MICRO ECONOMICS

1. Elasticity and its ApplicationElasticity and its Application
Suppose, you design websites for local businesses.
You charge Rs.200,000 per website, and currently sell 12
websites per month.
Your costs are rising (including the opportunity cost of your
time), so you’re thinking of raising the price to
Rs.250,000.
The law of demand says that you won’t sell as many
websites if you raise your price. How many fewer
websites? How much will your revenue fall, or might it
increase?

2.  Elasticity allows us to analyze supply and
demand with greater precision.
 It is a measure of how much buyers and
sellers respond to changes in market
conditions

3. Price Elasticity of Demand
 Price elasticity of demand measures how
much Qd
responds to a change in P
Price elasticity
of demand
=
Percentage change in Qd
Percentage change in P

4. =
Price Elasticity of Demand

5. Elasticity and Slope
 We can see that the elasticity is related to
the slope (and the derivative) but is not
quite the same as the slope of the demand
curve.
 While elasticity and slope are not the
same thing, we can roughly correlate
elastic demand with a shallow slope of the
demand curve, and conversely.

6. Elasticity and Slope

7. The figure above shows an
example of high elasticity: a
small decline in price (about
20%) leads to a large increase in
quantity (about 120%), so that
elasticity would be about 6.

9. This figure shows an example of
inelasticity: a large decrease in
price (about 75%) leads to a
small increase in quantity (about
25%), so that elasticity would be
about 0.33.

10. The Price Elasticity of Demand and Its
Determinants
Availability of Close Substitutes
Necessities versus Luxuries
Definition of the Market
Time Horizon

11. The Price Elasticity of Demand and Its
Determinants
 Demand tends to be more elastic :
 the larger the number of close
substitutes.
 if the good is a luxury.
 the more narrowly defined the market.
 the longer the time period.

12. Computing the Price Elasticity of Demand
 The price elasticity of demand is computed as
the percentage change in the quantity
demanded divided by the percentage change
in price.
P r i c e e l a s t i c i t y o f d e m a n d =
P e r c e n t a g e c h a n g e i n q u a n t i t y d e m a n d e d
P e r c e n t a g e c h a n g e i n p r i c e

13.  Example: If the price of an ice cream cone
increases from $2.00 to $2.20 and the
amount you buy falls from 10 to 8 cones, then
your elasticity of demand would be calculated
as:
Computing the Price Elasticity of Demand
P r i c e e l a s t i c i t y o f d e m a n d =
P e r c e n t a g e c h a n g e i n q u a n t i t y d e m a n d e d
P e r c e n t a g e c h a n g e i n p r i c e

14. The Midpoint Method: A Better Way to Calculate
Percentage Changes and Elasticities
 The midpoint formula is preferable when
calculating the price elasticity of demand
because it gives the same answer
regardless of the direction of the change.
P r i c e e l a s t i c i t y o f d e m a n d =
( ) / [ ( ) / ]
( ) / [ ( ) / ]
Q Q Q Q
P P P P
2 1 2 1
2 1 2 1
2
2
− +
− +

15. The Midpoint Method: A Better Way to Calculate
Percentage Changes and Elasticities
 Example: If the price of an ice cream
cone increases from $2.00 to $2.20 and
the amount you buy falls from 10 to 8
cones, then your elasticity of demand,
using the midpoint formula, would be
calculated as:

16. Computation of Price Elasticity
For a demand Function
At a point on a Demand Curve
Elasticity and Total Expenditure

17. The Variety of Demand Curves
 Inelastic Demand
 Quantity demanded does not respond strongly
to price changes.
 Price elasticity of demand is less than one.
 Elastic Demand
 Quantity demanded responds strongly to
changes in price.
 Price elasticity of demand is greater than one.

18. Computing the Price Elasticity of Demand
Demand is price elastic
$5
4
Demand
Quantity1000 50
-3
percent22-
percent67
5.00)/2(4.00
5.00)-(4.00
50)/2(100
50)-(100
ED
==
+
+
=
Price

19. The Variety of Demand Curves
 Perfectly Inelastic
 Quantity demanded does not respond to price
changes.
 Perfectly Elastic
 Quantity demanded changes infinitely with any
change in price.
 Unit Elastic
 Quantity demanded changes by the same
percentage as the price.

20. The Variety of Demand Curves
 Because the price elasticity of demand
measures how much quantity demanded
responds to the price, it is closely related to
the slope of the demand curve.

