Elasticity - Part I

Dr. Saima Khan (SaKn)

ECO 101: Introduction to Microeconomics

Department of Economics, School of Business,

North South University

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 Introduction

Learning Goals

 Price Elasticity of Demand

 Cross Elasticity of Demand

 Income Elasticity of Demand

 Price Elasticity of Supply

 Applications of PED
I Total Revenue
I Burden of Tax

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 Introduction

Price Elasticity of Demand (PED)

Price Elasticity of Demand

Responsiveness of quantity demanded to change in price

 Elastic vs Inelastic Demand

I Elastic Demand - respond/react A LOT to a price change;

I Inelastic Demand - respond/react VERY LITTLE to a price

change.

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 Introduction

Calculating the Price Elasticity of Demand

Percentage Change in Quantity Demanded

Ed =
Percentage Change in Price
% ∆ Qd
⇒ Ed =
%∆P

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 Introduction

Calculating the Price Elasticity of Demand

Price Elasticity of Demand: An Example

Say price of peanut butter increased by 10% leading to a fall in quantity
demanded by 20%. What is the Price Elasticity of Demand?

Percentage Change in Quantity Demanded

Ed =
Percentage Change in Price
−20%
⇒ Ed =
+10%

⇒ Ed = | − 2 |
Note: We take absolute value of Ed and ignore the -ve sign.
KEY QUESTION: Is Demand ELASTIC or INELASTIC?
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 Introduction

Deriving the Price Elasticity of Demand

Percentage Change in Quantity Demanded

Ed =
Percentage Change in Price
(Q2 − Q1 ) ∆Qd
× 100
Q1 Q1
⇒ Ed = =
(P2 − P1 ) ∆P
× 100
P1 P1
∆Qd P1
⇒ Ed = ·
Q1 ∆P
∆Qd P1
⇒ Ed = ·
∆P Q1

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 Introduction

Deriving Formula for Price Elasticity if Demand

PED: Consider a Price Decrease

Say price of organic coconut oil ↓ from $12 (P1 ) to $10 (P2 ). As a result,
quantity demanded ↑ from 50 (Q1 ) to 100 (Q2 ) jars. What is the price
elasticity of demand?

∆Qd P1
⇒ Ed = ·
∆P Q1
Q2 − Q1 P1
⇒ Ed = ·
P2 − P1 Q1
100 − 50 12
⇒ Ed = · = −6
10 − 12 50
Taking the absolute value: Ed = | − 6| = 6
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 Introduction

Deriving Formula for Price Elasticity if Demand

PED: Consider a Price Increase

Say price of organic coconut oil ↑ from $10 (P1 ) to $12 (P2 ). As a result,
quantity demanded ↓ from 100 (Q1 ) to 50 (Q2 ) jars. What is the price
elasticity of demand?

∆Qd P1
⇒ Ed = ·
∆P Q1
Q2 − Q1 P1
⇒ Ed = ·
P2 − P1 Q1
50 − 100 10
⇒ Ed = · = −2.5
12 − 10 100
Taking the absolute value: Ed = | − 5| = 2.5
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 Introduction

Deriving Formula for Price Elasticity if Demand

PED: Price Decrease vs. Price Increase
 When Price ↓: Ed = 6
 When Price ↑: Ed = 2.5

 We get slightly conflicting results for PED when look at P ↓

versus P ↑
 One workaround: Instead of P1 and Q1 use Average Price and
Average Quantity Demanded.

∆Qd Pavg
Ed = ·
∆P Qd avg

 Often called midpoint formula for calculating PED.

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 Introduction

Going Back to the Price Decrease Example

PED: Consider a Price Decrease

Say price of organic coconut oil ↓ from $12 (P1 ) to $10 (P2 ). As a result,
quantity demanded ↑ from 50 (Q1 ) to 100 (Q2 ) jars. What is the price
elasticity of demand?

