Lecture 4

Elasticity of Demand
Elasticity
• So, the basic law of demand tells us that a rise in price leads to a
decrease in quantity demanded.
• Now, the question is, by how much does quantity demanded decreases?
• The measure of the extent of responsiveness or sensitivity (by asking
how much) of quantity demanded to a change in price is what we call
elasticity.
Elasticity
• There are several elasticities that economists study. The more common
ones – price elasticity, income elasticity, cross elasticity; others not
so common – taste elasticity, population elasticity and other factors.
Price elasticity of demand
Price elasticity of demand
• Measures responsiveness of quantity demanded to change in price.
•Price elasticity of demand = %△QD/%△P
Price elasticity of demand
• Textbook page 45 Example 1:
Quantity demanded originally is 100 at a price of £2. There is a rise in
price to £3 resulting in a fall in demand by 75. Calculate the price
elasticity of demand.
• % △ QD
= [(QD2-QD1)/QD1]*100%
= [(75-100)/100]*100% = -25
• %△P
= [(P2-P1)/P1]*100%
= [(3-2)/2]*100% = 50
• Therefore, price elasticity of demand = -25/50 = -1/2.
Price elasticity of demand
• Because price elasticity is (almost) always negative – downward
sloping demand curve – we can omit the negative sign and just have
the absolute value. In this case, price elasticity is just ½.
• Now, what does this coefficient of ½ tell us?
• If price elasticity <1, it means that we are not that sensitive to a
change in price. If the price of the good increases, consumers will still
likely buy that good. E.g. of such goods are necessities.
• We say that demand is inelastic.
Price elasticity of demand
• If price elasticity >1, we are relatively more sensitive. If the price of
the good increases (even by a small margin), consumers’ reactions are
huge. They will likely not buy the good. E.g. of such goods are
luxuries.
• We say that demand is elastic.
• If price elasticity = 1, we say demand is unit-elastic/unitary elastic.
The %△ in quantity demanded offsets the %△ in price.
Extreme elasticities:
perfectly elastic,
perfectly inelastic
Price elasticity of demand: extremes
• In some cases, demand is perfectly
inelastic.
• There are some goods that consumers
pay no attention to price.
• E.g. snake anti-venom. If the price is
£1 or £1,000,000, there will still be
1,000 doses of quantity demanded.
• Quantity demanded is unaffected by
price.
• Price elasticity of demand = 0.
Price elasticity of demand: extremes
• The opposite extreme – demand is
perfectly elastic.
• A tiny rise in price causes quantity
demanded to drop to zero; or a tiny fall in
price causes quantity demanded to get
extremely large.
• E.g. pink tennis balls. If the price is £5,
consumers will buy any quantity. Above
£5, none. Below £5, will buy an extremely
large quantity of pink tennis balls.
• Price elasticity of demand = ∞.
Price elasticity varies along
demand curve
Price elasticity varies along demand curve
• Note: it is common mistake to
assume that price elasticity is the
same on all points along the
demand curve. This is not true.
Price elasticity varies.
• At higher prices, lower quantity
levels, price elasticity is elastic.
The extreme is ∞ - at point A (0,
Y).
Price elasticity varies along demand curve
• At lower prices, higher quantity
levels, price elasticity is inelastic.
The extreme is 0 – at point C (X, 0).
• Exactly halfway at point B, price
elasticity is unitary elastic.
• When economists want to
determine/calculate elasticity of any
two points on the demand curve –
what we call point elasticity of
demand. We will omit studying point
of elasticity for this course.
In a nutshell,
• Textbook page 46
Slopes of straight line demand curves
• Important note here, especially with elastic and inelastic curves: it
does not mean that if gradient slope is gentle, it demand is elastic.
Similarly, if slope is steep, demand is inelastic.
• A gentle-sloped elastic demand curve may be shown, but it is only
elastic because it is the top half of the line, not because it has a gentle
slope.
• A steep-sloped inelastic demand curve may be shown, but it is only
inelastic because it is the bottom half of the line, not because it has a
steep gradient.
Price elasticity of demand –
the mid-point method
Price elasticity of demand – mid-point
method
• Because sometimes price elasticities do not match e.g. %△P from rise
in price, and %△P from fall in price are not equal, economists come
up with the mid-point method.
• E.g. at £2, demand is 20 units. At £3, demand is 18 units.
• If it’s rise in price from £2 to £3, price elasticity is 1/5.
• If it’s fall in price from £3 to £2, price elasticity is 1/3.
• The mid-point method resolves this conflict of two price elasticities,
and the formula is slightly different.
• Price elasticity of demand, using mid-point method = %△QD/%△P
= [(QD2-QD1)/[(QD1+ QD2)/2]*100% / [(P2-P1)/ [(P1+ P2)/2]*100%
Factors determining
price elasticity
Factors determining price elasticity
• Just like there are conditions of demand (factors affecting demand),
there are factors too affecting price elasticity.
• 1. Availability of close substitutes
• If a good has close substitutes à people are more willing to consume
similar alternatives à which means people buy less of this good à
price elasticity of demand for this good is high (very sensitive).
• If good has no close substitutes, or difficult to obtain à people have
less-to-no choice but to buy this good à price elasticity for this good
is low (not as sensitive).
Factors determining price elasticity
• 2. Whether the good is a necessity of luxury
• If you must have the good (necessity) e.g. life-saving medicine, price
elasticity of demand is low.
• If you can live without the good (luxury) e.g. private jet, price
elasticity of demand is high.
Factors determining price elasticity
• 3. Share of income spent on good
• If the amount you spend on good accounts for a small fraction of your
income, price elasticity of demand tends to be low. You are likely to
buy (despite price changes).
• If the amount you spend on good accounts for a huge portion of your
income, price elasticity of demand tends to be high. You are likely not
to buy.
Factors determining price elasticity
• 4. Time elapsed since price change
• As consumers have more time to adjust to price changes, price
elasticity of demand overtime tends to increase.
• In other words, long-run price elasticity is often higher than short-run
elasticity.
• E.g. 1970s, gas prices increase drastically. Because there were no close
substitutes à people still have to consume gas à price elasticity of
demand of gas is low.
• But today – with electric cars, healthier habits, walking streets –
people have alternatives à price elasticity of demand of gas is high.
Elasticity matters, as changes to
price affects total revenue
 • Krugman, Wells, Graddy.
(2013). Chapter 5: Elasticity
Total revenue and Taxation. In Essentials of
Economics (3rd ed.), pp.150.
New York: Worth Publishers

