good for farmers (at least those
unaffected by the drought) if the demand for the crops is inelastic. The shift to the left of
the supply curve leads to a price increase that will raise total revenue if the price elasticity of
demand is less than 1.
Questions for Review
1. The price elasticity of demand measures how much quantity demanded responds to a change
2. The determinants of the price elasticity of demand include how available close substitutes
are, whether the good is a necessity or a luxury, how broadly defined the market is, and the
3. The main advantage of using the mid-point formula is that it uses a constant base whether
the change in price or quantity demanded is an increase or a decrease.
Chapter 5/Elasticity and Its Application ❖ 99
price. When the elasticity equals zero, demand is perfectly inelastic. There is no change in
quantity demanded when there is a change in price.
5. Figure 1 presents a supply-and-demand diagram, showing the equilibrium price, the
equilibrium quantity, and the total revenue received by producers. Total revenue equals the
equilibrium price times the equilibrium quantity, which is the area of the rectangle shown in
the figure.
Figure 1
6. If demand is elastic, an increase in price reduces total revenue. With elastic demand, the
7. A good with income elasticity less than zero is called an inferior good because as income
rises, the quantity demanded declines.
8. The price elasticity of supply is calculated as the percentage change in quantity supplied
10. The price elasticity of supply is usually larger in the long run than it is in the short run. Over
short periods of time, firms cannot easily change the sizes of their factories to make more or
11. Because the demand for drugs is likely to be inelastic, an increase in price will lead to a rise
in total expenditure. Therefore, drug users may resort to theft or burglary to support their
100 ❖ Chapter 5/Elasticity and Its Application
Problems and Applications
1. a. Mystery novels have more elastic demand than required textbooks, because mystery
novels have close substitutes and are a luxury good, while required textbooks are a
necessity with no close substitutes. If the price of mystery novels were to rise, readers
could substitute other types of novels, or buy fewer novels altogether. But if the price of
required textbooks were to rise, students would have little choice but to pay the higher
price. Thus, the quantity demanded of required textbooks is less responsive to price than
the quantity demanded of mystery novels.
c. Subway rides during the next five years have more elastic demand than subway rides
during the next six months. Goods have a more elastic demand over longer time
horizons. If the fare for a subway ride was to rise temporarily, consumers could not
switch to other forms of transportation without great expense or great inconvenience.
But if the fare for a subway ride was to remain high for a long time, people would
gradually switch to alternative forms of transportation. As a result, the quantity
demanded of subway rides during the next six months will be less responsive to changes
in the price than the quantity demanded of subway rides during the next five years.
2. a. For business travelers, the price elasticity of demand when the price of tickets rises from
$200 to $250 is [(2,000 – 1,900)/1,950]/[(250 – 200)/225] = 0.05/0.22 = 0.23. For
vacationers, the price elasticity of demand when the price of tickets rises from $200 to
$250 is [(800 – 600)/700] / [(250 – 200)/225] = 0.29/0.22 = 1.32.
3. a. The percentage change in price is equal to (2.20 – 1.80)/2.00 = 0.2 = 20%. If the price
elasticity of demand is 0.2, quantity demanded will fall by 4% in the short run
[0.20 0.20]. If the price elasticity of demand is 0.7, quantity demanded will fall by 14%
in the long run [0.7 0.2].
Chapter 5/Elasticity and Its Application ❖ 101
4. If quantity demanded fell, price must have risen. If total revenue rose, then the percentage
5. Both Billy and Valerie may be correct. If demand increases, but supply is “totally” inelastic,
equilibrium price will rise but the equilibrium quantity will remain the same. This would also
6. a. If your income is $10,000, your price elasticity of demand as the price of DVDs rises from
$8 to $10 is [(40 – 32)/36]/[(10 – 8)/9] =0.22/0.22 = 1. If your income is $12,000, the
7. Yes, an increase in income would decrease the demand for good X because the income
8. a. If Maria always spends one-third of her income on clothing, then her income elasticity of
demand is one, because maintaining her clothing expenditures as a constant fraction of
her income means the percentage change in her quantity of clothing must equal her
percentage change in income.
9. a. The percentage change in price (using the midpoint formula) is (1.50 – 0.25)/(0.875) ×
100% = 1.42.86%. Therefore, the price elasticity of demand is 4.3/142.86 = 0.03, which
is very inelastic.
10. Tom's price elasticity of demand is zero, because he wants the same quantity regardless of
the price. Jerry's price elasticity of demand is one, because he spends the same amount on
102 ❖ Chapter 5/Elasticity and Its Application
gas, no matter what the price, which means his percentage change in quantity is equal to the
percentage change in price.
11. a. With a price elasticity of demand of 0.4, reducing the quantity demanded of cigarettes by
20% requires a 50% increase in price, because 20/50 = 0.4. With the price of cigarettes
currently $2, this would require an increase in the price to $3.33 a pack using the
midpoint method (note that ($3.33 – $2)/$2.67 = .50).
12. In order to determine whether you should raise or lower the price of admissions, you need to
know if the demand is elastic or inelastic. If demand is elastic, a decline in the price of
admissions will increase total revenue. If demand is inelastic, an increase in the price of
admissions will cause total revenue to rise.
13. a. As Figure 2 shows, the increase in supply reduces the equilibrium price and increases the
equilibrium quantity in both markets.
c. In the market for computers (with elastic demand), the increase in supply leads to a
relatively large increase in the equilibrium quantity and a small decline in the equilibrium
price.
Chapter 5/Elasticity and Its Application ❖ 103
14. a. Farmers whose crops were not destroyed benefited because the destruction of some of
the crops reduced the supply, causing the equilibrium price to rise.
15. A worldwide drought could increase the total revenue of farmers if the price elasticity of
demand for grain is inelastic. The drought reduces the supply of grain, but if demand is