21. Figure 1 The Price Elasticity of Demand
Copyright©2003 Southwestern/Thomson Learning
(a) Perfectly Inelastic Demand: Elasticity Equals 0
$5
4
Quantity
Demand
1000
1. An
increase
in price . . .
2. . . . leaves the quantity demanded unchanged.
Price

22. Figure 1 The Price Elasticity of Demand
(b) Inelastic Demand: Elasticity Is Less Than 1
Quantity0
$5
90
Demand1. A 22%
increase
in price . . .
Price
2. . . . leads to an 11% decrease in quantity demanded.
4
100

23. Figure 1 The Price Elasticity of Demand
Copyright©2003 Southwestern/Thomson Learning
2. . . . leads to a 22% decrease in quantity demanded.
(c) Unit Elastic Demand: Elasticity Equals 1
Quantity
4
1000
Price
$5
80
1. A 22%
increase
in price . . .
Demand

24. Figure 1 The Price Elasticity of Demand
(d) Elastic Demand: Elasticity Is Greater Than 1
Demand
Quantity
4
1000
Price
$5
50
1. A 22%
increase
in price . . .
2. . . . leads to a 67% decrease in quantity demanded.

25. Figure 1 The Price Elasticity of Demand
(e) Perfectly Elastic Demand: Elasticity Equals Infinity
Quantity0
Price
$4 Demand
2. At exactly $4,
consumers will
buy any quantity.
1. At any price
above $4, quantity
demanded is zero.
3. At a price below $4,
quantity demanded is infinite.

26. Total Revenue and the Price Elasticity of
Demand
 Total revenue is the amount paid by buyers
and received by sellers of a good.
 Computed as the price of the good times the
quantity sold.
TR = P x Q

27. Figure 2 Total Revenue
Copyright©2003 Southwestern/Thomson Learning
Demand
Quantity
Q
P
0
Price
P × Q = $400
(revenue)
$4
100

28. Elasticity and Total Revenue along a
Linear Demand Curve
With an inelastic demand curve, an
increase in price leads to a
decrease in quantity that is
proportionately smaller. Thus, total
revenue increases.

29. Figure 3 How Total Revenue Changes When Price Changes:
Inelastic Demand
Copyright©2003 Southwestern/Thomson Learning
Demand
Quantity0
Price
Revenue = $100
Quantity0
Price
Revenue = $240
Demand
$1
100
$3
80
An Increase in price from $1
to $3 …
… leads to an Increase in
total revenue from $100 to
$240

30. Elasticity and Total Revenue along a
Linear Demand Curve
With an elastic demand curve, an
increase in the price leads to a
decrease in quantity demanded
that is proportionately larger. Thus,
total revenue decreases.

31. Figure 4 How Total Revenue Changes When Price Changes:
Elastic Demand
Copyright©2003 Southwestern/Thomson Learning
Demand
Quantity0
Price
Revenue = $200
$4
50
Demand
Quantity0
Price
Revenue = $100
$5
20
An Increase in price from $4
to $5 …
… leads to an decrease in
total revenue from $200 to
$100

32. Income Elasticity of Demand
 Income elasticity of demand measures
how much the quantity demanded of a
good responds to a change in
consumers’ income.
 It is computed as the percentage
change in the quantity demanded
divided by the percentage change in
income.

33. Computing Income Elasticity
I n c o m e e l a s t i c i t y o f d e m a n d =
P e r c e n t a g e c h a n g e
i n q u a n t i t y d e m a n d e d
P e r c e n t a g e c h a n g e
i n i n c o m e

34. Income Elasticity
 Types of Goods
 Normal Goods
 Inferior Goods
 Higher income raises the quantity
demanded for normal goods but lowers
the quantity demanded for inferior
goods.

35. Income Elasticity
 Goods consumers regard as
necessities tend to be income inelastic
 Examples include food, fuel, clothing,
utilities, and medical services.
 Goods consumers regard as luxuries
tend to be income elastic.
 Examples include sports cars, furs, and
expensive foods.

36. THE ELASTICITY OF SUPPLY
 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.
 Price elasticity of supply is the
percentage change in quantity supplied
resulting from a percent change in price.

