Elasticity and its Applications

Chen Zhao
University of Hong
Kong
Example: RMB appreciation
• Will the China’s trade balance (export – import) deteriorate if RMB
depreciates (say, from 1USD=6.8RMB to 1USD=7.2RMB)?

1. China’s imports become more expensive. Quantity demanded for import

may decrease.
2. China’s exports become less expensive. Quantity demanded for export
may increase.

• The impact of RMB appreciation on the trade balance depends on the

responsiveness of import demand and export demand to the appreciation .
Example: Tax on cigarette
• The government would like to discourage smoking by 5%. How much sales
tax should the government impose on cigarette?

• Government would like to raise tax revenue from cigarette sales. How
much tax rate should the government raise?
Example: Soda tax
o Soda consumption has been noted as a contributing factor to obesity.
Medical costs related to obesity is substantial. The government targets to
reduce soda consumption by 5% by levying a soda sales taxes.

o How much sales tax should the government impose on soda?

Why elasticity?
o To answer these questions, it would be the best to have an estimated
demand curve, an estimated supply curve, or a set of estimated supply and
demand curves.
P P S

Q Q
Why elasticity?
o Sometimes we do not have the luxury of estimated supply and demand, but
estimated elasticity can be computed relatively easily.

o In addition, elasticity may help us communicate with the general public.

o The concept of elasticity may also help us understand the shape of demand
and supply curves.
Elasticity of Demand
o We know there is an inverse relationship between price and quantity
demanded.

o But how much does quantity demanded change when price changes?
Elasticity of Demand
o A demand curve is elastic when an increase in price reduces the quantity
demanded a lot (and vice versa).

o When the same increase in price reduces quantity demanded just a little,
then the demand curve is inelastic.
Elasticity of Demand
Price The More Responsive Quantity
Demanded is to a Change in Price,
the More Elastic is the Demand
Curve

Same Price $50

Increase
$40

Elastic Demand

Inelastic Demand
Quantity
20 75 80

… Causes a Big Decrease in … Causes a Small Decrease in

Quantity Demanded if Demand is Quantity Demanded if Demand is
Elastic Inelastic
Elasticity
o Elasticity slope

o Elasticity = the percentage change in quantity divided by the percentage

change in price.

o BUT:
o If two linear demand (or supply) curves run through a common point,
then at any given quantity the curve that is FLATTER is MORE ELASTIC.
Determinants of the Elasticity of Demand: a preview
1. Availability of Substitutes (Fundamental Determinant)
2. Time Horizon
3. Category of product (specific or broad)
4. Necessities vs. Luxuries
5. Purchase Size
Determinants of the Elasticity of Demand
1. The availability of substitutes is very important.

o Fewer substitutes makes it harder for consumers to adjust Q when P

changes, so demand is inelastic.

o Many substitutes? Switching brands when prices change is EASY, so

demand is elastic.
Example: More substitutes due to patent expiry

When the patent expires on a brand-name

drug and 5 generic drugs come on the market,
what happens to the elasticity of demand of
the brand-name drug?

a) It becomes more elastic

b) It becomes less elastic
Determinants of the Elasticity of Demand
2. The time horizon matters.
o Less time to adjust means lower elasticity
o Over time consumers can adjust their behavior by finding substitutes
(making demand more elastic).
Determinants of the Elasticity of Demand
3. The classification of the good matters.
o The less specific the classification, the fewer substitutes there are
(making demand inelastic).
o And vice versa…
o E.g. the elasticity of demand is higher for “lettuce” than for “food.”

vs.
Determinants of the Elasticity of Demand
4. The nature of the good to the consumer can also affect the elasticity of
demand.
o For necessities, we do not change Q much when P changes
o For luxuries, we are more sensitive to P changes

vs.
Determinants of the Elasticity of Demand
5. The size of the purchase (relative to our budget) matters.
o We are less sensitive to price changes when the good feels cheap
(occupies only a small % of our budget)
o We are more sensitive to price changes when the good feels expensive
(occupies only a large % of our budget)

Budget Budget
Good X Good X
Others Others
Example: Price Elasticity Estimates
Good or service Price elasticity
Green peas -2.80
Restaurant meals -1.63
Automobiles -1.35
Electricity -1.20
Beer -1.19
Movies -0.87
Air travel (foreign) -0.77
Shoes -0.70
Coffee -0.25
Theater, opera -0.18

Why is the price elasticity of demand more than 14 times larger

for green peas than for theater and opera performances?
Mathematics of the Elasticity of Demand
o Elasticity of demand = the percentage change in quantity demanded
divided by the percentage change in price.

in which ∆ is the mathematical symbol for “change in”.

