BECO1000 Principles of Microeconomics (010), 2023/2024-1

ELASTICITY
(Textbook: Chapter 4)

Elasticity is a general concept that is used to quantify the responsiveness of one variable
to a change in another variable.
% change in A
Elasticity of A with respect to B =
% change in B

Price elasticity of demand

This is a unit-free measure of the responsiveness of the quantity demanded for a good
or service to a change in the price of the good or service, other things remaining the
same.
% change in QD of good Y
Price elasticity of demand for good Y =
% change in price of good Y

Using the midpoint formula

The percentage change in quantity demanded is calculated using the average quantity,
the average of the initial quantity and new quantity. The percentage change in price is
calculated as the average price, the average of the initial price and new price.

Suppose P1 = 20.5 and P2 = 19.5. Then P = P2 - P1 = -1.

% P = [P/(P1 + P2)/2]  100% = (-1/20)  100% = -5%

And Q1 = 9 and Q2 = 11. Then QD = Q2 - Q1 = 2.

% QD = [QD/(Q1 + Q2)/2]  100% = (2/10)  100% = 20%

Elasticity = 20% / -5% = -4 or |Elasticity| = 4

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By using the average price and average quantity, we get the same elasticity value
regardless of whether the price rises or falls.

According to the law of demand, price elasticity of demand is always negative. The
absolute value, or magnitude, of price elasticity of demand is usually considered, which
ranges from zero to infinity.

TYPES OF PRICE ELASTICTY OF DEMAN

If the quantity demanded remains constant when the price changes, then the price
elasticity of demand is zero and the good is said to have a perfectly inelastic demand.
One good that has a very low price elasticity of demand (perhaps zero over some price
range) is insulin. Insulin is of such importance to some diabetics that if the price rises
or falls, they do not change the quantity they buy.

If the percentage change in quantity demanded equals the percentage change in price,
then the price elasticity equals 1 and the good is said to have a unit elastic demand.

Between perfectly inelastic demand and unit elastic demand is a general case in which
the percentage change in quantity demanded is less than the percentage change in
price. In this case, the price elasticity of demand is between 0 and 1 and the good is said
to have an inelastic demand. Food and shelter are examples of goods with inelastic
demand.

If the quantity demanded changes by an infinitely large percentage in response to a tiny

price change, then the price elasticity of demand is infinity and the good is said to have
a perfectly elastic demand. An example of a good that has a very high elasticity of
demand (almost infinite) is a soft drink from two campus machines located side by side.
If the two machines offer the same soft drinks for the same price, some people buy from
one machine and some from the other. But if one machine’s price is higher than the
other’s, by even a small amount, no one buys from the machine with the higher price.
Drinks from the two machines are perfect substitutes. The demand for a good that has
a perfect substitute is perfectly elastic.

Between unit elastic demand and perfectly elastic demand is another general case in
which the percentage change in quantity demanded exceeds the percentage change in
price. In this case, the price elasticity of demand is greater than 1 and the good is said
to have an elastic demand. Automobiles and furniture are examples of goods that have
elastic demand.

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FACTORS INFLUENCING ELASTICITY OF DEMAND
Closeness of substitutes
The closer the substitutes for a good, the more (price) elastic is the demand for it. Oil
as fuel or raw material for chemicals has no close substitutes so the demand for oil is
inelastic. Plastics are close substitutes for metals, so the demand for metals is elastic.

In everyday language we call goods such as food and shelter necessities and goods such
as exotic vacations luxuries. A necessity has poor substitutes, so it generally has an
inelastic demand. A luxury usually has many substitutes, so it generally has an elastic
demand

Proportion of income spent on the good

The greater the proportion of income spent on a good, the more (price) elastic is the
demand for it.

If the price of gum rises, you consume almost as much as before. Your demand for gum
is inelastic. If apartment rents rise, you look for someone to share with. Your demand
for housing is not as inelastic as your demand for gum. Housing takes a big chunk of
your budget, and gum takes only a little. You barely notice the higher price of gum,
while the higher rent puts your budget under severe strain.

Time elapsed since price change

The longer the time that has elapsed since a price change, the more (price) elastic is
demand.

When the price of oil increased by 400 percent during the 1970s, people barely changed
the quantity of oil and gasoline they bought. But gradually, as more efficient auto and
airplane engines were developed, the quantity bought decreased. The demand for oil
became more elastic as more time elapsed following the huge price hike.

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Elasticity along a linear demand curve
The demand curve below is linear. The price elasticity of demand is not constant along
this demand curve.

At the midpoint of the demand curve, the price is $12.50 and the quantity is 25 pizzas
per hour. If the price rises from $10 to $15 a pizza, the quantity demanded decreases
from 30 to 20 pizzas an hour and the average price and average quantity are at the mid-
point of the demand curve. So price elasticity of demand is 1.

