Elasticity

and its
Applications
 Elasticity measures

• What are they?

– Responsiveness measures
• Why introduce them?
– Demand and supply responsiveness clearly matters for lots
of market analyses.
• Why not just look at slope?
– Want to compare across markets: inter market
– Want to compare within markets: intra market
– slope can be misleading
– want a unit free measure
 Why Economists Use
Elasticity
• An elasticity is a unit-free measure.
• By comparing markets using elasticities it does
not matter how we measure the price or the
quantity in the two markets.
• Elasticities allow economists to quantify the
differences among markets without
standardizing the units of measurement.
 What is an Elasticity?

• Measurement of the percentage change in

one variable that results from a 1% change in
another variable.
• Can come up with many elasticities.
• We will introduce four.
– three from the demand function
– one from the supply function
 2 VIP Elasticities

• Price elasticity of demand: how sensitive is the

quantity demanded to a change in the price of
the good.
• Price elasticity of supply: how sensitive is the
quantity supplied to a change in the price of
the good.
• Often referred to as “own” price elasticities.
 Examples of Own Price
Demand Elasticities
• When the price of gasoline rises by 1% the quantity
demanded falls by 0.2%, so gasoline demand is not
very price sensitive.
– Price elasticity of demand is -0.2 .
• When the price of gold jewelry rises by 1% the
quantity demanded falls by 2.6%, so jewelry demand
is very price sensitive.
– Price elasticity of demand is -2.6 .
Examples of Own Price
Supply Elasticities
• When the price of DaVinci paintings increases by
1% the quantity supplied doesn’t change at all, so
the quantity supplied of DaVinci paintings is
completely insensitive to the price.
– Price elasticity of supply is 0.
• When the price of beef increases by 1% the
quantity supplied increases by 5%, so beef supply
is very price sensitive.
– Price elasticity of supply is 5.
 Examples of Unit-free
Comparisons
• Gasoline and jewelry
– It doesn’t matter that gas is sold by the gallon for
about $1.09 and gold is sold by the ounce for about
$290.
– We compare the demand elasticities of -0.2 (gas)
and -2.6 (gold jewelry).
– Gold jewelry demand is more price sensitive.
 Examples of Unit-free
Comparisons
• Paintings and meat
– It doesn’t matter that classical paintings are sold
by the canvas for millions of dollars each while
beef is sold by the pound for about $1.50.
– We compare the supply elasticities of 0 (classical
paintings) and 5 (beef).
– Beef supply is more price sensitive.
Inelastic Economic Relations

• When an elasticity is small (between 0 and 1

in absolute value), we call the relation that it
describes inelastic.
– Inelastic demand means that the quantity
demanded is not very sensitive to the price.
– Inelastic supply means that the quantity supplied
is not very sensitive to the price.
Elastic Economic Relations

• When an elasticity is large (greater than 1 in

absolute value), we call the relation that it
describes elastic.
– Elastic demand means that the quantity
demanded is sensitive to the price.
– Elastic supply means that the quantity supplied is
sensitive to the price.
 Size of Price Elasticities
Unit elastic
Inelastic Elastic

0 1 2 3 4 5 6

• Unit elastic: own price elasticity equal to 1

 Inelastic: own price elasticity less than 1
 Elastic: own price elasticity greater than 1
General Formula for own
price elasticity of demand
• P = Current price of good X
• XD = Quantity demanded at that price
• DP = Small change in the current price
• DXD= Resulting change in quantity demanded

Percentage Change in Quantity Demanded

Elasticity 
Percentage Change in Price
 Note:

• The own price elasticity of demand is always

negative.
• Economists usually refer to the own price elasticity of
demand by its absolute value (ignore the negative
sign).
• So, even though the formula says that the own price
elasticity of demand is negative, we would say the
elasticity of demand is 1.5 in the first example and
0.67 in the second.
 Slope of the Demand Curve
• DP is the
Price
change in price. Demand
P
(DP<0) slope 
X
 DX is the
P
change in P+ DP
DP

quantity. DX

 slope =
DP/ DX
 1/slope =
DX/ DP X X + DX Quantity
Slope Compared to Elasticity

• The slope measures the rate of change of one

variable (P, say) in terms of another (X, say).
• The elasticity measures the percentage
change of one variable (X, say) in terms of
another (P, say).
 Supply Elasticities

• The price elasticity of supply is always positive.

• Economists refer to the price elasticity of supply by
its actual value.
• Exactly the same type of point and arc formulas are
used to compute and estimate supply elasticities as
for demand elasticities.
 Some Technical Definitions
For Extreme Elasticity Values
• Economists use the terms “perfectly elastic” and
“perfectly inelastic” to describe extreme values of
price elasticities.
• Perfectly elastic means the quantity (demanded or
supplied) is as price sensitive as possible.
• Perfectly inelastic means that the quantity
(demanded or supplied) has no price sensitivity at all.
Perfectly Elastic Demand

• We say that
Price
demand is
perfectly elastic
when a 1% change
Perfectly Elastic Demand (elasticity = ¥)
in the price would
result in an infinite
change in quantity
demanded.

Quantity
Perfectly Inelastic Demand

• We say that
Price
demand is
perfectly inelastic
when a 1% change
in the price would
Perfectly
result in no change Inelastic
Demand
in quantity (elasticity = 0)
demanded.

Quantity
 Perfectly Elastic Supply

• We say that supply

Price
is perfectly elastic
when a 1% change
in the price would
Perfectly Elastic Supply (elasticity = ¥)
result in an infinite
change in quantity
supplied.

Quantity
Perfectly Inelastic Supply

• We say that supply

Price
is perfectly
inelastic when a
1% change in the
price would result
Perfectly
in no change in Inelastic
Supply
quantity supplied. (elasticity = 0)

Quantity
Determinants of elasticity

• What is a major determinant of the own price

elasticity of demand?
– Availability of substitutes in consumption.

• What is a major determinant of the own price

elasticity of supply?
– Availability of alternatives in production.
 Reminders

• Value of own price elasticity usually changes

along a demand curve
– there are many interesting intra elasticity
applications
• Can also compare elasticities across markets
– there are interesting inter elasticity questions
Other Price Elasticities: Cross-
Price Elasticity of Demand
• Elasticity of demand with respect to the price of a
complementary good (cross-price elasticity)
– This elasticity is negative because as the price of a
complementary good rises, the quantity demanded of the
good itself falls.
– Example (from last week) software is complementary with
computers. When the price of software rises the quantity
demanded of computers falls.
– Cross-price elasticity quantifies this effect.
Other Price Elasticities: Cross
Price Elasticity of Demand
• Elasticity of demand with respect to the price of a substitute
good (also a cross-price elasticity)
– This elasticity is positive because as the price of a
substitute good rises, the quantity demanded of the good
itself rises.
– Example (from last week) hockey is substitute for
basketball. When the price of hockey tickets rises the
quantity demanded of basketball tickets rises.
– Cross-price elasticity quantifies this effect.
Other Elasticities: Income
Elasticity of Demand
• The elasticity of demand with respect to a consumer’s income
is called the income elasticity.
– When the income elasticity of demand is positive (normal good),
consumers increase their purchases of the good as their incomes rise
(e.g. automobiles, clothing).
– When the income elasticity of demand is greater than 1 (luxury good),
consumers increase their purchases of the good more than
proportionate to the income increase (e.g. ski vacations).
– When the income elasticity of demand is negative (inferior good),
consumers reduce their purchases of the good as their incomes rise
(e.g. potatoes).