Using the PED formula we just derived

∆Qd Pavg Q − Q1 Pavg

Ed = · = 2 ·
∆P Qd avg P2 − P1 Qd avg
100 − 50 11
Ed = · = −3.67
10 − 12 75
Taking absolute value, Ed = 3.67

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 Introduction

Homework: Calculating PED

Now try calculating the PED for the price increase case, using the
midpoint formula.

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 Introduction

Interpreting Price Elasticity of Demand

Table 1: Interpreting Price Elasticity of Demand

PED Terminology Interpretation

Ed > 1 Elastic A change in price leads to a more than proportionate change

in Q. demanded
if price changes by 1%, Qd changes by > 1%

Ed < 1 Inelastic A change in price leads to a less than proportionate change in

Q demanded.
if price changes by 1%, Qd changes by < 1%

Ed = 1 Unit Elastic A change in price leads to a proportionate change in Q. de-

manded
if price changes by 1%, Qd changes by 1%

Ed = ∞ Perfectly Elastic A change in price leads to EXTREME responsiveness/change

in Q demanded.

Ed = 0 Perfectly Inelastic A change in price leads to NO response/change in Q de-

manded.

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 Introduction

Elasticty of Demand: Graphs

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 Determinants of PED

Determinants of Price Elasticity of Demand

 No. of Substitutes

 Necessity vs Luxury

 Share/Percentage of Budget spent on the good in question

 Time

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 Determinants of PED

Determinants of PED: No. of Substitutes

 Say good A has 2 substitutes & good B has 15 substitutes

 Good A = Inelastic Demand - because consumers has very few
alternatives to switch to if price increases.
I Even though Qd falls, it cannot fall by that much - not very
responsive.
 Good B = Elastic Demand - because consumers have a lot of
options to switch to if price increases - very responsive to change
in price.

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 Determinants of PED

Determinants of PED: No. of Substitutes

Rule of Thumb
 Many substitutes for a good - Relatively Elastic Demand (higher
PED)
 Few substitutes for a good - Relatively Inelastic Demand (Lower
PED).

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 Determinants of PED

Determinants of PED: No. of Substitutes

 How many substitutes a good has depends on how we define it:

broad vs. narrow definition.
 Broad Definition ⇒ Few substitutes ⇒ people do not have
many alternatives to switch to if P ↑ ⇒ Demand is Inelastic.
I E.g. Laptop is a broad definition - alternatives can be
PC/desktop, tablets, phones, mainframe computers.
 Narrow Definition ⇒ Many substitutes ⇒ people have many
alternatives to switch to if P ↑ ⇒ Demand is Elastic.
I E.g. HP laptop is a narrow definition - alternatives can be
laptops by brands like Acer, Dell, Toshiba, Apple, Samsung etc.
as well as the substitutes mentioned above(PC/desktop, tablets,
phones, mainframe computers).

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 Determinants of PED

Determinants of PED: No. of Substitutes

Rule of Thumb
 Narrow definition: Many substitutes for a good - Relatively Elastic
Demand (higher PED)
 Broad definition: Few substitutes for a good - Relatively Inelastic
Demand (Lower PED).

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 Determinants of PED

Determinants of PED: Necessity vs Luxury

 If the price of salt increases, you wouldn’t really reduce

consumption of salt.
I Why? - because it is a necessity (a good you can’t do without)
I So Demand is not very responsive to ∆ Price ⇒ Inelastic
Demand.
 In contrast, consider how you would react if the price of chaat
masala/oregano increased.
I It is not essential to BD cooking - it is a luxury item (a good
you can do without)
I So if Price ↑, you will be more responsive & ↓ quantity
demanded ⇒ Elastic Demand.

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 Determinants of PED

Determinants of PED: Necessity vs Luxury

Rule of Thumb
 Necessity (a good you CANNOT do without) - Relatively Inelastic
Demand.
 Luxury (a good you CAN do without)- Relatively Elastic Demand.

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 Determinants of PED

Determinants of PED: Share of Budget

 Say you consume both pens and housing.

