ELASTICITY (PART 1)

HOW TO APPROACH THE STUDY OF

MICROECONOMICS
 Microeconomics is the branch of economics that
deals with human behaviour and choices as they
relate to relatively small units: an individual, a
firm, an industry, a single market.

 It involves players (consumers, business firms,

and factor owners) who have an objective, faces
some constraints and has to make choices.

 Let’s look at each of these players and what their

objective, constraints and choices are.
 All the choices are made in market settings, with
different markets having different setups.
Players Objective Constraints Choice
Consumers Maximize Finite Incomes Chose between
utility of Positive Prices different bundles
satisfaction by using marginal
consuming analysis
goods and
services
Firms as Maximize profit Positive Prices of Chose mix of factors
Buyers Resources/Factors and that will minimize
cover opportunity costs cost using marginal
analysis

Firms as Maximize profit -Consumers who wants Chose quantity to

Sellers to pay less for more produce, sell and
-Competitors who will decide on price
undercut prices

Factor Maximize -Finite amount of Chose to sell units of

Owners income earned factor factor based on
by selling -Market decides the marginal analysis
factors price they will get
ELASTICITY (PART 1)
 Price Elasticity of Demand: A measure of the
responsiveness of quantity demanded to changes
in price.
 Measured by dividing the percentage change in
the quantity demanded of a good by the
percentage change in its price.

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑 %Δ𝑄𝑑

 𝐸𝑑 = =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒 %Δ𝑃

 Coefficient of Price Elasticity of Demand. How do

we interpret this?
PRICE ELASTICITY OF DEMAND
 Using percentage changes can at times lead to
conflicting results depending on whether price
falls or rises.
 Economists compute price elasticity of demand
using midpoints as the base values of changes in
prices and quantities demanded
Δ𝑄𝑑
𝑄𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒
𝐸𝑑 = Δ𝑃
𝑃𝑎𝑣𝑒𝑟𝑎𝑔𝑒

 Numerically?
ELASTICITY IS NOT SLOPE
Point Price Quantity
Demanded
A 12 50
B 10 100
C 8 150

• What is the Price Elasticity of Demand from Point A to

B?
• What is the slope from A to B?
• What is the Price Elasticity of Demand from Point B to
C?
• What is the slope from B to C?

• Are they the same?

ELASTIC DEMAND
 The demand when the
percentage change in
quantity demanded is
greater than the
percentage change in
price. Quantity
demanded changes
proportionately more
than the price.
 %∆Qd > %∆P ➔ Ed > 1
➔ Demand is elastic
INELASTIC DEMAND
 The demand when the
percentage change in
quantity demanded is
less than the
percentage change in
price. Quantity
demanded changes
proportionately less
than the price.
 %∆Qd < %∆P ➔ Ed < 1
➔ Demand is inelastic
UNIT ELASTIC DEMAND
 The demand when the
percentage change in
quantity demanded is
equal to the percentage
change in price.
Quantity demanded
changes proportionately
to the price.
 %∆Qd = %∆P ➔ Ed = 1
➔ Demand is unit
elastic
PERFECTLY ELASTIC DEMAND CURVE
 The demand when a
small percentage
change in price causes
an extremely large
percentage change in
quantity demanded
(from buying all to
buying nothing.)

 Ed = ∞ (Infinitely
large)
PERFECTLY INELASTIC DEMAND CURVE
 The demand when the
quantity demanded does
not change as price
changes. So the demand
is completely
UNRESPONSIVE to
changes in demand.

 Ed = 0
SUMMARIZING…
PRICE ELASTICITY AND TOTAL REVENUE
(TOTAL EXPENDITURE)
 Total Revenue of a seller equals the price of a good
tines the quantity of the good sold.
TR = P * Q

 Question: Does rise in price mean higher revenue?

 When prices increases ➔ Quantity demanded will fall
because Demand is downward sloping.
 How does changes in prices impact total revenue?
 Whether TR increases or decreases or remains same,
depends on whether percentage change in quantity
demand is less than, greater than or equal to
percentage change in price ➔ Price Elasticity of
Demand.
ELASTIC DEMAND AND TOTAL REVENUE
 Quantity demanded
changes proportionately
more than the price.
 %∆Qd > %∆P ➔ Ed > 1 ➔
Demand is elastic
 If price falls, Qd rises by a
bigger percentage ➔ Sales
of the good rises by a
bigger percentage ➔ TR
revenue rises.
 If price rises, Qd falls by a
bigger percentage ➔ Sales
of the good falls by a
bigger percentage ➔ TR
revenue falls.
INELASTIC DEMAND AND TOTAL REVENUE
 Quantity demanded
changes proportionately
less than the price.
 %∆Qd < %∆P ➔ Ed < 1 ➔
Demand is inelastic
 If price falls, Qd rises by a
smaller percentage ➔
Sales of the good rises by a
smaller percentage ➔ TR
revenue falls.
 If price rises, Qd falls by a
smaller percentage ➔
Sales of the good falls by a
smaller percentage ➔ TR
revenue rises.
UNIT ELASTIC DEMAND AND TOTAL REVENUE

 Quantity demanded
changes proportionately
equal to the price.
 %∆Qd = %∆P ➔ Ed = 1 ➔
Demand is unit elastic
 If price falls, Qd rises by a
same percentage ➔ Sales
of the good rises by a same
percentage ➔ TR revenue
stays same.
 If price rises, Qd falls by
the same percentage ➔
Sales of the good falls by
same percentage ➔ TR
revenue stays same.
SUMMARIZING…
PRICE ELASTICITY OF DEMAND ALONG A
STRAIGHT-LINE DEMAND CURVE
 The price elasticity of demand for a straight-line
downward-sloping demand curve varies from
highly elastic to highly inelastic.

