Topics

Price Elasticity of Demand

Measuring Price Elasticity
Determinants of Price Elasticity of Demand
Arc elasticity, elasticity using mid point method, point elasticity
Shape of demand according to elasticity
Characteristics of Demand Elasticity
Price elasticity along a straight line demand curve
Price elasticity and total revenue
Income elasticity, cross price elasticity
Elasticity of supply
Determinants of elasticity of supply
 Introduction
• Key question about demand is how
responsive is consumption to a price
change?
• The demand curve provides a quantitative
answer
• But that answer is dependent on units of
measurement
• Elasticity does not depend on units of
measure!
 Price Elasticity of Demand
• Thus far we have talked about the impact
of changes in prices, incomes, costs, on
demand and supply in rather general
terms

• In fact, in real world, more precision is

needed
• Law of demand says that a higher price
will reduce quantity demanded, BUT BY
HOW MUCH  that is, will the number
sold decline by only a little or by a lot?
 Price Elasticity of Demand
• Price elasticity of demand measures in a
standardized way how responsive
consumers are to price change 
elasticity is another word for
responsiveness

• In simplest terms, the price elasticity of

demand measures the percent change in
quantity demanded divided by the percent
change in price
 What does the elasticity
“measure” really measure?
• The elasticity measure is a ratio
between two percentage measures: the
percentage change in one variable over
the percentage change in another
variable
• A price elasticity of -6.25 means that for
each one percent change in price the
quantity demanded will change by 6.25
percent.
 Price Elasticity of Demand
• Elasticity expresses a relationship
between two amounts
– The percent change in quantity demanded
– The percent change in price

• Because the law of demand states that

price and quantity demanded are inversely
related, the change in price and the
change in quantity demanded have
opposite signs  the price elasticity of
demand has a negative sign
 Price Elasticity of Demand

Price elasticity of demand 

Percentage change in quantity demanded
Percentage change in price
 Computing the Value of Elasticity

• The midpoint formula to

compute elasticity is:

Q2  Q1
x 100%
% Qd (Q 1  Q 2 ) / 2

% P P2  P1
x 100%
( P1  P2 ) / 2

10  5 5
x 100% x 100%
% Qd (5  1 0 ) / 2 6 6 .7 %
  7 .5 =   1 .6 7
% P 2  3 -1 - 4 0 .0 %
x 100% x 100%
(3  2 ) / 2 2 .5
 Price Elasticity of Demand Using
Midpoint Method
• Generalize the price elasticity formula
– If the price drops from p to p’, other things
constant, the quantity demanded increases
from q to q’
– The change in price can be represented as Δp
and the change in quantity as Δq
q
ED 
(q  q) / 2
p
(p  p) / 2
 Price Elasticity of Demand

• Measures the responsiveness of demand to

changes in price.
• It is the ratio of the percentage change in
quantity demanded to the percentage change
in price.
% c h a n g e in q u a n tity d e m a n d e d
p ric e e la s tic ity o f d e m a n d 
% c h a n g e in p ric e
• Its value is always negative, but stated in
absolute terms.
• The value of the line of the slope and the
value of elasticity are not the same.
 Arc (Price) Elasticity
P
Note that if we
increased the price,
(from 8 to 10 or 2 to 4)
a
the original P and Q 10 b
would be 2 and 8 and 8

18 and 90,
c
respectively. 4 d
2
Ep = (-10/18)/(2/8) = -2.22 D
8 18 80 90 Q
Ep = (-10/90)/(2/2) = -.11
 Arc Elasticity

To get the average elasticity between two

points on a demand curve we take the
average of the two end points (for both
price and quantity) and use it as the initial
value:
Q2-Q1 10
(Q1+Q2) 8+18
Ea = = -3.49
P2-P1 -2
(P1+P2) 10+8
Characteristics of Demand Elasticity

Value of Type of Magnitudes of Response to

Elasticity Demand Change Price Changes
 > |1| Elastic %Qd > %P Responsive
 < |1| Inelastic %Qd < %P Unresponsive
 = |1| Unitary elastic %Qd = %P Proportional

