Concept of Elasticity

Price Elasticity of Demand

Price Elasticity of Demand = The ratio
of the % changein the
quantity demanded of a product to a % change in its price OR

% increase
change inin its price demanded of a good resulting from a
quantity
1%
Price elasticity of demand can also be written as:

Ed =

where
∆Q / ∆P = Slope of Demand at point (P, Q)
Point elasticity of demand – Price elasticity at a particular
point on the demand curve.

Arc elasticity of demand = Price elasticity calculated over a range of

prices. Note: Ed value is negative for Normal Goods , since
quantity change is opposite of price change.
 Importance of ARC elasticity of demand

Consider 2 points on a demand curve:

Point 1 : P = 4 and Q = 20
Point 2: P = 10 and Q = 2
• Calculate Point Price Elasticity of Demand and Arc
Elasticity of Demand when change is from Point 1 to Point
2.
• Calculate Point Price Elasticity of Demand and Arc
Elasticity of Demand when change is from Point 2 to
Point 1.
(Own) Price Elasticity Ranges-- Normal and Giffen Goods
 Numerical Example
Yesterday, the price of envelopes was $3 a box, and I was willing to
buy 10 boxes. Today, the price has gone up to $3.75 a box, and I
am now willing to buy 8 boxes. Is my demand for envelopes
elastic or inelastic? What is my elasticity of demand? [Use point
elasticity formula]
Ans:
% Change in Quantity = (8 - 10)/(10) = -0.20 = -20%
% Change in Price = (3.75 - 3.00)/(3.00) = 0.25 = 25%
Elasticity = |(-20%)/(25%)| = |-0.8| = 0.8
The elasticity of demand is inelastic, since it between 0 and 1.

What would be the Own Price Elasticity of Demand on the Demand

Curve at different points?
 More on Own-Price Elasticity
• Price Elasticity of Demand not only depends on the slope of the
demand curve but also on the Price and Quantity.
• The elasticity, therefore, varies along the curve as price and
quantity Change. Slope is constant for linear demand curve.
• Near the top, because price is high and quantity is small, the
elasticity is large in magnitude, The elasticity becomes smaller as
we move down the curve.
 Practice Questions

• How would be the Demand Curves that are Perfectly

Elastic, Perfectly Inelastic and Unitary Elasticity?
• What about price elasticity of demand for two parallel demand
lines? Same or Different?
• How will a demand curve with unit elasticity at all points look
like?
 Unit Elasticity would imply that
at every point
% Change in Quantity = %
Change in Price

OR
At every point dQ * P = dP * Q

It is a
Rectangular
Hyperbola
Curve
 Cross Price Elasticity of Demand
Cross Price Elasticity of Demand = The rate of response of quantity
demanded of one good, due to a price change of another good.

• Point Formula
• Arc Formula
 Cross Price Elasticity of Demand (Examples)
Eg. Petrol Price and Demand for Petrol Cars =
Complements Apple Juice Price and Demand for Orange Juice =
Substitutes
Cross Price Elasticity of Demand… Analysis Diagrams
 Ranges for Cross Price Elasticity of Demand

Note--- There
are Shifts in
the Demand
Curve
 Price Elasticity of Supply
The responsiveness, or elasticity, of the quantity supplied of a good
or service to a change in its price or cost.
 Price Elasticity of Supply
Can PEoS be Negative? How does a Perfectly Elastic Supply
Curve and Perfectly Inelastic Supply Curve look like? Any
Examples?
 Elasticity of Supply- Example
Below are the supply schedules for natural rubber and man-made
rubber.

1. Calculate the price elasticity of supply for natural rubber and man-
made rubber. [Use Arc Elasticity of Supply Formula]
2. Comment on their values and suggest reasons why they differ.
Solution:
1. For Natural Rubber & Man-Made Rubber:
%Change in Price = (1.00-0.80)/[(1.00+0.80)/2] = 22.222%
For Natural Rubber:
% Change in Quantity = (1100-1000)/[(1100+1000)/2] = 9.524%
For Man-Made Rubber:
% Change in Quantity = (2800-2000)/[(2800+2000)/2] =
33.333%

Price Elasticity of Supply:

Natural Rubber = 9.524/22.222 = 0.4286
Man-Made Rubber = 33.333/22.222 = 1.5

2. Elasticity of Supply of Natural Rubber is < Elasticity of

Supply of Man-Made
Rubber
Natural Rubber is made from the extract of Rubber Tree while Man-made Rubber
uses raw material derived from Petroleum (which may be more easily
available)
 Income Elasticity
Income Elasticity = The measure of how responsive is the demand to
changes in income, when other factors are held constant.
Income Elasticity of a good of service is given by:

