Elasticity

Samarth Gupta
Email- [email protected]

November 2022

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Agenda for Sessions 6-8

Concept of Elasticity
Mathematical Formulae for Elasticity
▶ Percentage Formula
▶ Mid-Point Formula

Determinants of Elasticity
Exercises (Session 8)

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Elasticity

In every field, we are interested in whether and how one factor affects
another. Eg in demand curve?

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Elasticity

In every field, we are interested in whether and how one factor affects
another. Eg in demand curve?
Quantitative Social Sciences—putting a number or quantity to the
strength of change.

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Elasticity

In every field, we are interested in whether and how one factor affects
another. Eg in demand curve?
Quantitative Social Sciences—putting a number or quantity to the
strength of change.
Several ways of quantifying change—one unit change in x (income)
changes how many units in y (demand)?
Sessions 6-8: Introducing strength of change in demand curves

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Elasticity

Elasticity is one (of many) way to measure the strength of relationship

between two variables.

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Elasticity

Elasticity is one (of many) way to measure the strength of relationship

between two variables.
Imagine that input costs increase.

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Elasticity

Elasticity is one (of many) way to measure the strength of relationship

between two variables.
Imagine that input costs increase. Supply curve shifts inward. What
happens to P and Q?

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Elasticity

Elasticity is one (of many) way to measure the strength of relationship

between two variables.
Imagine that input costs increase. Supply curve shifts inward. What
happens to P and Q? P increases and Q decreases.

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Elasticity

Elasticity is one (of many) way to measure the strength of relationship

between two variables.
Imagine that input costs increase. Supply curve shifts inward. What
happens to P and Q? P increases and Q decreases.
Questions that we will answer: If price increases by 5%, how much will
quantity decrease by?

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Elasticity

Elasticity is one (of many) way to measure the strength of relationship

between two variables.
Imagine that input costs increase. Supply curve shifts inward. What
happens to P and Q? P increases and Q decreases.
Questions that we will answer: If price increases by 5%, how much will
quantity decrease by?
Note: we are putting a magnitude on the law of demand.

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Intuition

Quantity Demanded: Amount of good a consumer is willing and able to

buy at a price
Law of Demand: If price increases, amount of good a consumer is willing
and able to buy decreases.

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Intuition

Quantity Demanded: Amount of good a consumer is willing and able to

buy at a price
Law of Demand: If price increases, amount of good a consumer is willing
and able to buy decreases.
Elasticity: How much does willingness and ability changes if price
increases?
Visual Idea: from the graphs

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Measuring Price Elasticity of Demand: Percentage Formula

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Measuring Price Elasticity of Demand: Percentage Formula

Mistakes to avoid: Notice the numerator and denominator

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Percentage Formula

Exercise-1: Supply shifts back (because of??). Price increases from Rs.
100 to Rs. 125. Quantity decreases from 250 to 175. Use the percentage
formula to compute elasticity.

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Percentage Formula

Exercise-1: Supply shifts back (because of??). Price increases from Rs.
100 to Rs. 125. Quantity decreases from 250 to 175. Use the percentage
formula to compute elasticity.
Step-1: Compute percentage change in quantity
Step-2: Compute percentage change in prices
Step-3: Take ratio of amounts calculated in step-1 and step-2.

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Percentage Formula

Exercise-2: Supply shifts back. Price increases from Rs. 100 to Rs. 125.
Quantity decreases from 250 to 200. Use the percentage formula to
compute elasticity.

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Mid-Point Formula for Elasticity

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Mid-Point Formula

A market is in equilibrium at P = 100, Q=250. Supply shifts to the right

(out). Compute elasticity using the mid-point formula in each of the
following new points of equilibrium.

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Mid-Point Formula

A market is in equilibrium at P = 100, Q=250. Supply shifts to the right

(out). Compute elasticity using the mid-point formula in each of the
following new points of equilibrium.
1 P=75, Q = 325
2 P=75, Q = 275
3 P =85, Q=275
4 P=85, Q = 225
Note: One of these options is logically incorrect. Which one?

