Markets in

Action
 Elasticity
 As pointed out earlier, when the price of a
good rises (or falls), quantity demanded
falls (rises).
 Economists would like to know by how
much quantity demanded falls or rises in
response to a price change
 In other words, we would like to know how
responsive demand is to price changes.
 For instance, consumers’ response to a
change in the price of oil would differ from
that of Voltic Mineral Water.
 Market demand and Price Change
The figure shows that the two
demand curves respond
differently to the change in
price from P1 to P2
b
P2
c
Price

a
P1
D'

D
Q3 Q2 Q1
O
Quantity
 Elasticity
 Elasticity of demand measures the degree of
responsiveness of quantity demanded to changes
in the determinants of demand.
 Since not all the factors that affect demand can
be measured quantitatively, we will discuss three
types of demand elasticity:
 Price Elasticity of Demand

 Income Elasticity of Demand and

 Cross-Price Elasticity of demand

 Price Elasticity of demand
 Price elasticity of demand measures the degree of
responsiveness of quantity demanded to changes
in the commodity’s own price.
 Elasticity compares the size of the change in
quantity demanded to that price.
 Since quantity and price are measured in different
units, the only sensible way to measure elasticity is
to use proportionate or percentage changes.
 Measurement of Elasticity:




 Calculation of Elasticity


 Interpretation of Elasticity Figures
 Since demand curves are generally downward
sloping, it implies that percentage change in
price and that of quantity would have opposite
signs.
 That is, a percentage increase in price would be
accompanied by a percentage decrease in price
and vice versa.
 Either way, the price elasticity of demand is
always negative. In this class, I would ignore the
negative sign and interpret the absolute values.
 Interpretation of Elasticity Figures

 If PED = 0, then demand is Perfectly inelastic.

This means that demand does not respond at
all to changes in price. That is, no matter the
price, quantity demanded is the same.

 The demand curve is thus vertical as shown

below:
 Perfectly inelastic demand (PD = 0)
P
D

P2 b

P1 a

O Q1 Q
 Interpretation of Elasticity Figures

 If PED = -∞, then demand is Perfectly Elastic.

This means that demand responds to a small
change in price. That is, a small change in price
brings about infinitely large change in quantity
demanded.

 This is shown by a horizontal demand curve

 Infinitely elastic demand (PD = )
P

a b
P1 D

O Q1 Q2
Q
 Interpretation of Elasticity Figures

 If PED>1, then demand is Elastic. This is where

a change in price causes proportionately larger
change in the quantity demanded. In this case,
the value of elasticity will be greater than 1
since we are dividing a larger figure by a
smaller figure.

 This is shown by a relatively flatter demand

curve
 Elastic demand between two points

P(£)
b
5
a
4
D

0 10 20
Q (millions of units per period of time)
 Interpretation of Elasticity Figures

 If PED<1, then demand is Inelastic. This is

where a change in price causes proportionately
smaller change in the quantity demanded. In
this case, the value of elasticity will be less than
1 since we are dividing a smaller figure by a
larger figure.

 This is shown by a relatively steeper demand

curve
 Inelastic demand between two points
P(GH¢)

c
8

a
4

0 15 20
Q (millions of units per period of time)
 Interpretation of Elasticity Figures

 If PED =1, then demand is said to be unitary

Elastic. This is where price and quantity
demanded change by the same proportion. In
this case, the value of elasticity will be 1 since
we are dividing a figure by itself.

 The demand curve is a rectangular hyperbola:

 Determinants of Price Elasticity of Demand

 Determinants of price elasticity of demand

 number and closeness of substitute goods
 the proportion of income spent on the good
 Definition of the product (or market)
 time
 Q The price elasticity of demand for
holidays in Greece is likely to be high because
A. people tend to book up a long
time in advance.
B. there are plenty of different
holidays abroad to choose from.
C. expenditure on holidays
account for a relatively small
part of people’s total income.
D. holidays at home provide no
real alternative.
E. people need a holiday if they
are to cope with the year ahead
– and they prefer holidays
abroad.
 Price elasticity of demand and consumer
expenditure

 Price elasticity of demand and consumer

expenditure (P × Q)
 Total expenditure
4

P(£) 2

Consumers’ total expenditure

=
1 firms’ total revenue
= D
£2 x 3m = £6m
0
0 1 2 3 4 5
Q (millions of units per period of time)
 Elasticity

