3 - Demand & Supply Elasticity

12-08-2022
Unit
3
Elasticity of Demand & Supply
Price, Income, Cross & Supply Elasticity
Arjun Madan Ph D
Elasticity of Demand
 Elasticity of demand measures the degrees of responsiveness of the quantity
demanded of a commodity to a given change in any of the independent
variable that influence demand for that commodity.
 Mathematically, elasticity is the percentage change in the quantity demanded
to a percentage change in any of the independent variable, say price.
 Symbolically, % Q
ep =
% P
Business Economics (Micro) – Elasticity Analysis Arjun Madan Ph D 1

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Types of Elasticity
 Elasticity can be computed to show the effects of:
 a change in price on the quantity demanded
 Measures the degree of responsiveness of qty demanded to changes in price.
 a change in income on the demand function for a good
 Measures the degree of responsiveness of qty demanded to changes in income.
 a change in the price of a related good on the demand function for a good
 Measures the degree of responsiveness of qty demanded of commodity (X) to
changes in price of other commodity (Y).
 a change in the price on the quantity supplied
 Measures the degree of responsiveness of qty supplied to changes in
price.
Price Elasticity
 Sometimes called “Own Price Elasticity”
 It is the degree of the responsiveness of quantity demanded to a certain
percentage change in price.
 Symbolically, the price elasticity of demand is given as
% QD
ep = % P
Business Economics (Micro) – Elasticity Analysis Arjun Madan Ph D

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Range / Degree of Price Elasticity
 Perfectly Inelastic Demand Consumers are “completely unresponsive” to

price changes.
 Perfectly Elastic Demand Consumers are “infinitely responsive” to price
changes.
 Unit Elastic Demand Consumer’s response is “equal to” change in price.
 Relatively Elastic Demand Consumer’s response is “more than
proportionate” to change in price.
 Relatively Inelastic Demand Consumer’s response is “less than
proportionate” to change in price.
“Perfectly Inelastic Demand”

(one extreme case)
Price elasticity % change in Q 0%

= = =0
of demand % change in P 10%
D curve: P
D
vertical
P1
Consumers’
P falls
price sensitivity: P2
by 10%
none
Elasticity: Q
Q1
0
Q changes
by 0%
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“Relatively Inelastic Demand”
Price elasticity % change in Q < 10%

= = <1
D curve: P
relatively steep
P1
Consumers’
relatively low D
P falls Q
Elasticity: by 10% Q1 Q2
<1
Q rises less
than 10%
“Unit Elastic Demand”

= = =1
D curve: P
intermediate slope
P1
Consumers’
intermediate D
P falls Q
1
Q rises by 10%

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“Relatively Elastic Demand”
Price elasticity % change in Q > 10%

= = >1
D curve: P
relatively flat
P1
Consumers’
price sensitivity: P2 D
relatively high
P falls Q
>1
Q rises more
than 10%
“Perfectly Elastic Demand”

(the other extreme)
Price elasticity % change in Q any %

= = = infinity
D curve: P
horizontal
P2 = P1 D
Consumers’
price sensitivity:
extreme
P changes Q
infinity
Q changes
by any %
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Elasticity of a Linear Demand Curve
P The slope
ep =∞ of a linear demand
curve is constant,
ep > 1 but its elasticity
is not.
ep = 1
ep < 1
ep = 0 Q
Measuring Price Elasticity
 Elasticity can be computed at a point on a demand function or as an

average [arc] between two points on a demand function.
 Methods of measuring elasticity:
 Ratio Method (Percentage/Proportionate method) measure at a point on
demand curve
 Arc Method – measured over a range of price on the demand curve

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Defining Price Elasticity
Defining Price Elasticity
% change in quantity demanded

e p

% change in price
%Q At a point on a demand function this can be

ep = calculated by:
%P
Q2 - Q1 =Q Q
Q1 Q1
ep = =
P2 - P1 =P P
P1 P1

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As a matter of economics tradition we ignore

+2
Q
[2/3 = .66667] the minus sign, so ep = 2.3
Q31 % Q = 67%
ep = =
-2P % P = -28.5%
= -2.3 [rounded]
P
71 [-2/7= -.28571] The “own” price elasticity of demand
at a price of $7 is -2.3
Price decreases from $7 to $5
Px This is “point” price elasticity. It is calculated at a point
on a demand function. It is not influenced by the direction
or magnitude of the price change.
A
P1 = $7 P2- P1 = 5 - 7 =  P = -2
 P = -2 B Q2 - Q1 = 5 - 3 =  Q = +2
P2 = $5
However, there is a problem!
If the price changes from
D $5 to $7 the coefficient of
 Q = +2
elasticity is different!
Q1 = 3 Q2 = 5 Qx /ut
.

