Elasticity

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1. Price Elasticity of Demand
 Elasticity
– Responsiveness
 Price elasticity of demand
– Consumers’ responsiveness to a change in price
– Percentage change in quantity demanded divided
by percentage change in price

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Price Elasticity of Demand

%% q
EE
D D
%% p
q pp
EE
D D
 
((qq q ' ))//22 ( p( p p ' )p/' 2) / 2

 Law of demand
 ED negative
 Absolute value of ED positive
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 Categories of ED
 If %∆q < %∆p
– ED between 0 and 1
– Inelastic D
 If %∆q > %∆p
– ED greater than 1
– Elastic D
 If %∆q = %∆p
– ED = 1
– Unit elastic D 5
Elasticity and Total Revenue

 Total revenue = price * quantity

demanded at this price
 TR= p * q
 As p decreases
 If D elastic, TR increases
 If D inelastic, TR decreases
 If D unit elastic, TR unchanged

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Price Elasticity and the Linear D
Curve
 Linear D curve
– Constant slope
– Different elasticity
– D becomes less elastic as we move
downward
 D upper half: elastic
 D lower half: inelastic
 D midpoint: unit elastic
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 $100
90
(a) Demand and price elasticity
Demand, Price
a
80
Price per unit
70 b
Elastic, ED >1
Elasticity, and
60 Unit elastic, ED =1 Total Revenue
50
40 c Inelastic, ED <1 Where D is elastic, a
30 lower P increases TR
20
d Where D is inelastic, a
10 e D lower P decreases TR

0 100 200 500 800 900 1,000 Quantity per period

(b) Total revenue

$25,000
TR reaches a
Total
maximum at the rate
revenue
Total revenue

of output where D is
unit elastic
8

0 500 1,000 Quantity per period

Constant-Elasticity
Demand Curves
 Perfectly elastic D curve
– Horizontal; ED = ∞
– Consumers don’t tolerate P increases
 Perfectly inelastic D curve
– Vertical; ED = 0
– ‘Price is no object’
 Unit-elastic D curve
– %∆p causes an exact opposite %∆q
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Perfectly elastic D curve
Versus
Perfectly inelastic D curve

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 Constant-Elasticity Demand Curves
(a) Perfectly elastic (b) Perfectly inelastic (c) Unit elastic

Price per unit

Price per unit
Price per unit
D’

ED ’’ = 1
ED’’ = 0
ED = ∞ $10 a
p D
b
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D’’

0 Quantity per period0 Q 0

Quantity 60 100 Quantity
per period per period
Consumers demand all quantity
offered for sale at p, but demand Consumers demand Q Total revenue is the same
nothing at a price above p regardless of price for each p-q combination 11
 Summary of Price Elasticity of Demand
Effects of a 10 Percent Increase in Price

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 Determinants of Price
Elasticity of D

 ED is greater:
– The greater the availability of substitutes,
and the more similar the substitutes
– The more important the good as a share of
the consumer’s budget
– The longer the period of adjustment (time)

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Demand Becomes More Elastic over Time

Dw: one week after the price increase

Price per unit

$1.25 Dm: one month after the price increase

Dy: one year after the price increase

1.00 e

Dy
Dw Dm

0 50 75 95 100 Quantity per day

Dy is more elastic than Dm , which is more elastic than Dw 14
 Elasticity Estimates

 Short run
– Consumers have little time to adjust
 Long run
– Consumers can fully adjust to a price change
 Demand is more elastic in the long run

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Selected Price Elasticities of Demand (Absolute Values)

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2. Price Elasticity of Supply

 Elasticity
– Responsiveness
 Price elasticity of supply
– Producers’ responsiveness to a change
in price
– Percentage change in quantity supplied
divided by percentage change in price

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 Price Elasticity of Supply

%q
ES 
%p
q p
ES  
(q  q' ) / 2 ( p  p' ) / 2
 Law of supply
 ES positive
Categories of ES

