1. Chapter 4 Elasticities of Demand and Supply
Microeconomics
Curtis & Irvine, 2013

2. Learning Outcomes In this chapter we will examine…
Demand elasticity as a measure of responsiveness
Relationship between total expenditures and demand elasticity
Short-run and long-run elasticities
Cross-price elasticity
Income elasticity of demand
Price inflation and elasticities
Supply elasticity
Tax incidence and elasticities

3. The Price Elasticity of Demand
The law of demand states that there is an inverse relationship between P and Qd
The question for this chapter is: By how much does quantity demanded change in response to a change in price?
Elasticities are all about responsiveness of either Qd or Qs

4. The Price Elasticity of Demand
Definition…
Percentage Change in quantity demanded caused by a percentage in price
Calculation…
% Change in quantity demanded
% Change in Price

5. The Price Elasticity of Demand
Notation...
εd =
%ΔQ
ΔQ/Q ΔQ P = = x
%ΔP
ΔP/P ΔP Q
Example: a 10% price increase reduces
The quantity demanded by 20%
%ΔQ
-20%
εd = =
= -2
See Section 4-1 in the main text.
%ΔP
10%
The “-” shows that P and Q move in opposite directions, but we may omit it

6. The Price Elasticity of Demand
Choosing the denominator reference point – Midpoint
Average quantity = (Q1+Q2)/2
Average price = (P1+P2)/2
Example…
Price drops from $8.0 to $6.0 and quantity demand goes from 2 to 4
%ΔQ
ΔQ/(average Q)
2/3
εd = = =
= -2.33
%ΔP
ΔP/(average P)
-2/7
See value in table 4.1

7. The Demand for Gas – Arc Values
Let’s look at the elasticity values
Price
Quantity Demanded
Price Elasticity (Arc)
Price Elasticity (Point)
Total Revenue
10.0
-9.0
8.0 2
-2.33
6.0 4
-1.22
5.0 5
-0.82
4.0 6
-0.43
2.0 8
-0.11
0.0 10

8. The Demand for Gas –Point Values
Let’s determine the values
Price
Quantity Demanded
Price Elasticity (Arc)
Price Elasticity (Point)
Total Revenue
10.0
-9.0
8.0 2
-2.33
6.0 4
-1.22
5.0 5
-0.82
4.0 6
-0.43
2.0 8
-0.11
0.0 10
- 4.0
- 1.5
- 1.0
What about elasticity values at Intercepts? Next slide….

9. Elasticity Values at Intercepts
At the vertical intercept Q = 0
At the horizontal intercept P = 0
In the elasticity formula:
If P = 0 (horizontal intercept) then elasticity = 0
If Q = 0 (vertical intercept) then elasticity becomes infinitely large – think of a progressively smaller value of Q to consider what happens to the numerical value of the elasticity

10. The Demand for Gas - Revenue
Price
Quantity Demanded
Price Elasticity (Arc)
Price Elasticity (Point)
Total Revenue
= P x Q
10.0
-9.0 -∞
8.0 2
-2.33
-4.0
6.0 4
-1.22
-1.5
5.0 5
-0.82
-1.0
4.0 6
-0.43
-0.67
2.0 8
-0.11
-0.25
0.0 10 -0 16 24 25 24 16

11. Demand for Gas – in Graphic Form
The price elasticity varies along the length of a straight-line demand curve
P = 10.0
ε = - 9
High Elasticity Range (elastic)
P = 8.0
Midpoint (unit elastic)
ε = - 1
P = 5.0
Low Elasticity Range
(inelastic)
ε =
P = 2.0 5
Q = 10

12. Extreme Cases D D P1 P0 P2 Q0 Q1 Q2 Figure 4.2 (a) Zero Elasticity
Figure 4.2 (b) Infinite Elasticity D P1 D P0 P2 Q0 Q1 Q2
A change in price has no impact on Quantity
A change in quantity can be effected without any change in Price

13. Elastic and Inelastic Demand
Demand is Elastic
when the price elasticity (ignoring the negative sign) is > -1
Demand is Inelastic
when the price elasticity lies between -1 and 0
Demand is Unit Elastic
when the price elasticity is exactly one

14. Determinants of Price Elasticity
The ease with which consumers can substitute another good
Example...
Consumers can readily substitute one brand of detergent for another if the price rises
So we expect demand to be elastic for a particular brand
But if all detergent prices rise, the consumer cannot switch
So we expect demand to be inelastic for detergents as a group
Since it is difficult to find substitutes for life’s necessities (e.g. food, shelter etc.) their demand is inelastic
In general, the more narrowly we define a commodity, the easier it is to find a substitute, so the larger will be the price elasticity.
See Section 4-1 in the main text.

15. Determinants (cont’d)
Luxuries versus Necessities…
All other factors held constant, luxuries exhibit elastic demands
All other factors held constant, necessities exhibit inelastic demands

16. Using Price Elasticities
The Impact of Demand Elasticity on Price and Quantity Fluctuations
When demand is inelastic
A supply shock will have large impact on price and little impact on quantity D S2 S1 P2 B C
When demand is elastic
The same supply shock will only have small effect on price and a large impact on quantity P3 A P1 D’ Q3 Q2 Q1

17. Price Elasticity and Total Expenditure
There is an important relationship between the demand elasticity and total revenue/expenditure
Total revenue…
Price * Quantity = P*Q
Most demand curves have an elastic portion near the top and an inelastic portion near the bottom
Elastic Range A PA B PB
Expenditure increases
Midpoint
Inelastic Range C PC E PE QA QB
Expenditure decreases QC QE

18. Demand Elasticity and Total Expenditure
For a price fall: If demand is elastic, revenue from new sales will exceed the fall in revenue from existing sales—total revenue will rise D
Unit elasticity
Elastic
Inelastic
Quantity
Price 
The following figures show the D curve on the top aligned with the total revenue curve on the bottom
They both share the same horizontal axis with quantity demanded
The variable on the vertical axis for the total revenue curve is total revenue = P*Q
If demand is inelastic, revenue from new sales will be less than the fall in revenue from existing sales—total revenue will fall
Quantity
Revenue
Total
(+)TR < (-)TR
(+)TR > (-)TR
See section 4-2 and Figure 4-4 in the main text.

