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CHAPTER 3 - ELASTICITY

3.0 Introduction

We have so far looked at a general overview of demand and supply theory. Let us
proceed one step further. The demand curve summarizes information about how
consumers respond by changing their quantity demanded when price changes. But
nothing has actually been said about the responsiveness of the consumer. To illustrate
the concept of responsiveness, we ask a question like, “If the price of pencils increase,
by how much will quantity demanded fall?” Will quantity fall by a larger percentage
than the price or by less?

This concept of responsiveness is known as elasticity - specifically the question refers to


the elasticity of demand. Demand can respond to many things - prices, incomes of
consumers, prices of other goods etc. For now let us concentrate on a single demand
curve and thus only look at the responsiveness of quantity to changes in the price of the
good itself.

3.1 Price Elasticity of Demand

Price elasticity of demand (or sometimes known as own price elasticity of demand) is the
measure of how responsive is quantity demanded when the price of the good itself
changes. In other words, we are comparing the magnitude of the change in quantity
with the magnitude of the change in price. But to compare prices and quantities directly
is like trying to compare apples with oranges - they are two different things with different
measures. In order to obtain a value of magnitude that is independent of type of measure,
we rely on percentage changes. Hence the formula for price elasticity of demand is as
follows:

% change quantity
Elasticity of Demand η = % change price

More specifically:
Q2 – Q1

Q2 + Q1

2
η =
P2 – P1

P2 + P1

2
The value of η when calculated will always be negative because the demand curve
depicts a negative relationship. Hence when we calculate price elasticity of demand we
must always take the absolute value (the positive value). In other words, ignore the
negative sign. But this is only when we calculate price elasticity of demand. Let us now
discuss the possible values of η.

I. Elastic Demand

This is where η has a value of


1 < η < infinity
This is where a certain % change in price leads to a bigger % change in quantity
demanded. A relatively elastic demand curve will look like this:

Price

P0

P1

Demand

Q0 Q1 Quantity

The extreme case of elastic demand is where η takes on the value of infinity. This
means the slightest change in price will either cause quantity demanded to increase to
infinity or fall to zero. There is only one price at which equilibrium will occur. In this
case the demand curve is horizontal and elasticity has a value of infinity.

P
Perfectly Elastic Demand

Demand

Q
II. Inelastic Demand

This is where the value of η is


0 <η < 1
A certain % change in price leads to a smaller % change in quantity demanded. Demand
is not very responsive to changes in price.

Price

P0 Inelastic Demand
Function

P1

Demand
Quantity
Q0 Q1

The extreme case is where a change in price does not affect quantity demanded at all.
This is where η = 0.

Price
Demand

P0 Perfectly Inelastic Demand

P1

Quantity

III Unit Elastic Demand

This is the final case where η takes on the value of


η = 1
In other words, a certain % change in price is exactly matched by an equal % change in
quantity demanded.
A unit elastic demand curve looks like this:

Rectangular Hyperbola
Price

Unit Elastic Demand Curve


P0

P1

Demand
3.2 Determinants of Elasticity
Quantity
What determines the elasticityQ0 Q1
of a particular good?

1. Nature of the good

We can divide goods and services into two broad categories.

a) Necessities. These are goods that are essential for daily life and are
consumed for practicality, not so much for enjoyment. Examples of
necessities are things like rice, soap, tissue paper and perhaps laundry
services. Necessities tend to have fairly inelastic demand curves. The
reason is because firstly, even if the price increases by a lot, we tend not to
cut back too much on demand for necessities simply because we need
them too much. For example, even if the price of rice were to double, you
definitely will not halve your daily consumption of rice because it is an
essential part of a meal. Secondly, even if the price fell by a lot, you
would not increase consumption of necessities by a lot because there is
only so much you can consume. If the price of soap fell to 10 cents per
bar, you will definitely not use more than what you are using now unless
you decide to take twice as many baths per day as you do now. Imagine
bathing four times a day!

b) Luxuries. These are goods we would like to consume a lot of because


they give us a lot of enjoyment - but we can survive without them. Hence,
when their prices increase, we tend to cut back a lot on consumption of
luxuries because we can do without them. For example a meal at a fancy
restaurant is a luxury and we may indulge in one only on special occasions
- say a birthday. But if the price of meals there became half the current
price, we may decide to go there once a month (consumption increases by
twelve times). If the prices of meals there doubled, we can make do with
a meal at the local hawker center so consumption falls to zero. Quantity
of meals demanded therefore is very elastic.

