CHAPTER 4

Elasticity

Farrukh Wazir Khan

 Elasticity
• The Economic Concept of Elasticity
• The Price Elasticity of Demand
• The Cross-Elasticity of Demand
• Income Elasticity
• Elasticity and Revenue
• Elasticity of Supply
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The Economic Concept of Elasticity
Elasticity: The sensitivity of one variable to
another or, more precisely, the percentage
change in one variable relative to a
percentage change in another.
percent change in A
Coefficient of Elasticity 
percent change in B

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The Price Elasticity of Demand
Price elasticity of demand: The percentage
change in quantity demanded caused by a
1 percent change in price.
%D Quantity
Ep =
%D Price

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 Percentage Change : Price Elasticity of Demand

Price elasticity Percentage change in Qd

=
of demand Percentage change in P
P
Example: P rises P
2
by 10% P
Calculate 1
D
Ep of Demand = ? Q
Q2 Q1
Q falls
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 Arc Formula for Calculating Price Elasticity of Demand

The Price Elasticity of Demand

Arc elasticity: Elasticity which is measured
over a discrete interval of a demand
(or a supply) curve.
Q2  Q1 P2  P1
Ep  
(Q1  Q2 ) / 2 ( P1  P2 ) / 2

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 Arc Formula for Calculating Price Elasticity of Demand

Arc elasticity : Elasticity which is measured over a discrete interval of a

demand curve

Q2  Q1 P2  P1
Ep  
(Q1  Q2 ) / 2 ( P1  P2 ) / 2

Example : P rises

Calculate
Ep of Demand =?

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The Price Elasticity of Demand
The Point elasticity : Elasticity of a linear
demand function can be expressed as:

D Q P1
εP = x
D P Q1

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 Point Formula for Calculating Price Elasticity of Demand

The Price Elasticity of Demand

where d is ‘derivative’
of the function
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 Point Formula for Calculating Price Elasticity of Demand

Point Elasticity Example :

When Qd = 2,000 – 20P

Calculate Ep of Demand when P = $70 ?

dQ P1
εP = x =?
dP Q1

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The Price Elasticity of Demand
Elasticity differs
along a linear
demand curve.

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 The Price Elasticity of Demand

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 The Price Elasticity of Demand

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 The Price Elasticity of Demand

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 The Price Elasticity of Demand

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 The Price Elasticity of Demand

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 The Price Elasticity of Demand

Determinants of Elasticity
• Availability of close substitutes / Ease of substitution
• Proportion of total expenditures / fraction of income spent
• Definition of the Market
• Durability of product
– Possibility of postponing purchase
– Possibility of repair
– Used product market
• Length of time period
• Necessity or Luxury

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 The Price Elasticity of Demand

Market and Length of Time

As the time period lengthens consumers find way to adjust to the price change

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 The Price Elasticity of Demand

Derived demand: The demand for products or factors that are not
directly consumed, but go into the production of a final product.

The demand for such a product or factor exists because there is de

mand for the final product.
The derived demand curve will be more inelastic:
1. the more essential is the component in question.
2. the more inelastic is the demand curve for the final product.
3. the smaller is the fraction of total cost going to this component.
4. the more inelastic is the supply curve of cooperating factors.

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The Cross-Elasticity of Demand
Cross-elasticity of demand:
The percentage change in quantity consumed of one
product as a result of a 1 percent change in the price
of a related product.

%D Quantity of goodA
Ex =
%D Price of good B
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The Cross-Elasticity of Demand
Q2 A  Q1 A P2 B  P1B
Arc Elasticity Ex  
(Q1 A  Q2 A ) / 2 ( P1B  P2 B ) / 2

dQA PB
Point Elasticity εx = x
dPB QA

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The Cross-Elasticity of Demand

The sign of cross-elasticity for substitutes is

positive.
The sign of cross-elasticity for complements
is negative.

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 Income Elasticity
Income Elasticity of Demand:
The percentage change in quantity dem
anded caused by a 1 percent change in
income.
%D Quantity
EY =
%D Income

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 Income Elasticity
Q2  Q1 Y2  Y1
Arc Elasticity EY  
(Q1  Q2 ) / 2 (Y1  Y2 ) / 2

dQ Y
Point Elasticity εY = x
dY Q Categories of income elasticity

Superior goods EY > 1

Normal goods 0 > EY > 1
Inferior goods EY < 1

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The Price Elasticity of Demand
and Revenue

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 The Price Elasticity of Demand
and Revenue
There is a relationship between the price elasticity of
demand and revenue received.
Revenue = P x Q
• If price decreases and, in percentage terms, quantity rises more than pri
ce dropped, then total revenue will increase.
• If price decreases and, in percentage terms, quantity rises less than pr
ice dropped, then total revenue will decrease.

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 The Price Elasticity of Demand and Revenue

As price decreases
– revenue rises when
demand is elastic
– falls when it is inelastic
– reaches it peak when
elasticity of demand
equals 1.

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 The Price Elasticity of Demand and Revenue

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 The Price Elasticity of Demand and Revenue

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 The Price Elasticity of Demand and Revenue

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 The Price Elasticity of Demand
and Revenue
Marginal Revenue:
The change in total revenue resulting from chang
ing quantity by one unit.
D Total Revenue
MR =
D Quantity

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 The Price Elasticity of Demand
and Revenue
For a straight-line demand curve the
marginal revenue curve is twice as
steep as the demand.

At the point where marginal revenue

crosses the X-axis, the demand curve
is unitary elastic and total revenue
reaches a maximum.

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 Elasticity of Supply
Price Elasticity of Supply:
The percentage change in quantity supplied as a
result of a 1 percent change in price

%D Quantity supplied
ES =
%D Price

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 Elasticity of Supply
Q2  Q1 P2  P1
Arc elasticity Es  
(Q1  Q2 ) / 2 ( P1  P2 ) / 2

dQ P1
Point elasticity S  
dP Q1

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Elasticity of Supply
If the supply curve slopes upward and to the right,
the coefficient of supply elasticity is a positive number.

When the supply curve is more elastic, the effect of a change in

demand will be greater on quantity than on the price of the product.

With a supply curve of low elasticity, a change in demand will have a

greater effect on price than on quantity.

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 Other Elasticity Measures
Elasticity is encountered every time a change
in some variable affects quantities.
• Advertising expenditure
• Interest rates
• Population size

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 Elasticity Concepts - Summary

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 Chapter 4

Book :

• Managerial Economics Economic Tools for Today’s Decision Makers

Paul G. Keat, Philip K. Y. Young, Stephen E. Erfle - 7th Edition

Reading Assignment – Chapter 4 – ‘Demand’ : Price, Revenue, Income, Cross-Price

and Supply Elasticities

Next : Mathematics of Elasticity

Farrukh Wazir Khan