• Total revenue – total value of

sales of goods or services
• Total revenue = price x
quantity
• Here, price = $0.90, quantity =
1,100. Total revenue = $990.
• Now, let’s see how an increase in
price affects total revenue.
Total revenue affected by price change
• Here, price increases from $0.90
to $1.10.
• Due to quantity effect, total
revenue decreases (by area A).
• Due to price effect, total revenue
increases (by area C).
• In general, overall effect can go
either way, depending on price
elasticity of demand.
Total revenue – affected by price change –
can either increase or decrease
• Important note: an increase in
price does not always generate
more revenue. Sometimes it
backfires.
• E.g. increase in toll charges.
• If toll charges rise, people use
less of highways and use
alternative routes, total revenue
decreases.
• Total revenue decreases due to
quantity effect, and demand is
elastic.
Total revenue – affected by price change –
can either increase or decrease
• The opposite scenario is
if toll charges rise, and people
still have to use the highway,
total revenue increases.
• Total revenue increases due to
price effect, and demand is
inelastic.
Total revenue – affected by price change –
can either increase or decrease
• What if price falls e.g. a discount
on goods?
• If price falls, and quantity rises
significantly, total revenue
increases. Price effect stronger.
• E.g. luxury goods
• If price falls, and people do not
really care about the discount,
total revenue decreases.
Quantity effect stronger.
• E.g. necessities
Total revenue and price elasticity of demand
• The size of price elasticity of demand determines which effect – price
or quantity - is stronger. Thus, it tells us what happens to total revenue.
• If demand is inelastic (price elasticity of demand < 1),
a rise in price increases total revenue.
• If demand is elastic (price elasticity of demand > 1),
a rise in price decreases total revenue.
• If demand is unitary elastic (price elasticity of demand = 1),
a rise in price does not change total revenue.
• Graphically,

