Econ 100

Lecture 7
The sensivity of quantities demanded and supplied to changes in price (and other factors):

Elasticity

In our discussion of the demand and supply analysis, we already remarked that demand and supply curves may have very different shapes from good to good and from market to market.
The shape of a demand or supply curve reflects most of all the degree by which the quantity demanded or supplied changes in response to a change in price. We may focus first on demand curves as we talk about the responsiveness of Q to P.

If QD changes by a relatively large amount in response to a relatively small change in P, we would have a relatively flat demand curve. So a relatively flat demand curve shows that the quantity demanded is relatively sensitive (or responsive) to changes in the price. If, on the other hand, QD changes by a relatively small amount in response to a relatively large change in P, we would have a relatively steep demand curve.
So a relatively steep demand curve shows that the quantity demanded is relatively insensitive (or unresponsive) to changes in the price.

Sometimes it is necessary and/or useful to have a quantitative measure of how sensitive QD is with respect to a change in P. Example. Suppose the government is worried about the extensive use of cigarettes in the country and considering the imposition of a sales tax on the product to cause the price of cigarettes to increase and quantity demanded and sold to decrease. But what should the amount of the tax per unit (pack) of cigarettes be?
If QD of cigarettes is relatively sensitive to P, a relatively small tax per unit may be sufficient to bring about a certain decrease in the quantity of cigarettes used. But if QD is relatively insensitive, even a high tax will not be sufficient to achieve the targeted change in Q.

How to define a measure of the sensitivity (or responsiveness) of QD with respect to P?

Consider two demand curves,

one relatively flat, the other one relatively steep, that may each be the demand curve for a certain good. Since each of these may be the demand curve for the same good, they can be drawn on the same diagram. Now suppose the price is the same along both curves and then it changes by a certain amount. Let the change in price be denoted by P (note that P is positive if P increases and negative if P decreases).

If the price decreases (and P is negative),

QD will increase by the amount Q. Since Q will be larger along the flatter curve than it will be along the steeper curve, we can also say that (the absolute value of) the ratio Q/P will be larger along the flatter curve, or (the absolute value of) the ratio P/Q will be smaller along the flatter curve. Does this suggest a measure of sensitivity of Q with respect to P?

The ratio P/Q is (approximately) equal to the slope of the D curve at any point along the curve (for small P and Q).
This suggests that we use the slope of the D curve at any point as a measure of how responsive QD is to changes in P.

But the slope (or P/Q approximately) is not a good or reliable measure of sensitivity of Q with respect to P
for two reasons: (1) Slope changes as units in which Q is measured are changed, (2) we can not compare the sensitivities of QD with respect to P of two different goods (again because units of Q are different for two different goods). A few remarks about these follow.

Consider first the dependence of the numerical value of the slope to the choice of units.
Suppose the quantity of a certain good is measured in kgs and a 1 TL/kg decrease in P causes a 5000 kg increase in QD.

Then
Slope of D curve = 1 (TL/kg) / 5000 kg = 0.0002 The absolute value of this is small and the D curve appears rather flat.

Now let Q be measured in tons. Since 1 ton = 1000 kgs,

P = 1 TL/kg = 1000 TL/ton Q = 5000 kgs = 5 tons P/Q = 1000 TL/ton / 5 tons = 200 The absolute value of this is large and the D curve appears rather steep. Now which one is the case: Is this D curve flat or steep? Is QD sensitive or insensitive to changes in P?

Consider also the use of slope in comparing the sensitivities of quantities demanded wrt to changes in price for two different goods, such as wheat and cars. Quantity of wheat is measured in (say) tons of wheat and quantity of cars is measured in units of cars. Suppose market studies give the slopes of D curves as
Wheat: 200 TL/ton per ton of wheat Cars: 500 TL/car per car Is D for wheat more or less sensitive than D for cars? What would it mean to compare a number in TL/ton per ton of wheat with a number in TL/car per car anyway?

Because of such difficulties, slope of the D curve is not very satisfying as a measure of the sensitivity of QD with respect to changes in P, and a better measure is needed.
And since these difficulties are rooted in the fact that the numerical value of the slope depends on the choice of units, we may reasonably think that the measure we need should be independent of the choice of units. What would you suggest?