At prices above the midpoint, the price elasticity of demand is greater than 1: Demand
is elastic. To see that demand is elastic, let’s calculate the elasticity when the price rises
from $15 to $25 a pizza. You can see that quantity demanded decreases from 20 to zero
pizzas an hour. The average price is $20 a pizza, and the average quantity is 10 pizzas.
So price elasticity of demand is 4.

At prices below the midpoint, the price elasticity of demand is less than 1: Demand is
inelastic. For example, if the price rises from zero to $10 a pizza, the quantity demanded
decreases from 50 to 30 pizzas an hour. The average price is now $5 and the average
quantity is 40 pizzas an hour. So price elasticity of demand is 1/4.

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Total revenue and elasticity
total revenue from sale of good (TR) = price of good (P)  quantity sold (Q)
Does TR rise or fall in response to a price change?
Elastic demand: % P < % QD (P → TR)
Unit elastic demand: % P = % QD (P → ̅̅̅̅
TR)
Inelastic demand: % P > % QD (P → TR)

At a price of $25, the quantity sold is zero, so total revenue is zero. At a price of zero,
the quantity demanded is 50 pizzas an hour and total revenue is again zero. A price cut
in the elastic range brings an increase in total revenue - the percentage increase in
quantity demanded is greater than the percentage decrease in price. A price cut in the
inelastic range brings a decrease in total revenue - the percentage increase in quantity
demanded is less than the percentage decrease in price. At unit elasticity, total revenue
is at a maximum.

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Income elasticity of demand
This measures the responsiveness of the demand for a good or service to a change in
the income of the buyers, other things remaining the same. It tells us by how much a
demand curve shifts at a given price.
% change in QD of good Y
Income elasticity of demand for good Y =
% change in income

Income elasticities of demand can be positive or negative and they fall into three
interesting ranges:
⚫ Positive and greater than 1 (normal good, income elastic)
⚫ Positive and less than 1 (normal good, income inelastic)
⚫ Negative (inferior good)

When demand is income elastic, the percentage increase in quantity demanded exceeds
the percentage increase in income. Luxury goods fall in this category. When demand is
income inelastic, the percentage increase in quantity demanded is less than the
percentage increase in income. Necessities are generally income inelastic.

If the demand for a good is income elastic, the percentage of income spent on that good
increases as income increases. And if the demand for a good is income inelastic, the
percentage of income spent on that good decreases as income increases.

If the income elasticity of demand is negative, the good is an inferior good. The quantity
demanded of an inferior good and the amount spent on it decrease when income
increases. Goods in this category include small motorcycles, potatoes, and rice.
Low-income consumers buy these goods and spend a large percentage of their incomes
on them.

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Cross elasticity of demand
This measures the responsiveness of the demand for a good or service to a change in
the price of another good or service.
Cross elasticity of demand for good Y with respect to good X
% change in QD of good Y
=
% change in price of good X

The cross elasticity of demand can be positive or negative. If the cross elasticity of
demand is positive, demand and the price of the other good change in the same direction,
so the two goods are substitutes. If the cross elasticity of demand is negative, demand
and the price of the other good change in opposite directions, so the two goods are
complements.

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Price elasticity of supply
This measures the responsiveness of the quantity supplied of a good or service to a
change in the price of it, other things remaining the same.
% change in QS of good Y
Price elasticity of supply for good Y =
% change in price of good Y

According to the law of supply, price elasticity of supply is always positive, the value
of which ranges from zero to infinity.

If the quantity supplied is fixed regardless of the price, the supply curve is vertical and
the elasticity of supply is zero. Supply is perfectly inelastic. A special intermediate case
occurs when the percentage change in price equals the percentage change in quantity
supplied. Supply is then unit elastic. No matter how steep the supply curve is, if it is
linear and passes through the origin, supply is unit elastic. If there is a price at which
sellers are willing to offer any quantity for sale, the supply curve is horizontal and the
elasticity of supply is infinite. Supply is perfectly elastic. A curved supply curve is
illustrative of the different types of price elasticity of supply.

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FACTORS INFLUENCING ELASTICITY OF SUPPLY
Resource substitution possibilities
The more difficult it is to obtain the resources for producing a good or service, the less
(price) elastic is the supply of it.

Some goods and services can be produced only by using unique or rare productive
resources. These items have a low, perhaps even a zero, elasticity of supply. Other goods
and services can be produced by using commonly available resources that could be
allocated to a wide variety of alternative tasks. Such items have a high elasticity of
supply.

Time frame for supply decisions

The longer the time that has elapsed since a price change, the more (price) elastic is
supply.

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