-2Q [-2/5 = -.4]
% Q = -40%
5Q1
ep = =
% P = 40%
= -1 [this is called “unitary elasticity]
+2P
P51 [+2/5 = .4]
When the price increases from $5 to $7, the ep = -1 [“unitary”]
In the previous slide, when the price decreased from $7 to $5, ep = -2.3
The point price elasticity is Px ep = -2.3

different at every point!
A
P2 = $7 ep = -1
There is an  P = +2
P1 = $5 B
easier way!
D
 Q = -2
Q2= 3 Q1= 5 Qx /ut
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An easier way! By rearranging terms
Q this is a point on
Q P1 Q P1 the demand
Q1
ep = Q1 =
*
=
* function
P Q1 P P Q1
P1 this is the
slope of the
Given that when:
demand function
P1 = $7, Q1 = 3
Q P71
P2 = $5, Q2= 5 ep = -1 = -2.33
P * 3 1
Q
P2- P1 = 5 - 7 =  P = -2
P1 = $7, Q1 = 3
Q2 - Q1 = 5 - 3 =  Q = +2
Then, On linear demand functions the
Q = +2 slope remains constant so you
= -1
P -2 just put in P and Q
This is the slope of the demand Q = f(P)
Q = f (P)
The following information was Px
given
A
P1 = $7, Q1 = 3
$7
P2 = $5, Q2= 5 What is the Q
B
intercept?
$5
Q2 - Q1 = 5 - 3 = Q = +2
P2- P1 = 5 - 7 = P = -2 Px decreases
The slope of the demand function by 5. D
Q increases by 5
[Q = f(P)] is Q = +2 = -1
P -2
3 5
The slope [-1] indicates that for every
x
Q = 10
Q ut /
1 unit increase in Q, Px will decrease by 1.
Since Px must decrease by 5, Q must
The equation for the demand
increase by 5
function we have been using is Q = 10 when Px = 0
Q = 10 - 1P. A table can be The slope-intercept form
constructed. Q = a 10+ b -1 P

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using our formula,

The slope is -1 The intercept is 10 Q P1
=
For a simple demand function: Q = 10 - 1P ep * Q1
price quantity ep Total
P
the slope is -1, price is 7
Revenue
$0 10 0 Q P71
ep = (-1) = -2.3
$1 9 -.11 P
* Q31
$2 8 -.25 at a price of $7, Q = 3
$3 7 -.43
$4 6 -.67 Calculate ep at P = $9
$5 5 -1. Q=1
9
ep = (-1)
$6 4 -1.5 = -9
1
$7 3 -2.3 Calculate ep for all other
$8 2 -4. price and quantity
$9 1 -9 combinations.
$10 0 undefined
Notice that at higher prices

the absolute value of the price
elasticity of demand, ep, is
For a simple demand function: Q = 10 - 1P greater.
price quantity ep Total Total revenue is price times
Revenue
quantity; TR = PQ.
$0 10 0 0
$1 9 -.11 9 Where the total revenue [TR]
$2 8 -.25 16 is a maximum, ep is equal
21 to 1
$3 7 -.43
$4 6 -.67 24 In the range where ep < 1, [less
$5 5 -1. 25 than 1 or “inelastic”], TR increases as
$6 4 -1.5 24 price increases, TR decreases as P
decreases.
$7 3 -2.3 21
$8 2 -4. 16 In the range where ep > 1,
$9 1 -9 9 [greater than 1 or “elastic”], TR
$10 0 undefined 0 decreases as price increases, TR
increases as P decreases.
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The Midpoint Method

A Better Way to Calculate Percentage Changes and Elasticity
To solve the problem of a point elasticity that is different for every price
quantity combination on a demand function, an arc price elasticity can be used.
This arc price elasticity is an average or midpoint elasticity between any two
prices.
Typically, the two points selected would be representative of the usual range of
prices in the time frame under consideration.
The midpoint formula is preferable when calculating the price elasticity of
demand because it gives the same answer regardless of the direction of the
change.
Symbolically,
(Q 2 - Q1 ) / [(Q 2 + Q1 ) / 2]
Price elasticity of demand =
(P2 - P1 ) / [(P2 + P1 ) / 2]
The Midpoint Method
 Example: If the price of an ice cream cone increases from $2.00 to $2.20
and the amount you buy falls from 10 to 8 cones, then your elasticity of
demand, using the midpoint formula, would be calculated as:
(10 - 8)
(10 + 8) / 2 22%
  2.32
( 2.20 - 2.00) 9.5%
(2.00 + 2.20) / 2

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The Midpoint Method
The formula to calculate the average or arc price

elasticity is:
Q P1 + P2
P1 + P2 =
12 e =
p * Q1 + Q2
P
P1 = $7, Q1 = 3 Px The average or arc ep between
Q1 + Q2 = $5 and $7 is calculated,
P2 = $5, Q2= 5 8 A
Slope of demand
Q2 - Q1 = 5 - 3 = Q = +2 $7
P2- P1 = 5 - 7 = P = -2 B Q
$5
= - 1
P
Q
-1
P1 12
+ P2 D
ep = * Q1 8
+ Q2
= - 1.5
P
The average ep between $5 and $7 is -1.5 3 5 Qx ut /
The Midpoint Method
Given: Q = 120 - 4 P Calculate the point ep at each

price on the table.
Price Quantity ep TR
Calculate the TR at each price
$ 10 80 on the table.
Calculate arc ep between
$ 20 40
$10 and $20.
$ 25 20
Calculate arc ep between
$ 28 8 $25 and $28.
Calculate arc ep between $20 and $28.