Type of Substitutes
Elasticity Available
Elastic Many
Inelastic Few
 Price Elasticity of Demand
• Elasticity of Demand with respect to the good’s own
price
• EDxPx= %ΔQ/%ΔP or
• EDxPx= ΔQ/Q / ΔP/P or
• EDxPx= ΔQ/ΔP • P/Q
• For price elasticities of demand the sign is ignored as
they are all negative
• Elastic demand > 1
• Inelastic demand < 1
• Unit elastic demand = 1
 Calculating Percentage Changes
• Elasticity is a ratio of percentages, and it involves
computing percentage changes.
P2  P1
% c h a n g e in p ric e  x 100%
P1
Q2  Q
% c h a n g e in q u a n tity d e m a n d e d  1
x 100%
Q1

• Using the values on the graph to

compute elasticity, then:
 100%
p ric e e la s tic ity o f d e m a n d    3 .0
 3 3 .3 %
Shape of Demand According to
Elasticity
Type of Demand Inclination
Elastic Relatively Flat
Inelastic Relatively Steep
Elasticity of Demand

Price elasticity of demand

Estimated price elasticities of demand
elasticity coefficient
item short run long run
Airline travel 0.1 2.4
Medical care 0.3 0.9
Percentage Change in
Natural gas 1.4 2.1
Quantity Demanded
E  Auto tires 0.9 1.2
d Percentage Change in Price Stationery 0.5 0.6
Gasoline 0.2 0.7
Housing 0.3 1.9
Automobiles 1.9 2.2
Movies 0.9 3.7
Jewelry & watches 0.4 0.7
Radio & TV repair 0.5 3.8
Foreign travel 0.1 1.8
Glass, china, etc. 1.5 2.5
Interpreting the Value of Elasticity

Here is how to interpret two different

values of elasticity:
• When  = 0.2, a 10% increase in price
leads to a 2% decrease in quantity
demanded.
• When  = 2.0, a 10% increase in price
leads to a 20% decrease in quantity
demanded.
 Extreme Elasticities

Elasticity Value Type of Elasticity Substitutes Available

=0 Perfectly Inelastic None
= Perfectly Elastic Infinite
Hypothetical Demand Elasticities
for Four Products
Inelastic and Elastic Demand

P D
Elasticity = 0

Q
P
D
Elasticity = 
Q
P
Elasticity = 1
D Q
 Price Elasticity of Demand Over
an Arc
Px ($)
If measuring price elasticity
of demand over an arc use
15 the average P and Q
12.5 5
10
100 Dx

200 Qx
100
150 (Kgs)
EDxPx= 100/150 / 5/12.5 = .66/.4 = 1.66
EDxPx= 100/5 x 12.5/150 = 20 x .083 = 1.66
Price Elasticity of Demand at a
Point
EDxPx= ΔQ/ΔP • P/Q

ΔQ/ΔP = inverse of the slope of the demand

Pcurve
100
Slope = 2
Inverse of slope = 0.5
80
Elasticity = 0.5 x 4 = 2

D
20 50 Q
 Price Elasticity Along a Straight
Line Demand Curve

P
EDxPx > 1 Slope = 2/3
200
Inverse of slope = 1.5

100 EDxPx = 1
EDxPx < 1

150 300 Q

EDxPx > 1 Elastic Demand

EDxPx = 1 Unit Elastic Demand
EDxPx < 1 Inelastic Demand
 Elasticity and the Price Level
P | Ep | > 1 : Elastic
Along a linear demand curve as | Ep | < 1 : Inelastic
the price goes up, |elasticity |
| Ep | = 1 : Unit-elastic
increases.

a E =-3.49
10 b
Note that between points "a" 8
and "b" the (arc) elasticity of
the above demand curve is
-3.49, whereas between "c" and c E = -.17
4 d
"d" it is -.17. 2 D
8 18 80 90
 Elasticity Changes along a
Straight-Line Demand Curve
 6.4 • Along the elastic range,
elasticity values are
greater than one.

