ECN105

Economic Analysis and Policy 1

Elasticity
Sloman, Wride and Garratt, Chapter 3
 Elasticity

 Defining elasticity

 the responsiveness of demand and supply

 Price elasticity

 the responsiveness of demand or supply to a change

in price
 we’ll mainly talk about demand, but analysis of
supply is analogous
 Market supply and demand

S1
Price

a The effect on price of a shift

in supply depends on the
P1 responsiveness of demand
to a change in price.

D
O Q1
Quantity
 Market supply and demand
S2
S1

b
P2
Price

a
P1

D
O Q2 Q1
Quantity
 Market supply and demand
S2
S1

b The effect on price of a shift

P2
Price

in supply depends on the

responsiveness of demand
c to a change in price.
P3
a
P1
D'

D
O Q3 Q2 Q1
Quantity
 Elasticity

 Price elasticity of demand (PED)

 measures the sensitivity of the quantity demanded

of a good to a change in its price, ceteris paribus
PED = %Qd /%P = [Qd /Qd ]/ [P/P]

 use of proportionate or percentage changes

 PED is always negative as demand curve is
downward sloping
 the value (greater or less than -1)
 Refresher …

 NB 3 > 2 > 1 but -3 < -2 < -1

-3 -2 -1 0 1 2 3
| | | | | | |

 i.e. elasticity of -1.5 is less than elasticity of -1

 some texts ignore the sign and talk in absolute
numbers
 they might write: elasticity of -1.5 (ignoring the
negative sign) is greater than -1. We will not be
ignoring the sign. Be very careful!!
 Elasticity

 Determinants of price elasticity of demand

 number and closeness of substitute goods
 consumers easily substitute one brand of cereal for
another if the price rises, so we expect demand to be
elastic
 butif all cereal prices rise, the consumer cannot switch,
so we expect demand to be inelastic

 the proportion of income spent on the good

 time
 Elasticity

 Price elasticity of demand and consumer

expenditure (P × Q)
 effects of a price change on expenditure: elastic
demand
 Demand is elastic, when PED is less than -1
 i.e. when the % change in quantity demanded exceeds
the % change in price
 e.g. if quantity demanded falls by 7% in response to a 5%
increase in price, then PED = -7/5 = -1.4
 Elastic demand between two points

Expenditure falls
as price rises

P(£)
b
5
a
4
D

0 10 20
Q (millions of units per period of time)
 Elasticity

 Price elasticity of demand and consumer

expenditure (P × Q)
 effects of a price change on expenditure: inelastic
demand
 Demand is inelastic, when PED lies between -1
and 0
 i.e. when the % change in quantity demanded is smaller
than the % change in price
 e.g. if quantity demanded falls by 3.5% in response to a
5% increase in price then PED = -3.5/5 = -0.7
 Inelastic demand between two points
Expenditure rises
as price rises

c
8

P(£)

a
4

0 15 20
Q (millions of units per period of time)
 Elasticity

 Price elasticity of demand and consumer

expenditure (P × Q)
 effects of a price change on expenditure: elastic
demand

 effects of a price change on expenditure: inelastic

demand

 special cases
 Totally inelastic demand (PD = 0)
P
D

P2 b

P1 a

O Q1 Q
 Infinitely elastic demand (PD = )
P

a b
P1 D

O Q1 Q2
Q
 Unit elastic demand (PD = –1)
P

Expenditure stays the

same as price changes

a
20

b
8
D

O 40 100 Q
Elasticity and total expenditure/revenue

For a price For a price

increase decrease
Demand is Total exp Total exp
elastic decreases increases

Demand is Total exp does Total exp does

unit elastic not change not change

Demand is Total exp Total exp

inelastic increases decreases
 Elasticity

 Price elasticity of demand and consumer

expenditure (P × Q)
 effects of a price change on expenditure: elastic
demand

 effects of a price change on expenditure: inelastic

demand

 special cases

 applications to price decisions

 Elastic demand between two points

Expenditure falls
as price rises

P(£)
b
5
a
4
D

0 10 20
Q (millions of units per period of time)
 Inelastic demand between two points

Expenditure rises
as price rises
c
8

P(£)

a
4

0 15 20
Q (millions of units per period of time)
 Elasticity

 Price elasticity of demand and consumer

expenditure (P × Q)
 effects of a price change on expenditure: elastic
demand
 effects of a price change on expenditure: inelastic
demand
 special cases
 applications to price decisions
 different elasticities along a demand curve
Different elasticities along different portions of a demand curve
P
Elastic
a
demand
P1

b
P2

O Q1 Q2 Q
Different elasticities along different portions of a demand curve
P
a
P1

b Inelastic
P2 demand

c
P3
D

O Q1 Q2 Q3 Q
 Elasticity

 Measurement of elasticity: point elasticity

 the formula for price elasticity of demand

PED = (dQ/dP) x (P/Q)

 the elasticity of a straight-line demand ‘curve’

