PRICE ELASTICITY OF DEMAND

Definition of Elasticity
Elasticity measures how one variable responds to a change in another variable,
namely the percentage change in one variable resulting a one percentage change in
another variable. (The percentage change is independent of units.)
Elasticity is a dimensionless measure of the sensitivity of one variable to changes in another.
The terms elastic or inelastic describe the degree of responsiveness. A precise definition of
what can be said to mean responsive or unresponsive.
SOME BASIC CONCEPTS:
Elastic Demand demand for a product is elastic if its price elasticity is greater than 1 (E d
>1) i.e., the resulting percentage change in quantity demanded is greater than the percentage
change in price ( Q

> P )

Inelastic Demand demand for a product is inelastic if its price elasticity is less than 1
(Ed<1) i.e., resulting percentage change in quantity demanded is less than the percentage
change in price ( Q

< P .

Unit Elasticity The elasticity coefficient of demand or supply is equal to 1 (E d =1) i.e.,
percentage change in quantity is equal to percentage change in price implies that

P )
Perfectly Inelastic Demand Quantity demanded does not respond to a change in price (E d
= 0).
Perfectly Elastic Demand Quantity demanded will go from 0 to infinity at a particular
product price (Ed = ).
TYPES OF ELASTICITY OF DEMAND

Income Elasticity of Demand

Cross Price Elasticity of demand
Price Elasticity of demand

Income elasticity of demand

Income elasticity of demand measures the percentage change in quantity demanded resulting
from one percentage change in income. Similarly,
Q I
Q
Q
Q
=
I
I
I

EI =

The income elasticity of demand is usually positive

Cross Price Elasticity of Demand
Cross price elasticity of demand. Cross price elasticity of demand measures the percentage
change in quantity demanded of a good (x) resulting from one percentage change in price
of another good (y).

EQxPy =

Qx Py
Qx
Qx
Qx
=
Py
Py
Py

If y is a substitute of x, the cross price elasticity of demand is positive.

If y is a complement of x, the cross price elasticity of demand is negative.
Price Elasticity of Demand
The law of demand tells us that consumers will respond to a price decrease by buying more
of a product (other things remaining constant), but it does not tell us how much more the
consumers are willing to buy. But what price elasticity does is to tell us how much responsive
or sensitive this consumers are to this price changes.
Note:

If consumers are relatively responsive to price changes, demand is said to be elastic.

If consumers are relatively unresponsive to price changes, demand is said to be
inelastic.

With both elastic and inelastic demand, consumers behave according to the law of

demand; that is, they are responsive to price changes.

Price elasticity of demand is usually a negative number.
|EP | > 1 implies that Q > P

|EP | < 1 implies that

<

|EP | = 1 implies that

Price elasticity of demand measures the percentage change in quantity demanded resulting
from one percentage change in price. It is the percentage change in quantity demanded Q
divided by the percentage change in the price; EP =

Q
P

Because of the Law of Demand, if P is positive (price rises), then Q cannot be positive,
and in general is negative. Since the price elasticity of demand is never positive, we usually
ignore its sign (or use its absolute value | |).
EP =

Q
P

Therefore,

EP =

Q P
Q
Q
Q
=
P
P
P

Q Q 2Q 1
=
P P 2P 1
Where Q1/P1 = Initial quantity/Initial price respectively; Q2/P2 = New quantity/ new price
respectively.
Example 1: calculating the coefficient of price elasticity of demand
Q d = 8 2P.
When the price changes from 2 to 1, the price elasticity of demand is:

EP =

Q P
Q
Q
Q
Q
=
=
P P
P
P

EP =

Q 2
2
Q
4
=
=1
P 1
P

If the direction of change is opposite, from 1 to 2, then the price elasticity of demand is:

EP =

Q 1
2
Q
6
1
=
=
P
1
3
P
Determinants of Price Elasticity of Demand

1.

Availability of close substitutes: |E P | > 1 indicates that the good is price elastic, perhaps
because the good has many substitutes i.e. the greater the number of available substitutes,
the more elastic the demand. |EP | < 1 indicates that the good is price inelastic, perhaps

2.

because the good has few substitutes.

Necessities v. discretionary goods (or luxuries): necessities tend to have inelastic demands;
luxuries have elastic demand. |EP | > 1 indicates that the good is price elastic and perhaps
the type of good is a luxury good which depends on the buyers preferences. While |E P | <

3.

1 indicates that the good is price inelastic and a necessity good.

Time horizon: For consumption goods, the demand is more elastic in the long run. Because
people need goods for daily life and buy them constantly, the short run demand is inelastic.
Faced with high prices in the long run, they may change habits or nd more
substitutes. The greater the time horizon, the easier for consumers to nd substitutes, or
make do without, so the more elastic the demand. Demand is more elastic the longer the
period under consideration. For instance, if the price of a Coca-Cola goes up, one might
not switch to Pepsi at first, but the more time one has to pay the higher price, the more
willing the individual would want to try Pepsi and to determine whether Pepsi or other
substitute products are good enough.
For durable goods, the demand is more elastic in the short run. Consider cars. If
price of cars increase, in the short run people might use their current cars longer. In
the long run, though, people have to replace their cars.

4.

