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Elasticity Elasticity
Demand curves can come in different shapes
We know that quantity demanded
From very flat to very steep depends on many things
Very flat demand curve: a small change in So we can ask a more general question?
price has a large effect on quantity
How sensitive is demand to change in any
demanded
of the relevant factors:
Very steep curve: even a large change in
- Own price
price does not affect quantity demanded too
much - Income
Question: how sensitive is quantity - Related prices
demanded to price changes? - Etc.

Elasticities
Two situations:
Consider the market demand for a commodity, q
Situation 1 2
Let it depend on a factor y (which might be its own
price, or the price of a related good, or income). Quantity q1 q2

Then the elasticity of demand for q with respect to Y y1 y2

y is defined as:

the percentage change in q that results from Let q = q2 q1

a 1% change in y. y = y2 y1
It is the percentage change in q divided by the
percentage change in y.

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Since percentage changes are pure numbers, the

elasticity measure will always be a unit-free pure
number.
Elasticity of q with respect to y
q y
=[ ----x100] divided by [----x100]
q y
Therefore elasticity of quantity demanded
can be with respect to:
- own price (price-elasticity of
demand)
- any other price (cross price-
elasticity)

q y - income (income elasticity)

= ----x----
We will spend some time on the concept of
y q the price-elasticity of demand

Price Elasticity of Demand Calculation of elasticity

For downward sloping curves, prices and quantities Situation 1 Situation 2

move in opposite directions, so that the elasticity p1 = Rs.10 p2 = Rs.9.00
value is negative. q1 = 100 q2 = 105
To avoid this problem, we consider the absolute
Consider finite changes in prices and quantity:
value of the elasticity.

q p e = - [q/p]x[p/q],
e = - ----x---- = - (p/q)x(q/p).
p q q = q2 - q1 = 5

p = p2 - p1 = -1

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1. Point-elasticity measures. 2. Arc-elasticity measure.

e = - [q/p]x[p1/q1] To get rid of this ambiguity, take an average of
= -(-5)x(10/100) = 5/10 = .5 the values:

e = - [q/p]x[p2/q2] q [(p2 + p1)/2]

= -(-5)x(9/105) = 9/21 = 3/7 e = - ---------------------------
= .42 p [(q2 + q1)/2]

small changes in price -> not much = - [q/p][(p2 + p1)/(q2 + q1)]

difference between these two.
For larger changes, the differences
become substantial. = 5(19/205) = .46.

Price Elasticity Regions along

a Straight-Line Demand Curve
Observation
Price elasticity varies at
every point along a straight-
line demand curve
If the percentage change in q > the
percentage change in p, then e > 1, and
we have elastic demand.

a 1 If the percentage change in q = the

1 percentage change in p, e = 1 and we say
that demand is unit elastic.
Price

a/2 1
If the percentage change in q < the
percentage change in p, so that e < 1,
b/2 b demand is said to be inelastic.
Quantity

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Elasticities Three special cases

If (inverse) demand curve is a horizontal straight
In general, the price elasticity of demand line parallel to the quantity axis, then the price-
will be different at different points of the elasticity measure goes to infinity.
demand curve. - demand is perfectly elastic.

If the (inverse) demand curve is a vertical straight

There are three special cases where the
line, then e = 0 and demand is said to be
price elasticity is the same at all points of perfectly inelastic.
the demand curve.
An example of a demand curve that is iso-elastic
(has the same elasticity everywhere) is q = p-a.

Perfectly Elastic Demand Curve Perfectly Inelastic Demand Curve

P P
D

D D
Basic needs, minimum
requirements, absolute
necessities.

0 Q 0 D Q

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Range of Price Elasticities

Unit elastic
Inelastic Elastic

0 1 2 3 4 5 6

Unit elastic: own price elasticity equal to 1

Inelastic: own price elasticity less than 1
Elastic: own price elasticity greater than 1

Factors affecting price elasticity:

Range of elasticities
1. Availability of substitutes
Larger the availability of close substitutes, the more
elastic will demand be.

