Learning Outcomes

 Understand the meaning of elasticity of demand

 Understand that elasticity of demand can be with respect to income, other prices or own prices

 Similarly understand the meaning of elasticity of supply, the determinants of supply elasticity and the elasticity

of supply in short and long run

 Understand that a tax can have different incidence on demanders and suppliers depending on the elasticity of

demand or supply

 Understand normal and inferior goods by examining their income elasticity

 Understand substitutes and complements by examining their cross price elasticity

ELASTICITY OF DEMAND

Refers to responsiveness of demand to changes in own price, or other determinants of demand (or factors that affect

demand).

Own price elasticity of demand responsiveness of demand to changes in own price

Cross price elasticity of demand responsiveness of demand to changes in prices of

other products.(substitutes or complements)

Income elasticity of demand responsiveness of demand to changes in income

= % change in Quantity/ % change in price

Calculating % changes and the importance of average value of X in calculating elasticity of demand for X

The discussion below explains that when you take % change, you can end up with two answers, but you can get a unique answer for %

change if you take the change from the average value.

Say X1= 20 and it increases to X2=30. What is % change in X?

It can be (30-20)/30 = 1/3 if we take the change with respect to new value of X i.e. 30.

It can be (30-20)/20= ½ if we take the change with respect to initial value of X i.e. 20.

To avoid this ambiguity we take % change with respect to average value of X (i.e. the average of the initial and final values of x).
In our example, average value of X is (initial value + new value)/2 = (20+30)/2=25

Now after finding average value we can calculate a unique value for:

% change in X = (new value of X-old value of X)/Av value of X

= (30-20)/ 25= 10/25

Table 4.1

Commodity Reduction in Price (Cents) Increase in Qty Demanded (per month)

Cheese 40c per kg 7500 kg
T Shirts 40c per shirt 5000 shirts
CD Players 40c per CD player 100 CD players

Note that the change in price is the same in absolute terms for all products i.e. 40 cents. The data is incomplete as it does not tell us

what was the original price or the original quantity demanded- all it tells us is that what happens to demand when price falls by 40

cents

Table 4.2

Product Unit Original New Price Av Price Original New Quantity Av Quantity

Price ($) ($) Quantity

1 2 ($) 5 6=(4+5)/2

3=(1+2)/2 4
Cheese Kg 3.40 3.00 3.20 116250 123750 120000
T shirts Shirt 16.20 15.80 16.00 197500 202500 200000
CD Players Player 80.20 79.80 80.00 9950 10050 10000

In table 4.2 we start off with original prices and quantities and see what happens to them once prices fall by 40 c -

116250+7500=123750

Table 4.3

Product % fall in price % increase in Qty Elasticity of demand ()

(3)=2/1

(1) (2)
Cheese 12.5 6.25 0.5
T shirts 2.5 2.50 1.0
CD Players 0.5 1.00 2.0

% change in price: (3.4-3)/3.2=0.4/3.2=0.125=12.5%

% change in qty: (116250-123750)/120000=0.625=6.25%

Elasticity= 6.25/12.5=0.5
INTERPRETING ELASTICITIES

Demand elasticity will always have a negative value (because of opp. signs of price and quantity in elasticity formula)

But we always take positive value (that’s an age old convention). The higher the value the more elastic (responsive) the demand when

prices change.

Q. What value can the elasticity coefficient (i.e. own price elasticity coefficient) take?

A. Value of  is between 0 and infinity

 When % change in Q is greater than % change in P, demand is said to be elastic -  will take on value of greater than 1 to

infinity

 When % change in Q is less than % change in P, demand is said to be inelastic -  will take on value of less than 1 or more

precisely between 0 and 1

 When Q does not change at all and P changes – elasticity is 0 (Note that while elasticity can be +infinity, it cannot be –

infinity or less than zero)

 When % change in Q = % change in P, demand is said to be unitary elastic

Q. Would we observe a constant own price elasticity of demand along a demand curve?

A. Depends on the slope of the demand curve-

 If D curve is a st line demand curve its elasticity changes as we move along the curve (See fig 4-2)

 If D is horizontal or vertical elasticity is infinite or zero (see fig 4-3)

 If D curve is a hyperbola –it will have unitary elasticity, =1, ((See Fig 4-3)

Determinants of Elasticity of Demand

----Depends on availability of substitutes- if very close substitutes are available for X, changes in prices of those goods will have a

larger effect on quantity consumed of X- Thus a product with close substitutes tends to have an elastic demand and a product with no

close substitutes tends to have an inelastic demand

-----Depends on how much time is available to substitute- in SR not many products can be produced or introduced in market but over

longer run many substitutes can be developed by suppliers- Thus LR demand for a product is more elastic than SR demand (people

change their method of transportation over time –hence demand for gasoline is less elastic in SR than in LR)

Q. Would OPEC oil Producers experience a gain in revenues if they restricted the cartels supply of oil and thereby increased prices?
A. Depends on whether demand for oil is elastic or inelastic- their revenues will only increase if demand is inelastic and revenues

would fall if demand is elastic.

