PRINCIPLES OF MICROECONOMICS (HSS1021)

Chapter 5: Elasticity

Learning Objectives:

To study

 What is elasticity? What kinds of issues can elasticity help us to understand?

 What is the price elasticity of demand?
 How is it related to the demand curve?
 What is the income elasticity's of demand?
 What is the cross-price elasticity's of demand?
 What is the price elasticity of supply?

Context:

Chapter 5 introduces on what is elasticity and how elasticity measures the responsiveness of
quantity demanded or quantity supplied to one of its determinants. This chapter will focus on
calculation of price elasticity, income elasticity and cross price elasticity of demand using
both standard and mid-point computing method. It will also emphases on the calculation of
price elasticity of supply.

Keywords:

Elasticity, Price elasticity of demand, income elasticity of demand, cross price elasticity of
demand and price elasticity of supply.
 Chapter 5: Elasticity

Lecture Notes

Introduction:

When we introduced demand in chapter 4, we noted that consumers usually buy more of a
good when its price is lower, when their incomes are higher, when the price of substitutes for
the good are higher, or when the prices of complements of the good are lower. Our discussion
of demand was qualitative, not quantitative. That is, we discussed the direction in which
quantity demanded moves but not the size of the change. To measure how consumers respond
to changes in these variables, economists use the concept of elasticity.

Elasticity is the measure of responsiveness of quantity demanded or quantity supplied to a

change in one of its determinants and price elasticity of demand is a measure of how much
the quantity demanded of a good responds to a change in the price of that good, computed as
the percentage change in quantity demanded divided by the percentage change in price.

The Elasticity of Demand & Supply

Elasticity: Elasticity measure how responsive one variable is in response to another variable,
independent of units. It is a measure of the responsiveness of quantity demanded or quantity
supplied to a change in one of its determinants.

Elasticity of Demand / Supply is a numerical measure of the relative responsiveness of

quantity demanded (Qd) / quantity supplied (Qs) to a change in any one of its determinants
keeping other determinants constant.

Elasticity measures the percentage change in a variable in response to a percentage change in

another variable.

Elastic – stretchy, flexible, Index of reaction

Inelastic – rigid, inflexible

Larger the value of elasticity, the more responsiveness is quantity demanded / supplied to
changes in the determinant under consideration.
Elastic goods examples: Vacations, gasoline.

Inelastic goods examples: Food, salt, prescription drugs.

Some goods exhibit both elastic and inelastic characteristics depending on the time
horizon (i.e. some goods are inelastic on a short-term basis and become more elastic on a
long-term basis).

Factors that impact whether a good is elastic or inelastic:

1. Availability of close substitutes: Goods with close substitutes are generally more
elastic because consumers can switch from one good to a less expensive substitute.

2. Necessities vs. luxuries: Necessities tend to be inelastic: consumers must purchase

them no matter the price.

3. Definition of the market: Elasticity of a market is contingent on the boundaries for that
market. A narrow market is more elastic than a broad market because narrow markets
are more easily substituted. Example: “Ice cream” is a narrow market category. Other
sweets can be substituted for ice cream. Therefore ice cream is more elastic. “Food” is
a broad market. Food is a necessity and is more inelastic.

4. Time horizon: Goods can demonstrate more elastic demand over longer time horizons.
Example: In the short-term, gasoline might be inelastic. Over the long-term, gasoline
becomes more elastic as the market responds with more substitutes for consumers. For
instance, fuel efficient cars or greater telecommuting options.

Price Elasticity of Demand

The law of demand states that a fall in the price of a good raises the quantity
demanded. The price elasticity of demand measures how much the quantity demanded
responds to a change in price. Demand for a good is said to be elastic if the quantity
demanded responds substantially to changes in the price. Demand is said to be
inelastic if the quantity demanded responds only slightly to changes in price. The
price elasticity of demand for any good measures how willing customers are to buy
less of the good as its price rises. Because the demand curve reflects the many
economic, social, and psychological forces that shape consumer preferences, there is
no simple, universal rule for what determines the demand curve’s elasticity.

