ELASTICITY

Size of Changes in Market Equilibrium

 What determines the size of changes in market
equilibrium?
 Size of change in demand (or supply)
 The larger the shift in demand (or supply), the larger the effect
on price
 Steepness of the curve that does not shift
 If the supply curve shifts, the steeper the demand curve the
more the price changes and the less the amount bought and
sold changes
 Steepness reflects responsiveness to prices

2-2
Changes in Equilibrium for Two Extreme Demand Curves

2-3
Changes in Equilibrium for Two Extreme Supply Curves

2-4
Steepness of the demand curve

S”
S

Q
D2 D1
Elasticities of Demand and Supply
 A measure of the responsiveness of the amounts
demanded and supplied to changes in prices
 Not the same as the slope of the supply or demand
curve
 Slope of the curve depends on the units used to
measure the quantity of the good and its price
 Elasticity does not depend on units (e.g., gallons,
dozens, dollars per pound)

2-6
Demand Elasticities
 Demand curves can come in different
shapes
 From very flat to very steep
 Very flat demand curve: a small change in
price has a large effect on quantity
demanded
 Very steep curve: even a large change in
price does not affect quantity demanded too
much
 Question: how sensitive is quantity
demanded to price changes?
Elasticity
 We know that quantity demanded depends on many
things
 So we can ask a more general question.
 How sensitive is demand to change in any of the
relevant factors:
- Own price
- Income
- Related prices
- Etc.
Demand Elasticities

Consider the market demand for a commodity, q

Let it depend on a factor y (which might be its own

price, or the price of a related good, or income).

Then the elasticity of demand for q with respect to

y is defined as:

the percentage change in q that results from

a 1% change in y.

It is the percentage change in q divided by the

percentage change in y.
Two situations:

Situation 1 2

Quantity q1 q2

Y y1 y2

Let ∆q = q2 – q1
∆y = y2 – y1
Since percentage changes are pure numbers, the
elasticity measure will always be a unit-free pure
number.

Elasticity of q with respect to y

∆q ∆y
=[ ----x100] divided by [----x100]
q y

∆q y
= ----x----
∆y q
Therefore elasticity of quantity demanded
can be with respect to:
- own price (price-elasticity of
demand)
- any other price (cross price-
elasticity)
- income (income elasticity)

We will spend some time on the concept of

the price-elasticity of demand
P rice Elasticity of Dem and

For downward sloping curves, prices and quantities

move in opposite directions, so that the elasticity
value is negative.

To avoid this problem, we consider the absolute

value of the elasticity.

∆q p
e = - ----x---- = - (p/q)x(∆q/∆p).
∆p q
Calculation of elasticity

Situation 1 Situation 2
p1 = Rs.10 p2 = Rs.9.00
q1 = 100 q2 = 105

Consider finite changes in prices and quantity:

e = - [∆q/∆p]x[p/q],

∆q = q2 - q1 = 5

∆p = p2 - p1 = -1
1. Point-elasticity measures.
e = - [∆q/∆p]x[p1/q1]
= -(-5)x(10/100) = 5/10 = .5

e = - [∆q/∆p]x[p2/q2]
= -(-5)x(9/105) = 9/21 = 3/7
= .42

 “small changes” in price -> not much difference

between these two.
 For larger changes, the differences become
substantial.
2. Arc-elasticity measure.
To get rid of this ambiguity, take an average of the
values:

∆q [(p2 + p1)/2]
e = - ---------------------------
∆p [(q2 + q1)/2]

= - [∆q/∆p][(p2 + p1)/(q2 + q1)]

= 5(19/205) = .46.
Elasticities for Linear Demand Curves
 For linear demand curves remember that the
price elasticity of demand formula is:
 ∆Q  P 
E =  
d

 ∆P  Q 
 Notice that the first term is related to the slope
of the demand curve
 The second term is the initial price divided by
the initial quantity

2-17
Elasticities for Linear Demand Curves
 Notice that:
 Slope is constant along linear demand curve but (P/Q)
varies, so elasticity varies along the demand curve
 Demand is more elastic at higher prices since P is
larger and Q is smaller
 Demand is less elastic at lower prices since P is smaller
and Q is larger

2-18
P
Consider the straight-line
demand curve AB. What is e
A at the point C?