Graph the demand function [labeling all axis and functions], identify
which ranges on the demand function are price elastic and which are
price inelastic.

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The Midpoint Method
Given: Q = 120 - 4 P Calculate the point ep at each

price on the table.
Price Quantity ep TR
Calculate the TR at each price
$ 10 80 -.5 $800 on the table. TR = PQ
Calculate arc ep at between
$ 20 40 -2 $800
$10 and $20. ep = -1
20 -5 $500
$ 25 Calculate arc ep at between
$ 28 8 -14 $224 $25 and $28. ep = -7.6
Calculate arc ep at between $20 and $28. ep = -4
Graph the demand function and identify which ranges on the demand
function are price elastic and which are price inelastic.
At what price will TR be maximized? P = $15
Graphing Q = 120 - 4 P Price TR is maximum

where ep is -1 or TR’s
When ep is -1 TR is a maximum. slope = 0
The top “half” of the demand
When | ep | > 1 [elastic], TR and P
function is elastic.
move in opposite directions. (P has | ep | > 1 [elastic] TR
30
a negative slope, TR a positive slope.)
ep = -1
When | ep | < 1 [inelastic], TR and P
15 | ep |<1
move in the same direction. (P and TR
inelastic
both have a negative slope.)
Arc or average ep is the average 60 120 Q/ut
elasticity between two point on the demand
The bottom “half” of the demand
curve [or between two prices]. function is inelastic.
Price elasticity of demand describes
how responsive buyers are to change
in the price of the good. The more “elastic,” the more responsive to DP.

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An Application of Price Elasticity

The price elasticity of demand for milk is estimated between -.35 and -.5.
Using -.5 as a reasonable figure, there are several important observations that
can be made.
ep  % Q
What effect does a Since ep = -.5
10% increase in the Pmilk % P
have on the quantity that
individuals are willing to buy?
To solve for % Q
% Q
Multiply both sides by +10% -5%
(+10%)x e
( -.5
= p) = % Q x (+10%)
A 10% increase in the price of milk would % +10%
P
reduce the quantity demanded by about
Pmilk
5%.
P2
If price were decreased by 5%, what
P1 +10%
would be the effect on quantity Dmilk
demanded? A 10% increase -5%
in P reduces Q
Qmilk
by 5% Q2 Q1
% Q
ep  The price elasticity of demand is a measure of
% P the % Q that will be “caused” by a % P.
If the price elasticity of demand for air travel was estimated at -2.5, what
effect would a 5% decrease in price have on quantity demanded ?
% Q
-2.5 = % P
= +12.5% change in quantity demanded
- 5%
If the price elasticity of demand for wine was estimated at -.8, what
effect would a 6% increase in price have on quantity demanded ?
% Q
-.8 = % P = -4.8% decrease in quantity demanded
+6%

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Active Learning - 1
a) Given the demand function QD = 10 – b) Given the demand function QD = 44 –
2P. Calculate the point price elasticity when .5P. Calculate the point price elasticity when
P = $3 P = $8?
First, find out QD by plugging P = $3 in the First, find out QD by plugging P = $8 in the
demand function demand function
QD = 10 – 2(3) = 10 – 6 = 4 QD = 44 – .5(8) = 44 – 4= 40
8
Q P1 ep = -.5 * ep = -.10
ep = * 40
P Q1
c) P = 100 – 10Q and P = $50
3 10Q = 100P
ep = -2 * ep = 1.5
4 10Q = 10 – 0.1P = 10 - 0.1(50) = 5
50
ep = -0.1 * ep = –1.0
5
Active Learning - 2
a) Given the demand function b) Given the demand function
Q = 10 - 1/2 (P) and P = 4 P = 40 - 1/4Q
Solve for Q
Solution
1/4Q = 40 – P
Q = 10 – 1/2 (4 ) = 8 Q = 160 – 4P
Q P1 Find out P and Q
ep = *
P Q1 P = 160/4 = 30
1 4 Q= 160 – 4 (30) = 40
ep = – *
2 Q 30
ep = – 4P *
1 4 40
ep = – * ep = –.25
2 8 –120
ep = ep = –3
40
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Active Learning – 3
Given the demand function : P = 40 – 40/160Q,

40
find elasticity at P = $10, $20, and $30
Price of Goods X
30 ep==?– 3
ep Solution
20 ep=
ep =?– 1 First get the equation for the demand curve
10
ep =?
ep=-.33 P = 40 – 1/4Q
D Solve for Q  Q = 40 – P/0.25

40
? 80
? 120
? 160
Q = 160 – 4P
Quantity of Goods X
P = 10 and Q =?
Q= 160 – 4 (10) = 120
10
ep = –4* ep = –1/3 = –0.33
120
Demand for premium tennis balls is given as:

Q = 740 - 10P - 20T
Supply of premium tennis balls is given by:
Q = 2P - 20
Q is the quantity of tennis balls (in dozens), P is the price / dozen tennis
balls, and T is the price of playing tennis
Let T = $20
Solve for market equilibrium and price point elasticity

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Solution - 4
Q = 740 - 10P - 20(20)