37. Figure 6 The Price Elasticity of Supply
Copyright©2003 Southwestern/Thomson Learning
(a) Perfectly Inelastic Supply: Elasticity Equals 0
$5
4
Supply
Quantity1000
1. An
increase
in price . . .
2. . . . leaves the quantity supplied unchanged.
Price

38. Figure 6 The Price Elasticity of Supply
Copyright©2003 Southwestern/Thomson Learning
(b) Inelastic Supply: Elasticity Is Less Than 1
110
$5
100
4
Quantity0
1. A 22%
increase
in price . . .
Price
2. . . . leads to a 10% increase in quantity supplied.
Supply

39. Figure 6 The Price Elasticity of Supply
Copyright©2003 Southwestern/Thomson Learning
(c) Unit Elastic Supply: Elasticity Equals 1
125
$5
100
4
Quantity0
Price
2. . . . leads to a 22% increase in quantity supplied.
1. A 22%
increase
in price . . .
Supply

40. Figure 6 The Price Elasticity of Supply
Copyright©2003 Southwestern/Thomson Learning
(d) Elastic Supply: Elasticity Is Greater Than 1
Quantity0
Price
1. A 22%
increase
in price . . .
2. . . . leads to a 67% increase in quantity supplied.
4
100
$5
200
Supply

41. Figure 6 The Price Elasticity of Supply
Copyright©2003 Southwestern/Thomson Learning
(e) Perfectly Elastic Supply: Elasticity Equals Infinity
Quantity0
Price
$4 Supply
3. At a price below $4,
quantity supplied is zero.
2. At exactly $4,
producers will
supply any quantity.
1. At any price
above $4, quantity
supplied is infinite.

42. Determinants of Elasticity of Supply
 Ability of sellers to change the amount
of the good they produce.
 Beach-front land is inelastic.
 Books, cars, or manufactured goods are
elastic.
 Time period.
 Supply is more elastic in the long run.

43. APPLICATION of ELASTICITY
Can good news for farming be bad
news for farmers?
What happens to wheat farmers
and the market for wheat when
university agronomists discover a
new wheat hybrid that is more
productive than existing varieties?

44. THE APPLICATION OF SUPPLY,
DEMAND, AND ELASTICITY
 Examine whether the supply or demand
curve shifts.
 Determine the direction of the shift of the
curve.
 Use the supply-and-demand diagram to
see how the market equilibrium changes.

45. Figure 8 An Increase in Supply in the Market for Wheat
Copyright©2003 Southwestern/Thomson Learning
Quantity of
Wheat
0
Price of
Wheat
3. . . . and a proportionately smaller
increase in quantity sold. As a result,
revenue falls from $300 to $220.
Demand
S1
S2
2. . . . leads
to a large fall
in price . . .
1. When demand is inelastic,
an increase in supply . . .
2
110
$3
100

46. S1
A Tax on Sellers
A tax on
sellers shifts
the S curve
up by the
amount of
the tax.
A tax on
sellers shifts
the S curve
up by the
amount of
the tax.
P
Q
D1
$10.00
500
S2
430
$11.00PB =
$9.50PS =
Tax
Effects of a $1.50 per
unit tax on sellers
The price
buyers pay
rises, the
price sellers
receive falls,
eq’m Q falls.
The price
buyers pay
rises, the
price sellers
receive falls,
eq’m Q falls.

47. 430
S1
The Incidence of a Tax:
how the burden of a tax is shared among
market participants
P
Q
D1
$10.00
500
D2
$11.00PB =
$9.50PS =
Tax
Because
of the tax,
buyers pay
$1.00 more,
sellers get
$0.50 less.
Because
of the tax,
buyers pay
$1.00 more,
sellers get
$0.50 less.

48. CASE STUDY: Who Pays the
Luxury Tax?
The market for yachtsP
Q
D
S
Tax
Buyers’ share
of tax burden
Sellers’ share
of tax burden
PB
PS
Demand is
price-elastic.
Demand is
price-elastic.
In the short run,
supply is inelastic.
In the short run,
supply is inelastic.
Hence,
companies
that build
yachts pay
most of
the tax.
Hence,
companies
that build
yachts pay
most of
the tax.

49. AA CC TT II VV E LE L EE AA RR NN II NN GG 44::
Effects of a taxEffects of a tax
49
40
50
60
70
80
90
100
110
120
130
140
50 60 70 80 90 100 110 120 130Q
P
S
0
The market for
hotel rooms
D
Suppose gov’t
imposes a tax
on buyers of
$30 per room.
Find new
Q, PB, PS,
and incidence
of tax.