LECTURE NOTES :ELASTICITY

Elastic and Inelastic Demand

Let’s think about elasticity in the context of price and quantity demanded. While the law
of demand does tell us that more of a good will be bought at a lower price, it does not
tell us how much the quantity demanded will increase because of the price change. For
example, if a store owner raises prices, she can expect that the quantity demanded will
drop, but she might not know how sensitive customers will be to the change. How many
people will buy her products despite the price increase and how many people will be
driven away?
If a small change in price creates a large change in the quantity demanded, then we
would say that the demand is very elastic—that is, the demand is very sensitive to a
change in price. If, on the other hand, a large change in price results in a very small
change in demand in the quantity demanded, then we would say the demand
is inelastic. As we will see later, elastic and inelastic are relative concepts.  Here’s
a way to keep this straight: demand is inelastic when consumers are insensitive to
changes in price.

Consider the example of cigarette taxes and smoking rates—a classic example of
inelastic demand. Cigarettes are taxed at both the state and federal level. As you might
expect, the greater the amount of the tax increase, the fewer cigarettes are bought and
consumed. While the taxes are somewhat of a deterrent, demand doesn’t decrease as
much as the price increase, though. We can say, then, that the demand for cigarettes is
relatively inelastic.

You might think that elasticity isn’t an important consideration when it comes to the price
of cigarettes. Surely any reduction in the demand for cigarettes would be a good thing,
right? Does it really matter whether the demand is elastic or inelastic? It does. The
reason is that taxes on cigarettes serve two purposes: to raise tax revenue for
government and to discourage smoking. On one hand, if a higher cigarette tax
discourages consumption by quite a lot—meaning a very large reduction in cigarette
sales—then the cigarette tax on each pack will not raise much revenue for the
government. On the other hand, a higher cigarette tax that does not discourage
consumption by much will actually raise more tax revenue for the government (but not
have much impact on smoking rates). Thus, when Congress tries to calculate the
effects of altering its cigarette tax, it must analyze how much the tax affects the quantity
of cigarettes consumed. In other words, understanding the elasticity of cigarette
demand is key to measuring the impact of taxes on government revenue AND public
health.

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elastic demand:
when the calculated elasticity of demand is greater than one, indicating a high
responsiveness of quantity demanded or supplied to changes in price
elastic supply:
when the calculated elasticity of either supply is greater than one, indicating a high
responsiveness of quantity demanded or supplied to changes in price
inelastic demand:
when the calculated elasticity of demand is less than one, indicating that a 1 percent
increase in price paid by the consumer leads to less than a 1 percent change in
purchases (and vice versa); this indicates a low responsiveness by consumers to price
changes
inelastic supply:
when the calculated elasticity of supply is less than one, indicating that a 1 percent
increase in price paid to the firm will result in a less than 1 percent increase in production
by the firm; this indicates a low responsiveness of the firm to price increases (and vice
versa if prices drop)
midpoint elasticity approach:
Most accurate approach to solving for elasticity in which the percent changes in quantity
demanded and price are measured relative to the average quantity demanded and price;
the initial quantity demand is subtracted from the new quantity demanded; then divided
by the average of the two quantities demanded; similarly, the initial price is subtracted
from the new price, then divided by the average of the two prices  
point elasticity approach:
approximate method for solving for elasticity in which the percent changes are measured
relative to the initial quantity demanded and price;  the initial quantity demanded is
subtracted from the new quantity demanded, then divided by the initial quantity
demanded; similarly, the initial price is subtracted from the new price, then divided by the
initial price.  
unitary elasticity:
when the calculated elasticity is equal to one indicating that a change in the price of the
good or service results in a proportional change in the quantity demanded or supplied

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Calculating Price Elasticities Using the Midpoint

Formula

Midpoint Method
To calculate elasticity, we will use the average percentage change in both quantity and
price. This is called the midpoint method for elasticity and is represented by the
following equations:

The advantage of the midpoint method is that one obtains the same elasticity between
two price points whether there is a price increase or decrease. This is because the
formula uses the same base for both cases.

** Remember the Elasticity formula of

So taking that into consideration, let us have the following example:

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LECTURE NOTES :ELASTICITY MICROECONOMICS

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Price Elasticity of Supply

The price elasticity of supply measures how much quantity supplied changes in
response to a change in the price. The calculations and interpretations are analogous to
those we explained above for the price elasticity of demand. The only difference is we
are looking at how producers respond to a change in the price instead of how
consumers respond.