Price elasticity of demand: A measure of how much the quantity demanded of a

good responds to a change in the price of that good, computed as the percentage
change in quantity demanded divided by the percentage change in price.

Price elasticity of demand is relative responsiveness of quantity demanded of a

commodity to a change in price of that commodity, keeping other determinants of
demand constant.

Price elasticity of demand measures how much quantity demanded of a commodity

(Qd) responds to a change in its own price (P).

Loosely speaking, it measures the price-sensitivity of buyers’ demand.

Price elasticity of demand = Percentage change in Qd ∕Percentage change in P

Important Observations

Price elasticity, ep will always have a negative value, because of inverse relationship
between price and quantity demanded of a commodity.

Elasticity is unit less or dimension less concept.

The coefficient of elasticity is ordered according to absolute value as opposed to

algebraic value. Hence an elasticity of –2 is greater than an elasticity of -1.
Computing the Price Elasticity of Demand

Now that we have discussed the price elasticity of demand in general terms, let’s be more
precise about how it is measured. Economists compute the price elasticity of demand as
the percentage change in the quantity demanded divided by the percentage change in the
price. That is,

Price elasticity of demand = Δ% in QD / Δ%P

Price elasticity of demand= (% change in quantity demanded) / % change in price

A larger price elasticity implies a greater responsiveness of QD to change in price

Standard method of computing the percentage (%) change

= (end value – start value)/ start value × 100

The midpoint is the number halfway between the start & end values, also the average of
those values.

It doesn’t matter which value you use as the “start” and which as the “end” – you get the
same answer either way!

For Example:

The standard method gives different answers depending on where you start.

Price elasticity of demand = percentage change in quantity demanded / percentage change

in price
For example, suppose that a 10 percent increase in the price of candies causes candies
purchasing to fall by 20 percent. We calculate your elasticity of demand as

The PED is represented as 20 / 10 = 2.

In other words, the change in quantity demanded is twice the size of the change in the
price.

A larger price elasticity value implies a greater sensitivity to price changes for the
quantity demanded.

In the above example, the elasticity is 2, reflecting that the change in the quantity
demanded is proportionately twice as large as change in the price. Because the quantity
demanded of a good is negatively related to its price, the percentage change in quantity
will always have the opposite sign as the percentage change in price. In this example, the
percentage change in price is a positive 10 percent (reflecting an increase), and the
percentage change in quantity demanded is a negative 20 percent (reflecting a decrease).
For this reason, price elasticities of demand are sometimes reported as negative numbers.
In this chapter, we follow the common practice of dropping the minus sign and reporting
all price elasticities of demand as positive numbers.(Mathematicians call this the absolute
value).With this convention, a larger price elasticity implies a greater responsiveness of
quantity demanded to changes in price.

The Midpoint Method: A better way to calculate percentage changes and elasticities.

The midpoint method computes a percentage change by dividing the change by the
midpoint (or average) of the initial and final levels. Because the midpoint method gives
the same answer regardless of the direction of change, it is often used when calculating the
price elasticity of demand between two points.

The following formula expresses the midpoint method for calculating the price elasticity
of demand between two points, denoted (Q1, P1) and (Q2, P2) ;

Price elasticity of D = (Q2- Q1) / [(Q2 + Q1)/2] ∕ (P2 – P1) / [(P2 + P1)/2]

Where Q1 = Initial Quantity demanded

Q2 = Quantity demanded after price change

 P1 = Initial Price

P2 = Changed Price

The numerator is the percentage change in quantity computed using the midpoint method
and the denominator is the percentage change in price computed using the midpoint
method.

