Elasticity

Price elasticity of demand refers to how responsive consumers are to price changes. While higher
(lower) prices lead consumers to purchase less (more), in some instances consumers cut back
consumption to a large degree (called an elastic response) and in other instances they cut back
consumption relatively little (called an inelastic response.)

Elasticity is measured by the following formula:

(% change in qu.demanded)/(% change in price) = e.
Price Elasticity is not Slope. Price elasticity is not slope because the
slope of a demand curve is defined as the change in price divided by a
change in quantity. The slope is constant along a given demand curve.
In the nearby graph, we see that the slope is -2, measured as a price
change of 2 divided by a quantity change of 1.

elasticity

$6
4

3 4

D
Q

Price elasticity is the percentage change in quantity divided by the percentage change of price.
Percentage change thus considers each change in price and quantity and takes into consideration if
these changes are large or small in relative terms (versus absolute terms as in the case of slope).

A one dollar change is relatively large for a can of soda, but

relatively small for a car, and price elasticity takes this information
$6
into account by measuring percentage changes. An elastic demand is
defined as e > 1, which means that the percentage change in quantity 4
demanded > the percentage change in price.

D
Q

For instance, if the percentage change in price is 5%, and the percentage change in quantity is 10%,
the price elasticity of demand is 2 (= 10%/5%) and demand is elastic because e > 1.

An inelastic demand is defined as e < 1, which means that percentage change in quantity demanded
< the percentage change in price. If percentage change in price is 15%, and percentage change in
quantity is 10%, price elasticity of demand is .67 (= 15%/10%) and demand is inelastic because e <
1. We always take the absolute value of the elasticity coefficient, even though mathematically it is
always negative because price and quantity changes always go in opposite directions.

elasticity

This is an elastic demand because the percentage change in quantity is larger than the percentage
change in price.

10
8

10

30

While price falls

by 20%, quantity
rises by 200%.

quantity demanded is very

responsive to a price change
elasticity

This is an inelastic demand because the percentage change in quantity is smaller than the
percentage change in price. While price falls by 20%, quantity rises by 10%.

P
10

10 11

quantity demanded is very

unresponsive to a price change
elasticity

Total Expenditure (TE) is price times quantity purchased and is from the point of view of consumers;
e.g., if Mary bought 5 cups of coffee at $ 1per cup, her total expenditure would be $5, or $1*5. The
nearby schedule exhibits the demand for a particular good in the first 2 columns.
The 3rd column shows the total expenditure that would arise if the consumer were to purchase at the
various prices.
The 3rd column therefore is derived from the first 2 columns.

Price

Qu.
Demanded

TE

$10

2 units

$20

36

56

11

77

TE can also be shown as the area represented by $9 * 4

for example, or $36 as shown below.

P
$9
$36

D
elasticity

Q
5

This relation follows from the total expenditure equation: TE = P * Q. Remember price and quantity
demanded go in opposite directions (law of demand) and therefore if price falls (rises), quantity rises
(falls). When demand is elastic, the percentage change in quantity demanded > the percentage change
in price and therefore changes in total expenditure follow quantity changes. So, the quantity effect
dominates the price effect along a given elastic demand curve. So, if price rises (falls), quantity
demanded falls (rises) , and total expenditure falls (rises) as well when demand is elastic.

When demand is inelastic, the percentage change in quantity demanded < the percentage change in
price and therefore changes in total expenditure follow price changes.
So, the price effect dominates the quantity effect along a given inelastic demand curve.
So, if price rises (falls), quantity demanded falls (rises) , and total expenditure rises (falls) as well
when demand is inelastic.

elasticity

In this course we will always apply the arc elasticity formula when measuring price elasticity
coefficients. For example, consider the following segment off a demand schedule.

Price
$7
5

Qu. Demanded
2 units
4

e = Q/(Q1+Q2) = (2/6) = 2.0

P/(P1+P2) (2/12)

Applying the above formula, Q = 2 since the change in quantity demanded is 4-2; and
P = 2 since the change in price is 7-5; then (Q1, Q2) = (2,4) and (P1,P2) = (7,5). (We take
absolute values for the changes in price and quantity). The elasticity coefficient is 2, which
means that demand is elastic over this range of the demand curve. We use the arc elasticity
formula because the coefficient will vary determining on whether you measure it as a price
fall or a price hike. While the coefficients will vary depending on whether we are moving or
down a demand curve, they will all be elastic in this case.
You should now be able to determine that the arc elasticity coefficient for the following two
(P,Q) combinations: (8,10) and (7,11) is roughly .70.

elasticity

A simple test of whether a demand is price elastic or inelastic is to determine the direction of total
expenditures when price changes. Notice that as price falls, total expenditure rises and thus the demand
schedule below is of an elastic demand. The quantity effect dominates the price effect, which means that
e > 1, which is elastic. (You should check to see this is true by applying the arc elasticity formula we just
discussed to see that e>1 here.)