0_______________1________________+ 2. Time period: Product durability

Durable goods tend to be more price-elastic in the
Perfectly Unit Perfectly short run:
Inelastic Elasticity Elastic suppose price of TVs goes up by some
Demand Demand amount (say 5%)
purchase of TVs drops (say by 10%): e = 2
over time as TVs become old, people again
buy TVs in the longer run TV purchases go down
by 8% (say) => e = 1.6

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Factors affecting price elasticity: Some elasticity values

Salt 0.1
Matches 0.1
3. Time period: Adjustment Airline travel, short-run 0.1
Larger the time period, the higher the elasticity of Petrol, short-run 0.2
demand. Tobacco products, short-run 0.45
Suppose petrol prices go up Residential natural gas, long-run 0.5
Short run demand falls somewhat because Physician services 0.6
motorists drive less Movies 0.9
In the long run, people switch to smaller, Housing, owner occupied, long-run 1.2
more fuel-efficient cars quantity demanded of Restaurant meals 2.3
petrol goes down by a larger amount Airline travel, long-run 2.4

Relationship between elasticity and total

Elasticity and Total Revenue revenue
TR = pq
Will increasing the market price increase total
revenue? dTR = d(pq) = pdq + qdp
= qdp(1 e)
Will lowering the market price increase total
revenue? Consider what happens if price is lowered, so that
dp < 0.
These are important questions of pricing for
every firm dTR > 0 if 1 e < 0, i.e. e > 1

dTR = 0 if 1 = e

dTR < 0 if e < 1

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Elasticity Elasticity
Price () Price ()
Producer decides to lower price to attract sales Producer decides to reduce price to increase sales
% in Price = - 30%
10 % Price = -50%
% in Demand = + 300%
% Quantity Demanded = +20% e = 10 (Elastic)
e = 0.4 (Inelastic) Total Revenue rises
10
5 Total Revenue would fall Good Move!
Not a good move! 7
D

D
5 6
Quantity Demanded 5 Quantity Demanded 20

Elasticity Income-elasticity of Demand

If demand is price If demand is price em = (q/M)(M/q)
elastic: inelastic:
Increasing price Increasing price
would reduce TR would increase TR In the case of a normal good, em > 0, while
(% Qd > % P) (% Qd < % P) for an inferior good, it is < 0.
Reducing price would Reducing price would
increase TR reduce TR (% Qd <
(% Qd > % P) % P) If 0 < em < 1, then the good is called a
necessity, otherwise it is a luxury.

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Cross-price Elasticity of Demand Application - farming

The cross-price elasticity of the
commodity x with respect to the price p of
y is defined as
exy = (x/p)(p/x)
If this is positive, x and y are said to be
substitutes (Coke and Pepsi), while if this is
negative, the commodities are said to be
complements (tea and sugar).
Suppose that university agronomists
discover a new wheat hybrid that is more
productive than existing varieties.
What happens to wheat farmers?
The discovery of the new wheat hybrid
affects the supply curve it shifts to the
right.
The demand curve remains the same

Application - farming Application - farming

What happens to the total revenue received by
Price of wheat
D S the farmers?
S Q rises but P falls
The demand for basic foodstuffs such as wheat
is usually inelastic, for these items are relatively
inexpensive and have few good substitutes
Hence fall in P is substantial while rise in Q is
S S small
D
Revenue to all wheat farmers taken together
Quantity of wheat
falls

