Elasticity

Modified by
Prof. M. Harun-Ar-Rashid
 Elasticity Concepts
 Meaning of elasticity: If Y=f(X), elasticity
measures the responsiveness of Y due to
changes in X.
 A given change in X brings about a change in
Y. The elasticity measure attempts to compare
the relative change in Y with to the relative
change in X.
 Mathematical formulation: %Y Y / Y
 
%X X / X
 Elasticity
 The term elasticity refers to the percentage
change in dependent variable divided by the
percentage change in independent variable.
That is , if Y = f(X), i.e., Y depends on X , the
elasticity of y with respect to x is

Percentage change in dependent variable

Elasticity 
Percentage change in the independent variable
Percentage change in y %Y
Elasticity of Y  
Percentage change in x %X
 Elasticity Values
The elasticity values (in absolute terms) can range
from zero to infinity; each with definite
interpretations.

 0 Perfectly inelastic
 1 Inelastic
 1 Unit elastic
 1 Elastic
  Perfectly elastic
 Elasticity of Demand
The elasticity of demand is the measure
responsiveness of demand for a commodity to
the change in any of its determinants. We
studied that the determinants of demand are the
commodity’s own price, income, price of related
goods (substitutes and complements ),
 3 Demand Elasticity
Concepts
 We shall study 3 demand elasticity concepts:

Own price elasticity : responsiveness of
quantity demanded of a good to changes in
own-price.

Cross price elasticity – responsiveness of
quantity demanded of good A to changes in
price of good B (substitute or complement)

Income elasticity – responsiveness of quantity
demanded of a good due to changes in income.
 Own-Price Elasticity
 Own priceelasticity of demand (ε) – measure
of responsiveness of quantity demanded to
changes in price

%  inQ
 d
%  in P
 Elasticity of demand
Elasticity of demand is
Percentage in change in quantity demanded
d 
Percentage change in price
Q Q
100
% Q Q Q
  
% P P P
100
P P
Proportati onate chaneg in quantity demanded

Proportati onate chaneg in price
Q P Q P
   
Q P P Q
dQ P
In terms of differenti ation  
dP Q
 Two ways of measuring
elasticity
 Point elasticity  elasticity is measured for a
single point

More precise since elasticity changes at every
point on demand curve

Can be obtained if demand function is known
 Arc elasticity  computed for two points
along a demand curve

Done if we have limited number of observations
 Point Elasticity
P
%Qd Qd / Q Qd P
   
%P P / P P Q
 slope P/Q
Price

P1 A

0 Q1 Q

Quantity
 Arc Elasticity

P
Q2  Q1 P2  P1
  
Q2  Q1 P2  P1
Diff Q Diff P
  
Sum Q Sum P
Price

P1 A

B
P2

0 Q1 Q2 Q

Quantity
 Arc Elasticity: Example

P
200-100 30-20
  
200+100 30+20

100 10 1 5
     5 / 3 1.66
Price

A
300 50 3 1
30

B
20

0 100 200 Q

Quantity
 Elasticity Along a Linear Demand Curve

• Elasticity goes down as

P
you move down along a
D linear demand curve.

Elastic •The upper half is elastic,

the lower half is inelastic.
P1
•At the mid-point of the
Unit Elastic
demand curve, elasticity is
Price

P unitary.
Inelastic

D
0 Q1 Q Q
Quantity
 Geometric derivation of ε

P %Q Q / Q Q P
   
%P P / P P Q
A
DC BD DC
  
BD OD OD
BC

AB
E B
Price

O D C
Q
Quantity
 Geometric derivation of ε
BC

AB
P P

A A

C C
0 Q 0 Q

Elastic at B Inelastic at B
Demand function: Qd = 20 - 2P
Price Quantity Slope Elasticity
10 0 -2 
9 2 -2 -9.00
8 4 -2 -4.00
7 6 -2 -2.33
6 8 -2 -1.50
5 10 -2 -1.00
4 12 -2 -0.67
3 14 -2 -0.43
2 16 -2 -0.25
1 18 -2 -0.11
0 20 -2 0.00
 Special Case:
 Perfectly Inelastic Demand Curve:

P D
• A vertical demand curve
implies that any change in price
will not lead to a change in
quantity demanded.
Price

%Qd 0
   0
%P 

0 Q

Quantity
 Special Case:
 Perfectly Elastic Demand Curve:
• A horizontal demand curve
P implies that a very small change
in price will lead to an infinitely
large change in quantity
demanded.
D
Price

%Qd 
   
%P 0

0 Q

Quantity
 Elasticity and Total Revenue
 Total revenue (from the point of view of a
seller) is equal to the quantity sold multiplied
by the price.
 TR = P x Q
 It is of interest to the seller what happens to his
TR if he raises or lowers his price, knowing
that if he does, consumers will adjust their
purchases.
What happens to TR when price increases?
Answer: it depends on the elasticity of demand

%Q

%P

Elastic TR decreases
P Q
Unitary TR unchanged
P Q
Inelastic TR increases
P Q
What happens to TR when price decreases?

