Price, Income

and Cross Elasticity

Elasticity – the concept
 The responsiveness of one variable to
changes in another
 When price rises, what happens

to demand?
 Demand falls
 BUT!
 How much does demand fall?
Elasticity – the concept
 If price rises by 10% - what happens to
demand?
 We know demand will fall
 By more than 10%?
 By less than 10%?
 Elasticity measures the extent to which

demand will change

Elasticity
 4 basic types used:
 Price elasticity of demand
 Price elasticity of supply
 Income elasticity of demand
 Cross elasticity
Elasticity
 Price Elasticity of Demand
◦ The responsiveness of demand
to changes in price
◦ Where % change in demand
is greater than % change in price – elastic
◦ Where % change in demand is less than % change in
price - inelastic
 Elasticity

The Formula:
% Change in Quantity Demanded
___________________________
Ped =
% Change in Price

If answer is between 0 and -1: the relationship is inelastic

If the answer is between -1 and infinity: the relationship is elastic

Note: PED has – sign in front of it; because as price rises

demand falls and vice-versa (inverse relationship between
price and demand)
Elasticity
Price (£)
The demand curve can be a
range of shapes each of which
is associated with a different
relationship between price and
the quantity demanded.

Quantity Demanded
 Elasticity
Price
Totalimportance
The revenue is of
price x
elasticity
quantity
is sold. In this
the information it
example, TR = £5 x 100,000
provides on the effect on
= £500,000.
total revenue of changes in
price.
This value is represented by
the grey shaded rectangle.
£5

Total Revenue

100 Quantity Demanded (000s)

 Elasticity
Price
If the firm decides to
decrease price to (say) £3,
the degree of price elasticity
of the demand curve would
determine the extent of the
increase in demand and the
change therefore in total
£5 revenue.

£3

Total Revenue
D
100 140 Quantity Demanded (000s)
Elasticity
Price (£)
Producer decides to lower price to attract sales

10 % Δ Price = -50%
% Δ Quantity Demanded = +20%
Ped = -0.4 (Inelastic)
5 Total Revenue would fall
Not a good move!

D
5 6
Quantity Demanded
 Elasticity
Price (£)
Producer decides to reduce price to increase sales
% Δ in Price = - 30%
% Δ in Demand = + 300%
Ped = - 10 (Elastic)
Total Revenue rises
10
Good Move!
7
D

5 Quantity Demanded 20
Elasticity
 If demand is price  If demand is price
elastic: inelastic:
 Increasing price  Increasing price
would reduce TR would increase TR
(%Δ Qd > % Δ P) (%Δ Qd < % Δ P)
 Reducing price  Reducing price
would increase TR would reduce TR
(%Δ Qd > % Δ P) (%Δ Qd < % Δ P)
Elasticity
 Income Elasticity of Demand:
◦ The responsiveness of demand
to changes in incomes
 Normal Good – demand rises
as income rises and vice versa
 Inferior Good – demand falls

as income rises and vice versa

Elasticity

 Income Elasticity of Demand:

 A positive sign denotes a normal good

 A negative sign denotes an inferior good
Elasticity
 For example:
 Yed = - 0.6: Good is an inferior good but inelastic – a rise in
income of 3% would lead to demand falling by 1.8%

 Yed = + 0.4: Good is a normal good but inelastic –

a rise in incomes of 3% would lead to demand rising by 1.2%

 Yed = + 1.6: Good is a normal good and elastic –

a rise in incomes of 3% would lead to demand rising by 4.8%

 Yed = - 2.1: Good is an inferior good and elastic –

a rise in incomes of 3% would lead to a fall in demand of 6.3%
Elasticity

 Cross Elasticity:
 The responsiveness of demand

of one good to changes in the price of a

related good – either
a substitute or a complement

% Δ Qd of good t
__________________
Xed =
% Δ Price of good y
Elasticity
 Goods which are complements:
◦ Cross Elasticity will have negative sign (inverse
relationship between the two)
 Goods which are substitutes:
◦ Cross Elasticity will have a positive sign (positive
relationship between the two)
Elasticity

 Price Elasticity of Supply:

