CH: 6 Elasticity, Consumer Surplus, Ed = (change in quantity demanded / mid-point

and Producer Surplus of quantities)

PRICE ELASTICITY OF DEMAND (change in price / mid-point of price)

The responsiveness (or sensitivity) of

consumers to a price change is measured by a
product’s price elasticity of demand. WHY USE PERCENTAGES RATHER THAN
ABSOLUTE AMOUNTS IN MEASURING
Relatively elastic or simply elastic: Highly CONSUMER RESPONSIVENESS?
responsive i.e. Small change in price causes large
change in quantity demanded.  Different units of numerator and
denominator.
Relatively inelastic or simply inelastic: Highly  We can correctly compare consumer
unresponsive i.e. Substantial price changes responsiveness to changes in the prices of
cause only small changes in the quantity different products e.g. It makes little sense
demanded. to compare the effects on quantity
demanded of (1) a $1 increase in the price
of a $10,000 used car with (2) a $1 increase
The Price-Elasticity Coefficient and Formula in the price of a $1 soft drink.

Coefficient of price-elasticity of demand: Ed will always be a negative number as gradient

Degree to which demand is price elastic or
of demand curve us negative.
inelastic.

Ed of -4 is greater than -2.

Denoted by Ed

We ignore the minus sign in the coefficient of

price elasticity of demand and show only the
absolute value to avoid confusion.
Since %age change = change / original:
Such ambiguity does not arise with supply
because price and quantity supplied are
positively related. All elasticity of supply
coefficients therefore are positive numbers.

Interpretations of Ed
Both the above formulas as basically the same.
Elastic Demand: Ed will be greater than 1.
Elasticity should be the same whether price
rises or falls. However, when quantity changes, Inelastic Demand: Ed will be less than 1.
for example, from 10 to 20, it is a 100 percent
increase. But when quantity falls from 20 to 10 Unit Elasticity: Ed is exactly 1.
along the identical demand curve, it is a 50
percent decrease. Same is the case with price. Perfectly inelastic: Ed will be 0 (No change in
quantity demanded as price changes e.g. drugs
for addicts)

The simplest solution to the problem is to use

the mid point formula
Perfectly elastic: Ed will be infinite (Infinite At c => TR = $40 (light orange + orange)
change in quantity demanded as price changes At d => TR = $20 (orange + brown)
i.e. )
As price decrease from c to d, TR decreases

Unit Elasticity:

Total revenue constant at all prices.

TheTotal-RevenueTest

Total revenue (TR): Total amount the seller

receives from the sale of a product in a
particular time period

TR = P(product price) x Q(quantity sold)

Total revenue is the rectangular area under the At e => TR = $30 (light orange + orange)
graph of quantity-price curve. At f => TR = $30 (orange + brown)

Elastic: As price decrease from c to d, TR doesn’t change.

When price and total revenue are inversely THE TEST: When price and total revenue:
proportional.
a) Directly proportional = Inelastic
b) Inversely proportional = Elastic
c) Not proportional i.e. TR constant = Unit
elastic

You need to know that elasticity typically varies

over the different price ranges of the same
demand curve.

At a => TR = $20 (light orange + orange)

At b => TR = $40 (orange + brown)

As price decrease from a to b, TR increases

Inelastic:

When price and total revenue are directly

proportional.
For all downsloping straight-line and most other Substitutability: Number of substitute goods
demand curves, demand is more price-elastic available is directly proportional to price
toward the upper left (here, the $5-$8 price elasticity of demand of each good.
range of D) than toward the lower right (here,
the $4-$1 price range of D). The elasticity of demand for a product depends
on how narrowly the product is defined.
WHY? Demand for Reebok sneakers is more elastic
than is the overall demand for shoes. Many
other brands are readily substitutable for
Reebok sneakers, but there are few, if any, good
substitutes for shoes.
in the upper- left segment of the demand curve,
the percentage change in quantity is large
because the original reference quantity is small. Proportion of Income: Price of a good relative to
Similarly, the percentage change in price is small consumers’ incomes is directly proportional to
in that segment because the original reference price elasticity of demand.
price is large. The relatively large percentage
change in quan- tity divided by the relatively Luxuries versus Necessities The more that a good
small change in price yields a large Ed —an is considered to be a “luxury” rather than a
elastic demand. The reverse holds true for the “necessity,” the greater is the price elasticity of
lower-right segment of the demand curve demand.

