Chapter 5: Elasticity and Its Application

December, 2021

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Elasticity
Elasticity of Y w.r.t X: A measure of the responsiveness of Y to
change in X. Elasticity is defined as: (Percentage change in
Y)/(Percentage change in X).

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Elasticity
Elasticity of Y w.r.t X: A measure of the responsiveness of Y to
change in X. Elasticity is defined as: (Percentage change in
Y)/(Percentage change in X).
Elasticity (in economics): A measure of the responsiveness of
quantity demanded or supplied to a change in one of its determinants.

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Elasticity
Elasticity of Y w.r.t X: A measure of the responsiveness of Y to
change in X. Elasticity is defined as: (Percentage change in
Y)/(Percentage change in X).
Elasticity (in economics): A measure of the responsiveness of
quantity demanded or supplied to a change in one of its determinants.
Price Elasticity of Demand: A measure of how much the quantity
demanded of a good responds to a change in the price of that good,
computed as the percentage change in quantity demanded divided by
the percentage change in price.

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Elasticity
Elasticity of Y w.r.t X: A measure of the responsiveness of Y to
change in X. Elasticity is defined as: (Percentage change in
Y)/(Percentage change in X).
Elasticity (in economics): A measure of the responsiveness of
quantity demanded or supplied to a change in one of its determinants.
Price Elasticity of Demand: A measure of how much the quantity
demanded of a good responds to a change in the price of that good,
computed as the percentage change in quantity demanded divided by
the percentage change in price.
Since the quantity demanded of a good is negatively related to its
price, the percentage change in quantity will always have the opposite
sign as the percentage change in price.

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Elasticity
Elasticity of Y w.r.t X: A measure of the responsiveness of Y to
change in X. Elasticity is defined as: (Percentage change in
Y)/(Percentage change in X).
Elasticity (in economics): A measure of the responsiveness of
quantity demanded or supplied to a change in one of its determinants.
Price Elasticity of Demand: A measure of how much the quantity
demanded of a good responds to a change in the price of that good,
computed as the percentage change in quantity demanded divided by
the percentage change in price.
Since the quantity demanded of a good is negatively related to its
price, the percentage change in quantity will always have the opposite
sign as the percentage change in price.
This implies that price elasticity of demand is always negative.
We will focus only on absolute values of price elasticity of demand.
A larger price elasticity implies a greater responsiveness of quantity
demanded to changes in price.
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Determinants of Elasticity of Demand

Availability of Close Substitutes: Goods with close substitutes tend

to have more elastic demand because it is easier for consumers to
switch from that good to others.

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Determinants of Elasticity of Demand

Availability of Close Substitutes: Goods with close substitutes tend

to have more elastic demand because it is easier for consumers to
switch from that good to others.
Necessities versus Luxuries: Necessities tend to have inelastic
demands, whereas luxuries have elastic demands. Why?

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Determinants of Elasticity of Demand

Availability of Close Substitutes: Goods with close substitutes tend

to have more elastic demand because it is easier for consumers to
switch from that good to others.
Necessities versus Luxuries: Necessities tend to have inelastic
demands, whereas luxuries have elastic demands. Why?
Definition of the Market: Narrowly defined markets tend to have
more elastic demand than broadly defined markets because it is easier
to find close substitutes for narrowly defined goods.

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Determinants of Elasticity of Demand

Availability of Close Substitutes: Goods with close substitutes tend

to have more elastic demand because it is easier for consumers to
switch from that good to others.
Necessities versus Luxuries: Necessities tend to have inelastic
demands, whereas luxuries have elastic demands. Why?
Definition of the Market: Narrowly defined markets tend to have
more elastic demand than broadly defined markets because it is easier
to find close substitutes for narrowly defined goods.
Time Horizon: Goods tend to have more elastic demand over longer
time horizons as consumers can better adjust their behaviour over
longer horizon.

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Computing Price Elasticity of Demand

For any two points A and B on the demand curve, the elasticity from
point A to point B seems different from the elasticity from point B to
point A. Why?

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Computing Price Elasticity of Demand

For any two points A and B on the demand curve, the elasticity from
point A to point B seems different from the elasticity from point B to
point A. Why?
Suppose (Q1 , P1 ) is point A and (Q2 , P2 ) is point B. Price elasticity
2 −Q1 )/Q1 (Q2 −Q1 )/Q2
of demand from A to B is (Q (P2 −P1 )/P1 and from B to A is (P2 −P1 )/P2 .
The above problem can be avoided by using midpoint method
(prescribed method) to calculate price elasticity of demand as:
(Q2 −Q1 )/(Q2 +Q1 )/2
(P2 −P1 )/(P2 +P1 )/2
A more precise approach (outside the scope of this book) would be to
calculate price elasticity of demand at a point using calculus as: dQ P
dP Q .