(constant slope dQ/dP)

 the elasticity of a curved demand curve

dQ/dP is the slope of the tangent to the curve at the point
 Measuring elasticity at a point
50
Ped = (1 / slope) x P/Q

= -100/50 x 30/40
= -60/40
= -1.5
r
30
P

0 40 100
Q
 Elasticity

 Measurement of elasticity: point elasticity

 the formula for price elasticity of demand
 dQ/dP x P/Q
 the elasticity of a straight-line demand ‘curve’
(constant dQ/dP)
 the elasticity of a curved demand curve
 dQ/dP is the tangent to the curve
 different elasticities along a straight-line demand
curve
Different elasticities along a straight-line demand curve
10
Ped = (1 / slope) x P/Q
n
8

m
6

P
l
4
Demand
k
2

0
0 10 20 30 40 50
Q
Different elasticities along a straight-line demand curve
10
Ped = (1 / slope) x P/Q
n
8 (1 / slope) is constant
= -50/10 = -5
m But P/Q varies:
6
at n, P/Q = 8/10
P at m, P/Q = 6/20
atl l, P/Q = 4/30
4
l Demand
k
2

0
0 10 20 30 40 50
Q
 Elasticity of supply

 Price elasticity of supply (PES)

 measurement
 PES = %QS /%P = [QS/QS ]/[P/P]

 determinants
 the amount that costs rise as output rises

 time period
 Income elasticity of demand

 Measures the sensitivity of quantity demanded to a

change in income, ceteris paribus
 IED = %QD/%I = [QD /QD ]/[I/I]

 can be positive or negative

 determinants
 degree of necessity
 proportion of income spent on the good
 Income elasticity of demand

 A good is a normal good if an increase in income

results in an increase in the demand for the good

 A normal good has a positive income elasticity of demand

 an increase in income leads to an increase in the

quantity demanded
 A luxury good has an income elasticity of demand
greater than 1
 A necessity has an income elasticity between 0 and 1
 Income elasticity of demand

 A good is an inferior good if an increase in

income results in a decrease in the demand for the
good

 An inferior good has a negative income elasticity of

demand
 an increase in income leads to a fall in quantity
demanded
 Cross-price elasticity of demand

 The cross price elasticity of demand for good i with

respect to the price of good j is:
(%Qd of good i)/( % P of good j )
= [Qdi/Qdi]/[Pj/Pj]
ceteris paribus
 This may be positive or negative
 The cross price elasticity tends to be positive if two
goods are substitutes e.g. tea and coffee
 The cross price elasticity tends to be negative if two
goods are complements e.g. tea and milk
  Two goods are said to be substitutes if an increase
(decrease) in the price of one good leads to an increase
(decrease) in the demand 18/10
of the other good
/2013

eg tea and coffee

price of tea increases – quantity demanded for tea decreases
(movement along)
demand for coffee increase (shift)

Price of Price of
Tea Coffee

D’
D D

Quantity
Quantity of of Coffee
Tea
  Two goods are said to be complements if an increase
(decrease) in the price of one good leads to a decrease
(increase) in the demand 18/10
of the other good
/2013

eg DVD and DVD Player:

price of DVD increase – quantity demanded for DVD
decreases (movement along), demand for DVD players also
decreases (shift)

Price of Price of
DVD DVD
Players

D
D’
D
Quantity of
Quantity of DVD Players
DVD
 The time dimension

 Short-run and long-run price adjustment

 short- and long-run demand and supply curves

 short- and long-run adjustment to a change in

demand or supply
Response of supply to an increase in demand
P

P1
a

D1
O Q1 Q
Response of supply to an increase in demand
P

P1
a

D2
D1
O Q1 Q
Response of supply to an increase in demand
P
S short-run

b
P2

P1
a

D2
D1
O Q1 Q2 Q
Response of supply to an increase in demand
P
S short-run

b S long-run
P2 c
P3
P1
a Supply is more elastic
in the long run

D2
D1
O Q1 Q2 Q3 Q
Response of demand to an increase in supply
P
S1

a
P1

O Q1 Q
Response of demand to an increase in supply
P
S1

S2

a
P1

O Q1 Q
Response of demand to an increase in supply
P
S1

S2

a
P1

P2 b

D short-run

O Q1 Q2 Q
Response of demand to an increase in supply
P
S1

S2

a
P1 c Demand is more
P3 elastic in the long run
P2 b
D long-run

D short-run

O Q1 Q2 Q3 Q
 Indirect taxes

 Specific and ad valorem taxes

 Effects on supply curve

 Effect of a tax on the supply curve
P

S + specific tax
S

amount of
specific tax

A tax shifts the supply curve

upwards by the amount of
the tax per unit.