Mathematics of the Elasticity of Demand
Example:
o If the price of oil increases by 10% and over a period of several years, the
quantity demanded falls by 5%, then the long run price elasticity of demand
for oil is:

 5%
 0.5
10%
or 0.5 (in absolute terms)
Mathematics of the Elasticity of Demand
o Elasticity of demand is always negative, so we typically drop the negative
sign and use absolute value instead.

o If the |η| < 1, the demand is inelastic.

o If the |η| > 1, the demand is elastic.
o If the |η| = 1, the demand is unit elastic.
Unit elastic

Elastic inelastic

-3 -2 -1 0
Mathematics of the Elasticity of Demand

Hence, given a change from (P0, Q0) to (P1, Q1),

(Q1 – Q0) / Q0
η=
(P1 – P0) / P0
Mathematics of the Elasticity of Demand
Example:
o If the price of oil increases from 100 to 110 and over a period of several
years, the quantity demanded falls from 100 trillion barrels to 95 trillion
barrels then the long run price elasticity of demand for oil is:

(95  100) / 100  5%

  0.5
(110 - 100)/100 10%
or 0.5 (in absolute terms)
Mathematics of the Elasticity of Demand
Example:
o If the price of oil falls from 110 to 100 and over a period of several years,
the quantity demanded increases from 95 trillion barrels to 100 trillion
barrels then the long run price elasticity of demand for oil is:

(100  95) / 95 5.26%

  0.579
(100 - 110)/110 - 9.09%
or 0.579(in absolute terms)
Using the Midpoint Formula for Elasticity
o To erase the natural bias associated with choice of base point, we calculate
the elasticity of demand using the percentage change relative to the
midpoint:
Using the Midpoint Formula
Example:
o When price is $10, the quantity demanded is 100. When the price rises to
$20, the quantity demanded is 90.

(90 − 100 )
% Δ 𝑄 𝑑= × 100 %=− 10 . 5 %
(100 +90 )/ 2

(20 − 10 )
% Δ 𝑃= × 100 %=66 . 6 %
(10 +20 )/ 2

η=
Point Formula for Elasticity
(Q1 – Q0) / Q0
o Original definition: η=
(P1 – P0) / P0
(Q1 – Q0) / [(Q1 + Q0)/2]
o Midpoint formula: η=
(P1 – P0) / [(P1 + P0)/2]
o They are approximately the same if (P0, Q0) and (P1, Q1)
are very close.
o Hence, when the change is small:

Price elasticity at point (P0, Q0) ≈ ≈

A Graphical Interpretation of Elasticity
 For small changes in price,

𝑃 1
𝐸 𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑎𝑡 𝐴= ×
𝑄 𝑠𝑙𝑜𝑝𝑒

A
P
Price

P+ P
Q

Q Q+ Q
Quantity
Calculating the Elasticity of Demand
𝑃 1 𝑣𝑒𝑟𝑡𝑖𝑐𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑐𝑒𝑝𝑡 20
𝜂= × 𝑠𝑙𝑜𝑝𝑒= =− =− 4
𝑄 𝑠𝑙𝑜𝑝𝑒 ℎ𝑜𝑟𝑖𝑧𝑜𝑛𝑡𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑐𝑒𝑝𝑡 5
20
D
8 1 8 2
16 η= × =− =−
3 (− 4) 12 3

12
Price

A Question:
8
What is the elasticity
of demand when P = $8?
4

1 2 3 4 5

Quantity
Elasticity of Demand: Along a linear demand
𝑃 1
𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 = ×
12 𝑄 𝑠𝑙𝑜𝑝𝑒
When P = $4
4 1
η= × =− 2
4 (−6 / 12) When P = $1
1 1 1
η= × =−
6 10 (−6 / 12) 5
Price

4 Observation
Price elasticity varies at every
D
point along a straight-line
1 demand curve

4 6 10 12

Quantity
Elasticity of Demand: Along a linear demand

𝑃 1 Observation
𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 = ×
𝑄 𝑠𝑙𝑜𝑝𝑒 Price elasticity varies at
every point along a straight-
line demand curve

a η <−1

η=− 1
Elastic
Price

a/2 η >−1

Inelastic

b/2 b
Quantity
Elasticity of Demand: at common point
What is the price elasticity of Demand for D1 & D2 when P = $4?