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Recap

Elasticity
Percentage Formula
Mid-Point Formula

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Today’s Agenda

Classification of Elasticity
Relationship between Elasticity and Revenue
Determinants of Elasticity
Exercises

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Classification of Elasticity

Higher the elasticity, we say demand curve is more elastic.

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Classification of Elasticity

Higher the elasticity, we say demand curve is more elastic.

Elasticity is a method to classify demand curve, hence classify consumer
behaviour of willingness and ability.

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Classification of Elasticity

Higher the elasticity, we say demand curve is more elastic.

Elasticity is a method to classify demand curve, hence classify consumer
behaviour of willingness and ability.
If elasticity < 1, demand curve is inelastic
If elasticity > 1, demand curve is elastic

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Some Extreme Cases: Perfectly Inelastic Curve

Quantity demanded does not change for any price change. Eg;
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Some Extreme Cases: Perfectly Inelastic Curve

Quantity demanded does not change for any price change. Eg; water
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Some Extreme Cases: Perfectly Elastic Curve

Quantity demanded goes to zero for any price change. Eg;

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Some Extreme Cases: Perfectly Elastic Curve

Quantity demanded goes to zero for any price change. Eg; ??

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Determinants of Elasticity

What determines elasticity? When would a demand curve have elasticity

greater than or less than 1?

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Determinants of Elasticity

What determines elasticity? When would a demand curve have elasticity

greater than or less than 1?
Elasticity—how fast does willingness and ability change as price
increases?
If willingness and ability can change rapidly with price, then elasticity will
be higher.

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Determinant-1: Availability of Substitutes

When a price of any good increases, people’s willingness and ability can
change. How?

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Determinant-1: Availability of Substitutes

When a price of any good increases, people’s willingness and ability can
change. How? because people can choose substitutes
If substitutes are plenty, then change in consumer behaviour is easy. If
substitutes are scarce, then change in consumer behaviour is
difficult.

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Determinant-1: Availability of Substitutes

When a price of any good increases, people’s willingness and ability can
change. How? because people can choose substitutes
If substitutes are plenty, then change in consumer behaviour is easy. If
substitutes are scarce, then change in consumer behaviour is
difficult.
Eg; prices of milk and Pepsi increase by 10%. In which market, would you
observe a higher decline in quantity demanded?

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Determinant-1: Availability of Substitutes

When a price of any good increases, people’s willingness and ability can
change. How? because people can choose substitutes
If substitutes are plenty, then change in consumer behaviour is easy. If
substitutes are scarce, then change in consumer behaviour is
difficult.
Eg; prices of milk and Pepsi increase by 10%. In which market, would you
observe a higher decline in quantity demanded?

Elasticity is higher when substitutes are available.

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Determinant-2: Type of good as luxury or necessity

Consider renting a house or staying in a 5-star hotel. For which good, is

the willingness hard to change?

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Determinant-2: Type of good as luxury or necessity

Consider renting a house or staying in a 5-star hotel. For which good, is

the willingness hard to change?
Necessary good—people’s willingness hard to change even when price
increases.

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Determinant-2: Type of good as luxury or necessity

Consider renting a house or staying in a 5-star hotel. For which good, is

the willingness hard to change?
Necessary good—people’s willingness hard to change even when price
increases.

Elasticity is higher for luxury goods.

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Determinant-3: Definition of good/market

Consider the market for ALL beverages and market for coffee.
ALL beverages a broad definition. Coffee a narrowly defined one type of
beverage.

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Determinant-3: Definition of good/market

Consider the market for ALL beverages and market for coffee.
ALL beverages a broad definition. Coffee a narrowly defined one type of
beverage.
Corollary of Determinant-1: A broadly defined market has few substitutes.
Hence, low elasticity
Eg; toothpaste versus Colgate toothpaste, Khadi shirts versus
clothing.