Q = 340 - 10P What is the price elasticity of
demand?
Set QD = QS Q P1
ep = *
340 - 10P = 2P - 20 P Q1
360 = 12P 30
ep = –10 *
P = $30 40
Plug in the value of P in either D or ep = –7.5

S equation to find equilibrium Q
QS = 2(30) - 20
Equilibrium Q = 40
Suppose the sale of bicycles in Pune at various prices are as follows:
Price of Bicycles Quantity demanded/month

000 of bicycles
500 25
700 22
1000 15
Calculate the arc elasticity of demand between:

(i) The price of 500 and 1000
(ii) The price of 500 and 700
(iii) The price of 1000 and 700

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Solution – 5
(i) The price of 500 and 1000 (ii) The price of 500 and 700
Change in quantity demanded: 25 – 15 = 10 Change in quantity demanded: 22 – 25 = -3
Change in price is 500 – 1000 = 500 Change in price is: 500 – 700 = 200
Q P1 + P2 Q P1 + P2
ep = * ep = *
P Q1 + Q2 P Q1 + Q2
10 500 +1000 –3 500 + 700

ep = * ep = *
500 25 + 15 200 25 + 22
10 1500
ep = * ep = 0.015 * 25.53
500 40
ep = 0 .38
15000 3
ep = = = 0 .75
20000 4
Solution – 5
(iii) The price of 1000 and 700
Change in quantity demanded: 25 – 15 = 10
Change in price is 500 – 1000 = 500
Q P1 + P2
ep = *
P Q1 + Q2
7 1000 + 700
ep = *
300 15 + 22
ep = 0.023 * 45.94
ep = 1.05
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Assume that the average price of a new hatchback cars in Pune is ₹5, 60,000 and 90000
cars are sold at this price in a year. If the price elasticity of demand for new cars is 1.7
what will be the effect on annual sales when the average price of a new car declines to
₹5,45,000?
Solution
Given: Q
ep = 4.56*90,000
ep = 1.7 P Q2 = 90,000+
100
P1 = 5,60,000 Q
1.7 = Q2 = 90,000+4,104
P2 = 5,45,000 2.68
∆P = 15000 = 2.68% Q = 1.7 * 2.68 = 4.56% Q2 = 94,104
Q1 = 90000
Price Elasticity and Total Revenue

Total revenue is the total receipts or total sales
value from the quantity sold by the firm at a given
P
price. D
TR = P x Q
Average revenue is revenue earned per unit of 50
output. It can be obtained by dividing the total
TR = P.Q =
revenue by number of units sold. 50 x 100 =
5000
D
TR
AR = =P 100 Q
Q
Marginal revenue is the extra revenue earned by
selling an additional unit of the product. Marginal
revenue is the net addition made to the total
revenue.
∆TR TR
MR = MR =
∆Q Q
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Relation b/w TR and Price Elasticity

Q
140 ep > 1 At higher prices a decrease in P will increase the TR
120 TR = 120(1) = 120
Somewhere between P = 80 and 60 TR is maximised
100 TR = 100(2) = 200
80
TR = 80(3) = 240 As price falls TR maximises but will fall at lower P
TR = 70(3.5) = 245
60
ep < 1
TR = 60(4) = 240
40 TR = 40(5) = 200 If P falls and TR rises, then ep > 1 or elastic
20 TR = 20(6) = 120
If P rises and TR falls, then ep > 1 or elastic
0
TR 300 1 2 3 4 5 6 7 P
If P falls and TR also falls, then ep < 1 or
250 inelastic
@245 TR is Max
200
150 If P rises and TR also rises, then ep < 1 or
elastic
100
50
TR If P (rise or fall), there is no TR, then ep = 1
0
1 2 3 4 5 6 7
Consider the demand equation Q = 80 - 10P. Calculate the point-price
elasticity of demand (ep) and total revenue (TR) for P = 0 to P = 8.
Solution
0
ep = –10 * =0
Q P1 80
ep = *
P Q1 Q2 = 80 – 10 (1)
TR = P * Q Q2 = 70
1
Q1 = 80 – 10 (0) ep = –10 * = 0.14
70
Q1 = 80

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Solution – 8
P Q Q/P P/Q ep TR
0 80 – 10 0 0 0
1 70 – 10 0.014 –0.14 70
2 60 – 10 0.033 –0.33 120
3 50 – 10 0.060 –0.60 150
4 40 – 10 0.100 –1.00 160
5 30 – 10 0.167 –1.67 150
6 20 – 10 0.300 –3.00 120
7 10 – 10 0.700 –7.00 70
8 0 – 10 infinity infinity 0
A scenario…
 You are a tax consultant in a small town catering to local businesses. You
charge $200 per month as retainer fees, and currently serves 12 firms.
 Your costs are rising (including the opportunity cost of your time), so you
consider raising the price to $250.
 The law of demand says that you won’t serve as many firms if you raise
your price.
 How many fewer firms?
 How much will your revenue fall, or might it increase?

