05 Elasticity

Elasticity
THE MARKET MECHANISM
Figure 2.3
Supply and Demand
The market clears at price P0

and quantity Q0.
At the higher price P1, a surplus

develops, so price falls.
At the lower price P2, there is a

shortage, so price is bid up.
● surplus Situation in which the quantity

supplied exceeds the quantity demanded.
● shortage Situation in which the quantity
demanded exceeds the quantity supplied.
Different types of goods
Normal goods Inferior goods
• A good that experiences an increase in demand • An inferior good is one whose demand
due to an increase in consumers income. drops when people's incomes rise.
• +ve ey Example: second hand clothes
Examples: Clothes, Furniture
Luxurious goods
Giffen goods • They are not deemed essentials or necessities to live.
▪ It is a rare forms of inferior goods that have These goods are highly desired and can be purchased
no ready substitute or alternative. when a consumer's income rises.
▪ Focuses on a low income, non-luxury Examples : cleaning and cooking services, handbags and
products. luggage, certain automobiles
▪ Examples: bread, rice, and potatoes.
Veblen goods
A Veblen good is an item whose increase in price may actually results in higher sales. These types of
goods are often a subset of a luxury good, and this type of good often defies many traditional
concepts of economics.
Examples: designer jewellery, fine wines, luxury cars
Paradox in economics
The situation where the variables fail to follow the generally laid principles and
assumptions of the theory and behave in an opposite fashion.
• Giffen paradox
Veblen paradox
Abnormal market behavior where consumers
purchase the higher-priced goods whereas similar low-
priced (but not identical) substitutes are available.
Elasticity
• What it is?
• Measurement
• Inferences
Elasticity ?
Elasticity: Response of X to change in Y
Elasticity of QD or QS: Response of QD or QS
A measure of the
responsiveness of quantity
demanded or quantity
supplied to a change in
one of its determinants
Price elasticity of demand

Responsiveness of quantity demanded
of a good to a change in the price of that commodity.
𝒅
𝐞𝒑
Other Demand Elasticities
Income Elasticity of Demand

Income elasticity of demand
of a good to a change in the Income of the consumer.
Cross-Price Elasticity of Demand

Cross-Price elasticity of demand
of a good to a change in the price of another good.
The Price Elasticity of Demand and Its Determinants
Availability of Close Substitutes
Goods with close substitutes tend to have more elastic
demand because it is easier for consumers to switch from
that good to others.
Necessities versus Luxuries
Necessities tend to have inelastic demands, whereas
luxuries have elastic demands.
Definition of the Market
Depends on how we draw the boundaries of the market.
Narrowly defined markets - tend to have more elastic demand than broadly
defined markets because it is easier to find close substitutes for narrowly defined
goods.
Time Horizon Goods tend to have more elastic demand over longer time
horizons. When the price of gasoline rises, the quantity of gasoline demanded falls
only slightly in the first few months. Over time, however, people buy more fuel efficient
cars, switch to public transportation, and move closer to where they work.
Within several years, the quantity of gasoline demanded falls more substantially
Measuring Elasticity ?
• Percentage method
• Midpoint method
• Point or Geometrical (or Graphical) method
• Total outlay method
• Arc Method
Elasticity ?
• Percentage method
computed as
the percentage change
in quantity demanded
divided by the percentage
change in price
Other Demand Elasticities
Income Elasticity of Demand
Cross-Price Elasticity of Demand

Measuring Elasticity ? Price
• Problem with Percentage method B

6
A
4
80 120
From point A to B From point B to A
Price Increase 50% Price Falls by 33%

Quantity fall by 33% Quantity Raise by 50%
price elasticity of demand is 33/50, or 0.66. price elasticity of demand 50/33, or 1.5.
We go for Midpoint method
Midpoint: Price $5 Quantity 100 (40% and e=1)

Midpoint method
• The following formula expresses the midpoint method for calculating the price elasticity of demand
between two points, denoted (Q1, P1) and (Q2, P2):
DD curve with various elasticities
Price Elasticity of Demand
Elastic Inelastic
Tomato Hyundai Car Car Salt
-∞ -4.6 -4.3 -1.3 E = -1 -0.1 0

Infinitely Unitary Completely
Elastic Elastic Inelastic
Total Revenue and the Price Elasticity of Demand
Total Revenue
the amount paid by
buyers and received
by sellers of a good,
computed as the price
of the good times the
quantity sold
P×Q
Some general rules:
• When demand is inelastic (a price elasticity less than 1),
price and total revenue move in the same direction:
If the price increases, total revenue also increases.
• When demand is elastic (a price elasticity greater than 1),

price and total revenue move in opposite directions:
If the price increases, total revenue decreases.
• If demand is unit elastic (a price elasticity exactly equal to 1),

