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Module 12
Interpreting the Price Elasticity of Demand
What’s New in the Fourth Edition?
• New Economics in Action.
• Handouts for use in class.
Module Objectives
• What factors influence the size of these various elasticities?
• Why is it vitally important to determine the size of the relevant elasticity before setting prices or
government fees?
How Elastic is Elastic?
Creating Student Interest
• Ask students to identify some of the goods they buy that have inelastic demand. In other words,
when the price of that good goes up, the student still buys about the same quantity of the good.
Students will probably suggest gas and other necessities. Now ask students to name some of the
goods they buy that have elastic demand. These are goods that they buy a lot less of when the price
goes up. They will probably suggest different luxury goods (Starbuck’s coffee or meals eaten out),
or perhaps expensive goods (cars and electronics).
Presenting the Material
• Students usually do not have trouble understanding the difference between elastic and inelastic.
Emphasize that if the percentage change in quantity demanded is greater than the percentage change
in price, demand is responsive or elastic. Students find the discussion of the factors that help
determine whether a good is elastic or inelastic most interesting if you pick a varied selection of
goods and use these to motivate the discussion. Some goods are suggested in the table that follows.
Alternatively, ask students to suggest goods they think are relatively elastic or inelastic.
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Product
Price elasticity
of demand
Determinants
of elasticity
Eggs
0.32
small part of the consumer’s budget
Milk
0.63
necessity; few substitutes
Soft drinks
0.79
small part of the consumer’s budget
Gasoline in the long run
0.24
necessity
Module Outline
I. How Elastic is Elastic?
A. Demand can be elastic (if the price elasticity of demand is greater than 1), inelastic (if the
price elasticity of demand is less than 1), and unit-elastic (if the price elasticity of demand is
exactly 1). These are illustrated in text Figure 12-2, shown below.
Housing
large proportion of a consumer’s budget
Restaurant meals
Airline travel (leisure)
there are many substitutes; luxury good
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Figure 12-2
B. Elasticity affects total revenue.
1. Except in the rare case of a good with perfectly elastic or perfectly inelastic demand,
when a seller raises the price of a good, two effects are present.
a. A price effect: After a price increase, each unit sold sells at a higher price, which
tends to raise revenue. The price effect is the change in price times the new quantity.
b. A quantity effect: After a price increase, fewer units are sold, which tends to lower
revenue. The quantity effect is the change in quantity sold times the original price.
2. The price elasticity of demand determines which effect predominates and therefore
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offset each other.
3. Total revenue is illustrated as an area below a demand curve: price × quantity sold.
Figure 12-3
II. Price Elasticity Along the Demand Curve
A. At the top of a linear demand curve, the price elasticity of demand is elastic between two
price points. As you move to the bottom of a linear demand curve, the price elasticity of
demand is more inelastic.
B. At higher prices, consumers are more sensitive to a price change because the purchase
represents a larger share of the budget. At lower prices, the purchase is a smaller share
of the budget, and consumers are not as responsive to a price change.
III. What factors determine the price elasticity of demand?
A. The availability of close substitutes
1. The price elasticity of demand will tend to be high if there are close substitutes.
2. The price elasticity of demand will tend to be low if there are no close substitutes.
B. Whether the good is a necessity or a luxury
Case Studies in the Text
Economics in Action
Responding to Your Tuition Bill—This EIA uses elasticity of demand to explain how enrollment responds
to tuition changes.
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Ask students the following questions:
1. According to one study, a 10% increase in tuition at a four-year university would decrease
enrollment by how much? (Price elasticity of demand was estimated to be 0.67, so a 10%
increase in tuition would decrease enrollment by 6.7%. X/10 = 0.67 so X = 6.7.)
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Handout 12-1
Date_________ Name____________________________ Class________ Professor________________
Ranking Goods by Their Price Elasticity (5–10 minutes)
Rank the following six goods from 1 to 6 in order of most elastic (1) to least elastic (6):
______Salt
______Audi A4 car
______A doctor’s visit
______T-bone steaks
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Answers:
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Handout 12-2
Date_________ Name_________________________Class________ Professor____________
Why Do Business Travelers Pay More?
Calculate the price elasticity of demand of airline tickets for vacation travelers using the midpoint
formula. Then, calculate the price elasticity of demand of airline tickets for business travelers.
Vacation travelers
Business travelers
P1 = $200
P1 = $200
Elasticity of vacation travelers:
Elasticity of business travelers:
Why does the elasticity of demand differ for these types of travelers?
How does the total revenue change for each group of travelers when the price increases from $200 to
$220? Calculate the price effect and the quantity effect of the price change, and then use that
information to determine if demand is elastic or inelastic.
P2 = $220
P2 = $220
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Answers:
Calculate the price elasticity of demand of airline tickets for vacation travelers using the midpoint
formula. Then, calculate the price elasticity of demand of airline tickets for business travelers.
For vacation travelers:
• Total revenue before the price change is $200 × 10,000 tickets = $2 million