ELASTICITY

Prof. (Dr.) Vandana Bhavsar

 What is an Elasticity?
Measurement of the percentage change in one
variable that results from a 1% change in
another variable.
It is Responsiveness measure
Can come up with many elasticities.
We will introduce four.
three from the demand function
one from the supply function
 Why Economists Use
Elasticity?
An elasticity is a unit-free measure.

Elasticities allow economists to quantify the

differences among markets without standardizing
the units of measurement.

Why introduce them?

Demand and supply responsiveness clearly
matters for lots of market analyses.
To compare across markets: inter market
To compare within markets: intra market
 DEMAND & SUPPLY
ELASTICITY
Price elasticity of demand: how sensitive
is the quantity demanded to a change in
the price of the good.
Price elasticity of supply: how sensitive
is the quantity supplied to a change in the
price of the good.
Often referred to as own price
elasticities.
 OWN PRICE ELASTICITY
P = Current price of good X
XD = Quantity demanded at that price
P = Small change in the current price
XD= Resulting change in quantity demanded
Percentage Change in Quantity Demanded
E.O.DP
Percentage Change in Price
P = Current price of good X
XS = Quantity Supplied at that price
P = Small change in the current price
XS= Resulting change in quantity supplied
Percentage Change in Quantity Supplied
E.O.SP
Percentage Change in Price
 Price Elasticity of Demand
When the price of
milk rises by 1%
the quantity Price elasticity
demanded falls by
0.2%, so milk of demand is
demand is not -0.2 .
very price
sensitive [D2]

When the price of

ice cream rises by
1% the quantity Price elasticity D1
demanded falls by
2.6%, so ice cream of demand is
demand is very -2.6.
price sensitive D2
[D1].
Quantity
 Perfectly Elastic Demand
We say that demand is
perfectly elastic when
a 1% change in the Price

price would result in

an infinite change in
Perfectly Elastic Demand (elasticity = )
quantity demanded.

O
Quantity
Perfectly Inelastic Demand
We say that demand
is perfectly inelastic
when a 1% change in Price

the price would

result in no change
in quantity
demanded. Perfectly
Inelastic
Demand
(elasticity = 0)

O
Quantity
 Price Elasticity of Supply
When the price of
oil increases by 1%
the quantity S1
supplied increases Price
by 0.2%, so the elasticity of
quantity supplied S2
supply is 0.2.
of oil is less
sensitive to the
price [S1].

When the price of

beef increases by
1% the quantity Price
supplied increases elasticity of
by 5%, so beef supply is 5.
supply is very price
sensitive [S2]. Quantity
 Perfectly Elastic Supply
Price

We say that supply is

Perfectly Elastic Supply (elasticity = )
perfectly elastic when a
1% change in the price
would result in an
infinite change in
quantity supplied.
Quantity
 Perfectly Inelastic Supply
We say that supply is
perfectly inelastic Price

when a 1% change in
the price would result
in no change in Perfectly
quantity supplied. Inelastic
Supply
(elasticity = 0)

Quantity
 contd
Milk and Ice Cream
It doesnt matter that milk is sold by the
gallon and ice cream is sold by the pint .
We compare the demand elasticities of -0.2
(milk) and -2.6 (ice cream).
Ice cream demand is more price sensitive.
Oil and Beef
It doesnt matter that oil is sold by barrels
while beef is sold by the ounce
We compare the supply elasticities of 0.2 (oil)
and 5 (beef).
Beef supply is more price sensitive.
 Size of Price Elasticities

Unit elastic
Inelastic Elastic

0 1 2 3 4 5 6

Unit elastic: own price elasticity equal to 1

Inelastic: own price elasticity less than 1
Elastic: own price elasticity greater than 1
 Determinants of Price
Elasticity
Availability of substitutes
Nature of commodity
Weight age in the total
consumption
Time fraction in
adjustment of
consumption patterns
Range of commodity use
Proportion of market
supplied
 Measurements of P.E.O.D

1) Point Method
2) Arc Method
3) Total Expenditure Method
4) Percentage/Proportionate Method
5) Revenue Method
 Point Formula for Own P.E.O.D
The exact formula for calculating an elasticity at
the point A on the demand curve.
Note: well take absolute value

P A
X D

elasticity A

P
atA
X

MB Lower segment of DC
E at point M
MA Upper Segment of DC
 Slope of the Demand Curve
Price

P is the change in
price. (P<0)
ADemand
P
slope
X
X is the change in P M
quantity. P+ P
P
M
X

slope = P/ X

1/slope = X/P B
X X + X Quantity
 ARC METHOD FORMULA
When elasticity is computed between two separate
points on a curve.