◦ The responsiveness of supply to changes
in price
◦ If Pes is inelastic - it will be difficult for
suppliers to react swiftly to changes in price
◦ If Pes is elastic – supply can react quickly to
changes in price

% Δ Quantity Supplied
____________________
Pes =
% Δ Price
Determinants of Elasticity
 Time period – the longer the time under
consideration the more elastic a good is likely to be
 Number and closeness of substitutes –
the greater the number of substitutes, the more
elastic
 The proportion of income taken up by the product
– the smaller the proportion the more inelastic
 Luxury or Necessity - for example, addictive drugs
Importance of Elasticity
 Relationship between changes
in price and total revenue
 Importance in determining

what goods to tax (tax revenue)

 Importance in analysing time lags in

production
 Influences the behaviour of a firm
 Price Elasticity of Demand
Example :
If the percentage change is not given in a problem, it can be computed using the
following formula:
Ed = Q2-Q1) /P2-P1)X (P1 + P2)/(Q1+Q2)

Because of the inverse relationship between Qd and Price, the Ed coefficient will
always be a negative number. But, we focus on the magnitude of the change by
neglecting the minus sign and use absolute value

Examples:
1.  If the price of Product A  increased by 10%,  the quantity demanded decreased
by 20%. Then the coefficient for  price elasticity of the demand of Product A is:
Ed = percentage change in Qd / percentage change in Price = (20%) / (10%) = 2

2. If the quantity demanded of Product B has decreased from 1000 units to 900
units as price increased from $2 to $4 per unit, the coefficient for Ed is:
Ed = (Q2-Q1) /P2-P1)X (P1 + P2)/(Q1+Q2)= - 0.16
Take the absolute value of - 0.16, Ed = 0.16
 Characteristics:

Ed approaches infinity, demand is perfectly elastic. Consumers are

very sensitive to price change.

Ed > 1, demand is elastic. Consumers are relatively responsive to

price changes.

Ed = 1, demand is unit elastic. Consumers’ response and price

change are in same proportion.

Ed < 1, demand is inelastic. Consumers are relatively unresponsive

to price changes.

Ed approaches 0, demand is perfectly inelastic. Consumers are

very insensitive to price change.
 An Example
DEMAND FUNCTION FOR PRODUCT X: P = 2.5-
0.01Q

P = PRICE; Q = QUANTITY, TR = TOTAL

REVENUE
Ed = PRICE ELASTICITY OF DEMAND

          A     B      C       D       E        F        G       

H         I        J
Q:       0    50   100    150   200    250    300   350  
400   450
P:       4.5   4     3.5     3       2.5       2       1.5      1     
0.5      0
Ed:      17    5     2.6   1.57       1     0.64   0.38   
0.2    0.06
Determinants of Price Elasticity of Demand

1. # of Substitutes: If a product can be easily substituted, its demand is elastic, like Gap's jeans. If a
product cannot be substituted easily, its demand is inelastic, like gasoline.

2. Luxury Vs Necessity: Necessity's demand is usually inelastic because there are usually very few
substitutes for necessities. Luxury product, such as leisure sail boats, are not needed in a daily bases.
There are usually many substitutes for these products. So their demand is more elastic.

3. Price/Income Ratio: The larger the percentage of income spent on a good, the more elastic is its
demand. A change in these products' price will be highly noticeable as  they affect consumers' budget
with a bigger magnitude. Consumers will respond by cutting back more on these product when price
increases. On the other hand, the smaller the percentage of income spent on a good, the less elastic is its
demand.

4. Time lag: The longer the time after the price change, the more elastic will be the demand. It is because
consumers are given more time to carry out their actions. A 1-day sale usually generate less sales change
per day as a sale lasted for 2 weeks.
 Total Revenue Test
Total revenue (TR) is calculated by multiplying price (P) per unit and quantity (Q) of the good sold.

TR = P x Q

The total revenue test is a method of estimating the price elasticity of demand. As Ed will impact the total
revenue, we can estimate the Ed by looking at the movement of the total revenue.

