Chapter 4

Elasticity

4.1 Elasticity
- Price elasticity of demand is a measure of the extent to which quantity demanded responds
to a change in the good’s own price.

4.2 Price elasticity of demand

Price elasticity defined
- Price elasticity of demand – the percentage change in the quantity demanded that
results from a 1% change in price. It is a measure of the responsiveness of the quantity
demanded of that good to changes in its price.

- Calculated by
- Elastic demand – demand is elastic with respect to price If price elasticity of demand is
greater than 1.
- Inelastic demand – demand is inelastic with respect to price if price elasticity of demand
is less than 1.
- Unit elastic demand – demand is unit elastic with respect to price if price elasticity of
demand equals 1.
- Price elasticity of demand will always be negative or zero, since price changes move in
opposite direction from changes in quantity demanded.
- But for convenience sake negative sign is dropped and we use absolute value.

Determinants of price elasticity of demand

- Substitution possibilities. The price elasticity of demand will tend to be higher for
products for which close substitutes are readily available.
- Budget share. Big-ticket items tend to have higher price elasticities of demand than
small-ticket items.
- Time. The more efficient an appliance is, the higher it’s price. The price elasticity of
demand for any good or service will be higher in the long run than in the short run.
- Econometrics – a branch of economics that uses statistical techniques to analyse data on
economic variables in order to test economic theories.

Price elasticity of demand at work

- The price elasticity of demand for luxury goods is generally elastic.
- Knowledge of price elasticity of demand helps us to anticipate consumer behaviour and
to design more effective policies.
4.3 A graphical interpretation of price elasticity
- P is current price of the good, Q the quantity demanded at that price, ΔP represent a
small change in the current price and ΔQ the resulting change in quantity demanded.

- Or

- Or

Price elasticity at a given point that lies on different demand curves

- When price and quantity are the same, price elasticity of demand is always greater for
the less steep of the two demanded curves.

Price elasticity at different points along a given straight-line demand curve

- Price elasticity has a different value at every point along a straight-line demand curve.
- The price elasticity of demand at the midpoint of any straight-line demand curve always
takes the value 1.
- Demand is elastic on the top half, unit elastic at the midpoint, and inelastic on the
bottom half of a straight-line demand curve.

Exceptions to the rule – two special cases

- Perfectly elastic demand – demand is perfectly elastic with respect to price if price
elasticity of demand is infinite. This occurs when the demand curve is horizontal.

-
- Perfectly inelastic demand – demand is perfectly inelastic with respect to price if price
elasticity of demand is zero. This occurs when the demand curve is vertical.

-
4.4 Elasticity and total expenditure
- The total daily expenditure on a good is simply the daily number of units bought (Q)
times the price (P) for which it sells.
- Total expenditure = total revenue – the dollar amount that consumers spend on a
product (P*Q) is equal to the dollar amount that sellers receive.
- The two factors that determine total revenue – [rice and quantity – will thus always
move in opposite direction because of law of demand.
- For goods whose demand curve is a straight line, total expenditure reaches a maximum
at the price corresponding to the midpoint of the demand curve.
- When price elasticity is greater than 1, changes in price and changes in total expenditure
always move in opposite directions.
Ø For an elastically demanded product, the percentage change in quantity will be
larger than the corresponding percentage change in price.
- When price elasticity is less than 1, price changes and total expenditure changes always
move in the same direction

4.5 Income elasticity and cross-rice elasticity of demand

- Cross-price elasticity of demand – percentage by which the quantity demanded of a
good changes in response to a 1% change in the price of a second good.
- Income elasticity of demand – percentage by which the quantity demanded of a good
changes in response to a 1% change in income.
- The elasticity of these two may be either positive or negative!
- The income elasticity of demand for inferior goods is negative.
- The income demand for normal goods is positive.
- When the cross-price elasticity of demand for two goods is positive, they are substitutes.
- When it is negative, the two goods are complements.

4.6 The price elasticity of supply

- Price elasticity of supply – the percentage change in quantity supplied that occurs in
response to a 1% change in price.

-
- Price elasticity of supply decreases as we move up and to the right along a straight-line
supply curve.
- The price elasticity of supply is equal to 1 at any point along a straight-line supply curve
that passes through the origin, since P/Q is the same at every point.
- Price elasticity of supply is zero at every point along a vertical supply curve. I.e. perfectly
inelastic.
-
- Perfectly elastic supply – supply is perfectly elastic with respect to price if elasticity of
supply is infinite. This occurs when the supply curve is horizontal.
- If marginal cost of a product is constant, the price elasticity of supply is infinite.
- The elasticity of supply is infinite at every point along a horizontal supply curve.

Determinants of supply elasticity

- The key to predicting how elastic the supply of a good will be is to know the terms on
which additional units of inputs involved in producing that good can be acquired. The
easier it is, the higher the price elasticity.
- Flexibility of inputs
Ø If the input is useful for productions of other goods, it is relatively easy to lure
additional inputs away from their current uses, making supply of that good
relatively elastic with respect to price.
- Mobility of inputs
Ø The price elasticity of supply increases each time a new highway is built, or when
the telecommunication network improves. Supply in the construction industry is
made more elastic with respect to price by the fact that builders are willing to
move between states.
- Ability to produce substitute inputs
Ø The number of people with the requisite skills can be increased, as can the amount
of specialized machinery.
- Time
Ø The price elasticity of supply will be higher for most goods in the long run the in the
short run.
Ø If a product can be copied, and if the inputs needed for its production are used in
roughly fixed proportions and are available at fixed market prices, then the long-
run supply curve for that product will be horizontal.
Ø Unique and essential inputs are the only truly significant supply bottleneck.

4.7 Elasticity in action

- Knowing about elasticity can also help explain why the prices of some goods and services
remain fairly stable over time while in other markets, prices are highly volatile.