Note: [∆q/∆p] = EB/CE,

D C
p = CE, q = OE

B
O E Q
A Straight Line Demand Curve

Then price-elasticity at a point C on the demand

curve = (EB/CE)(CE/OE) = EB/OE
= (BC/CA)
(by property of similar triangles).

At the mid-point of the demand curve, e = 1.

All points above this have elasticity greater than 1.

Demand at all points below the mid-point is inelastic.

Price Elasticity Regions along
a Straight-Line Demand Curve
Observation
Price elasticity varies at
every point along a straight-
line demand curve

a ε >1
ε =1
Price

a/2 ε <1

b/2 b
Quantity
If the percentage change in q > the
percentage change in p, then e > 1, and
we have elastic demand.

If the percentage change in q = the

percentage change in p, e = 1 and we say
that demand is unit elastic.

If the percentage change in q < the

percentage change in p, so that e < 1,
demand is said to be inelastic.
Price Elasticity and the
Steepness of the Demand Curve

What is the price elasticity of

demand when P = Rs.4?
12

 
D1  4  1  1
∈D1 =    =
 4  12  2
 6
6
Price

 
 4  1 
4 ∈D2 =    =2
 4  6 
D2  12 

4 6 12

Quantity
Price Elasticity and the
Steepness of the Demand Curve

12 Observation
If two demand curves have a
point in common, the steeper
curve must be less elastic with
D1
6
respect to price at that point
Price

D2

4 6 12

Quantity
Price elasticity
 Suppose that we have a differentiable demand function
Q = Q(P).
 Then elasticity at a point (P*, Q*) on the demand
curve is
E = -(dQ/dP)(P*/Q*)
where dQ/dP is evaluated at (P*, Q*)
Example: Let Q = p-a
Then dQ/dP = (-a) p-a-1
E = -[(-a) p-a-1][p/p-a] = a (independent of the point on
the demand curve)
Three special cases
If (inverse) demand curve is a horizontal straight line
parallel to the quantity axis, then the price-elasticity
measure goes to infinity.
- demand is perfectly elastic.

If the (inverse) demand curve is a vertical straight line,

then e = 0 and demand is said to be perfectly
inelastic.

An example of a demand curve that is iso-elastic (has

the same elasticity everywhere) is q = p-a.
Perfectly Elastic Demand Curve
P

D D

0 Q
Perfectly Inelastic Demand Curve
P
D

“Basic needs, minimum

requirements, absolute
necessities.”

0 D Q
Range of elasticities

0_______________1________________+∞
Perfectly Unit Perfectly
Inelastic Elasticity Elastic
Demand Demand
Factors affecting price elasticity:

1. Availability of substitutes
Larger the availability of close substitutes, the more
elastic will demand be.

2. Demand will be more elastic when buyers of the

product regard it as a discretionary purchase rather
than as a necessity

3. If buyers are wealthy and the item accounts for a

very small part of the total expenditure, then
demand will be less elastic
Factors affecting price elasticity:

4. Time period of adjustment-flexibility over the

long run
Larger the time period, the higher the elasticity of
demand.
Suppose petrol prices go up
Short run demand falls somewhat because
motorists drive less
In the long run, people switch to smaller,
more fuel-efficient cars – quantity demanded of
petrol goes down by a larger amount
Elasticity and Total Revenue

 What do you think?

 Will increasing the market price always increase
total revenue?

