Introduction to Elasticity

What is Elasticity?

Elasticity measures how responsive one variable is to changes in another variable. In

economics, we use elasticity to measure how sensitive quantity demanded or supplied is to
changes in various factors.

Why Elasticity Matters:

●​ Helps businesses make pricing decisions

●​ Helps governments predict effects of taxes and regulations
●​ Explains why some markets are more volatile than others
●​ Determines who bears the burden of taxes

Types of Elasticity We'll Study:

1.​ Price Elasticity of Demand - How quantity demanded responds to price changes
2.​ Income Elasticity of Demand - How quantity demanded responds to income
changes
3.​ Cross-Price Elasticity of Demand - How quantity demanded responds to changes
in prices of other goods
4.​ Price Elasticity of Supply - How quantity supplied responds to price changes

Price Elasticity of Demand

Definition

Price Elasticity of Demand measures how responsive quantity demanded is to changes in

price.

Formula: Price Elasticity of Demand = % Change in Quantity Demanded / % Change in

Price

Alternative Formula: Ed = (ΔQ/Q) / (ΔP/P)

Where:

●​ ΔQ = Change in quantity demanded

●​ Q = Original quantity demanded
●​ ΔP = Change in price
●​ P = Original price

Calculating Percentage Changes

Percentage Change Formula: % Change = (New Value - Old Value) / Old Value × 100

Example:

●​ Price increases from $10 to $12: % Change = ($12 - $10) / $10 × 100 = 20%
●​ Quantity decreases from 100 to 80: % Change = (80 - 100) / 100 × 100 = -20%
●​ Price Elasticity = -20% / 20% = -1

The Midpoint Method

To avoid problems with direction of change, economists often use the midpoint method:

Midpoint Formula: Ed = [(Q2 - Q1) / ((Q2 + Q1)/2)] / [(P2 - P1) / ((P2 + P1)/2)]

This gives the same result regardless of whether price increases or decreases.

Interpreting Price Elasticity Values

Sign: Price elasticity of demand is almost always negative (due to law of demand)

Magnitude: We typically focus on the absolute value

Classification:

●​ |Ed| > 1: Elastic Demand - Quantity is very responsive to price changes

●​ |Ed| < 1: Inelastic Demand - Quantity is not very responsive to price changes
●​ |Ed| = 1: Unit Elastic Demand - Quantity changes proportionally to price
●​ |Ed| = 0: Perfectly Inelastic Demand - Quantity doesn't change when price changes
●​ |Ed| = ∞: Perfectly Elastic Demand - Any price increase causes quantity to drop to
zero

Examples of Elastic and Inelastic Goods

Elastic Demand (|Ed| > 1):

●​ Luxury goods (jewelry, expensive cars)

●​ Goods with many substitutes (brand-name cereals)
●​ Non-essential goods (restaurant meals, entertainment)
●​ Goods that represent a large portion of income

Inelastic Demand (|Ed| < 1):

●​ Necessities (food, medicine, gasoline)

●​ Goods with few substitutes (insulin for diabetics)
●​ Goods that are habit-forming (cigarettes, coffee)
●​ Goods that represent a small portion of income (salt, toothpicks)

Factors Affecting Price Elasticity of Demand

1.​ Availability of Substitutes
○​ More substitutes → More elastic demand
○​ Fewer substitutes → Less elastic demand
2.​ Necessity vs. Luxury
○​ Necessities → Inelastic demand
○​ Luxuries → Elastic demand
3.​ Time Period
○​ Short run → Less elastic (people need time to adjust)
○​ Long run → More elastic (more time to find alternatives)
4.​ Proportion of Income
○​ Large portion of income → More elastic
○​ Small portion of income → Less elastic
5.​ Brand Loyalty/Habit
○​ Strong habits → Less elastic
○​ Weak habits → More elastic
6.​ Definition of Market
○​ Broadly defined (food) → Less elastic
○​ Narrowly defined (pizza) → More elastic

Elasticity and Total Revenue

Total Revenue

Total Revenue = Price × Quantity

The Total Revenue Test

The relationship between elasticity and total revenue helps businesses make pricing
decisions:

When Demand is Elastic (|Ed| > 1):

●​ Price increase → Total revenue decreases

●​ Price decrease → Total revenue increases
●​ Strategy: Lower prices to increase revenue

When Demand is Inelastic (|Ed| < 1):

●​ Price increase → Total revenue increases

●​ Price decrease → Total revenue decreases
●​ Strategy: Raise prices to increase revenue

When Demand is Unit Elastic (|Ed| = 1):

●​ Price changes don't affect total revenue

●​ Total revenue is maximized
Why This Relationship Exists

Elastic Demand:

●​ When you raise price, you lose a lot of customers

●​ The percentage decrease in quantity is larger than the percentage increase in price
●​ Revenue falls

Inelastic Demand:

●​ When you raise price, you lose few customers

●​ The percentage decrease in quantity is smaller than the percentage increase in price
●​ Revenue rises

Business Applications

●​ Movie theaters: Offer student discounts because student demand is more elastic
●​ Airlines: Charge business travelers more because their demand is less elastic
●​ Utilities: Can raise rates because demand for electricity is inelastic
●​ Luxury brands: May raise prices to signal exclusivity (assuming demand stays
inelastic)

Income Elasticity of Demand

Definition

Income Elasticity of Demand measures how responsive quantity demanded is to changes

in income.