Price RISES Price RISES Price RISES

Total Revenue INCREASES Total Revenue DECREASES Total Revenue UNCHANGED
Price effect stronger than Qty. Qty. effect stronger than Qty. effect and Price effect offset
effect Price effect each other

Inelastic Elastic Unitary Elastic

<1 >1 =1
P P P

P1
P1
P1
P P P
D
D
D
Q Q Q
Q1 Q Q1 Q Q1 Q
 Other demand elasticities:
income elasticity,
cross elasticity
Changes in quantity demanded are dependent not only on
changes in price, but also on others: changes in consumers’
incomes, and changes in prices of related goods.
Income elasticity
Income elasticity
• Measures responsiveness of quantity demanded of a good to a change
in your income.
• E.g. if incomes increase by 5%, demand for housing increases by 10%.
• Since both incomes and demand for housing increase, housing is
considered for these higher-income households, a normal good – we
talked about this earlier.

• Income elasticity of demand

= %△QD / %△income
(note: the denominator is not price).
Income elasticity
• Now, if income elasticity is calculated to be >1, we say demand is
income elastic. The good is a normal good, likely a luxury.
• If income elasticity <1, we say demand is income inelastic. The good
is a normal good, but likely a necessity.
• If income elasticity = 0, the demand for the good remains unchanged
when income rises.
• Now, the other scenario is this: if incomes increase, demand for a good
decreases. This good for these higher-income earners is an inferior
good.
Income elasticity
• Since demand for this inferior good decreases, when we calculate
income elasticity, the coefficient will be negative i.e. income elasticity
<0.
• Note here: unlike price elasticity, the negative sign here matters! A
negative income elasticity tells us that the good is an inferior good.
• And of course, the opposite: if incomes fall, demand for good
decreases – giving up some taxi rides and taking more bus rides.
income elasticity of bus rides as inferior goods <0.
• Note: when we say inferior good, it does not necessarily mean inferior
in quality.
Cross elasticity
Cross elasticity
• Measures responsiveness of quantity demanded of a good to a change
in price of another good.

•Cross elasticity of demand

= %△QD of Good B / %△Price of
Good A
• E.g. if the price of beef increases by 10%, demand for chicken
increases by 20%.
Cross elasticity
• Since beef and chicken are substitutes, cross elasticity coefficient is
positive.
• Or to switch things around, if cross elasticity is positive, the
relationship is that both are likely to be substitutes.
• The bigger the positive cross elasticity coefficient, the closer/stronger
the substitutability.
Cross elasticity
• If cross elasticity is negative, both goods are likely complements. Or
if both goods are complements, we should derive a cross elasticity
coefficient that is negative.
• The bigger the negative cross elasticity coefficient, the closer the
complementary relationship.
• If cross price elasticity is negative and small (slightly under 0), they
are weak complements.
• Again, the minus sign tells us this relationship (substitutes or
complements), so we cannot omit the sign.
In summary,
• Economists study elasticity to understand (measure) the extent of
responsiveness of consumers’ quantity demanded to change in
variables.
• We studied in this unit these variables: change in price (price
elasticity), change in income (income elasticity), and change in price
of related good (cross elasticity).
• We also studied the factors affecting price elasticity.
• Elasticity size informs (affects) total revenue.
Readings and assignment
• Essential – please read Units 9, 10 of textbook.
• Ibid. Unit 9: Price elasticity of demand. In Economics (6th ed.), pp.44-53. UK:
Anderton Press Ltd.
• Ibid. Unit 10: Income and cross elasticities. In Economics (6th ed.), pp.54-60.
UK: Anderton Press Ltd.
• Assignment
• Please attempt the unit questions in the textbook.