Point Formula-

Arc Formula-
 Elasticity at a Point for a Given Curve [Calculus]
In general, if Demand is given by a function: Q = D(p)
Notice that here the quantity demanded of the good is being written as a function
of the price.
The derivative of quantity demanded with respect to the good's price will be
written dQ/dP = D’(p).
Then the own-price elasticity of demand is given by:
  D’(p) * [p/D(p)]
(Eg. from Source: Petersen et. al., Managerial Economics)
The demand for handkerchiefs produced by a Daman manufacturer has been
estimated to be P = 30 – Q/200
a) Compute the point elasticity at P = Rs. 10 and P = Rs. 15
b) How does the point elasticity vary with increase in price from Rs. 10 to Rs.
15?
Ans. (a) Q = -200P + 6000 Therefore D’(P) = -200
At P = 10 Point elasticity = D’(P) * [P/D(P)] = (-200) * [10/ (-200 * 10 +6000)]
= -0.5 and at P = 15 Point Elasticity = -1
(b) As price rises the demand becomes more elastic.
 Continue..
Suppose Demand Function for a particular product X is given by
QX= a0 + a1PX + a2N + a3I + a4PY where
PX = Price of commodity X.
N = Number of Consumers in the Market.
I = Consumer Income.
PY = Prices of related commodities. (Complements or Substitutes)
Then, another Specific Version of Point Price Elasticity of Demand
Formula is defined in terms of the price slope coefficient
(a1 = ΔQ/ΔP) of the above linear demand equation.
Price Elasticity of Demand at a specific point (P1,Q1) = a1 * P1/Q1
Where a1 = above slope coefficient .
P1 = Price and Q1 = Quantity at P1
 Example Problem
(Source: Salvatore Dominick, Managerial Economics In a Global Economy, Seventh Edition)

Gary operates an automobile detailing business. An automobile

detailer restores a car to the level of cleanliness and perfection
that it had when it was new. His fastidious nature, attention to
detail, and ability to effectively manage employees have helped
to make his business profitable, but he believes that more
information about the market would allow him to operate more
efficiently. He uses regression analysis to estimate the demand
function for his business and gets the following result:
QX = 235 - 3PX + 40A - 20U + 8PW
The number of detailing jobs he gets per month (QX) depends on
the price he charges per job (PX), his monthly advertising
expenditures (A) measured in $1,000s, the regional percentage
unemployment rate (U), and the average price charged by local
car wash businesses (PW) for a standard wash and wax.
 Example Problem (Solution)
1. Is a wash and wax at the local car wash a complement
or a substitute for automobile detailing? How can you tell?
Ans. A wash and wax at the local car wash is a substitute
for
detailing.
When two goods are substitutes, the demand for one good
increases when the price of other good increases. In this case,
the slope coefficient associated with the variable PW (the price
of a wash and wax at the local car wash) is positive, which
means that the goods are substitutes.
2. Gary is currently charging $65 per detailing job and spending
$3,500 per month on advertising. The regional unemployment
rate is 7.5% and the average price of a wash and wax at a local
car wash is $15. How many detailing jobs per month can Gary
expect under these conditions?
Ans. QX = 235 - 3PX + 40A - 20U + 8PW
 Example Problem (Contd.)
3. Calculate the point price elasticity of demand under
current conditions. Is it elastic or inelastic?
Ans. EP= -3(65/150) = -1.3 which means Elastic demand

4. Assume that Gary increases his advertising expenditures to

$4,500 and raises his price to $70 and that all other conditions
remain unchanged. Calculate the point price elasticity of
demand.
Ans. QX = 235 - (3)(70) + (40)(4.5) - (20)(7.5) + (8)(15) = 175
EP = -3(70/175) = -1.2
 Elasticity and Tax Incidence
• The analysis, or manner, of how the burden of a tax is divided between
consumers and producers is called tax incidence.
• Since a tax can be viewed as raising the costs of production, this could
also be represented by a leftward shift of the supply curve, where the
new supply curve would intersect the demand at the new quantity Qt.
• An excise tax introduces a wedge between
the price paid by consumers (Pc) and the
price received by producers (Pp).
• When the demand is more elastic than
supply, the tax incidence on consumers Pc –
Pe is lower than the tax incidence on
producers Pe – Pp.
• Of the total price paid by consumers, part is
retained by the sellers and part is paid to the
government in the form of a tax.
• Here, the tax burden falls disproportionately on the sellers, and a larger
proportion of the tax revenue (the shaded area) is due to the resulting
lower price received by the sellers than by the resulting higher prices
paid by the buyers.
 Elasticity and Tax Incidence (Contd.)
b) When the supply is more elastic than demand, the tax incidence on
consumers Pc – Pe is larger than the tax incidence on producers Pe – Pp.
• When the demand is inelastic, consumers are
not very responsive to price changes, and the
quantity demanded remains relatively
constant when the tax is introduced.
• Eg. In the case of smoking, the demand is
inelastic because consumers are addicted to
the product.
• The government can then pass the tax
burden along to consumers in the form of
higher prices, without much of a decline in
the equilibrium quantity.
• Thus, if demand is more inelastic than supply, consumers bear
most of the tax burden, and if supply is more inelastic than
demand, sellers bear most of the tax burden.
• Note that in a market where both the demand and supply are very
elastic, the imposition of an excise tax generates low revenue.