ELASTICITY
Size of Changes in Market
Equilibrium
What determines the size of changes in
market equilibrium?
Size of change in demand (or supply)
The larger the shift in demand (or supply), the
larger the effect on price
Steepness of the curve that does not shift
If the supply curve shifts, the steeper the
demand curve the more the price changes and
the less the amount bought and sold changes
Steepness reflects responsiveness to prices
2-2
Changes in Equilibrium for Two Extreme
Demand Curves
2-3
Changes in Equilibrium for Two Extreme Supply
Curves
2-4
Steepness of the demand curve
P
S”
S
Q
D2 D1
Elasticities of Demand and Supply
A measure of the responsiveness of the
amounts demanded and supplied to
changes in prices
Not the same as the slope of the supply
or demand curve
Slope of the curve depends on the units
used to measure the quantity of the good
and its price
Elasticity does not depend on units (e.g.,
gallons, dozens, dollars per pound) 2-6
Demand Elasticities
Demand curves can come in different
shapes
From very flat to very steep
Very flat demand curve: a small change in
price has a large effect on quantity
demanded
Very steep curve: even a large change in
price does not affect quantity demanded too
much
Question: how sensitive is quantity
demanded to price changes?
Elasticity
We know that quantity demanded
depends on many things
So we can ask a more general question.
How sensitive is demand to change in any
of the relevant factors:
- Own price
- Income
- Related prices
- Etc.
Demand Elasticities
Consider the market demand for a commodity, q
Let it depend on a factor y (which might be its own
price, or the price of a related good, or income).
Then the elasticity of demand for q with respect to
y is defined as:
the percentage change in q that results from
a 1% change in y.
It is the percentage change in q divided by the
percentage change in y.
Two situations:
Situation 1 2
Quantity q1 q2
Y y1 y2
Let Dq = q2 – q1
Dy = y2 – y1
Since percentage changes are pure numbers, the
elasticity measure will always be a unit-free pure
number.
Elasticity of q with respect to y
Dq Dy
=[ ----x100] divided by [----x100]
q y
Dq y
= ----x----
Dy q
Therefore elasticity of quantity demanded
can be with respect to:
- own price (price-elasticity of
demand)
- any other price (cross price-
elasticity)
- income (income elasticity)
We will spend some time on the concept of
the price-elasticity of demand
Price Elasticity of Demand
For downward sloping curves, prices and quantities
move in opposite directions, so that the elasticity
value is negative.
To avoid this problem, we consider the absolute
value of the elasticity.
Dq p
e = - ----x---- = - (p/q)x(Dq/Dp).
Dp q
Calculation of elasticity
Situation 1 Situation 2
p1 = Rs.10 p2 = Rs.9.00
q1 = 100 q2 = 105
Consider finite changes in prices and quantity:
e = - [Dq/Dp]x[p/q],
Dq = q2 - q1 = 5
Dp = p2 - p1 = -1
1. Point-elasticity measures.
e = - [Dq/Dp]x[p1/q1]
= -(-5)x(10/100) = 5/10 = .5
e = - [Dq/Dp]x[p2/q2]
= -(-5)x(9/105) = 9/21 = 3/7
= .42
“small changes” in price -> not much
difference between these two.
For larger changes, the differences
become substantial.
2. Arc-elasticity measure
To get rid of this ambiguity, take an average
of the values:
Dq [(p2 + p1)/2]
e = - ---------------------------
Dp [(q2 + q1)/2]
= - [Dq/Dp][(p2 + p1)/(q2 + q1)]
= 5(19/205) = .46.
ACTIVE LEARNING
Calculate an elasticity
Use the following
information to
calculate the
price elasticity
of demand
for hotel rooms:
©stefanolunardi/Shutterstock.com
if P = $135, Qd = 8600
if P = $165, Qd = 7400
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
ACTIVE LEARNING
Applying the principles
Use midpoint method to calculate
% change in Qd
(8600 – 7400)/8000 = 15%
% change in P
($165 – $135)/$150 = 20%
The price elasticity of demand equals
15%
= 0.75
20%
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Elasticities for Linear Demand Curves
For linear demand curves remember that the
price elasticity of demand formula is:
DQ P
E
d
DP Q
Notice that the first term is related to the
slope of the demand curve
The second term is the initial price divided by
the initial quantity
2-19
Elasticities for Linear Demand Curves
Notice that:
Slope is constant along linear demand curve
but (P/Q) varies, so elasticity varies along
the demand curve
Demand is more elastic at higher prices
since P is larger and Q is smaller
Demand is less elastic at lower prices since
P is smaller and Q is larger
2-20
P
Consider the straight-line
demand curve AB. What is e
A at the point C?