2. Availability of close substitutes.

The demand for a good tends to be more elastic the more substitutes there are.
For example if the price for Coke went up by 20 cents, many of us will not
hesitate to switch to Pepsi. Hence the response of quantity becomes very
sensitive to the slightest price changes. On the other hand, when something has
few close substitutes, even if prices change by a lot, quantity demanded will not
change by that much. For example insulin has no substitutes so even if its prices
double, quantity demanded will not change by much because the diabetic depends
on it for survival. Notice that broader categories of goods such as food and
toothpaste tend to have fewer substitutes than individual brands within those
categories such as chicken and Colgate. Hence broader categories have more
inelastic demand than demand for individual brands.

3. Fraction of income spent on the good.

The smaller the fraction of income spent on the good, the more inelastic the
demand. For example, salt costs 30 cents per packet. Our income is
$1000/month. Salt therefore represents 0.03% of our income.. So if the price of
salt doubles to 60 cents, it still takes only 0.06% of our income and therefore our
demand for it will not change by much. However, let us consider a bottle of white
wine. Currently we may consume three bottles per month at a price of $50/bottle.
This takes up 15% of our income. If the price doubles to $100/bottle, the fraction
of our income taken up will rise to 30%. The larger the fraction of income taken
up by a good, the larger the impact of any given price change. Hence we tend to
react more and demand becomes more elastic.

4. Time

Demand for products tends to be more elastic in the long run and less elastic in
the short run. Let us look at a household’s consumption of petroleum. In 1973,
the price of petroleum rose by 400%. In the immediate run – the instant after the
increase in the price of petrol, the household may not be able to do anything to
change quantity because it has already planned the events for that day and
therefore has to do a certain amount of driving that day - which it cannot avoid.
Hence demand for petrol in the immediate run is completely inelastic. However,
over the short run, say the next few weeks and months, the household will
definitely begin to economize on its use of petrol by increasing the usage of
public transport, car-pooling and so on. Hence quantity demanded does respond
but it falls only slightly. In the long run the household may reduce its usage of
petrol even further by buying a more economical car or switching to a Liquid
Petroleum Gas run car. So the quantity response is even greater. In the very long
run - centuries ahead, people can probably do away with petrol altogether by
inventing cars that run on alternative fuels. Demand is perfectly elastic.

Looking at it graphically, the three demand curves will look like this:

Price
Demand - Immediate Run

Demand - Long Run

Demand - Short Run

Quantity

3.3 Elasticity and Total Expenditure (Revenue)

One of the uses of knowing the elasticity of demand for a particular product is it tells us
valuable information about whether total expenditures will increase or decrease when
prices change. Because total expenditures will eventually become the total revenues of
the producer, they too pay a lot of attention to elasticities when deciding on price
changes. It may seem logical to think that when the price of something goes up, the total
expenditure on that thing will also go up. This may not be the case. Let us first define
what we mean by total expenditures. The diagram is on the next page. Total expenditure
is given by the formula:

Total Expenditure = price x quantity traded


In the diagram it is the shaded area P0 x Q0. It is obvious from this formula that there are
two components of Total Expenditure - the price component and the quantity component.

Price

P0

Total Expenditure
(Total Revenue)
Demand

Q0 Quantity
Because the demand function entails a negative relationship between price and quantity,
whenever there is a change in price, there will be two opposing forces working to change
total expenditure. Let us look at the case of a price increase.

Total Expenditure(?) = Price (increasing) x Quantity(decreasing)

The price increase increases the price component of total expenditure (TE). Hence TE
will tend to increase. However, at the same time, quantity will be falling and thus TE
will also have a tendency to decrease. What the eventual outcome will be will depend on
the relative strengths of the price and quantity influences.

This is where elasticity plays an important role. The elasticity of the demand curve tells
us whether a percentage change in price leads to a larger, smaller or equal change in
quantity. Let us first look at the case of an elastic demand. For demand to be elastic, the
following must hold:

%change in quantity > %change in price

Therefore if price increases by 10%, quantity must fall by a larger percentage, say 20%.
In such a case, when price increases, the quantity effect will be larger than the price effect
and TE will decrease. The reverse is also true, when price decreases, TE will increase.
This is contrary to the commonsense argument that when price of something goes up you
spend more.

