Elasticity

EduSure School
Economics PG Entrance
Economics: Elasticity

1. Motivation and a general definition As we have seen, economists are

often interested in the way that one variable A affects another variable B. Economists,
for example, are often interested in the way that changes in various prices affect the
quantity demanded of a good.
One coherent way to address these different units of measure is to denominate all
these changes in percentage terms. This of elasticity

eB,A = percentage change in B = B/B = BA

percentage change in A A/A AB

2. Price Elasticity of Demand Perhaps the most important elasticity

measure is own price elasticity, or the responsiveness of changes in a price on the
quantity of that good consumed.
a. Definition

eQ,P = percentage change in Q = Q/Q = QP

percentage change in P P/P PQ

Barring a Giffen Good relationship, own price elasticity measures are always negative
numbers (since Q/P<0). However, economists often divide goods by the magnitude of
the quantity response. If |eQ,P|<-1, then consumers are said to be insensitive, or inelastic
consumers of a good. On the other hand, if |eQ,P|>-1 then consumers are said to be
sensitive.
b. Price Elasticity and Total Expenditures. A common way to
explain these notions of “sensitivity” and “insensitivity” is in terms of the effects of a
price change on total expenditures. Recall, that total expenditures equal PQ. Write Q as
a function of P (for example Q = 10 –P ; to raise quantity one must lower price). Then
take the partial derivate w.r.t. P.

PQ(P) = Q + Q(P)
P P

Pulling Q out of the RHS

TR = (1 + eQ,P )Q
P

Notice that TR will move with price if demand is inelastic ( |eQ,P|<1) and TR will move
inversely with price if demand if elastic (|eQ,P|>1).

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Graphically, this can easily be seen by considering price changes at different points along
a linear demand curve.

P P P

Price box
P
1

Qty Box

Qty Box> Price Box Qty Box = Price Box Qty Box < Price Box
Elastic Segment Unitary Elastic Segment Inelastic Segment

In the leftmost panel, observe that when price changes, the effects on total revenue can be
divided into a “price box” and a “quantity box”. In the case of a price reduction, for
example, the price box is the revenues lost from units that would have sold at the higher
price (Dimension PQ). The quantity box denotes the extra revenues realized from lower
the price (Dimension QP). The left panel illustrates a situation where TR moves
inversely with the price change. This is an elastic segment of the demand curve (recall
|eQ,P| = |(Quantity box)/ (Price Box)| = |QP /QP| >1). People are price sensitive in the
sense that total revenue increases when price falls.
The right most panel illustrates an inelastic segment (|eQ,P| = |(Quantity box)/
(Price Box)| = |QP /QP| <1), Here consumers are price insensitive, in the sense that
TR falls with a price reduction – or, equivalently, TR increases with a price increase.
More revenues are gained from consumers staying in the market and paying the higher
price than are lost from consumers leaving the market.
The middle panel illustrates a unitary elastic segment, where the price box just
equals the quantity box (and eQ,P| = |(Quantity box)/ (Price Box)| = |QP /QP| =1). Here
the price and quantity boxes indicate that price and quantity effects are exactly offsetting.

3. Income Elasticity of Demand Another standard type of elasticity

assesses the responsiveness of consumers to a change in income levels. This is termed
income elasticity of demand

eQ,I = percentage change in Q = Q/Q = QI

percentage change in I I/I IQ

Unlike own price elasticity, income elasticity can be positive or negative. The sign and
the magnitude of income elasticity is important.

eQ,I > 1 goods are luxury goods or cyclical normal

goods (e.g., automobiles)
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0 < eQ,I < 1 goods are normal goods (e.g., food)

eQ,I < 0 goods are inferior goods

4. Cross Price Elasticity of Demand Another standard elasticity deals with

the response of one good to the change in the price of a related good. This is
termed cross price elasticity

eQ,P’ = percentage change in Q = Q/Q = QP’

percentage change in P’ P’/P’ PQ

As with income elasticities, cross price elasticities can be positive or negative.

The sign is important.

eQ,P’>0 implies goods are substitutes

eQ,P’<0 implies goods are complements (the same as own price changes)

Example: Elasticities are easily understood in terms of a linear demand function.

For example, consider the market demand function

X = 10 - 2PX + .1I1 + .5PY

Obviously, the positive coefficient on the income parameter indicates that the
good is a normal good, while the positive coefficient on PY indicates that the products are
substitutes.
Suppose PX = 5, I = 40 and PY = 4. Then
X = 10 -2(5) + .1(40) + .5(4)
= 6

Then eQ,P = -2(5)/6 = -1.67, the firm is on the elastic portion its
demand curve
eQ,I = .1(40)/6 = 0.67, the product is a normal, noncyclical
good.
eQ,P’ = .5(4)/6 = 0.33, good Y is a substitute.

C. Relationships Between Elasticities

1. Sum of income Elasticities for all Goods. We have developed elasticity
in terms of market demand. If we further treat individuals uniformly as representative
consumers, then we can derive some important relationships between elasticities.
Consider the case of homogeneous customers with two goods, forming the market budget
constraint is
PXX + PYY = I.
Market demands for X and Y are

X = dX(PX, PY, I)
and

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Y = dY(PX, PY, I).

Further, assume these demand functions are homogeneous of degree zero in prices
and income. Differentiating the budget constraint w.r.t. I,
PX(X/I) + PY(Y/I) = 1

This expression can be readily converted into elasticities .

