Elasticity...

…is a concept that relates the responsiveness

(or sensitivity) of one variable to a change in another
variable.
• Elasticity of A with respect to B = %
change in A / % change in B
• Elasticity answers the question of how much one
variable will change when another one changes.
With elasticity we will be able to answer the question:
If the price of a good increases by a certain amount, then
how much will the quantity demanded decrease by
because of this.
Why is elasticity important?
 Importance of elasticity
• Many business and economic decisions are not
based on if something will happen, but buy how
much will it change by:
Example: How much should business firms raise or
lower their prices and by?
Will total revenue (this affects profit) go up or down
when price increases? By how much?
• The effects of public policy will be different
depending on the elasticity of the good in question…
…for example: How much will the price of a good
increase if a tax is placed on it?
 Price Elasticity of Demand...
...measures the responsiveness of quantity demanded (QD)
of a good to the change in the price of the good (P).
• Price elasticity of demand =
% change in QD / % change in P.
• It is a number(unit free measurement) that represents
the % change in QD for a 1% change in price.
• Example: Suppose the price of a good rises by 5%. We
observe that the quantity demanded declines by 10%.
The price elasticity of demand is -10% / 5% = - 2.
• This means for every 1% change in price, the quantity
demanded of this good will change by - 2%.
 Calculating elasticity
Sometimes we must first find the % change in a variable from
some absolute numbers to calculate elasticity
• Example: Suppose the price of a Fore Golf car is
$10,000 and Fore sells 500,000 of them.
• Fore then raises it’s price to $11,000. The next year they
find they have sold 465,000 Golf cars
• What is the price elasticity of demand for Fore Golf
cars?
• Price elasticity of demand =
% change in QD / % change in P
• We can use what is called the mid-point formula to
calculate the % change in QD and P...
…the mid point formula uses the average of the beginning
and ending values to calculate the % change
 Calculating elasticity
Price elasticity of demand = % change in QD / % change in P.
% change in QD = change in QD / average of the 2 quantities
% change in QD = Q2 - Q1 / {(Q2 + Q1)/2} x 100%
% change in QD = 465,000 - 500,000 / {(465,000 + 500,000)/2} x 100%
% change in QD = -35,000 / 482,500 x 100%
% change in QD = - 7.25%
% change in P = change in P/ average of the 2 prices
% change in P = P2 - P1 / {(P2 + P1)/2} x 100%
% change in P = $11,000 - $10,000 / {($11,000 + $10,000) / 2} x 100%
% change in P = 1,000 / 10,500 x 100%
% change in P = 9.52%
Price elasticity of demand = - 7.25 / 9.52 = - 0.76
Interpretation: A 1% increase in Fore Golf Cars will reduce
their quantity demanded by 0.76%
This calculation can be reduced to a more manageable
formula:
Price elasticity Q2 - Q1 P2 + P1 465,000 - 500,000 $11,000 +$10,000
x = x
of Demand = Q2 + Q1 P2 - P1 465,000 + 500,000 $11,000 -$10,000
- 35,000 $21,000
= x
965,000 $1,000
= - 0.0363 x 21
= - 0.76
• Importance: Given any 4 of the above variables you can always
find the 5th.
• Suppose Fore Golf want sell 550,000 (instead of 500,000) cars and
know the elasticity is -0.76. If the original price was $10,000 you
can find the price they must charge to sell 550,000 cars!
• Once a firm estimates it’s price elasticity it can estimate changes
in sales from a price change; or to reach a sales target, estimate
how much to cut prices.
 Given any two points on a demand curve we
Price can calculate it’s elasticity between the two points