Elasticity
Elasticity measures the percentage change in QD that occurs as a result of a unit percentage change in P, or
Elasticity = %QD / %P To be precise, it is called the price elasticity of demand. Suppose the price elasticity of demand for a certain good is equal to 2.75. What does this mean? This means that, if the price of the good increases by 1%, quantity demanded of that good will decrease by 2.75%. Furthermore, we can calculate that, if P increases by 4%, QD will decrease by 4% x 2.75 = 11%.

Finally, if P was 20 TL/ton and QD was 500 tons before P (and hence Q) changed, we can calculate the changes in price and quantity as P = 4% x 20 TL/ton = 0.80 TL/ton
QD = 11% x 500 tons = 55 tons

Recall that a percentage changes in Q and P are defined as

%Q = Q / Q %P = P / P If Q is measured in kgs, for example, the units of the first of these are (kg / kg) which is unitless, and that of the second are (TL/kg) / (TL/kg), also unitless. Therefore, elasticity itself is a unitless number.

Therefore, price elasticity of demand will be a number such as 0.5, 1, 2.75, and this number (or the numerical value of elasticity) will remain unchanged even if the units of Q are changed.
It is also possible to compare the sensitivity of QD of a certain good with that of QD of another good because two pure numbers can be compared. Suppose that P elasticity of D for wheat is 0.5 whereas P elasticity of D for cars is 2.75. This will mean that QD of cars is more sensitive to a change in P of cars than QD of wheat is to a change in P of wheat.

Note that, since for a large majority of goods P and QD will move in opposite directions,
P and QD that appear in the ratio giving the elasticity will have opposite signs, and, consequently, the price elasticity of demand will be a negative number.

Since it is expected that elasticity will be negative for a good unless it is explicitly mentioned that the D curve is not negatively sloped, it has become customary to drop the minus sign as price elasticities of demand are reported.
In the rest of this lecture we will follow this practice and...

 give price elasticities of demand as positive numbers.

Therefore, when the price elasticity of demand for a good is given as 3 instead of 3, it should automatically be understood that what is meant is that QD decreases by 3% if P increases by 1% for that good. Before we begin to talk about other aspects of this measure called elasticity, it will be useful to talk about what factors the price elasticity of demand may be determined by.

Factors affecting the price elasticity of demand

The following are among the most important factors that affect the price elasticity of demand for a specific good (or service):

Availability of close substitutes

Necessities versus luxuries Definition of the market Proportion of income devoted to the product Time horizon

So that...

(price) elasticity (of demand) tends to be higher...

if close substitutes are available

for luxuries than it is for necessities

if the good is defined more narrowly

if the proportion of income devoted to the good is larger in the long run than in the short run

Let us now go back to the definition of (price) elasticity (of demand):

Elasticity = %QD / %P or, since %Q = Q / Q and %P = P / P, Elasticity = (Q / Q) / (P / P)

or
Elasticity = (Q / Q) x (P / P) which may be rewritten as Elasticity = (P / Q) x (Q / P)

One can recognize the ratio Q / P in the last expression as the inverse of P / Q which will be approximately equal to the slope of the demand curve if the changes in P and Q are small.
Therefore, elasticity can be written as E = (P / Q) x (1 / s)

where E denotes the elasticity and s the slope of the demand curve.
Since not only P or Q but also s will in general change along a curve, elasticity will not remain constant along a demand curve except for some special demand curves.

This fact creates some difficulties in the use and calculation of elasticities.
First, about the use of elasticity in calculating the change in Q as a result of a change in P. Suppose you know the slope of a demand curve at a point with a given P and Q. Since

P / Q s

or Q (1/s) x P

which can be rewritten as Q / Q (P / Q) x (1/s) x (P / P) we have %Q E x %P

Therefore, using the elasticity calculated by using the formula E = (P / Q) x (1/s) will enable you to calculate the percentage change in Q only approximately.
And/But the smaller the change in P or the less curved the demand curve, the better will the approximation be.

Second, about the calculation of the elasticity itself.

Suppose you find that P and Q will move from a point A on a demand curve to another point B on the same demand curve.

Calculation of elasticity by using A as the initial point will in general give a different result than the calculation that is done by using B as the initial point. Starting from A: E = (PA / QA) x (Q/P)
Starting from B: E = (PB / QB) x (Q/P) For this reason, some researchers prefer to use another elasticity formula which is called the midpoint elasticity (or arc elasticity): E = (Pm / Qm) x (Q/P) where Pm is the arithmetic average of PA and PB and Qm is the arithmetic average of QA and QB so that....

 the point at which P = Pm and Q = Qm is the midpoint

between points A and B (that is, the midpoint on a straight line connecting A and B).

