Introduction to Microeconomics

Fall 2021 Econ 2011

Fall 2020
Lecture 11*
Lecture Notes & Main Texbook
Part II: How Markets work
Elasticity

Lecture Slides are just for guidance, you have to

take lecture notes in class. Kareman M. Shoair
What is Elasticity
• Elasticity measures how much one variable responds to changes in
another variable.
• There are multiple types of elasticity.
1. 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.
• Formula :
Price elasticity of demand = % change in quantity demanded /% change
in price.
Price elasticity = Percentage change in Qd

of demand
Percentage change in P
 Price Elasticity of Demand
Example:
Price elasticity P
of demand equals
P rises by
20% P2
- 25% = 1.25 (absolute
value) P1
+20% D
Along a D curve, P and Q move in
opposite directions, which would Q
make price elasticity negative. Q2 Q1
We will drop the minus sign and Q falls by
report all price elasticities as 25%
positive numbers.
Calculating The Price Elasticity of Demand
1. Standard Method
2. Mid-Point Method
Calculating Percentage Changes
Standard method
of computing the
Demand for percentage (%) change:
your Coffee
P end value (new) – start(old) value
x 100%
start value(old)
B
$250
A Going from A to B,
$200
the % change in P equals
D
($250–$200)/$200 = 25%
Q
8 12
Calculating Percentage Changes
Problem:
The standard method gives
Demand for different answers depending
your Coffee on where you start.
P
From A to B,
B P rises 25%, Q falls 33%,
$250
A elasticity = 33/25 = 1.33
$200

D From B to A,
P falls 20%, Q rises 50%,
Q
8 12 elasticity = 50/20 = 2.50
Calculating Percentage Changes
• 2. Midpoint Method:

end value – start value

Midpoint
x 100%
(average)

§ The midpoint is the number halfway between the

start and end values, the average of those values.
§ It doesn’t matter which value you use as the start and
which as the end—you get the same answer either
way!
Calculating Percentage Changes
• Using the midpoint method, the % change
in P equals

$250 – $200
x 100% = 22.2%
$225
§ The % change in Q equals
12 – 8
x 100% = 40.0%
10
§ The price elasticity of demand equals

40/22.2 = 1.8
 Classification of Elasticity

1.When the price elasticity of demand is greater than one, demand is

defined to be elastic.
2.When the price elasticity of demand is less than one, the demand is
defined to be inelastic.
3.When the price elasticity of demand is equal to one, the demand is said
to have unit elasticity.
 Exercise

1. Use the following information to calculate the price elasticity

of demand for hotel rooms:
if P = $70, Qd = 5000
if P = $90, Qd = 3000
 Answer
Use midpoint method to calculate
% change in Qd (5000 – 3000)/4000 = 50%

% change in P ($70 – $90)/$80 = -25%

50%/-25%= - 2

The price elasticity is 2

EXAMPLE 4:

• The price of gasoline rises 20%. Does Qd drop

more in the short run or the long run? Why?
• There’s not much people can do in the
short run, other than ride the bus or train.
• In the long run, people can buy smaller cars
or live closer to where they work.
• Lesson: Price elasticity is higher in the
long run than the short run.
 The Variety of Demand Curves

Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.

There are 5 different classifications of D curve :

“Perfectly inelastic demand” (one extreme case)
Price elasticity % change in Q 0%
= = =0
of demand % change in P 10%

P
D curve: D
vertical
P1
Consumers’
price sensitivity: P2

none
P falls by Q
Elasticity: 10% Q1

0 Q changes
by 0%
“Inelastic demand”
Price elasticity % change in Q < 10%
= = <1
of demand % change in P 10%

P
D curve:
relatively steep
P1
Consumers’
price sensitivity: P2

relatively low D

P falls by Q
Elasticity: 10% Q1 Q2

<1
Q rises less than
10%
“Unit elastic demand”
Price elasticity % change in Q 10%
= = =1
of demand % change in P 10%

P
D curve:
intermediate slope
P1
Consumers’
price sensitivity: P2
D
intermediate
P falls by Q
Elasticity: 10% Q1 Q2

1 Q rises by 10%
“Elastic demand”
Price elasticity % change in Q > 10%
= = >1
of demand % change in P 10%

P
D curve:
relatively flat
P1
Consumers’
price sensitivity: P2 D
relatively high
P falls by Q
Elasticity: 10% Q1 Q2

>1 Q rises more than

10%
“Perfectly elastic demand” (the other extreme)
Price elasticity % change in Q any %
= = = infinity
of demand % change in P 0%

P
D curve:
horizontal
P2 = P1 D
Consumers’
price sensitivity:
extreme
P changes by 0% Q
Elasticity: Q1 Q2

infinity Q changes
by any %
Elasticity of a Linear Demand Curve
P The slope
200% of a linear
$30 E= = 5.0 demand
40%
curve is
67% constant,
20 E= = 1.0
67% but its
elasticity
40%
10 E= = 0.2 is not.
200%