 Application:
 Could reducing the supply of illegal drugs
cause an increase in drug-related burglaries?
 The Effect of Extra Border
Patrols on the Market for Illicit Drugs
Total Expenditure = P x Q
S Rs.2500 = Rs.50 x 50
S’ Rs.3200 = Rs.80 x 40

S’
80
P(Rs./ounce)

S
50

D
40 50
Q(1,000s of ounces/day)
Relationship between elasticity and total
revenue
TR = pq

dTR = d(pq) = pdq + qdp

= qdp(1 – e)

Consider what happens if price is lowered, so that

dp < 0.

dTR > 0 if 1 – e < 0, i.e. e > 1

dTR = 0 if 1 = e

dTR < 0 if e < 1

The relationship between elasticity and revenue can be represented
clearly with a simple example. Suppose that the equation of the
demand curve is Q = a – P, i.e. P = a – Q. The total revenue is TR =
PQ = aQ – Q2 which, for non-negative values of TR can be
represented by the following graphs:

For this expression, the price-elasticity

e = -(∆Q/∆P)(P/Q = -(-1)(P/Q) = (a –
Q)/Q = a/Q – 1
It can then be shown that e > 1 when
Q < a/2, i.e. in the rising part of the
curve,
e = 1 when Q = a/2 (at the peak point
of the curve) and e < 1 for Q > a/2.
Income-elasticity of Demand
em = (∆q/∆M)(M/q)

In the case of a normal good, em > 0, while for an

inferior good, it is < 0.

If 0 < em < 1, then the good is called a necessity,

otherwise it is a luxury.
Cross-price Elasticity of Demand
The cross-price elasticity of the commodity x with
respect to the price p of y is defined as

exy = (∆x/∆p)(p/x)

If this is positive, x and y are said to be substitutes

(Coke and Pepsi), while if this is negative, the
commodities are said to be complements (tea and
sugar).
Uses of Cross-price elasticity
1. Forecasting change of demand
Let us suppose that Limes and Oranges are substitute cold
drinks. The cross elasticity of demand between Limes and
Oranges is +1.5.
The manufacturer of Limes receives the information that the
price of Oranges is about to fall by 10%. The manufacturer of
Limes can then predict by how much the demand of its
product will fall as a result of fall in price of Oranges.
2. Classification of market
Higher the value of cross elasticity of demand between the
products, greater will be the competition in the market, and
lower the value of cross elasticity, the market will be less
competitive.
Price Elasticity of Supply
 Suppose that q now refers to quantity supplied.
The price elasticity of the supply of q with respect to
the price p is defined as
es = (∆q/∆p)(p/q)
Since supply curves are upward-sloping, this
expression will be non-negative – no need to put a
negative sign in front of the expression
 Calculating the Price
Elasticity of Supply Graphically

A = (4 12)(12 4 ) = 1 S

Qs = AP B
5
P
A
4
Q
Price

B = (5 15 )(15 5 ) = 1

0 12 15
Quantity
In general, even for straight line supply curves,
the price elasticity of supply will vary from point
to point.

For example : P = 10 + 2Qs

Two points on the line are (Qs = 1, P = 12, and

Qs = 2, P = 14)

Show that the price elasticities at these two

points are different.
Application - Farming
 Suppose that university agronomists discover a new
wheat hybrid that is more productive than existing
varieties.
 What happens to wheat farmers?
 The discovery of the new wheat hybrid affects the
supply curve – it shifts to the right.
 The demand curve remains the same
Application - Farming
Price of wheat
D S
S’

S S’ D
Quantity of wheat
Application - Farming
 What happens to the total revenue received by the
farmers?
 Q rises but P falls
 The demand for basic foodstuffs such as wheat is
usually inelastic, for these items are relatively
inexpensive and have few good substitutes
 Hence fall in P is substantial while rise in Q is small
 Revenue to all wheat farmers taken together falls
Application - Farming
 If farmers are made worse off by the discovery of
the new hybrid, why do they adopt it?
 Each farmer is a small part of the market
 For any price, it makes sense for each farmer to
adopt the hybrid
 But when they all do it, the supply curve shifts and
together, they are worse off
Application - Farming
 Certain agricultural programs try to help farmers by
inducing them not to plant crops on all their land
 The purpose is to reduce the supply of farm products
and thereby raise prices
 With inelastic demand, farmers as a whole receive
greater revenue
 No single farmer, by himself, would have found it
profitable to leave some land fallow
Price Support
 Another way for the government to help the farmers is
by having a support price, at which price the
government stands prepared to buy any amount
supplied by the farmers
 Over time, this may lead to the growth of “buffer
stocks”
 Will perish if just stockpiled
 Some can be used for employment generation
programmes, or meeting food requirements in a lean
year
 What to do with the rest?
Wheat export allowed to free storage space
3 July 2012