Another way of showing what happens to total expenditure is

graphically. The demand curve below is elastic; i.e., the
quantity effect dominates the price effect. So, when
dropping price, TE should rise since the drop in price is
relatively smaller than the change in quantity demanded.
Changes in TE are reflected in areas defined by price and
quantities.

Price

Quantity
Demanded

TE

$10

1 units

$10

18

24

TE at price $10, is area A+B. TE at price $9 is area B+C.

Casual inspection reveals that A+B < B+C and so a price $10
reduction leads to an increase in TE and thus is price 9
elastic. In other words, TE rises from $10 to $18 when
price falls from $10 to $9 in this case. Notice also that a
price hike will lower TE when demand is price elastic.

1
elasticity

D
2

never drawn to scale

Notice that as price falls, total expenditure falls and thus the demand schedule below is of an inelastic
demand. The price effect dominates the quantity effect, which means that e < 1, which is elastic.
The demand curve below is inelastic; i.e., the price effect
dominates the quantity effect. So, when dropping price, TE
should fall since the drop in price is relatively larger than the
change in quantity demanded.

TE at price $10, is area A+B. TE at price $9 is area B+C.

Casual inspection reveals A+B > B+C and so a price reduction P
decreases TE and thus is price inelastic. Also notice that a price
hike will raise TE when demand is price inelastic.

Inelastic
Price

Quantity
Demanded

TE

$10

100 units

$100
0

101

909

102

816

D
Q

(As shown in the lecture, most demand schedules show segments of both elasticity and inelasticity).
elasticity

True-False
1. Price cuts in an elastic part of a demand curve generate increases in total revenue.
2. A firm operating in an inelastic part of the demand curve it confronts will always earn more
revenue if it raises the price of its output.
3. If the quantity sold rises by 1% when the price of a good is cut by 2%, the price elasticity of
demand is roughly 2.
4. A price cut in the inelastic part of a demand curve will cause total revenue to fall.
5. A firm's attempt to increase total revenue via a sale would be most likely to succeed if
consumer demand is inelastic.
6. Slope is a precise indicator of elasticity.

elasticity

10

1. Which of the following statements about demand elasticity is correct?

A) If demand is price-inelastic, an increase in price will reduce total expenditures.
B) If demand is price-elastic, an increase in price will increase total expenditures.
C) If demand is price-inelastic, an increase in price will increase total expenditures.
D) If demand is price-elastic, an increase in price will leave total expenditures unchanged.
2. Along a linear demand curve, elasticity
A) increases as price falls.
B) is independent of price.
C) decreases as price falls.
D) is constant since the slope is constant.
3. Elasticity of demand tends to be greater
A) the longer the time period involved.
B) the more complements the good has.
C) the lower the income elasticity of demand.
D) the more widely defined the commodity class.
4. Which of the following would tend to exhibit the most inelastic demand?
a. soft drinks
b. pepsi
c. coke
d. root beer
5. Suppose a minimum wage is legislated whereby wages must be $3 above equilibrium. In which case would
more workers be put out of work? When the demand for labor is
a. elastic
b. inelastic
c. elasticity does not matter here
elasticity

11

6. Use the following table about the demand for pens to answer the following question.
Price
Quantity of Demand
$10
1 unit
9
3
8
5
7
6
If price falls from $8 to $7, demand is:
a. elastic
b. inelastic
c. neither
7. All else equal, expensive goods tend to have
demand relative to cheaper goods.
a. more elastic
b. more inelastic
c. weaker
d. stronger
e. none of these
8. Suppose that, as the price of toothpicks fell from $1.00 per box to $50 cents per box, quantity demanded rose from
20 boxes to 22 boxes. This indicates that the demand for toothpicks is
a. elastic
b. inelastic
c. not enough information to know
9. If the percentage change in quantity demanded is greater than the percentage change in price, demand in that
price range is
a. elastic
b. inelastic
c. not enough information to answer
10. The price elasticity of demand is determined by all of the following except the
a. costs of producing the good
b. time period under consideration
c. availability of substitute goods
d. amount of spending on the good compared to the consumers income
elasticity

12

As discussed in lecture, the determinants of price elasticity of demand are (1) how many
substitutes exist; (2) expenditure size compared to budget; (3) whether good is a luxury or
necessity; and (4) time period of analysis.

Statutory vs. Economic Incidence of a Tax.