O Q
 Effect of a tax on the supply curve
P S + ad valorem tax

O Q
 Effect of specific tax

 Tax on production (seller), Figure 1:

 Intersection of the demand curve and the new supply
curve give the new equilibrium quantity (Q2), and the
price paid by the buyer (PD ). PS = PD – tax

 Tax on consumption (buyer), Figure 2:

 Intersection of the supply curve and the new demand
curve give the new equilibrium quantity (Q2), and the
price received by the seller (PS ). PD = PS + tax

 It does not matter whether the specific tax is levied

on seller or buyer, the outcome is same
 Effect of a tax on price and quantity
P

P1

D
O Q1 Q
 Figure 1. Effect of production tax on
P equilibrium
18/10
/2013 S+
tax
S
PD

P1

Ps = PD - tax

D
O Q2 Q1 Q
 P
Figure 2. Effect of consumption tax on
equilibrium18/10
/2013

S
PD = PS + tax

P1

Ps

D+ D
tax
O Q2 Q1 Q
 Effect of specific tax

 Case of no tax:
 P1 is equilibrium price, such that P1 = PD = PS
 With tax
 PD ≠ PS
 The two prices differ by the amount of the tax.
 Price paid by the buyer (PD) increases.
 Increase in price for the buyer (PD – P1) is less than the value of
the tax.
 Price received by the seller (PS) decreases
 Decrease in price for the seller (P1 – PS) is less than the value of
the tax.
 Quantity traded in equilibrium falls from Q1 to Q2
 Effect of specific tax

 The overall effect of a tax depends on the

difference between D and S at each point
 But this doesn’t mean that producers and
consumers are equally affected by a tax

 Tax incidence is the share paid by producers or

consumers
 It is determined by the relative elasticities of supply
and demand
 Incidence of tax: inelastic demand
P
S + tax

P1

D
O Q1 Q
 Incidence of tax: inelastic demand
P
S + tax
P2
S

P1

D
O Q2 Q1 Q
 Incidence of tax: inelastic demand
P
S + tax
P2
S

CONSUMERS’
SHARE

P1
PRODUCERS’ SHARE
P2 - t

D
O Q2 Q1 Q
 Incidence of tax: elastic demand
P S + tax

P1

O Q1 Q
 Incidence of tax: elastic demand
P S + tax

S
P2
CONSUMERS’
SHARE
P1

D
PRODUCERS’
SHARE

P2 - t

O Q2 Q1 Q
 Incidence of tax: inelastic supply
P S + tax

P1

O Q1 Q
 Incidence of tax: inelastic supply
P S + tax

P2
P1 CONSUMERS’ SHARE

PRODUCERS’ SHARE
D
P2 - t

O Q2 Q1 Q
 Incidence of tax: elastic supply
P S + tax

P1

O Q1 Q
 Incidence of tax: elastic supply
P S + tax

P2
S
CONSUMERS’
SHARE
P1
PRODUCERS’
P2 - t SHARE

O Q2 Q1 Q
 Tax incidence

• If demand is more inelastic than supply, then consumers

will pay more of the tax than suppliers

• If supply is more inelastic than demand, then consumers

will pay less of the tax than suppliers

• Holding one curve constant, the bigger the difference in

elasticities, the bigger the difference in tax incidence
 Incidence of tax: inelastic demand Incidence of tax: elastic demand
P P S + tax
S + tax

P2
S
S
CONSUMERS’ P2
CONSUMERS’
SHARE
SHARE
P1
P1
PRODUCERS’ SHARE PRODUCERS’
D
P2 - t
SHARE

P2 - t

D
O Q2 Q1 Q O Q2 Q1 Q

Incidence of tax: inelastic supply Incidence of tax: elastic supply

P S + tax P S + tax

S P2
S
CONSUMERS’
SHARE
P2
P1 CONSUMERS’ SHARE P1
PRODUCERS’
SHARE
P2 - t
PRODUCERS’ SHARE
D D
P2 - t

O Q2 Q1 Q O Q2 Q1 Q
 Tax incidence
66

Demand Supply Result

Normal Perfectly elastic Consumer pays
Normal Perfectly inelastic Supplier pays
Perfectly elastic Normal Supplier pays
Perfectly inelastic Normal Consumer pays

 Task for you: draw a graph illustrating each of

the above cases