Intro Demand Elasticities Supply Elasticities Tax Incidence

Lecture 3: Elasticities
Intro Demand Elasticities Supply Elasticities Tax Incidence

Learning Objectives

After reading chapter 4, and by the end of this lecture you should understand...
Demand elasticity as a measure of responsiveness.
Relationship between total expenditures and
demand elasticity.
Price elasticities and public policy.
The short-run, the long-run and inflation.
Cross-price elasticity.
Income elasticity of demand.
Supply elasticity.
Tax incidence and elasticities.
Intro Demand Elasticities Supply Elasticities Tax Incidence

Elasticity: a measure of responsiveness

The law of demand states that there is an

inverse relationship between P and Qd .

The question for this chapter is: by how

much does quantity demanded change in
response to a change in price?

Elasticities are all about responsiveness of

either Qd or Qs
Intro Demand Elasticities Supply Elasticities Tax Incidence

Price elasticity of demand

Percentage change in quantity demanded %∆Q

εd = =
Percentage change in price %∆P

εd < −1 =⇒ Demand is Elastic

−1 < εd < 0 =⇒ Demand is Inelastic

εd = −1 =⇒ Demand is Unit Elastic

Intro Demand Elasticities Supply Elasticities Tax Incidence

Calculating percentage change

Choosing the reference point to calculate the percentage change:

Q2 −Q1
1 Point Elasticity: %∆Q = Q1 × 100

2 Midpoint Elasticity: %∆Q = Q2 −Q1 × 100

Q1 +Q2
2
Intro Demand Elasticities Supply Elasticities Tax Incidence

Elasticity variation with linear demand

Price
Price ($) Quantity Elasticity Total
demanded value revenue
($)
10 0 0
9 1 -9.0 9 Vertical intercept: ε = −∞
8 2 16 P = 10
7 3 -2.33 21 High elasticity range (elastic)
6 4 24 8
5 5 -1.0 25 Midpoint of D: ε = −1
4 6 24
3 7 -0.43 21 5
2 8 16
1 9 -0.11 9 Low elasticity range (inelastic)
0 10 0 2
Horizontal intercept: ε = 0
Quantity
2 5 8 Q = 10
Intro Demand Elasticities Supply Elasticities Tax Incidence

Demand elasticity and total expenditure

Revenue increases with Revenue

quantity sold up to sales of 5 Revenue at maximum
where elasticity is unity
units. Beyond this output, the
decline in price that must
Rev= $25
accompany additional sales
causes revenue to decline. Rev= $16

Quantity
5 8
Intro Demand Elasticities Supply Elasticities Tax Incidence

Extreme cases

When the demand curve is Price

Dv
vertical (Dv ), the elasticity is
zero: A change in price from Zero
P1 to P2 has no impact on the elasticity

quantity demanded because P2

the numerator in the elasticity
formula has a zero value. Infinite
elasticity
When D becomes more P1 Dh
horizontal the elasticity D′
becomes larger and larger at Large
elasticity
P1 , eventually becoming
infinite. Quantity
Q0
Intro Demand Elasticities Supply Elasticities Tax Incidence

Using demand elasticity

In the lower part of the demand Price

D S2 S1
curve D, demand is inelastic: At the
point A, a shift in supply from S1 to
S2 induces a large percentage
increase in price, and a small
percentage decrease in quantity P2
demanded.

In contrast, for the demand curve D′

that goes through the original P3 A
equilibrium, the region A is now an P1
elastic region, and the impact of the D′
supply shift is contrary: The %∆P is
smaller and the %∆Q is larger.
Quantity
Q3 Q2 Q1
Intro Demand Elasticities Supply Elasticities Tax Incidence

Determinants of price elasticity of demand

The ease with which consumers can substitute another good:

Consumers can readily substitute one brand of detergent for another if price ↑
So we expect demand to be elastic for a particular brand
But if all detergent prices rise, the consumer cannot switch
So we expect demand to be inelastic for detergents as a group

Since it is difficult to find substitutes for life’s necessities (e.g. food, shelter
etc.) their demand is inelastic.
Luxuries versus Necessities
All other factors held constant, luxuries exhibit elastic demands
All other factors held constant, necessities exhibit inelastic demands
Intro Demand Elasticities Supply Elasticities Tax Incidence

Short-run & Long-run Elasticity

In the short run, consumers may not be able (or ready) to adjust their pattern
of expenditure.

