Elasticity and Its applications

What is elasticity ?
• Elasticity is a general concept that can be used
to quantify the response in one variable when
another variable changes.

• Elasticity of Y with respect to X can be stated

as follow:
%∆𝑌
=
%∆𝑋
 The Elasticity of Demand
• Price elasticity of demand is a measure of
how much the quantity demanded of a good
responds to a change in the price of that
good.

• It is the ratio of the percentage change in

quantity demanded to the percentage change
in price; or:
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
𝑝𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
 Computing the elasticity of demand
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
• 𝑝𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒

• Its value is always negative (why ?), but stated in absolute terms.

• Example: If the price of an apple increases from Rp2.00 to Rp2.20

and the amount of apple demanded falls from 10 to 8 kg, then the
elasticity of demand (𝜀) would be calculated as:

(8 − 10)
× 100% −20%
𝜀= 10 = = −2 = −2 = 2
(2.2 − 2.0) 10%
× 100%
2
 A better method of calculation: the
Midpoint Method
• The midpoint formula is preferable when calculating the price elasticity of
demand because it gives the same answer regardless of the direction of
the change.

𝑄2 − 𝑄1
𝑄2 + 𝑄1 /2
𝜀=
𝑃2 − 𝑃1
𝑃2 + 𝑃1 /2

• From the above example, the price elasticity of demand is:

8 − 10
8 + 10 /2 22%
𝜀= = = 2.32
2.2 − 2.0 9.5%
2.2 + 2.0 /2
 How to interpret the value of the
elasticity of demand ?
• When ε = 0.2
A 10% increase in price leads to a 2% decrease in
quantity demanded; or:
A 1% increase in price lead to a 0.2% decrease in
quantity demanded.

• When ε = 2.0
A 10% increase in price leads to a 20% decrease in
quantity demanded; or:
A 1% increse in price lead to a 2% decrease in quantity
demanded.
 The Degree of Demand Elasticity
• Inelastic Demand:
– Price elasticity of demand is less than one.
– Quantity demanded does not respond strongly to
price changes.

• Elastic Demand:
– Price elasticity of demand is greater than one.
– Quantity demanded responds strongly to changes
in price.
 The Degree of Demand Elasticity
• Perfectly Inelastic
– Quantity demanded does not respond to price
changes.
• Perfectly Elastic
– Quantity demanded changes infinitely with any
change in price.
• Unit Elastic
– Quantity demanded changes by the same
percentage as the price.
The characteristics of demand curve

The more horizontal, the more elastic.

The more vertical, the more inelastic.
 The characteristics of demand curve

Horizontal demand curve Vertical demand curve

Determinants of demand elasticity
• Availability of substitutes -- demand is more elastic
when there are more substitutes for the product.

• Importance of the item in the budget -- demand is

more elastic when the item is a more significant
portion of the consumer’s budget.
– How does the degree of elasticity of staple goods (such as
rice) and luxury goods (such as cars)?.

• Time frame -- demand becomes more elastic over

time.
 Total Revenue and the Price Elasticity
of Demand

• Total revenue (TR) is the amount paid by

buyers and received by sellers of a good.
• Computed as the price of the good (P) times
the quantity sold (Q), as follows:

TR = P x Q
 Figure: Total Revenue
Price

Rp4

P × Q = Rp400
P (revenue) Demand

0 100 Quantity

Q
 Pricing policy in the case of inelastic
demand
Price Price

Rp3

Revenue = Rp240
Rp1
Revenue = Rp100 Demand Demand

0 100 Quantity Quantity

80

In the case of inelastic demand, a rise in prices led to an increase in total revenue.
What do you think if the price is lowered ?.
 Pricing policy in the case of inelastic
demand
Price Price

Rp5

Rp4

Demand
Demand

Revenue = Rp200 Revenue = Rp100

0 50 Quantity 0 20 Quantity

In the case of elastic demand, a rise in prices led to a decrease in total revenue.
What do you think if the price is lowered ?.
 Cross-price elasticity of demand
• Cross-price elasticity of demand: A measure
of the response of the quantity of one good
demanded to a change in the price of another
good.

% change in quantity of Y demanded

cross- price elasticity of demand 
% change in price of X
 Income Elasticity of Demand
• Income elasticity of demand measures how
much the quantity demanded of a good
responds to a change in consumers’ income.

% change in quantity demanded

income elasticity of demand 
% change in income
 Income Elasticity of Demand
• Types of Goods: normal goods and inferior goods.
– Higher income raises the quantity demanded for
normal goods but lowers the quantity demanded for
inferior goods.
• Goods consumers regard as necessities tend to be
income inelastic
– Examples include food, fuel, clothing, utilities, and
medical services.
• Goods consumers regard as luxuries tend to be
income elastic.
– Examples include sports cars, and expensive foods.
 The Price Elasticity of Supply
• Price elasticity of supply is a measure of how
much the quantity supplied of a good
responds to a change in the price of that
good.

% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑

Price elasticity of supply =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
 Determinants of Elasticity of Supply
• Ability of sellers to change the amount of the
good they produce.
– Beach-front land is inelastic.
– Books, cars, or manufactured goods are elastic.

• Time period.
– Supply is more elastic in the long run.
 The Characteristics of the Elasticity
of Supply
Value of Type of Supply Magnitudes of Response to Inclination
Elasticity Change Price Changes
>1 Elastic %Qs > %P Responsive Relatively Flat

<1 Inelastic %Qs < %P Less responsive Relatively

Steep
=1 Unit elastic %Qs = %P Proportional Inclination of
45 degrees.
=o Perfectly %P > 0 No respond Vertical/steep
inelastic %Qs = 0
=∞ Perfectly %P = 0 Very responsive Horizontal/flat
elastic %Qs > 0

Homework: Show with graphs of all the supply curve !

 Application
• What happens to rice farmers and the market for
rice when university agronomists discover a new
rice hybrid that is more productive than existing
varieties?.

1) Examine whether the supply or demand curve shifts.

2) Determine the direction of the shift of the curve.
3) Use the supply-and-demand diagram to see how the
market equilibrium changes.
4) Can good news for farming be bad news for
farmers?.
 The impact of the discovery of a new rice hybrid
Price of rice
1. When demand is inelastic,
an increase in supply ....

S1
S2

Rp3
2....leads to a large
fall in price.... 4. .... As a result, revenue
Rp2 falls from Rp300 to Rp220.

Demand

0 100 110 Quantity of rice

3. ... and a proportionately smaller

increase in quantity sold.