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 In our scenario, if you raise your price from $200 to $250, would your
revenue rise or fall?
 A price increase has two effects on revenue:
 Higher P means more revenue on each unit
you sell.
 But you sell fewer units (lower Q),
due to Law of Demand. If demand is elastic, then
 Which of these two effects is bigger? price elasticity of demand > 1 %
change in Q > % change in P
It depends on the price elasticity of demand.
The fall in revenue from lower Q is greater
than the increase in revenue from higher P, so
revenue falls.
Elastic demand increased

(elasticity = 1.8) revenue due to
P lost
higher P
If P = $200, revenue
Demand for your
due to
Q = 12 and revenue = services
$250 lower Q
$2400.
$200
If P = $250, D
Q = 8 and
revenue = $2000.
When Demand is elastic, Q

8 12
a price increase causes revenue
to fall.

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 If demand is inelastic, then

price elasticity of demand < 1
% change in Q < % change in P
 The fall in revenue from lower Q is smaller than the increase in revenue
from higher P, so revenue rises.
 In our example, suppose that Q only falls to 10 (instead of 8) when you
raise your price to $250.

Now, demand is increased
inelastic: revenue due
elasticity = 0.82 to higher P
P Demand for yourlost
If P = $200, services revenue
Q = 12 and revenue = due to
$2400. $250 lower Q
If P = $250, $200
Q = 10 and D
revenue = $2500.
When Demand is Q
10 12
inelastic, a price increase
causes revenue to rise.
45
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What Determines Price Elasticity?

 To learn the determinants of price elasticity, we look at a series of examples.
Each compares two common goods.
 In each example:
 Suppose the prices of both goods rise by 20%.
 The good for which Qd falls the most (in percent) has the highest price elasticity
of demand.
Which good is it? Why?
 What lesson does the example teach us about the determinants of the price
elasticity of demand?
Example 1: Breakfast Cereal vs. Sunscreen

 The prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why?
 Breakfast cereal has close substitutes
(e.g., idli/dosa, Poha/upma, paratha, etc.),
so buyers can easily switch if the price rises.
 Sunscreen has no close substitutes,
so consumers would probably not
buy much less if its price rises.
 Lesson: Price elasticity is higher when close substitutes are available.

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Example 2: “Blue Jeans” vs. “Clothing”
 The prices of both goods rise by 20%.

 For a narrowly defined good such as
blue jeans, there are many substitutes
(khakis, chinos, shorts, etc.).
 There are fewer substitutes available for broadly defined
goods.
(There aren’t too many substitutes for clothing,
other than living in a nudist colony.)
 Lesson: Price elasticity is higher for narrowly defined
goods than broadly defined ones.
Example 3: Insulin vs. Caribbean Cruises
 The prices of both of these goods rise by 20%.

 To millions of diabetics, insulin is a necessity.

A rise in its price would cause little or no decrease in demand.
 A cruise is a luxury. If the price rises,

some people will forego it.
 Lesson: Price elasticity is higher for luxuries than for necessities.

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Example 4. Number of Use of a Commodity
 The prices of both goods rise by 20%.

 Milk has composite demand i.e. it can be used for multiple

purposes. When the price rise, consumer will use milk only for
essential purpose.
 Lipsticks on the other hand has only one use.

(So I believed until I saw this !!!)
https://www.youtube.com/watch?v=NZkg_4ZyLM0
 Lesson: The greater the number of uses the higher the

price elasticity of demand and vice-versa.
Example 5: Gasoline in the Short Run vs. Gasoline in

the Long Run
 The price of gasoline rises by 20%.

 Does Qd drop more in the short run or the
long run? Why?
 There’s not much people can do in the
short run, other than ride the bus or carpool.
 In the long run, people can buy smaller cars
or live closer to where they work.
 Lesson: Price elasticity is higher in the
long run than the short run.

12-08-2022
Income Elasticity of Demand
 The degree of responsiveness of demand with respect to change in

consumer’s income is called income elasticity of demand.
 It measures how much the quantity demanded of a good responds to a
change in consumers’ income.
 It is computed as the percentage change in demand divided by the
percentage change in income.
 Symbolically,
%Q
eY =
%Y
 Where
 Y = Income

12-08-2022

 Unlike price elasticity of demand which is always negative because of the
law of demand, income elasticity can be negative, positive, or zero.
 Positive income elasticity simply means that as income rises, demand also
rises.
 We define a good with positive income elasticity as a normal good.
 Negative income elasticity simply means that as income rises, demand falls.
 Goods with negative income elasticity are called inferior goods.
Computing Income Elasticity
 As with PED both arc and point methods can be used.