The Variety of Demand Curves

Economists classify demand curves according to their elasticity. Demand is considered

elastic when the elasticity is greater than 1, which means the quantity moves
proportionately more than the price. Demand is considered inelastic when the elasticity is
less than 1, which means the quantity moves proportionately less than the price. If the
elasticity is exactly1, the quantity moves the same amount proportionately as the price,
and demand is said to have unit elasticity. Because the price elasticity of demand measures
how much quantity demanded responds to changes in the price, it is closely related to the
slope of the demand curve.

Inelastic Demand

Quantity demanded does not respond strongly to price changes.

Percentage change in quantity demanded is less than percentage change in price.

Price elasticity of demand is less than one.

Elastic Demand

Quantity demanded responds strongly to changes in price.

Percentage change in quantity demanded is more than percentage change in price.

Price elasticity of demand is greater than one.

The price elasticity of demand is not equal to the slope of the demand curve.

The price elasticity of demand is closely related to the slope of the demand curve.

5 different classifications of Demand curve.…

The following figures show the five cases. In the extreme case of zero elasticity, demand
is perfectly elastic, and the demand curve is vertical. In this case, regardless of the price,
the quantity demanded stays the same. As the elasticity rises, the demand curve gets flatter
and flatter. At the opposite extreme, shown in the following cases, demand is perfectly
elastic. This occurs as the price elasticity of demand approaches infinity and the demand
curve becomes horizontal, reflecting the fact that a very small changes in the price lead to
huge changes in the quantity demanded.

Demand is Perfectly Inelastic (ep = 0) when any change in price does not bring any
change in quantity demanded.

Demand is Relatively Inelastic (0<ep <1) when proportionate change in price is greater
than proportionate change in quantity demanded.
Demand is Unitary Elastic (ep =1) when proportionate change in price results an equally
proportionate change in quantity demanded.

Demand is Relatively Elastic (1<ep <∞) when proportionate change in quantity

demanded is greater than proportionate change in price.

Demand is Perfectly Elastic (ep = ∞) when demand changes significantly, even if there is
no change in price.
Rule of thumb: “The flatter the demand curve that passes through a given point, the
greater the price elasticity of demand. The steeper the demand curve that passes
through a given point, the smaller the price elasticity of demand.”

Other Demand Elasticities

In addition to the price elasticity of demand, economists use other elasticities to

describe the behaviour of buyers in a market.

Income elasticity of demand:

Income elasticity of demand measures how the quantity demanded changes as

consumer income changes. It is calculated as the percentage change in quantity
demanded divided by the percentage change in income. It also a measure of how much
the quantity demanded of a good responds to change in a consumers’ income.

‘…the responsiveness of demand to a change in consumer income, Y’

It is computed as the percentage change in the quantity demanded divided by the

percentage change in income.

If we substitute variable ‘income’ for variable ‘price’, then the formula for measuring
income-elasticity of demand is same as for measuring price-elasticity of demand

Income elasticity of demand for normal goods is always positive except for inferior
goods.

Income elasticity of demand for essential or necessary goods is always less than unity.

Income elasticity of demand for comfort or semi-luxury goods is almost equal to unity.

Income elasticity of demand for luxury goods is greater than unity.

Example: 24 Blue Ray Disc demanded (Qd) when consumer’s income (Y) is Rs.
20000. When income increased to Rs. 25000, demand for Blue Ray Disc increases to
30. Calculate income elasticity of demand. (use mid-point method)
Solution:

ey = % ∆ in Qd / % ∆ in Y

= ((30 -24)/(30+24)) / ((25000 – 20000) / (25000+20000))

= (6 / 54 ) / (5000 / 45000) = ( 1/9 ) / (1/9) = 1

Unitary income elasticity of demand implying 1% increase in income of the consumer

leads to 1 % increase in quantity demanded of Blue Ray Disc in question is a normal
commodity since income elasticity of demand is positive.

Cross-price elasticity of demand:

The cross price elasticity of demand measures how much the quantity demanded of one
good responds to a change in the price of another good.

