Concepts of Elasticity

It is noted that consumers usually buy more of a good when its price is lower, when their incomes
are higher, when the prices of its substitutes are higher, or when the prices of its complements are
lower. The discussion of demand was qualitative, not quantitative. That is, it discussed the
direction in which quantity demanded moves but not the size of the change. To measure how much
consumers respond to changes in these variables, the relevant concept is elasticity. The basic
formula for calculating a coefficient is the %∆Q/%∆P (∆ means change). After calculating the
coefficient, the absolute value (meaning positive or negative doesn’t matter) can be used to
determine the elasticity. Elasticity values are as follows:
 Absolute value of coefficient = 0: perfectly inelastic
 Absolute value of coefficient <1 (but not zero): relatively inelastic
 Absolute value of coefficient = 1: unit elastic
 Absolute value of coefficient >1 (but not ∞ or undefined): relatively elastic
 Absolute value of coefficient = ∞ or undefined: perfectly elastic.

%∆Q/%∆P gives a price elasticity coefficient. Demand curves have a negative price elasticity
coefficient due to the demand curve’s inverse relationship between price and quantity. Supply
curves have a positive price elasticity coefficient due to the direct relationship between price and
quantity.

Price Elasticity of Demand:

The law of demand states that a fall in the price of a good raises the quantity demanded. The price
elasticity of demand measures how much the quantity demanded responds to a change in price.
Demand for a good is said to be elastic if the quantity demanded responds substantially to changes
in the price. Demand is said to be inelastic if the quantity demanded responds only slightly to
changes in the price. Economists compute the price elasticity of demand as the percentage change
in the quantity demanded divided by the percentage change in the price.

The price elasticity of demand for any good measures how willing consumers are to buy less of
the good as its price rises. Because a demand curve reflects the many economic, social, and
psychological forces that shape consumer preferences, there is no simple, universal rule for what
determines a demand curve’s elasticity. There are however certain recognized factors that
influences the price elasticity of demand.

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. For example, butter and
margarine are easily substitutable. A small increase in the price of butter, assuming the price of
margarine is held fixed, causes the quantity of butter sold to fall by a large amount.
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Necessities versus Luxuries Necessities tend to have inelastic demands, whereas luxuries have
elastic demands. When the price of a doctor’s visit rises, people will not dramatically reduce the
number of times they go to the doctor, although they might go somewhat less often.
Definition of the Market The elasticity of demand in any 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.
For example, food, a broad category, has a fairly inelastic demand because there are no good
substitutes for food. Ice-cream, a narrower category, has a more elastic demand because it is easy
to substitute other desserts for ice cream. Vanilla ice cream, a very narrow category, has a very
elastic demand because other flavors of ice cream are almost perfect substitutes for vanilla.

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.
Expenses The product with relatively higher prices tend to be elastic. For example, demand for a
perennial may not be affected because of the high percentage change in price, which may not be
true for an expensive item like care.

When a large change in price causes a small change in quantity demanded, the demand curve is
relatively Inelastic. That is, consumers are relatively Insensitive to price change. Relatively
inelastic demand curves tend to be more vertical than horizontal. If consumers demand the same
quantity of good regardless of the price, the demand curve is perfectly inelastic; consumers are
perfectly Insensitive to price change. Perfectly inelastic demand curves are vertical. Goods or
services that have inelastic demand curves tend to be: necessities, having few substitutes, and are
relatively inexpensive.

Figure B16: Perfectly Inelastic and Inelastic Demand Curve

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When a small change in price causes a large change in quantity demanded, the demand curve is
relatively elastic. That is, consumers are especially sensitive to the price change. Relatively elastic
demand curves tend to be more horizontal than vertical. If consumers will demand any quantity at
one maximum price, the demand curve is perfectly elastic; consumers are perfectly sensitive to the
price change. Perfectly elastic demand curves are horizontal. Goods/services that have elastic
demand curves then to be luxury or not necessary, have many substitutes, and are relatively
expensive.

Figure B17: Perfectly Elastic and Elastic Demand Curve

There is another type of elasticity and it is called unit elastic. A unit elastic demand curve will have
equal price increases because proportional decreases in quantity demanded.

Total Revenue and Price Elasticity of Demand

When it comes to the price elasticity of demand, the simplest way to determine elasticity is the
total revenue (TR) test. The formula for total revenue is P x Q. On a demand curve, quantities fall
as prices rise and quantities rise as prices fall. If the price rises and TR increases (P and TR are
going in the same direction), the demand curve is inelastic. If the price falls and TR decreases
(again P and TR are going in the same direction, the demand curve is also inelastic. If the price
rises and TR falls (P and TR are going in opposite directions, the demand curve is elastic. If the
price falls and TR rises (again PR and TR are going in opposite directions, the demand curve is
also elastic. If price changes do not change TR the demand curve is unit elastic (an increase or
decrease in price keeps TR the same).

A straight line demand curve will have an elastic portion at the top, an inelastic portion on the
bottom and a unit elastic point in the middle. If there is a Marginal Revenue curve on the graph it
can help you determine elasticity. Decreasing price increases total revenue as quantity increases
as long marginal revenue is greater than zero. The Unit Elastic portion of the demand curve is
where the MR=0. Then decreasing price decreases total revenue since the marginal revenue is
negative. In this range, the demand curve is inelastic.