Midpoint elasticity is thought to be useful or reliable because it gives you the same elasticity value between two given points on a demand curve regardless of the direction of the change along the curve.

Classifying demand curves according to their elasticity

We will now see different demand curves and compare them with respect to their elasticity.
There will be five demand curves. Let us first consider two extreme ones: QD extremely unresponsive to P QD extremely responsive to P

One extreme: Totally unresponsive Q

When QD is extremely unresponsive to P, it will not change no matter how large P is.
This means that Q = 0 or %Q = 0 and therefore E = 0

The graph of demand will be a vertical line.

Such a demand curve is designated as perfectly inelastic.

This is the limit case for steeper and steeper demand curves.

The other extreme: Infinitely responsive Q

When QD is extremely responsive to P, it will change by a very large amount no matter how small P is.
This means that Q = or %Q = and therefore E =

The graph of demand will be a horizontal line.

Such a demand curve is designated as perfectly elastic.

This is the limit case for flatter and flatter demand curves.

Cases in between
All the other demand curves will be in between these two extremes.
Those that are relatively steep and close to a vertical line with zero elasticity will have small elasticities and will be called inelastic, And those that are relatively flat and close to a horizontal line with infinite elasticity will have large elasticities and will be called elastic. Then there must be a certain demand curve that is just on the border that separates inelastic curves from elastic ones. What is the elasticity of that curve?

We take E = 1 to be the demand curve that separates elastic from inelastic demand curves. So,
E < 1 corresponds to %Q < %P, inelastic D, E > 1 corresponds to %Q > %P, elastic D.

And a D curve with E = 1 is called unit-elastic.

But why should a demand curve with unit elasticity be the one between elastic and inelastic curves? Why not take E = 5 for example?

The answer is as follows. Consider first a market in equilibrium, so QD = QS. Therefore,

P x QD = P x QS or Total expenditure = Total revenue

(paid by buyers)
Therefore we can take

(received by sellers)

Total revenue = P x QD. Now... if E = 1, then...

QD will decrease (or increase) by the same percentage as P increases (or decreases), and, consequently, total revenue will remain approximately unchanged. Example. Suppose E = 1 and P increases by 4%. Then QD will decrease also by 4%. This means that P will rise to 1.04 times its initial value and QD will fall to 0.96 times its initial value, and, consequently, total revenue will change to 1.04 x 0.96 = 0.9984 times its initial value, which means that total revenue will remain unchanged because 0.9984 1. In other words, if E = 1 for a demand curve, PxQ will be constant along that curve.

What about the total revenue along other demand curves? (Let us denote total revenue by R.)
If the demand curve is inelastic, P and R will move in the same direction. In other words, An increase in P will cause R to increase and a decrease in P will cause R to decrease. Think in terms of the extreme case: If D curve is perfectly inelastic and E = 0, Q is constant, and as P doubles, R will also double.

If, on the other hand, the demand curve is elastic, P and R will move in opposite directions. In other words,
An increase in P (hence, a decrease in Q) will cause R to decrease and a decrease in P (hence, an increase in Q) will cause R to increase.

You can think of this case as Q and R moving in the same direction. In terms of an extreme case: If D curve is highly elastic so that E =100, as P decreases by 1% it (stays roughly constant), Q will increase by 100% (it will double). As P is (roughly) constant and Q doubles, R will also (roughly) double.

Example. Consider farmers producing agricultural products, say, wheat. Suppose one year the weather goes unusually well in the entire country and the quantity produced of wheat is unusually large. This sounds like good news for farmers, but is it really so?
Quantity produced being large at the end of a season means that supply of wheat increases and, as a result, equilibrium price of wheat decreases (along the demand curve). This could still be good news for the farmers because their total revenue could increase if the demand for wheat were elastic. But wheat, like other necessities, has an inelastic demand and consequently the total revenue decreases when production of wheat increases. Good weather may be bad news for farmers.

Now recall two of the things we have seen so far:

(a) In general, elasticity changes along a demand curve (so E may be < 1 over some portion of a demand curve whereas it is > 1 over some other portion of the same curve), and (b) As P rises, total revenue rises also if E < 1 but it falls if E > 1. If we put these two together, we arrive at the conclusion that as P rises, total revenue may increase for some range of P and it may decrease for some other range of P. Let us see an example...