 .29
• Along the inelastic range,
elasticity values are less
than one.
 Elasticity and Total Revenue
• Knowledge of price elasticity is especially
valuable because it indicates the effect of
a price change on total revenue

• Total revenue (TR) is the price (p)

multiplied by the quantity demanded (q) at
that price  TR = p x q

• What happens to total revenue when price

decreases?
 Elasticity and Total
Revenue
• A lower price means producers get less
for each unit sold which tends to decrease
total revenue

• However, a lower price increases quantity

demanded which tends to increase total
revenue

• Thus, the overall impact of a lower price

on total revenue depends on the net result
of these opposite effects
 Price Elasticity of Demand and
Total Revenue
• If the price elasticity of demand is > 1, then a
reduction in price will increase demand more
than proportionately and TR (P x Q) will
increase.
• If the price elasticity of demand = 1, then a
reduction in price will increase demand in
proportion and TR will be unchanged
• If the price elasticity of demand is < 1, then a
reduction of price will increase demand less than
proportionately and TR will fall.
 Elasticity and Total Revenue
• Specifically
– When demand is elastic, the percent increase
in quantity demanded exceeds the percent
decrease in price  total revenue increases

– When demand is unit elastic, the two are equal

 total revenue remains unchanged

– When demand is inelastic, the percent

increase in quantity demanded is more than
offset by the percent decrease in price  total
revenue decreases
 Price Elasticity of Demand and
Total Revenue
P
E>1
E=1
E<1
D
Q
TR Max TR

TR TR
rising falling
Q
 TR 0 = 220 x 120 = 26,400

TR1 = 180 x 140 = 25,200

D2
D1
TR2 = 180 x 200 = 36,000

220

180

0 Q
120 140 200
 Important Observations

•When demand is elastic, a decrease in

price will result is an increase in the
revenue (sales).
•When demand is inelastic, a decrease in
price will result is a decrease in the
revenue (sales).
•When demand is unit-elastic, an
increase (or a decrease) in price will not
change the revenue (sales).
 Factors that Affect Price
Elasticity of Demand
• The closeness of substitutes
- the more close substitutes the higher the price
elasticity of demand
• The proportion of income spent on the good
- the higher the proportion of income spent on the
good the higher the price elasticity of demand
• The time elapsed
- The more time elapsed the more elastic the
demand
 Availability of Substitutes
• The greater the availability of substitutes
for a good and the closer the substitutes,
the greater the good’s price elasticity of
demand

• The number and similarity of substitutes

depend on how we define the good  the
more broadly we define a good, the fewer
the substitutes and the less elastic the
demand
 Proportion of Consumer’s
Budget
• Because spending on some goods
represents a large share of the
consumer’s budget, a change in the price
of such a good has a substantial impact
on the amount consumers are able to
purchase

• Generally, the more important the item is

as a share of the consumer’s budget,
other things constant, the greater will be
the income effect of a change in price 
the more price elastic will be the demand
for the item
 A Matter of Time
• The process of finding substitutes takes
time

• Thus, the longer the adjustment period,

the greater the consumers’ ability to
substitute away from relatively higher-
priced products toward lower-priced
substitutes  the more responsive the
change in quantity demanded is to a given
change in price
 Elasticity Estimates
• When estimating price elasticity,
economists often distinguish between a
period during which consumers have little
time to adjust – the short run – and a
period during which consumers can more
fully adjust to a price change – the long
run.
 Other Elasticity Measures
Recall: “Elasticity” is a (standard) measure
of the degree of sensitivity ( or
responsiveness) of one variable to changes
in another variable.
• Income Elasticity: a measure of the degree of
sensitivity of demand for a good (or service) to
changes in consumers’ (buyers’) income
• Cross Price Elasticity: a measure of the degree
of sensitivity of demand for a good (or service) to
changes in the price of another good or service
 Income Elasticity of Demand
• The elasticity of demand for good X with respect to
income (I)

• EDxI= %ΔQX/%ΔI or
• EDxI= ΔQX/QX / ΔI/I or
• EDxI= ΔQX/ΔI • I/QX

• EDxI > 1 normal and income elastic

• EDxI < 1 > 0 normal and income inelastic
• EDxI <0 inferior good
• Necessaries, luxuries and income levels
 Income Elasticity of Demand
• The income elasticity of demand
measures how responsive demand is to a
change in income