‘…the responsiveness of demand of a commodity to a change in the price of its related

(substitutes and complementary) commodities

It is computed as the percentage change in the quantity demanded divided by the

percentage change in the price of substitute or complementary commodities.

Positive cross elasticity: Substitutes

Negative cross elasticity: Complementary commodities

Zero cross elasticity: Independent commodities

The greater the absolute value of cross elasticity of demand, the more intense is the
relationship existing between the two goods.

Example: 2 units of Coke is demanded (Qd) when the price of Red Bull is Rs. 20.
When price of Red Bull increases to Rs. 25, demand for Coke increases to 4. Calculate
cross elasticity of demand using mid-point method.

Answer: ePB = % ∆ in Qd of Coke / % ∆ in Price of Red Bull

= ((4 -2)/ (4+2)) / ((25 – 20) / (25+20))

= (2 / 6) / (5 / 45) = ( 1/3 ) / (1/9) = 3

Cross elasticity of demand is elastic in nature, implying 1% increase in price of Red
Bull leads to 3 % increase in quantity demanded of Coke.

Coke and Red Bull in question are substitute commodities since cross elasticity of
demand is positive.

The Elasticity of Supply

When we introduced supply in chapter 4, we noted that producers of a good offer to

sell more of it when the price of the good rises. To turn from qualitative to quantitative
statement about quantity supplied, we once again use the concept of elasticity.

Price elasticity of supply:

The law of supply states that the higher prices raise the quantity supplied. The price
elasticity of supply measures how much the quantity supplied responds to changes in
the price. Supply of a good is said to be elastic if the quantity supplied responds
substantially to changes in the price. Supply is said to be inelastic if the quantity
supplied responds only slightly to change in the price. The price elasticity of supply
depends on the flexibility of sellers to change the amount of the good they produce. A
measure of how much the quantity supplied of a good responds to a change in the price
of that good, commuted as the percentage change in quantity supplied divided by the
percentage change in price.

Computing the price elasticity of supply:

Now that we have a general understanding about the price elasticity, let’s be more
precise. Economists compute the price elasticity of supply as the percentage change in
the quantity supplied divided by the percentage change in the price.

Price elasticity of supply = percentage change in quantity supplied / percentage change

in price

The following formula expresses the midpoint method for calculating the price
elasticity of supply between two points, denoted (Q1, P1) and (Q2, P2) ;

Price elasticity of S = (Q2- Q1) / [(Q2 + Q1)/2] ∕ (P2 – P1) / [(P2 + P1)/2]
Where Q1 = Initial Quantity supplied

Q2 = Quantity supplied after price change

P1 = Initial Price

P2 = Changed Price

Example: An increase in the price of milk from Rs.2.85 to Rs.3.15 per gallon raises the
amount of milk produced from 9,000 to 11,000 gallons per month.

Percentage change in price (using midpoint method) = (3.15-2.85) / 3.00 * 100 = 10%

Percentage change in quantity supplied = (11,000-9,000 / 10,000) * 100 = 20%

Price elasticity of supply = 20% / 10% = 2

The quantity supplied changes proportionately twice as much as the price.

Some experts argue that long-term effects will differ from short-term impacts. Higher
prices over longer periods of time might discourage experimentation (due to higher
barrier to entry).

Conclusion:

Elasticity measures the responsiveness of Qd or Qs to one of its determinants.

Price elasticity of demand equals percentage change Qd in divided by percentage

change in P. When it’s less than one, demand is “inelastic.” When greater than one,
demand is “elastic.”

Demand is less elastic in the short run, for necessities, for broadly defined goods, or for
goods with few close substitutes.

The income elasticity of demand measures how much quantity demanded responds to
changes in buyers’ incomes.

The cross-price elasticity of demand measures how much demand for one good
responds to changes in the price of another good.
Price elasticity of supply equals percentage change in Qs divided by percentage change
in P. When it’s less than one, supply is “inelastic.” When greater than one, supply is
“elastic.”