Elasticity of Demand

Elasticity: the Concept

 The responsiveness of one variable to changes in

another
 When price rises, what happens to demand?
 Quantity demanded falls
 BUT!
 How much does demand fall?
 “Elasticity” is a (standard) measure of the degree of
sensitivity (or responsiveness) of one variable to
changes in another variable.
 % Change in One variable
Ed = __________________________
% Change in another variable

The elasticity measure is a ratio between two percentage

measures: percentage change in one variable over the
percentage change in another variable
Types of Elasticity of Demand

 Price Elasticity of Demand

 Income Elasticity of Demand
 Cross-price Elasticity of Demand or Just
Cross Elasticity
Price Elasticity of Demand:

 The (self) price elasticity of demand is a measure of the

degree of sensitivity of demand to changes in the (self)
price, ceteris paribus.

 2 situations:
 Where % change in quantity demanded is greater
than % change in price – elastic
 Where % change in quantity demanded is less than %
change in price - inelastic
Degrees
 Perfectly Elastic Demand
 ep=∞ (in absolute terms)
 Unlimited quantities can be sold at the prevailing price and even
a negligible increase in price would result in zero change in
quantity demanded
 Perfectly elastic demand curve is a horizontal line, parallel to the
quantity axis

p
D D

O x
More than Unit Elastic demand
or More Elastic
 ep>1 (in absolute terms),
 A proportionate change in quantity demanded is more than a
proportionate change in price
 Flatter demand curve

y
D

O x
Unitary Elastic Demand:
 ep =1 (in absolute terms)
 Rectangular hyperbola, asymptotic to the axes
 Uncommon in real life

y
D

O x
Relatively inelastic demand:
 ep<1 (in absolute terms)
 Steeper demand curve
 Necessities, since they are less responsive to a given
change in price

y D

O x
Perfectly inelastic demand:
 ep=0 (in absolute terms)
 Quantity demanded is totally unresponsive to changes in
price.
 Neutral goods
 Vertical demand curve, parallel to the price axis

y D

D
O x
 Elasticity (more)

1. Ratio (Percentage) Method

% Change in Quantity Demanded

___________________________
Ped =
% Change in Price

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

demand falls and vice-versa (inverse relationship between
price and demand)
General Formula for Price Elasticity

 P = Current price of a good

 Q = Quantity demanded at that price
 P = Small change in the current price
 Q = Resulting change in quantity demanded

Percentage Change in Quantity Demanded

Elasticity 
Percentage Change in Price

Q
d ln Q
Elasticity  Q 
P d ln P
P
Slope Compared to Elasticity
 The slope measures the rate of change of one variable
(Q, say) in terms of another (P, say).
 The elasticity measures the percentage change of one
variable (Q, say) in terms of another (P, say).
Slope of the Demand Curve
 P is the
change in P
price. (P<0)
Price Demand slope 
Q
 Q is the P
change in P - P
P

quantity. Q

 slope =
P/ Q

Q Q + Q Quantity
Elasticity: Mathematical Definition
P
slope 
Q

1 Q

slope P

P 1
elasticity 
Q slope
Exercise: Linear Demand
 Compute the elasticity
at the point indicated Quantity Price
10 40
in red on the table 11 38
(Q=18,P=24). 12 36
13 34
 Slope = -2 14 32
15 30
 1/Slope = -1/2 16 28
17 26
 P/Q = 24/18 = 4/3 18 24
19 22
 Elasticity = -2/3 20 20
Other Methods of Measurement
 2. Arc Elasticity Method
 Used in case the available figures on price and
quantity are discrete
 To calculate price elasticity of demand between any
two points on the demand curve.
 To find the elasticity at the midpoint of an arc between
any two points on a demand curve, by taking the
average of the prices and quantities.
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
1/2(Q1+Q2)
Ep =
P2-P1
1/2 (P1+P2)
P D
a
10 b
8

c
4
2 d D

80 90 Q
8 18
Sign of Demand Elasticity

 Price elasticity of demand is always negative.

 Economists usually refer to the price elasticity of demand
by its absolute value (ignore the negative sign).
 So, even though the formula says that the price elasticity
of demand is negative, we would say the elasticity of
demand is 1.5 or 0.67.
Elasticity and the Price Level
| Ep | > 1 : Elastic
P | Ep | < 1 : Inelastic
Along a linear demand curve as | Ep | = 1 : Unit-elastic
the price goes up, |elasticity |
increases.
a E = -3.46
10 b
8
Note that between points "a"
and "b" the (arc) elasticity of E = -0.17
c
the above demand curve is 4 d
-3.46, whereas between "c" and 2 D
"d" it is -0.17.
8 18 80 90
3. Total Outlay Method

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).

According to this method we can know the Elasticity of demand from the effect on the
total expenditure as a result of change in price which can be in two forms-

(A) Fall in price

Price Quantity Total Nature of Elasticity of

demanded Expenditure Demand
Rs. 10 200 2000
Unit Elasticity
Rs. 8 250 2000

Rs. 10 200 2000

More Elastic
Rs. 8 280 2240

Rs. 10 200 2000

Less Elastic
Rs. 8 240 1920
(B) Rise in price

Price Quantity Total Nature of Elasticity of

demanded Expenditure Demand
Rs. 8 250 2000
Unit Elasticity
Rs. 10 200 2000

Rs. 8 250 2000

More Elastic
Rs. 10 180 1800

Rs. 8 250 2000

Less Elastic
Rs. 10 240 2400
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
Price Total revenue is price x quantity sold. In this
The importance of elasticity is the information it
example, TR = £5 x 100,000 = £500,000.
provides on the effect on total revenue of changes
in price.
This value is represented by the grey shaded
rectangle.

£5

Total Revenue

100 Quantity Demanded (000s)

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)
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
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
 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 would  Reducing price would
increase TR reduce TR (%Δ Qd <
(%Δ Qd > % Δ P) % Δ P)
4. Point Method or the Geometric
Method
y
A
ep = ∞
Lower segment of demand curve
ep >1 ep =
Upper segment of demand curve
Price
ep = 1
M

ep <1

ep = 0
O B x
Quantity

Elasticity on a Linear Demand Curve

Income Elasticity of Demand:
The responsiveness of demand to changes in
incomes

Proportionate Change in Quantity Demanded of Comm X

_____________________________________________
Ped =
Proportionate Change in income of consumer

 Normal Good – demand rises as income rises and vice versa

 Inferior Good – demand falls as income rises and vice versa
 Neutral Good – no change in demand as income changes
 Income Elasticity of Demand:

 A positive sign denotes a normal good

 A negative sign denotes an inferior good
 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%
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
 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 of demand are interpreted
as follows
Value Descriptive Terms
Ed = 0 Perfectly inelastic demand
- 1 < Ed < 0 Inelastic or relatively inelastic demand

Unit elastic, unit elasticity, unitary elasticity, or unitarily

Ed = - 1
elastic demand

- ