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Economics 1: Lectures 6-7

Elasticity

Ioana R. Moldovan
University of Glasgow
Demand elasticity

Elasticity measures the sensitivity of one variable to a change in another variable.

Price elasticity of demand: is the percent change in quantity demanded divided by


the percent change in price that brought it about.
percent change in quantity demanded %Q
= =
percent change in price %P
Qnew Qold Pnew Pold
%Q = 100 and %P = 100
Qold Pold
or we can write it as
   
%Q Q/Q Q P Q P
= = = =
%P P/P Q P P Q

The demand elasticity is negative, indicating the opposite movement in quantity de-
manded and the price of the good. When comparing elasticities, we however consider
their absolute values.
The price elasticity of demand ranges from zero to (minus) infinity




=0 perfectly inelastic








<1 inelastic
 

 %Q 

 
=  =1 unit elastic
 %P 






>1 elastic







= perfectly elastic
Elasticity and Total Spending (Revenue)
Total revenue: T R = P Q

We know that along a demand curve a decrease in price is associated with an increase in
quantity. What happens to total spending (or total revenues for the firms) will depend
on the elasticity.

Elastic demand: %Q > %P = as P , Q by relatively more and T R

Inelastic demand: %Q < %P = as P , Q by relatively less and T R

For very small changes in both price and quantity, the proportional change in revenues
can be approximated as:
%T R %P + %Q

Example: x% rise in the price of electricity: = y% decline in Watts used

P=1 Q=10 TR = P*Q=10 %TR %P + %Q


10% 1.1 -8% 9.2 10.12 1.2% 2%
1% 1.01 -0.8% 9.92 10.0192 0.192% 0.2%
0.1% 1.001 -0.08% 9.992 10.001992 0.01992% 0.02%
Elasticity Along a Straight Demand Curve

Price Quantity Total Revenue


(P ) (Q) (T R = P Q) Q/P P/Q Ed = (Q/P ) (P/Q)
10 0 0
9 1 9 1 9 9
8 2 16 1 4 4
7 3 21 1 2.33 2.33
6 4 24 1 1.5 1.5
5 5 25 1 1 1
4 6 24 1 0.67 0.67
3 7 21 1 0.43 0.43
2 8 16 1 0.25 0.25
1 9 9 1 0.11 0.11
0 10 0 1 0 0

D curve eqn. : P = 10 Q
The elasticity is:
 
Q/Q Q P
= =
P/P P Q



P .
Elasticity of demand along a straight line varies with the price-quantity ratio Q
Q/P is constant but
 
P
as P and Q
Q
So, moving downwards

on the D-curve, the elasticity of demand declines as the price-
P falls.
quantity ratio Q



Ed > 1 above midpoint




Ed = 1 at midpoint






Ed < 1 below the midpoint
General Notation (Optional):

Demand equation:
P = a bQ
and you can check that (P = a, Q = 0) and (P = 0, Q = a/b) are the extreme points.

The slope of the demand curve is given by:


P a
slope = = = b = constant
Q a/b

At midpoint:
P a/2
= =b
Q a/2b
   
1 P 1
Ed (midpoint) = = b=1
slope Q b
P
a
elasticity > 1

C (elasticity =1)
a/2
elasticity < 1

0 a/2b a/b Q

TR

TRmax
Elasticity and Total Revenue when Demand is Linear

0 a/2b a/b Q
Two intersecting demand curves
P
D1

P o ld

P new
D2

Q o ld Q1 Q2 Q

%Q1 %Q2
Elasticity D1 curve : 1 = and Elasticity D2 curve : 2 =
%P %P
Q1 Qold Q2 Qold
%Q1 = while %Q2 =
Qold Qold

Q1 < Q2 = 1 < 2
At the point of intersection of the two demand curves, D1is steeper and less elastic
(more inelastic). D2 curve is flatter and more elastic.
Elasticity measured over a range.

Assume price of beer drops from 3 to 2 and quantity demanded increases from 100
to 125 bottles
   
2 3 1  125 100  1
%P =  = and %Q =  =
3  3 
100  4
%Q 1/4 3
= = = = 0.75 < 1
%P 1/3 4

Now, what if the price increased? price increases from 2 to 3 and quantity demanded
decreases from 125 to 100 bottles
   
3 2 1  100 125  1
%P =    = and %Q =    =
2  2 125  5
%Q 1/5 2
= = = = 0.4 < 1
%P 1/2 5

Differences occur because we operate with discrete changes. To avoid this, measure
elasticity using the midpoint formula. To do this, we compute the percent change
in price and quantity, using the average of the two points, rather than the initial (old)
values.
P P1 P0 Q Q1 Q0
%P = = P +P

and %Q = = Q +Q

P 1 0 Q 1 0
2 2

%Q
=
%P

Elasticity of demand depends on various factors such as:

 availability of close substitutes/ how (in)dispensable the good is: if a good has close
substitutes, it will have a more elastic demand. A good with few/no close substitutes
will have an inelastic demand.

 how the good/product is defined: broad categories (groups) of goods, e.g. food, may
have few or no substitutes and hence an inelastic demand. A good within a group of
similar or related products (e.g. pasta, meat, fruit in the food category) will have a
rather elastic demand as they have closer substitutes.

 time-span considered elasticity can change over time: elasticity of demand tends to
be greater the longer the time-span considered. Items that have few substitutes in the
short-run may develop ample substitutes over longer time periods.
Cross price elasticity: is the percent change in quantity demanded divided by the
percent change in the price of some other product. Substitute goods have positive cross-
price elasticities. Products that are complements have negative cross-price elasticities.

Income elasticity: is the percent change in the quantity demanded divided by the per-
cent change in income. Normal goods have a positive income elasticity, inferior goods
have a negative income elasticity. A zero income elasticity indicates that a rise in income
leaves the quantity demanded unchanged. Also, at very high levels of income, a further
increase in income might cause a decrease in the quantity demanded of a particular
good.

qm

Positive income elasticity


Quantity

Negative income elasticity


[inferior good]

Zero income
elasticity

0 y1 y2
Income
Supply Elasticity
Elasticity of supply: measures the ratio of the percentage change in the quantity
supplied of a product to the percentage change in its price. Supply elasticity is normally
positive as the supply curve tends to slope upwards. But a perfectly inelastic supply
(vertical supply curve) has a zero elasticity, while a perfectly elastic supply (horizontal
supply curve) has an infinite supply elasticity.

A linear supply curve that goes through the origin (i.e. nothing is supplied if the price
is zero) has a unit elasticity at all points along the curve. To see this,
S curve eqn : P = bQ
   
Q P 1 P
= =
P Q slope Q
 
1
= b=1
b

The elasticity of supply of a good depends on how easy it is to shift resources into
the production of that good and how the costs of producing the commodity vary as its
production varies. As in the case of demand, supply tends to be more elastic over longer
time periods.

Reading material: Lipsey & Chrystal (2011): Chapter 4.