Elasticity and its Application

Concept of Elasticity

Elasticity is used to describe the behavior of

buyers and sellers in the market
Elasticity is a measure of the quantity
demanded or supplied to one of its
determinants
Elasticity of demand measures how much
quantity demanded responds to change in one
of its determinants
Price elasticity of demand is a measure of
how much the quantity demanded of a good
responds to a change in the price of that good

Concept of Elasticity
Price e of demand=
% change in quantity demanded/ % change in price

Remember price elasticity of demand is

always negative
Price e of demand determines whether the
demand curve is steep or flat
Demand for a good is elastic if the quantity
demanded responds substantially to
changes in the price
Demand for a good is inelastic if the
quantity demanded responds only slightly
to changes in the price

Determinants of Price Elasticity of

Demand

Necessities (inelastic) versus luxuries

(elastic)
Availability of close substitutes (highly
elastic)
Definition of the market
Time horizon

Computing Price Elasticity of Demand

Using the midpoint method

The midpoint method gives us the same
price elasticity of demand between two
points regardless of the direction of change
The midpoint method computes a % change
by dividing the change by midpoint of the
initial and final levels
Always use midpoint method to calculate
elasticity between two points

Variety of Demand Curves

Perfectly inelastic demand (e=0)

Inelastic demand (e<1)
Unit elastic demand (e=1)
Elastic demand (e>1)
Perfectly elastic demand (e=infinity)
The flatter the curve passing through a given
point, the greater the elasticity of demand
The steeper the curve passing through a given
point, the smaller the elasticity of demand

Total revenue and the Price Elasticity

of Demand

TR= PxQ
TR changes as one moves along the demand
curve due to changing price elasticity of demand
The slope of a linear demand curve is constant
but its elasticity is not
The following general rules apply:

When demand is inelastic, a price increase raises TR,

and a price decrease reduces TR
When demand is elastic, a price increase reduces TR,
and a price decrease raises TR
In case of unit elastic demand, a change in the price
does not affect TR

Other Demand Elasticities

Income elasticity of demand =% change in

quantity demanded/ % change in income

Normal goods (positive income elasticity)

Inferior goods (negative income elasticity)
Necessities (small income elasticity)
Luxuries (high income elasticity)

Cross price elasticity of demand= % change in

quantity demanded of good X/ % change in price
of good Y

Substitutes (positive cross-price elasticity)

Complements (negative cross-price elasticity)

Elasticity of Supply
Price elasticity of supply is a measure of how
much the quantity supplied of a good responds to
a change in the price of that good
Price elasticity of supply=
% change in quantity supplied/ % change in price
Determinants of elasticity of supply:
Flexibility of sellers to change their production
levels
Time period (short versus long)

Elasticity of Supply

Supply of a good is elastic if the quantity supplied

responds substantially to changes in price
Supply of a good is inelastic if the quantity
supplied responds slightly to changes in price
Computing price elasticity of supply using midpoint
method

(Change in quantity/midpoint of initial and final

quantity) / (change in price/midpoint of initial and final
price)

Variety of Supply Curves

Perfectly inelastic supply (e=0)

Inelastic supply (e<1)
Unit elastic supply (e=1)
Elastic supply (e>1)
Perfectly elastic supply (e=infinity)
The flatter the curve passing through a given
point, the greater the elasticity of supply
The steeper the curve passing through a given
point, the smaller the elasticity of supply

Variety of Supply Curves

Price elasticity of supply varies over the

supply curve in some markets. Why?
e<1

Price

e>1

QS

Applications of supply, demand,

and elasticity

Impact of change in technology on market

equilibrium

Can good news for farming be bad news for farmers?

Advanced technology results in a new market equilibrium

with lower prices and larger quantity sold in the market.

Behavior of supply and demand in the SR and

LR

Why did OPEC fail to keep the price of oil high?

In the SR supply and demand are inelastic and in the LR

both of them are elastic

Applications of supply, demand,

and elasticity

Impact of policy on market equilibrium

Does drug interdiction policy increase or

decrease drug-related crime?

Drug related crime increases in the SR and

decreases in the LR
Drug education policy would reduce drug usage
and drug- related crime in the SR.