AF1605 Introduction to Economics

Topic 3: Elasticity of Demand

Lecturer: Chau Tak Wai

School of Accounting and Finance

 Price elasticity of demand

 Cross elasticity of demand

 Income elasticity of demand

 Price elasticity of supply

 Per-unit tax and price elasticities

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 Price elasticity of demand (ε) is a measure of the responsiveness of
changes in quantity demanded to changes in its own price.
 It is defined as percentage change in quantity demanded divided by
percentage change in price.
 A unitless measure of the quantity response: independent of the unit
of price and quantity.

New Q – Initial Q
Percentage change in quantity = × 100
Initial Q

New P – Initial P
Percentage change in price = × 100
Initial P

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 Therefore, ΔQ
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 Q0
𝜀= =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃 Δ𝑃
𝑃0

Δ𝑄 𝑃0
𝜀= ×
Δ𝑃 𝑄0

1 𝑃0
𝜀= ×
𝑠𝑙𝑜𝑝𝑒 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 𝑐𝑢𝑟𝑣𝑒 𝑄0

 Notice that ε (in principle) is always negative. (Why?)

 Normally, we ignore the minus sign and use the absolute value.
 Note: slope is not the same as elasticity. 4
 When we use the above formula to consider a change between two
points on the demand curve/schedule. We call this an arc elasticity.

 If we use initial value as the denominator, for the same price change over
the same interval, percentage change in price depends on whether the
price rises or falls.
 For example, if price falls from $10 to $9, percentage change in price
equals 10%. If price rises from $9 to $10, percentage change in price
equals 11.11%.
 Similar reasoning applies to change in quantity.

 To avoid this problem, we can use the mid-point method:

Change in Q / Average Q
ε =
Change in P / Average P
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 When we consider a change between two points on the demand
curve/schedule, it is an arc elasticity.

 People also calculate the elasticity at a point on the demand curve, which
approximates a small change around this point. This is only applicable to
continuous case only.

1 𝑃0
 Recall that 𝜀 = ×
𝑠𝑙𝑜𝑝𝑒 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 𝑐𝑢𝑟𝑣𝑒 𝑄0
 Since the slope of a curve at a point is defined (slope of tangent), the
point elasticity can be defined by evaluating the slope, P and Q at a
specific point on the demand curve.

 Example: If the demand curve is given by P = 5 – Q. What is the demand

elasticity when P = 3?
 1/slope = -1, P=3, Q=2. Therefore, 𝜀=1 x (3/2) =1.5.
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1. Elastic demand (ε > 1) if |% change in Q| > |% change in P|

2. Unit elastic demand (ε = 1) if |% change in Q| = |% change in P|

3. Inelastic demand (ε < 1) if |% change in Q| < |% change in P|

4. Perfectly elastic demand (ε = ) if change in Q is infinite when there is a

change in P (a horizontal demand
curve)

5. Perfectly inelastic (ε = 0) if Q does not change when there is a

demand change in P (a vertical demand curve)

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Here we use arc elasticity.

ε = ------------------ = ε = -------------------- =

8
ε = --------------------- =

9
10
 Demand curve: P = 6 - Q/5
 Let’s calculating the point
elasticity of demand at various
points using the formula
1 𝑃
𝜀=| |×
𝑠𝑙𝑜𝑝𝑒 𝑄
P Q P/Q |1/slope| 𝜀
5 5
4 10
3 15
2 20
1 25
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Note: This is a continuous demand curve. I just pick some points for illustration.
 For a linear demand curve, each
point on the demand curve has
ε =|1/slope| x (P/Q)
different values of price elasticity of
demand.

 At any price above the midpoint,

demand is elastic.

 At the midpoint, demand is unit

elastic.

 At any price below the midpoint,

demand is inelastic.

 Same slope, different elasticity.

 Slope ≠ Elasticity
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 Price elasticity of demand depends on two major factors:
 Availability of substitutes
 Proportion of income spent

 Proportion of income spent

 When the proportion of income spent on a good is high, when its price
increases, the increase in expenditure is large.
 People would then reduce the quantity to a larger extent in response (to
make it affordable, and possibly switch to substitutes).
 Therefore, the higher the proportion of income spent on that good and
the more elastic is the demand for the good.
 e.g. salt versus housing (size / quality)

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 Availability of substitutes
 The demand for a good is more elastic if it is easier to find a substitute.

 For example:
 Luxury versus Necessity
 The demand for a necessity tends to be more inelastic.
 The demand for a luxury tends to be more elastic.
 Example: surgical masks vs movie tickets
 Narrowness of definition
 The demand for a narrowly defined good tends to be more elastic.
 The demand for a broadly defined good tends to be more inelastic.
 Example: jeans vs clothing
 Time elapsed since price change
 The longer the time elapsed since the price change, the more elastic is the
demand for the good, as people may take time to search for substitutes.
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Source: https://opentextbc.ca/principlesofeconomics/chapter/5-3-elasticity-and-pricing/#Table_05_04
 Which of the following is not correct about elasticity of
demand?