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 Figure B18: Total Revenue and Elasticity of Demand

Figure (B18) illustrates 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.

Other Demand Elasticity

In addition to the price elasticity of demand, economists use other elasticity to describe the
behavior of buyers in a market.

Income elasticity Income elasticity is about how much a change in consumer income causes a
change in quantity demanded. Normal goods (most goods fall into this category) are goods that
consumers buy more of when their incomes rise, and less of when their incomes fall. Inferior goods
are goods like one-ply toilet paper, top ramen, or generic brand products. When consumers’
incomes rise, consumers buy less of these goods, and when incomes fall, they buy more. One of
the non-price determinants of demand is changes in income. Income elasticity tells us how much
a change in income will shift the demand for a good or service. The formula for income elasticity
is %∆Q/%∆Income. Normal goods have a positive income elasticity coefficient since increases in
incomes cause increases in the demand for normal goods. Inferior goods have a negative income
elasticity coefficient. This is because increases in incomes cause decrease in the demand for
inferior goods.

Cross-Price elasticity Cross-price elasticity is about substitutes and complements. Substitutes are
goods that can be used in place of each other; like butter and margarine, or jam and jelly. When
the price of one increases, the demand for the other also increases. Complements are goods that
are used together; like bread and butter or toothbrushes and toothpaste. When the price of one
increases, demand for the other decreases. The cross-price elasticity tells us how much a change

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in the price of one impacts the demand for the other. When there is a change in the price of
substitute or complement, the demand for the good in question will change. The formula for cross-
price elasticity is %∆Q/%∆P (P is the price of the other good). Substitute goods will have a positive
coefficient because an increase in the price of a substitute will cause an increase in the demand for
the good in question. Complementary goods will have a negative coefficient because an increase
in the price of a complement will cause a decrease in the demand for the good in question.

Price Elasticity of Supply

The law of supply states that higher prices raise the quantity supplied. The price elasticity of supply
measures how much the quantity supplied responds to changes in the price. Supply of a good is
said to be elastic if the quantity supplied responds substantially to changes in the price. Supply is
said to be inelastic if the quantity supplied responds only slightly to changes in the price.

Figure B19: Perfectly Elastic, Perfectly Inelastic, and Unit Elastic Supply

The price elasticity of supply depends on the flexibility of sellers to change the amount of the good
they produce. In most markets, a key determinant of the price elasticity of supply is the time period
being considered. Supply is usually more elastic in the long run than in the short run. Over short
periods of time, firms cannot easily change the size of their factories to make more or less of a
good. Thus, in the short run, the quantity supplied is not very responsive to the price. By contrast,
over longer periods, firms can build new factories or close old ones. In addition, new firms can
enter a market, and old firms can exit. Thus, in the long run, the quantity supplied can respond
substantially to price changes.

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 Figure B20: Inelastic and Elastic Supply

Price elasticity of supply is calculated as the percentage change in the quantity supplied divided
by the percentage change in the price. Because the price elasticity of supply measures the
responsiveness of quantity supplied to the price, it is reflected in the appearance of the supply
curve.

Box B2: Elasticity and Bank Account

An effective interest rate policy targeted at prospective consumer depositors must be concerned
with the interest rate elasticity of the deposit accounts. Interest rate elasticity is a measure of the
depositors’ response to fluctuations in consumer account interest rates.
Deposit elasticity can be defined as dD = dD/di
D where: D = deposit level; i = deposit rate. The relationship or correlation of the elasticity can be
either negative or positive, significant or insignificant. A negative elasticity value with respect to
interest rates and deposit account demand would indicate that an increase in interest rates will
subsequently lead to a decrease in deposits and a decrease in interest rates will lead to an increase
in deposits. There is no theoretical basis for such a relationship and I do not expect this to occur. I
will assume that the depositors represented in this data set are rational individuals seeking to
maximize their interest utility. Within an econometric model the elasticity coefficient measures
the effect that a 1 percent change in an independent variable will have on the dependent variable.
For the purposes of this study, I will be analyzing the effect of a percentage change in interest rates
on the respective deposit account level. The effect of other theoretically significant variables will
also be analyzed.

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Indicative Questions and Exercises

1. Define the price elasticity of demand and the income elasticity of demand.
2. List and explain the four determinants of the price elasticity of demand discussed in the chapter.
3. If the elasticity is greater than 1, is demand elastic or inelastic? If the elasticity equals zero, is
demand perfectly elastic or perfectly inelastic?
4. On a supply-and-demand diagram, show the equilibrium price, equilibrium quantity, and the
total revenue received by producers.
5. If demand is elastic, how will a price increase change total revenue? Explain.
6. What do we call good with an income elasticity less than zero?
7. How is the price elasticity of supply calculated? Explain what it measures.
8. If a fixed quantity of a good is available, and no more can be made, what is the price elasticity
of supply?
9. A storm destroys half the fava bean crop. Is this event more likely to hurt fava bean farmers if
the demand for fava beans is very elastic or very inelastic? Explain.

10. ‘A life-saving medicine without any close substitutes will tend to have a small elasticity of
demand.’- Do you agree? Explain your answer.
11. A price change causes the quantity demanded of a good to decrease by 30 percent, while the
total revenue of that good increases by 15 percent. Is the demand curve elastic or inelastic? Explain.
12. ‘Utility concept is also relevant for the banking and financial products/services’-Explain the
statement.

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