A linear demand curve

Elasticity varies between zero and infinity over a linear demand curve.
At the Q intercept (when P = 0), E = 0 At the midpoint, E = 1 At the P intercept (when Q = 0), E = Between Q intercept and midpoint, 0 < E < 1 (inelastic)

As P changes, E will change continously so that

Between P intercept and midpoint, 1 > E < (elastic)

It follows that, as P falls starting from the P-intercept of the D curve (as Q rises starting from 0), R will first rise (until the midpoint) and then fall (after the midpoint). If we combine this with the fact that R = 0 both
at the Q intercept (because P = 0) and at the P intercept (because Q = 0), we can draw a sketch of the graph of how the revenue changes as P and Q vary.

Other elasticities
So far, we have defined elasticity as
E = %QD / %P because we wanted to talk about the responsiveness of QD to P. But actually, elasticity is a general concept that can be used to measure the responsiveness of any variable (say, Y) to any other variable (say, X):

E = %Y / %X
and defining elasticity as E = %QD / %P was just a specific application of this concept (that is why we called E = %QD / %P not just elasticity but price elasticity of demand).

We can now change the variable in the denominator of the ratio giving the elasticity and define other elasticities of demand, for example: Income elasticity of demand
E = %QD / %I where I denotes income, Cross-price elasticity of demand E = %QD of good A / %P of good B

where B is one of the other goods and can be either a substitute or a complement.

Income elasticity will be

Positive for normal goods Negative for inferior goods and Smaller for necessities

Larger for luxuries

Cross-price elasticity will be Positive for substitutes Negative for complements

Elasticities of supply
We can also change the variable in the numerator of the ratio giving the elasticity to quantity supplied of a good and define elasticities of supply. For example, if we keep identifying the variable in the denominator with the price of the good, we obtain
Price elasticity of supply

E = %QS / %P
or the percentage increase in QS per unit percentage increase in P.

Price elasticity of supply measures the responsiveness of quantity supplied of a good by producers or sellers or firms to changes in the price of the good. The easier it is to increase the amount of the good produced or available for sale, the higher will be this responsiveness. Hence an important factor affecting the price elasticity of supply is the time horizon because as time passes it is easier for existing producers to acquire and allocate more resources (land, machines, factory buildings) to the production of this good and for more producers to enter the market.

Classifying supply curves according to their elasticity

We will now see different supply curves and compare them with respect to their elasticity.
There will be five supply curves. Let us first consider two extreme ones: QS extremely unresponsive to P QS extremely responsive to P

One extreme: Totally unresponsive Q

When QS is extremely unresponsive to P, it will not change no matter how large P is.
This means that Q = 0 or %Q = 0 and therefore E = 0

The graph of supply will be a vertical line.

Such a supply curve is designated as perfectly inelastic.

This is the limit case for steeper and steeper supply curves.

The other extreme: Infinitely responsive Q

When QS is extremely responsive to P, it will change by a very large amount no matter how small P is.
This means that Q = or %Q = and therefore E =

The graph of supply will be a horizontal line.

Such a supply curve is designated as perfectly elastic. This is the limit case for flatter and flatter supply curves.

Cases in between
All the other supply curves will be in between these two extremes.
Those that are relatively steep and close to a vertical line with zero elasticity will have small elasticities and will be called inelastic, And those that are relatively flat and close to a horizontal line with infinite elasticity will have large elasticities and will be called elastic. Then there must be a certain supply curve that is just on the border that separates inelastic curves from elastic ones. What is the elasticity of that curve?

We take E = 1 to be the supply curve that separates elastic from inelastic supply curves. So,
E < 1 corresponds to %Q < %P, inelastic S, E > 1 corresponds to %Q > %P, elastic S.

And a S curve with E = 1 is called unit-elastic.

One can verify that a linear supply curve with E = 1 will pass exactly through the origin (it will have neither a positive Q-intercept nor a positive Pintercept), regardless of its slope.
A linear supply curve with E < 1 will have a positive Q-intercept, and A linear supply curve with E > 1 will have a positive P-intercept.

In general, elasticity will change along a supply curve. One example is a supply curve which is relatively flat (so, E > 1) for relatively small values of Q and relatively steep (E < 1) for relatively large values of Q.
Such a supply curve reflects the fact that it is relatively easy to increase production when the production is well below capacity but it becomes harder and harder to increase it when the capacity limit is reached.