Look at the diagram on the next page. When the price increases from P 1 to P0, quantity
demanded falls from Q1 to Q0. TE or Total Revenue (TR) changes from the area (P1 D Q1
0) to area (P0 C Q0 0). The loss in TE resulting from the fall in quantity is the shaded area
B and the increase in TE resulting from the increase in price is area A. As you can see,
area A is smaller than B, so there is a net fall in TE. Hence, if the demand curve for a
particular market looks like the one above, a supplier will not want to increase prices
because he would end up with less revenue. Instead, cutting prices will tend to benefit
him more.

Price

C
P0
A
D
P1
Demand
B

0 Q0 Q1 Quantity

When the demand curve is inelastic the reverse is true. In order to have an inelastic
demand curve, the following condition must hold:

% change in quantity < % change in price

Hence, a change in price will result in a larger price effect than quantity effect. So if the
price increases, the tendency for TE to increase (because price increases) will be greater
than the tendency for TE to fall (because quantity falls). Thus TE will increase when
price increases and fall when price falls. Look at the diagram below.

When price increases, the loss in TE resulting from the fall in quantity (area B) will be
smaller than the gain in TE resulting from the price increase (area A). In such a situation,
traders will tend to increase prices rather than decrease it. This is one of the reasons why
governments tend to keep a close eye on the prices of foodstuffs. As you may recall from
our earlier discussion on elasticities, necessities tend to have more inelastic demands
compared to luxuries. Thus, the temptation for sellers to increase prices and reap bigger
profits is quite large. hence governments must impose some sort of control on prices by
watching whether suppliers purposely restrict supply or not (to drive up the price of the
item).
Price

P0
A

P1

Demand

Q0 Q1 Quantity

We are now in a position to prove something very important, namely that even though a
demand curve is a straight line, this doesn’t mean elasticity is constant throughout. To do
this we have to look at how a given change in price has different effects on TE depending
on where on the demand curve you happen to be. Look at the diagram on the next page.

Let us look at a fall in price. When prices fall from P 0 to P1 at the top of the demand
curve, the fall in TE resulting from the fall in price (area A) is less than the gain in TE
resulting from the gain in quantity (area B). As a result, the fall in price actually leads to
a gain in TE. This tells us that the demand curve (over this price range) is elastic.
However, if we allow for the same price fall further down the demand curve, we get very
different results. Here, the same price fall actually leads to a fall in total expenditure
(area C > area D), which means that over this range of prices, the demand curve must be
inelastic.

Price

P0
A
P1

P0’
C
P1’
D Demand

Q0 Q1 Q0’Q1’ Quantity
Hence, elasticity varies over a straight line demand curve. Elasticity starts off with a
value of infinity right at the top of the demand curve, and gradually lessens until it
reaches zero at the bottom. Hence, elasticity must equal to one exactly in the middle of a
straight line demand curve. Look at the diagram below.

Price Elasticity = infinity

Elasticity = 1

Demand

Elasticity = 0

Quantity

Up until now, we have been studying the responsiveness of quantity demanded to


changes in the price of the good itself. But quantity responds to other things as well. We
now turn to a few other elasticities.

3.4 Income Elasticity of Demand

The question asked here is, “As income changes, how does the demand for a particular
good change?” The answer lies with the income elasticity of demand and its formula is
as follows:

η % change in quantity demanded


Y
=
% change in price
Specifically:
Q2 – Q1

Q2 + Q1

2
η =
Y Y2 – Y1

Y2 + Y1

Where Y = income.

The value of the income elasticity of demand ranges from negative infinity to positive
infinity. Unlike price elasticity of demand, the sign of the income elasticity of demand is
very important. Here we have to distinguish between two goods:

a) Normal Goods
Normal goods are goods which have a positive income elasticity of demand. In
other words, as income goes up, quantity demanded also goes up. For example,
the richer you are, the more airline flights you consume. Normal goods can be
elastic or inelastic, depending on their nature. Normal goods which are
necessities will tend to be income inelastic

0 < η <1
Y

The reason is similar to that of necessities when prices change. Even if you
become a millionaire, your consumption of soap will not exceed one bar per day.
Hence the demand for soap tends to be unresponsive to the level of your income.
When the normal goods are luxuries, income elasticity will be greater than one.

