1. Elasticity

2. Aims & Objectives
After studying this lesson, you would be able to understand
Elasticity of Demand & its practical application
Elasticity of Supply & its practical application

3. Elasticity of Demand

4. Elasticity of demand
This measures the responsiveness of quantity demanded of a good or a service by a consumer to change in factors like price, income, price of related products etc.
The three main types of elasticity of demand are:
Price elasticity
Income elasticity
Cross elasticity

5. Price elasticity of demand
This measures the responsiveness of quantity demanded of a good or service by a consumer to change in its own price.
It is defined as
Ep = (% change in quantity demanded)/(% change in price of the
good or service)
= [(ΔQ/Q) * 100]/[(ΔP/P )*100]
Where, ΔQ denotes change in quantity
ΔP denotes change in price
Q denotes original quantity
P denotes original price

6. Arc vs Point elasticity
Arc elasticity measures the responsive of demand to large changes in prices as measured over an arc of the demand curve. The formula for arc price elasticity is given as,
Ep = [(Q2-Q1)/1/2(Q2+Q1) /[(P2-P1)/1/2(P2+P1)
Point elasticity measures the responsive of demand to very small changes in prices . The formula for arc price elasticity is given as,
Ep = [(ΔQ/Q) * 100]/[(ΔP/P )*100]

7. Note: Price Elasticity of Demand Formula
Use percentages
Unit free measure
Compare responsiveness across products
Eliminate the minus sign
Easier to compare elasticities
Absolute changes depend on the choice of units. For example, a change in the price of a $10,000 car by $1 is very different than a change in the price a of $1 can of beer by $1. The auto’s price is rising by a fraction of a percent while the beer’s price is rising 100 percent.
Percentages also make it possible to compare elasticities of demand for different products.
Because of the inverse relationship between price and quantity demanded, the actual elasticity of demand will be a negative number. However, we ignore the minus sign and use absolute value. This makes it less confusing to interpret the elasticity coefficient.
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8. Elastic vs Inelastic demand
Elastic demand - Products with price elasticity greater than one are said to be price elastic. This is usually the case for luxury goods. These are
Sensitive to price changes
Large change in quantity
Inelastic demand - Products with price elasticity of demand less than 1 are said to be price inelastic. This usually the case of necessary goods. These are
Insensitive to price changes
Small change in quantity
Law of demand tells us that consumers will respond to a price decrease by buying more of a product (other things remaining constant), but it does not tell us how much more. The degree of responsiveness or sensitivity of consumers to a change in price is measured by the concept of price elasticity of demand.
If demand is elastic, there is a large change in quantity demanded even when price changes by a small amount. When demand is inelastic, there is a very small change in quantity demanded even when there is a large change in price.
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9. Interpretation of Elasticity of Demand
Ed > 1 demand is elastic
Ed = 1 demand is unit elastic
Ed < 1 demand is inelastic
Extreme cases
Perfectly inelastic - when demand is unresponsiveness to changes in price. Demand curve is vertical
Perfectly elastic - when any quantity of the product can be sold at a given price. Demand curve is horizontal
Unit elasticity: When proportional change in quantity is exactly equal to 1. Demand curve is rectangular hyperbolic in shape
Normally, elasticity varies between 0 to infinity as one moves up along an demand curve with elasticity being 1 at the mid point of the demand curve

