Elasticity

 What is elasticity in Economics?

Elasticity is a measure of a variable's sensitivity to a change in another variable.

Elasticity refers the degree to which individuals, consumers or producers change their
demand or supply in response to price or income changes.

On other meaning, elasticity used to assess the change in consumer demand as a

result of change in a good or service’s price.

 General equations:
Elasticity=%change ∈quantity ÷ %change∈ price
Elasticity >1(the demand is affected by the price)
Elasticity <1(the demand is insensitive¿ price)

 General rules:

Elastic product:

If the quantity demand of the product changes drastically when its price increases or
decreases.
Ex: Bouncy balls.

Bouncy balls are highly elastic in that they aren't a necessary good.
Inelastic product:

If the quantity demand of the product not changes or changes very little when its
price fluctuates.
Ex: Insulin.
Insulin is a product that is highly inelastic.

 Why elasticity is important?

- Elasticity is important to understand the relation between substitutes

goods.
- Elasticity is important to understand the relation between complements
goods.
- Elasticity is important to understand the relation between the income and
nature of the good. (normal, necessary, luxury, Inferior).
- The elasticity of good or service directly affects customer retention rates of
a company.

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 - Businesses are striving to sell products that have inelastic demand; so the
customers will remain loyal to the company even the price increases.
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 What we shall study in Elasticity?

A. Price Elasticity of Demand.
B. Cross price Elasticity.
C. Income Elasticity of Demand.

A. Price Elasticity of Demand.

- We know that when the supply increases, the equilibrium price falls
and the equilibrium quantity increases.
- But dose the price fall by large or small amount and quantity
increased by large or small amount?
The answer depends on the responsiveness of the quantity
demanded.

LO1: Calculating price elasticity of Demand. (average price and

quantity, mid-point method/ARC method).
Ep=% ∆ Q ÷ % ∆ P

Ep is always (-) value as long as the demand is down sloping

therefore, we ignore the signal. (it is absolute value).

Ex-1: If the price of milk increased by 20% and as on result sales milk
decreased by 10%, find Elasticity of the price.
Answer:
Ep=−10 % ÷ 20 %=−0.5

Ex-2:
If:
2
 P Qd
8 15
10 5

Calculate Ep (Elasticity of the price)

Answer:
%∆ Q ∆Q ∆P
Ep= = ×100 ÷ × 100
% ∆ P Qave Pave
∆Q ∆P
Ep= ÷
Qave Pave
∆ Q Pave 10 9
Ep= × = × =4.5
∆ P Qave −2 10

Ex-3: Pizza
Price Pizza Quaninty Pizza
20.5 9
19.5 11

Ep=% ∆ Q ÷ % ∆ P
∆Q ∆P
Ep= ÷
Qave Pave
2 1
Ep= ÷ =4
10 20

 Pave (Price avarge) = (P1+P2) / 2 = (20.5+19.5)/2= 20

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  Qave (Qaninty avarge) = (Q1+Q2)/2 = (9+11)/2=10
 ∆ Q = (Q1-Q2) = (9-11) = -2
 ∆ P = (P1-P2) = (20.5-19.5)

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LO2: Inelastic and Elastic Demand.

What is the possible elasticities of Demand?
Answer:

1- Perfectly inelastic demand.

Ep=ZERO
Ex: Insulin.
Insulin is of such importance to some diabetics that if the price rises
or falls, they do not change the quantity they buy.

2- Unit elastic demand.

Ep=1 , % ∆ Q=% ∆ P

3- Inelastic demand.
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 Ep<1 , % ∆ Q<% ∆ P

Ex: Food.
Food is an example of good with inelastic demand.

4- Perfectly elastic demand.

Ep=∞

Ex: Soft Drinks and any good that has a perfect substitute.

5- Elastic demand.
Ep>1 , % ∆ Q>% ∆ P

Ex: Cars & Furniture.

Lo-3: Total Revenue and Elasticity

 The total revenue = P*Q

When the price changes the total revenue also changes.
The change in the total revenue depends on the elasticity of demand;
how?

- If demand is elastic, a 1 percent price cut increases the quantity sold

by more than 1 percent and total revenue increases.

- If demand is inelastic, a 1 percent price cut increases the quantity sold

by less than 1 percent and total revenue decreases.

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 - If demand is unit elastic, a 1 percent price cut increases the quantity
sold by 1 percent and total revenue does not change.

 The total price test.

 If a price cut increases total revenue, demand is elastic.

 If a price cut decreases total revenue, demand is inelastic.
 If a price cut leaves total revenue unchanged, demand is unit
elastic.

Lo-4: The Factors that Influence the Elasticity

The elasticity of demand for a good depends on:

 The closeness of substitutes.

 The proportion of income spent on the good.
 The time elapsed since the price change.

B- Cross Elasticity of Demand.

The cross elasticity of demand is a measure of responsiveness of the
demand for a good to a change in the price of substitute or complement.

On other meaning we calculate the change in demand of one good to its

substitute or complement good.
How to calculate Cross Elasticity of Demand?

Ex , y=% ∆ Qx ÷ % ∆ Py=¿

Answers:
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 1- Ex , y=+ value= X∧Y are substitutes.
2- Ex , y=−value= X∧Y are complments .
3- Ex , y=ZERO=X∧Y are not related .

Ex for substitutes (Pizza & Burger)

Price-1 Quantity-1 Price-2 Quantity-2

Pizza - 9 - 11
Burger 1.5 - 2.5 -

Calculate the cross elasticity of demand & the relation between the
Pizza & Burger.

% ∆ Q of Pizza
Ep , b=
%ΔP of Burger ¿
¿
+20 %
Ep , b= =0.4 .
+50 %
- Cross Elasticity of demand is 0.4.
- Pizza & Burger are substitutes.

Ex for Complements (Pizza & Pepsi)

Price-1 Quantity-1 Price-2 Quantity-2

Pizza - 11 - 9
Pepsi 1.5 - 2.5 -

Calculate the cross elasticity of demand & the relation between the
Pizza & Pepsi.

% ∆ Q of Pizza
Ep , b=
%ΔP of Pepsi ¿
¿
−20 %
Ep , b= =−0.4 .
+50 %
- Cross Elasticity of demand is -0.4.
- Pizza & Pepsi are complements.

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 C- Income Elasticity of Demand.

Income elasticity of demand is a measure of the responsiveness of the

demand for a good or service to change in income.

Ei=% ∆ Q÷ % ∆ I =¿

Answers:
1- Ei=+value∧¿ 1=luxury good=income elastic
2- Ei=+value∧¿ 1=necessary good =income inelastic
3- Ei=−value Inferior good