Lecture 2: Chap 4

Block 3: Elasticity

(Own) Price Elasticity of Demand (PED)

• PED: measures the responsiveness of quantity demanded (QD) of a good to changes in
its own price, ceteris paribus. “Queen”
𝑫
% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑸
𝑷𝑬𝑫 =
% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒑𝒓𝒊𝒄𝒆
“Princess” PED = 0
• PED is negative as long as there is a negative relationship between price & QD. P
(i.e. the demand curve slopes downwards). D
$3
• When |PED| = 0, demand is perfectly price inelastic. $2
o QD does not change at all when price changes (i.e. vertical demand curve). $1
Q
• When |PED| < 1, demand is price inelastic. 10
o QD changes by a smaller % than a given % change in price PED = 
P
• When |PED| > 1, demand is price elastic.
o QD changes by a bigger % than a given % change in price D
• When |PED| = , demand is perfectly price elastic. Q
o QD has an infinitely large response when price changes (i.e. horizontal demand curve).

Practice (2017 Finals Zone B MCQ Q4) (Price inelastic demand)

You are told that the own price elasticity of demand for a good is –0.5. Which of the following
statements is correct?

a. X
If the price increases by $1 then the quantity of the good demanded increases by 0.5.
b. X
If the price decreases by $1 then the quantity of the good demanded decreases by 0.5.
c. If the price increases by 1% then the quantity of the good demanded increases by 0.5%. X
✓ d. If the price increases by 1% then the quantity of the good demanded decreases by 0.5%.

Practice (Subject Guide Sample Exam MCQ) (Price elastic demand)

In Côte d’Ivoire the own-price elasticity of demand for beef is –1.91. If the price of beef rises by 10
per cent, the quantity demanded of beef: % 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑸𝑫
𝑷𝑬𝑫 =
% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒑𝒓𝒊𝒄𝒆
a. rises by more than 10 per cent % 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑸𝑫
b. falls by less than 10 per cent −𝟏. 𝟗𝟏 =
+𝟏𝟎%
✓ c.
d.
falls by more than 10 per cent
rises by less than 10 per cent. % 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑸𝑫 = −𝟏. 𝟗𝟏 × 𝟏𝟎%
= −𝟏𝟗. 𝟏%

Determinants of PED
1. Degree of Necessity
• Demand for necessities is more price inelastic than demand for luxury goods. E.g. |PED|life-
saving medicine < |PED|holidays, |PED|rice < |PED|caviar

• Demand for addictive goods tend to be more price inelastic. E.g. |PED|cigarettes < |PED|milk

2. Degree of Substitutability
• More substitutes → more price elastic demand. |PED|taxi  after Grab entered the market.

3. Definition → more substitutes

• More narrow definition → more price elastic demand. E.g. |PED|Esso petrol > |PED|petrol
narrow broad
4. Time-span
• Long run → more time to adjust to price changes (i.e. to change habits or find substitutes)
→ more price elastic demand

5. Share of budget / Proportion of income

• Bigger share of budget → more price elastic demand. |PED|car of rich person < |PED|car of
poor person, E.g. |PED|real cars > |PED|toy car.
By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
bigger share smaller share
1|Page
 Lecture 2: Chap 4 + about. 5% +10% – 5%
Block 3: Elasticity TRold = P x Q

TRnew = 1.1P x 0.95Q

Relationship between PED & Revenue
= 1.045 PQ > PQ = TRold
• Total spending = total revenue = P x Q
Elasticity Change in P Change in QD Total Revenue (P x Q)
|PED| < 1  () 10%  () < 10%  ()
|PED| > 1  () 10%  () > 10%  ()
(Demand is unit elastic) |PED| = 1  () 10%  () exactly 10% Unchanged
|PED| = 0  () 10% unchanged  ()
• To  TR,  price when demand is price inelastic &  price when demand is price elastic

Practice (Subject Guide Sample Exam MCQ) “1”

When price elasticity of demand is greater than unity (in absolute value), revenue will:
(price elastic demand)
a. X
increase with an increase in price
b. X
decrease with a fall in price.
✓ c.
d.
decrease with an increase in price.
remain unchanged with any change in price. X (true only if |PED| = 1)
----------------------------------------------------------------------------------------------------------------------------- ----------
Suppose that a firm currently charges a price of £100 per unit & at this price its total revenue is
|PED| > 1
£70,000. Suppose also that at this price, demand is elastic. Now the firm raises its price by £20 per
unit. Explaining your answer, state which of the following quantities the firm might sell after the
price increase
Method 2