10. Perfectly inelastic demand
Extreme Cases P D1
Perfectly inelastic demand
(Ed = 0)
This extreme situation is called perfectly inelastic demand and it is very rare. The demand curve would be vertical and graphs as a line parallel to the vertical axis. The elasticity coefficient is 0. An example of a perfectly inelastic demand might be a diabetic’s demand for insulin.
Perfectly inelastic demand
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11. Extreme Cases Perfectly elastic demand P D2 Perfectly elastic demand
(Ed = ∞)
This extreme situation, in which a small price reduction would cause buyers to increase their purchases from zero to all that it is possible to obtain, is perfectly elastic demand, and the demand curve would be horizontal. The elasticity coefficient is infinite. An example of a perfectly elastic demand is a firm’s demand curve in a purely competitive industry who is unable to change the price.
Perfectly elastic demand
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12. Application of price elasticity of demand: The Total Revenue test
Total Revenue = Price X Quantity
Inelastic demand
P and TR move in the same direction
Elastic demand
P and TR move in opposite directions
Total-revenue test is the easiest way to judge whether demand is elastic or inelastic. This test can be used in place of the elasticity formula, unless there is a need to determine the elasticity coefficient. The total revenue test is important to understand the relationship between price elasticity and total revenue.
Demand is inelastic if a decrease in price results in a fall in total revenue, or an increase in price results in a rise in total revenue.
Demand is elastic if a decrease in price results in a rise in total revenue, or if an increase in price results in a decline in total revenue.
Demand is unit elastic if total revenue does not change when the price changes.
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13. Total Revenue Test Lower price and elastic demand
Revenue gained = Blue area exceeds revenue lost = yellow area $3 2 1 Q P a b
A lower price and elastic demand means that total revenue will rise. Blue gain (extra total revenue from extra sales) exceeds orange loss (the loss in total revenue from the higher price). D1
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14. Total Revenue Test Lower price and inelastic demand
Revenue lost = Yellow area exceeds Revenue gained = blue area $4 3 2 1 Q P c
A lower price and inelastic demand means that total revenue will fall. Blue gain (extra total revenue from extra sales) is less than the orange loss (the loss in total revenue from the higher price). d D2
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15. Total Revenue Test Lower price and unit elastic demand
Revenue gained = Blue area equals Revenue lost = yellow area $3 2 1 Q P e f
A lower price and unit-elastic demand, means that total revenue is unchanged. Blue gain (extra total revenue from extra sales) is exactly equal to the orange loss (the loss in total revenue from the higher price). D3
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16. Elasticity and Total Revenue$8 7 6 5 4 3 2 1 a b c d e f g h
Elastic
Ed > 1
Unit Elastic
Ed = 1
Price
Inelastic
Ed < 1 D 1 2 3 4 5 6 7 8
Quantity Demanded
$20 18 16 14 12 10 8 6 4 2
This graph shows the relationship between price elasticity of demand for movie tickets and total revenue. Demand curve D in (a) is based on Table 4.1 and is marked to show that the hypothetical weekly demand for movie tickets is elastic at higher price ranges and inelastic at lower price ranges. The total-revenue curve, TR, in (b) is derived from demand curve D. When price falls and TR increases, demand is elastic; when price falls and TR is unchanged, demand is unit elastic; and when price falls and TR declines, demand is inelastic.
You can see from the graph that elasticity changes along a demand curve. Demand tends to be more elastic in the upper-left portion of demand and more inelastic in the lower-right portion of demand.
(Thousands of Dollars)
Total Revenue TR 1 2 3 4 5 6 7 8
Quantity Demanded
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17. Summary of Price Elasticity of Demand
Price Elasticity of Demand: A Summary
Absolute Value of Elasticity Coefficient
Demand Is:
Description
Impact on Total Revenue of a:
Price Increase
Price Decrease
Greater than 1
(Ed > 1)
Elastic or relatively elastic
Qd changes by a larger percentage than does price
Total Revenue decreases
Total Revenue increases
Equal to 1
(Ed = 1)
Unit or unitary elastic
Qd changes by the same percentage as does price
Total revenue is unchanged
Total revenue
is unchanged
Less than 1
(Ed < 1)
Inelastic or relatively inelastic
Qd changes by a smaller percentage than does price
Total revenue increases
Total revenue decreases
This is a summary of the rules and concepts related to the elasticity of demand. This is an excellent table to study and help you prepare for the test. It’s a great summary of all of the different pieces to consider with elasticity and get an idea of how they fit together and change.
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18. Elasticity and Pricing Power
Charge different prices based on price elasticities
Example:
Higher prices for Business air travelers
Some firms have “market power” or “pricing power” that allows them to set their product at prices that are in their best interests. For some goods and services, firms may find it advantageous to determine differences in price elasticity of demand and then charge different prices to different buyers.
Business air travelers have a more inelastic demand for air travel, so they are charged higher prices since they will stay pay it. Families are sensitive to prices, so firms will charge lower prices for children as a result of the more elastic demand.
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19. Determinants of Elasticity of Demand
Substitutability - More substitutes, demand is more elastic
Proportion of Income - Higher proportion of income, demand is more elastic
Luxuries vs. Necessities - Luxury goods, demand is more elastic
Time - More time available, demand is more elastic
With more substitutes available, consumers have more alternative options, so when there is a change in price, there is a greater percentage change in quantity demanded, making the demand more elastic. The broader the definition of the market, the more elastic the demand. With a more narrow definition of the market, demand is more inelastic.
The greater the proportion of income needed to buy the good the more elastic the demand. Consumers will be more sensitive to changes in prices because the price change can result in thousands of dollars difference.
Since luxuries are goods that consumers can go without, they will change the amount they purchase by a greater amount even if the price changes by a small amount.
It takes time to alter the amount being purchased, so the more time available, the more elastic the demand. A person doing their Christmas shopping on Christmas Eve has a very inelastic demand because he/she doesn’t have the time to look around for alternative purchases.
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20. Income elasticity of demand
This measures the responsiveness of quantity demanded of a good or service to a change in the consumer’s income.
It is defined as
EI = (% change in quantity demanded)/(% change in income
of the consumer)
= [(ΔQ/Q) * 100]/[(ΔI/PI)*100]
Where, ΔQ denotes change in quantity
ΔI denotes change in price
Q denotes original quantity
I denotes original price

