Chapter 5: Elasticity and Its Application

Rate of change and slope

Problems with slope
The concept of elasticity
Elasticity: a measure of the responsiveness of quantity demanded or quantity supplied to a
change in one of its determinants
Superiority of elasticity compared to slope
Concept of percentage change
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
Determinants of the Price Elasticity of Demand
• The availability of close substitutes to the good
• The passage of time
• Whether the good is a luxury or a necessity
• The definition of the market
• The share of the good in the consumer’s budget
A numerical example of calculating price elasticity of demand
Types of demand elasticity
Elastic demand: Demand is elastic when the percentage change in the quantity demanded is
greater than the percentage change in price, so the price elasticity is greater than 1 in
absolute value.
Unit-elastic demand: Demand is unit elastic when the percentage change in quantity
demanded is equal to the
percentage change in price, so the price elasticity is equal to 1 in absolute value.
Inelastic demand: Demand is inelastic when the percentage change in quantity demanded is
less than the percentage change in price, so the price elasticity is less than 1 in absolute value.
Graphs of different types of elastic demand curve
Examples:
Zero elastic
Inelastic
Unit elastic
Elastic
Very large elastic
Few elasticities from real life
Total revenue and elasticity of demand

The examples in this figure illustrate some general rules:

• When demand is inelastic (a price elasticity less than 1), price and total revenue move in the
same direction.
• When demand is elastic (a price elasticity greater than 1), price and total revenue move in
opposite directions.
• If demand is unit elastic (a price elasticity exactly equal to 1), total revenue remains
constant when the price changes.
The Price Elasticity of Demand for Breakfast Cereal
MIT economist Jerry Hausman has estimated the price elasticity of demand for breakfast
cereal. He divided breakfast cereals into three categories: children’s cereals, such as Trix and
Froot Loops; adult cereals, such as Special K and Grape-Nuts; and family cereals, such as
Corn Flakes and Raisin Bran. Some of the results of his estimates are given in the following
table:

Just as we would expect, the price elasticity for a particular brand of raisin bran was larger in
absolute value than the elasticity for all family cereals, and the elasticity for all family cereals
was larger than the elasticity for all types of breakfast cereals. If Post increases the price of its
raisin bran by 10 percent, sales will decline by 25 percent, as many consumers switch to
another brand of raisin bran. If the prices of all family breakfast cereals rise by 10 percent,
sales will decline by 18 percent, as consumers switch to child or adult cereals. In both of
these cases, demand is elastic.
But if the prices of all types of breakfast cereals rise by 10 percent, sales will decline by only
9 percent. Demand for all breakfast cereals is inelastic.
Source: Jerry A. Hausman, “Valuation of New Goods under Perfect and Imperfect Competition,” in Timothy F.
Bresnahan and Robert J. Gordon, eds., The Economics of New Goods, Chicago: University of Chicago Press,
1997.
Price and Revenue Don’t Always Move in the Same Direction
New York City officials believed they needed more revenue to maintain 35 city-owned
recreation centers. To raise the additional revenue, the city’s parks department increased the
annual membership fee to use the centers from $75 to $150. According to an article in the
New York Times, “the department had hoped to realize $4 million in new revenue, but in fact,
it lost about $200,000.” The article also explains that the parks department had expected a 5
percent decline in memberships due to the price increase.
a. What did the parks department believe about the price elasticity of demand for
memberships in its recreation centers?
b. Is demand for memberships actually elastic or inelastic? Briefly explain. Illustrate your
answer with a graph showing the demand curve for memberships as the parks department
believed it to be and as it actually is.
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
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
quantity demanded of the first good divided by the percentage change in the price of the
second good

Price elasticity of supply: 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
Graphs of different types of elastic supply curve
Examples:
Zero elastic
Inelastic
Unit elastic
Elastic
Very large elastic
Price Elasticity, Cross-Price Elasticity, and Income Elasticity in the Market for
alcoholic beverages
Many public policy issues are related to the consumption of alcoholic beverages. These issues
include underage drinking, drunk driving, and the possible beneficial effects of red wine in
lowering the risk of heart disease. Knowing how responsive the demand for alcohol is to
changes in price provides insight into these policy issues. Christopher Ruhm of the University
of Virginia and colleagues have estimated statistically the following elasticities. (Spirits
refers to all beverages that contain alcohol, other than beer and wine.)

These results indicate that the demand for beer is inelastic. A 10 percent increase in the price
of beer will result in a 3 percent decline in the quantity of beer demanded. Somewhat
surprisingly, both wine and spirits are complements for beer rather than substitutes. A 10
percent increase in the price of wine will result in an 8.3 percent decrease in the quantity of
beer demanded. Previous studies of the price elasticity of beer had found that beer was a
substitute for other alcoholic drinks. Ruhm and his colleagues argue that their results are
more reliable because they use Uniform Product Code (UPC) scanner data on prices and
quantities sold in grocery stores. They argue that these price data are more accurate than the
data used in many previous studies that included the prices of only one brand each of beer,
wine, and whiskey. The results in the table also show that a 10 percent increase in income
will result in a 0.9 percent increase in the quantity of beer demanded. So, beer is a normal
good. According to the definitions given earlier, beer would be classified as a necessity
because it has an income elasticity that is positive but less than 1.
Source: Christopher J. Ruhm, et al., “What U.S. Data Should Be Used to Measure the Price Elasticity of
Demand for Alcohol,” Journal of Health Economics, Vol. 31, No. 16, December 2012.
Does Drug Interdiction Increase or Decrease Drug-Related Crime