Statutory incidence refers to tax law concerning who is responsible for paying the tax
authority. For instance, a tax of $4 may be imposed on each pack of cigarettes sold and in this
case statutory incidence is placed on the seller (e.g., drug store or convenience store). If
sellers are able to raise prices on cigarette packs by $3 per pack, then 75% of the $4 tax falls
on consumers.
Economic incidence refers to who shoulders the real burdens of the tax, and in this case,
some of the economic incidence will be borne by consumers ($3) and some will be borne by
sellers ($1). Notice, that the statutory incidence fully falls on the seller ($4) in this case,
although knowledge of the statutory incidences reveals little about the economic incidence of
the tax.

elasticity

13

Suppose a $3 excise tax is levied on each bag of potato chips sold in California, and so the
statutory incidence is levied on the sellers. Supply curves will rise by the amount of the tax per
unit, as shown below.
Prior to the tax, this seller offers 10 units of output at $10 per unit.
The excise tax causes the supplier to now offer 10 units of output at $13 per unit.
(Each output now carries an additional $3 of cost to the supplier.)

S+ tax

S
$13
10

10

elasticity

14

Suppose each pack of gum is subject to a $1 per unit excise tax. The excise tax is added (vertically) to
the supply curve to make S+tax which then intersects demand and sets a new equilibrium price at P2
and quantity of Q2.
The next step is to determine the economic incidence of this tax. The question becomes: how
much of the tax, at quantity Q2, is borne by the consumer and how much by the seller?

Notice that, at Q2, the full tax is equal to the vertical

distance between S and S+tax, or distance P2P3.

S+ tax
S

So the question becomes: how much of P2P3 is borne by

consumers and how much by sellers?

P2

Consumers bear the higher price, or distance P1P2.

P1

Sellers then must bear what ever is left over, which is

distance P3P1. Notice that P1P2 + P3P1 = P3P2, the
full tax.

P3
D

Q2 Q1

In sum, the statutory tax is equal to P2P3 (the vertical distance between S and S+tax) and is
imposed entirely on the seller. The economic incidence is borne by both consumers (P1P2) and
sellers (P3P1).
elasticity

15

How is Economic Incidence of an Excise Tax Related to Price Elasticity of Demand? Both elastic &
inelastic demands are displayed here thus making it easy to compare economic incidences of taxes.

S+tax

S
Elastic
Demand

With elastic demand, price rises little, thus indicating

consumers bear relatively little, and sellers relatively
much, of economic incidence. Products with relatively
elastic demands include coca-cola (e = 3.8) thus
suggesting that a tax on its use would mostly exert tax
burdens on the sellers.

S+tax
P

In the case of inelastic demand, price rises much, thus

indicating consumers bear relatively much, and sellers
relatively little, of economic incidence. Products with
relatively inelastic demands include gasoline (e = .09 to .31),
medicine (e = .31), beer (e = .3 to .9), rice (e = .55) and
cigarettes (e = .8).

Inelastic Demand

elasticity

16

The following estimates of price elasticity of demand demonstrate the wide range of price
sensitivities of consumers. Air travel ranges from 0.3 (1st class), to 1.5 (pleasure travel). The
relatively inelastic demand for 1st class travel explains why this category rarely exhibits sales,
while the relatively elastic demand for pleasure travel is a category where sales are frequent.
Consider, for example, the graphs below. Total expenditure at P1 is A+B and, at P2, B+C.
Casual inspection reveals that total expenditure rises (falls) in the pleasure travel (1st class)
category when sales are held. Rising prices reveal the opposite: total expenditure falls (rises)
in the pleasure travel (1st class) category.
1st Class

Pleasure Travel

P
P1

P2
B

D
C

True-False
7. A tax on salt will be borne primarily by the buyer.
8. A tax on gasoline will be borne primarily by the seller.
elasticity

17

Price Elasticity of Supply measures the responsiveness of producers to price changes and is defined
as the percentage change in quantity supplied divided by the percentage change in price. Supply
curves that are relatively elastic (inelastic) undergo relatively large (small) changes in quantity
supplied when price changes occur.
Consider how the supply curves below respond to a price increase from P1 to P2. S1 undergoes a
relatively large increase in production and S2 undergoes a relatively small increase. Thus, S1 is
relatively price elastic and S2 is relatively price inelastic.

S2
S1

P2
P1

Q1 Q2

Q3
elasticity

18

Suppose consumer tastes for a apples rises as displayed below. Equilibrium prices rise, but it is
clear that price rises the most when supply is relatively inelastic (i.e., S2) than when relatively
elastic (i.e., S1). Equilibrium quantity rises as well, but rises the most under the relatively elastic
supply (i.e., S1).

