CONCEPT OF ELASTICITY

AND ITS APPLICATION

Lecturer: Eric Ekobor-Ackah Mochiah

1
 Introduction
• So we know the laws of demand and supply respectively.
What we don’t know is the rate of the quantity increase or
decreases.

• By how much will quantity increase or decrease if price

increases or decreases by one percent???

• Elasticity is the concept economists use to describe the

steepness or flatness of curves or functions.

• Elasticity is a pure ratio independent of units.

• Under elasticity of demand, we will analyze three types which

include price elasticity, cross-price elasticity and income
elasticity. 2
 Own Price Elasticity of Demand
• Price elasticity of demand is measured as the percentage
change in the quantity demanded relative to a percentage
change in its own price.
%Q Q / Q Q P
ED     Point elasticity of demand
%P P / P P Q
Q P1  P2
ED   Arc elasticity of demand
P Q1  Q2
• For a smooth (differentiable) demand curve, the price
elasticity of demand is given by
Q P
ED  
P Q
3
 Classifications Of P.E.D
Perfectly Elastic Demand: Elasticity Equals Infinity
Price

1. At any price
above $4, quantity
demanded is zero.
$4 Demand

2. At exactly $4,
consumers will
buy any quantity.

0 Quantity
3. At a price below $4,
quantity demanded is infinite.

4
 Classifications Of P.E.D
Elastic Demand: Elasticity Is Greater Than 1
Price

$5

4 Demand
1. A 22%
increase
in price . . .

0 50 100 Quantity

2. . . . leads to a 67% decrease in quantity demanded.

5
 Classifications Of P.E.D
Unit Elastic Demand: Elasticity Equals 1
Price

$5

4
1. A 22% Demand
increase
in price . . .

0 80 100 Quantity

2. . . . leads to a 22% decrease in quantity demanded.

6
 Classifications Of P.E.D
Inelastic Demand: Elasticity Is Less Than 1

Price

$5

4
1. A 22% Demand
increase
in price . . .

0 90 100 Quantity

2. . . . leads to an 11% decrease in quantity demanded.

7
 Classifications Of P.E.D
Perfectly Inelastic Demand: Elasticity Equals 0

Price
Demand

$5

4
1. An
increase
in price . . .

0 100 Quantity

2. . . . leaves the quantity demanded unchanged.

8
 Size Of Price Elasticity
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
 Points To Note
• Elasticity changes along straight-line curves

• Elasticity is not the same as slope.

• Elasticity changes along straight line supply and

demand curves–slope does not.

10
 Elasticity Along A Demand Curve
Ed = ∞
Elasticity declines along demand
$10 curve as we move toward the
9 quantity axis
8 Ed > 1
7
6
Price

Ed = 1
5
4
3 Ed < 1
2
1 Ed = 0
0 1 2 3 4 5 6 7 8 9 10 Quantity

11
 Determinants of P.E.D
FACTORS DEGREE OF ELASTICITY
LESS ELASTIC (INELASTIC) MORE ELASTIC
Number of Fewer substitutes More substitutes
substitutes
Nature of good Necessity Luxury
Time period Short-run Long-run
Price/income ratio Small part of budget Large part of budget

Habit formation Attached to a product Categories of product

(specific brands)

Number of uses Limited use Several uses

12
 Cross-price Elasticity Of Demand
• Since firms often produce an entire line of products, it has a
special interest in how a change in the price of one product
will affect the demand for another

• It is defined as the percent change in the demand of one good

divided by the percent change in the price of another good

• The cross elasticity of demand is:

Qb/Qb Pm Qb
E QbPm  
Pm/Pm Qb Pm
13
 Classification Of Cross-price
Elasticity Of Demand
• Classification:
– If (Edyx > 0): implies that as the price of good X increases, the
quantity demanded of Good Y also increases. Thus, Y and X are
substitutes in consumption.

– If (Edyx < 0): implies that as the price of good X increases, the
quantity demanded of Good Y decreases. Thus Y & X are
Complements in consumption.

– If (Edyx = 0): implies that the price of good X has no effect on

quantity demanded of Good Y. Thus, Y & X are Independent in
consumption.

14
 Income Elasticity Of Demand
• Income elasticity of demand measures the percentage
change in quantity demanded resulting from a one percent
change in income.

• It is the amount by which the quantity demanded changes in

response to a one-percent change in income

• Mathematically, the income elasticity of demand is :

Q/Q I Q
EI  
I/I Q I
15
Income Elasticity Of Demand (E )
I
Classification
• Classification:
– If EI > 0, then the good is considered a normal good.

