INTRODUCTION TO MICROECONOMICS – UNIT 3 – Elasticity

Chapter Three: ELASTICITY

Elasticity measures of the responsiveness of quantity demanded (and supply) to a change
in price and income.In the previous lecture we saw how shifts in demand and supply
curves enable us to determine the direction of the change in the equilibrium price and
quantity. With an understanding of price elasticity, we will be able to make more precise
statements about the effects of such changes.

The JUTC has seen its operating costs soaring over the last decade, while its revenue
remains flat. You have been hired as a consultant to the JUTC to inform it of ways to
increase its revenue. Would you recommend higher or lower fares?

Higher fares: reduce the number of passengers according to the law of demand. If the
number of passengers declined by a small percentage, then the higher fares paid by those
travelling with the JUTC may increase its revenue. What if the fall-off in passenger
numbers as a result of the higher fares causes revenue to fall?

Lower fares: According to the law of demand, a fall in fares will boost passenger
numbers, which could raise revenue.

The final answer would depend on the responsiveness of the quantity demanded to a price
change – the elasticity of demand. In other words, you have to compute the
responsiveness of passengers travelling on JUTC buses to a change in its fares.

Price elasticity of demand

The law of demand states that higher prices will reduce the quantity demanded and vice
versa. The task here is to determine the extent of the percentage change in quantity
demanded and prices – that is, by how much QD will change as a result of a change in
price.

Price elasticity of demand is the ratio of the percentage change in QD (dependent

variable) to a percentage change in (price (independent variable). For example, if QD is a
function of price, QD = f(price), then

price elasticity of demand =

%ΔQd
PED=ε =(−)
%ΔP

A variable is more responsive if the percentage change in that variable, say QD, is large
relative to the percentage change in price.Since the price elasticity of demand shows the
responsiveness of QD to a price change, it reflects a movement along the demand
curve.Given a downward-sloping demand curve, the price elasticity of demand is always
negative, where price and QD move in opposite directions (have opposite signs) and their
ratio is negative. That is, a negative percentage change in price implies that the
percentage change in QD is positive, and vice versa.Hence, the minus sign at the front of
the formula above simply makes the elasticity a positive number.To compute the price

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INTRODUCTION TO MICROECONOMICS – UNIT 3 – Elasticity

elasticity of demand, the percentage changes in price and QD must first be calculated
before computing the ratio.If a 3 per cent reduction in the price of chicken led to a 9 per
cent increase in the quantity of chicken demanded, then the price elasticity of demand for
chicken would be –(9/-3) = 3.

Range and Meaning of Elasticity

Price elasticity can range between a value of zero and infinity. The values of zero, one
and infinity are special cases.
In general, elasticity will be either less or greater than one.

 Inelastic demand (< 1). A given percentage change in price leads to a smaller
percentage change in quantity demand.
 Elastic demand (> 1). A given percentage change in price leads to a larger
percentage change in quantity demand.
 Perfectly inelastic (= zero). A given percentage change in price leads to no change
in quantity demand - a vertical demand curve.
 Unit elastic (= 1). A given percentage change in price leads to an equal percentage
change in quantity demand.
 Perfectly elastic (= infinity). Any increase in price (however small) leads to zero
demand. Hence, a horizontal demand curve - consumers will purchase as much as
they want at the going price, but only at that price.

The ratio of the percentage change in quantity demanded to the percentage change in
price changes continuously along such a curve.At the top of the curve, the percentage
change in quantity is large (since the level of quantity is relatively low) while the
percentage change in price is small (since the level of price is relatively high). Thus,
demand will be relatively elastic at the top of the demand curve. At the bottom of the
curve, the same change in quantity demanded is a small percentage change (since the
level of quantity is large) while the change in price is now a relatively large percentage
change (since the level of price is low). Thus, demand is relatively inelastic at the bottom
of the demand curve.

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INTRODUCTION TO MICROECONOMICS – UNIT 3 – Elasticity

Elasticity declines continuously along a linear demand curve. Highly elastic at the top
and highly inelastic at the bottom, while it becomes smaller as price declines and quantity
rises. At some point, demand changes from being elastic to inelastic. The point at which
that occurs, of course, is the point at which demand is unit elastic.