Answer: it depends on the elasticity of demand

%Q

%P

Elastic TR increases
P Q
Unitary TR unchanged
P Q
Inelastic TR decreases
P Q
Determinants of price elasticity of demand

(1) the availability of good substitutes for the commodity


 more substitutes, more elastic
(2) the number of uses the good can be put into

 more uses, more elastic
(3) the price of the good relative to the consumer's purchasing
power

 if good takes a larger share of budget, likely to be more elastic
(4) the time frame under consideration

 longer period of time, more elastic
(5) location along the demand curve.

 recall ideas on “elasticity and the linear demand curve”
 The Determinants of Price
Elasticity of Demand
 The exact value of price elasticity for a commodity
is determined by a wide variety of factors. The two
factors considered by economists are (i) the
availability of substitutes and (ii) time. The better
the substitutes for a product, the higher the price
elasticity of demand.. The longer the period of
time, the more the price elasticity of demand for
that product. The price elasticity of necessary
goods will have lower elasticity than luxuries.
 The elasticity of demand depends
on the following factors:
 1.Nature of the commodity: The
demand for necessities is inelastic
because the demand does not change
much with a change in price. But the
demand for luxuries is elastic in
nature.
 2. Extent of use: A commodity having a
variety of uses has a comparatively
elastic demand.
 3. Range of substitutes: The commodity
which has more number of substitutes has
relatively elastic demand. A commodity
with fewer substitutes has relatively
inelastic demand.
 4. Income level: People with high
incomes are less affected by price changes
than people with low incomes.
 5. Proportion of income spent on the
commodity: When a small part of income
is spent on the commodity, the price
change does not affect the demand
therefore the demand is inelastic in nature.
 6. Urgency of demand / postponement of purchase:
The demand for certain commodities are highly
inelastic because you cannot postpone its purchase.
For example medicines for any sickness should be
purchased and consumed immediately.
 7. Durability of a commodity: If the commodity is
durable then it is used it for a long period. Therefore
elasticity of demand is high. Price changes highly
influences the demand for durables in the market.
 8. Purchase frequency of a product/
recurrence of demand: The demand for
frequently purchased goods are highly
elastic than rarely purchased goods.
 9. Time: In the short run demand will be
less elastic but in the long run the demand
for commodities are more elastic.
 Cross Price Elasticity of Demand
 Definition:responsiveness of quantity
demand of a good to changes in price of other
goods.
%Qdx
 Formula: exy 
%P y

 Sign: + for substitutes,

- for complements
 Cross Elasticity of demand
Cross Elasticity of demand is
Percentage in change in quantity demanded of Commodity x
d 
Percentage change in price of commodity y
Qx Qx
100
%Qx Qx Qx
  
%Px Py 100 Py
Py Py
Proportationate chaneg in quantity demanded

Proportationate chaneg in price
Qx Py Qx Py
   
Qx Py Py Qx
dQx Py
In terms of differentiation  
dPy Qx
 Example of Cross Elasticity
 Tasty company markets coffee brand X and estimated the
following regression of the demand for its brand of coffee:
 QX = 1.5 ̶ 3.0PX +0.88M + 2.0PY ̶ 0.6PS +1.2A
 Where QX= Sales of coffee brand X in India, in million of pounds
per year
 PX = Price of coffee brand, in dollars per pound
 M = Personal disposable income, in trillions of dollars per year.
 PY = Price of the competitive brand of coffee, in dollars per pound.
 PS = Price of sugar, in dollar per pound.
 A=Advertising expenditure for coffee brand X, in hundreds of
thousands of dollars per year.
 Example of Cross Elasticity
 Suppose also that this year, P X
=$2, M = $2.5, PY
X
= $1.80, PS = $0.50, and A = $1, substituting these
value in equation
 QX = 1.5 ̶ 3.0PX +0.8M + 2.0PY ̶ 0.6PS +1.2A
 QX = 1.5 ̶ 3(2) +0.8(2.5) +2(1.80) ̶ 0.6(0.50) + 1.2 (1) =2
 QX =2
X

 Thus, this year the firm would sell 2 million pounds of coffee brand X
 Example of Cross Elasticity
 This firm can use this information to find the
elasticity of the demand for coffee brand X
with respect to its price, income, the price of
competitive coffee brand Y, the price of sugar,
and advertising. Thus,
2 2.5
 P  3( )  3,  M 0.8( ) 1,
2 2
1.8 0.50
 XY 2( ) 1.8,  XS  0.6( )  0.15,
2 2
1
 A 1.2( ) 0.6,
2
 Income Elasticity of Demand
 Definition: responsiveness of quantity
demanded of a good to changes in income

 Formula: %Qdx
 xI 
%I
 Sign: + for normal goods
- for inferior goods
 Elasticity of Income
Elasticity of Income is
Percentage in change in quantity demanded
d 
Percentage change in income
Q Q
100
% Q Q Q
  
