Elasticity and Its Applications

Introduction
• The demand and supply analysis helps us to
understand the direction in which price and
quantity would change in response to shifts in
demand or supply.
• What economists would like to know is ‘what
will happen to demand/supply when the
price changes?’
 Learning Outcomes-
should be able;
• To define elasticity and How elasticity is
measured at a point or over a range.
• Explain the meaning and significance of price
elasticity of demand and supply.
• Distinguish between the 5 categories of price
elasticity of demand.
• Explain the determinants of price elasticity of
demand and supply
• Define income elasticity and cross elasticity of
demand. How income elasticity is measured and
how it varies with different types of goods.
• How the sensitivity of quantity demanded to a
change in price is measured by the elasticity of
demand and what factors influence it.
• How elasticity is measured at a point or over a
range.
• How income elasticity is measured and how it
varies with different types of goods.
• How elasticity of supply is measured and what it
tells us about conditions of production.
• Some of the difficulties that arise in trying to
estimate various elasticities from sales data
 Elasticity . . .

• … is a measure of how much buyers and

sellers respond to changes in market
conditions.
 THE ELASTICITY OF DEMAND
Price elasticity of demand (PED)
• measure of how much the quantity demanded
of a good responds to a change in the price of
that good.
• PED is the percentage change in the quantity
demanded if the price of the product changes
by one percent, ceteris paribus.
Computing the Price Elasticity of Demand

• Point formula.

Percentage change in quantity demanded

Price elasticity of demand =
Percentage change in price
Q2  Q1
%changein qty demanded  *100
Q1
P2  P1
% changein price  *100
P1
Example

• If the price of bread increases from $2.00 to

$2.20 and the amount you buy falls from 10 to
8 loaves, then your elasticity of demand would
be calculated as:

(10  8)
 100 20%
10  2
(2.20  2.00)
 100 10%
2.00
Important aspects and implications
• Calculated by using percentage changes,
relative changes not absolute changes
• PD is a ratio, called elasticity coefficient
• It enable us to compare how consumers react
to changes in the prices of different goods and
services.
• Has a negative sign.
The Midpoint Method: A Better Way to
•Calculate
The midpoint formula
Percentage is preferable
Changes when
and Elasticities
calculating the price elasticity of demand
because it gives the same answer regardless
of the direction of the change.
• The elasticity is also called arc elasticity-
calculated by comparing two points.
(Q 2  Q1 ) / [(Q 2  Q1 ) / 2]
Price elasticity of demand =
(P2  P1 ) / [(P2  P1 ) / 2]
Example Using The Midpoint Method:

• If the price of bread increases from $2.00 to

$2.20 and the amount you buy falls from 10 to
8 loaves, then your elasticity of demand, using
the midpoint formula, would be calculated as:

(10  8)
(10  8) / 2 22%
  2.32
(2.20  2.00) 9.5%
(2.00  2.20) / 2
Interpreting numerical elasticities

• Ranges 0 <η < ∞

• Different categories.
• Extreme cases
η = 0: Perfectly Inelastic
– Price change no effect on quantity demanded.
– Vertical demand curve.
η = ∞: Perfectly Elastic
– A tiny change in price will lead to an indefinitely large
change in quantity demanded.
The Variety of Demand Curves
• Realistic ranges
• η < 1: Inelastic Demand
– % change in quantity demanded is less than the %
change in price..
• η > 1: Elastic Demand
– % change in quantity demanded is greater than
the % change in price.
• η = 1: Unit Elastic
• N.B. Negative sign is ignored, only the
absolute value is considered.
Figure 1 The Price Elasticity of Demand

(a) Perfectly Inelastic Demand: Elasticity Equals 0

Price
Demand

$5

4
1. An
increase
in price . . .

0 100 Quantity

2. . . . leaves the quantity demanded unchanged.

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 Figure 1 The Price Elasticity of Demand

(b) Inelastic Demand: Elasticity Is Less Than 1

Price

$5

4
1. A 22% Demand
increase
in price . . .

0 90 100 Quantity

2. . . . leads to an 11% decrease in quantity demanded.

Figure 1 The Price Elasticity of Demand

(c) Unit Elastic Demand: Elasticity Equals 1

Price

$5

4
1. A 22% Demand
increase
in price . . .

0 80 100 Quantity

2. . . . leads to a 22% decrease in quantity demanded.