19. Short-Run and Long-Run Elasticity
In the short run, consumers may not be able (or ready) to adjust their pattern of expenditure
If price changes persist, consumers are more likely to adjust
Demand thus tends to be
more elastic in the long run
but relatively inelastic in the short run
See Section 4-4 in the main text.

20. The Cross-Price Elasticity of Demand
The cross-price elasticity of demand for good x with respect to the price of good y is:
% change in quantity demanded of good x
% change in the price of good y
This may be positive or negative
The cross-price elasticity is positive if two goods are substitutes e.g. electronic books and paper books
See Section 4-5 in the main text.
The cross-price elasticity is negative if two goods are complements e.g. electronic books and electronic readers

21. The Income Elasticity of Demand
The income elasticity of demand measures the sensitivity of quantity demanded to a change in income:
% change in quantity demanded of a good
% change in consumer income
The income elasticity may be positive or negative
Why?......
See Section 4-6 in the main text.

22. Normal and Inferior Goods
A Normal Good has a positive income elasticity of demand
an increase in income leads to an increase in demand
e.g. Most things we consume
An Inferior Good has a negative income elasticity of demand
an increase in income leads to a fall demand
e.g. Kraft Dinner
A Luxury Good has an income elasticity of demand greater than 1
It is a particular type of normal good
e.g. wine
See Section 4-6 in the main text.

23. Income and the Demand Curve
For an increase in income...
Quantity
Price D0
NORMAL GOOD
INFERIOR GOOD D1
Demand curve
moves to the right D1
Demand curve
moves to the left
See Section 4-6 in the main text, and Figure 4-5.

24. Inflation and Demand Elasticity
Price inflation exists in most economies
e.g. All prices rose in 2009 by 2%
When computing the price elasticity of demand for one good we use the price change of that good relative to the inflation rate
Example: If good X increase in price by 5%, its quantity declines by 1%, and the inflation rate is 2%
εd =
%ΔQ
-1% -1 = =
%ΔP 3% 3

25. % change in quantity supplied
Elasticity of Supply
Measures the responsiveness of the quantity supplied to a change in price….
% change in quantity supplied
% change in price
Same definition as price elasticity of demand except that it applies to the supply curve

26. Alternative Supply Elasticities
S elasticity => zero implies large price increases
From point A, a shift in demand will induce a different quantity response, depending on the supply elasticity S Bz P1 B BI P0
S elasticity approaching infinity implies large quantity increases A D1 D Q0 Q1

27. The Cross-Price Elasticity of Supply
The cross-price elasticity of supply for good x
with respect to the price of good y is:
% change in quantity supplied of good x
% change in the price of good y
See Section 4-5 in the main text.

28. Elasticities and Taxes
An understanding of elasticities is vital to evaluating the impact of a government’s taxation policies
Will an increase in the tax rate really raise total revenue?
Types of taxes
specific type (a fixed dollar levy per unit sold)
ad valorem type (a percentage levy)
Incidence of the tax
How the tax burden is shared by buyers and sellers?
In most cases an increase or decrease in the tax changes the price
Therefore in examining tax incidence, one has to examine the net effect of the tax on the equilibrium price

29. Tax Incidence with Elastic Supply
$3, consumer pays
Tax causes supply to shift St
Price to buyer increases B
$4 = Tax
Pt=8 S A
P0=5
Price to supplier declines because of upward sloping supply curve and lower quantity traded
Pts=4 C
$1, supplier pays Qt Q0
The more elastic the supply curve, the greater is the incidence or the buyer

30. Tax Incidence with Inelastic Supply
Suppose the market price increases by $1 in response to the tax S B
$4 = Tax
P1=6
$1, consumer pays
P0=5 A
$3, supplier pays
Pts=2 C
The more inelastic the supply curve, the greater is the incidence or the supplier Qt Q0

31. Identifying elasticities
(b)
Price
Price
We observe points A, B, C. Do we know they define a demand curve?
Supplya
* A
Supplyb
* A
* B
Supplyc
* B
* C
* C
Demand
Quantity
Quantity
If these points define a demand curve, we must know that the supply curve alone has shifted in such a way as to result in these equilibrium price-quantity combinations

32. Chapter Summary
The elasticity of demand measures the responsiveness of quantity demanded to changes in price
Arc elasticity vs. point elasticity
Along a linear demand curve, the elasticity falls as we move from high prices to low prices
Demand as elastic, inelastic, and unit elastic
Cross-price elasticity of demand

33. Chapter Summary
In computing the price elasticity, the price change must be net of the inflation rate
Income elasticity of demand; inferior and normal goods
The elasticity of supply measures the responsiveness of quantity supplied to change in price
The incidence of a tax depends upon the supply and demand elasticities