Determinants of Price Elasticity of Demand

What makes the demand for some goods elastic and the demand for others inelastic? Or a
consumer to buy a product, it must pass the cost-benefit test. The main determinants of
price elasticity of demand are as follows:

1. Substitutability - the ease with which one good can be substituted for another. The
more and closer substitutes available for a good, the more elastic the demand tends to
be. For example, salt has no close substitutes, so the demand is highly inelastic and
the QD is insensitive to price changes.However, if there are no close substitutes for
the good, then its demand is likely to be less price elastic.
2. Commodity or budget share - the proportion of income spent on the good. In
general, the larger the % of income absorbed by the good, the higher the elasticity,
ceteris paribus, since the greater is your incentive to look for substitutes when the
price of the item increase.
3. Time - demand tends to be more elastic in the long-run as consumers often need time
to adjust their spending patterns (e.g. find substitutes)

An understanding of the factors that influence the price elasticity of demand is important
to consumers and also the design effective public policy. If two demand curves have a
point in common, the steeper curve will have a lower elasticity than the other with respect
to price at that point. This does not mean that the steeper curve is less elastic at every
point.

Calculation of Price Elasticity

There are two ways to compute the value of price elasticity of demand, depending on
whether small or large changes in price are being considered.

1. Point Elasticity–the coefficient of price elasticity of demand at a particular point on a

demand curve. The point elasticity computation is usually used when the price change is
small.

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INTRODUCTION TO MICROECONOMICS – UNIT 3 – Elasticity

ε =¿

ε =¿

where X and P represent the initial quantity and price, respectively, and the triangle
means a “change in” the variable.

Numerical example
Calculate the price elasticity of demand for good X when price changes from $20 to
$20.50 and quantity demanded changes from 300 units to 290 units per month. Using
these figures, we can calculate the point elasticity as follows:

∆X and ∆P are changes in the respective variables (X and P), where ∆X = 290 – 300 = -
10 and ∆P = $20.50 - $20.00 = $0.50. So,

ε =¿

¿¿

¿¿

¿ 1.32

Another example: suppose the taxi fare from Papine to HalfWay Tree rose by 60 per cent,
and taxi drivers find that passengers fell by 80 per cent. The price elasticity of demand
for the journey from Papine to Half Way Tree would be:

%Δ Qd −80 %
PED= = =−1. 33
%ΔP 60 %

2. Arc Elasticity
The measureof the price elasticity of demand between two points on a demand curve is
referred to as the arc elasticity. This is also referred to as the mid-point mehtod.Wehave
to compute the percentage changes between these two points on the demand curve.The
percentage change between the two points is measured as the change in the variable (QD
or price) divided by the averagevalue of the variable [((Q1 + Q2)/2) or ((P1 + P2)/2)].The
value of the arc elasticity will be the same irrespective of the direction of the change -
whether we move from point A to point B or from point B to point A. This method gives
us an estimate of the price elasticity of demand since itcalculates the price elasticity at the
midpoint over a range A to B. For a more precise calculation of the price elasticity of
demand, we would normally use the point elasticity of demand, which as stated above is
the response of a dependent variable (QD) to an extremely small change in an
independent variable (Price).

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INTRODUCTION TO MICROECONOMICS – UNIT 3 – Elasticity

Suppose that we wish to measure the elasticity of demand in the interval between a price
of $4 and a price of $5. In this case, if we start at $4 and increase to $5, price has
increased by 25%. If we start at $5 and move to $4, then price has fallen by 20%. Which
percentage change should be used to represent a change between $4 and $5?

To avoid ambiguity, the most common measure to use is thearc elasticity in which the
midpoint of the interval is used as the base value in computing elasticity. Under this
approach, the price elasticity formula becomes:

Price elasticity of demand=¿

where
Q1 +Q 2
Qm = and
2
P1 + P2
P m=
2

Suppose that quantity demanded falls from 60 to 40 when the price rises from $3 to $5.
The arc elasticity measure is given by:

Price elasticity of demand=¿

In this interval, demand is inelastic (since Ed< 1).

