Department of Economics

Lecture Notes for Chapter 18
Elasticity
ECON 210, Spring 2001
Dr. Edward L. Millner
Phone: 828-1717
email: elmillne@vcu.edu
URL: www.people.vcu.edu/~emillner/eco210

"Starbucks last raised retail prices two years ago. At that time there was little sales loss, the company said. While a large coffee can cost as much as $2.50, John S. Glass, analyst at BT Alex. Brown, estimated the increase could add 3% to sales at stores open at least one year. He called demand for a cup of Starbucks "fairly inelastic" to cost."

• P ­ Þ Q_D ¯
• P ¯ Þ Q_S ¯
• Income ­ Þ Q_D ­ for normal goods
• P of substitute ­ Þ Q_D ­
• However, supply and demand does not indicate whether the changes in Q_D and Q_S will be large or small

• Indicates whether the quantity demanded decreases a lot or a little when price rises
• Shortened titles
• Price elasticity
• Elasticity of demand
• Elasticity
• Measures responsiveness of consumers to D P
• Suppose that both the average price of a gallon of gasoline and the average price of a quart of soft drink are $1.50 and that the quantity demanded for both goods is 1000. Complete the following table with your best guesses. Remember - the law of demand implies that the Q_D for both goods be less than 1000. Then plot the two demand curves.

• Increased availability of Substitutes
• Demand becomes more elastic as the good is defined more narrowly
• E_D for shoes > E_D for running shoes > E_D for Nike running shoes > E_D for Nike Air Max Triax Plus
• Increase in proportion of budget spend on item
• Increase in time to respond
• Make a list of actions that consumers may take to reduce the quantity of fuel oil demanded when the price of fuel oil rises. Now, put a check by the actions that you think consumers would take within 1 month of the price increase. Put a star next to the actions that you think would take at least a year to implement.
• Suppose the price of gasoline increases from $1.50 to $2.00 on March 1, 2000. Complete the following table.

• Creates difference between demands in long, medium, and short runs, all else equal
• Question 4, Chapter 18

• An increase in supply decreases P_E and increases Q_E
• A decrease in supply increases P_E and decreases Q_E
• The effect on P_E decreases as the demand becomes more elastic
• If supply changes, then the effect on P_E is greatest in the short run and least in the long run
• The effect on Q_E increases as the demand becomes more elastic
• If supply changes, then the effect on Q_E is least in the short run and greatest in the long run
• Suppose that a market is in equilibrium at a price of $3 and quantity of 100. Now suppose that the supply for the product increases and that, as a consequence, the equilibrium price and quantity one month later are $2 and 120, respectively. All else equal, would you expect the price six months later to be $1.50? $2.50? All else equal, would you expect the quantity six months later to be 130? 110?

Price elasticity of demand is a ratio of two percentage changes (% D)

• E_D = % D in Q_D / % D in P, all else equal
• E_D = the % D in Q_D which occurs when P increases by 1%, all else equal
• To avoid having different values for price increases than for price decreases, the % D s are usually computed by using the average of the values as the base
• Base Q_D = (Q_D' + Q_D) / 2
• Base P = (P' + P) /2
• Compute the price elasticity of demand if Q_D increases from 20 to 30 when price decreases from $110 to $90, all else equal.

• Problem 8, Chapter 18

• The demand whose E_D is farther from zero is more elastic (or less inelastic)
• A demand curve with E_D = -2 is more responsive or elastic (or less inelastic) than one with E_D = -1.5
• A demand curve with E_D = -2 is less responsive or elastic (or more inelastic) than one with E_D = -3
• Suppose that E_D = -0.5 for demand curve A and E_D = - 0.75 for demand curve B. Which demand is more elastic, A or B? Which market's consumers are more sensitive to changes in price, A or B?