Note: [Dq/Dp] = EB/CE,
D C
p = CE, q = OE
B
O E Q
A Straight Line Demand Curve
Then price-elasticity at a point C on the
demand curve = (EB/CE)(CE/OE) = EB/OE
= (BC/CA)
(by property of similar triangles).
At the mid-point of the demand curve, e = 1.
All points above this have elasticity greater
than 1.
Demand at all points below the mid-point is
inelastic.
Price Elasticity Regions along
a Straight-Line Demand Curve
Observation
Price elasticity varies at
every point along a straight-
line demand curve
a 1
1
Price
a/2 1
b/2 b
Quantity
If the percentage change in q > the
percentage change in p, then e > 1, and
we have elastic demand.
If the percentage change in q = the
percentage change in p, e = 1 and we say
that demand is unit elastic.
If the percentage change in q < the
percentage change in p, so that e < 1,
demand is said to be inelastic.
Price Elasticity and the
Steepness of the Demand Curve
What is the price elasticity of
demand when P = Rs.4?
12
D1
4 1 1
D1
4 12 2
6
6
Price
4 1
4 D2 2
4 6
D2 12
4 6 12
Quantity
Price Elasticity and the
Steepness of the Demand Curve
12 Observation
If two demand curves have a
point in common, the steeper
curve must be less elastic with
D1
6
respect to price at that point
Price
D2
4 6 12
Quantity
Price elasticity
Suppose that we have a differentiable
demand function Q = Q(P).
Then elasticity at a point (P*, Q*) on the
demand curve is
E = -(dQ/dP)(P*/Q*)
where dQ/dP is evaluated at (P*, Q*)
Example: Let Q = p-a
Then dQ/dP = (-a) p-a-1
E = -[(-a) p-a-1][p/p-a] = a (independent of
the point on the demand curve)
The Variety of Demand Curves
The price elasticity of demand is closely
related to the slope of the demand curve.
Rule of thumb:
The flatter the curve, the bigger the
elasticity.
The steeper the curve, the smaller the
elasticity.
Five different classifications of D
curves.…
“Perfectly inelastic demand” (one extreme case)
Price elasticity % change in Q 0%
= = =0
of demand % change in P 10%
D curve: P
D
vertical
P1
Consumers’ P falls
price sensitivity: by 10%
P2
none
Q
Elasticity: Q1
0 Q changes
by 0%
“Inelastic demand”
Price elasticity % change in Q < 10%
= = <1
of demand % change in P 10%
D curve: P
relatively steep
Consumers’ P falls P1
by 10%
price sensitivity: P2
relatively low D
Q
Elasticity: Q1 Q2
<1
Q rises less
than 10%
“Unit elastic demand”
Price elasticity % change in Q 10%
= = =1
of demand % change in P 10%
D curve: P
intermediate slope
P1
Consumers’ P falls
price sensitivity: by 10%
P2
intermediate D
Q
Elasticity: Q1 Q2
1
Q rises by 10%
“Elastic demand”
Price elasticity % change in Q > 10%
= = >1
of demand % change in P 10%
D curve: P
relatively flat
Consumers’ P falls P1
price sensitivity: by 10%
P2 D
relatively high
Q
Elasticity: 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%
D curve: P
horizontal
P2 = P1 D
Consumers’
price sensitivity: P changes
extreme by 0%
Q
Elasticity: Q1 Q2
infinity
Q changes
by any %
Range of Price elasticity of Demand
0_______________1________________+
∞
Perfectly Unit
Perfectly
Inelastic Elasticity Elastic
Demand Demand
EXAMPLE
Insulin vs. Caribbean Cruises
The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
To millions of diabetics, insulin is a necessity.
A rise in its price would cause little or no
decrease in demand.
A cruise is a luxury. If the price rises,
some people will forego it.
Lesson: Price elasticity is higher for luxuries
than for necessities.
EXAMPLE 4
Petrol in the Short Run vs. Petrol in the Long Run
The price of petrol 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 carpool.