• Measures the percent change in demand

divided by the percent change in income

• Categories
– Goods with income elasticities less than zero
are called inferior goods  demand declines
when income increases
 Income Elasticity of
Demand
– Normal goods have income elasticities greater
than zero  demand increases when income
increases
• Normal goods with income elasticities
greater than zero but less than 1 are called
income inelastic goods  demand
increases but not as much as does income

• Goods with income elasticity greater than 1

are called income elastic  demand not
only increases when income increases but
increases by more than does income
 Cross-Price Elasticity of
Demand
• Since firms often produce an entire line of
products, it has a special interest in how a
change in the price of one product will
affect the demand for another

• The responsiveness of the demand for

one good to changes in the price of
another good is called the cross-price
elasticity of demand
 Cross-Price Elasticity of
Demand
• Defined as the percent change in the
demand of one good divided by the
percent change in the price of another
good

• Its numerical value can be positive,

negative, or zero depending on whether
the goods are substitutes, complements,
or unrelated, respectively
 Substitutes and Complements

• If an increase in the price of one good

leads to an increase in the demand for
another good, their cross-price elasticity is
positive  the two goods are substitutes

• If an increase in the price of one good

leads to a decrease in the demand for
another, their cross-price elasticity is
negative  the two goods are
complements
 Other Important Elasticities

• Elasticity of supply: A measure of the

response of quantity of a good supplied to
a change in price of that good. Likely to be
positive in output markets.

% c h a n g e in q u a n tity s u p p lie d
e la s tic ity o f s u p p ly 
% c h a n g e in p ric e
 Price Elasticity of Supply
• The price elasticity of supply equals the
percentage change in quantity supplied
divided by the percentage change in price

• Since the higher price usually results in an

increased quantity supplied, the percent
change in price and the percent change in
quantity supplied move in the same
direction  the price elasticity of supply
is usually a positive number
 Elasticity of Supply

P S

50
10
40
100

100 200 Q

ESxPx = 100/10 x 45/150 = 3

Categories of Supply Elasticity
• The terminology for supply elasticity
is the same as for demand elasticity
– If supply elasticity is less than 1.0,
supply is inelastic
– If it equals 1.0, supply is unit
elastic
– If it exceeds 1.0, supply is elastic
Determinants of supply elasticity
• The elasticity of supply indicates how
responsive producers are to a change in
price
• Their responsiveness depends on how
easy it is to alter output when price
changes
– If the cost of supplying additional units rises
sharply as output expands, then a higher price
will elicit little increase in quantity supplied
– But if the marginal cost rises slowly as output
expands, the lure of a higher price will prompt
a large increase in output
 Length of Time
• Just as demand becomes more
elastic over time as consumers
adjust to price changes, supply also
becomes more elastic over time as
producers adjust to price changes

• The longer the time period under

consideration, the more able
producers are to adjust to changes in
relative prices
 Note
• The units cancel out, so elasticity is not
dependent on units used in the data
• For straight-line demand curves, the value
of elasticity changes as you move along
the curve
• The closer you are to the vertical axis the
more elastic demand
• The closer to the horizontal axis the more
inelastic
An Increase in Supply in the Market for Wheat

Price of
Wheat 1. When demand is inelastic,
2. . . . leads an increase in supply . . .
to a large fall S1
in price . . . S2

$3

Demand

0 100 110 Quantity of

Wheat
3. . . . and a proportionately smaller
increase in quantity sold. As a result,
revenue falls from $300 to $220.
Copyright©2003 Southwestern/Thomson Learning
 Some demand issues
• Is the demand for all food elastic or
inelastic?
• Is the demand for all meat elastic or
inelastic?
• Is the demand for chicken elastic or
inelastic?
• Is the demand for prime rib elastic or
inelastic?
 Some demand issues
• Is the demand for all food elastic or
inelastic?
• Is the demand for all meat elastic or
inelastic?
• Is the demand for chicken elastic or
inelastic?
• Is the demand for prime rib elastic or
inelastic?