Elasticity

Elasticity defined
• The price elasticity of demand compares the
percent change in quantity demanded to the
percent change in price.
• To calculate PED we first calculate percent
change in quantity demanded and the
corresponding percent change in price as we
move along the demand curve.

2
% change in QD= Change in QD/initial QD *100

% change in price= change in price/initial P *100

Suppose when price rises from $20 to $21 , the

quantity demanded falls from 10 million to 9.9
million vaccinations. Therefore change in Qd is
O.1 m vaccinations.
3
• So the percent change in QD:
• -0.1 m vaccinations/10m vaccinations*100
• =-1%
• Percent change in Price: $1/20*100=5%
• PED= % change in QD/% change in P
• = 1%/5%=0.2

4
• The law of demand says that demand curve are
downward sloping, so price and quantity
demanded always move in the opposite
directions. This means that the PED is a negative
number. However, it is inconvenient to repeatedly
write a minus sign. So when economists talk
about PED, they usually drop the minus sign and
report the absolute value of price elasticity of
demand. So we drop the minus sign here.

5
• The larger the PED, the more responsive the QD
is to price. When PED is large---when consumers
change their QD by a large percentage compared
with the percentage change in price---economists
say that demand is highly elastic.
• As for example a price elasticity of 0.2 indicates a
small response of QD to price. That is QD will fall
by a relatively small amount when price rises.
That is what economists call inelastic demand.

6
 An Alternative Way to Calculate PED

• Here we discuss a technical issue that arises

when we calculate percent changes in
variables and how economists deal with it.
• Consider the following data for some good:
• Price Quantity demanded
Situaion A $0.90 1100
Situation B $1.10 900

7
• From the above data, if we calculate PED
going from situation A (initial price) to
situation B (to a rise in price), we get PED=.818

• But if we calculate PED going from situation B

(initial price) to situation A (a fall in price) we
get PED=1.22
• So we get two different PED for the same data.

8
• To avoid this difficulty economists use an
alternative way to calculate PED known as
Mid-point method.
• The mid-point method replaces the usual
definition of the percent change in a variable
say X , with a slightly different definition:
% change in X= change in X/average value of X
*100

9
• Using the previous data the PED according to mid-
point method will be:
• % change in QD=-200/(900+1100)*100=-20%
• & % change in P=$.20/($.90+$1.10)*100=20%

• So PED= 20%/20%=1 dropping the minus sign.

• The important point is that we get the sam e result
whether we go up the demand curve for situation A
to situation B or down from situation B to situation A.

10
 Categories of elasticitiy
• Perfectly elastic demand
• Perfectly inelastic demand
• Unit elastic demand
• Relatively elastic or elastic demand
• Relatively inelastic demand

11
 Elasticity & Total Revenue
• Why does it matter whether demand is unit
elastic, inelastic or elastic?
• Because this classification predicts how
changes in the price of the good will affect TR
earned by producers from the sale of that
good.
• In many real-life situations it is crucial to know
how price changes affect TR .

12
• Except in the case of a good with perfectly
elastic or perfectly inelastic demand, when a
seller raises the price of the good, two
countervailing effects are present:
• A price effect: after a price increase each unit
sold sells at a higher price which tends to raise
revenue
• A quantity effect: After a price increase, fewer
units are sold, which tends to lower revenue.
13
• The PED tells us what happens to TR when price
changes: its size determines which effect is stronger:
• If the demand for good is unit-elastic an increase in
price does not change TR . In this case QE and PE
exactly offset each other.
• If the demand for a good is inelastic, a higher price
increases TR. In this case PE is stronger than QE.
• If the demand for a good is elastic, an increase in
price reduces TR. In this case QE is stronger than PE

14
 Factors determining PED
• Whether close substitutes are available
• Whether the good is a necessity or a luxury
• Share of income spent on the good
• Time

15
 Other demand elasticities
• Cross-price elasticity of demand
• Income elasticity of demand
• Supply elasticity of demand

16
 Cross Price Elasticity
Ecr= % change in quantity demanded of good A/
% change in the price of good B.
Ecr = ∆QA/∆PB *

17
 Applications of S, D and Elasticity
• Can good news for farming be bad news for farmers?
• What happens to wheat farmers and the market for
wheat when university agronomists discover a new
wheat hybrid that is more productive than existing
varieties?
• We answer such questions in three steps:
• First, we examine whether the S or D curve shifts.
• Second, we consider which direction curve shifts.
• Third, we use the S-and-D diagram to see how the
market equilibrium changes.
18
 S1 S2

$3

$2

Demand

100 110

19
• In this case the discovery of new hybrid shifts the
supply curve to the right.
• The demand curve remains the same. Because
consumers’ desire to buy new wheat products at any
given price is not affected by the introduction of a new
hybrid.
• Figure 8 shows an example of such a change.
• When the S curve shifts from S1 to S2, the quantity of
wheat sold increases from 100 to 110 and the price of
wheat falls from $3 to $2.
20
• Does this discovery make farmers better off?
• To answer this question consider what happens to
total revenue (TR) received by farmers.
• Farmers’ TR is PQ and the discovery affects the
farmers in two conflicting ways:
• 1.The hybrid allows farmers to produce more
wheat (Q rises).
• 2. But now each bushel of wheat sells for less $ (P
falls)
21
• Whether TR rises or falls depends on elasticity of demand.
• In practice, the demand for basic foodstuffs such as wheat is
usually inelastic because these items are relatively
inexpensive and have few good substitutes.
• When the D curve is inelastic, a decrease in P causes TR to
fall.
• As shown in the figure, the price of wheat falls substantially,
whereas the quantity of wheat sold rises only slightly.
• TR falls from $300 to $220.
• The discovery of hybrid lowers the TR that farmers receive for
the sale of their crops.

22
• If farmers are made worse off by the discovery of this
new hybrid, why do they adopt it?
• The answer is that in a competitive market like wheat,
since each farmer is only a small part of the market
for wheat, he or she takes the price of wheat as given.
• For any given price of wheat, it is better to use new
hybrid to produce and sell more wheat.
• Yet when all famers do this, the supply of wheat
increases, the price falls and farmers are worse off.

23
• Although this example may at first seem
hypothetical, it helps to explain a major change
in the US economy over the past century.
• 200 years ago, most Americans lived on farms.
• Knowledge about farm methods was
sufficiently primitive that most Americans had
to be farmers to produce enough food to feed
the nation’s population.

24
• Yet over time, advances in farm technology
increased the amount of food that each
farmers could produce. This increase in food
supply, together with inelastic demand,
caused farm revenues to fall, which in turn
encouraged people to leave farming.

25
• When analyzing the effects of farm technology or farm
policy, it is important to keep in mind what is good for
farmers is not necessarily good for society as a whole.
• Improvement in farm technology can be bad for
farmers but it is surely good for consumers who pay
less for food.
• Similarly a policy aimed at reducing the supply of farm
products may raise the incomes of farmers by raising
prices, but it does so at the expense of consumers.

26