Example: The table below shows the demand for bottled water in Kingston

Price (US$) QD
(per bottle) (bottles per week)
$1.00 500
$1.50 400
$2.00 300
$2.50 200
$3.00 100

Calculate the price elasticity of demand (PED)for bottled water for a price rise from $1.00 to
$1.50. Is demand elastic or inelastic for this price change?

Answer:

%Δ Qd (500+400 )/2 )
( 400−500
x 100
PED= =
( (1+1 .5 )/2 )
%ΔP 1 . 5−1
x 100

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INTRODUCTION TO MICROECONOMICS – UNIT 3 – Elasticity

PED=
( 900 /2 )
−100
x 100

( 20.5.5/2 ) x 100

PED=
( 450 )
−100
x 100
=
−22 .22
=−0. 56
( 1 .25 ) x 100
0.5 40

Since PED = -0.56, the demand for bottle water is inelastic.

Elasticity and total revenue

Total revenue is defined as: total revenue = price times quantityTR = P X Q
To find out the extent to which a price change will affect total revenue, we will look at
the absolute value of price elasticities of demand in three categories as shown in the table
below.

When the value of the price Demand is

elasticity of demand is
>1 Price elastic
=1 Unit price elastic
<1 Price inelastic

Recall that changes in price and quantity demanded move in opposite direction. The
movement in total revenue will depend on the direction of the variable which changes by
the larger percentage. However, if both variables change by the same percentage, there
will be no change in total revenue. If the demand is price elastic, where QD changes by a
larger percentage than price, the change in total revenue will follow the direction of the
change in QD. An increase in QD will increase total revenue, and vice versa. If demand
is price inelastic, where the percentage change in price is greater than in QD, total
revenue will follow the direction of the movement in the change in price. An increase in
price will increase total revenue, and a decrease in price will reduce it. For unit price
elasticity, where both price and QD change by the same percentage, there will be no
change in the total revenue.

Suppose that a firm is facing a downward sloping demand curve for its product. How will
revenue change if pricefalls:

 an increase in total revenue when demand is elastic,

 no change in total revenue when demand is unit elastic, and
 a decrease in total revenue when demand is inelastic.

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INTRODUCTION TO MICROECONOMICS – UNIT 3 – Elasticity

Example: During the month of May, the demand for bread from National was 10,000 per
day at a price of $270 per bread. The total revenue earned from bread was 10,000
multiplied by $270 = $2,700,000 or $2.7 million. In June, the price of bread went up to
$300 and the quantity demanded fell to 9,600 per day. This means that the total revenue
went up to $2,880,000 (9,600 x $300) or $2.88 million, although less bread was
consumed at the higher price. The reason for the higher total revenue was that the higher
price more than make up for the fall in the quantity demanded.

We can use the arc elasticity method to compute the price elasticity of demand.

PED=
%Δ Qd
=
( 9600−10000
( 9600+10000)/2 )
x 100
=
(
−400
19600/2
x 100)
%ΔP
( 300−270
)
(300+270)/2
x 100
( )
30
570/2
x 100

PED=
(9800 ) =−0. 041 =−0 . 39
−400

(285 )
30 0 . 105

The demand is inelastic, and this is the reason why total revenue increased when there
was an increase in the price of bread. It should be noted that the positive percentage
change in price was greater than the negative percentage change in quantity demanded.

In a similar manner, an increase in price will lead to:

 a reduction in total revenue when demand is elastic,

 no change in total revenue when demand is unit elastic, and
 an increase in total revenue when demand is inelastic.

If demand is And price Then total revenue

Elastic Rises Falls
Falls rises
Inelastic Rises rises
Falls falls

The diagram below illustrates the relationship that exists between total revenue and
demand elasticity along a linear demand curve.

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INTRODUCTION TO MICROECONOMICS – UNIT 3 – Elasticity

Total revenue increases as quantity increases (and price decreases) in the region in which
demand is unit elastic. Total revenue falls as quantity increases (and price decreases) in
the inelastic portion of the demand curve. Total revenue is maximized at the point at
which demand is unit elastic.