 The formula for point elasticity it is –
Q Y
eY = *
Y Q
 The formula for arc (or ‘adjusted’) income elasticity is:

Q Y1 + Y2
eY =
*
Y Q 1 + Q2

12-08-2022
Income Elasticity : [normal goods]

Income elasticity is a measure of the change in
% Qx demand [a “shift” of the demand function] that is
ey = “caused” by a change in income.
% Y
The increase in income, Y, increases demand
[Where Y = income] to D2. The increase in demand results in a
At a price of P1 , the quantity demanded
larger quantity being purchased at the same
given the demand D is Q1 . D1 is the
Price [P1].
demand function when the income is Y1 . P Due to increase
in income,
For a “normal good” an increase in
demand
income to Y2 will “shift” the demand to increases
the right. This is an increase in demand P1
to D2.
D2
%  Y > 0; %  Q> 0; therefore, D1
ey > 0 [it is positive]
Q1 Q2 Q/ut
.
Income Elasticity [continued. . .] [normal goods]
A decrease in income is associated with a decrease in

% Qx the demand for a normal good.
ey = % Y For a decrease in income [-Y],
the demand decreases; i.e. shifts
At income Y1, the demand D1 represents to the left, at the price [P1 ], a
the relationship between P and Q. At smaller Q2 will be purchased.
a price [P1] the quantity [Q1] is P
demanded.
A decrease in income,
% Y < 0 [negative]; % Q < 0 [negative]; decreases
so, ey < 0 [ positive] demand
P1
For either an increase or decrease in income
the ey is positive. A positive relationship
[positive correlation] between Y and Q D1
D2
is evidence of a normal good.
Q2 Q1 Q/ut

12-08-2022
Income Elasticity: [inferior goods]
There is another classification of goods where changes in income

shift the demand function in the “opposite” direction.
An increase in income [+Y] reduces demand.
-%%Q
Q xx
An increase in income reduces -e e= y =
y
the amount that individuals P % Y
+Y
are willing to buy at each price
of the good. Income elasticity decreases
is negative: - ey demand
P1
The greater the absolute value
of - ey, the more responsive buyers
are to changes in income
- %Q x
D2 D1
Q2 Q1 Q/ut
.
.
Income Elasticity: [inferior goods]
Decreases in income increase the demand for inferior goods.
A decrease in income [-Y] increases demand.
+
% %Q
Qxx
A decrease in income [- Y]
results in an increase in demand, P - eey y 
% Y
the income elasticity of demand -Y
is negative
P1
For both increases and decreases in
D2
income the income elasticity is negative
for inferior goods. The greater the
absolute value of ey, the more responsive
+%Q x D1
buyers are to changes in income Q1 Q2 Q/ut

. .
12-08-2022
Examples of Income Elasticity
 Normal goods, [0 < ey < 1 ], (between 0 and 1)

 coffee, chicken, Coca-Cola, food, Physicians’ services, ice-cream, …etc.
 Superior goods, [ ey > 1], (greater than 1)
 movie tickets, foreign travel, wine, new cars, . . . etc.
 Inferior goods, [ey < 0], (negative)
 Bajra, bidies, zunka-bhakar, country liquor, public transport, . . . etc.
Types of Income Elasticity
 Negative Income Elasticity - Ey < 0 (giffen goods)
 Zero Income Elasticity - Ey = 0 (neutral goods)
 Income Elasticity less than one - Ey < 1 (necessity)
 Income Elasticity equal to one - Ey = 1 (normal goods)
 Income Elasticity more than one - Ey > 1 (luxury)

12-08-2022
Income elasticity of demand
The market demand function is given by –
QX = 900 - 2PX + 0.05I
Where,
QX = quantity demanded of good X,
PX = price of good X, and
I = income of the consumers
Calculate the income elasticity of demand, assuming PX = $50 and I = $100,000
Solution – 9
Step 1: Solve for QX
100,000
QX = 900 – 2(50) + 0.05(100,000) 0.05 * = 0.862
5800
QX = 900 – 100 + 5000
Positive coefficient so good X is a
QX = 5800 normal good
Interpretation
Step 2: Find out the slope coefficient
 QX A 1% increase in income increases
= 0.05 (Given in the equation) the quantity demanded of good X by
 PY 0.862 %
Step 3: Apply income elasticity formula

Q Y Y
ep = * =b *
Y Q Q
12-08-2022
Income elasticity of demand
The market demand function is given by –
QX = 500 - PX + 0.5PY – 0.4I
Where,
QX = quantity demanded of good X,
PX = price of good X,
PY = price of good Y, and
I = income of the consumers
Calculate the income elasticity of demand, assuming PX = $100, PY = $100 and I

= $50
Solution – 10
50
QX = 500 – 100 + 0.5(100) – 0.4(50) –0.4 * = – 0.047
430
QX = 500 – 100 + 50 – 20
Negative coefficient so good X is a
QX = 430 inferior good
Step 2: Find out the slope coefficient A 1% increase in income decreases

the quantity demanded of good X by
 QX 0.047 %
= – 0.4 (Given in the equation)
 PY
Step 3: Apply income elasticity formula

Q Y Y
ep = * =b*
Y Q Q
12-08-2022
Cross Price Elasticity
Cross Price Elasticity
 The demand for a good is generally associated with the demand for another
good.
 Therefore, change in the price of one good produces change in the demand
of another good.
 The extent of relationship between two related goods can be measured by
cross-elasticity of demand.
Cross-elasticity of demand measures the responsiveness of quantity

demanded of a good with respect to change in the price of its
substitute or complementary good.