$0 Q
0 20 40 60
But….What Determines the Elasticity of Demand ??
Determinants of the Price Elasticity of
Demand
1. Availability of Close Substitutes: the more substitutes a good has, the more
elastic its demand.
Example : Cereals VS sunscreen
The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
Breakfast cereal has close substitutes
(e.g., bread, eggs, cheeses),
so buyers can easily switch if the price rises.
Sunscreen has no close substitutes,
so consumers would probably not
buy much less if its price rises.
Determinants of the Price Elasticity of
Demand
2. Necessities versus Luxuries: necessities are more price inelastic.
Example : Electricity Vs Caribbean Cruises.
• A rise in its price of electricity would cause little decrease in demand.
• A cruise is a luxury. If the price rises,
some people will forego it.
Determinants of the Price Elasticity of
Demand
3. Definition of the market: narrowly defined markets have more elastic demand
than broadly defined markets .
• Example : Black Jeans Vs. Clothes
For a narrowly defined good such as
black jeans, there are many substitutes
(blue jeans, any other kind of trousers…..etc).
There are fewer substitutes available for broadly defined goods.
(There aren’t too many substitutes for clothes)
Determinants of the Price Elasticity of
Demand
4.Time Horizon: goods tend to have more elastic demand over longer time
horizons.
• Example :Gasoline in the Short Run vs. Gasoline in the Long Run.
The price of gasoline rises 20%. Does Qd drop more in the short run or the
long run? Why?
There’s not much people can do in the short run, other than ride the bus
or train.
In the long run, people can buy smaller cars
or live closer to where they work.
Summary of Determinants of the Price Elasticity of
Demand

• Availability of Close Substitutes: the more substitutes a good has, the more
elastic its demand.
• Necessities versus Luxuries: necessities are more price inelastic.
• Definition of the market: narrowly defined markets (ice cream) have more
elastic demand than broadly defined markets (food).
• Time Horizon: goods tend to have more elastic demand over longer time
horizons.
Price Elasticity and Total Revenue
If we increase the Price from $200 to $250 , would our revenue rise
or fall?
Revenue = P x Q
A price increase has two effects on revenue:
1. Higher P means more revenue on each unit
you sell.
2. But you sell fewer units (lower Q),
due to law of demand.
Which of these two effects is bigger?
It depends on the price elasticity of demand.
Price Elasticity and Total Revenue
Price elasticity Percentage change in Q
=
of demand Percentage change in P

Revenue = P x Q
• If demand is elastic, then
price elast. of demand > 1
% change in Q > % change in P
• The fall in revenue from lower Q is greater
than the increase in revenue from higher P,
so revenue falls.
Price Elasticity and Total Revenue
Elastic demand increased revenue
(elasticity = 1.8) Demand
due to higher for
P
P
your websiteslost revenue
due to lower
If P = $200, Q

Q = 12 and revenue $250

= $2400.
$200
If P = $250, D
Q = 8 and
revenue = $2000.
Q
When D is elastic, 8 12
a price increase
causes revenue to fall.
Price Elasticity and Total Revenue
Price elasticity Percentage change in Q
=
of demand Percentage change in P

Revenue = P x Q
• If demand is inelastic, then
price elast. of demand < 1
% change in Q < % change in P
• The fall in revenue from lower Q is smaller
than the increase in revenue from higher P,
so revenue rises.
• In our example, suppose that Q only falls to 10
(instead of 8) when you raise your price to $250.
Price Elasticity and Total Revenue
Now, demand is increased revenue
inelastic: due to Demandfor
higher P
elasticity = 0.82 P your websiteslost revenue
due to lower
If P = $200, Q
Q = 12 and revenue
$250
= $2400.
$200
If P = $250,
Q = 10 and D

revenue = $2500.
When D is inelastic, Q
10 12
a price increase
causes revenue to rise.
Elasticity and expenditure/revenue

A. Pharmacies raise the price of insulin by 10%. Does total

expenditure on insulin rise or fall?
B. As a result of a fare war, the price of a luxury cruise falls
20%.
Does luxury cruise companies’ total revenue
rise or fall?
Answers
A. Pharmacies raise the price of insulin by 10%. Does total
expenditure on insulin rise or fall?
Expenditure = P x Q
Since demand is inelastic, Q will fall less
than 10%, so expenditure rises.
Answers
B. As a result of a fare war, the price of a luxury cruise falls
20%.
Does luxury cruise companies’ total revenue
rise or fall?
Revenue = P x Q
The fall in P reduces revenue,
but Q increases, which increases revenue. Which effect is
bigger?
Since demand is elastic, Q will increase more than 20%,
so revenue rises.
APPLICATION: Does Drug Interdiction Increase or Decrease Drug-
Related Crime?
• One side effect of illegal drug use is crime: Users often
turn to crime to finance their habit.
• We examine two policies designed to reduce illegal drug
use and see what effects they have on drug-related crime.
• For simplicity, we assume the total dollar value of drug-
related crime equals total expenditure
on drugs.
• Demand for illegal drugs is inelastic, due to addiction
issues.
 Policy 1: Interdiction
Interdiction reduces new value of drug-related
crime
the supply of drugs. Price of
Drugs S2
D1
S1
P2
Since demand for drugs is
inelastic,
P rises propor-tionally P1
initial value of
drug-related
more than Q falls. crime

Result: an increase in Q2 Q1 Quantity

total spending on drugs, and in drug- of Drugs
related crime
 Policy 2: Education
new value of drug-related
crime
Education reduces the Price of
Drugs
demand for drugs.
D2 D1
S

P and Q fall.
initial value of
P1
drug-related
Result: crime
P2
A decrease in total spending
on drugs, and in drug-related
crime.
Q2 Q1 Quantity
of Drugs
Other Demand Elasticities……
Income Elasticity of Demand
John’s income rises from $20,000 to $22,000 and the quantity of chicken he buys each week falls from
2 kg to 1 kg.

% change in quantity demanded = (1−2)/1.5 = -0.6667 = -66.67%

% change in income = (22,000 −20,000)/21,000 = 0.0952 = 9.52%
income elasticity = 66.67%/9.52% = -7.00
Ø Chicken is an inferior good for John.