Total Revenue Test

Ed > 1, total revenue will decrease as price increases. P and TR moves in opposite directions. Producers
can increase total revenue ( TR = Price x Quantity) by lowering the price. Therefore, most department
stores will have sales to attract customers. Apparel's demand is elastic.

Ed < 1, total revenue will increase as price increases. P and TR moves in the same direction. Producers
can increase total revenue by raising the price. Inelastic demand for agricultural products helps to explain
why bumper crops depress the prices and total revenues for farmers. See example
 TR Test Example
DEMAND FUNCTION FOR PRODUCT X: P = 2.5-0.01Q
P = PRICE; Q = QUANTITY, TR = TOTAL REVENUE
Ed = PRICE ELASTICITY OF DEMAND
          A      B       C       D       E        F        G        H         I        J
Q:       0     50   100     150     200    250    300   350   400   450
P:       4.5    4     3.5       3        2.5       2       1.5      1      0.5      0
TR:      0    200    350     450      500    500    450   350    200     0
Ed:      17     5    2.6      1.57       1     0.64    0.38    0.2    0.06

ELASTICITY OF DEMAND;
FROM A TO E Ed >1     TR increases
FROM E TO F Ed =1      TR remains same.
FROM F TO J Ed <1       TR decreases.
 Price Elasticity of Supply
Definition:
Law of supply tells us that producers will respond to a price drop by producing less, but it
does not tell us how much less. The degree of sensitivity of producers to a change in price
is measured by the concept of price elasticity of supply.

Price elasticity formula: Es = percentage change in Qs / percentage change in Price.

If the percentage change is not given in a problem, it can be computed using the following
formula:

Q2-Q1) /P2-P1)X (P1 + P2)/(Q1+Q2)=

Because of the direct relationship between Qs and Price, the Es coefficient will always be a
positive number.
Examples:
1.  If the price of Product A  increased by 10%,  the quantity supplied increases by 5%.
Then the coefficient for  price elasticity of the supply of Product A is:
Es = percentage change in Qs / percentage change in Price = (5%) / (10%) = 0.5

2. If the quantity supplied of Product B has decreased from 1000 units to 200 units as
price decreases from $4 to $2 per unit, the coefficient for Es is:
Es Q2-Q1) /P2-P1)X (P1 + P2)/(Q1+Q2)= = 2
 Characteristics & Determinants
Characteristics:

Es approaches infinity, supply is perfectly elastic. Producers are very sensitive to price change .

Es > 1, supply is elastic. Producers are relatively responsive to price changes.

Es = 1, supply is unit elastic. Producers’ response and price change are in same proportion.

Es < 1, supply is inelastic. Producers are relatively unresponsive to price changes.

Es approaches 0, supply is perfectly inelastic. Producers are very insensitive to price change.

It is impossible to judge elasticity of a supply curve by its flatness or steepness. Along a linear supply curve, its elasticity changes.

Determinants:

1. Time lag: How soon the cost of increasing production rises and the time elapsed since the price change influence the Es. The more rapidly
the production cost rises and the less time elapses since a price change, the more inelastic the supply. The longer the time elapses, more
adjustments can be made to the production process, the more elastic the supply.

2. Storage possibilities: Products that cannot be stored will have a less elastic supply. For example, produces usually have inelastic supply due
to the limited shelf life of the vegetables and fruits.
 Cross Elasticity of Demand
Definition:
Cross elasticity (Exy) tells us the relationship between two products. it measures the
sensitivity of quantity demand change of product X to a change in the price of product Y.
Formula: Exy = percentage change in Quantity demanded of X / percentage change in
Price of Y.
 
Characteristics:
Exy > 0,  Qd of X and Price of Y are directly related. X and Y are substitutes.
Exy approaches 0, Qd of X  stays the same as the Price of Y changes. X and Y are not
related.
Exy < 0, Qd of X and Price of Y are inversely related. X and Y are complements.
 
Examples:
1. If the price of Product A  increased by 10%,  the quantity demanded of B increases by 15
%. Then the coefficient for the cross  elasticity of the A and B is :
Exy = percentage change in Qx / percentage change in Py = (15%) / (10%) = 1.5 > 0,
indicating A and B are substitutes.