P1 Q2 - Q1 P2 + P1
Price elasticity
= x
of Demand (Pd) Q2 + Q1 P2 - P1

P2

Quantity
Q1 Q2

• Since elasticity is unit free it is better than using the slope of a line
for measuring the responsiveness of variables.
• Still, the price elasticity of demand will affect the way we draw the
demand curve.
 Types of Elasticity's
• Economists group the numbers that are
calculated into different types of elasticity
depending on which percentage change is
greater: price or quantity
• Depending on the number that is calculated we
put that number into 1 of 5 different types
• We ignore the minus sign (use absolute value)
when doing so.
Price Price

P1 P1

P2 P2
D
D
Q1 Q2 Quantity Q1 Q2 Quantity
Elastic Demand: 1< Pd < Inelastic Demand: 0 < Pd < 1
the % change in QD is greater than the % change in QD is less than the
the % change in P that caused it. % change in P that caused it.
Indicates that consumers are very Indicates that consumers are not
responsive or sensitive to price very responsive or sensitive to price
changes and there will be small
changes and there can be large changes in QD.
changes in QD.
Price Price Price

Quantity Quantity Quantity

Perfectly Inelastic demand Unit Elastic demand Perfectly Elastic demand
Pd = 0 Pd = 1 Pd =

8
the % change in QD is
Quantity demanded does Any change is price will
the same as the %
not change at all no matter change in P cause QD to go to zero
how much price changes Practical application:
that caused it.
A firm facing this demand
Example: Prescription drugs curve can sell all that it
that are needed to live wants at this predetermined
price, but no higher
…no substitutes available …infinite perfect substitutes
 Total Revenue and Elasticity
• Total Revenue (TR) = Price (P) x Quantity (Q)
• If a business firm raises the price it charges will total
revenue go up?
• It depends, because when price increases, quantity
decreases
• While the price increase will raise revenue per unit,
the firm will sell less units.
• The elasticity of demand will determine whether
total revenue goes up or down when price goes up or
down.
 Total Revenue = Price x Quantity
Price This is shown by the Light Blue
shaded area on the graph
P2

P1

TR =
PxQ
D
Q2 Q1 Quantity

• When price increases, the firm gains the green area in

revenue...
...but will lose the red area because of the decline in sales.
Let’s draw an inelastic demand curve and
compare the areas gained and lost.
 Price Total Revenue = Price x Quantity

P2 Inelastic Demand: P increase > Q decrease

P1

TR =
PxQ
D
Q2 Q1 Quantity

• The % increase in P is greater than the % decrease in QD

The revenue gained from the P increase > revenue lost from the
QD decrease.
The green area is greater than the red area
Total revenue increases when price rises for an inelastic good!
 Price Total Revenue = Price x Quantity

Elastic Demand: P increase < Q decrease

P2
P1

TR =
PxQ D

Q2 Q1 Quantity

• The % increase in P is less than the % decrease in QD

The revenue gained from the P increase < revenue lost from the
QD decrease.
The green area is less than the red area
Total revenue decreases when price rises for an elastic good!
 Elasticity and Total Revenue: Summary
Effect of an Effect of a decrease
Type of Change in quantity increase in price in price on total
demand Value of Ed versus change in price on total revenue revenue
Elastic Greater than Larger percentage Total revenue Total revenue
1.0 change in quantity decreases increases
Inelastic Less than 1.0 Smaller percentage Total revenue Total revenue
change in quantity increases decreases
Unitary Equal to 1.0 Same percentage change Total revenue Total revenue does
elastic in quantity and price does not change not change