 A. When slope is constant along a demand curve, the elasticity

of demand can be changing.

 B. When the demand is elastic at a point on the demand curve,

the percentage change in quantity is higher than the
percentage change in price.

 C. Demand for Oolong tea is more inelastic than the demand

for all tea.

 D. Demand for size of rental housing can be very inelastic in a

short period of time, but it is more elastic for a longer period of
time. 17
 Total revenue (TR) received by sellers equals the price of the
good multiplied by the quantity of the good sold (P × Q).

 Total revenue also equals total expenditure paid by buyers.

 Note: Don’t mix up price with total expenditure. Price is quoted

per unit quantity unless otherwise specified.

 There is a specific relationship between the elasticity of

demand and change in revenue under a price change along the
same demand curve.
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 In brief, the direction of change in total revenue follows the direction of
change of price or quantity which changes in a higher percentage.
 Mathematically,
Δ𝑇𝑅 = 𝑃 + Δ𝑃 𝑄 + Δ𝑄 − 𝑃𝑄
= 𝑃𝑄 + Δ𝑃 × 𝑄 + 𝑃 × Δ𝑄 + Δ𝑃 × Δ𝑄 − 𝑃𝑄
= Δ𝑃 × 𝑄 + 𝑃 × Δ𝑄 + Δ𝑃 × Δ𝑄
 Dividing both sides by TR = P x Q, we have
Δ𝑇𝑅 Δ𝑃 𝑄 𝑃(Δ𝑄) Δ𝑃 Δ𝑄
% change in TR = × 100% = + + × × 100%
𝑇𝑅 𝑃𝑄 𝑃𝑄 𝑃 𝑄
Δ𝑃 Δ𝑄
≈ × 100% + × 100%
𝑃 𝑄
= % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃 + % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄
 The cross-term can be negligible when both change in P and change in Q
are small. (e.g. (-0.05)x0.05=-0.0025).
 Note also that the two % changes are in opposite signs. Thus, the final
direction of change in TR depends on the one with a higher % change. 19
20
Should a producer increase or decrease the price of the product to
increase his total revenue under each of the following cases?

TR decreases TR decreases

TR increases
TR increases

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 ε =|1/slope| x (P/Q)

P Q TR
5
4
3
2
1

Note: This is a continuous demand curve. I just pick some points for illustration.
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Elastic demand → Price and total revenue change in the
opposite direction.

Inelastic demand → Price and total revenue change in the same

direction.

Unit elastic demand → Price change leaves total revenue unchanged.

Perfectly inelastic demand → Price and total revenue change in the same
direction and in the same proportion.

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 Suppose a bus route increased its price by 5%, and number
of passengers this bus route carried decreased by 1%.
(Assume that it is the bus company trying to set the price
along the demand curve.) Which of the following is true?

Demand Elasticity Change in Revenue

A elastic decrease
B inelastic increase
C unitary elastic unchanged
D perfectly inelastic increase

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 Cross (price) elasticity of demand is a measure of the extent to which the
demand for a good changes when the price of a substitute or complement
changes, other things remaining the same.

Cross elasticity Percentage change in quantity demanded of a good

of demand =
Percentage change in the price of one of its
substitutes or complements

Δ𝑄𝐵 Δ𝑃𝐴
𝜀𝐴𝐵 = ( )/( )
𝑄𝐵 𝑃𝐴
 The cross elasticity of demand for substitutes in consumption is positive.
 The cross elasticity of demand for complements in consumption is negative.
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The red lines denote the queues observed during daily rush hours on the CHT’s connecting roads. A
vehicular trip via the 1.8 km CHT may take up to 30 minutes.

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Own Price elasticity:

Cross Price elasticity:

Eastern with Western

Eastern with Hung Hom

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 Income elasticity of demand is a measure of the extent to which the
demand for a good changes when income changes, other things
remaining the same.

Income elasticity Percentage change in quantity demanded of a good

of demand =
Percentage change in income
Δ𝑄𝐴 Δ𝐼
𝜀𝑖 = ( )/( )
𝑄𝐴 𝐼

Income elasticity of demand of a normal good is positive.

Income elasticity of demand for an inferior good is negative.
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1) Which one of the following statements is INCORRECT regarding
income elasticity of demand?
(a)One of the reasons why the income elasticity of demand for a good is negative
is that the good has some better-quality substitutes.
(b) A normal good has a positive income elasticity of demand.
(c)The income elasticity of demand for a luxury is likely to be large.
(d)The income elasticity of an inferior good lies between 0 and 1.

2) If the cross elasticity of demand is -4 between French fries and orange juice in
McDonalds and their income elasticities of demand are 0.6 and 1.5 respectively.
Which of the following is NOT correct?
(a) French fries and orange juice are complements in consumption
(b) French fries and orange juice are substitutes in consumption
(c) French fries is a normal good.
(d) Orange juice is a normal good.
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 Price elasticity of supply is a measure of the extent to which the quantity
supplied of a good changes when the price of the good changes.