I Pens account for 3% of your monthly budget.
I House rent accounts for 50% of your monthly budget.
 Which one do you think will have more elastic demand? inelastic
demand?
 When price of pens ↑, you don’t respond much in terms of
quantity demanded ⇒ Why? you don’t really feel it because it’s
such a small share of your budget ⇒ Inelastic Demand.
 When rent ↑ ⇒ It really hurts your wallet ⇒ So you respond by
looking for other flats and move out ⇒ Elastic Demand.

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 Determinants of PED

Determinants of PED: Share of Budget

Rule of Thumb
 Small percentage of your income spent on this good - Relatively
Inelastic Demand.
 Large percentage of your income spent on this good - Relatively
Elastic Demand.

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 Determinants of PED

Determinants of PED: Time

 Say your rent increases on Sunday.

 You won’t be able to move out on Tuesday (even if you wanted
to) because then you would end up homeless and living on the
street!
I So in the short term, you cannot respond much to a sudden
rent increase ⇒ Inelastic Demand.
 However, in a longer term ⇒ you can look for alternatives (find
other flats) and change your lifestyle (find a smaller flat that
costs less)
I In the Long term ⇒ you have time to respond to rent increase
⇒ Elastic Demand.

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 Determinants of PED

Determinants of PED: Time

Rule of Thumb
 Short Term (have no time to respond) - Relatively Inelastic Demand.
 Long Term (have time to respond/make changes) - Relatively
Elastic Demand.

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 Determinants of PED

Determinants of Elasticity: Sample Questions

1. The demand for fizzy drinks is inelastic. Explain using your

understanding of the determinants of price elasticity of demand.
2. The demand for petrol is elastic. True or Fasle? Explain your
answer.
3. The demand for fans in Iceland is inelastic. Do you agree?
Justify.
All 3 examples were discussed in class. Refer to your class notes for
detailed answer to these questions.

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 Determinants of PED

Elasticity is NOT slope

 Elasticity 6= Slope of the Demand Curve.

 Once again, let’s take the case of P ↓ from $12 to $10 and
quantity demanded ↑ from 50 to 100 units.
 Elasticity is about percentage ∆ y due to ∆ x:
∆Qd Pavg 50 11
Ed = · = · = −3.67
∆P Qd avg −2 75
 Slope deals with ratio of ∆ y due to ∆ x:
∆Y ∆P −2
Slope = = = = −0.04
∆X ∆Qd 50

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 Determinants of PED

Price Elasticity of Demand and Total Revenue

 Total Revenue = Price × Quantity ⇒ TR = P × Q

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 Determinants of PED

Price Elasticity of Demand and Total Revenue

 Elastic Demand
I P ↑ ⇒ Q. Demanded ↓ A LOT (more than proportionately)
 downward pressure of Q outweighs upward pressure of P ⇒ TR
↓.
I P ↓ ⇒ Q. Demanded ↑ A LOT (more than proportionately).
 upward pressure of Q outweighs downward pressure of P ⇒ TR
↑.

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 Determinants of PED

Price Elasticity of Demand and Total Revenue

 Inelastic Demand
I P ↑ ⇒ Q. Demanded ↓ VERY LITTLE (less than
proportionately).
 upward pressure of P outweighs downward pressure of Q ⇒ TR
↑.
I P ↓ ⇒ Q. Demanded ↑ VERY LITTLE (less than
proportionately) .
 downward pressure of P outweighs upward pressure of Q ⇒ TR
↓.

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 Determinants of PED

Price Elasticity of Demand and Total Revenue

 Unit Elasticity
I P ↑ ⇒ Q. Demanded ↓ proportionately ⇒ TR unchanged.
I P ↓ ⇒ Q. Demanded ↑ VERY LITTLE proportionately ⇒ TR
unchanged.

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 Determinants of PED

Elasticity along a straight line demand curve

 P ↑ from $8 to $9 ⇒
Ed = 5.66
 P ↑ from $2 to $3 ⇒
Ed = 0.33
 This is simply because:
I At higher prices ⇒ people
more sensitive to price
changes (candy=Snicker bars)
I At lower prices ⇒ people
less sensitive to price
changes (candy=Safari bars)

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