In the long run, people can buy smaller cars
or live closer to work.
Lesson: Price elasticity is higher in the
long run than the short run.
The Determinants of Price Elasticity:
A Summary
The price elasticity of demand depends
on:
the extent to which close substitutes are
available
whether the good is a necessity or a luxury
how broadly or narrowly the good is defined
the time horizon—elasticity is higher in the
long run than the short run
Elasticity and Total Revenue
What do you think?
Will increasing the market price always
increase total revenue?
Application:
Could reducing the supply of illegal drugs
cause an increase in drug-related burglaries?
The Effect of Extra Border
Patrols on the Market for Illicit Drugs
Total Expenditure = P x Q
S Rs.2500 = Rs.50 x 50
S’ Rs.3200 = Rs.80 x 40
S’
80
P(Rs./ounce)
S
50
D
40 50
Q(1,000s of ounces/day)
Relationship between elasticity and total
revenue
TR = pq
dTR = d(pq) = pdq + qdp
= qdp(1 – e)
Consider what happens if price is lowered, so that
dp < 0.
dTR > 0 if 1 – e < 0, i.e. e > 1
dTR = 0 if 1 = e
dTR < 0 if e < 1
The relationship between elasticity and revenue can be represented
clearly with a simple example. Suppose that the equation of the
demand curve is Q = a – P, i.e. P = a – Q. The total revenue is TR =
PQ = aQ – Q2 which, for non-negative values of TR can be
represented by the following graphs:
For this expression, the price-elasticity
e = -(DQ/DP)(P/Q = -(-1)(P/Q) = (a –
Q)/Q = a/Q – 1
It can then be shown that e > 1 when
Q < a/2, i.e. in the rising part of the
curve,
e = 1 when Q = a/2 (at the peak point
of the curve) and e < 1 for Q > a/2.
Income-elasticity of Demand
em = (Dq/DM)(M/q)
In the case of a normal good, em > 0,
while for an inferior good, it is < 0.
If 0 < em < 1, then the good is called a
necessity, otherwise it is a luxury.
Cross-price Elasticity of Demand
The cross-price elasticity of the
commodity x with respect to the price p of
y is defined as
exy = (Dx/Dp)(p/x)
If this is positive, x and y are said to be
substitutes (Coke and Pepsi), while if this is
negative, the commodities are said to be
complements (tea and sugar).
Uses of Cross-price elasticity
1. Forecasting change of demand
Let us suppose that Limes and Oranges are substitute cold
drinks. The cross elasticity of demand between Limes and
Oranges is +1.5.
The manufacturer of Limes receives the information that
the price of Oranges is about to fall by 10%. The
manufacturer of Limes can then predict by how much the
demand of its product will fall as a result of fall in price of
Oranges.
2. Classification of market
Higher the value of cross elasticity of demand between the
products, greater will be the competition in the market, and
lower the value of cross elasticity, the market will be less
competitive.
Price Elasticity of Supply
Suppose that q now refers to quantity
supplied.
The price elasticity of the supply of q with
respect to the price p is defined as
es = (Dq/Dp)(p/q)
Since supply curves are upward-sloping, this
expression will be non-negative – no need
to put a negative sign in front of the
expression
Calculating the Price
Elasticity of Supply Graphically
A 4 12 12 4 1 S
Qs = AP B
5
P
A
4
Q
Price
B 5 15 15 5 1
0 12 15
Quantity
In general, even for straight line supply curves,
the price elasticity of supply will vary from point
to point.
For example : P = 10 + 2Qs
Two points on the line are (Qs = 1, P = 12, and
Qs = 2, P = 14)
Show that the price elasticities at these two
points are different.
Application - Farming
Suppose that university agronomists
discover a new wheat hybrid that is more
productive than existing varieties.
What happens to wheat farmers?
The discovery of the new wheat hybrid
affects the supply curve – it shifts to the
right.
The demand curve remains the same
Application - Farming
Price of wheat
D S
S’
S S’ D
Quantity of wheat
Application - Farming
What happens to the total revenue received by
the farmers?
Q rises but P falls
The demand for basic foodstuffs such as wheat
is usually inelastic, for these items are relatively
inexpensive and have few good substitutes
Hence fall in P is substantial while rise in Q is
small
Revenue to all wheat farmers taken together
falls
Application - Farming
If farmers are made worse off by the
discovery of the new hybrid, why do they
adopt it?