21. Classification of goods on basis of income elasticity value
Inferior good: income elasticity of demand is negative
Normal good: income elasticity of demand is positive
Necessities : income elasticity is less than 1
Luxuries: income elasticity is greater than 1

22. Cross price elasticity of demand
This measures the responsiveness of quantity demanded of a good or service to a change in price of a related good
It is defined as
Exy = (% change in quantity demanded of X )/(% change in
price of Y)
= [(ΔQx/Qx) * 100]/[(ΔPy/Py )*100]
Where, ΔQx denotes change in quantity of good X
ΔPy denotes change in price of good Y
Qx denotes original quantity of X
Py denotes original price of Y

23. Classification of goods on basis of cross elasticity value
Substitute goods: cross elasticity of demand is positive
Complementary goods: cross elasticity of demand is negative
Unrelated goods: cross elasticity of demand is zero

24. Elasticity of Supply

25. Price Elasticity of Supply
Measures sellers’ responsiveness to price changes
Elastic supply, producers are responsive to price changes
Inelastic supply, producers are not responsive to price changes
We know that at higher prices firms are willing and able to produce more, whereas at lower prices firms are willing and able to produce less. Price elasticity of supply measures how sensitive firms are to price changes. This means that even for small changes in price, firms will greatly alter the quantity being produced. On the other hand, when supply is inelastic, this means that the firm is unresponsive to price changes and therefore will not change the amount being produced by much, even when the change in price is large.
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26. Price Elasticity of Supply
Formula to compute elasticity
Es > 1 supply is elastic
Es < 1 supply is inelastic
Percentage Change in Quantity
Supplied of Product X
Percentage Change in Price
of Product X
Es =
We use percentages so it doesn’t matter which unit of measure we are using. The concept of price elasticity also applies to supply. The elasticity formula is the same as that for demand, but we must substitute the word “supplied” for the word “demanded” everywhere in the formula. Just like with price elasticity of demand, we will compute the price elasticity of supply using the midpoint formula.
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27. Price Elasticity of Supply
Time is primary determinant of elasticity of supply
Time periods considered are
Market period
Short Run
Long Run
The ease of shifting resources between alternative uses is very important in price elasticity of supply because it will determine how much flexibility a producer has to adjust his/her output to a change in the price. The degree of flexibility, and therefore the time period, will be different in different industries.
The market period means that there is no time to adjust output in response to a price change. Some industries may not have a market period.
The short run means that there is enough time to adjust output by increasing or decreasing the variable inputs but not the fixed inputs.
The long run means that there is enough time to adjust output by increasing or decreasing all inputs.
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28. Elasticity of Supply: The Market Period
Perfectly inelastic supply P Q Sm Pm
There is no time to adjust to a price change, making the supply perfectly inelastic. With a perfectly inelastic supply, the increase in demand does not change the quantity at all.
If we look at the case of the tomato farmer, we can see that on market day he or she loads the truck and goes to the market where upon arriving discovers the price is much higher (lower) than anticipated. The farmer cannot increase (decrease) the amount supplied, this is the market period. P0 D2 D1 Q0
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29. Elasticity of Supply: The Short Run
Supply is more elastic than in market period P Q Ss Ps
In the short run there is enough time to adjust output by increasing or decreasing the variable inputs but not the fixed inputs. Supply is more elastic than in the market period, thereby resulting in a smaller increase in price but also an increase in quantity.
In the short run, the tomato farmer can increase (decrease) the supply somewhat by increasing (decreasing) the variable inputs like labor, fertilizer, irrigation, etc. However, the tomato farmer cannot increase (decrease) the size of the farm in this time period because farm size is fixed. P0 D2 D1 Q0 Qs
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30. Elasticity of Supply: The Long Run
Supply is even more elastic than in the short run P Q Sl Pl
In the long run there is enough time to adjust output by increasing or decreasing all inputs since all inputs are variable by this time. This means that supply will be even more elastic and with the same increase in demand, there is an even greater increase in the quantity than in the short run, but a smaller increase in price.
In the long run all inputs are variable even the farm size. The tomato farmer can expand (reduce) the size of the farm in regards to long run price increases. P0 D2 D1 Q0 Ql
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31. Thank You