Handout 2

Elasticity & Surplus

Dr. Subir Sen, Assistant Professor, IIT Roorkee

The problems are adapted from various textbooks.1

Consider the following statement: ”the prices of computers decrease by 8% ”.

The above statement may have very little value for the firms. If the demand function is known, the firms
can predict the impact of price change on quantity demanded. What firms require is a numerical value
that would highlight the responsiveness of quantity demanded to change in price. This information is
invaluable to firms as their total revenue depends on both prices and quantity sold.
Consider the following demand function: qxD = f (px , py , I)
where, qxD is quantity demanded of good x, px is price of good x, py is price of good y and I is income.
The concept of elasticity can help one to measure responsiveness of quantity demanded to change in own
price (px ), cross-price (py ) and income (I).

1 Price Elasticity of Demand

Price elasticity of demand measures the responsiveness (sensitivity) of quantity demanded to changes in
the good’s own price and hence also referred to as the own price elasticity. It is represented by the formula:
∆Q
Percentage change in quantity demanded %∆QD Q
.100
εD = = = ∆P
(1)
Percentage change in price %∆P P
.100

∆Q P
εD = .
∆P Q
The negative sign associated with εD indicates the direction and magnitude of the responsiveness of
one variable with respect to the another. There is a convention that the value of elasticity is given in
absolute terms (|εD |).

Point Elasticity of Demand: Consider a linear demand function, P = a − bQ, and the objective to
calculate price elasticity at any point P0 . From demand function, we obtain Q0 . Therefore,
∆Q P 1 P0
εD |(Q0 ,P0 ) = . = .
∆P Q b Q0
Point elasticity of demand depends on price and vertical intercept only. Considering the above point
elasticity,
1 P P
εD = . = . . . since, P = a − bQ ⇒ bQ = P − a
b Q P −a

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Please inform the course instructor if there are any typo-errors and mistakes in calculation

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 Arc Elasticity of Demand: This measures the elasticity of demand over an interval on the demand
function. The averages of prices and quantities at the beginning and end of the stated interval is used.
For example, the arc elasticity over the coordinates (Q1 , P1 ) and (Q2 , P2 ) is given by:

∆Q P1 + P2
εD = . (2)
∆P Q1 + Q2
This formula is also referred to as the mid-point elasticity formula.

Coefficient of Price Elasticity of Demand: Three categories of price elasticity: elastic(εD > 1),
inelastic (εD < 1) and unit elastic(εD = 1)

• Example 1: Determine the elasticity of demand when the price falls from 136 to 119, given the
demand function P = 200 − Q2

Solution: Given P1 = 136 and P2 = 119, the corresponding values of Q1 and Q2 are obtained from
the demand equation are ±8 and ±9 respectively. ∆Q = 1 and ∆P = 17
∆Q 136 1 136
εD |(8,136) = . = . =1
∆P 8 17 8
∆Q 119 1 119
εD |(9,119) = . = . = 0.78
∆P 9 17 9

It is not at all clear what to take for P and Q. Clearly we are getting two different answers depending
on the choice. A sensible compromise is to use their average and take:
P = 1/2(136 + 119) = 127.5
Similarly, averaging the Q values gives
Q = 1/2(8 + 9) = 8.5
Hence,
∆Q (P1 + P2 )1/2 1 127.5
εD = . = . = 0.88
∆P (Q1 + Q2 )1/2 17 8.5
• Example 2: Given the demand function: P = 50 − 2Q. Find the elasticity when the price is 30. Is
demand inelastic, unit elastic or elastic at this price?

Solution: To find dQ
dP
we differentiate Q with respect to P. However, we are actually given a formula
for P in terms of Q. So we need to transpose P = 50 − 2Q for Q. Adding 2Q to both sides gives,
P + 2Q = 50 ⇒ 2Q = 50 − P ⇒ Q = 25 − 12 P
Hence, dQ
dP
= −1/2
Given that P = 30 so, at this price, demand is Q = 25 − 1/2(30) = 10
dQ P0 1 30
εD = . = . = 1.5
dP Q0 2 10

Since εD = 1.5 > 1, demand is elastic at this price.