If price changes persist, consumers are more likely to adjust.

Demand thus tends to be
more elastic in the long run.
but relatively inelastic in the short run.

Supply will also be more elastic with the passage of time

Intro Demand Elasticities Supply Elasticities Tax Incidence

Cross-price elasticity of demand

Cross-price elasticity of demand is the percentage change in the quantity

demanded of a product divided by the percentage change in the price of
another.
percentage change in quantity demanded of x %∆Qx
εd(x,y) = =
percentage change in price of good y %∆Py

εd(x,y) < 0 =⇒ complements

εd(x,y) > 0 =⇒ substitutes
Intro Demand Elasticities Supply Elasticities Tax Incidence

Income elasticity of demand

Income elasticity of demand is the percentage change in quantity demanded

divided by a percentage change in income.

percentage change in quantity demanded %∆Q

ηd = =
percentage change in income %∆I

ηd > 0 =⇒ Normal good

0 < ηd < 1 =⇒ Necessity
ηd > 1 =⇒ Luxury
ηd < 0 =⇒ Inferior good
Intro Demand Elasticities Supply Elasticities Tax Incidence

Income elasticity and shifts in demand

For an increase in income, Price

D D1 D2
demand curve can either shift
to right or left.
A shift from A to B reflects a
lower income elasticity than a P0
A B C

shift to C.
A leftward shift in the
demand curve in response to
an income increase would
Quantity
denote a negative income Q0 Q1 Q2
elasticity – an inferior good.
Intro Demand Elasticities Supply Elasticities Tax Incidence

Elasticity of Supply

Elasticity of supply measures the responsiveness of quantity supplied to a

change in the price.
percentage change in quantity supplied %∆Q
εs = =
percentage change in price %∆P

If the law of supply holds =⇒ εs > 0

Intro Demand Elasticities Supply Elasticities Tax Incidence

Cross-price elasticity of supply

Cross-price elasticity of supply is the percentage change in the quantity

supplied of a product divided by the percentage change in the price of
another.

percentage change in quantity supplied of x %∆Qx

εs(x,y) = =
percentage change in price of good y %∆Py
Intro Demand Elasticities Supply Elasticities Tax Incidence

Short-run & Long run elasticity of supply

Demand drops suddenly between t

and t + 1. Equilibrium moves from P
point A to B. DJ
SLR
DA S′ S
In the long run some producers exit $60 A
and the supply curve shifts towards
the origin. Following this, the
equilibrium is C. C

Joining points such as A and C $20 B

yields a long run supply curve; it is

more elastic than the short run 65 100
Q
supply, when the number of
suppliers is fixed.
Intro Demand Elasticities Supply Elasticities Tax Incidence

Elasticities and tax incidence

Tax Incidence describes how the burden of a

tax is shared between buyer and seller.

more elastic supply curve means that the

incidence falls more on the consumer.

less elastic supply curve means the incidence

falls more on the supplier.
Intro Demand Elasticities Supply Elasticities Tax Incidence

Tax incidence with elastic supply

The imposition of a specific tax of $4 Price

shifts the supply curve vertically by
$4. D St

The final price at B (Pt ) increases by

$3 over the equilibrium price at A. $4=tax
At the new quantity traded, Qt , the B S
supplier gets $4 per unit (Pts ), the Pt = 8
government gets $4 also and the
consumer pays $8. A
P0 = 5
The greater part of the incidence is Pts = 4
C
upon the buyer, on account of the
relatively elastic supply curve: His
price increases by $3 of the $4 tax. Quantity
Qt Q0
Intro Demand Elasticities Supply Elasticities Tax Incidence

Tax incidence with inelastic supply

The imposition of a specific tax of $4 Price

shifts the supply curve vertically by St S
$4. D

$4=tax
The final price at B (Pt ) increases by
$2 over the no-tax price at A. At the
new quantity traded, Qt , the
supplier gets $3 per unit (Pts ), the B
Pt = 7
government gets $4 also and the
A
consumer pays $7. P0 = 5

The incidence is shared equally by Pts = 3

C
suppliers and consumers.
Quantity
Qt Q0