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Determinant-3: Definition of good/market

Consider the market for ALL beverages and market for coffee.
ALL beverages a broad definition. Coffee a narrowly defined one type of
beverage.
Corollary of Determinant-1: A broadly defined market has few substitutes.
Hence, low elasticity
Eg; toothpaste versus Colgate toothpaste, Khadi shirts versus
clothing.

Price elasticity is smaller for broadly defined markets.

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Determinant-4: Short Run versus Long Run

Consider the following situation. Youtube charges people to use its

services.
In the short run, consumer behaviour hard to change. Is it true?
In the long run, consumer behaviour changes. Why?

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Determinant-4: Short Run versus Long Run

Consider the following situation. Youtube charges people to use its

services.
In the short run, consumer behaviour hard to change. Is it true?
In the long run, consumer behaviour changes. Why? substitutes become
available, consumers stop becoming addicted, etc.

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Determinant-4: Short Run versus Long Run

Consider the following situation. Youtube charges people to use its

services.
In the short run, consumer behaviour hard to change. Is it true?
In the long run, consumer behaviour changes. Why? substitutes become
available, consumers stop becoming addicted, etc.

Price elasticity of good is higher in the long run.

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Exercises

Which of the following good has lower elasticity?

Medicines
Crocin

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Exercises

Which of the following good has lower elasticity?

Medicines
Crocin
Which of the following has higher elasticity?
Fruits
Apples

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Exercises

Which of the following good has lower elasticity?

Anti-cancer drugs
Analgesics (used for digestion)

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Exercises

Which of the following good has lower elasticity?

Anti-cancer drugs
Analgesics (used for digestion)
Which of the following has the lowest elasticity?
Medicines
Starbucks Coffee
Chayoos Chai
Maggi

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Elasticity and Revenue

In a market, price is Rs. 100 and Quantity is 500 units. What is the total
revenue in the market?

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Elasticity and Revenue

In a market, price is Rs. 100 and Quantity is 500 units. What is the total
revenue in the market?
Total Revenue: Value of all goods purchased; P*Q = 500,000

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Elasticity and Revenue

In a market, price is Rs. 100 and Quantity is 500 units. What is the total
revenue in the market?
Total Revenue: Value of all goods purchased; P*Q = 500,000
Question: Price in this market increases. Would total revenue increase or
decrease?

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Elasticity and Revenue

In a market, price is Rs. 100 and Quantity is 500 units. What is the total
revenue in the market?
Total Revenue: Value of all goods purchased; P*Q = 500,000
Question: Price in this market increases. Would total revenue increase or
decrease?
Answer depends on elasticity.

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Elasticity and Revenue

Elasticity is less than 1. A 10% increase in price increase happens. What

happens to revenue, TR = P.Q?

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Elasticity and Revenue

Elasticity is less than 1. A 10% increase in price increase happens. What

happens to revenue, TR = P.Q?
Since elasticity < 1, %tage change in Q < %tage change in P.
P ↑ by 10% but Q ↓ by less than 10%. Since TR = P.Q, TR ↑.

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Elasticity and Revenue

Elasticity is less than 1. A 10% increase in price increase happens. What

happens to revenue, TR = P.Q?
Since elasticity < 1, %tage change in Q < %tage change in P.
P ↑ by 10% but Q ↓ by less than 10%. Since TR = P.Q, TR ↑.
Analogously, if elasticity is > 1, then increase in P leads to a fall in
TR.

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Elasticity and Revenue: Summary

P increases P decreases
Elasticity <1 TR ↑ TR ↓
Elasticity >1 TR ↓ TR ↑
Elasticity = 1 ? ?

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Exercises

In a market, supply curve shifts back. Calculate price elasticity of demand

in each of the following scenarios (using the percentage change formula),
classify the demand curve as either elastic or inelastic and describe what
will happen to the revenue in the market.
Price increases from 15 to 25 and quantity demanded decreases from
1250 to 1150.
Price decreases from 75 to 65 and quantity demanded increases from
500 to 400.
Price decreases from 100 to 80 and quantity demanded increases from
1000 to 1200.