• Example 3: Given the demand function: P = −Q2 − 4Q + 96. Find the price elasticity of demand
when P = 51. If this price rises by 2%, calculate the corresponding percentage change in demand.

Solution: Given that P = 51, so to find the corresponding demand we need to solve the quadratic
equation −Q2 − 4Q + 96 = 51.

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 ⇒-Q2 − 4Q + 45 = 0 √
−b± (b2 −4ac)
To do this we use the standard formula 2a
The above gives: Q = −9&5. The negative value can be ignored, since it does not make sense to
have a negative quantity, so Q = 5.
dP
= −2Q − 4
dQ

dQ 1 1
= dP =
dP dQ
−(2Q + 4)
dQ −1
Putting Q = 5, dP
= 14

dQ P0 1 51
εD = . = . = 0.73
dP Q0 14 5

Since εD = 0.73 < 1, demand is inelastic at this price. To discover the effect on Q due to a 2% rise
in P we return to the original definition:
percentage change in demand
εD =
percentage change in price

We know that εD = 0.73 and that the percentage change in price is 2, so

percentage change in demand
0.73 =
2

Percentage change in demand = 0.73 × 2 = 1.46%

In general, price rise leads to a fall in demand. Therefore, a rise in price by 2% will lead to a fall in
demand by 1.46%.

2 Cross-Price and Income Elasticity of Demand

A more general demand function is of the form:

QA = f (PA , PB , I, . . .)

where, PA is own-price, PB is price of other goods (substitutes or complements) and I is income.

Cross-Price Elasticity of Demand: This measures the percentage change in QA with respect to
change in PB keeping PA and I constant. It is denoted as:
δQA PB
εC = .
δPB QA

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 Income Elasticity of Demand: This measures the percentage change in QA with respect to change
in I keeping PA and PB constant. It is denoted as:
δQA I
εI = .
δI QA
NOTE: For interpretation of εC and εI refer class notes

• Example 4: Given the demand function: Q = 100 − 2P + PA + 0.1I, where P = 10, PA = 12(is the
alternative good) and I = 1000, find the (a) price elasticity of demand, (b) cross-price elasticity of
demand and (c) income elasticity of demand. Is the alternative good substitutable or complementary?

Solution: We begin by calculating the value of Q when P = 10, PA = 12 and I = 1000. The demand
equation gives:
Q = 100 − 2(10) + 12 + 0.1(1000) = 192
(a) To find the price elasticity of demand we partially differentiate Q = 100 − 2P + PA + 0.1I with
respect to P to get:
δQ
δP
= −2
δQ P 10
εP = . = −2. = 0.10 (ignoring negative sign
δP Q 192
b) To find the cross-price elasticity of demand we partially differentiate Q = 100 − 2P + PA + 0.1I
with respect to PA to get:
δQ
δPA
=1
δQ PA 12
εC = . = 1. = 0.06
δPA Q 192
The fact that this is positive shows that the two goods are substitutable. To find the cross-price
elasticity of demand we partially differentiate Q = 100 − 2P + PA + 0.1I with respect to I to get:
δQ
δI
= 0.1
δQ PA 1000
εI = . = 1. = 0.52
δI Q 192
• Calculate price elasticity for the demand function: qpn = c.