Copyright©2003 Southwestern/Thomson Learning

 Figure 1 The Price Elasticity of Demand

(d) Elastic Demand: Elasticity Is Greater Than 1

Price

$5

4 Demand
1. A 22%
increase
in price . . .

0 50 100 Quantity

2. . . . leads to a 67% decrease in quantity demanded.

 Figure 1 The Price Elasticity of Demand

(e) Perfectly Elastic Demand: Elasticity Equals Infinity

Price

1. At any price
above $4, quantity
demanded is zero.
$4 Demand

2. At exactly $4,
consumers will
buy any quantity.

0 Quantity
3. At a price below $4,
quantity demanded is infinite.
 Elasticity and total revenue
• Negatively sloped demand curve does not have a
constant elasticity, even though it does have a
constant slope.
• PED can be used to determine by how much the
total expenditure by consumers changes when
the price of the product changes.
• Elasticity varies along a linear demand curve.
• Total revenue

TR = P x Q
Example: Assume a demand curve has the equation
Qd = 22 - 2P

Price($) Qd E Total revenue($)

0 22 0 0

5.50 11 -1 60.50

11 0 infinity 0
 Example: Assume a demand curve has the equation
Qd = 22 - 2P

Price($) Qd Edp Total revenue($)

0 22 0 0
1 20 -0.1 20
E<1 2 18 -0.22 36
3 16 -0.38 48
4 14 -0.57 56
5 12 -0.83 60
5.50 11 -1 60.50
6 10 -1.2 60
7 8 -1.75 56
E>1 8 6 -2.67 48
9 4 -4.5 36
10 2 -10 20
11 0 infinity 0
 Note: elasticity varies over
the length of a ‘straight line’
Price
demand curve. Why tend to
be elastic in the high price
$11 Elastic >1 range and inelastic in low
price range?

Unit Elastic = 1

$5.50

Inelastic < 1

D
0
11 22 Quantity Demanded
 elastic • Change in TR
unit of a product in
P
inelastic response to a
price change
depends on
elasticity of
Total revenue DD.
• Elastic range
decrease in
price will
TR
increase TR
• Inelastic range,
a decrease in
Quantity price will
reduce TR
 Price elasticity of demand and total revenue

Total Revenue (TR) = Price X Quantity sold

When Ƞ > 1 a rise in price leads to fall in TR

When Ƞ < 1 a rise in p - rise in TR

When Ƞ > 1 a fall in p - rise in TR

When Ƞ < 1 a fall in p - fall in TR

When Ƞ = 1 a rise/fall in p - no change in TR

 Determinants of PED
• Availability of Close Substitutes
- Products with close substitutes tend to have more
elastic demand. Reverse is true
• Definition of the Market or product
- Any one of a group of related products will have a
more elastic demand than the group as a whole.
- Narrowly defined products eg mealie meal (broad –
inelastic) but brands of mealie meal (red seal,
victoria, probrands – narrow - elastic)
• What
DegreeDetermines The Price Elasticity
of complementarity
of Demand?
- With high complementary goods the PED
tends to be low
• Time Horizon, more elastic in the LR than SR
• Type of want to be satisfied
- Necessities versus Luxuries, PED tends to be
lower for necessities than that of luxuries
• the good or service is a large share of the
consumer's budget- the greater proportion of
income spent on a product, the greater will be
the PED.
The Price Elasticity of Demand and Its
Determinants
• Demand tends to be more elastic :
– the larger the number of close substitutes.
– if the good is a luxury.
– the more narrowly defined the market.
– the longer the time period.
 Application of price elasticity of
demand

Who is vitally concerned with the

concept of PED?
• retail businesses especially those
selling/holding stock
–perishable goods
–fashion trend items
–large stock variations seasonally
• budgeting governments
• nations specialising in primary resource
exports
 Application of price elasticity of demand

Why is it an important concept?