On D1 𝑃 1
12 𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 = ×
4 1 1 𝑄 𝑠𝑙𝑜𝑝𝑒
η= × =−
D1 4 (−12/ 6) 2
Observation
On D2 If two demand curves
6 4 1
η= × =− 2 have a point in
4 (−6 / 12)
common, the steeper
Price

4 curve must be less

elastic with respect to
D2
price at that
common point.

4 6 12

Quantity
Perfectly Elastic Demand Curve

𝑃 1
𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 = ×
𝑄 𝑠𝑙𝑜𝑝𝑒
Perfectly elastic
demand (elasticit y  - )
Price

Quantity

If the price increases a little, the quantity demanded will drop to zero.
If the price drops a little, the quantity demanded will increase a lot.
Perfectly Inelastic Demand Curve

Perfectly inelastic
demand (elasticity  0)
Price

𝑃 1
𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 = ×
𝑄 𝑠𝑙𝑜𝑝𝑒

Quantity

The quantity demanded is not responsive to any change in price.

Elasticity of Demand and Total Revenue
o A firm’s revenues are equal to price per unit times quantity sold.
o Revenue = Price x Quantity

o The elasticity of demand directly influences revenues when the price of the
good changes.

o Firm’s revenue = consumer’s expenditure

Example: The Demand Curve for Movie Tickets
Price ($/ticket) Total expenditure ($/day)
12
12 0
10 1000
10
8 1600
8 6 1800
Price ($/ticket)

4 1600
6 2 1000
0 0
4

0 1 2 3 4 5 6
Quantity (100s of tickets/day)
Total Expenditure as a Function of Price
Total revenue is at a maximum at the midpoint
on a straight-line demand curve.

12
1,800

10 1,600

Total expenditure ($/day)

8
Price ($/ticket)

1,000
6

0 1 2 3 4 5 6 0 2 4 6 8 10 12
Quantity (100s of tickets/day) Price ($/ticket)
Example: Expenditure on shelter
• What happens to total expenditure on shelter when the price is reduced from
$12/sq yd to $10/sq yd?

Price ($/sq yd) When price goes down,

total expenditure will
rise [fall] if the gain
16 Reduction in expenditure from from sale of additional
14 sale at a lower price units is larger [smaller]
12 E than the loss from the
10 Increase in expenditure from sale of existing units at
8 the lower price.
additional sales
6
4 F G
2
Quantity (sq yds/wk)
0  4 6 8 10 1214 16
Elasticity and Total Expenditure

If demand is... A price increase will... A price reduction will...

reduce total increase total

expenditure expenditure
elastic
  
P x Q = P Q P x Q = PQ

increase total reduce total

expenditure expenditure
inelastic
  
P x Q = PQ P x Q = PQ
Example:
Why the War on Drugs is Hard to Win?
o Because demand for most illegal drugs is inelastic, drug dealers earn
greater revenue and gain more power as the drug war becomes more
effective.
Example:
Why the War on Drugs is Hard to Win?
o Because demand for most illegal drugs is inelastic, drug dealers earn
greater revenue and gain more power as the drug war becomes more
effective.
Price

Price with prohibition

Price without prohibition

Quantity
Inference
If a fashionable clothing store raised its prices by 25 percent, what does that
tell you about the store’s estimate of the price elasticity of demand for its
products?

a) They think it’s elastic

b) They think it’s inelastic
A demand curve with unitary elasticity

Unitary elastic: PQ=constant

P
Elasticity equals -1 at any (p,q) pair.
(dQ/dP) (P/Q)=-1
(dQ/Q)/(dP/P)=-1
(d lnQ)/(d lnP)=-1
lnQ = - lnP + c
lnQ + lnP = c
ln(QP) = c
QP = exp(c)

Q
A demand curve with constant elasticity

Constant elasticity: PkQ=constant

P
Elasticity equals -k at any (p,q) pair.