 Faced with a severe space constraint in the country’s

overflowing granaries, the government today cleared
export of two million tons of wheat from its buffer
stock that is expected to clear storage space for new
crops.

This was approved by the Cabinet Committee on
Economic Affairs. Informed sources said after the
CCEA meeting that export with a floor price of $228
(about Rs 12,400) per ton.
 At present, the government is grappling with the
problem of storage capacity.
 India, the world’s second-largest producer of wheat,
had harvested a record 90.23 million tons in 2011-12
crop year (July-June), leading to a record procurement
of nearly 38 million tons so far this year.
 Its godowns are overflowing with a record 82 million
tons of rice and wheat against the storing capacity of
only 64 million tons.
 The export of two million tons would involve an outgo
of Rs 1,263 crore.
TAXES
 Governments levy taxes to raise revenue for
public projects, to pay for wages and salaries
in the public sector, to pay interest on debt,
etc..
Taxes
 A specific tax is a fixed rupee amount that
must be paid on each unit bought or paid
 An ad valorem tax is a tax that is stated as
a percentage of the good’s price
 The incidence of a tax indicates how
much of the tax burden is borne by various
market participants

15-52
Taxes
 In studying the effects of taxes it’s important
to distinguish between the amount a
consumer pays for a good and the amount a
firm receives
 Use Pb for the amount a consumer pays, Ps
for the amount a firm receives
 If the tax is T per unit, then Ps = Pb - T
The Burden of a Tax
 Consider the effect of a specific tax of T rupees per
liter paid by gas stations on their sales of gasoline
 Graphically, there are three ways to determine the
tax’s effect:
 Shift the supply curve up by T
 Shift the demand curve down by T
 Use a wedge between the amounts consumers
pay and firms receive
 All three methods yield the same results
 Makes no difference whether the tax is levied on
consumers or producers

15-54
Effects of a Specific Tax
 Shifting the supply curve is one way to
determine a specific tax’s effects
 Demand curve remains unchanged
 For any price paid by consumers, firms
now receive less than when there is no tax
 Won’t be willing to supply as much as
before
 Supply curve with the tax is a distance T
above the original supply curve

15-55
Effects of a Specific Tax
 New equilibrium price paid by
consumers is price at which the
demand curve and new supply curve
cross
 Amount bought and sold falls
 Price paid by consumers rises; price
received by firms falls
 In a competitive market the burden of a
tax is shared by consumers and firms
Effects of a Specific Tax – Shifting the Supply
Curve
ST
Price Paid by Consumers ($/gallon)

Increase in S
Consumer Cost
per Gallon Po + T
B
Pb T

Po A
Ps = Pb - T

Decrease in
Firms’ Receipts
per Gallon
D

QT Qo
Gallons of Gas per Month

15-57
Tax Incidence
 Incidence of a tax depends on the shapes of the
demand and supply curves
 In general, the more elastic is demand and less
elastic is supply, the more of the tax is borne by
firms
 Firms cannot pass on the tax to the consumers
because the latter are sensitive to price changes
 Consumers bear the larger share of the tax
when demand is less elastic than supply

15-58
Incidence of a Specific Tax – Two Special
Cases

15-59
Effects of a Specific Tax – Shifting the
Demand Curve

15-60
Linear demand and supply
Let Qd = a – bpb
and Qs = c + dps
Also, ps = pb - t
Equilibrium requires
a – bpb= c + dps
Then a – b(ps+ t) = c + dps
Solving for the equilibrium price ps*, we get
ps* = (a – c – bt)/(d + b)