 One of the most important applications of price

elasticity is its relationship with the total
amount the consumer spends on the product

 Note that total expenditure is the same as total

revenue received by firms for the sale of the
product.
 Elastic Demand

 Remember that as price rises, quantity demanded

falls.
 When demand is elastic, quantity demanded
changes proportionately more than price . Thus
change in quantity has a bigger effect on consumer
expenditure than does the change in price.
 Thus:
 As Price rises, Qty falls proportionately more; thus
TE falls
 As Price falls, Qty rises proportionately more; thus
TE rises.
 Elastic demand between two points

Expenditure falls
as price rises

P(£)
b
5
a
4
D

0 10 20
Q (millions of units per period of time)
 Inelastic Demand
 When demand is price inelastic, price changes
proportionately more than quantity. Thus change
in price has a bigger effect on total consumer
expenditure than does the change in quantity.

 As Price rises, Qty falls proportionately less; thus

TE rises

 As Price falls, Qty rises proportionately less; thus

TE falls

 THEREFORE FOR INELASTIC DEMAND, PRICE

AND EXPENDITURE CHANGE IN THE SAME
DIRECTION
 Inelastic demand between two points
Expenditure rises
as price rises

c
8

P(£)

a
4

0 15 20
Q (millions of units per period of time)
 Totally inelastic demand (PD = 0)
P
D

P2 b

P1 a

O Q1 Q
 Infinitely elastic demand (PD = )
P

a b
P1 D

O Q1 Q2
Q
 Unit elastic demand (PD = –1)
P

Expenditure stays the

same as price changes

a
20

b
8
D

O 40 100 Q
 Elastic demand between two points

Expenditure falls
as price rises

P(£)
b
5
a
4
D

0 10 20
Q (millions of units per period of time)
 Inelastic demand between two points

Expenditure rises
as price rises
c
8

P(£)

a
4

0 15 20
Q (millions of units per period of time)
Different elasticities along different portions of a demand curve
P
a
P1

O Q1 Q
Different elasticities along different portions of a demand curve
P
Elastic
a
demand
P1

b
P2

O Q1 Q2 Q
Different elasticities along different portions of a demand curve
P
a
P1

b Inelastic
P2 demand

c
P3
D

O Q1 Q2 Q3 Q
 Arc Elasticity
 Arc elasticity measures elasticity between two point
on the demand curve.

 We Q/averageQ ÷ P/average P

 Or
 Measuring elasticity using the arc method
10

m
8

n
6

P (£)

2 Demand

0
0 10 20 30 40 50
Q (000s)
 Measuring elasticity using the arc method
10
Q P
Ped =  mid P
mid Q
m
8

7 P = –2
n
6
Q = 10
P (£) Mid P
4

2 Demand

0
0 10 15 20 30 40 50
Mid Q Q (000s)
 Measuring elasticity using the arc method
10
Q P
Ped =  mid P
mid Q
m
10 -2
8 =
15
 7
7 P = –2
n
6
Q = 10
P (£) Mid P
4

2 Demand

0
0 10 15 20 30 40 50
Mid Q Q (000s)
 Measuring elasticity using the arc method
10
Q P
Ped =  mid P
mid Q
m
10 -2
8 =
15
 7
7 P = –2 = 10/15 x -7/2
n
6
Q = 10
P (£) Mid P
4

2 Demand

0
0 10 15 20 30 40 50
Mid Q Q (000s)
 Measuring elasticity using the arc method
10
Q P
Ped =  mid P
mid Q
m
10 -2
8 =
15
 7
7 P = –2 = 10/15 x -7/2
n
6 = -70/30
Q = 10
P (£) Mid P
4

2 Demand

0
0 10 15 20 30 40 50
Mid Q Q (000s)
 Measuring elasticity using the arc method
10
Q P
Ped =  mid P
mid Q
m
10 -2
8 =
15
 7
7 P = –2 = 10/15 x -7/2
n
6 = -70/30
Q = 10 = -7/3 = -2.33
P (£) Mid P
4

2 Demand

0
0 10 15 20 30 40 50
Mid Q Q (000s)
Q If the price of good X rises from £9 to £11 and
as a result quantity demanded falls from 100
units to 60 units, what is the price elasticity of
demand between these prices?
20% 20% 20% 20% 20%

