Elasticity

Week 3: Elasticity Concept
Dr. Junaid Ahmed

Learning Objectives
1. Define the price elasticity of demand and understand how to

calculate it.
2. Understand the determinants of the price elasticity of demand.
3. Understand the relationship between the price elasticity of
demand and total revenue.
4. Define the cross-price elasticity of demand and the income
elasticity of demand, and understand their determinants and
how they are calculated.
5. Use price elasticity and income elasticity to analyze economic
issues.
6. Define the elasticity of supply, and understand its main
determinants and how it is calculated.
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
• The law of demand tells us that consumers will respond
to a decline in a product’s price by buying more of that
product.
• But how much more of it will they purchase?
• That amount can vary considerably by product and over

different price ranges for the same product.
Sensitivity of Quantity Demanded to
Price
• Elasticity – the percentage change in a variable in
response to a given percentage change in another
variable.
• Price elasticity of demand (e) – the percentage
change in the quantity demanded in response to a
given percentage change in the price, at a particular
point on the demand curve.
• Loosely speaking, it measures the price-sensitivity of
buyers’ demand.
Price Elasticity of Demand
• Formally,
Q
%Q Q Q p
  
%p p p Q
p
– where D indicates a change.
• Example
– If a 1% increase in price results in a 3% decrease in
the quantity demanded, the elasticity of demand is
3%
e  3.
1%
Price Elasticity of Demand
• Along a linear demand curve with a function of:
Q  a  bp
– Where −b is the ratio of the fall in quantity to the rise in
price:
Q
b 
p
– the elasticity of demand is
Q p p
  b
p Q Q
Problem 1
• The estimated demand curve for the U.S. corn is:
Q  15.6  0.5 p
– where Q is the quantity demanded in billion bushels
per year and p is the price in dollars per bushel.
– What is the elasticity of demand at the point on the
demand curve where the price is p = $7.20 per bushel?
Answer
• Substitute the slope coefficient b, the price,
and the quantity values into Equation 3.4.
• The slope coefficient for this demand equation
is b = 0.5 (and a = 15.6). Substituting b = 0.5,
p = $7.20, and Q = 12 into Equation 3.4, we
find that the elasticity of demand at this point
on the demand curve is:
p 7.20
  b  0.5   0.3
Q 12
What determines price elasticity of
demand?
Determinants of price elasticity of demand:
1. Availability of close substitutes.
2. Necessities versus luxuries
3. Definition of the market
4. Share of expenditure on the good in the
consumer’s budget.
5. The length of time involved
The price elasticity of demand for breakfast cereal
 What happens
when the price of
cereal rises?
 Changes in the
quantity demanded
for particular brands
versus changes in
the quantity
demanded for the
market as a whole.
Elasticity Along the Demand Curve
• The elasticity of demand varies along most demand

curves.
– The elasticity of demand is different at every point
along a downward-sloping linear demand curve.
– the elasticities are constant along horizontal and
vertical linear demand curves.
Figure 2 Elasticity Along the Corn Demand Curve
LINEAR DEMAND CURVE
• The price elasticity of demand depends

not only 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 this 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.
• With a linear demand curve, the higher

• The price, the more elastic the
• demand curve
Horizontal Demand Curve
• Along a horizontal demand curve, elasticity
is infinite – perfectly elastic demand.
– People are willing to buy as much as firms
sell at any price less than or equal to p * .
– If the price increases even slightly above p*,
demand falls to zero.
– A small increase in price causes an infinite drop in
quantity demanded.
Vertical Demand Curve
• Along a vertical demand curve, elasticity is zero –
perfectly inelastic demand.
– If the price goes up, the quantity demanded is
unchanged.
– A demand curve is vertical for essential goods: goods
that people feel they must have and will pay anything
to get.
Figure 3 Vertical and Horizontal Demand Curves
Demand Elasticity and Revenue
• Any shock that changes the equilibrium price to
change will affect the industry’s revenue.
• Whether the revenue rises or falls when the
equilibrium price increases depends on the elasticity
of demand.
– With elastic demand, a higher price reduces revenue.
– With inelastic demand, a higher price increases
revenue.
Figure 4(a) Effect of a Price Change on Revenue
Figure 4(b) Effect of a Price Change on Revenue
Problem 2
• Does a price increase cause revenue to rise or fall if
the demand curve is elastic at the initial price? How
does revenue change if the demand curve is
inelastic?
Problem 2: Answer
1. Show that if the demand curve is elastic at the initial
price, then area C is relatively small.
2. Consider the extreme case where the demand curve
is perfectly inelastic and then generalize to the
inelastic case.
Solved Problem 3.2: Answer
Application: Amazon Prime
Demand Elasticities Over Time
• Demand elasticities may be different in the short-run
and the long-run.
• The difference depends on substitution and storage
opportunities.
• For most goods elasticities tend to be larger in the
long-run.
• For easily storable or durable goods, the reverse is
true.
Income Elasticity
• Formally,
Q
%Q Q Q Y
  