S2
S1

P3
P2
P1

D2

D1

Q1 Q2 Q3

Q
elasticity

19

Perfectly Inelastic Supply (e = 0)

The graph below left displays a perfectly inelastic supply curve. It is vertical, meaning that there is
a fixed quantity of product that equals the quantity where the supply curve intersects the horizontal
axis. An example might be this weeks fresh fish catch at a local market. For example, the seafood
market might receive 100 salmon this week. Also notice that equilibrium price is entirely
determined by the location of the demand curve. D1 means that the equilibrium price is relatively
low and D2 means a relatively high equilibrium price. Demand does not determine equilibrium
quantity as long as supply is perfectly inelastic.

S2

S1

S3

P2

P2

P1
D2

P1

P3
D

D1
100

50

100

150

Notice that prices might be quite different as dependent on how many salmon come in next week,
as well as what the demand might be. The graph above right shows how next weeks catch might
cause the equilibrium price and quantity to vary, given one demand D. Of course, demand might
rise or fall as well thus adding to further uncertainty over what equilibrium price will emerge.

elasticity

20

Supply curves will most often have both elastic and inelastic segments. The typical case is that
supply is price elastic at relatively low production quantities and price elastic at relatively large
quantities. The reasoning is that businesses often have great ability to alter production levels at
low levels of production by increasing variable inputs at relatively constant resource costs. For
example, hire another worker, offer an existing employee a few additional hours or simply keep a
factory open for a few more hours each week. But, there is a limit to productive capacity
(consistent with the law of diminishing marginal returns) and so price must rise quickly with
additional output eventually. The graph below shows the typical case. Note the relative
differences in price and quantity changes among the elastic and inelastic segments.

inelastic
Percentages changes in quantity are
larger (smaller) than percentage
changes in price along the elastic
(inelastic) segments.
elastic

elasticity

21

Deadweight Loss and Elasticities

To minimize the deadweight loss of taxation, we should tax only those goods for which demand or
supply, or both, is relatively inelastic. For such goods, a tax has little effect on behavior because
behavior is relatively unresponsive to changes in the price. That is, quantity falls relatively little.
P

P
S

S
Deadweight loss is
larger when
demand is elastic

P
C

Excise
tax = T

P
C
P
E

Excise
tax = T

P
E
P
P

Deadweight loss is
smaller when
demand is
inelastic

P
P
D
Q
T

Q
E

Quantity

Q Q
T E

Quantity

P
S
Deadweight loss
is larger when
supply is elastic

P
C

P
C

Excise
tax = T
P
E
P
P

Excise
tax = T

P
E

Deadweight
loss is smaller
when supply is
inelastic

P
P

D
Q
T

Q
E

D
Q

Q Q
T E

Using Taxes to Correct Negative Externalities

Negative Externality: when private markets fail to allocate on basis of full social costs.
Policymakers attempt to correct problem by using taxes to force producers to act on the full
social costs at S (social costs) rather than S (private costs). The correct tax equals the vertical
difference between S (social costs) and S (private costs) and thus equals ab per unit of
production. The efficient equilibrium lies at Pe, Qe thus indicating that markets tend to price too
low and produce too much in the presence of negative externalities. Tax revenue = ePeab.
Without the tax, (P,Q) is the market outcome.

S (social costs)
S (private costs)

Pe

P
e

Qe Q

elasticity lecture

24

Key Concepts
Price Elasticity of Demand
Price Elasticity is not Slope
Elastic Demand
Inelastic Demand
Perfectly Inelastic Demand
Total Expenditure (TE)
Relationships Between TE, Elasticity and Price Changes
Arc Elasticity
Determinants of Price Elasticity of Demand
Statutory Incidence vs. Economic Incidence of a Tax
Connections between Economic Incidence of a Tax and Elasticity
(Do Consumers or Producers Bear More of the Economic Incidence?)
Tax Revenue
How Taxes Create Deadweight Losses (DWL)
Deadweight Losses Rise with Size of Tax
When Demand is Relative Inelastic (Elastic), DWL of Tax is Small (Large)
DWL of the Corporate Tax (Corporate Tax Earnings Taxed Twice)
Effects of Minimum Wage Law Depends on Price Elasticity of Demand
Price Elasticity of Supply
Elastic Supply vs. Inelastic Supply
Perfectly Inelastic Supply
Deadweight Loss and Elasticity
Effects of Minimum Wage Law Depends on Price Elasticity of Supply
Correcting Externalities Through Taxes
elasticity

25

1T
2T
3F
4T
5F
6F
7T
8F

1C
2C
3A
4A
5A
6A
7A
8B
9A
10 A

elasticity

26