2. If the price of Product A  increased by 10%,  the quantity demanded of B decreases by

15 %. Then the coefficient for the cross  elasticity of the A and B is :
Exy = percentage change in Qx / percentage change in Py = (- 15%) / (10%) = - 1.5 < 0,
indicating A and B are complements.
 Income Elasticity of Demand
Definition:
Income elasticity of demand (Ey, here y stands for income) tells us the relationship a
product's quantity demanded and income. It measures the sensitivity of quantity
demand change of product X to a change in income.

Price elasticity formula: Ey = percentage change in Quantity demanded / percentage

change in Income

If the percentage change is not given in a problem, it can be computed using the
following formula:
Percentage change in Qx where Q1 = initial Qd, and Q2 =  new Qd.
Percentage change in Y where Y1 = initial Income, and Y2 = New income.
Putting the two above equations together:
Ey = {(Q1-Q2) / (Y1-Y2) X (Y1 + Y2/Q1+Q2)]
 
Characteristics:
Ey > 1,  Qd and income are directly related. This is a normal good and it is income
elastic.
0< Ey<1,  Qd and income are directly related. This is a normal good and it is income
inelastic.
Ey < 0, Qd and income are inversely related. This is an inferior good.
Ey approaches 0, Qd   stays the same as income changes, indicating a necessity.

Example:
If income  increased by 10%,  the quantity demanded of a product increases by 5 %.
 ELASTICITIES OF SUPPLY AND DEMAND

● elasticity Percentage change in one variable

resulting from a 1-percent increase in another.
Price Elasticity of Demand

● price elasticity of demand Percentage change

in quantity demanded of a good resulting from a
1-percent increase in its price.

(2.
 ELASTICITIES OF SUPPLY AND DEMAND

Linear Demand Curve

● linear demand curve Demand curve that is a
straight line.
Figure 2.11

Linear Demand Curve

The price elasticity of demand depends

not only on the slope of the demand
curve but also on the price and quantity.
The elasticity, therefore, varies along the
curve as price and quantity change. Slope
is constant for this linear demand curve.
Near the top, because price is high and
quantity is small, the elasticity is large in
magnitude.
The elasticity becomes smaller as we
move down the curve.
 2.4 ELASTICITIES OF SUPPLY AND DEMAND

Linear Demand Curve

Figure 2.12

(a) Infinitely Elastic Demand

For a horizontal demand

curve, ΔQ/ΔP is infinite.
Because a tiny change in
price leads to an enormous
change in demand, the
elasticity of demand is
infinite.

● infinitely elastic demand Principle that consumers will buy as

much of a good as they can get at a single price, but for any higher
price the quantity demanded drops to zero, while for any lower
price the quantity demanded increases without limit.
 2.4 ELASTICITIES OF SUPPLY AND DEMAND

Linear Demand Curve

Figure 2.12

(b) Completely Inelastic Demand

For a vertical demand curve,

ΔQ/ΔP is zero. Because the
quantity demanded is the same no
matter what the price, the elasticity
of demand is zero.

● completely inelastic
demand Principle
that consumers will buy
a fixed quantity of a
good regardless of its
price.
 ELASTICITIES OF SUPPLY AND DEMAND

Other Demand Elasticities

● income elasticity of demand Percentage change

in the quantity demanded resulting from a 1-percent
increase in income. (2.2)

● cross-price elasticity of demand Percentage

change in the quantity demanded of one good
resulting from a 1-percent increase in the price of
another. (2.3)

Elasticities of Supply
● price elasticity of supply Percentage change in
quantity supplied resulting from a 1-percent
increase in price.
 ELASTICITIES OF SUPPLY AND DEMAND

Point versus Arc Elasticities

● point elasticity of demand Price elasticity at a

particular point on the demand curve.
Arc Elasticity of Demand

● arc elasticity of demand Price elasticity

calculated over a range of prices.
(2.4)
2.4 ELASTICITIES OF SUPPLY AND DEMAND

For a few decades, changes in the wheat market

had major implications for both American
farmers and U.S. agricultural policy.
To understand what happened, let’s examine the behavior of
supply and demand beginning in 1981.