✓a. 300 (Working: P x Q = 120 x 300 = 36,000) TR = P x Q

70, 000 = 100 x Q
b. 600 (Working: P x Q = 120 x 600 = 72,000)
c. X
900 (Working: P x Q = 120 x 900 = 108,000)
Q = 700
When P, Q should 
d. X
1,200. (Working: P x Q = 120 x 1200 = 144,000) Since |PED|>1; elastic, we expect the 20% in P to result in
a bigger %  in Q.
Working: 300−700
TR = P x Q = 70,000 Option a), % ∆ in Q = × 100% = −57% > 20%
700
600−700
(20%) (>20%) () Only option a) shows a  in TR Option b), % ∆ in Q =
700
× 100% = −14% < 20%

Income Elasticity of Demand (IED)

• IED: measures the responsiveness of quantity demanded of a good to changes in real
income, ceteris paribus. “Queen”
𝑫
% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑸
𝑰𝑬𝑫 =
% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒓𝒆𝒂𝒍 𝒊𝒏𝒄𝒐𝒎𝒆
Income  50%
• IED < 0: Inferior goods (e.g. second-hand goods) P
→ income , demand & hence QD 
$10
• IED > 0: Normal Goods
→ income , demand & hence QD  DLG4
DIG2 D1 DNE3
(Income inelastic demand)
Qty. of good
o 0 < IED < 1: Necessity (e.g. water) 40 80 100 160
→ income  10%, demand & hence QD  < 10%
(Income elastic demand) – 50% + 25% + 100%
o IED > 1: Luxury good (e.g. branded cars, jewellery)
→ income  10%, demand & hence QD  > 10%

Practice (2017 Finals Zone A MCQ Q1) (IED > 1 → Income elastic demand; luxury good)

You are told that the income elasticity of demand for a good is 2. Which of the following statements
is correct?

a. X
If income increases by $1 then the quantity of the good demanded increases by 2. +2%
b. X
If the price increases by 1% then the quantity of the good demanded decreases by 2%. 𝑃×𝑄
c. As income increases the proportion of income spent on the good decreases. X
𝑃𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛 =
𝐼𝑛𝑐𝑜𝑚𝑒
✓ d. If income increases by 1% then the quantity of the good demanded increases by 2%.
+1%
% ∆ 𝑖𝑛 𝑄𝐷 +2%
𝐼𝐸𝐷 = = =2
% ∆ 𝑖𝑛By Mr William
𝑖𝑛𝑐𝑜𝑚𝑒 +1%Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
2|Page
Lecture 2: Chap 4
Block 3: Elasticity

Practice (Subject Guide Sample Exam MCQ) (income)

If demand for pork is given by: QD = 200 – 6P + 2Y, when the price of pork is £8, a rise in consumers’
income from £100 to £150 leads to: law of demandnormal good

a. X
a fall in demand & an income elasticity of –0.14, pork is an inferior good (income , Qpork  → normal good)
✓ b.
c.
a rise in demand & an income elasticity of 0.57, pork is a normal good & a necessity
X
a rise in demand & an income elasticity of 0.57, pork is a luxury good (YED = 0.57 < 1 → necessity)
d. X
a fall in demand & an income elasticity of –0.57, pork is an inferior good. (income , Qpork  → normal good)

Working:
Income  by 50%
When income = 100, QD = 200 – 6(8) + 2(100) = 352 % ∆ 𝑖𝑛 𝑄𝐷 +28.4%
𝐼𝐸𝐷 = = = 0.568 = 0.57 (2 𝑑𝑒𝑐𝑖𝑚𝑎𝑙 𝑝𝑙𝑎𝑐𝑒)
When income = 150, QD = 200 – 6(8) + 2(150) = 452 % ∆ 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒 +50%
452−352
Hence % change in QD = 𝑥 100% = + 28.4%
352

Cross-price Elasticity of Demand (CED)

• CED measure the responsiveness of quantity demanded of a good A to a change in the
price of another good B, ceteris paribus. “Queen”

% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑸𝑫 𝒐𝒇 𝒈𝒐𝒐𝒅 𝑨
𝑪𝑬𝑫 =
% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒑𝒓𝒊𝒄𝒆 𝒐𝒇 𝒈𝒐𝒐𝒅 𝑩

• CED = 0: independent / unrelated (e.g. burgers & keyboard)

→ PB , demand for good A & hence QDA unchanged
Positive because spelling of substitutes has lots of “+”
• CED > 0: substitutes (e.g. Coke & Pepsi)
→ PB , demand for good A & hence QDA 

• CED < 0: complements (e.g. cars & petrol)

→ PB , demand for good A & hence QDA 

• The larger (smaller) the magnitude of CED, the stronger (weaker) the
substitute/complement relationship.