> 1
η
Y

The airline flights is a good example of a luxury which you will consume more of
as your income levels increase. As a businessman becomes more prosperous, he
will tend to have more dealings with other countries and hence will tend to fly
more.

b) Inferior Goods
Inferior goods have an income elasticity of less than zero, a negative income
elasticity of demand. The quantity demanded for inferior goods declines when
income increases. This is mainly because people switch to the consumption of
superior goods. For example, when you are poor you tend to eat salt fish and rice
for all three meals a day. Hence your demand for salt fish is high. But as you
grow richer, you can afford to eat fresh fish and chicken so the quantity of salt
fish demanded decreases. Salt fish is thus an inferior good and has a negative
income elasticity of demand.

3.5 Cross Price Elasticity of Demand

The quantity demanded of any good also depends on the prices of other goods. The cross
price elasticity of demand measures the responsiveness of the quantity demanded for a
good in response to the changes in the price of another good.

The relevant formula is as follows:

η % change in quantity demanded for Good A


X
=
% change in price of Good B
Specifically:

QA2 – QA1

QA2 + QA1

2
η =
X P – PB1
B
2

PB2 + PB1

Where A and B are two different goods.

Note that as in the case of income elasticity of demand, the negativity or positivity of the
value we calculate bears some significance so we do not ignore them.

The value of the cross price elasticity of demand depends on the relationship between the
two goods. It can be either negative or positive. Here again we have two categories.
a) Complements
Complements are good which are jointly consumed. For example bread and
butter, cars and tyres. When the price of cars increases, the quantity of cars
demanded falls. Because tyres are jointly consumed with cars, the demand for
tyres will also fall. Hence there is a negative relationship between the price of
cars and the demand for tyres. The cross price elasticity of demand for tyres with
respect to cars is thus negative.
η X< 0

The larger the value of the negativity, the closer the two goods are as
complements. Cars and tyres tend to have a large negative value because they are
always consumed jointly - one car to four tyres.

b) Substitutes
Substitutes are goods which can replace each other. For example butter and
margarine, mutton and beef and so on. When the price of butter increases, the
quantity demanded for butter decreases. People substitute butter for margarine.
Thus the quantity demanded for margarine will increase even though its price has
not changed. Therefore there is a positive relationship between the price of butter
and the quantity demanded for margarine. The cross price elasticity of demand
for margarine with reference to butter is positive.
η X > 0

The larger the value of the positivity, the closer the two goods are as substitutes.

3.6 Elasticity of Supply

Because the supply curve relates the price of the good to quantity supplied, the concept of
elasticity applies here as well.

η % change in quantity supplied


S
=
% change in price
Specifically:
QS2 – QS1

QS2 + QS1

2
η =
S P2 – P1

P2 + P1
S
Where Q = quantity supplied. 2
Because in our analysis the supply curve is upward sloping, the price elasticity of supply
is always positive.

The value of the price elasticity of supply depends on two factors.

a) Ease of Obtaining Inputs


A good example of this is to ask ourselves what the price elasticity of supply of
the Mona Lisa is. The answer is zero. Regardless of whether price goes up or
down, there is only one Mona Lisa in the world and the quantity supplied cannot
be changed because firstly Leonardo Da Vinci is dead and secondly even if he
were still alive, a masterpiece is a one off thing. It can never be perfectly
reproduced. Goods that have easily obtainable raw materials tend to have
relatively elastic supply curves. For example the supply of cakes is fairly elastic
because it is easy to obtain flour, butter, sugar and eggs. If the price of cakes
increases, it is a simple matter to bake more cakes. On the other hand the supply
of airplanes is less elastic because it takes a long time to build an airplane. Even
if the price of airplanes went up, it would take at least a few years before the new
airplanes are ready to be flown.

b) Technological Sophistication
The more technologically sophisticated the production of something is, the harder it is for
supply to adjust to price changes. Supply is therefore less elastic. Again let us look at
cakes. It is quite easy to bake a basic cake. If the price of cakes increases, anybody can
get the ingredients to bake more cakes for sale (assuming they have the equipment as
well). On the other hand a nuclear power generation facility is very technologically
sophisticated. Because of the dangerous nature of the materials being handled,
construction must follow the technical specifications very closely to prevent accidents. It
takes more than a decade to build one nuclear power facility and almost as long to train
the engineers to run the place. Thus if the price of nuclear generated energy were to
increase, the response would be fairly slow. Supply is inelastic.