Chapter 5: Elasticity and its
application
Elasticity of Demand
• A higher price will lead to a lower quantity demanded. What you may
not know is how much lower the quantity demanded will be.
Similarly, the law of supply states that a higher price will lead to a
higher quantity supplied. The question is: How much higher? This
chapter will explain how to answer these questions and why they are
critically important in the real world.
• To find answers to these questions, we need to understand the
concept of elasticity.
• Elasticity is an economics concept that measures responsiveness of
one variable to changes in another variable.
Taxes on Cigarettes (Sin Tax)
• Government increasing the National Calamity Contingent Duty (NCCD)
on cigarettes anywhere between 212% to 388% depending on
cigarette stick sizes.
• Price of cigarettes will go up by 6-7% in case of lower priced packs where the
stick size is small and has borne the maximum increase in duties, while for the
larger size sticks and premium packs the price hike will be 4 to 5%.
In her Budget speech, finance minister Nirmala Sitharaman said: “As a
revenue measure, I propose to raise excise duty, by way of National Calamity
Contingent Duty on cigarettes and other tobacco products.
Elasticity
• Elasticity is the measure of the responsiveness of quantity demanded or quantity
supplied to a change in one of its determinants.
• Elastic change-We can usefully divide elasticities into three broad categories: elastic,
inelastic, and unitary.
• An elastic demand or elastic supply is one in which the elasticity is greater than one (e
> 1), indicating a high responsiveness to changes in price.
• Elasticities that are less than one (e<1) indicate low responsiveness to price changes
and correspond to inelastic demand or inelastic supply.
• Unitary elasticities indicate proportional responsiveness of either demand or supply (e
= 1).
Price Elasticity of Demand
• Price elasticity of demand is a measure of the responsiveness of
quantity demanded to a change in price.
• It is a measure of how much the quantity demanded of a good
responds to a change in the price of that good computed as the
percentage change in quantity demanded divided by the percentage
change in price.
• = -2
Determinants of Price Elasticity of Demand
• Availability of close substitutes
• The more the substitutes the more the elastic the demand will be.
• The share of the budget spent on the good
• Eg 1- Purchase of Smart TV
• Eg 2-Purchase of inexpensive items
• Necessary Vs Luxury Goods
• Goods which people see as necessities will have inelastic demand (water
,electricity, LPG, house rent)
• Luxury goods will have elastic demand
Determinants of Price elasticity of Demand
• Time and Adjustment process
• Immediate run-inelastic demand
• Short run – elastic demand
• Long run – elastic demand
Computing the Price Elasticity of Demand
• Percentage Method
• Mid Point method or Arc elasticity
• Point Elasticity
• Mid Point Method –
Practice Problem on Mid point Method
Calculate only the ARC elasticity for the following. In each case state
whether the calculated value is elastic, inelastic, or unitary.
1. P0 = $89; Q0 = 1000; P1 = $99; Q1 = 950
2. P0 = $89; Q0 = 1000; P1 = $99; Q1 = 700
3. P0 = $69; Q0 = 200; P1 = $79; Q1 = 195
4. P0 = $3.99; Q0 = 12,000; P1 = $3.79; Q1 = 12,950
Point Elasticity
Elasticity of a Linear Demand Curve
Difference between Arc elasticity and point
elasticity Point elasticity
Arc elasticity
• Arc elasticity is measured over • Point elasticity refers to
an arc of demand curve. measuring elasticity of
demand at a particular point
on the demand curve.
Practice Problem on Point Elasticity
• The demand function for a cola-type drink in general is:
• Qd = 20 - 2P
• Calculate the point elasticity of demand at prices of $5 and $9.
Figure 1 The Price Elasticity of Demand
(a) Perfectly Inelastic Demand: Elasticity Equals 0
Price
Demand
€5
4
1. An
increase
in price . . .
0 100 Quantity
2. . . . leaves the quantity demanded unchanged.
Copyright©2003 Southwestern/Thomson Learning
Figure 1 The Price Elasticity of Demand
(b) Inelastic Demand: Elasticity Is Less Than 1
Price
€5
4
1. A 22% Demand
increase
in price . . .
0 90 100 Quantity
2. . . . leads to an 11% decrease in quantity demanded.
Figure 1 The Price Elasticity of Demand
(c) Unit Elastic Demand: Elasticity Equals 1
Price
€5
4
1. A 22% Demand
increase
in price . . .
0 80 100 Quantity
2. . . . leads to a 22% decrease in quantity demanded.
Copyright©2003 Southwestern/Thomson Learning
Figure 1 The Price Elasticity of Demand
(d) Elastic Demand: Elasticity Is Greater Than 1
Price
€5
4 Demand
1. A 22%
increase
in price . . .
0 50 100 Quantity
2. . . . leads to a 67% decrease in quantity demanded.
Figure 1 The Price Elasticity of Demand
(e) Perfectly Elastic Demand: Elasticity Equals Infinity
Price
1. At any price
above €4, quantity
demanded is zero.
€4 Demand
2. At exactly €4,
consumers will
buy any quantity.
0 Quantity
3. At a price below €4,
quantity demanded is infinite.
Figure 2 Total Revenue
Price
€4
P × Q = €400
P
(revenue) Demand
0 100 Quantity
Q
Copyright©2003 Southwestern/Thomson Learning
Elasticity and Total Revenue Along a Linear
Demand Curve
• Total revenue = Price × Quantity
• When Demand is Inelastic (Price elasticity less than 1) Price and Total
Revenue moves in same Direction i.e Price increases, TR also
increases.
• When Demand is elastic (Price elasticity greater than 1) Price and
Total Revenue moves in opposite direction. Price increases and TR
decreases.
• When Demand is unit elastic (Price elasticity equal to 1) Total Revenue
remains constant when price changes.
