CECN 104 – Introduction to Microeconomics

CHAPTER 6: PRICE ELASTICITY OF DEMAND AND SUPPLY

ELASTICITY
 Responsiveness of quantities to changes in price and other determinants (can be for
producer or consumer side)
 Gives us a measure of responsiveness

= % change in Quantity
---------------------------------
% change in determinant
 Range: zero to infinity

PRICE ELASTICITY OF DEMAND

- LAW OF DEMAND SAYS…
o All else the same, increase in price = decrease in quantity demanded (vice-versa)
o Elasticity= HOW MUCH does quantity demanded change in response to change
in price

When QD responds STRONGLY to a change in P  demand is ELASTIC

When QD responds WEAKLY to a change in P  demand is INELASTIC

ED= % change in quantity demanded of product X

-------------------------------------------------------------
% change in price of product X
**Percentage change is not affected by choice of measurement units

Absolute change is the same (1 unit) but the

percentage change is different
 UNIT ELASTICITY : ED = 1
ELASTIC Demand : ED > 1
INELASTIC Demand : ED < 1
EXTREME cases : ED = 0  ED = infinity

 Perfectly Inelastic Demand – vertical line (quantity stays the same but price increases)
 Perfectly Elastic Demand – horizonal line (price stays the same but quantity increases)
 Unit elasticity – NOT LINEAR

ELASTICITY AND SLOPE

- Elasticity varies over the different price ranges of the same demand curve
Slope: ratio of absolute changes in price and quantity
Elasticity: ratio of (relative) percentage changes in the price and quantity
LINEAR demand: constant slope but NOT constant elasticity

IN SUMMARY:
- Demand is more elastic toward the upper left (higher price range)
- Demand is less elastic toward the lower right (low price range)
- Elasticity declines as we move from higher to lower prices

ELASTICITY AND TOTAL REVENUE

TOTAL REVENUE (TR) = PRICE X QUANTITY

Shaded area is the revenue before

the price cut

When P1 cuts to P2  quantity

increases

TR INCREASES  ELASTIC
 Shaded area is the revenue before
the price cut (P1 x Q1)

Cut in price is bigger than the gain

in quantity

TR DECREASES  INELASTICE

Cut in price is equal to the gain in

quantity

TR STAYS THE SAME  UNIT ELASTIC

You can then calculate elasticity

and Total Revenue

DETERMINANTS OF ELASTICITY OF DEMAND

SUBSTITUTABILITY
- Larger the number of substitutes available, the greater the price elasticity of demand
- No close substitutes  high inelastic demand
PROPORTION OF INCOME
- Greater the proportion of income spent on a good, the greater the price elasticity of
demand for it
LUXURIES VERSUS NECESSITIES
- Luxuries: relatively elastic demand
- Necessities: relatively inelastic demand
TIME
- Longer the period, the more elastic the demand
APPLICATIONS OF ED
LARGE CROP YIELDS
- Farm products: inelastic demand (necessities)
- Good harvest depress both prices and total revenues (income) of farmers
SALES TAXES
- If demand is elastic, when the government raisers the tax, sales will be reduced and the
tax revenue will decline

ELASTICITY OF SUPPLY

Percentage change in quantity supplies of product X

ES =-------------------------------------------------------------------------------
Percentage change in price of product X

 Perfect inelastic supply  vertical line (quantity stays the same, price can be infinite)
 Perfect elastic supply  horizontal line (price stays the same, quantity can be infinite)
 Unit elastic  linear supply curves that pass through origin

** a curved supply curve is elastic for small quantities and inelastic for larger ones

IMMEDIATE MARKET PERIOD: SHORT RUN: LONG RUN:

Large increase in price  Increase in price  more Small Increase in price 
perfect inelastic supply elastic supply even more elastic supply

APPLICATIONS OF PRICE ELASTCITIY OF SUPPLY

ANTIQUES
- Antiques: High inelastic supply
- Higher income  higher demand  higher price
- Reproductions: more elastic supply
- increased demand raises their price only slightly
VOLATILE GOLD PRICES
- costly and time-consuming
- supply inelastic
- many uses: jewellery, coins, financial investment
- demand: more elastic
- relatively small changes in demand  relatively large changes in price

CHAPTER 6: CROSS AND INCOME ELASTICITY AND TAX INCIDENCE

CROSS ELASTICITY OF DEMAND
Percentage change in quantity demanded of product X
Exy = ------------------------------------------------------------------------------
Percentage change in the price of product Y
 substitute goods  positive sign (if the price of y goes down, less x will be demanded)
SAME DIRECTION
 complementary goods  negative sign (if price of why goes down, more x demanded)
OPPOSITE DIRECTION
 independent goods  near zero
INCOME ELASTCITY OF DEMAND
Percentage change in quantity demanded
Ei = ----------------------------------------------------------------
Percentage change in INCOME
 NORMAL goods  positive sign
 INFERIOR goods  negative sign (more income  less demand)

- Income elasticity helps explain expansion and contraction of industries as the economy
grows with rising income

TAX INCIDENCE
 - If consumers, producers or both will pay the tax
- The incidence of a sales tax depends on the relative elasticities of demand and supply
o More elastic demand favours buyers
o More elastic supply favours sellers
- All else equal, the greater the elasticities of supply and demand, the greater the change
in quantity, the greater the efficiency loss

Tax incidence is equally shared

ELASTIC DEMAND INELASTIC DEMAND

ELASTIC SUPPLY INELASTIC SUPPLY

TIME OF ADJUSTMENT AND ELASTICITY

- Magnitude of change in equilibrium price and quantity following shift in demand and/or
supply depends on time allowed for adjustment