– If EI < 0, then the good is considered an inferior good

– High income elasticity of demand exist for luxury goods

(elasticity >1)

– Low income elasticity of demand exist for necessities

(0<income elasticity<1 )

16
 Price Elasticity of Supply
• The price elasticity of supply determines whether the
supply curve is steep or flat.

• It measures the percentage change in the quantity

supplied that will occur in response to a one-percent
change in its price

%QS QS / QS QS P

ES     Point elasticity of supply
%P P / P P QS
QS P1  P2
ES   Arc elasticity of supply
P QS 1  QS 2
17
 The Price Elasticity Of Supply
Perfectly Elastic Supply: Elasticity Equals Infinity
Price

1. At any price
above $4, quantity
supplied is infinite.

$4 Supply

2. At exactly $4,
producers will
supply any quantity.

0 Quantity
3. At a price below $4,
quantity supplied is zero.
18
 The Price Elasticity of Supply
Elastic Supply: Elasticity Is Greater Than 1
Price

Supply

$5

4
1. A 22%
increase
in price . . .

0 100 200 Quantity

2. . . . leads to a 67% increase in quantity supplied.

19
 The Price Elasticity Of Supply
Unit Elastic Supply: Elasticity Equals 1
Price

Supply
$5

4 (If SUPPLY is unit elastic

and linear, it will begin at
1. A 22%
increase
the origin.)
in price . . .

0 100 125 Quantity

2. . . . leads to a 22% increase in quantity supplied.

20
 The Price Elasticity of Supply
Inelastic Supply: Elasticity Is Less Than 1
Price

Supply
$5

4
1. A 22%
increase
in price . . .

0 100 110 Quantity

2. . . . leads to a 10% increase in quantity supplied.

21
 The Price Elasticity of Supply
Perfectly Inelastic Supply: Elasticity Equals 0

Price
Supply

$5

4
1. An
increase
in price . . .

0 100 Quantity

2. . . . leaves the quantity supplied unchanged.

22
How The Price Elasticity Of Supply
Can Vary

Price
Elasticity is small Supply
(less than 1).
$15

12 1. an
Elasticity is large
(greater than 1).

4
3
0 Quantity
100 200 500
525

23
 Determinants Of Elasticity Of Supply
FACTORS DEGREE OF ELASTICITY
LESS ELASTIC (INELASTIC) MORE ELASTIC
Storage Cannot be stored Can be stored
possibilities
Substitution cost Not easily shifted from Easily shifted from
one product to another one product to
another
Time period Short run Long run
Spare capacity Limited capacity Excess capacity
Inventory Limited raw materials Availability of raw
materials
Production costs High cost Low cost
24
 APPLICATION OF ELASTICITY
Application 1: Managerial Decisions And
Elasticity
• You are a supermarket manager and you want to offer a
10% price cut in shirts. You want to know how much more
shirts you need to have to satisfy your clients.

• Managers would have to analyze whether an increase in

price will be prudent in helping increase the total revenue of
the firm.

• This decision by management ought to be done with respect

to the type of elasticity of demand for the good or service.

• When studying this phenomenon, one variable firms often

want to study is total revenue. 25
 Price Elasticity and Total Revenue
Elastic demand increased
Demand for
(elasticity = 1.8) P revenue due
your websiteslost
to higher P
revenue
If P = $200,
due to
Q = 12 and revenue $250 lower Q
= $2400.
$200
If P = $250, D
Q = 8 and
revenue = $2000.
When D is elastic, Q
8 12
a price increase
causes revenue to fall.
26
 Price Elasticity and Total Revenue
Now, demand is
increased
Demand for
inelastic:
revenue
yourdue
websites
elasticity = 0.82 P to higher P lost
If P = $200, revenue
due to
Q = 12 and revenue
$250 lower Q
= $2400.
$200
If P = $250,
Q = 10 and D
revenue = $2500.
When D is inelastic, Q
10 12
a price increase
causes revenue to rise.
27
Total Revenue Along a Demand Curve

28
Total Revenue and ED

Price Inelastic Demand Price Elastic Demand

| ED | < 1 | ED| > 1

P P

Q Q

TR TR
29
 Application 2: Advertising
• The market share of the firm is improved
with a successful advertising technique
because consumers’ sensitivity are largely
weakened. Response to price increases will
be less, hence firms can make more profits.

D D
30
Application 3: Price Discrimination
• Different customers are charged different prices for
the same product, due to differences in price elasticity
of demand

• Higher prices should be charged for customers with

the inelastic demand whiles lower prices should be
charged for customers with a more elastic demand.

• Customers who are willing to pay the highest prices

are charged a high price, and customers who are more
sensitive to price differentials are charged a low price.

31
Application 4: P.E.D And The Farmers’
Dilemma
• Can good harvest season be bad news for farmers?

• Price elasticity gives us the answer:

– Bad crop year: supply decreases, prices for farm products
rise, but quantity demanded doesn’t fall very much. The
quantity demanded of farm products is not very
responsive to changes in prices.