% M M M
100
M M
Proportati onate chaneg in quantity demanded

Proportati onate chaneg in income
Q M Q M
   
Q P M Q
dQ M
In terms of differenti ation  
dM Q
 Example

1. Given the demand for beef

Qb = 4850 ‒ 5Pb +1.5Pm + 0.1M with money
income M=10,000, Pb=200, and the price of mutton
Pm = 500
Calculate (i) Own Price elasticity
(ii) Cross Price elasticity
(iii) Income Elasticity
 Example
 2. Given Qx = 750 ‒ 2Px+0.02M, Where Px= 25
and Income M = 5000. Find (a) the price
elasticity of demand and (b) the income
elasticity.
 3. Given Q = 400 ‒8P+0.05M, where P=15 and
M = 12,000. Find (a) the income elasticity of
demand and (b) the growth potential of the
product, if income is expanding by 5 percent a
year (c) Comment on the growth potential of the
product.
4. Given Q1= 100 ‒ P1 + 0.75P2 ‒ 0.25P3 + 0.0075M.
At P1 = 10, P2 = 20, P3 = 40, and M = 10,000 . Find
the different cross price elasticity of demand.
5. Given Q1= 50 ‒ 4P1 + 3P2 + 2P3 + 0.001M. At P1
=5, P2 = 7, P3 = 3, and M = 11,000 . (a) Use cross
price elasticity to determine the relationship good 1
and the other two goods. (b) Determine the effect on
Q1 of 10 per cent price increase for each of the other
goods individually
 Factors Influencing Elasticity Of
Supply
 1. Nature of the commodity: If the
commodity is perishable in nature then the
elasticity of supply will be less. Durable
goods have high elasticity of supply.
 2. Time period: If the operational time period
is short then supply is inelastic. When the the
production process period is longer the
elasticity of supply will be relatively elastic.
 3. Scale of production: Small scale
producer’s supply is inelastic in nature
compared to the large producers.
 4. Size of the firm and number of products:
If the firm is a large scale industry and has
more variety of products then it can easily
transfer the resources. Therefore supply of
such products is highly elastic.
 5. Natural factors: Natural calamities
can affect the production of agricultural
products so they are relatively inelastic.
 6. Nature of production: If the
commodities need more workmanship,
or for artistic goods the elasticity of
supply will be high.
 Some Applications
 Minimum Price Policy– floor prices to protect
producers (price support) or workers
(minimum wage)
 Maximum Price Policy – price ceilings to
protect consumers (fares, rice price, LPG
price, etc.
 Tax Incidence – who bears the burden when
tax is imposed on the producer?
 Minimum price policies
 prices cannot go below a specified price
 E.g. price support for agricultural commodities,
minimum wages
 floor price is usually set above the equilibrium
price and it causes a surplus
 Floor Price
(minimum price policy)

Examples:
P
Minimum wages,
price support for
S rice farmers
surplus

Pf To be effective, a floor price

(Pf) must be set above the
equilibrium price(P*)
P*
Price

D
0 Q1 Q* Q
Quantity
 Maximum price policy
(price ceiling)
 price cannot be set above a specified price
 Example: maximum fares allowed public
transport operators
 Usually set below the equilibrium price and
causes a shortage
 Price Ceiling
(maximum price policy)

P
Examples:
S
Price control of
rice, rents, LPG

Pf
To be effective, a price
P* ceiling (Pf) must be set
Price

below the equilibrium

price(P*)
Pc

shortage
D
0 Q1 Q* Q
Quantity
 Tax incidence
 Concerned with effects of government tax
policies on consumption and production.
 The tax could either be a specific or
excise tax or an ad valorem tax.

specific tax or excise tax  tax per unit of
the product

ad valorem tax  tax as percentage of the
selling price.
 Tax incidence
 Question: Who bears the greater portion of
tax? Is it the consumer or the producer?
 Supply and demand analysis of a specific tax:

the tax is likely to be paid for by producers and
consumers

the tax is likely to raise the equilibrium price, but
by an amount less than the tax.
 Tax Incidence

P
S1

S0
P0+ t
tax
P1+ t
Price

P0

P1

D
0 Q1 Q2 Q0 Q

Quantity
 Tax Incidence
D
P
S1

S0
P0+ t
tax
Price

P0 If demand is Perfectly
Inelastic : all of the
tax is passed on to
consumers.

0 Q0 Q

Quantity
 Tax Incidence: Perfectly Elastic Demand

P
S1

S0

tax
Price

D
P0
If demand is Perfectly
Elastic : all of the tax
burden is borne by the
producer.

0 Q1 Q0 Q

Quantity
 Consumer Surplus
P

S1
Consumer surplus:
difference between
what a consumer is
Price

willing to pay and

P1
what he actually pays
for the good.

0 Q1 Q

Quantity
 Consumer Surplus
P

S1
S2

When market price

Price

P1 decreases, consumer
surplus becomes
bigger
P2

0 Q1 Q2 Q

Quantity
 Producer Surplus
P

S1
Producer surplus:
difference between what a
producer receives (market
Price

price) and the amount that will

P1
motivate him to supply the
product (marginal costs must
be recovered).

0 Q1 Q

Quantity