• E_D = 0 Þ perfectly inelastic
• 0 > E_D > -1 Þ inelastic
• E_D = -1 Þ unitary elastic
• - ¥ > E_D < -1 Þ elastic
• E_D = - ¥ Þ perfectly elastic
• If E_D = -0.75, is the demand elastic, unit elastic, or inelastic?

• TR = P x Q sold
• The working assumption for this section is that Q sold = Q_D
• TR = P x Q_D
• Since P ­ Þ Q_D ¯ , the effect of a price increase on TR is indeterminate
• If demand is elastic then Q_D falls by a "large" amount and TR will fall
• If demand is inelastic then Q_D falls only a "little" and TR will rise
• Compute the effect on TR if Q_D decreases from 30 to 20 when price increases from 90 to 110, all else equal.

• If demand is inelastic then an increase in price will raise TR and a decrease in price will reduce TR
• Crude oil
• Medical care
• If demand is elastic then an increase in price will reduce TR and a decrease in price will raise TR
• Coca-Cola
• Automobiles
• Question 1, Chapter 18

Price elasticity of supply = % D in Q_S / % D in P, all else equal

• Indicates whether the quantity supplied increases a lot or a little when price rises
• Shortened title is elasticity of supply
• Measures responsiveness of producers to D P
• E_S = the % D in Q_S which occurs when P increases by 1%, all else equal

E_S can be used to compare responsiveness of producers to D s in P

• The more responsive supply is called more elastic or less elastic
• The less responsive supply is called less elastic or more inelastic
• A supply curve with E_S = 2 is more responsive or elastic (or less inelastic) than one with E_S = 1.5
• A supply curve with E_S = 2 is less responsive or elastic (or more inelastic) than one with E_S = 3
• Suppose that E_S = 0.5 for supply curve A and E_S = 0.75 for supply curve B. Which supply is more elastic, A or B?
• The supply becomes more elastic as producers have more time to adjust to price changes

• E_S = 0 Þ perfectly inelastic
• E_S = ¥ Þ perfectly elastic
• Problem 11c, Chapter 18

• An increase in demand increases P_E and Q_E
• A decrease in demand decreases P_E and Q_E
• The effect on P_E decreases as the supply becomes more elastic
• If demand changes, then the effect on P_E is greatest in the short run and least in the long run
• The effect on Q_E increases as the supply becomes more elastic
• If demand changes, then the effect on Q_E is least in the short run and greatest in the short run
• Suppose that a market is in equilibrium at a price of $3 and quantity of 100. Now suppose that the demand for the product increases and that, as a consequence, the equilibrium price and quantity one month later are $4 and 120, respectively. All else equal, would you expect the price six months later to be $5? $3.50? All else equal, would you expect the quantity six months later to be 130? 110?

Income elasticity of demand = %D Q_D / %D Income, all else equal

• Indicates whether the quantity demanded increases or decreases when income rises and the magnitude of the change
• Measures the direction and responsiveness of consumers changes in income
• E_Income= the % D in Q_D which occurs when income increases by 1%, all else equal
• E_Income > 0 for normal goods
• Income ­ Þ Q_D ­
• Income ¯ Þ Q_D ¯
• E_Income < 0 for inferior goods
• Income ­ Þ Q_D ¯
• Income ¯ Þ Q_D ­
• Good 1, Problem 10, Chapter 18

Cross price elasticity of demand = % D in Q_D of one good / % D in P of another good, all else equal

• Indicates whether the quantity demanded of one good increases or decreases when the price of another good rises and the magnitude of the change
• Measures the direction and responsiveness of consumers of one good to D P of another good
• E_CrossP = the % D in Q_D of good X which occurs when the price of good Y increases by 1%, all else equal
• E_CrossP > 0 for substitute goods
• P of Y ­ Þ Q_D of X ­
• P of Y ¯ Þ Q_D of X ¯
• E_CrossP < 0 for complements
• P of Y ­ Þ Q_D of X ¯
• P of Y ¯ Þ Q_D of X ­
• Questions 6 and 7, Chapter 18
• Problem 14, Chapter 18