Practice (2018 Finals Zone B MCQ Q1)

Bubble tea is a popular drink in Singapore. Which of the following statements about the effects of an
increase in the price of bubble tea on demand for chicken soup is not correct?

a. Demand for chicken soup decreases if bubble tea and chicken soup are complements.
b. Demand for chicken soup increases if bubble tea and chicken soup are substitutes.
✓ c. The cross price elasticity of demand for chicken soup with respect to bubble tea is

% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑐ℎ𝑖𝑐𝑘𝑒𝑛 𝑠𝑜𝑢𝑝 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑

% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑏𝑢𝑏𝑏𝑙𝑒 𝑡𝑒𝑎

d. Some people dislike bubble tea and never drink it. The increase in the price of bubble tea has
no effect on their demand for chicken soup. (Unrelated goods → CED = 0)

Practice (2018 Finals Zone A MCQ Q3)

The price of cake has increased. Which of the following statements about the effects on the demand
for oranges is correct?

X
a. Demand for oranges increases if cake and oranges are complements.
X
b. Demand for oranges decreases if cake and oranges are substitutes.
X
c. If you know the income elasticity of demand for oranges, you can predict whether demand for
cross-price
oranges increases or decreases when the price of cake increases.
✓ d. Some health-conscious consumers eat oranges regularly but never eat cake. The increase in
the price of cake has no effect on their demand for oranges. (Unrelated goods → CED = 0)

By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
3|Page
 IED > 1 → Luxury good
Lecture 2: Chap 4
Block 3: Elasticity CEDXY > 0 → substitutes
|PED| > 1 → Price elastic demand

Practice (Subject Guide Sample Exam MCQ)

An estimation of demand facing a particular firm produced the following information with regard to the
elasticities of the demand function for x: Own price: –2; income: 1.5; cross price, y: 0.8; cross
price z: 3. Where x, y & z are goods & M is income. Therefore:
CEDXZ > 0 → substitutes (But as the CED here is larger, Good X & Z are stronger substitutes than good X & Y)
Select one: –2% about –1%
+1% (Quantity)
a. If the price of x rose, your sales would fall but your total revenues would increase.
–1% +2%
X
✓b. If the price of x fell, your sales would increase & so would your total revenues. about +1%
–1% +2%
c. If the price of x fell, your sales would increase but your revenues would fall. about +1% X
X–2%
d. If the price of x rose, your sales would increase & so would your revenues.
+1%
With reference to the same information as above:

Select one:
a. Commodities x & z are complements while x & y are gross substitutes.
b. Commodities x & z are complements & so are x & y.
✓c. Commodities x & z are gross substitutes & so are x & y.(because both their CED are positive)
d. Commodities x & z are gross substitutes but x & y are complements.

*PED along a given linear demand curve (advanced material)

“change”
• Price elasticity of demand:
𝑫 𝑫 𝑫
𝑸𝟏 − 𝑸𝟎 𝑷𝟏 − 𝑷𝟎 ∆𝑸 ∆𝑷 ∆𝑸𝑫 𝑷 ∆𝑸𝑫 𝑷 𝒅𝑸 𝑷
𝑷𝑬𝑫 = 𝑫
÷ = 𝑫 ÷ = 𝑫 × = × = ×
𝑸𝟎 𝑷𝟎 𝑸 𝑷 𝑸 ∆𝑷 ∆𝑷 𝑸𝑫 𝒅𝑷 𝑸

o For inverse demand function (P = …) We used the above mathematical

▪ E.g. P = 20 – ½Q manipulation to get another
formula for PED. Similarly for the
→ dP/dQ = –½ → dQ/dP = 1/–½ = – 2 others,
→ PED = dQ/dP x P/Q = –2 x (P/Q) 𝒅𝑸𝑫 𝑰
𝑰𝑬𝑫 = × 𝑫
o For direct demand function (Q = …) 𝒅𝑰 𝑸
▪ E.g. Q = 40 – 2P (same as inverse demand function above) 𝒅𝑸𝑫
𝑿 𝑷𝒀
→ dQ/dP = –2 𝑪𝑬𝑫 = × 𝑫
𝒅𝑷𝒀 𝑸𝑿
→ PED = dQ/dP x P/Q = –2 x (P/Q) (same!)
𝒅𝑸𝑺 𝑷
• Along a linear demand curve, dQ/dP is a constant. 𝑷𝑬𝑺 = ×
𝒅𝑷 𝑸𝑺
• As price  Q  hence |PED|  as we move down along a demand curve.
constant for linear demand
Price
𝒅𝑸 𝑷
𝑷𝑬𝑫 = × (as we move down; right of demand)
𝒅𝑷 𝑸