(dQ/dP) (P/Q)=-k
(dQ/Q)/(dP/P)=-k
(d lnQ)/(d lnP)=-k
lnQ = - k lnP + c
lnQ + k lnP = c
ln(QPk) = c
QPk = exp(c)

Q
Estimation of constant elasticity

Demand curve with constant elasticity: PkQ=constant

P lnQ = - k lnP + c

Elasticity equals -k at any (p,q) pair.

Suppose we have collected (p,q) on a
demand curve.
Run a regression

lnQ = a + b lnP + e

The estimate of the slope term is an estimate

of the price elasticity of the demand curve.

Q
Cross-Price Elasticity of Demand
o The Cross-Price Elasticity of Demand measures how sensitive the demand
for good A is to the price of good B.

o Cross-Price Elasticity of Demand:

Cross-Price Elasticity of Demand
o For substitutes, Cross-Price Elasticity of Demand is positive.
o An increase in the price of one brand of milk will increase the demand for
other brands.

o For complements, Cross-Price Elasticity of Demand is negative.

o An increase in the price of milk causes a decrease in demand for Oreos.
Income Elasticity of Demand
o The Income Elasticity of Demand measures how sensitive the demand of a
good is to changes in income.

o Income Elasticity of Demand:

Income Elasticity of Demand
o The income elasticity of demand can be used to distinguish normal from
inferior goods.

o For normal goods, Income Elasticity is positive.

o For luxury goods, Income Elasticity is greater than one.
o For inferior goods, Income Elasticity is negative.
Elasticity of Supply
o The law of supply indicates a direct relationship between price and quantity
supplied.
o But how strong is that relationship?
Elasticity of Supply
o A supply curve is
o elastic if a rise in price increases the quantity supplied a lot and a
decrease in price decreases the quantity supplied a lot.

o inelastic if a rise in price increases the quantity supplied just a little.

Elasticity of Supply

Price per
Unit Inelastic Supply

$50 Elastic Supply

Same Price
Increase $40

Quantity
80 85 170
…Causes a Small Increase in
Quantity Supplied if Supply is
Inelastic …Causes a Big Increase in Quantity
Supplied if Supply is Elastic
Elasticity
o Elasticity slope

o Elasticity = the percentage change in quantity divided by the percentage

change in price.

o BUT:
o If two linear demand (or supply) curves run through a common point,
then at any given quantity the curve that is FLATTER is MORE ELASTIC.
Determinants of Elasticity of Supply
1. Change in Per-Unit Costs with Increased Production
2. Time Horizon
3. Share of Market for Inputs
4. Geographic Scope
Determinants of Elasticity of Supply
1. How quickly do per-unit costs increase when more is produced?
o If increased production is very expensive, then the supply curve will be
inelastic.
o If production can increase with little extra cost, then the supply curve will
be elastic.

Ivory: increasing collection costs, inelastic supply

Determinants of Elasticity of Supply
2. The time horizon matters.
o Immediately following a price increase, producers can expand output only
using their current capacity (making supply inelastic).
o Over time, however, producers can expand their capacity (making supply
elastic).
Determinants of Elasticity of Supply
3. The share of the market for the inputs used in production matters.
o Supply is elastic when the industry can be expanded without causing a big
increase in the demand (and price) for the industry’s inputs.
o Supply is inelastic when industry expansion causes a significant increase
in the demand/price for inputs.
Determinants of Elasticity of Supply
4. The geographic scope of the market matters.
o The wider the scope of the market of a good, the less elastic its supply.
o The narrower the scope of the market of a good, the more elastic its
supply.

Similar to the coverage of the good category in

the discussion of elasticity of demand.
Mathematics of Elasticity of Supply
o Elasticity of supply = the percentage change in quantity supplied divided by
the percentage change in price.

in which ∆ is the mathematical symbol for “change in”.

o If the η < 1, the supply is inelastic.
o If the η > 1, the supply is elastic.
o If the η = 1, the supply is unit elastic.
Mathematics of Elasticity of Supply
o When given two points on the supply curve, use the midpoint formula:

(Q1 – Q0) / [(Q1 + Q0)/2]

η=
(P1 – P0) / [(P1 + P0)/2]

o When considering a small change around a point (P 0, Q0), use the point
formula:

Price elasticity at point (P0, Q0) =

A Supply Curve for Which Elasticity Declines in Quantity
8 1 10 1 5
𝐴 : η= × =2 𝐵: η= × =
2 2 3 2 3
S
B 𝑃 1
10 𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑎𝑡 𝑎𝑝𝑜𝑖𝑛𝑡= ×
𝑄 𝑠𝑙𝑜𝑝𝑒
A
88
Observations:
Price

1. Elasticity >0
2. Elasticity >1 for linear supply curve
4 that has a positive Y-intercept.
3. Elasticity decreases as quantity
increases.