Formula: Income Elasticity = % Change in Quantity Demanded / % Change in Income

Alternative Formula: Ei = (ΔQ/Q) / (ΔI/I)

Types of Goods Based on Income Elasticity

Normal Goods (Ei > 0):

●​ Demand increases when income increases

●​ Most goods are normal goods

Inferior Goods (Ei < 0):

●​ Demand decreases when income increases

●​ Examples: generic brands, public transportation, ramen noodles

Luxury Goods (Ei > 1):

●​ Subset of normal goods
●​ Demand increases more than proportionally to income
●​ Examples: jewelry, expensive cars, fine dining

Necessity Goods (0 < Ei < 1):

●​ Subset of normal goods

●​ Demand increases less than proportionally to income
●​ Examples: food, clothing, housing

Applications of Income Elasticity

●​ Business planning: Luxury goods companies do well in economic booms

●​ Economic development: As countries get richer, demand shifts from necessities to
luxuries
●​ Investment decisions: Industries with high income elasticity are more cyclical

Cross-Price Elasticity of Demand

Definition

Cross-Price Elasticity of Demand measures how responsive the quantity demanded of

one good is to changes in the price of another good.

Formula: Cross-Price Elasticity = % Change in Quantity Demanded of Good A / % Change

in Price of Good B

Alternative Formula: Exy = (ΔQx/Qx) / (ΔPy/Py)

Types of Goods Based on Cross-Price Elasticity

Substitute Goods (Exy > 0):

●​ When price of one good increases, demand for the other increases
●​ Examples: Coke and Pepsi, butter and margarine, movies and streaming

Complement Goods (Exy < 0):

●​ When price of one good increases, demand for the other decreases
●​ Examples: cars and gasoline, printers and ink cartridges, phones and phone cases

Unrelated Goods (Exy ≈ 0):

●​ Price changes in one good don't affect demand for the other
●​ Examples: shoes and apples, cars and books

Applications of Cross-Price Elasticity

●​ Business strategy: Understanding competitor relationships
●​ Product bundling: Selling complements together
●​ Market definition: Determining industry boundaries for antitrust analysis

Price Elasticity of Supply

Definition

Price Elasticity of Supply measures how responsive quantity supplied is to changes in

price.

Formula: Price Elasticity of Supply = % Change in Quantity Supplied / % Change in Price

Alternative Formula: Es = (ΔQs/Qs) / (ΔP/P)

Interpreting Supply Elasticity Values

Sign: Price elasticity of supply is typically positive (due to law of supply)

Classification:

●​ Es > 1: Elastic Supply - Quantity supplied is very responsive to price changes

●​ Es < 1: Inelastic Supply - Quantity supplied is not very responsive to price changes
●​ Es = 1: Unit Elastic Supply - Quantity supplied changes proportionally to price
●​ Es = 0: Perfectly Inelastic Supply - Quantity supplied doesn't change when price
changes
●​ Es = ∞: Perfectly Elastic Supply - Producers will supply any amount at the market
price

Factors Affecting Price Elasticity of Supply

1.​ Time Period

○​ Immediate run: Very inelastic (can't change production quickly)
○​ Short run: Somewhat elastic (can change variable inputs)
○​ Long run: More elastic (can change all inputs, build new facilities)
2.​ Availability of Inputs
○​ Easy to obtain inputs → More elastic supply
○​ Difficult to obtain inputs → Less elastic supply
3.​ Storage Possibilities
○​ Goods that can be stored → More elastic supply
○​ Perishable goods → Less elastic supply
4.​ Production Flexibility
○​ Flexible production processes → More elastic supply
○​ Specialized production → Less elastic supply

Examples
Elastic Supply:

●​ Manufactured goods (can increase production in response to higher prices)

●​ Services (can hire more workers relatively easily)

Inelastic Supply:

●​ Housing (takes time to build new homes)

●​ Agricultural products in short run (planting seasons limit quick changes)
●​ Rare collectibles (can't produce more antiques)

Applications of Elasticity
Tax Incidence

Tax Incidence refers to who actually bears the burden of a tax.

Key Principle: The more inelastic side of the market bears more of the tax burden.