12-08-2022
Cross Elasticity - Substitutes
 When the goods are substitutes a change in price of one usually leads
to a change in the demand for other goods.
 A rise in price of coffee leads to a rise in demand for tea.
 Cross elasticity is positive in case of substitutes
Cross Elasticity – Complements
 If the goods are compliments a change in price of one usually leads to a

change in the demand for other goods.
 A rise in price of butter leads to a fall in demand for bread.
 Cross elasticity is negative in case of complements

12-08-2022
Computing Cross Elasticity
The cross elasticity of demand between any two goods X and Y is obtained by
dividing the proportionate change in the quantity demanded of X by the
proportionate change in the price of Y.
Symbolically,
%  Q x
e xy

%  P y
Computing Cross Elasticity

Cross price elasticity between two goods is measured by -
∆Qx P
= ∆Py ∗ Q y
x
∆QX can be calculated by subtracting original demand for X (QX) from increase
in demand (QX1),
∆QX = QX1 – QX
Similarly, ∆PY is the difference between the new price of Y (PY1) and original
price for Y (PY).
∆PY = PY1 – PY

12-08-2022
Types of Cross Elasticity of Demand

 Positive Cross Elasticity of Demand
 The quantity demanded for coffee has increased from 500 units to 550 units with
increase in the price of tea from ₹8 to ₹10. Calculate the cross elasticity of demand
and state the type of relationship between coffee (X) and tea(Y).
Change in Q Therefore,
∆QX = QX1 – QX = 550 – 500 = 50 units. = ∗

Change in P
= 0.4
∆PY = PY1 – PY = Rs. 2
Cross elasticity for substitute
is positive
Types of Cross Elasticity of Demand

 Negative Cross Elasticity of Demand
 The quantity demanded for X decreases from 220 to 200 units with the rise in
prices of Y from ₹10 to ₹ 12.
Change in Q Therefore,
∆QX = QX1 – QX = 200 – 220= –20 units = ∗

Change in P
= -0.45
∆PY = PY1 – PY = ₹12 – ₹10 = ₹2
Cross elasticity for
complement is negative

12-08-2022
Cross-price elasticity of demand , [exy] [substitutes]
When the price of tofu increases, it will tend to increase the demand for paneer.
People will substitute paneer, which is relatively cheaper, for tofu, which is
relatively more expensive.
When paneer is $2, Qp paneer
[price of paneer]
When tofu is $1.50, Qp tofu
[price of tofu]
Pp is purchased.
Pt is purchased. at Pp = $2 more
price of tofu increases
increase paneer will be bought
The quantity demanded demand
2 of tofu decreases. to substitute for
2 the smaller
for an increase
1.50 in P tofu, quantity of
t demand for tofu.
p p’
-Qt paneer increases
Qt’ Qt tofu/ut Qp Qp’ paneer/ut
.
Cross-price elasticity of demand , [exy] [compliments]

as more crayons are
purchased, the
Pc Pcb demand for colour
a decrease in the price increase books increases.
of crayons, demand At the same
P1
price a larger
$3
Po
-Pc quantity will
be bought
Dc Dcb’
Dcb
Q1 Q2 crayons 2000 2500 colour books

increases the quantity demanded + Qb
of crayons for compliments, the cross
- ebc + Qb
%Q of b
ebc
negative = elasticity is negative for price
%P
- Pcof c increase or decrease.

12-08-2022
Cross-Price Elasticity
 exy > 0 [positive], suggests substitutes, the higher the coefficient the better
the substitute
 exy < 0 [negative], suggests the goods are compliments, the greater the
absolute value the more complimentary the goods are
 exy = 0,
Cross-Price elasticity of demand
The demand function is given by –
QX = 2,500 - 4PX + 0.75PY
Where, QX = quantity demanded of good X, PX = price of good X, and

PY = price of good Y
Calculate the cross price elasticity of demand, assuming PX = $300 and PY = $200

12-08-2022
Solution – 11
200
QX = 2,500 - 4(300) +0.75(200) 0.75 = 0.103
1450
QX = 2,500 – 1200 + 150
Positive coefficient so good X and Y
QX = 1,450 are substitute
Step 2: Find out the slope coefficient A 1% increase in the price of good Y
increases the quantity demanded of
 QX good X by 0.103%
= 0.75 Given in the equation
 PY
Step 3: Cross price elasticity formula

 QX PY
ep = *
 PY QX
Cross-Price elasticity of demand
The market demand for good X is:
QX = 500 - PX – 0.5PY
Where,
QX = quantity demanded of good X
PX =price of good X
PY = price of good Y
Calculate the cross price elasticity of demand, assuming PX = $100 and PY = $200

12-08-2022
Solution – 12
200
QX = 500 - 100 - 0.5(200) 0.5 = –0.333
300
QX = 500 – 100 – 100
Negative coefficient so good X and
QX = 300 Y are complements
Step 2: Find out the slope coefficient A 1% increase in the price of good Y
decreases the quantity demanded of
 QX good X by 0.333 %
= 0.5 Given in the equation
 PY
Step 3: Apply cross price elasticity formula

 QX PY
ep = *
 PY QX
Price Elasticity of Supply
Price elasticity of Percentage change in Qs

=
supply Percentage change in P
 Price elasticity of supply measures how much Qs responds to a

change in P.
 Loosely speaking, it measures sellers’

price-sensitivity.
 Again, use the midpoint method to compute the

percentage changes.