The Proportion of Price relative to Income The higher the price of a good relative to
consumers incomes, the greater the price elasticity of demand. For instance, a 100%
increase (from 5 Naira to 10 Naira) in the price of a sachet of pure water is a very low
fraction of an individual with an annual salary of 2 million naira, compared to a 100%
increase in the price of a power bike (from 350,000 Naira to 700,000 Naira) So the price
elasticity of demand on the sachet of pure water will be much more inelastic than on the
power bike.
Example 2:
P1 = 8

P2 = 7

Q1 = 40

Q2 = 48

a. Calculate the coefficient of price elasticity of demand. Interpret your result based on
its coefficient and the characteristics of the good.
b. What would a 20% increase in price result in?
c. What would a 20% increase in the quantity demanded result in?
Q

= 48 - 40 = 8

= 7 8 = -1

a.
Q
8
8
Q
40
=
=1.6
P
1
P
Interpretation
The price of the good is demand elastic (|EP | > 1). This means that for every 1 %
change in price (decrease), there is a 1.6 % change in quantity demanded (increase).
Type of good:
|EP | > 1 indicates that the good has close substitutes, it means it has many substitutes.
OR; it could also be a luxury good. OR; it could also be a common good which is
elastic in the long run. Or; it could also be durable a good in the short run
b. What would a 20% increase in price result in?

EP =

Q P
Q
Q
Q
Q
=
=
P P
P
P

Q= P EP

Q=20 1.6
Q=32

Interpretation: a 20% increase in price will lead to a 32% decrease in quantity

demanded
c. What would a 20% increase in the quantity demanded result in?
Q P
Q
Q
Q
Q
EP = P = P = P
P
P= Q/ EP

P=20 /1.6 = - 12.5%

P=12.5

Interpretation: a 20% increase in quantity demanded will lead to a 12.5% decrease in

the price of the good

ELASTICITY AND TOTAL REVENUE

Total revenue (TR) is calculated by multiplying price (P) per unit and quantity (Q) of the
good sold. TR = P x Q
The total revenue test is a method of estimating the price elasticity of demand. As EP will
impact the total revenue, we can estimate the EP by looking at the movement of the total
revenue. Suppose the rm considers increasing the price of its good. There are two eects:

A price eect: After a price increase, each unit sold sells for a higher price, which tends to
raise revenue.
A quantity eect: After a price increase, fewer units are sold, which tends to lower revenue.
Total Revenue Test
Total-revenue test is the easiest way to judge whether demand is elastic or inelastic.

Elastic demand and the total-revenue test: Demand is elastic (|E P | > 1) if a decrease in
price results in a rise in total revenue, or if an increase in price results in a decline in

total revenue. (Price and revenue move in opposite directions).

Inelastic demand and the total-revenue test: Demand is inelastic (|E P | < 1) if a
decrease in price results in a fall in total revenue, or an increase in price results in a
rise in total revenue. (Price and revenue move in same direction). Inelastic demand
for agricultural products helps to explain why bumper crops depress the prices and

total revenues for farmers.

Unit elasticity and the total-revenue test: Demand has unit elasticity if total revenue
does not change when the price changes.

Example 3:
Suppose the current toll on a bridge is 10 naira, but the highway department must raise extra
money for road repairs. Will raising the toll to 11 Naira increase or decrease total revenue?
Suppose 1,000 cars cross the bridge each day at the current price, what is TR
Total revenue = P * Q = 10 1000 = 10,000.00 Naira
Given that the Price Elasticity of Demand is
-

Inelastic, Ep = 0.5;
Elastic, Ep = 2.0 and
Unit-elastic, Ep = 1.0.

Solution
a. Inelastic Demand
Suppose the price elasticity of demand is 0.5; what eect will the 10 percent increase in the
toll have on total revenue?
We need to solve for the quantity sold at 11 Naira

Percentage change in price

EP =

-0.5 =

-0.5 =

Q Q 2Q 1 P
Q 2Q 1
Q
Q
Q
Q
=
=
=
P P P 2P 1
P 2P 1
P
P

Q Q 21000 Q 21000
10
Q
1000
1000
=
=
=
P P
1110
0.1
P
10
Q 21000
1000
0.1

-0.05 =

Q 21000
1000

- 50 = Q2 1000
Q2 = 950
So, Q2 = 950; then the
Total Revenue (TR) = 11 * 950 = 10,450 Naira
Comment: An increase in price increased total revenue (from 10,000 to 10,450 Naira). In
this case, the price eect is stronger than the quantity eect.
b. Elastic Demand (Ep = 2.0 )
Answer; Q2 = 800, TR= 8,800 Naira
Comment: An increase in price reduced total revenue (from 10,000 to 8,800). In this case,
the price eect is weaker than the quantity eect.
c. Unit Elastic Demand (Ep = 1.0 )
Answer; Q2 = 900, TR = 9,900 Naira appr. 10,000 Naira
Comment: An increase in price does not change total revenue (9,900 appr. 10,000). In this
case the two eects o-set each other

APPLICATION OF PRICE ELASTICITY OF DEMAND

Demand for farm products are highly inelastic. Because farm products are necessity
goods.
Thus, increases in output of cassava will lower the price of cassava and therefore lower
the (total revenue) income of farmers.

For farmers, therefore, large crop may be

undesirable. If the government wishes to increase farmers income, they may wish to
restrict farmers output.
Illegal Drugs.
Proponents for legalization of certain drugs argue that once drugs are legalized, prices of
these drugs would fall dramatically (since they are cheap to make). Because demand by drug
addicts is highly inelastic, these lower prices would not result in much increase in demand.
As such, total expenditures on illegal drugs would fall and thereby make it unprofitable to
finance drug trade.
Opponents of legalization claim that demand for drugs like cocaine and heroin is more
elastic than we think because a portion of the users are dabblers who try it when prices are
low. Thus, the lower prices associated with legalization would increase consumption by these
dabblers, and these dabblers might even become addicts. These opponents also think that
legalizing drugs would make them more socially acceptable, thereby increasing demand. As
such, opponents believe legalization would lead to higher drug revenue and support the
continuation of drug trade.