• When demand is inelastic, price and total revenues are

directly related. Price increases generate higher revenues.
• When demand is elastic, price and total revenues are
indirectly related. Price increases generate lower revenues.
What determines price elasticity of demand ?
• Most important is the number of substitute goods.
More substitutes = higher elasticity. Why?
Consumers can easily switch from one good to another.
If there are few or no substitutes then switching is
impossible…
…consumers will find it hard to reduce purchases of the good
when price increases
• How important is the item in a consumers budget?
The price elasticity of salt will be very low because it is
insignificant in a consumers budget
Housing, car payments are a much higher proportion of
a budget and will have a higher elasticity
• Time is also important, because more substitute goods
appear and the consumer can change his behavior.
 Some calculated price elasticity of demand.
Item Short-run elasticity Long run elasticity
Gasoline - 0.4 -1.5
Housing - 0.3 -1.88
Tobacco products - 0.46 -1.89
Automobiles -1.87 -2.24
Movies -0.87 -3.67
Furniture -1.26
Books, Magazines, Newspapers -0.32
 Other measures of Elasticity.
• 1. Income Elasticity of Demand..... measures the
responsiveness of consumer purchases to changes
in consumer income.
• Income elasticity =
% change in consumer demand / % change in income
• Why is it important?
• Determines if a good is a normal good (a positive
number) or an inferior good (a negative number).
• Goods with positive numbers greater than 1
(income elastic) are sometimes referred to as
“luxuries”; goods with positive numbers less
than 1 (income inelastic) are referred to as
“necessities”
 Other measures of Elasticity
Firms that produce income elastic goods do very
well in prosperous times...
....but very bad during recessions.
For “necessities” the opposite is true.
• With this knowledge, firms can plan production
according to expectations of consumers income.
 Some calculated income elasticity of demand.
Item Short-run elasticity Long run elasticity
Potatoes -0.81
Pork 0.27 0.18
Beef 0.51 0.45
Autos 5.50 1.07
Jewelry 1.00 1.60
Foreign travel 0.24 3.09
Physician Services 0.28 1.15
Movies 3.41
Restaurant meals 1.61
Clothing 0.51
Telephone 0.32
 Cross elasticity of demand...
...measures the responsiveness of buyers to the
purchase of one good in response to changes in
the price of another good (substitute or
complementary)
• Cross elasticity=
% change in quantity of good X
% change in price of good Y
• Positive number = goods are substitutes
• Negative number = goods are complements
• Zero = goods are unrelated
 Price elasticity of Supply...
…measures the responsiveness of quantity
supplied (QS) by business firms to changes in the
price of a good (P).
• Price elasticity of supply =
% change in QS / % change in P
• This is always a positive number.
Elastic supply...greater than 1 but less than infinity
Inelastic supply...greater than 0 but less than 1
Price Price Price Elasticity of Supply
S
S
P2 P2

P1 P1

Q1 Q2 Quantity
Elastic Supply: 1< Ps <
the % change in QS is greater than
the % change in P that caused it.
Indicates that Firms are very
responsive or sensitive to price
changes and are willing and able to
make a lot more of the product
available with small price increases.
Q1 Q2 Quantity
Inelastic Supply: 0 < Ps < 1
the % change in QS is less than the
% change in P that caused it.
Indicates that Firms are not very
responsive or sensitive to price
changes and are either not able or
willing to make more of this product
available without a large price
increase.
Price Price Price

Quantity Quantity Quantity

Perfectly Inelastic Supply Unit Elastic Supply Perfectly Elastic Supply
Ps = 0 PS = 1 Ps=

8
the % change in QS is
Quantity supplied does Any change is price will
the same as the %
not change at all no matter cause QS to go to zero
change in P
how much price changes Practical application:
that caused it.
A firm is willing to make
Example: Fixed seating at as much of this product
a theater or arena. available at a constant price
(Could happen if costs do
not change)
 Factors influencing the
Price elasticity of supply
1. How much does the cost per unit of output rise
as quantity supplied increases?
The more it (costs /output) increases the more
inelastic supply will be.
If costs don’t rise at all as QS increases then
supply is perfectly elastic.
2. Time is a factor in costs per unit.
Usually, as time increases, costs per unit do not
rise as much and supply is more elastic.
Firms find better and faster ways of production
 Application using Elasticity
• Tax Burden (Who pays an excise tax?)
The government places an excise tax on the
suppliers of a good such as tobacco, liquor, and
gasoline.
Do business firms simply pass the entire tax to
consumers in the form of higher prices?
(This is called tax shifting)
It depends on the elasticity of demand and supply.
• Knowing both elasticity allows economists to
determine who pays the greater amount of an
excise tax on sellers of a good.
Price This graph initially shows a good without the excise tax...
S2 S1
$3.50 S2 is $0.50 cents greater
$3.25