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Variety of Demand Curves

Economists classify demand curves according to their elasticity.

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Variety of Demand Curves

Economists classify demand curves according to their elasticity.

Demand is considered elastic when the elasticity is greater than 1,
which means the quantity moves proportionately more than the price.
Demand is considered inelastic when the elasticity is less than 1, which
means the quantity moves proportionately less than the price.
Demand is said to have unit elasticity if elasticity is exactly 1, which
means the quantity moves the same amount proportionately as the
price.

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Perfectly Inelastic Demand Curve

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Inelastic Demand Curve

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Unit Elastic Demand

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Elastic Demand

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Perfectly Elastic Demand

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Total Revenue and the Price Elasticity of Demand

Total revenue, PQ increases with price if demand is inelastic,

decreases with price when demand is elastic and stays unchanged with
price when elastic of demand is unity.

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Total Revenue and the Price Elasticity of Demand

Total revenue, PQ increases with price if demand is inelastic,

decreases with price when demand is elastic and stays unchanged with
price when elastic of demand is unity.

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Elasticity and Total Revenue along a Linear Demand Curve

Even though the slope of a linear demand curve is constant, the

elasticity is not.

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Elasticity and Total Revenue along a Linear Demand Curve

Even though the slope of a linear demand curve is constant, the

elasticity is not.
As we move along the linear demand curve in the direction of
increasing price, the price elasticity of demand also increases. Why?
Note that price elasticity of demand= dQ P
dP Q .
dQ
dP is constant along the linear demand curve and as we move along
P
the linear demand curve in the direction of increasing price, Q increases
since Q decreases as P increases.
This implies that the product of dQ P
dP and Q increases in magnitude as
price increases leading to higher elasticity.

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Other Demand Elasticities

The Income Elasticity of Demand: The income elasticity of

demand measures how the quantity demanded changes as consumer
income changes. It is calculated as the percentage change in quantity
demanded divided by the percentage change in income. That
is,income elasticity of demand=(Percentage change in quantity
demanded)/(Percentage change in income)
Normal goods have positive income elasticities and inferior goods
have negative income elasticities. Why?
Necessities, such as food and clothing, tend to have small income
elasticities while luxuries, such as movie tickets and diamonds, tend to
have large income elasticities.

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Other Demand Elasticities...

The cross-price elasticity of demand measures how the quantity

demanded of one good responds to a change in the price of another
good. It is calculated as the percentage change in quantity demanded
of good 1 divided by the percentage change in the price of good 2.
That is, Cross-price elasticity of demand = (Percentage change in
quantity demanded of good 1)/(Percentage change in the price of
good 2).
Cross-price elasticity of demand is positive in case of substitutes and
negative in case of complements. Why?

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Price Elasticity of Supply
Price Elasticity of Supply A measure of how much the quantity
supplied of a good responds to a change in the price of that good,
computed as the percentage change in quantity supplied divided by
the percentage change in price. That is, Price elasticity of supply =
(Percentage change in quantity supplied)/(Percentage change in
price).
Supply of a good is said to be elastic (inelastic) if the quantity
supplied responds substantially (only slightly) to changes in the price.
The price elasticity of supply depends on the flexibility of sellers to
change the amount of the good they produce.
Beachfront land has an inelastic supply because it is almost impossible
to produce more of it, whereas, manufactured goods tend to have
elastic supplies because firms that produce them can run their factories
longer in response to a higher price.
Supply is usually more elastic in the long run than in the short run as
firms are better able to adjust their production capacities or enter/exit
a market in the long run.
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Variety of Supply Curves: Perfectly Inelastic Supply Curve

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Variety of Supply Curves: Inelastic Supply Curve

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Variety of Supply Curves: Unit Elastic Supply

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Variety of Supply Curves: Elastic Supply

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Variety of Supply Curves: Perfectly Elastic Supply

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Applications: Can Good News for Farming Be Bad News
for Farmers?
Researchers have devised a new hybrid of wheat that raises the
amount farmers can produce from each acre of land by 20 percent.

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Applications: Can Good News for Farming Be Bad News
for Farmers?
Researchers have devised a new hybrid of wheat that raises the
amount farmers can produce from each acre of land by 20 percent.

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Applications: OPEC Was Able To Raise Oil Price in Short
Run but Failed to Maintain High Prices in Long Run

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Applications: OPEC Was Able To Raise Oil Price in Short
Run but Failed to Maintain High Prices in Long Run...

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Applications: Does Drug Interdiction Increase or Decrease
Drug-Related Crime?

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Applications: Does Drug Interdiction Increase or Decrease
Drug-Related Crime?...

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References

1 N. Gregory Mankiw (2012), Principles of Economics, 6th edition.

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