The slope of a demand curveis not a sound basis Luxuries can easily be forgone.
for judging elasticity. The slope of the curve is
computed from absolute changes in price and WHAT ABOUT THE DEMAND FOR A COMMON
quantity, while elasticity involves relative or PRODUCT LIKE SALT?
percentage changes in price and quantity.
It is highly inelastic on three counts: Few good
Price Elasticity and the Total-Revenue Curve sub-stitutes are available; salt is a negligible
item in the family budget; and it is a “necessity”
rather than a luxury.

Time: Generally, product demand is more elastic

the longer the time period under consideration.
Consumers often need time to adjust to changes
in prices e.g. Consumers may not immediately
reduce their purchases very much when the
price of beef rises by 10 percent, but in time
they may shift to chicken, pork, or fish.

Applications of Price Elasticity of Demand

Large Crop Yields: The demand for most farm

Lowering the ticket price in the elastic range of products is highly inelastic. As a result,
demand—for example, from $8 to $5—increases increases in the output of farm tend to depress
total revenue, and vice versa both the prices of farm products and the total
revenues (incomes) of farmers.
When price either decreases from $5 to $4 or
increases from $4 to $5, total revenue remains Excise Taxes: Because a higher tax on a product
$20,000. with elastic demand will bring in less tax
revenue, legislatures tend to seek out products
In the inelastic range of demand curve D, that have inelastic demand—such as liquor,
lowering the price—for example, from $4 to gasoline, and cigarettes—when levying excises.
$1—decreases total revenue, and vice versa.
Decriminalization of Illegal Drugs:
Determinants of Price Elasticity of Demand
Favour:
 a) Reduce drug trafficking significantly by Elastic supply: Es will be greater than 1.
taking the profit out of it.
b) Crack cocaine and heroin, for example, Inelastic supply: Es will be less than 1.
are cheap to produce and could be sold
at low prices in legal markets Because
Unit Elasticity: Es is exactly 1.
the demand of addicts is highly
inelastic, the amounts consumed at the
lower prices would increase only Es is never negative, since price and quantity
modestly. Addicts’ total expenditures supplied are directly related.
for cocaine and heroin would decline,
and so would the street crime that The degree of price elasticity of supply depends
finances those expenditures on how easily—and therefore quickly—
producers can shift resources between
Against: alternative uses.

a) demand for cocaine and heroin is far

more elastic than proponents think
b) the lower prices associated with the The easier and more rapidly producers can shift
legaliza- tion of hard drugs would resources between alternative uses, the greater
increase consumption by dabblers, who the price elasticity of supply.
use hard drugs when their prices are
low but who abstain or substitute, say, We can expect a greater response, and therefore
alcohol when their prices are high greater elasticity of supply, the longer a firm has
c) might make drug use more socially to adjust to a price change.
acceptable, increasing the demand for
cocaine and heroin. The longer the time, the greater the resource
“shiftability.”

Price Elasticity of Supply: The Market Period

PRICE ELASTICITY OF SUPPLY
Market period: The period that occurs when
The responsiveness (or sensitivity) of producers the time immediately after a change in market
to a price change is measured by a product’s price is too short for producers to respond with
price elasticity of supply. a change in quantity supplied.

Elastic supply: If the quantity supplied by Suppose the owner of a small farm brings to
producers is relatively responsive to price market one truckload of tomatoes that is the
changes entire season’s output. The supply curve for the
tomatoes is perfectly inelastic (vertical); the
Inelastic supply: If the quantity supplied by farmer will sell the truckload whether the price
producers is relatively unresponsive to price and demand is high or low. Why? Because the
changes farmer can offer only one truckload of tomatoes
even if the price of tomatoes is much higher than
anticipated and the product is perishable, so has
to sell all before they are useless.

Though the price of tomatoes may fall far short

of production costs, the farmer will nevertheless
Es = Coefficient of price elasticity of supply. sell out to avoid a total loss through spoilage.