Percentage change in quantity supplied

Price elasticity of
=
supply Percentage change in the price
Δ𝑄𝑆 Δ𝑃
𝜀𝑆 = ( )/( )
𝑄𝑆 𝑃

 If the price elasticity of supply is greater than 1, supply is elastic.

 If the price elasticity of supply equals 1, supply is unit elastic.

 If the price elasticity of supply is less than 1, supply is inelastic.

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Influences on the Price Elasticity of Supply
The two main influences are:
 Storage possibilities
 Production possibilities
 Time elapsed since price change

Storage Possibilities
 The supply of a storable good is more elastic, as we can more flexibly
adjust the inventories.
 e.g. fresh fruits vs stationery/household goods

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Production Possibilities
 If extra amount of goods can be produced at a similar cost, it would have a
more elastic supply. (e.g. can readily employ more inputs from other
production or there are some excess capacity.)
 If it is much more costly to get extra inputs to increase production, the
supply tends to be more inelastic. (e.g. difficult to get extra inputs or
already close to full capacity.)
 Goods that can be produced in only a fixed quantity have a perfectly
inelastic supply. (e.g. seats in a stadium)
Time Elapsed Since Price Change
• As more time passes after a price change, producers find it easier to
change their production plans (obtaining more or less inputs), so supply
becomes more elastic.

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 Consider the case of a per-unit sales
tax of $10 imposed to the sellers for
selling this good.
 What will happen?

 Consumers pay a price P that

includes the tax.
 Sellers now can only receive (P-10)
for selling one unit after giving $10
to the government.
 They are willing to sell the quantity
at (P-10) from the original supply
curve.
 It means the supply curve shifts
upward by exactly $10.

 Demand curve remains unchanged.

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 The new equilibrium price, as shown in the
demand supply diagram, rises to $105 from
$100 in this case.
 Caution: The market equilibrium price rises,
but generally by LESS than the amount of per-
unit tax.
 The market equilibrium quantity drops from
5,000 units to 2,000 units.

 Generally, when demand curve is downward

sloping and supply curve is upward sloping:
 Increase in price is less than the amount
of tax.
 Price paid by buyers is higher than
before.
 Price received (net of tax) by sellers is
lower than before.
 The $10 per-unit tax is shared by both
the buyers and sellers. 34
 Consumer Tax Burden

 Tax revenue (or tax expenditure

or tax burden) equals the per-
unit tax multiplied by the new
market quantity.
 Tax burden by buyers:
(price with tax – price before tax)
x quantity after tax.
 Tax burden by sellers:
(price before tax - (price with tax
– amount of tax)) x quantity
after tax
 Caution: The party who takes
the tax money to the
government is NOT necessarily
the one who bear the burden of
the tax. Producer tax burden 35
 The relative tax burden is related to the relative size of price elasticity of
demand and price elasticity of supply.
 Given the same price elasticity of supply, if price elasticity of demand is
higher (more elastic), the proportion of tax burden to consumers is
lower.
 Given the same price elasticity of supply, if price elasticity of demand is
lower (more inelastic), the proportion of tax burden to consumers is
higher.
 Intuition: More inelastic demand means the consumers depend on this
good more instead of trying to substitute it by other goods. Thus, they
have to bear more the negative consequence of an increase in tax.

 Similarly, given the same price elasticity of demand, if price elasticity of

supply is higher (more elastic), the lower the proportion of tax burden
to the producers and vice versa.

 The tax burden would be equally shared if the price elasticity for
demand and supply are the same. 36
 37
Source: Principles of Economics from University of Minnesota Online Library
 Which of the following about a per-unit tax imposed to sellers
is INCORRECT?

 A. The supply curve shifts upward by the amount of per-unit

tax.

 B. The new equilibrium quantity is lower.

 C. The new equilibrium price paid by buyers increases by the

amount of tax.

 D. The tax burden for sellers becomes higher if demand is more

elastic.

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 Q: What if the tax is imposed to consumers (consumers pay a tax separately on
top of the market price?
 A: Demand curve will shift downward by the amount of per-unit tax, as the
consumers deduct the money paid to the government from those to the market.

 Q: If instead the government provides a per-unit subsidy to sellers of the good,

how will it change the demand or supply curve?
 A: The seller takes the subsidy from the government when they sell a unit to
consumers. Therefore, sellers are willing to sell at a lower price in the market
exactly by the amount of the subsidy.
 Thus, the supply curve shifts downward by the amount of per-unit subsidy.

 Q: If the government provides a per-unit subsidy to buyers of the good, how will
it change the demand or supply curve?
 A: The demand curve will shift upward by the amount of subsidy.
 Since consumers can receive money from the government for buying each unit
of the good, the consumer is willing to pay more in the market by the amount of
subsidy, as the price includes the subsidy.

 You may continue to derive the market outcome under the above situations.
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 Price elasticity of demand

 Cross elasticity of demand

 Income elasticity of demand

 Price elasticity of supply

 Per-unit tax and price elasticities

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