 As we move towards the right (price falling and

Qd rising), elasticity of the demand curve
reduces.

 As elasticity is reducing from left to right, total

revenue will also change.
PRICE ELASTICITY OF DEMAND ALONG A
STRAIGHT-LINE DEMAND CURVE (CONT)
DETERMINANTS OF PRICE ELASTICITY OF
DEMAND
 Four Factors determine Price Elasticity of
Demand:

1. Number of substitutes
2. Necessities versus luxuries
3. Percentage of one’s budget spent on the good
4. Time
DETERMINANTS OF PRICE ELASTICITY OF
DEMAND (CONT)
 Number of Substitutes:
➔ The more substitutes there are for a good, the higher
the price elasticity of demand will be; the fewer
substitutes there are for a good, the lower the price
elasticity of demand will be.
➔ The more broadly defined the goods is, the fewer the
substitutes it will have; the more narrowly defined
the goods is, the more the substitutes it will have

 Necessities versus Luxuries: The more a good is

considered luxury (a good we can go without) rather
than a necessity (a good we can’t do without), the
higher the price elasticity of demand will be.
DETERMINANTS OF PRICE ELASTICITY OF
DEMAND (CONT)
 Percentage of One’s Budget Spent on the
Good:
➔ The greater the percentage of one’s budget that
goes to purchase a good, the higher the price
elasticity of demand will be; the smaller the
percentage of one’s budget that goes to purchase
a good, the lowerer the price elasticity of demand
will be

 Time:
➔ The more time that passes (since the price
change), the higher the price elasticity of demand
for the good will be; the less time that passes, the
lower the price elasticity of demand for the good.
CROSS ELASTICITY OF DEMAND
 Measures the responsiveness in the quantity
demanded of one good to changes in the price of
another good.

 Defined as the percentage change in the quantity

demanded of one good divided by the percentage
change in the price of another good.

𝐸𝐶
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑜𝑛𝑒 𝑔𝑜𝑜𝑑
=
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑎𝑛𝑜𝑡ℎ𝑒𝑟 𝑔𝑜𝑜𝑑
CROSS ELASTICITY OF DEMAND
 This concept is often used to determine whether two
goods are substitutes or complements and the degree
to which one good is a complement to or substitute for
another.

 Substitutes: Price increases in one leads to a rise in

Quantity demanded of the other good. So if 𝐸𝐶 > 0 ⇒
Goods are substitutes

 Complements: Price increases in one leads to a fall in

Quantity demanded of the other good. So if 𝐸𝐶 < 0 ⇒
Goods are complements

 The higher (bigger positive number) the cross

elasticity of demand is ➔ greater degree of
substitution
INCOME ELASTICITY OF DEMAND
 Measures the responsiveness of quantity demanded to
changes in income.

 Define as the percentage change in quantity demanded

of a good divided by the percentage change in income.
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑
𝐸𝑌 =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐼𝑛𝑐𝑜𝑚𝑒

 Since using percentage changes can at times lead to

conflicting results, the following is also used:
Δ𝑄𝑑
𝑄𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒
𝐸𝑑 =
Δ𝑌
𝑌𝑎𝑣𝑒𝑟𝑎𝑔𝑒
INCOME ELASTICITY OF DEMAND (CONT)
 If Income elasticity of demand is positive (Ey > 0)
➔ normal good.
 The demand for an inferior good decreases as
income increases. So if Income elasticity of
demand is negative (Ey < 0) ➔ inferior good

Comparing %∆Qd to %∆P

 If %∆Qd > %∆P ➔Ey >1, demand is considered to
be income elastic
 If %∆Qd < %∆P ➔ Ey <1, demand is considered to
be income inelastic.
 If %∆Qd = %∆P ➔ Ey =1, demand is considered to
be unit elastic
PRICE ELASTICITY OF SUPPLY

 Measures the responsiveness of quantity

supplied to changes in price.
 Defined as the percentage change in quantity
supplied of a good divided by the percentage
change in the price of the good.

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑆𝑢𝑝𝑝𝑙𝑖𝑒𝑑

 𝐸𝑌 =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒

 Supply can be classified as elastic, inelastic, unit

elastic, perfectly elastic, or perfectly inelastic.
PRICE ELASTICITY OF SUPPLY
PRICE ELASTICITY OF SUPPLY AND TIME
 The longer the period of adjustment to a change
in price, the higher the price elasticity of supply.
 Additional production takes time.

 Reducing production takes time.

 Example: Housing market.

➔ If price increases of houses, will we be able to

increase houses in short run? No.
➔ In long run? Yes ➔ Dedicate more resources from
production of other things to produce houses,
hence increasing supply. Price Elasticity of
Supply Increases
SUMMARY OF THE FOUR ELASTICITY
CONCEPTS
ELASTICITY AND TAX
 Refer to class lecture and book