By setting the quantity supplied equal to the quantity

demanded, we can determine the market-clearing price of
wheat for 1981:
2.4 ELASTICITIES OF SUPPLY AND DEMAND

Substituting into the supply curve equation, we get

We use the demand curve to find the price elasticity of demand:

Thus demand is inelastic.

We can likewise calculate the price elasticity of
supply:

Because these supply and demand curves are

linear, the price elasticities will vary as we move
along the curves.
2.5 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Demand
Demand
Figure 2.13
(b) Automobiles: Short-Run and Long-Run
Demand Curves

. If price increases, consumers initially

defer buying new cars; thus annual
quantity demanded falls sharply.

In the longer run, however, old cars wear

out and must be replaced; thus annual
quantity demanded picks up. Demand,
therefore, is less elastic in the long run
than in the short run.
2.5 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Demand
Income Elasticities
Income elasticities also differ from the short run to
the long run.
For most goods and services—foods, beverages,
fuel, entertainment, etc.— the income elasticity of
demand is larger in the long run than in the short run.
For a durable good, the opposite is true. The short-
run income elasticity of demand will be much larger
than the long-run elasticity.
2.5 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Demand
Cyclical Industries
● cyclical industries Industries in which sales tend
to magnify cyclical changes in gross domestic
Figure 2.14
product and national income.
GDP and Investment in Durable
Equipment
Annual growth rates are
compared for GDP and
investment in durable
equipment.
Because the short-run GDP
elasticity of demand is larger
than the long-run elasticity for
long-lived capital equipment,
changes in investment in
equipment magnify changes in
GDP. Thus capital goods
industries are considered
“cyclical.”
2.5 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Demand
Cyclical Industries
Figure 2.15
Consumption of Durables versus
Nondurables
Annual growth rates are compared for
GDP, consumer expenditures on
durable goods (automobiles,
appliances, furniture, etc.), and
consumer expenditures on nondurable
goods (food, clothing, services, etc.).
Because the stock of durables is large
compared with annual demand, short-
run demand elasticities are larger than
long-run elasticities. Like capital
equipment, industries that produce
consumer durables are “cyclical”
(i.e., changes in GDP are magnified).
This is not true for producers of
nondurables.
 2.5 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Demand

TABLE 2.1 Demand for Gasoline

Number of Years Allowed to Pass Following
a Price or Income Change
Elasticity 1 2 3 5 10
Price −0.2 −0.3 −0.4 −0.5 −0.8
Income 0.2 0.4 0.5 0.6 1.0

TABLE 2.2 Demand for Automobiles

Number of Years Allowed to Pass Following
a Price or Income Change
Elasticity 1 2 3 5 10
Price −1.2 −0.9 −0.8 −0.6 −0.4
Income 3.0 2.3 1.9 1.4 1.0
2.5 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Supply
Supply
Figure 2.16
Copper: Short-Run and Long-Run
Supply Curves
Like that of most goods, the
supply of primary copper, shown
in part (a), is more elastic in the
long run.
If price increases, firms would
like to produce more but are
limited by capacity constraints in
the short run.
In the longer run, they can add to
capacity and produce more.
2.5 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Figure 2.17

Price of Brazilian Coffee

When droughts or
freezes damage Brazil’s
coffee trees, the price of
coffee can soar.
The price usually falls
again after a few years,
as demand and supply
adjust.
2.5 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Figure 2.18

Supply and Demand for Coffee

(c) In the long run, supply is

extremely elastic; because
new coffee trees will have had
time to mature, the effect of
the freeze will have
disappeared. Price returns to
P 0.
2.6 UNDERSTANDING AND PREDICTING THE
EFFECTS OF CHANGING MARKET CONDITIONS

Figure 2.19
Fitting Linear Supply and Demand
Curves to Data
Linear supply and demand curves
provide a convenient tool for
analysis.
Given data for the equilibrium
price and quantity P* and Q*, as
well as estimates of the elasticities
of demand and supply ED and ES,
we can calculate the parameters c
and d for the supply curve and a
and b for the demand curve. (In
the case drawn here, c < 0.) The
curves can then be used to analyze
the behavior of the market
quantitatively.