0 22 3 Quantity
A Supply Curve for Which Elasticity is unity
4 12
𝐴 : η= × =1
12 4

5 15 S
𝐵: η= × =1
15 5 𝑃 1
𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑎𝑡 𝑎𝑝𝑜𝑖𝑛𝑡= ×
B 𝑄 𝑠𝑙𝑜𝑝𝑒
5
A
P The price elasticity of supply
4 will always equal 1 at any
Q
point along a straight-line
Price

supply curve that passes

through the origin.

0 12 15
Quantity
A Perfectly Inelastic Supply Curve

What is the price elasticity of supply of land within Central?

S
Price ($/acre)

Elasticity = 0 at every
point along a vertical
supply curve

0
Quantity of land in Central
(1,000s of acres)
A Perfectly Elastic Supply Curve

If MC is constant, then the

price elasticity of supply at every point
Price (cents/cup) along a horizontal supply curve is infinite

14 S

0
Quantity of lemonade
(cups/day)
Example: Slave redemption
o Does slave redemption create more slavery? How will slave traders respond
to an increase in demand for slaves?

Harvard Sophomore Jay Williams redeems slaves in the

Sudan
Example: Slave redemption
Slave Redemption Works Best If the Supply Curve for Slaves is
When the Supply Curve for Elastic, Slave Redemption is less
Slaves is Perfectly Inelastic helpful

The effectiveness of the Slave Redemption

depends on the elasticity of supply!
Example: Will gun buyback programme be effective in
reducing guns on the street?

o The supply of guns to a local region is very elastic, so

o local buybacks don’t affect the number of guns on the
street (nor affect their price.)

The effectiveness of the gun buyback programme depeds

on the elasticity of supply!

What if we can
make it a national or
global buybacks?
Example: The SR and LR impact of an increase in demand
o A computer manufacturer makes an experimental computer chip that critics
praise, leading to a huge increase in the demand for the chip. How elastic
is supply in the short run? What about the long run? Graph both.
Example: The SR and LR impact of an increase in demand
Price

S (short run)

S (long run)
B

A C

D1
D0

Quantity of computer chips

Elasticity and Quick Predictions
P

S (inelastic)

S (elastic)
B

A C A given increase in demand will

have a lower impact on the
market price when the supply is
more elastic.

D1
D0

Q
Elasticity and Quick Predictions
P
S

B A given increase in demand will

have a lower impact on the
A market price when the demand is
more elastic.

D1(i)
D0(ii) D0(i)
D1(ii)
Q
Elasticity and Quick Predictions
o Two simple formulas allow for quick predictions of price
changes (using elasticities):

%  change ∈demand
% Δ 𝑃 ¿ a shift ∈ demand =
¿ 𝜂 𝑑 ∨+𝜂 𝑠

%  change ∈supply
% Δ 𝑃 ¿ a shift ∈ supply =−
¿𝜂 𝑑 ∨+𝜂 𝑠

Can verify the directions graphically. Do not worry about the mathematics.
Example: Why are the fares so different?
If you start in Kansas City and you fly to Honolulu round-trip, the fare is a lot
lower than if you start the same trip in Honolulu and fly to Kansas City round-
trip. Passengers travel on same planes, consuming the same fuel, the same in-
flight amenities, and so on. So why are the fares so different?
Example: Why are the fares so different?
• If you are starting in Kansas City and going to Honolulu, you are probably going on vacation.
You could go to lots of different places. You could go to Florida, to Barbados, to Cancun.
Because vacationers have many destinations to choose from, airlines must compete fiercely
for their business. Given economies of scale inherent in larger aircraft, carriers have a
strong incentive to fill additional seats by targeting lower prices to the people who are more
sensitive to price – vacationers.
• But if you are starting in Honolulu on a trip to Kansas City, you are probably not a
vacationer. More likely, you either have business or family reasons for traveling. So you
are probably not shopping for a destination if you are going to Kansas City.
• That is why the fares are so different.