FACULTY OF BUSINESS ADMINISTRATION

ECONOMICS I
ECN101
[Handout]
C h a p t e r F o u r

4 ELASTICITY

Elasticity
• The price elasticity of demand measures how strongly buyers respond to a change in the
price of a good.
• The price elasticity of demand can be used to make quantitative predictions of how
changes affect the price and quantity demanded of a good.
• The income elasticity of demand measures how strongly demanders respond to a
change in income, and the cross elasticity of demand measures how strongly demanders
respond to the change in the price of another good.
• The price elasticity of supply measures how strongly producers respond to a change in
the price of a good.

I. Price Elasticity of Demand

• In general, elasticity measures responsiveness. The price elasticity of demand measures
how responsive demanders are to a change in the price of the good. This information is
often useful for both businesses and governments because it can predict the impact of a
price change on total revenue or total expenditure.
Calculating Price Elasticity of Demand
• The price elasticity of demand is a units-free measure of the responsiveness of the
quantity demanded of a good to a change in its price when all other influences on a
buyer’s plans remain unchanged. The price elasticity of demand is equal to the absolute
value of:
Percentage change in quantity demanded
.
Percentage change in price
• The demand elasticity formula yields a negative value, because price and quantity move
in opposite directions. However, it is the magnitude, or absolute value, of the measure
that reveals how responsive the quantity change has been to a price change. So we use
the magnitude or the absolute value of the price elasticity of demand.
• The table to the right has two points on the Price Quantity
demand curve for pizza from a particular (dollars per demanded
pizza parlor. pizza) (pizzas per week)
• The absolute value of the percent change 14 500
in quantity demanded is 16 400

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 [(500 − 400)  450]  100 = 22.2 percent.
• The absolute value of the percentage change in price is [($14 − $16)  $15]  100 =
13.3 percent.
• Between these two points on the demand curve, the price elasticity of demand is
22.2%  13.3% = 1.67.

Inelastic and Elastic Demand

• If the price elasticity of demand is less than 1.0, the good is said to have an inelastic
demand. In this case, the percentage change in the quantity demanded is less than the
percentage change in price.
• If the quantity demanded remains constant when the price changes, then the good is
said to have perfectly inelastic demand. The price elasticity of demand is 0 and
the good’s demand curve is a vertical line.
• If the price elasticity of demand is equal to 1.0, the good is said to have a unit elastic
demand. In this case, the percentage change in the quantity demanded equals the
percentage change in price.
• If the price elasticity of demand is greater than 1.0, the good is said to have an elastic
demand. In this case, the percentage change in the quantity demanded exceeds the
percentage change in price.
• If the quantity demanded changes by an
Furniture 1.26
infinitely large percentage in response to a tiny
price change, then the good is said to have Motor Vehicles 1.14
perfectly elastic demand. The price elasticity Clothing 0.64
of demand is infinite. Oil 0.05
• The table has some “real-life” elasticities from the
book.

Elasticity Along a Linear Demand Curve

• With the exception of a vertical demand
curve and a horizontal demand curve
(along which the elasticity is 0 and infinite,
respectively) the price elasticity of demand
changes when moving along a linear demand
curve.
• As the figure illustrates, at points on the
demand curve above the midpoint, the
price elasticity of demand is elastic while
at points below the midpoint, the price
elasticity of demand is inelastic. At the
midpoint, the price elasticity of demand is
unit elastic.

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Total Revenue and Elasticity
• The total revenue from the sale of a good equals the price of the good multiplied by
the quantity sold.
1. If demand is elastic: a 1 percent price cut, increases the quantity sold by more than
1 percent and total revenue increases.
2. If demand is unit elastic: a 1 percent price cut, increases the quantity sold by 1
percent and total revenue does not change.
3. If demand is inelastic: a 1 percent price cut, increases the quantity sold by less than
1 percent and total revenue decreases.
• The total revenue test is a method of estimating the price elasticity of demand by
observing the change in total revenue that results from a change in price, when all other
influences on the quantity sold remain the same.
1. If a price cut increases total revenue, demand is elastic. And if a price hike decreases
total revenue, demand is elastic.
2. If a price cut does not change total revenue, demand is unit elastic. And if a price
hike does not change total revenue, demand is unit elastic.
3. If a price cut decreases total revenue, demand is inelastic. And if a price hike
increases total revenue, demand is inelastic.
• Similarly, when a price changes, a consumer’s change in expenditure depends on the
consumer’s elasticity of demand.
• If demand is elastic, then a price cut means that expenditure on the item increases.
• If demand is inelastic, then a price cut means that expenditure on the item
decreases.
• If demand is unit elastic, then a price cut means that expenditure on the item does
not change.

The Factors that Influence the Elasticity of Demand

The magnitude of the price elasticity of demand depends on:
• The closeness of substitutes: The closer and more numerous the substitutes for a good
or service, the more elastic the demand. This is critical for understanding demand in the
market structure section later in the book.
• The proportion of income spent on the good: The greater the proportion of income
spent on a good or service, the more elastic the demand.
• The amount of time elapsed since the price change: The longer the time elapsed since
the price change, the more elastic the demand.

II. More Elasticities of Demand

Income Elasticity of Demand

• The income elasticity of demand is a measure of the responsiveness of the demand
for a good to a change in the income, other things remaining the same.
• The income elasticity of demand is equal to:
Percentage change in quantity demanded
.
Percentage change in income

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 The changes in the quantity demanded and income are percentages of the average
income and quantity demanded over the range of change.
• The income elasticity of demand is positive for normal goods and negative for inferior
goods.
• If the income elasticity of demand is greater than 1, demand is income elastic and the
good is a normal good. As income increases, the percentage of income spent on
income elastic goods increases.
• If the income elasticity of demand is positive but less than 1, demand is income
inelastic and the good is a normal good. As income Airline Travel 5.82
increases, the percentage of income spent on income
inelastic goods decreases. Restaurant Meals 1.61
• If the income elasticity of demand is negative the Clothing 0.51
good is an inferior good. Food 0.14
• The table has some “real-life” income elasticities from
the book.

Cross Elasticity of Demand

• The cross elasticity of demand is a measure of the responsiveness of the demand for
a good to a change in the price of a substitute or complement, other things remaining
the same.
• The cross elasticity of demand is equal to:
Percentage change in quantity demanded
.
Percentage change in price of a substitute or complement
The changes in the quantity demanded and the price are percentages of the average
price and quantity demanded over the range of change.
• The cross elasticity of demand is positive for substitutes and negative for complements.

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