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Application - farming
If farmers are made worse off by the
discovery of the new hybrid, why do they
adopt it?
Each farmer is a small part of the market
For any price, it makes sense for each
farmer to adopt the hybrid
But when they all do it, the supply curve
shifts and together, they are worse off
Application - farming
Certain agricultural programs try to help
farmers by inducing them not to plant crops
on all their land
The purpose is to reduce the supply of farm
products and thereby raise prices
With inelastic demand, farmers as a whole
receive greater revenue
No single farmer, by himself, would have
found it profitable to leave some land fallow
7/6/2017
Application - farming
Certain agricultural programs try to help
farmers by inducing them not to plant crops
on all their land
The purpose is to reduce the supply of farm
products and thereby raise prices
With inelastic demand, farmers as a whole
receive greater revenue
No single farmer, by himself, would have
found it profitable to leave some land fallow
Price Support
Another way for the government to help the
farmers is by having a support price, at which
price the government stands prepared to buy any
amount supplied by the farmers
Over time, this may lead to the growth of buffer
stocks
Will perish if just stockpiled
Some can be used for employment generation
programmes, or meeting food requirements in a
lean year
What to do with the rest?
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Wheat export allowed to free storage space
3 July 2012
Faced with a severe space constraint in the
countrys overflowing granaries, the government
today cleared export of two million tons of wheat
from its buffer stock that is expected to clear
storage space for new crops.
This was approved by the Cabinet Committee on
Economic Affairs. Informed sources said after the
CCEA meeting that export would happen with a
floor price of $228 (about Rs 12,400) per ton.
TAXES
Governments levy taxes to raise revenue
for public projects, to pay for wages and
salaries in the public sector, to pay interest
on debt, etc..
7/6/2017
At present, the government is grappling with
the problem of storage capacity.
India, the worlds second-largest producer of
wheat, had harvested a record 90.23 million
tons in 2011-12 crop year (July-June),
leading to a record procurement of nearly 38
million tons so far this year.
Its godowns are overflowing with a record 82
million tons of rice and wheat against the
storing capacity of only 64 million tons.
The export of two million tons would involve
an outgo of Rs 1,263 crore.
Taxes
A specific tax is a fixed rupee amount
that must be paid on each unit bought or
paid
An ad valorem tax is a tax that is stated
as a percentage of the goods price
The incidence of a tax indicates how
much of the tax burden is borne by
various market participants
15-40
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Taxes The Burden of a Tax

Consider the effect of a specific tax of T
In studying the effects of taxes its rupees per liter paid by gas stations on
important to distinguish between the their sales of gasoline
amount a consumer pays for a good and Graphically, there are three ways to
the amount a firm receives determine the taxs effect:
Use Pb for the amount a consumer pays, Shift the supply curve up by T
Ps for the amount a firm receives Shift the demand curve down by T
If the tax is T per unit, then Ps = Pb - T Use a wedge between the amounts
consumers pay and firms receive
All three methods yield the same results
Makes no difference whether the tax is
levied on consumers or producers 15-42

Effects of a Specific Tax Shifting the

Effects of a Specific Tax Supply Curve
Shifting the supply curve is one way to
determine a specific taxs effects ST
Price Paid by Consumers ($/gallon)

Increase in S
Demand curve remains unchanged Consumer
Cost per Po + T
B
For any price paid by consumers, firms Gallon Pb T

now receive less than when there is no Po A

tax Ps = Pb - T

Wont be willing to supply as much as Decrease in

Firms
before Receipts per
Gallon D

Supply curve with the tax is a distance QT Qo

T above the original supply curve Gallons of Gas per Month

15-43 15-44

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Effects of a Specific Tax
New equilibrium price paid by
consumers is price at which the
demand curve and new supply curve
cross
Amount bought and sold falls
Price paid by consumers rises;
price received by firms falls
In a competitive market the burden of
a tax is shared by consumers and
firms
Incidence of a Specific Tax Two
Special Cases
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Tax Incidence
Incidence of a tax depends on the shapes of
the demand and supply curves
In general, the more elastic is demand and
less elastic is supply, the more of the tax is
borne by firms
Firms cannot pass on the tax to the
consumers because the latter are sensitive to
price changes
Consumers bear the larger share of the tax
when demand is less elastic than supply
15-46
Effects of a Specific Tax Shifting the
Demand Curve
15-48
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