$3.00
} $0.50
than S1, reflecting the tax
But the equilibrium
price($3.25) occurs where
the new supply curve
intersects the demand curve.
(Surplus at $3.50)
D
Q2 Q1 Quantity of gasoline
Suppose the government then decides to put a $0.50 cent tax per
gallon on gasoline…
…an excise tax will raise the cost of a gallon of gasoline by the
amount of the tax: $0.50, which will cause the supply curve to
shift upward {decrease in supply} by $0.50.
By comparing the price consumers pay and firms receive after the
tax (compared to the before tax price) we can determine how much
of the tax has been paid by consumers and firms.
Price Firms receive $3.25 per
S2 S1 gallon from the consumer
Out of that $3.25 they must
pay $0.50 to the government
$3.25 Firms only receive $2.75 out
of every gallon of gas sold
$3.00
Tax paid by consumer
$2.75
Tax paid by firms
D Total tax paid to Gov’t
Q2 Q1 Quantity of gasoline
By comparing the price consumers pay and firms receive after the
tax (compared to the before tax price) we can determine how much
of the tax has been paid by consumers and firms.
•Consumers pay $0.25 of the tax and firms pay $0.25 of the tax
•The Green area represents consumers share, the Light Blue area
represents firms share of the tax
Price What if Demand for gas is
S2 S1 inelastic while Supply is the
$3.40

$3.00
} $0.50
same as before (unit elastic)

Tax paid by consumer

$2.90 Tax paid by firms
Total tax paid to Gov’t

D
Q2 Q1 Quantity of gasoline
Consumers pay $0.40 of the tax and firms pay $0.10 of the tax
Why do consumers pay more of the tax when demand is inelastic?
Since consumers don’t respond very much to price changes
firms are able to pass on most of the tax in the form of higher
prices without a large reduction in sales
Price What if while Demand for
S2 S1 gas is elastic Supply is the

$3.10
$3.00
} $0.50
same as before (unit elastic)

Tax paid by consumer

Tax paid by firms
D
$2.60 Total tax paid to Gov’t

Q2 Q1 Quantity of gasoline
Consumers pay $0.10 of the tax and firms pay $0.40 of the tax
Why do Firms pay more of the tax when demand is elastic?
Since consumers respond very much to price changes firms are
unable to pass on very much of the tax in the form of higher
prices due to the large loss in sales.
 Tax incidence and elasticity
• Government gets more revenue from taxing
goods and services that are inelastic...
…quantity sold does not go down as much
• Rule of Thumb: The more inelastic side of the
market will pay the GREATER PROPORTION
of the tax.
Price Example Tax Burden:
$3.50 S2 Extreme Case

$3.00
} $0.50
S1
Tax paid by consumer
Tax paid by firms
Total tax paid to Gov’t
D

Q2 Q1 Quantity of gasoline

If Supply is perfectly elastic, Consumers pay all the tax.

Price S2 Example Tax Burden:
$3.50
Extreme Case
S1

$3.00
} $0.50
Tax paid by consumer
Tax paid by firms
Total tax paid to Gov’t
D

Q1 Quantity of gasoline

If Demand is perfectly inelastic, Consumers pay all the tax.

Price Example Tax Burden:
S2 Extreme Case
S1

$3.03
$3.00
} $0.50
Tax paid by consumer
Tax paid by firms
Total tax paid to Gov’t
$2.53
D
Q2Q1 Quantity of gasoline

If Supply is almost perfectly inelastic, Firms pay virtually

all of the tax.