Q. Can farmers increase their revenues by dropping prices?

A. Yes only if demand is elastic (fall in price should generate huge increase in demand such that P x Q increases. If demand is

inelastic and Q does not increase with fall in price, the total revenue to farmers P x Q would fall with a fall in price.

These ideas shows relationship \between total revenue of firms (which is total expenditure of consumers) and quantity demanded...

Note that total expenditure of consumers (which is the same as total revenue of firms producing those products) first rises with

increase in quantities purchased and then starts falling despite the fact that more quantities are still being purchased. Note that up to

10,000 units of demand the expenditure is rising and then after 10000 units it starts to fall and goes to zero at 20000 units of

consumption demand.

Q. Why may this be so?

A. The expenditure PQ is composed of prices and quantities – therefore TE= P x Q. Along the demand curve prices are

throughout falling and quantities are throughout rising so direction of change of TE is inderminate. However, the answer lies in

understanding that elasticity of demand (or response of demand to changes in price) is different over the initial range (top LHS) of the

demand curve as compared to the latter part (bottom RHS) of the D curve.

Initially the increase in demand is much more than the fall in price so that TE rises- in other words over the initial range of the demand

curve demand is more elastic (i.e. change in demand is more than change in price). We note that TEs continually increase till P=2 and

D=10000, but after that further fall in prices does not lead to much larger increase in demand (i.e. fall in P is greater than increase in

D, therefore TE=PQ falls).

Note that in absolute value demand is continually increasing with fall in prices but at prices less than P=2, the incremental increase in

demand is less than the incremental decrease in price. In other words at P less than 2 Demand keeps becoming more and more

inelastic. The effect of this demand inelasticity is that TE eventually becomes zero when D=20,000 units.

PRICE ELASTICITY OF SUPPLY FIG 4-6

Measures the elasticity of supply of goods with respect to changes in market prices.

It is denoted s = % change in quantity supplied

 % change in market price

The sign of s is positive because both numerator and denominator are always positive. The reason that numerator and denominator

are both positive is that we are considering the supply curves which have positive slopes.

However, there are special cases of supply curves whose slopes may not be positive-they could be vertical or horizontal. A very steep

S curve means that a unit increase (decrease) in price has a very small increase (increase) in Q supplied. It means steeper S curve is

less elastic or inelastic.

Vertical S curve has s = 0, steeper S curves will have small values of elasticity of supply

Horizontal S curve-has s =, flatter S curves will have large values of elasticity of supply

Special case of S curve: Any positively sloped S curve passing through origin will have s = 1.

Look at smaller triangle and larger triangle-their angles are equal (similar triangles) therefore ratios of their sides are equal

p/q= p/q

and we know from definition that s = q/q

p/p

= q/p . p/q

Substitute for p/q = q/p . p/q

= 1 (means that the % change in quantity supplied equals the % change in price)

DETERMINANTS OF SUPPLY ELASTICITY

Depends on how easy it is to substitute factors of production towards the prodn of those goods whose price has risen. Naturally we

will not see this substitution in very diverse products cars and cabbages etc, rather close products e.g different kinds of detergents or

soaps or other very close substitutes-

How quickly S responds to increase the prodn of the product whose P has risen depends on whether the costs will also rise as

substitution in prodn is made- if that’s the case then supply may not be responsive to increase in price.
Generally in SR supply is not that responsive as compared to LR when costs can be better controlled and factors of prodn can be better

combined to produce the product whose price has risen. Therefore SR S curves are relatively inelastic compared to LR S curves.

What Determines Income Elasticity (discussion of income consumption curves)

Y = % change in quantity demanded

% change in income

↑ Y → ↑ D --- for normal goods; therefore Y ≥ 0

↑ Y → ↓ D --- for inferior goods; therefore Y ≤ 0

Income elasticity of Normal Goods will definitely be positive (greater than 0) but can be greater than unity (elastic) or less than unity

(inelastic) depending on whether the change in Q demanded is greater or less than the change in income..

If Y is greater than 1, we say that demand is income elastic

If Y is less than 1, we say that demand is income inelastic

Defining Inferior and Normal Goods in terms of Elasticity (See table 4-4 for examples of such goods and their empirically observed

elasticities)

Inferior Goods have Y less than zero

Normal Goods which are inelastic have Y between zero and one

Normal Goods which are elastic have Y greater than one

CROSS ELASTICITY OF DEMAND

xy = % change in Q demanded of X---

% change in price of good Y

-  ≤xy ≤ 

If cross elasticity is >0 it’s a substitute – that is ↑ in price of Y leads to ↑ in D for X – Demand curve of X will shift right

If cross elasticity is <0 it’s a complement – that is ↑ in price of Y leads to ↓in D for X – Demand curve of X will shift left