(PXX/I)(X/I)I/X + (PYY/I )(Y/I)I/Y = 1

writing PXX/I = sx and PYY/I = sy yields

sxeX,I + sYeY,I = 1

Thus, the share weighted sum of the income elasticities for all good equals 1.
(e.g., if income increases 10%, expenditures must increase 10%). Thus, for every
“luxury” good (with income elasticity greater than 1) there must be offsetting goods witn
income elasticities less than 1.

2. Slutsky Equation in Elasticities Recall the Slutsky equation

X = X | - X X
PX PX |U = constant I

This expresión may be converted into elasticities by multiplying by PX/X

X PX = X PX | - X[ X I ] PX
PX X PX X |U = constant IX I

eXP = eSXP - eXI sx

Where
eSXP denotes the compensated price elasticity of demand
and
sx denotes the share of income spent on X.

Notice that the above (bolded expression provides an additional reason to use
uncompensated demand: When sx is small uncompensated and compensated elasticities
are very similar.

3. Homogeneity As a final example of relationships between elasticities, we

exploit the fact that demand functions are homogeneous of degree zero in prices and
income.
Prior to developing this relationship, we review Euler’s Theorem. A function that
is homogeneous of degree m, means that, for any t>0.

f(tX1, tX2, …. , tXn) = tmf(X1, X2, …. , Xn).

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Thus a function that is homogenous of degree zero implies

f(tX1, tX2, …. , tXn) = f(X1, X2, …. , Xn).

Euler’s theorem states that a function that is homogeneous of degree m, then

f1X1+ f2X2 +… fnXn = mf(X1, X2, …. , Xn)

When m=0, then the Euler’s theorem states that the sum of the quantity weighted
first derivatives equals zero.

Now, consider a demand function X = dx(Px, Py, I)

By Euler’s Theorem

(X/PX) PX + (X/PY)PY +(X/I)I = 0

Convert to elasticities by dividing by X,

(X/PX) PX /X+ (X/PY)PY/X +(X/I)I/X = 0/X

eX,Px + e X,Py + e X,,I = 0

This is another way to state the homogeniety of degree zero property of demand
functions. An equal percentage change in all prices and incomes will leave the quantity
demanded of X unchanged.

Example: Cobb-Douglas Elasticities Consider the Cobb Douglas demand function

U(X,Y) = XY where  +  = 1.

Demand functions are

X = I/PX Y = I/PY

The elasticities are easy to calculate. For example,

eX,Px = (X/PX) PX /X = (-I/PX2)( PX /X)

= (-I/PX2)( PX2 /I )
= -1
Similarly
eX,I = 1

eX,Py = 0

eY,Py = -1

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eY,I = 1

eY,Px = 0

Hence these demand functions have elementary elasticity values. Further

sX = PXX/I = PXI/PXI = 

sY = PYY/I = 

The constancy of income shares provides another way of shown the unitary
elasticity of demand.

Homogeneity holds trivially,

eX,Px + e X,Py + e X,,I = 0

-1 + 0 + -1 = 0

Finally, consider the elastcity version of the Slutsky equation.

eXP = eSXP - sx eXI

-1 = eSXP - (1)

Thus

eSXP = -(1 - ) = -

In words, the compensated price elasticity of demand for one good is the income
share for the other good. This is special case of the more general result that

eSXP = -(1 - sx)

where  is the elasticity of substitution.

D. Types of Demand Curves. Economists consider various types of demand

forms. Here in closing we consider some of the problems associated with two of these
functions.
1. Linear Demand Consider a demand function of the form

Q = a + bP + cI + dP’

Where a, b, c and d are demand parameters, and .

b<0 (the good is not a giffen good)

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c>0 (the good is normal)

d< > 0 if the related good is a gross substitute or a gross complement.

Holding I and P’ constant

Q = a’ + bP

Where a’ = a + cI + dP’. Clearly this describes a l linear demand curve.

Further, changes in a’ will shift demand. Despite the simplicity of this demand statement.
Linear demand has the deficiency that elasticity changes as one moves along the demand
function. To see this notice that
eX,Px = (X/PX) PX /X = bP/Q
Obviously as P rises Q falls, and demand becomes more elastic.

Example: Linear Demand. Consider a demand function

Q = 36 – 3P.
Price elasticity of demand is

eX,Px = -3P/Q = -3P/(36 – 3P)

Notice demand is unit elastic when P = 6. For P>6 demand is elastic. For P<6
demand is inelastic. Because elasticity varies with price on a linear demand curve, one
must be very careful to specify the point at which elasticity is being measured. In
empirical work with linear demand curves, it is conventional to report the arc price
elasticity, that is, the average elasticity over the average price prevailing for a period.

2. Constant Elasticity Demand If one want to assume that elasticities are constant
use an exponential function.

Q = aPbIcP’d
Where a>0, b<0, c>0 (a normal good) and d<>0, as for the linear good. Notice
that one can easily “linearize” such a function by taking natural logarithms (ln)

lnQ = lna + blnP + clnI + dlnP’.

Notice that one can estimate the parameters of such a function with ordinary least
squares. Notice also that

eQ,P = (Q/P) P /Q = b aPb-1IcP’d P/(aPbIcP’d)

= b
Thus, the price elasticity of demand is constant.

Example: Elasticities, Exponents and Logarithms. Notice in the above example

that income and cross price elasticities are also directly read from the exponents of the
demand functions

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eQ,I = c ; eQ,P’ = d

Therefore, from a linear regression, one can read elasticities without having to
make any mathematical computations. For example, if one estimated

lnQ = 4.61 - 1.5lnP + .5ln(I) + ln(P’)

We know that
eQ,P = -1.5 ; eQ,I = .5
and eQ,P’ = 1

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