Elasticity of Demand and Supply
What the exam tests
Elasticity measures responsiveness. The exam tests formulas, determinants, revenue implications and tax incidence, often with numerical calculations.
Core rules
- PED = percentage change in quantity demanded / percentage change in price. Use the midpoint formula for arc elasticity: (ΔQ / average Q) / (ΔP / average P). Demand is elastic if |PED| > 1, inelastic if < 1, unit elastic at 1.
- Total revenue rises with a price cut only when demand is elastic; it falls when demand is inelastic.
- Income elasticity is positive for normal goods, negative for inferior goods and above 1 for luxuries. Cross-price elasticity is positive for substitutes and negative for complements.
- PES measures quantity supplied response; it is lower in the short run because capacity and inputs are fixed.
- Statutory incidence is not economic incidence: the more inelastic side bears more of a tax.
Worked example
Price falls from 10 to 8 and quantity rises from 100 to 130. Midpoint PED = ((130 - 100) / 115) / ((8 - 10) / 9) = (30/115) / (-2/9) = -1.17, so demand is elastic. Revenue before is 100 × 10 = 1,000; after is 130 × 8 = 1,040. The price cut raises revenue, consistent with elastic demand. If PED were -0.5, the same price cut would reduce revenue.
Traps
- Using the initial value as the base in both percentage changes, which makes the answer depend on direction.
- Confusing a steep curve with inelastic demand at every point; on a linear demand curve elasticity changes along the curve.
- Treating a negative income elasticity as a mistake; it identifies an inferior good.
- Assuming the legal taxpayer bears the tax; market prices adjust.