OriginalQ NewQ
originalQ NewQ
E
OriginalP NewP
OriginalP NewP
Q1 - Q2 P1 P2
E
Q1 Q2 P1 P2
 Using Demand Elasticity: Total
Expenditures

Do the total expenditures on a product go up or

down when the price increases?
The price increase means more spent for each
unit.
But, quantity demanded declines as price rises.
So, we must measure the price elasticity of
demand to answer the question.
 Express Way Toll Example
Current toll for the Pune Mumbai Express Way is
Rs 2.00/trip.
Suppose the quantity demanded at Rs 2.00/trip is
1,00,000 trips/hour.
If the price elasticity of demand for Highway trips is
2.0, what is the effect of a 10% toll increase?
Toll increase of 10% implies a 20% decline in the
quantity demanded.
Trips fall to 80,000/hour.
Total expenditure falls to Rs. 176,000/hour (=
80,000 x Rs. 2.20).
Rs. 176,000 < Rs. 200,000, the revenue from a Rs.
2.00 toll.
 contd..
Now suppose the elasticity of demand for
Highway trips is 0.5.
How would the number of trips and the
expenditure on tolls be affected by a 10%
increase in the toll?
Toll increase of 10% implies a 5% decline in the
quantity demanded.
Trips fall to 95,000/hour.
Total expenditure rises to Rs. 209,000/hour (=
95,000 x Rs. 2.20).
Rs. 209,000 > Rs. 200,000, the revenue from a
Rs. 2.00 toll.
Elasticity, Total Expenditures
& Total Revenue
A price increase will increase total
expenditures/total revenue if, and only if, the
price elasticity of demand is less than 1 in
absolute value (between -1 and zero)
Inelastic demand
A price reduction will increase total expenditures
/total revenue if, and only if, the price elasticity
of demand is greater than 1 in absolute value
(less than -1).
Elastic demand
 Cross- Price Elasticity of
Demand
Elasticity of demand with respect to the price of a
complementary good (cross-price elasticity)
This elasticity is negative because as the price of a
complementary good rises, the quantity demanded of
the good itself falls.
Example software is complementary with computers.
When the price of software rises the quantity
demanded of computers falls.
% change in the Dx
Ec
% change in the Py
Qx Py
Ec or
Qx Py
Qx Py
Ec
Py Qx
 contd

Elasticity of demand with respect to the price of a

substitute good (also a cross-price elasticity)
This elasticity is positive because as the price of a
substitute good rises, the quantity demanded of the
good itself rises.
Eg. hockey is substitute for basketball. When the
price of hockey tickets rises the quantity demanded of
basketball tickets rises.
Cross-price elasticity quantifies this effect.
 Income Elasticity of Demand
The elasticity of demand with respect to a consumers income
is called the income elasticity.
When the income elasticity of demand is positive (normal
good), consumers increase their purchases of the good as
their incomes rise (e.g. automobiles, clothing).
When the income elasticity of demand is greater than 1
(luxury good), consumers increase their purchases of the
good more than proportionate to the income increase (e.g.
foreign tours).
When the income elasticity of demand is negative (inferior
good), consumers reduce their purchases of the good as their
incomes rise (e.g. bajra, jowar).

% change in the Dx
Ey
% change in the Y
Qx Y Qx Y
Ey
Qx Y Y Qx
 contd
There are 3 main types
Positive Income Elasticity
Egs. Normal goods
Unit Income Elasticity
Elastic Income Elasticity
Inelastic Income Elasticity
Negative Income Elasticity
Egs. Inferior/Giffen goods
Zero Income Elasticity
Egs. Salt, postcard, newspaper, candles,
buttons etc