Consider the situation where the price of bread rose from $270 to $300 per loaf, but
quantity demanded fell from 10,000 per day to 9,600.

The first thing to do is to calculate the total revenue before and after the price change.
This shows that

Total revenue (before price change) = $270 × 10,000 = $2,700,000.

Total revenue (after price change) = $300 × 9,600 = $2,880,000.

From the above calculations, we can predict the price elasticity of demand from the
movements (or changes) in the price of bread and total revenue. Since total revenue
increased when the price increased, this must lead to a situation where the demand for
bread is inelastic.

Cross-price elasticity of demand

When we discussed the determinants of demand, it was stated that the demand for a good
is affected by the prices of related goods. It was noticed in the recent past that a reduction
in the price of green banana led to an increase the demand for yam. This suggests that
green banana and yam are complements. However, the reduction in the price of green
banana led to a decrease in the demand for rice, which suggests that the relationship
between green banana and rice is a substitution one. The value of the cross price elasticity
of demand would determine whether two goods are complements, substitutes, or
unrelated.

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INTRODUCTION TO MICROECONOMICS – UNIT 3 – Elasticity

Cross-price elasticity measures the percentage change in the quantity demanded of good
X with respect to the percentage change in the price of good Y, ceteris paribus. It is
calculated using the following formula:

or

Recall that the point elasticity method is used when there is a small percentage change in
price; whereas the arc elasticity method is applied whenever the percentage change is
large.

The point elasticity is given as

∆X/X
ε XY =
∆ P /P

While the arc elasticity is

||
∆ QA
Q
Cross Price elasticity of demand= Am
∆P
PB m

Q A mis the average quantity of good A

PB mis the average price of good B

The choice of method depends on the type of data provided

Cross-price elasticity can be either positive or negative. If εxy> 0 (positive) the two
goods are substitutes,where an increase in the price of Y induces a rise in the QD of
good X. If εxy< 0 (negative), the two goods are complements. The greater the absolute
value of the εxy, the greater the degree of substitutability or complementarity between the
two goods. If the two goods (X and Y) are unrelated, then a change in the price of Y will
not affect the demand for X. This absence of a relationship between these two goods
means that the cross price elasticity of demand is zero.

If cross-price elasticity is The goods are

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INTRODUCTION TO MICROECONOMICS – UNIT 3 – Elasticity

Negative Complements
Positive Substitutes

Example:
During the month of August 2016, the Jamaica Urban Transit Company (JUTC) raised its
fare by 10 per cent. This led to a 10 per cent increase in passengers’ demand for robot
taxis plying the Papine to Halfway Tree route. The cross price elasticity of demand for
robot taxis as a result of price increase administered by JUTC was 1.0, which shows that
the two services are substitutes.

Income Elasticity of Demand

Income elasticity measures the percentage change in the quantity demanded with respect
to the percentage change in consumers' income, ceteris paribus.

or

||
∆Q
Qm
Income elasticity of demand=
∆I
Im

Either one of the formula will be used, depending on the size of the percentage change in
income.

Income elasticity can be either positive (normal good) or negative (inferior good). If 0
<εI< 1, then quantity demanded rises by smaller percentage than income or an increase in
income results in a reduction in the quantity of the good demanded. If εI> 1 then quantity
demanded rises by larger percentage than income implying that quantity demanded is
quite responsive to changes in income. The former goods are often called necessities and
the latter luxury goods. The following table summarises this information.

If income elasticity is: The good is:

Negative Inferior
Positive (<1) Normal and a Necessity
Positive (>1) Normal and a luxury

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INTRODUCTION TO MICROECONOMICS – UNIT 3 – Elasticity

An increasing share of income is spent on luxury goods as income increases. This means
a 10% increase in income must be associated with a greater than 10% increase in
spending (say 20 per cent) on luxury goods. On the other hand, a smaller share of income
is spent on necessities as income rises.

All luxury goods are normal goods, while all inferior goods are necessities. Normal
goods may be either necessities or luxuries.