Total revenue remains constant when the price changes.
Elasticity of Supply
SHORT-RUN VERSUS LONG-RUN ELASTICITIES
Demand
Figure 2.13
(a) Gasoline: Short-Run and Long-Run
Demand Curves
In the short run, an increase in price
has only a small effect on the quantity
of gasoline demanded. Motorists may
drive less, but they will not change the
kinds of cars they are driving
overnight.
In the longer run, however, because

they will shift to smaller and more fuel-
efficient cars, the effect of the price
increase will be larger. Demand,
therefore, is more elastic in the long
run than in the short run.
SHORT-RUN VERSUS LONG-RUN ELASTICITIES
Demand
Income Elasticities
Income elasticities also differ from the short run to the long run.
For most goods and services—foods, beverages, fuel,
entertainment, etc.— the income elasticity of demand is larger in
the long run than in the short run.
For a durable good, the opposite is true. The short-run income
elasticity of demand will be much larger than the long-run
elasticity.
MARKET DEMAND
Elasticity of Demand
Denoting the quantity of a good by Q and its price by P, the price

elasticity of demand is
(4.1)
Inelastic Demand
When demand is inelastic, the quantity demanded is relatively

unresponsive to changes in price. As a result, total expenditure on the
product increases when the price increases.
Elastic Demand
When demand is elastic, total expenditure on the product decreases
as the price goes up.
MARKET DEMAND
Isoelastic Demand
● isoelastic demand curve Demand curve with a constant price
elasticity.
Figure 4.11
Unit-Elastic Demand Curve
When the price elasticity

of demand is −1.0 at
every price, the total
expenditure is constant
along the demand curve
D.
Price falls from 9 to 6 = 33%

Quantity increase from 600 to 900 = 33%
MARKET DEMAND
Isoelastic Demand
TABLE 4.3 Price Elasticity and Consumer Expenditures

Demand If Price Increases, If Price Decreases,
Expenditures Expenditures
Inelastic Increase Decrease
Unit elastic Are unchanged Are unchanged
Elastic Decrease Increase
CONSUMER SURPLUS
TABLE 4.3 Price Elasticity and Consumer Expenditures

● consumer surplus Difference between what a consumer
is willing to pay for a good and the amount actually paid.
Consumer Surplus and Demand
Figure 4.13
Consumer Surplus
Consumer surplus is the

total benefit from the
consumption of a product,
less the total cost of
purchasing it.
Here, the consumer

surplus associated with
six concert tickets
(purchased at $14 per
ticket) is given by the
yellow-shaded area:
$6 + $5 + $4 + $3 + $2 +
$1 = $21
CONSUMER SURPLUS
Consumer Surplus and Demand

Figure 4.14
Consumer Surplus Generalized
For the market as a whole,

consumer surplus is
measured by the area under
the demand curve and above
the line representing the
purchase price of the good.
Here, the consumer surplus is

given by the yellow-shaded
triangle and is equal to
1/2 × ($20 − $14) × 6500 =
$19,500.
Consumer Surplus
◼Individual consumer surplus is the difference

between the maximum amount that a consumer is
willing to pay for a good and the amount that the
consumer actually pays.

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Elasticity

THE MARKET MECHANISM

Supply and Demand

The market clears at price P0

At the higher price P1, a surplus

At the lower price P2, there is a

● surplus Situation in which the quantity

Price elasticity of demand

Income Elasticity of Demand

Cross-Price Elasticity of Demand

Income Elasticity of Demand

Cross-Price Elasticity of Demand

• Problem with Percentage method B

From point A to B From point B to A

Price Increase 50% Price Falls by 33%

We go for Midpoint method

Midpoint: Price $5 Quantity 100 (40% and e=1)

Tomato Hyundai Car Car Salt

-∞ -4.6 -4.3 -1.3 E = -1 -0.1 0

• When demand is elastic (a price elasticity greater than 1),

• If demand is unit elastic (a price elasticity exactly equal to 1),

In the longer run, however, because

Denoting the quantity of a good by Q and its price by P, the price

When demand is inelastic, the quantity demanded is relatively

Unit-Elastic Demand Curve

When the price elasticity

Price falls from 9 to 6 = 33%

TABLE 4.3 Price Elasticity and Consumer Expenditures

TABLE 4.3 Price Elasticity and Consumer Expenditures

Consumer surplus is the

Here, the consumer

Consumer Surplus and Demand

Consumer Surplus Generalized

For the market as a whole,

Here, the consumer surplus is

◼Individual consumer surplus is the difference

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