Solution:The demand function is: qpn = c

Tking tog on both sides:

logq + nlogp = logc

⇒ logq = logc − nlogp
Differentiating with respect to p,
1 dq n
. =0−
q dp p
dq p
D = . = −n
dp q

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 3 Consumer’s & Producer’s Surpluses
The demand function, P = f (Q), sketched in the figure below, gives the different prices that con-
sumers are prepared to pay for various quantities of a good. At Q = Q0 the price P = P0 . The total
amount of money spent on Q0 goods is then Q0 × P0 , which is given by the area of the rectangle
OABC. Now, P0 is the price that consumers are prepared to pay for the last unit that they buy,
which is the Q0 th good. For quantities up to Q0 they would actually be willing to pay the higher
price given by the demand curve. The shaded area BCD therefore represents the benefit to the
consumer of paying the fixed price of P0 and is called the consumer’s surplus, denoted by CS. The
value of CS can be found by observing that

Figure 1: CS = area BCD = area OABD - Figure 2: PS = area BCD = area OABC -
area OABC area OABD

The supply function, P = g(Q), sketched in the figure above gives the different prices at which
producers are prepared to supply various quantities of a good. At Q = Q0 the price P = P0 .
Assuming that all goods are sold, the total amount of money received is then Q0 P0 , which is given by
the area of the rectangle OABC. Now, P0 is the price at which the producer is prepared to supply
the last unit, which is the Q0 th good. For quantities up to Q0 they would actually be willing to
accept the lower price given by the supply curve. The shaded area BCD therefore represents the
benefit to the producer of selling at the fixed price of P0 and is called the producer’s surplus, PS.

• Example 5: Find the consumer’s surplus at Q = 5 for the demand function: P = 30 − 4Q.

Solution: In this case, f (Q) = 30 − 4Q and Q0 = 5. The price is easily found by substituting
Q = 5 ⇒ P0 = 10 The formula for consumers surplus:
Z Q0
CS = f (Q)dQ − Q0 P0
0
R5
gives: CS = 0
(30 − 4Q)dQ − 5(10)

= [30Q − 2Q2 ]50 − 50 = [30(5) − 2(5)2 ] − [30(0) − 2(0)2 ] − 50 = 50

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 • Example 6: Given the demand function: P = 35 − Q2D and supply function: P = 3 + Q2S . Find the
producers surplus assuming pure competition.

Solution: On the assumption of pure competition, the price is determined by the market. Before
we can calculate the producer’s surplus we therefore need to find the market equilibrium price and
quantity. The equilibrium quantity is 4 and the corresponding price is 19.
The formula for the producers surplus,

RQ
P S = Q0 P0 − 0 0 g(Q)dQ
gives,
Q3 4
R4
P S = 4(19) − 0 (3 + Q2 )dQ = 76 − [3Q + ]
3 0
= 76 − [3(4) + 13 (4)3 ] − [3(0) − 13 (0)3 ]
= 42 32

Problems for Practice

1. Given the demand function: P = 100 − Q. Calculate the price elasticity of demand when the price
is (a) 10 (b) 50 (c) 90. Is the demand inelastic, unit elastic or elastic at these prices?

2. Given the demand function: P = 1000 − 2Q, calculate the arc elasticity as P falls from 210 to 200.

3. Given the demand equation: P = −Q2 − 10Q + 150. Find the price elasticity of demand when Q = 4.
Estimate the percentage change in price needed to increase demand by 10%.

4. Given the demand function is :P = 60 − 0.2Q, calculate the price elasticity of demand when (a) price
decreases from 50 to 40 and (b) price decreases from 20 to 10. Interpret the elasticity coefficient in
both the cases.

5. Given the demand function: Q = 500 − 3P − 2PA + 0.01Y where P = 20, PA = 30 and Y = 5000.
Find: (a) the price elasticity of demand, (b) the cross-price elasticity of demand, and (c) the income
elasticity of demand. If income rises by 5%, calculate the corresponding percentage change in demand.
Is the good inferior or superior?

6. Calculate price elasticity for the demand function q m pn = c.

7. Given the demand equation: P = 50 − 2QD and supply equation: P = 10 + 2QS . Calculate (a) the
consumer’s surplus and (b) the producer’s surplus assuming pure competition.

8. Given the demand function P = −Q2D − 4QD + 68 and the supply function P = Q2S − 2QS + 12. Find
(a) the consumer’s surplus and (b) the producer’s surplus.