Extra
10 𝑑𝑄 𝑃
A 𝑷𝑬𝑫 = ×
𝑑𝑃 𝑄
𝑃 𝑑𝑄
= ×
𝑄 𝑑𝑃
𝑃 𝑑𝑃
= ÷
𝑄 𝑑𝑄
5
M 𝑺𝒍𝒐𝒑𝒆𝑹𝒂𝒚
(mid-point) =
𝑺𝒍𝒐𝒑𝒆𝒅𝒆𝒎𝒂𝒏𝒅

B
𝒅𝑷
= -½ PED
𝒅𝑸
Quantity
0 10 20
𝒅𝑸 𝟐
= − = −𝟐
𝒅𝑷 𝟏

By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
4|Page
Lecture 2: Chap 4
Block 3: Elasticity

Practice (Subject Guide Activity 3.2)

Given the following information, calculate the PED at Point X, Y & Z, expressing the elasticities as
positive numbers in the diagram below:
𝑸𝟏 − 𝑸𝟎 𝑷𝟏 − 𝑷𝟎 ∆𝑸𝑫 𝑷
𝑷𝑬𝑫 = ÷ =
𝑸𝟎 𝑷𝟎 ∆𝑷 𝑸𝑫

16
|PED| > 1 |−2 × | = | − 2 × 2| = | − 4| = 4 > 1
→P
8
→ Q  by bigger % 10 1
|−2 × | = | − 2 × | = | − 1| = 1
→ TR  20 2
5 1 1 1
|−2 × | = |−2 × | = |− | = < 1
30 6 3 3

(Mid-point) |PED| < 1

→P
|PED| = 1
→ Q  by smaller %
→ P  ()
→ TR 
→ Q  () by same %
→ TR unchanged

𝑑𝑃 1
=−
𝑑𝑄 2

• Total revenue is maximised when |PED| = 1 (i.e. at mid-point of demand).

Price Elasticity of Supply

• PES measures the responsiveness of quantity supplied of a good to changes in its own
price, ceteris paribus. “Queen”
𝑺
% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑸 ∆𝑸𝑺 𝑷
𝑷𝑬𝑺 = =
% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒑𝒓𝒊𝒄𝒆 ∆𝑷 𝑸𝑺

• PES is always positive due to the positive relationship between price & quantity supplied
(i.e. Law of supply) as shown by the upward sloping supply curve.

o For inverse supply function (P = …)

▪ E.g. P = 20 + ½Q
→ slope = dP/dQ = ½ → dQ/dP = 1/½ = 2
→ PES = 2 x (P/Q)

o For direct supply function (Q = …)

▪ E.g. Q = 40 + 2P (same as inverse supply function above)
→ slope = dQ/dP = 2
→ PES = 2 x (P/Q) (same!)

• PES = 0: perfectly price inelastic supply; vertical supply curve

• PES < 1: price inelastic supply; supply curve intersects quantity axis
• PES = 1: unit elastic supply; supply curve intersects point of origin
• PES > 1: price elastic supply; supply curve intersects price-axis
• PES = : perfectly price elastic supply; horizontal supply curve

Practice (Subject Guide Activity 3.8)

For the following direct supply function, calculate & interpret the PES when Q = 10 & P = 2.5.
Direct Supply
𝑺
Function: QS = 5 + 2P
𝒅𝑸 𝑷 𝟐. 𝟓 𝟓
× =𝟐× = = 𝟎. 𝟓 (𝒑𝒓𝒊𝒄𝒆 𝒊𝒏𝒆𝒍𝒂𝒔𝒕𝒊𝒄 𝒔𝒖𝒑𝒑𝒍𝒚)
PES = ___________________________________________________________________________
𝒅𝑷 𝑸𝑺 𝟏𝟎 𝟏𝟎
By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
5|Page
 Lecture 2: Chap 4
Block 3: Elasticity
Per unit tax
Tax Incidence P
S2
• Specific / per unit tax: a tax that is a particular amount per unit of a good/service. S1
o $0.80 tax per litre of petrol t
o Causes supply to  & shift up in a parallel manner by the amount of the tax
Q
• Ad valorem / percentage tax: a tax that is a percentage of the value/price of a good/service.
o E.g. 7% GST % tax
o Causes supply to  & shift up & become steeper P S2
(Gap) S1
• A sales tax drives a wedge between the price paid by consumers (the demand price)
& the price received by producers (the supply price)
(Kept) Q
• Tax incidence measures who eventually pays (what proportion of) the tax.