Examples:

●​ Gasoline tax: Demand is inelastic, so consumers pay most of the tax

●​ Luxury yacht tax: Demand is elastic, so producers pay most of the tax

Price Discrimination

Businesses can charge different prices to different groups based on elasticity differences:

●​ Airlines: Business travelers (inelastic) pay more than leisure travelers (elastic)
●​ Movie theaters: Adults (less elastic) pay more than children/seniors (more elastic)
●​ Software: Businesses (inelastic) pay more than students (elastic)

Government Policy

Minimum Wage Effects:

●​ If labor supply is inelastic and labor demand is elastic, minimum wage causes
significant unemployment
●​ If labor demand is inelastic, minimum wage causes less unemployment

Sin Taxes (on cigarettes, alcohol):

●​ Effective at reducing consumption if demand is elastic

●​ Generate revenue if demand is inelastic
●​ Most sin taxes face inelastic demand, so they're better for revenue than reducing
consumption
Agricultural Markets

●​ Supply inelastic in short run: Weather shocks cause large price swings
●​ Demand inelastic: Farmers' total revenue may actually increase when crops fail
(higher prices offset lower quantities)

Elasticity Along the Demand Curve

Important Insight

For a linear demand curve, elasticity varies along the curve:

●​ Upper portion: Elastic (|Ed| > 1)

●​ Middle portion: Unit elastic (|Ed| = 1)
●​ Lower portion: Inelastic (|Ed| < 1)

Why This Happens:

●​ At high prices, small price changes represent small percentage changes

●​ At high prices, quantity is low, so small quantity changes represent large percentage
changes
●​ Therefore, at high prices, demand is elastic

Implication for Total Revenue:

●​ Revenue increases as you move down the demand curve until the midpoint
●​ Revenue decreases as you continue down past the midpoint
●​ Revenue is maximized at the unit elastic point

Key Terms to Remember

Price Elasticity of Demand: Responsiveness of quantity demanded to price changes

Elastic Demand: |Ed| > 1, quantity very responsive to price

Inelastic Demand: |Ed| < 1, quantity not very responsive to price

Unit Elastic Demand: |Ed| = 1, quantity changes proportionally to price

Total Revenue: Price × Quantity

Total Revenue Test: Method to determine elasticity based on revenue changes

Income Elasticity of Demand: Responsiveness of quantity demanded to income changes

Normal Good: Demand increases when income increases (Ei > 0)

Inferior Good: Demand decreases when income increases (Ei < 0)

Luxury Good: Demand increases more than proportionally to income (Ei > 1)

Necessity Good: Demand increases less than proportionally to income (0 < Ei < 1)

Cross-Price Elasticity: Responsiveness of quantity demanded to changes in other goods'

prices

Substitute Goods: Cross-price elasticity is positive

Complement Goods: Cross-price elasticity is negative

Price Elasticity of Supply: Responsiveness of quantity supplied to price changes

Tax Incidence: Who bears the burden of a tax

Practice Questions
Calculating Elasticity

1.​ Price Elasticity Calculation: When the price of coffee increases from $4 to $5,
quantity demanded decreases from 100 cups to 80 cups per day. Calculate the price
elasticity of demand.
2.​ Using the Midpoint Method: Movie ticket prices rise from $8 to $12, and attendance
falls from 500 to 300 people per showing. Calculate elasticity using the midpoint
method.
3.​ Income Elasticity: When average income in a city rises from $40,000 to $50,000,
the quantity of restaurant meals demanded increases from 10,000 to 15,000 per
month. Calculate income elasticity and classify the good.

Total Revenue Analysis

4.​ Revenue Effects: A movie theater currently charges $10 and sells 200 tickets per
showing. If demand is elastic, what happens to total revenue if they:
○​ Increase price to $12?
○​ Decrease price to $8?
5.​ Pricing Strategy: A business discovers that demand for its product has elasticity of
-0.5. Should it raise or lower prices to increase revenue? Why?

Classification Problems

6.​ Classify these goods as elastic or inelastic and explain why:

○​ Insulin for diabetics
○​ Designer handbags
○​ Gasoline
○​ Ice cream
○​ Cigarettes
7.​ Cross-Price Elasticity: When the price of iPhones increases by 10%, the quantity
demanded of iPhone cases decreases by 15%. What is the cross-price elasticity?
What type of relationship do these goods have?

Real-World Applications

8.​ Tax Policy: The government wants to reduce cigarette consumption and is
considering a tax. If cigarette demand is inelastic, will the tax be effective at reducing
smoking? Who will bear most of the tax burden?
9.​ Business Strategy: An airline notices that business travelers have inelastic demand
while vacation travelers have elastic demand. How should this affect their pricing
strategy?
10.​Agricultural Markets: A drought reduces the corn harvest by 20%, but corn prices
increase by 50%. What does this tell you about the elasticity of demand for corn?
What happens to farmers' total revenue?

Advanced Analysis

11.​Elasticity and Market Power: Company A faces elastic demand while Company B
faces inelastic demand. Which company has more market power? Why?
12.​Time and Elasticity: Explain why the demand for gasoline is more inelastic in the
short run than in the long run. What are the implications for gas tax policy?
13.​Income Effects: During a recession, sales of luxury cars fall dramatically while sales
of used cars increase. Explain this using income elasticity concepts.

Critical Thinking

14.​Drug Pricing: Pharmaceutical companies often charge very high prices for
life-saving medications. Using elasticity concepts, explain:
○​ Why they can charge these prices
○​ The ethical concerns this raises
○​ What policy options might address these concerns
15.​Digital Goods: How might elasticity concepts apply differently to digital goods (like
software or streaming services) compared to physical goods? Consider factors like
marginal cost, piracy, and network effects.