LECTURE 6:

Concepts of Elasticities
 Elasticity Concepts
own price elasticity of demand ε
• measures the degree of responsiveness of quantity
demanded to changes in the own price of the good

Ed = percentage change in quantity demanded of good X

percentage change in the price of good X

% D in Q
e = d
% D in P
Two measures to compute Elasticity
P
formula:
P1
A
Q -Q P -P
B e= d2 d1 ÷ 2 1
P2
Q +Q P +P
D d1 d2 1 2

0 Q1 Q2 Q

arc elasticity Þ computed for two points along a

demand curve
point elasticity Þ elasticity is measured for a single point
Numerical Example and Interpretation:
Own Price Elasticity of Demand
 Numerical Example and Interpretation: Own Price
Elasticity of Demand
Ø MRT Ridership (per day) and Price
Ø P1 = 10, Q1 = 350,000
Ø P2 = 12, Q2 = 320,000
Ø ΔP = P2-P1 = 2 ; ΔQ = Q2-Q1 = -30,000
Ø P1 + P2 = 22 ; Q1 + Q2 = 670,000
Ø ε =( ΔQ / [Q1+Q2]) ÷ (ΔP /[P1+P2])
= (-30,000/670,000) ÷ (2)/(22)
ε = - 0.49 à a 1% increase in the price of MRT rides results in
a 0.49% decrease in qty demanded (or in ridership)
 Range of Elasticity Values
Ø The elasticity values (in absolute terms) can
range from zero to infinity; each with definite
interpretations.
Elasticity Description
values
e =0 Perfectly inelastic

e <1 Inelastic

e =1 Unit elastic
e >1 Elastic
e =µ Infinitely elastic
Elasticity values and a linear demand
curve

P D Elastic Unit elastic

(at midpoint of D-curve)
Price P1
P Inelastic

0 Q1 Q Q
Quantity
 Perfectly elastic and
perfectly inelastic demand
Perfectly inelastic Perfectly elastic
P P
D

Price
Price

P D

0 Q Quantity 0 Quantity
 Interpretation of Elasticity Values
1. Elastic = %∆ in Qd > %∆ in the own P
Þ quantity demanded is relatively sensitive to price
changes
2. Inelastic = %∆ in Qd < %∆ in the own P
Þ quantity demanded is relatively insensitive to price
changes
3. Unit elastic = %∆ in Qd = %∆ in the own P
Þ quantity demanded matches proportional change in
price
4. Perfectly inelastic Þ a price change does not change
qty demanded
5. Perfectly elastic Þ a small change in price causes
changes in qty demanded
 Price Elasticity and Total Revenues
Information about the own price elasticity of demand is
extremely important to producers for pricing decisions.

Total revenues (TR) = P * Q

If ­P Þ ¯Qd Þ effect on TR not certain

To determine effect on TR, need info on elasticity

Ø Eg.#1: If demand is price elastic, ­P Þ |%¯ Qd| > |%P ­|
Þ ¯ TR

Ø Eg.#2: If demand is price inelastic, ­P Þ |%¯ Qd| < |%P ­|

Þ ­ TR

Ø Eg.#3: If demand is unit elastic, ­P Þ |%¯ Qd| = |%P ­| Þ

TR does not change
 Price Elasticity and Total Revenues
Information about the own price elasticity of demand is
extremely important to producers for pricing decisions.

ELASTICITY PRICE TOTAL REVENUE

Unit Elastic Increases Does not change
Elastic Increase Decrease
Inelastic Increase ?

ELASTICITY PRICE QUANTITY TOTAL

DEMANDED REVENUE
Unit Elastic Increases Decreases Does not change
(proportionally)
Elastic Increase Decreases Decrease
Inelastic Increase Small decrease Increase
 Price Elasticity and Total Revenues
Illustration: The product is originally sold at Php 10.

ELASTICITY PRICE QUANTITY TOTAL INTERPRETA

DEMANDED REVENUE TION
Unit Elastic 10 10 100 Does not
change
Elastic 12 8 96 Decrease
Inelastic 12 9 108 Increase
 Determinants of own
price elasticity of demand

1. the availability of good substitutes for the

commodity
Þ more substitutes, more elastic
2. the number of uses the good can be put
into
Þ more uses, more elastic
3. the price of the good relative to the
consumer's purchasing power
Þ if good takes a larger share of budget,
likely to be more elastic
 Determinants of own
price elasticity of demand (2)
4. the time frame under consideration
Þ longer period of time, more elastic
5. location along the demand curve.
Þ recall ideas on “elasticity and the linear demand curve”
 Income elasticity of demand
Ø Income elasticity (Ei) º measures the responsiveness
of quantity demanded to changes in income

% D in Q
h=
E I = d
% D in Income
EI = I2-I1 x Q1 + Q2
I1 + I2 Q2 – Q1
 Interpretation of Income Elasticity of Demand
Values
Øh < 0 (e.g., -1.5, -0.75) Þ inferior good
Ø h > 0 Þ normal good
l 0 < h < 1 Þ “necessity” Þ demand relatively not
responsive to changes in income (e.g., +0.75, +0.5) (e.g.
food, water)
l h > 1 Þ “luxury” Þ demand relatively responsive to
changes in income (e.g., +2.75, +1.6) (car, jewelry,
appliance)
 Cross price elasticity of demand

Ø cross price elasticity of demand º measures the

responsiveness of quantity demanded for one good
to changes in the price of another good.
Ø E.g, 2 goods: X and Y

% D in Q
!Exy = dx
% D in Py
 Interpretation of
Cross Price Elasticity Values
Ø substitute goods Þ !
E
xy > 0
l E.g. +2.5, + 0.75

Ø complementary goods Þ !E x < 0

y

l E.g. -2.0, - 0.5

 Price elasticity of supply
• measures the degree of responsiveness of
quantity supplied to changes in the own price
of the good

% D in Q s
e s= d
% D in P
N.B. Time and the elasticity of supply
 Tax Incidence
Ø effects of government tax policies on consumption
and production. The tax could either be a specific or
excise tax or an ad valorem tax.
Ø specific tax or excise tax Þ tax per unit of the product
Ø ad valorem tax Þ tax as percentage of the selling
price.
 Who bears the greater portion
of the tax?
Ø Supply and demand analysis of a specific tax
l the tax is likely to paid for by producers and consumers
l the tax is likely to raise the equilibrium price, but by an
amount less than the tax
 Application of Elasticity Concept:
Tax incidence
Suppose: Php 2 specific tax on
P cigarettes

S1
12 P0 + t S0
A
11 P1 + t tax
10 P0 Tax paid by consumer B
Tax paid by producer
9 P1 C
D

0 Q1 Q2 Q0 Q
10 15 20 Taxc = new P*-old P*
or ( P1+t) - Po
Taxp = old P*-Pp or
Po – P1
 Additional points: Tax Incidence

Ø distribution of the tax burden depends on the own price

elasticity of demand
Ø if demand is more price elastic, the burden of the tax is likely
to shouldered more by the producers. Consider the extreme
case of a perfectly elastic demand.
Ø if demand is less price elastic, the burden of the tax is likely
to shouldered more by the consumers. Consider the extreme
case of a perfectly inelastic demand.
 All tax borne by consumer
Note:
P Experiment with
D perfectly elastic
S2 D-curve.

S1
12 P0 + t Tax borne by tax
consumer
10 P0

0 Q* Q