A. 2/–80 = –0.025
B. –80/2 = –40
C. 0.2/–0.5 = –0.4
D. –0.5/0.2 = –2.5
E. –1
A. B. C. D. E.
 Measuring elasticity at a point
Ped = (1 / slope) x P/Q

r
P

0
Q
 Measuring elasticity at a point
50
Ped = (1 / slope) x P/Q

r
30
P

0 40 100
Q
 Measuring elasticity at a point
50
Ped = (1 / slope) x P/Q

= -100/50 x 30/40

r
30
P

0 40 100
Q
Different elasticities along a straight-line demand curve
10
Ped = (1 / slope) x P/Q
n
8

m
6

P
l
4
Demand
k
2

0
0 10 20 30 40 50
Q
Different elasticities along a straight-line demand curve
10
Ped = (1 / slope) x P/Q
n
8 (1 / slope) is constant
= -50/10 = -5
m
6

P
l
4
Demand
k
2

0
0 10 20 30 40 50
Q
Different elasticities along a straight-line demand curve
10
Ped = (1 / slope) x P/Q
n
8 (1 / slope) is constant
= -50/10 = -5
m But P/Q varies:
6
at n, P/Q = 8/10
P
l
4
Demand
k
2

0
0 10 20 30 40 50
Q
Different elasticities along a straight-line demand curve
10
Ped = (1 / slope) x P/Q
n
8 (1 / slope) is constant
= -50/10 = -5
m But P/Q varies:
6
at n, P/Q = 8/10
P at m, P/Q = 6/20
at l, P/Q = 4/30
4
l Demand
k
2

0
0 10 20 30 40 50
Q
 Price elasticity of supply
 measurement: QS/QS ÷ P/P

 determinants

 the amount that costs rise as output rises

 The less the MC of producing an additional output, the more
elastic supply will be.

 This can occur if there is excess capacity, supplies of inputs are

readily available, etc

 time period
 immediate period, short-run and long-run

 The longer the time allowed the more firms are able to vary
inputs, and output in response to price changes and the more
elastic supply will be.
 Elasticity

 Price elasticity of supply

 determinants
 the amount that costs rise as output rises

 time period
 Q In which one of the following cases is
good X likely to have a more
price-elastic supply than good Y?
A. It is more costly to shift from
producing X to another product
than from Y to another product.
B. The supply of Y is considered
over a longer period of time
than X.
C. X is a minor by-product of Y.
D. Consumers find it easier to find
alternatives to Y than to X.
E. The cost of producing extra units
increases more rapidly in the
case of Y than in the case of X.
 Income elasticity of demand

 Or for the mid-point formula

 determinants
degree of necessity
proportion of income spent on the good
 Q The data in the table refer to the income
elasticities of demand for various commodities.
Which one is a normal good and income inelastic?
Wine and spirits 2.60
Travel abroad 1.14
Dairy produce 0.53
Bread and cereals –0.50
Coal –2.02

A. Wine and Spirits

B. Travel Abroad
C. Dairy Produce
D. Bread and cereals
E. Coal
Cross-price elasticity of demand
 Q If a rise in the price of good X results
in the amount of money spent on
good Y remaining the same, then

A. X and Y are perfect substitutes. 20% 20% 20% 20% 20%

B. X and Y are perfect complements.

C. the cross-price elasticity of
demand for Y with respect to X
is infinite.
D. the cross-price elasticity of
demand for Y with respect to X
is 1.
E. the cross-price elasticity of
demand for Y with respect to X
is 0. A. B. C. D. E.
 Government Intervention:
Indirect taxes

 These are taxes that are not paid directly by the consumer,
but indirectly through the sellers of the good.
 A tax on the expenditure on goods. Indirect taxes include
value added tax (VAT) and duties on tobacco, alcoholic
drinks and petrol.
 In contrast, direct taxes (such as income tax) which are
paid directly out of people’s incomes.
 Indirect taxes can be levied as specific and ad valorem
taxes
 Specific tax is an indirect tax of a fixed sum per unit sold.
 Ad valorem tax is an indirect tax of a certain percentage of the price
of the good.
 Effect of a tax on the supply curve
P

S + specific tax
S

amount of
specific tax

A tax shifts the supply curve

upwards by the amount of
the tax per unit.