Mid-point formula for supply:

Es = (change in quantity supplied / mid-point of

quantities)

(change in price / mid-point of price)

For our tomato farmer, the market period may
be a full growing season; for producers of goods
that can be inexpensively stored, there may be Smaller price rise (P0 to Pl) and a larger output
no market period at all. increase (Q0 to Ql) in response to the increase in
demand from D1 to D2.
Price Elasticity of Supply: The Short Run
Regardless of the degree of elasticity or
The short run in microeconomics is a period of inelasticity, price and total revenue always move
time too short to change plant capacity but long together, so no total-revenue test
enough to use the fixed-sized plant more or less
intensively. Applications of Price Elasticity of Supply

In the short run, our farmer’s plant (land and Antiques and Reproductions: The high price of
farm machinery) is fixed. But he does have time an antique results from strong demand and
in the short run to cultivate tomatoes more limited, highly inelastic supply. For one-of- a-
intensively by applying more labor and more kind antiques, the supply is perfectly inelastic
fertilizer to the crop. The result is a somewhat
greater output in response to a presumed In contrast, supply of modern “made-to-look-
increase in demand; this greater output is old” art is elastic. When the demand for
reflected in a more elastic supply of tomatoes. reproductions increases, the firms making them
simply boost production. Because the supply of
reproductions is highly elastic, increased
demand raises their prices only slightly.

Volatile Gold Prices: The supply of gold is

inelastic. Because of the inelastic supply of gold,
even relatively small changes in demand
produce relatively large changes in price.

CROSS ELASTICITY AND INCOME ELASTICITY

OF DEMAND
The increase in demand from D1 to D2 is met by
an increase in quantity (from Q0 to Qs), so there The consumption of a good also is affected,
is a smaller price adjustment (from P0 to Ps) than besides change in price, by a change in the price
of a related product or by a change in income.
would be the case in the market period. The
equilibrium price is therefore lower in the short
run than in the market period. Cross Elasticity of Demand

Price Elasticity of Supply: The Long Run Cross elasticity of demand (Cross-Price
elasticity of demand): Measures how sensitive
consumer purchases of one product are to a
The long run in microeconomics is a time
change in the price of some other product.
period long enough for firms to adjust their
plant sizes and for new firms to enter (or
existing firms to leave) the industry.

Results in larger supply.

Exy = Coefficient of cross elasticity
Normal Goods: Income-elasticity coefficient Ei is
Unlike price elasticity, we allow the coefficient positive, meaning that more of them are
of cross elasticity of demand to be either demanded as incomes rise. But the value of Ei
positive or negative. varies greatly among normal goods.

Substitute Goods: If cross elasticity of demand is Inferior Goods: Income-elasticity coefficient Ei is

positive, meaning that sales of X are directly negative. Purchase of inferior goods inversely
proportional to change in the price of Y, then X proportional to income.
and Y are substitute goods. The larger the
positive cross-elasticity coefficient, the greater is Products with relatively high income elastic- ity
the substitutability between the two products. coefficients, such as automobiles (Ei = +3),
housing (Ei=+1.5), and restaurant meals (Ei =
Complementary Goods: When cross elasticity is +1.4), are generally hit hardest by recessions
negative, we know that X and Y are (business downturns)
complementary goods; an increase in the price
of one decreases the demand for the other. The
larger the negative cross- elasticity coefficient, Products we view as essential tend to have
the greater is the complementarity between the lower income elasticity coefficients than
two goods. products we view as luxuries.

Independent Goods: A zero or near-zero cross

elasticity suggests that the two products being
consid- ered are unrelated or independent
goods.

Substitute goods: Exy is +ve

Complementary goods: Exy is +-ve

Independent goods: Exy is 0

Application: e.g. suppose that Coca-Cola is

considering whether or not to lower the price of
its Sprite brand. Not only will it want to know
something about the price elasticity of de- mand
for Sprite (will the price cut increase or decrease
total revenue?), but it will also be interested in
knowing if the increased sales of Sprite will
come at the expense of its Coke brand. How
sensitive are the sales of one of its products
(Coke) to a change in the price of another of its
products (Sprite)? By how much will the
increased sales of Sprite “cannibalize” the sales
of Coke?

Income Elasticity of Demand

Income elasticity of demand: Measures the

degree to which consumers respond to a change
in their incomes by buying more or less of a
particular good.