Each farmer is a small part of the market
For any price, it makes sense for each
farmer to adopt the hybrid
But when they all do it, the supply curve
shifts and together, they are worse off
Application - Farming
Certain agricultural programs try to help
farmers by inducing them not to plant crops
on all their land
The purpose is to reduce the supply of farm
products and thereby raise prices
With inelastic demand, farmers as a whole
receive greater revenue
No single farmer, by himself, would have
found it profitable to leave some land fallow
Price Support
Another way for the government to help the
farmers is by having a support price, at which
price the government stands prepared to buy
any amount supplied by the farmers
Over time, this may lead to the growth of “buffer
stocks”
Will perish if just stockpiled
Some can be used for employment generation
programmes, or meeting food requirements in a
lean year
What to do with the rest?
Wheat export allowed to free storage
space
3 July 2012
Faced with a severe space constraint in the
country’s overflowing granaries, the government
today cleared export of two million tons of wheat
from its buffer stock that is expected to clear
storage space for new crops.
This was approved by the Cabinet Committee on
Economic Affairs. Informed sources said after the
CCEA meeting that export with a floor price of
$228 (about Rs 12,400) per ton.
At present, the government is grappling
with the problem of storage capacity.
India, the world’s second-largest producer
of wheat, had harvested a record 90.23
million tons in 2011-12 crop year (July-
June), leading to a record procurement of
nearly 38 million tons so far this year.
Its godowns are overflowing with a record
82 million tons of rice and wheat against
the storing capacity of only 64 million tons.
The export of two million tons would
involve an outgo of Rs 1,263 crore.
TAXES
Governments levy taxes to raise revenue
for public projects, to pay for wages and
salaries in the public sector, to pay
interest on debt, etc..
Taxes
A specific tax is a fixed rupee amount
that must be paid on each unit bought or
paid for
An ad valorem tax is a tax that is stated
as a percentage of the good’s price
The incidence of a tax indicates how
much of the tax burden is borne by
various market participants
15-57
Taxes
In studying the effects of taxes it’s
important to distinguish between the
amount a consumer pays for a good and
the amount a firm receives
Use Pb for the amount a consumer
pays, Ps for the amount a firm receives
If the tax is T per unit, then Ps = Pb - T
The Burden of a Tax
Consider the effect of a specific tax of T
rupees per liter paid by petrol pumps on
their sales of petrol
Graphically, there are three ways to
determine the tax’s effect:
Shift the supply curve up by T
Shift the demand curve down by T
Use a wedge between the amounts
consumers pay and firms receive
All three methods yield the same results
Makes no difference whether the tax is
levied on consumers or producers
Effects of a Specific Tax
Shifting the supply curve is one way to
determine a specific tax’s effects
Demand curve remains unchanged
For any price paid by consumers, firms
now receive less than when there is no
tax
Won’t be willing to supply as much as
before
Supply curve with the tax is a distance
T above the original supply curve
Effects of a Specific Tax
New equilibrium price paid by
consumers is price at which the
demand curve and new supply curve
cross
Amount bought and sold falls
Price paid by consumers rises;
price received by firms falls
In a competitive market the burden
of a tax is shared by consumers and
firms
Effects of a Specific Tax – Shifting the
Supply Curve
ST
Price Paid by Consumers ($/gallon)
Increase in S
Consumer Cost
per Gallon Po + T
B
Pb T
Po A
P s = Pb - T
Decrease in
Firms’ Receipts
per Gallon
D
QT Qo
Gallons of Gas per Month
15-62
Tax Incidence
Incidence of a tax depends on the shapes of
the demand and supply curves
In general, the more elastic is demand and
less elastic is supply, the more of the tax is
borne by firms
Firms cannot pass on the tax to the
consumers because the latter are sensitive to
price changes
Consumers bear the larger share of the tax
when demand is less elastic than supply
Incidence of a Specific Tax – Two
Special Cases
15-64
Effects of a Specific Tax – Shifting the
Demand Curve
15-65
Linear demand and supply
Let Qd = a – bpb
and Qs = c + dps
Also, ps = p b - t
Equilibrium requires
a – bpb= c + dps
Then a – b(ps+ t) = c + dps
Solving for the equilibrium price ps*, we get
ps* = (a – c – bt)/(d + b)