O Q
 Effect of a tax on the supply curve
P S + ad valorem tax

amount of
ad valorem tax
This tax swings the supply
curve upwards. The higher
the price, the higher the
absolute amount of tax for
a given percentage

O Q
 Q VAT is an example of:

A. a specific tax. 20% 20% 20% 20% 20%

B. an excise duty.
C. a direct tax.
D. an ad valorem tax.
E. a tax on the final
value of a product.

A. B. C. D. E.
 Indirect taxes

 Specific and ad valorem taxes

 Effects on supply curve

 The incidence of taxation

 the producers' share

 the consumers' share
 Effect of a tax on price and quantity
P

P1

D
O Q1 Q
 Effect of a tax on price and quantity
P
S + tax

P1 + tax
S
P2

P1
New equilibrium price
(after tax) is P2

D
O Q2 Q1 Q
 Indirect taxes

 Specific and ad valorem taxes

 Effects on supply curve

 The incidence of taxation

 the producers' share

 the consumers' share

 Elasticity and the incidence of taxation

 Incidence of tax: inelastic demand
P
S + tax

P1

D
O Q1 Q
 Incidence of tax: inelastic demand
P
S + tax
P2
S

P1

D
O Q2 Q1 Q
 Incidence of tax: inelastic demand
P
S + tax
P2
S

CONSUMERS’
SHARE

P1
PRODUCERS’ SHARE
P2 - t

D
O Q2 Q1 Q
 Incidence of tax: elastic demand
P S + tax

P1

O Q1 Q
 Incidence of tax: elastic demand
P S + tax

S
P2

P1

O Q2 Q1 Q
 Incidence of tax: elastic demand
P S + tax

S
P2
CONSUMERS’
SHARE
P1

O Q2 Q1 Q
 Incidence of tax: elastic demand
P S + tax

S
P2
CONSUMERS’
SHARE
P1

D
PRODUCERS’
SHARE

P2 - t

O Q2 Q1 Q
 Incidence of tax: inelastic supply
P S + tax

P1

O Q1 Q
 Incidence of tax: inelastic supply
P S + tax

P2
P1

O Q2 Q1 Q
 Incidence of tax: inelastic supply
P S + tax

P2
P1 CONSUMERS’ SHARE

O Q2 Q1 Q
 Incidence of tax: inelastic supply
P S + tax

P2
P1 CONSUMERS’ SHARE

PRODUCERS’ SHARE
D
P2 - t

O Q2 Q1 Q
 Incidence of tax: elastic supply
P S + tax

P1

O Q1 Q
 Incidence of tax: elastic supply
P S + tax

P2
S

P1

O Q2 Q1 Q
 Incidence of tax: elastic supply
P S + tax

P2
S
CONSUMERS’
SHARE
P1

O Q2 Q1 Q
 Incidence of tax: elastic supply
P S + tax

P2
S
CONSUMERS’
SHARE
P1
PRODUCERS’
P2 - t SHARE

O Q2 Q1 Q
 Incidence of tax: inelastic demand Incidence of tax: elastic demand
P P S + tax
S + tax

P2
S
S
CONSUMERS’ P2
CONSUMERS’
SHARE
SHARE
P1
P1
PRODUCERS’ SHARE PRODUCERS’
D
P2 - t
SHARE

P2 - t

D
O Q2 Q1 Q O Q2 Q1 Q

Incidence of tax: inelastic supply Incidence of tax: elastic supply

P S + tax P S + tax

S P2
S
CONSUMERS’
SHARE
P2
P1 CONSUMERS’ SHARE P1
PRODUCERS’
SHARE
P2 - t
PRODUCERS’ SHARE
D D
P2 - t

O Q2 Q1 Q O Q2 Q1 Q
 Q The producer’s share of a tax will be larger:
A. the greater the elasticity of
both demand and supply.
B. the less the elasticity of both 20% 20% 20% 20% 20%

demand and supply.

C. the less the elasticity of
demand and the greater the
elasticity of supply.
D. the greater the elasticity of
demand and the less the
elasticity of supply.
E. the closer the elasticity of
demand is to –1 and the closer
the elasticity of supply to 1. A. B. C. D. E.
 Indirect taxes

 Specific and ad valorem taxes

 Effects on supply curve

 The incidence of taxation

 the producers' share

 the consumers' share

 Elasticity and the incidence of taxation

 Implications for tax policy