• Consumers bear taxes to the extent that prices have increased.

• Producers bear taxes to the extent that the  in prices is insufficient to cover the tax.

• Whichever party (consumers or producers) is less price sensitive (either in demand or

supply) will bear the greater share of the burden of the tax.

Government

|PED| < PES |PED| > PES

→ Greater tax incidence on consumers → Greater tax incidence on producer
Price Price
S1
S1
B
PnewC = $14 = P1 S0
S0
Consumer PnewC = $11 = P1 B
tA Consumer A
PoldP = PoldC =$10= P0 Pold old
P = P C = $10 = P
0 Delastic
Producer
Producer t
PnewP = $9 = P1- t =$5
C
Dinelastic PnewP = $6 = $11–$5 = P1- t C
$5Quantity
= Quantity
0 Q1 Q0
0 Q1Q0

By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
6|Page
Lecture 2: Chap 4
Block 3: Elasticity

Practice (Subject Guide Activity 3.10)

QD = 30 – 4P
QS = – 6 + 8P
t = 0.375 where t is a specific tax that has to be paid by suppliers.
Calculate
i. the equilibrium quantities with & without the tax
• At equilibrium without the tax, • At equilibrium with the tax,
QD = QS & PD = PS QD = QS & PS = PD – t
30 – 4P = – 6 + 8P 30 – 4PD = – 6 + 8(PD – t)
12P = 36 30 – 4PD = – 6 + 8PD – 8(0.375)
P=3 12PD = 30 + 6 + 8(0.375)
Q = 30 – 4(3) PD = 3.25 ()
= 30 – 12
Q = 30 – 4(3.25)
= 18
= 17 ()
----------------------------------------------------------------------------------------------------------------------------
ii. the  in the price paid by consumers & the  in consumer surplus
•  in price paid by consumers = 3.25 – 3 = 0.25
• Consumer surplus = difference between max. buyers willing & able to pay & actual
price paid.
• Max. consumer price occurs when QD = 0.
0 = 30 – 4P → Pmax = 7.5
• Initial CS = ½ (max. price – initial price)(initial qty.)
= ½ (7.5 – 3)(18) = 40.5
• New CS = ½ (max. price – new price)(new qty.)
= ½ (7.5 – 3.25)(17) = 36.125
•  CS = Initial CS – New CS = 40.5 – 36.125 = 4.375
----------------------------------------------------------------------------------------------------------------------------
iii. the  in the price received by suppliers & the  in producer surplus
• Producer surplus = difference between min. sellers willing & able to accept & actual
price received.
• Min. producer price occurs when QS = 0.
0 = – 6 + 8P → Pmin = 0.75
• Initial PS = ½ (initial price – min. price)(initial qty.)
= ½ (3 – 0.75)(18) = 20.25
• New PS = ½ (new after-tax price – min. price)(new qty.)
= ½ ( 3.25 – 0.375 – 0.75)(17) = 18.0625
•  PS = Initial PS – New PS = 20.25 – 18.0625 = 2.1875
----------------------------------------------------------------------------------------------------------------------------
iv. the tax revenue received by the government
• Tax Revenue = per unit tax x after-tax equilibrium qty.
= t x Qnew
= 0.375 x 17
= 6.375
----------------------------------------------------------------------------------------------------------------------------
v. the deadweight loss of the tax.
• Deadweight loss
= Initial Economic Surplus – (New Economic Surplus + Govt. Tax Revenue)
= (40.5 + 20.25) – (36.125 + 18.0625 + 6.375)
= 0.1875

By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
7|Page
 Lecture 2: Chap 4
Block 3: Elasticity

Practice (Subject Guide Activity 3.11)

Here you see the football fans’ demand curve d for televised football matches together with the
Football Association’s (FA) supply curve s for such matches. The market for televised matches clears
where the two curves cross, hence when 10 matches are televised for £6 each. Suppose now that
the government introduces a tax of £4 per televised match. The figure shows that the number of
televised matches falls from 10 to 6. For these 6 matches fans pay £8 but the FA earns only £4 as
the difference goes into the government’s coffers.
St