• Influences resource allocation

• Impacts on marketing strategies
• Affects governments policies
–protection of international trade
–social impact of pricing policy
• Affects cultural / tourism attractions etc
 Other demand elasticities

Income and Cross price

 Income elasticity of demand
(ȠY)
Income elasticity of demand [is] a
measure of how much the quantity
demanded of a good responds to a
change in consumers’ income

Formula:
ȠY = percentage change in quantity
demanded /
percentage change in income
 Percentage change
in quantity demanded
Income elasticity of demand =
Percentage change
in income
 Income elasticity of demand
• Response to a ‘normal good’ - ȠY > 1.
- quantity demanded increases as income
increases.
–the direction is positive, but the size of the
increase in quantity demanded is extremely
variable from good to good.
–ȠY for normal goods can be > or < 1.
- Normal goods can be classified as
luxuries or necessities
–0< ȠY < 1; income – inelastic necessities
- Examples include food, fuel, clothing,
utilities, and medical services
 Income elasticity of demand

• ȠY > 1; income – elastic luxuries

• Examples include sports cars and expensive
foods.
• The more necessary an item is in the
consumption pattern of consumers,
the lower is its income elasticity.
 Income elasticity of demand
For ‘inferior goods’ - ȠY < 1.
- the quantity demanded will move in the
opposite direction.
• Higher income can lead to a reduced
demand for cheaper cuts of meat, second
hand clothing and furniture.
• Inferior goods have negative income
elasticities
• Income increases and the quantity
demanded decreases
 Cross-price elasticity of demand ( ȠXY)
• This measure of elasticity allows us to
determine whether two goods are substitutes
or compliments
“Cross-price elasticity of demand [is] a measure of
how much the quantity demanded of one good
responds to a change in the price of another good”
(Mankiw, (2007) p. 96).
It is measured by:
percentage change in quantity demanded of
good 1 divided by the percentage change in
the price of good 2.
- -∞ < ȠXY < ∞
 Cross price elasticity of
demand
- ȠXY > 0
A positive cross-price elasticity
indicates the two goods are
substitutes
 Cross price elasticity of
demand
• ȠXY < 0
• A negative cross-price elasticity
indicates the two goods are
compliments.

• Knowledge of cross elasticity

can be important in matters of
competition pricing
 Price elasticity of supply (Ƞs)

Price elasticity of supply [is] a

measure of how much the quantity
supplied of a good responds to a
change in the price of that good”
(Mankiw, (2017)
Computing the Price Elasticity of
Supply
Formula:
Point and Midpoint
Percentage change
in quantity supplied
Price elasticity of supply =
Percentage change in price
 Interpretation of price elasticity of
supply

- Ƞs > 1; elastic
Realistic
- Ƞs < 1; inelastic range

- Ƞs =1; unit

- Ƞs =0; perfectly inelastic Extreme

cases
- Ƞs = ∞; perfectly elastic
 Determinants of Elasticity of Supply

• Responsiveness of quantity supplied ‘ will depend on

Substitution and Production costs
Substitution
depends on how easy it is for firms to shift from the
production of other products to the one whose price has
risen. (discuss – agric – land vs labour transfer)
Production costs
- Ƞs also depends on how costs behave as output vary.
- if rising output lowers unit cost of production, more will
be produced → elastic supply
.
 Determinants of Elasticity of
Supply
- if rising output increases cost of production, less
will be produced → inelastic supply.

Time frame
- It is difficult to change quantity supplied in the
short run but easy in the long run.

- Supply tends to be more elastic in the long run

than short run because it usually takes time for
producers to alter productive capacity in
response to price change.
• Example : the planting cycle of crops -
maize in Zimbabwe.
• Zim government usually increase the price
during tussling stage.
• This has no influence on how much maize
will get planted for this year’s crop.
• If the price persist, it will influence the
amount get planted next season.
• Note: The supply of some goods is
totally inelastic even in the long run.
 Application of price elasticity of
demand: Impact on government policies

Why do governments in developed economies

target the following when imposing taxes?

• tobacco products, ( cigarettes)

• alcoholic beverages, beer, spirits (brandy,
whisky, gin)
• table wines red and white, casks and bottles
• petrol and petrol products
• motor vehicles, passenger and commercial
 APPLICATIONS OF ELASTICITY

• a) Incidence of Tax
• b)charging fares in a stadium.
• What happens to wheat farmers and the
market for wheat when university
agronomists discover a new wheat hybrid
that is more productive than existing
varieties?
Figure 8 An Increase in Supply in the Market for Wheat

Price of
Wheat 1. When demand is inelastic,
2. . . . leads an increase in supply . . .
to a large fall S1
in price . . . S2

$3

Demand

0 100 110 Quantity of

Wheat
3. . . . and a proportionately smaller
increase in quantity sold. As a result,
revenue falls from $300 to $220.
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