Price elasticity of supply is the percentage change in the quantity of a good or service
supplied divided by the percentage change in the price. Since this elasticity is measured
along the supply curve, the law of supply holds, and thus price elasticities of supply are
always positive numbers.
We describe supply elasticities as elastic, unitary elastic and inelastic, depending on
whether the measured elasticity is greater than, equal to, or less than one.
elastic supply:
supply responds more than proportionately to a change in price; i.e. the percent
change in quantity supplied is greater than percent change in price

inelastic supply:
supply responds less than proportionately to a change in price; i.e. the percent
change in quantity supplied is less than percent change in price

unitary elastic supply:

supply responds exactly proportionately to a change in price; i.e. the percent
change in quantity supplied is equal to the percent change in price

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Categories of Elasticity
The language of elasticity can sometimes be confusing. We use the word elasticity to
describe the property of responsiveness in economic variables. We also describe the
responsiveness as (relatively) elastic or (relatively) inelastic. It gets worse. We can also
describe elasticity as perfectly elastic or perfectly inelastic. How to we keep these
different meanings understood? That is the purpose of this section.
We mentioned previously that elasticity measurements are divided into three main
ranges: elastic, inelastic, and unitary, corresponding to different parts of a linear
demand curve.
Demand is described as elastic when the computed elasticity is greater than 1,
indicating a high responsiveness to changes in price. Computed elasticities that are less
than 1 indicate low responsiveness to price changes and are described
as inelastic demand. Unitary elasticities indicate proportional responsiveness of 
demand. In other words, the percent change in quantity demanded is equal to the
percent change in price, so the elasticity equals 1. These ranges are summarized in
Table 1, below.

It is important to note that both elastic and inelastic are relative terms, as shown in
Figure 1, below. As one moves down the demand curve from top left to bottom right, the
measured elasticity is much greater than one (very elastic), then just greater than one
(somewhat elastic), then equal to one (unitary elastic, then less than one (somewhat
inelastic), and finally much less than one (very inelastic). Note that the epsilon
symbol, ε, is often used to represent elasticity.
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*POINTS to REMEMBER**

perfectly (or infinitely) elastic:

the extremely elastic situation of demand or supply where quantity changes by an infinite
amount in response to any change in price; horizontal in appearance
perfectly inelastic:
the highly inelastic case of demand in which a percentage change in price, no matter
how large, results in zero change in the quantity; thus, the price elasticity of demand is
zero; vertical in appearance
(relatively) elastic:
the percentage change in quantity demanded is greater than the percentage change in
price; measured price elasticity of demand is greater than one (in absolute value)
(relatively) inelastic: 
the percentage change in quantity demanded is less than the percentage change in
price; measure price elasticity of demand is less than one (in absolute value)
unitary elastic:
when a given percent price change in price leads to an equal percentage change in
quantity demanded

Price Elasticity and Total Revenue

Price elasticity of demand describes how changes in the price for goods and the
demand for those same goods relate. As those two variables interact, they can have an
impact on a firm’s total revenue. Revenue is the amount of money a firm brings in from
sales—i.e., the total number of units sold multiplied by the price per unit. Therefore, as
the price or the quantity sold changes, those changes have a direct impact on revenue.
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Businesses seek to maximize their profits, and price is one tool they have at their
disposal to influence demand (and therefore sales). Picking the right price is tricky,
though. What happens with a price increase? Will customers buy only a little less, such
that the price increase raises revenues, or will they buy a lot less, such that the price
increase lowers revenues? Might the company earn more if it lowers prices, or will that
just lead to lower revenue per unit without stimulating new demand? These are critical
questions for every business.

If demand is elastic at a given price level, then should a company cut its price, the
percentage drop in price will result in an even larger percentage increase in the quantity
sold—thus raising total revenue. However, if demand is inelastic at the original quantity
level, then should the company raise its prices, the percentage increase in price will
result in a smaller percentage decrease in the quantity sold—and total revenue will rise.

REMEMBER :

Total revenue:  the price of an item multiplied by the number of units sold: TR = P x Qd

Let’s explore some specific examples. In both cases we will answer the following
questions:

1. How much of an impact do we think a price change will have on demand?

2. How would we calculate the elasticity, and does it confirm our assumption?
3. What impact does the elasticity have on total revenue?

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References :

https://www.investopedia.com/terms/e/elasticity.asp

https://courses.lumenlearning.com/wm-microeconomics

https://youtu.be/eylEJ8OKFKE

https://youtu.be/XOC_nIQ5its

https://youtu.be/HHcblIxiAAk

Modules in Microeconomics by Dr. Elenita Paet

LECTURE NOTES :ELASTICITY MICROECONOMICS