12-08-2022
Price Elasticity of Supply
Price elasticity of Percentage change in Qs

=
supply Percentage change in P
P
Example: S
Price P rises
P2
elasticity by 8%
P1
of supply equals
Q
16% Q1 Q2
= 2.0
8% Q rises
by 16%
82
The Variety of Supply Curves
 The slope of the supply curve is closely related to price elasticity of

supply.
 Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
 Five different classifications.…

83
12-08-2022
“Perfectly inelastic” (one extreme)

= = =0
of supply % change in P 10%
S curve: P
S
vertical
P2
Sellers’
none
P rises Q
Elasticity: Q1
by 10%
0
Q changes
by 0%
“Inelastic”
Price elasticity % change in Q < 10%
= = <1
S curve: P
S
relatively steep
P2
Sellers’
relatively low
P rises Q
Elasticity: Q1 Q2
by 10%
<1
Q rises less
than 10%
12-08-2022
“Unit elastic”

= = =1
S curve: P
intermediate slope S
P2
Sellers’
intermediate
P rises Q
Elasticity: Q1 Q2
by 10%
=1
Q rises
by 10%
“Elastic”
Price elasticity % change in Q > 10%
= = >1
S curve: P
relatively flat S
P2
Sellers’
relatively high
P rises Q
Elasticity: Q1 Q2
by 10%
>1
Q rises more
than 10%
87
12-08-2022
“Perfectly elastic” (the other extreme)
Price elasticity % change in Q any %

= = = infinity
S curve: P
horizontal
P2 = P1 S
Sellers’
price sensitivity:
extreme
P changes Q
Elasticity: Q1 Q2
by 0%
infinity
Q changes
by any %
88

3 - Demand & Supply Elasticity

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12-08-2022

Elasticity of Demand & Supply

Price, Income, Cross & Supply Elasticity

Business Economics (Micro) – Elasticity Analysis Arjun Madan Ph D 1

Business Economics (Micro) – Elasticity Analysis Arjun Madan Ph D 2

Business Economics (Micro) – Elasticity Analysis Arjun Madan Ph D

Range / Degree of Price Elasticity

 Perfectly Inelastic Demand Consumers are “completely unresponsive” to

Business Economics (Micro) – Elasticity Analysis Arjun Madan Ph D

“Perfectly Inelastic Demand”

Price elasticity % change in Q 0%

“Relatively Inelastic Demand”

Price elasticity % change in Q < 10%

“Unit Elastic Demand”

Price elasticity % change in Q 10%

Business Economics (Micro) – Elasticity Analysis Arjun Madan Ph D 7

“Relatively Elastic Demand”

Price elasticity % change in Q > 10%

“Perfectly Elastic Demand”

Price elasticity % change in Q any %

Elasticity of a Linear Demand Curve

Business Economics (Micro) – Elasticity Analysis Arjun Madan Ph D 10

Measuring Price Elasticity

 Elasticity can be computed at a point on a demand function or as an

Business Economics (Micro) – Elasticity Analysis Arjun Madan Ph D 11

Defining Price Elasticity

Business Economics (Micro) – Elasticity Analysis Arjun Madan Ph D 12

Defining Price Elasticity

% change in quantity demanded

%Q At a point on a demand function this can be

Business Economics (Micro) – Elasticity Analysis Arjun Madan Ph D 13

As a matter of economics tradition we ignore

The point price elasticity is Px ep = -2.3

An easier way! By rearranging terms

Business Economics (Micro) – Elasticity Analysis Arjun Madan Ph D 16

Business Economics (Micro) – Elasticity Analysis Arjun Madan Ph D 17

using our formula,

Business Economics (Micro) – Elasticity Analysis Arjun Madan Ph D 18

Notice that at higher prices

The Midpoint Method

Business Economics (Micro) – Elasticity Analysis Arjun Madan Ph D 20

The Midpoint Method

Business Economics (Micro) – Elasticity Analysis Arjun Madan Ph D 21

The Midpoint Method

The formula to calculate the average or arc price

Business Economics (Micro) – Elasticity Analysis Arjun Madan Ph D 22

The Midpoint Method

Given: Q = 120 - 4 P Calculate the point ep at each

Calculate arc ep between $20 and $28.

Business Economics (Micro) – Elasticity Analysis Arjun Madan Ph D 23

The Midpoint Method

Given: Q = 120 - 4 P Calculate the point ep at each

Calculate arc ep at between $20 and $28. ep = -4

Business Economics (Micro) – Elasticity Analysis Arjun Madan Ph D 24

Graphing Q = 120 - 4 P Price TR is maximum

Business Economics (Micro) – Elasticity Analysis Arjun Madan Ph D 25

An Application of Price Elasticity

Business Economics (Micro) – Elasticity Analysis Arjun Madan Ph D 27

Given the demand function : P = 40 – 40/160Q,

D Solve for Q  Q = 40 – P/0.25

Demand for premium tennis balls is given as:

Business Economics (Micro) – Elasticity Analysis Arjun Madan Ph D 31

Q = 740 - 10P - 20(20)