 If %∆q < %∆p

– ES between 0 and 1
– Inelastic S
 If %∆q > %∆p
– ES greater than 1
– Elastic S
 If %∆q = %∆p
– ES = 1
– Unit elastic S
Constant-Elasticity Supply Curves

 Perfectly elastic S curve

– Horizontal; ES = ∞
– Producers supply 0 at a price below P
 Perfectly inelastic S curve
– Vertical; ES = 0
– Goods in fixed supply
 Unit-elastic S curve
– %∆p causes an exact same %∆q
– S curve is a ray from the origin
 Constant-Elasticity Supply Curves
(a) Perfectly elastic (b) Perfectly inelastic (c) Unit elastic

Price per unit

Price per unit
Price per unit
S’
S’’
ES’’ = 1

ES’ = 0
ES = ∞ $10
p S
5

0 0
Quantity Q 0
Quantity 10 20 Quantity
per period per period per period
Firms supply any amount of
output demanded at p, but Quantity supplied is Any %∆p results in the
supply 0 at prices below p. independent of the price same %∆q supplied. 21
Determinants of Supply Elasticity

 ES is greater:
– If the marginal cost rises slowly as output
expands
– The longer the period of adjustment (time)
Supply Becomes More Elastic over Time
Sw Sm
Sw: one week after the
Sy
price increase
$1.25
Sm: one month after the
Price per unit

price increase
1.00
Sy: one year after the
price increase

0 100 110 140 200 Quantity per day

Sw is less elastic than Sm, which is less elastic than Sy 23

 3. Income Elasticity of Demand

 Demand responsiveness to a change in consumer income

 Percentage change in demand divided by the percentage
change in income that caused it
 Inferior goods
– Negative income elasticity
 Normal goods
– Positive income elasticity

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Income Elasticity of Demand

 Normal goods
– Income inelastic
• Elasticity between 0 and 1
• Necessities
– Income elastic
• Elasticity > 1
• Luxuries
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Selected Income Elasticities of Demand

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 The Market for Food and ‘The Farm Problem’

 Demand
 Price inelastic
 Total revenue falls when P falls
 Income inelastic
 D increases
 Technological improvements
 S increases

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The Demand for Grain
The D for grain tends to be inelastic.
As the market P falls, so does TR.

Price per bushel

$5

1
D

0 5 10 11 Billions of bushels per year 28

The Effect on Increases in Demand and Supply on Farm Revenue

$8 S’

Price per bushel Technological advance

- sharp increase in S
Increase in consumer income
4 - small increase in D
Drop in P
Drop in total revenue
D’
D

0 5 10 14
Billions of bushels per year 29
4. Cross-Price Elasticity of Demand

 Responsiveness of D for one good to changes in P

of another good
 %∆ in demand for one good divided by %∆ in price
of another good
– If positive: substitutes
– If negative: complements
– If zero: unrelated

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Price Elasticity and Tax Incidence

 Tax
– Decrease in S by the amount of tax

 Tax incidence
– Consumers: high P
– Producers: net-of-tax receipt

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Price Elasticity and Tax Incidence

 The more price elastic the D:

– The more tax producers pay
– The less tax consumers pay

 The more elastic the S:

– The less tax producers pay
– The more tax consumers pay
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Effects of Price Elasticity of D on Tax Incidence
(a) Less elastic demand (b) More elastic demand

$0.20 Tax
St St

$1.15
S $1.05 S
1.00 1.00
Price per ounce

Price per ounce

0.95 $0.20 Tax 0.85
D’

0 9 10 Millions of ounces per day 7 10

The more elastic the D curve, the more tax is paid by producers (lower net-of-tax receipt) 33
Effects of Price Elasticity of Supply on Tax Incidence
(a) More elastic supply (b) Less elastic supply

$0.20 Tax S t”
St ’
S”

$1.15
S’ $1.05
1.00 1.00 $0.20 Tax

Price per ounce

Price per ounce

0.95 0.85
D’’ D’’

0 8 10 Millions of ounces per day 9 10

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The more elastic the S curve, the more tax is paid by consumers as a higher price.
Questions?

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