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Exercises

Question 4, Chapter 5: A price change causes the quantity demanded of

a good to decrease by 30 percent, which leads to an increase in total
revenue by 15 percent. Is this good elastic or inelastic?

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Exercises

Imagine you run a coffee shop. The coffee that you sell is quite ordinary
and routinely available around the city. You would like to increase your
revenue. Should you increase or decrease your price?

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Exercises

Imagine you run a coffee shop. The coffee that you sell is quite ordinary
and routinely available around the city. You would like to increase your
revenue. Should you increase or decrease your price?
You decide to procure exclusive coffee beans which are not available
anywhere else. Now you want to increase your revenue. Should you
increase or decrease your price?

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Exercises

Imagine you run a coffee shop. The coffee that you sell is quite ordinary
and routinely available around the city. You would like to increase your
revenue. Should you increase or decrease your price?
You decide to procure exclusive coffee beans which are not available
anywhere else. Now you want to increase your revenue. Should you
increase or decrease your price?

Product differentiation allows one to have more influence on prices.

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Today’s Agenda

Other Elasticities
Mock Quiz

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Mock Quiz
Question-1; Lazear (1999): Workers in an auto-glass factory were paid a
fixed hourly wage. The company shifted to pay piece-rate income; i.e. the
more glasses they fixed, the more they got paid. Company found that the
productivity of employees increased. Why should that be?
1 Markets are usually a good way to allocate resources
2 People face trade-offs
3 Rational people respond to incentives
4 Governments can sometimes make markets work better

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Mock Quiz
Question-1; Lazear (1999): Workers in an auto-glass factory were paid a
fixed hourly wage. The company shifted to pay piece-rate income; i.e. the
more glasses they fixed, the more they got paid. Company found that the
productivity of employees increased. Why should that be?
1 Markets are usually a good way to allocate resources
2 People face trade-offs
3 Rational people respond to incentives
4 Governments can sometimes make markets work better
Question-2: Person 1 believes that Public Sector employees get paid
little. They are just lazy. Person 2 says if they were paid more on
performance, they would perform well. Which principle of economics is
person 2 referring to?
1 Markets are usually a good way to allocate resources
2 People face trade-offs 30 / 37
Mock Quiz

Question-2: Person 1 believes that Public Sector employees get paid

little. They are just lazy. Person 2 says if they were paid more on
performance, they would perform well. Which principle of economics is
person 2 referring to?
1 Markets are usually a good way to allocate resources
2 People face trade-offs
3 Rational people respond to incentives
4 Governments can sometimes make markets work better

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Mock Quiz

Question-3: Coal, which is an essential ingredient in many industries,

become more expensive. What should happen in the market for steel
which is coal-intensive?
1 Supply curve shifts to the right
2 Demand curve shits to the left
3 Supply curve shifts to the left
4 Demand curve shifts to the right

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Mock Quiz

Question-4: Continuing with the above market, what would happen to

the equilibrium price and quantity in the market for steel?
1 Price increases, Q decreases
2 Price decreases, Q decreases
3 Price increases, Q increases
4 Price decreases, Q decreases

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Mock Quiz
Question-5: A research conducted last year suggests that the demand
curve for steel is inelastic. Which of the two graphs best illustrate the
demand curve for steel?

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Mock Quiz

Question 6: Given your answer in question 5, what would happen to the

revenue of steel plants?
1 Total revenue will decrease
2 Total revenue will increase
3 Total revenue will not change

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Mock Quiz

Question 7: In the above scenario, price of steel increases from 5000 per
ton to 6000 per ton, while production declines from 10000 tons to 9000
tons. Verify that price elasticity of demand is less than 1.

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Mock Quiz

Question 8: An economist reasons that over time coal prices, or any input
prices, will have smaller and smaller effect on steel prices and probably
even an opposing effect on total revenue. Why is that?
1 Demand curve will become more elastic over time
2 Steel will become a luxury over time
3 Steel will become a narrowly defined market over time
4 Supply curve of steel will shift to the right over time

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