– Good crop year: supply increases, prices for farm products

fall, but quantity demanded doesn’t increase very much.
The quantity demanded of farm products is not very
responsive to changes in prices

32
An Increase in Supply in the Market for
Wheat
Price of
Wheat 1. When demand is inelastic,
2. . . . leads an increase in supply . . .
to a large fall S1
in price . . . S2

$3

Demand

0 100 110 Quantity of

Wheat
3. . . . and a proportionately smaller
increase in quantity sold. As a result,
revenue falls from $300 to $220.
33
Copyright©2003 Southwestern/Thomson Learning
 Application 5: Elasticity And OPEC
• Organization Of Petroleum Exporting Countries (OPEC)
basically is an organization for countries who produce and sell
oil.

• The oil market has always been a major controversy for world
economies over several decades.
– Normally, the amount of barrels of oil produced may be
manipulated to impact on the price level especially in the short-
run.

• Supply is inelastic because the quantity of known oil reserves

and the capacity for oil extraction cannot be changed quickly.

• Demand is also inelastic because buying habits do not

respond immediately to changes in price. 34
 A Reduction In Supply In The World
Market For Oil
(a) The Oil Market in the Short Run (b) The Oil Market in the Long Run
Price 1. In the short run, when supply and demand Price
are inelastic, a shift in supply. . . 1. In the long run, when supply and demand
are elastic, a shift in supply. . .
S2
S1 S2 S1
P2

2. … leads to a
1. an large increase P2 1. an
P1 in price P1

2. … leads to a
Demand small increase Demand
in price

0 Quantity 0 Quantity
When the supply of oil falls, the response depends on the time horizon. In the short run,
supply and demand are relatively inelastic, as in panel (a). Thus, when the supply curve
shifts from S1 to S2, the price rises substantially. By contrast, in the long run, supply and
demand are relatively elastic, as in panel (b). In this case, the same size shift in the supply
curve (S1 to S2) causes a smaller increase in the price. 35
 Application 6: P.E.D And Government
Decisions On Taxation
• One way in which governments increases its revenue base is
through taxes.

• An indirect tax is a hidden tax. It is not a like direct tax which

is charged on top of the total of your purchases.

• When governments impose taxes to maximize tax revenue,

they have to consider the elasticity of demand of the industry
that is being taxed.

• A tax imposition in the market primarily falls on the producer.

– Who bears the burden of the tax? The consumer or the
producer?

36
 The Burden of Taxation

A tax paid by the supplier shifts P S1

the supply curve up by the
amount of the tax (=t)
S0
Both producer and P1 t
consumer surplus decrease
P0
P1-t
Positive government revenue

D
Deadweight loss exists Q
Q1 Q0

37
 The Burden of Taxation
Demand is relatively elastic Demand is relatively inelastic
P P Consumers
pay more
Producers S1 S1
pay more
S0 S0
t P1 t
P1
P0
P0
P1-t
P1-t
D

D
Q1 Q0 Q Q1 Q0
Q

38
 Taxes and Consumer and Producer Surplus
Tax revenue: A + C
Loss of consumer surplus: A+B
Deadweight loss: B +F
Loss of producer surplus: C+F S’

100

K S
85

A B
60
F
C
30
L

10 D

Q
0 100 270
39
 What Goods Should Be Taxed?
Goal of Government Most effective when
Raise revenue, limit deadweight
Demand or supply is inelastic
loss
Change behavior Demand or supply is elastic
Elasticity Who bears the burden?
Demand inelastic and supply Consumers
elastic
Supply inelastic and demand Producers
elastic
Both supply and demand elastic Shared, but the group whose S
or D is more inelastic pays more
40
Application 7: P.E.D And Illicit Drug Use
• Governments may formulate various policies or even increase
the personnel involved in the fight against illicit drugs.

• However, whether the fight may be won by government or

not depends on the elasticity of demand for the drug.
– Normally, these drugs are inelastic.

• Suppose the government increases the number of federal

agents devoted to the war on drugs.
– What happens in the market for illegal drugs?

– Will this policy have any positive influence on the crime rate, for
example in the economy?

41
 Cont…
• When the government stops some drugs from entering
the country and arrests more smugglers,
– It raises the cost of selling drugs and, therefore, reduces
the quantity of drugs supplied at any given price.

– The direct impact is consequently on the sellers of drugs

rather than the buyers.

42
 Policies To Reduce The Use Of Illegal
Drugs
(a) Drug banning (b) Drug Education
1. Drug interdiction reduces
Price the supply of drugs. . . Price 1. Drug education reduces
the demand for drugs . . .
2. … which S2 2. . . . which
raises the S1 reduces the
price . . . price . . .
Supply
P2
1. an P1 1. an
3. … and P2
P1 reduces the
quantity sold

3. … and reduces
Demand D2 D1
the quantity sold

0 Q2 Q1 Quantity 0 Q2 Q1 Quantity
Drug prohibition reduces the supply of drugs from S 1 to S2, as in panel (a). If the demand
for drugs is inelastic, then the total amount paid by drug users rises, even as the amount
of drug use falls. By contrast, drug education reduces the demand for drugs from D 1 to
43
D2, as in panel (b). Because both price and quantity fall, the amount paid by users falls