%Y Y Y Q
Y
– where Y stands for income.
• Example
– If a 1% increase in income results in a 3% increase in
quantity demanded, the income elasticity of demand is
3%
x  3.
1%
The Income Elasticity: Example
• The estimated demand function for avocados is:
Q  104  40 p  20 pt  0.01Y
– where we measure quantity in millions of lbs per
month, avocado and tomato prices in dollars per lb,
and average monthly income in dollars.
Question: what would be the income elasticity of
demand for avocados if Q = 80 and Y = 4,000?
Cross-Price Elasticity
• Formally,
Q
%Q Q po
 Q 
%po po po Q
po
– where Po stands for price of another good.
• Example
– If a 1% increase in the price of a related good results in a
3% decrease in quantity demanded, the cross-price
elasticity of demand is
3%
  3.
1%
Cross-Price Elasticity
• If the cross-price elasticity is negative, the goods are
complements.
• If the cross-price elasticity is positive, the goods are
substitutes.
Cross-Price Elasticity: Example
• Again, the estimated demand function for avocados is:
Q  104  40 p  20 pt  0.01Y
Question: what would be the cross-price elasticity

between the price of tomatoes and the quantity of
avocados if Q = 80 and pt = $0.80?
Elasticity of Supply
• Formally,
Q
%Q Q Q p
  
%p p p Q
p
– where Q indicates quantity supplied.
• Example
– If a 1% increase in price results in a 2% increase in
quantity supplied, the elasticity of supply is
2%
  2.
1%
Elasticity of Supply
• Along a linear supply curve with a function of:
Q  g  hp
– Where h is the slope or
Q
h
p
– the elasticity of supply is
Q p p
 h
p Q Q
Elasticity of Supply: Example
• The estimated linear supply function for corn is:
Q  10.2  0.25 p
– where Q is the quantity of corn supplied in billion
bushels per year and p is the price of corn in dollars
per bushel.
– If p = $7.20 and Q = 12, the elasticity of supply is:
Q P 7.20
  0.25   0.15
p Q 12
Figure 3.5 Elasticity Along the Corn
Supply Curve
2.4 Elasticities of Supply and Demand (6 of 6)
Point versus Arc Elasticities
point elasticity of demand Price elasticity at a particular point on the demand curve.
ARC ELASTICITY OF DEMAND
arc elasticity of demand Price elasticity calculated over a range of prices.
Arcelasticity: EP  ( ΔQ ΔP )(P Q) (2.4)
Supply Elasticities Over Time
• Supply elasticities may differ in the short-run and the
long-run.
• The difference depends on the ability to convert fixed
inputs into variable inputs.
• Firms’ long-run supply elasticity is generally greater
than short-run elasticity.
EXAMPLE 5
THE MARKET FOR WHEAT
During recent decades, changes in the wheat market

had major implications for both American farmers and
U.S. agricultural policy.
To understand what happened, let’s examine the

behavior of supply and demand beginning in 1981.
Supply : QS 1800  240P
Demand : QD  3550  266P
By setting the quantity supplied equal to the quantity demanded, we can determine the
market-clearing price of wheat for 1981:
QS  QD
1800  240P  3550  266P
506P 1750
P  $3.46 per bushel
Substituting into the supply curve equation, we get
Q  1800  (240)(3.46)  2630 million bushels
EXAMPLE 5
THE MARKET FOR WHEAT
We use the demand curve to find the price elasticity of demand:

P Δ QD 3.46
EPD   ( 266)   0.35
Q ΔP 2630
Thus demand is inelastic.
We can likewise calculate the price elasticity of supply

P Δ QS 3.46
EPS   (240)  0.36
Q ΔP 2630
Suppose that a drought caused the supply curve to shift far enough to the left to push the
price up to $4.00 per bushel. In this case, the quantity demanded would fall to 3550 –
(266)(4.00) = 2486 million bushels. At this price and quantity, the elasticity of demand would
be
4.00
EPD  ( 266)   0.43
2480
Effects of a Sales Tax
1. What effect does a sales tax have on equilibrium prices
and quantity as well as on tax revenue?
2. Are the equilibrium price and quantity dependent on
whether the government collects a specific tax from the
suppliers or their customers?
3. Is it true, as many people claim, that producers pass
along to customers any taxes collected from producers?
That is, do consumers pay the entire tax?
4. Do comparable ad valorem and specific taxes have
equivalent effects on equilibrium prices and quantities
and on tax revenue?
Two Types of Sales Taxes
• Ad valorem tax - for every dollar the consumer
spends, the government keeps a fraction,  ,
which is the ad valorem tax rate.
• Specific tax (or unit tax) - where a specified dollar
amount, t, is collected per unit of output.
Figure 3.6(a) Specific Tax Collected
from Producers
Figure 3.6(b) Specific Tax Collected
from Customers
Solved Problem 3.4
• Show mathematically the effects on the
equilibrium price and quantity of corn from a
specific tax of t = $2.40 collected from suppliers,
as illustrated in panel a of Figure 3.6.
1. Show how the tax shifts the supply curve.
2. Determine the after-tax equilibrium price by equating
the after-tax supply function and the original demand
function.
3. Determine the after-tax equilibrium quantity by
substituting the equilibrium price in either the
demand function or the after-tax supply function.
Tax Incidences
• The government sets a new specific tax of t, it raises
the tax from 0 to t, so the change in the tax is
t  t  0  t .
• The incidence of a tax on consumers is the share
of the tax that consumers pay.
p
• The incidence of the tax that falls on consumers is ,
t
the amount by which the price to consumers rises as a
fraction of the amount the tax increases.
Tax Effects Depend on Elasticities (1 of 2)
• The tax incidence on customers depends on the
elasticities of supply and demand.
– The price customers pay increases by:
  
p    t
   
• If   0.3 and   0.15, a change of a tax of
t  $2.40 causes the price buyers pay to rise by
   0.15
p    t   $2.40  80¢
    0.15  [ 0.3]
Tax Effects Depend on Elasticities (2 of 2)
• The incidence of tax that consumers pay is
Dp h
=
Dt h - e
– Therefore, the incidence of the corn tax on
consumers is
0.15 1

0.15  [ 0.3] 3
Solved Problem 3.5
• If the supply curve is perfectly elastic and demand
curve is downward sloping, what is the effect of a $1
specific tax collected from producers on equilibrium
price and quantity, and what is the incidence on
consumers? Why?
Figure 3.7 Comparison of an Ad
Valorem and a Specific Tax
Solved Problem 3.6
• If the short-run supply curve for fresh fruit is perfectly
inelastic and the demand curve is a downward-sloping
straight line, what is the effect of an ad valorem tax on
equilibrium price and quantity, and what is the
incidence on consumers? Why?
Who Pays the Gasoline Tax?

Elasticity

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Elasticity

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Week 3: Elasticity Concept

Dr. Junaid Ahmed

1. Define the price elasticity of demand and understand how to

• But how much more of it will they purchase?

• That amount can vary considerably by product and over

• The elasticity of demand varies along most demand

• The price elasticity of demand depends

• The elasticity, therefore, varies along the

• With a linear demand curve, the higher

Question: what would be the cross-price elasticity

ARC ELASTICITY OF DEMAND

arc elasticity of demand Price elasticity calculated over a range of prices.

Arcelasticity: EP  ( ΔQ ΔP )(P Q) (2.4)

THE MARKET FOR WHEAT

During recent decades, changes in the wheat market

To understand what happened, let’s examine the

We use the demand curve to find the price elasticity of demand:

We can likewise calculate the price elasticity of supply

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