New
PnewC = Pnewe = £8 CS
X
CS →
Govt revenue X
CS
PoldP = PoldC = Polde = £6 Govt DWL
Tax Rev. t = $4

X
PS →
X
PS
Govt revenue

PnewP = 8 – 4 = £4 New
PS
£2

As a result of the tax: producer

consumer

X & the welfare of the FA decreases.

a. The welfare of fans increases
X
b. The welfare of fans decreases & the welfare of the FA increases.

c. X tax revenues to compensate

Both fans & the FA lose welfare but the government raises enough
them.
✓ d. Both fans & the FA lose welfare & the government does not raise enough tax revenues to
compensate them. ∵ The total loss in CS & PS > tax revenue
X welfare. Neither consumers nor producers would welcome a tax.
e. Both fans & the FA collected
gain
Both consumer & producer surplus will be lost!

Practice (Subject Guide Sample Exam Long Question)

1.a. Discuss the meaning of elasticity & the various types. What determines the price elasticity of
demand for a certain good? Who is likely to find this information useful?

Ans: Elasticity generally describes the responsiveness of quantity demanded to a change in price. It
can refer to a change in the price of the good itself (own-price elasticity) or a change in the price of a
complement or substitute (cross-price elasticity). The change in quantity supplied in response to a
change in price is known as supply elasticity, whilst a change in demand in response to a change in
consumer income is known as the income elasticity of demand). The determinants of price elasticity
include the closeness of substitutes and how narrowly the good is defined. Knowing the elasticity of
demand is very useful for firms as it tells them whether to raise or lower prices or keep them constant.
It is also useful for governments when setting sales taxes.

By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
8|Page
Lecture 2: Chap 4
Block 3: Elasticity

1.b. Assume that the market demand for barley is given by:

Q = 1,900 – 4PB + 0.1M + 2PW

Where Q is the quantity of barley demanded, PB is the price of barley, M is income (say per capita
income of consumers) & PW is the price of wheat. The prices of wheat & barley are each 200 (say £s
per tonne) & M is 1,000. The slopes for barley demand, wheat demand & income are –4, 2 & 0.1
respectively.

Calculate the own price elasticity of demand, the income elasticity of demand & the cross-price elasticity
of the demand for barley with respect to the price of wheat.

Ans: Own price elasticity = –4*200/1600 = –0.5; cross-price elasticity = 2*200/1600 = 0.25; income-
elasticity = 0.1*1000/1600 = 0.1

1. c. Calculate & illustrate graphically the impact on welfare of a specific tax of 37.5p per unit to be paid
by suppliers when QD = 30 – 4P & QS = –6 + 8P. How do the welfare implications change if the tax is
paid by consumers instead of suppliers?

Ans: See activity SG3.10 for DWL and tax. No change to welfare if consumers pay the tax instead of
producers.

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2. Interpret the following elasticities for petrol:

Demand elasticity: –0.39

Income elasticity: 1.2
Supply elasticity: 0.7

a. Do there appear to be good substitutes for petrol in the preferences of buyers?

Ans: No. Demand is price inelastic (elasticity = –0.39). This price insensitivity suggests that
there are not good substitutes for petrol in the preferences of buyers.)

b. Does petrol appear to be a luxury or a necessity in the preferences of buyers?

Ans: A luxury is a commodity with an income elasticity greater than one. Luxuries are such that
as income increases, the proportion of total expenditure spent on the commodity increases. For
petrol, the income elasticity = 1.2. As income increases, the proportion of total expenditure
spent on petrol increases. Hence, it is a luxury good (according to this data).

c. Do firms appear to have excess capacity in the petrol industry?

Ans: No. Supply is price inelastic (=0.7). This means that as price increases, sellers are not
able to initiate large changes in the amount offered for sale to take advantage of the higher
market price. One reason for this may be that they do not have a lot of spare capacity.

Acknowledgements & References

Economics 11e by David Begg, Gianluigi Vernasca, Stanley Fischer, Rudiger Dornbusch
ISBN: 0077154517. Publisher: Mc Graw Hill

Subject Guide 2016 for EC 1002 Introduction to Economics by O. Birchall assisted by D. Verry
University of London International Programmes

By Mr William Tan, using UOL EC1002 Subject Guide & David Begg’s Economics 11e
9|Page