From the information in the following table,

Quantity
Income Demanded
$10,000 50
$20,000 60
$30,000 70
$40,000 80
$50,000 90

1. Calculate the income elasticity of demand for this good if income increases from $10,000 to
$20,000. Since the change is not a small percentage, the arc elasticity is used for the computation

 60  50 
  x100
%Qd  (50  60) 2  18.18%
IED     0.27
% I  20,000  10,000  66.67%
  x100
 (10,000  20,000) 2 

2. Calculate the income elasticity of demand for this good if income increases from $40,000 to
$50,000.
 90  80 
  x100
%Qd  (80  90) 2  11 .75%
IED     0.53
% I  50,000  40,000  22.22%
  x100
 (40,000  50,000) 2 

Is this a normal or an inferior good? How can you tell?

It is a normal good since a positive income elasticity of demand is associated with normal goods

Does the proportion of household income spent on this good increase or decrease as income
increases?

It increases

Is this good considered an economic luxury, an economic necessity, or neither? Why?

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INTRODUCTION TO MICROECONOMICS – UNIT 3 – Elasticity

Economic necessity since εI<1

Price elasticity of supply
From the law of supply, it was noted that the price and quantity supplied usually move in
the same direction, that is, they have the same sign which signals that the price elasticity
of supply is usually positive. This means that the bigger the price elasticity of supply, the
more responsive the supply of that good to a change in price. Thus, if the price elasticity
of supply is greater than 1, ε S> 1, the supply is price elastic, unit price elastic if it is equal
to 1, ε S = 1, and price inelastic if it is less than 1,ε S< 1.

The price elasticity of supply is:

The point or arc elasticity computation will be used depending on the size of the price
change.

A perfectly inelastic supply curve is vertical, where the price elasticity of supply is zero.
For prices above a certainlevel, the supply curve becomes perfectly inelastic for some
goods for which only a finite quantity is available. This is also true for highly perishable
commodities that must be sold on the day they are brought to market. A fisherman with
no storage facilities, for example, must sell all of the fish caught at the end of a given day
at whatever price can be received.

A perfectly elastic supply curve is horizontal. The supply curve facing a single buyer in a
market in which there are a very large number of buyers and sellers is likely to appear to
be perfectly elastic (or close to this, anyway). This will occur when each buyer is a
"price-taker" who has no effect on the market price.

The short run is defined as the period of time in which capital is fixed (only one factor is
variable). All inputs are variable in the long run.

Determinants of Supply Elasticity

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INTRODUCTION TO MICROECONOMICS – UNIT 3 – Elasticity

It is expected that supply will be more elastic in the long run than in the short run since
firms can expand or contract their capital in the long run. In the short run, an increase in
the price of personal computers may result in increased employment, more overtime, and
additional shifts in computer factories. In the long run, though, higher prices will lead to a
larger expansion in output as new factories are built.

Flexibility of inputs that can be used in the production of other goods, and if it is
relatively easy to lure that input away from their current uses the supply of that good is
relative elastic with respect to price.

Mobility of inputs: if inputs can be transported easily from one point to another, an
increase in the price of a production one market will enable a producer in that market to
summon inputs from other markets.

Ability to produce substitute inputs

Time is an important determinant of the price elasticity of supply. In the short-run,

changes in supply will be very small since most factors of production are fixed, so there
will be a low price elasticity of supply. However, in the long-run, the supply response
will be more price elastic.Suppose house rents in Mona increase, in the short–run the
increase in rent is likely to induce house owners to rent out a relatively small number of
additional rooms. However, with higher rents, owners may seek to increase rooms for
rental at a more vigorous pace. In the short-term, the supply response is likely to be fairly
modest, implying a low price elasticity of supply. In the longer-term, the supply curve is
likely to be much more price elastic. Over time, more houses and apartments can be built.

Tax incidence
The distribution of the burden of a tax depends on the elasticity of demand and supply.
When supply is more elastic than demand, consumers bear a larger share of the tax
burden. Producers bear a larger share of the burden of a tax when demand is more elastic
than supply.

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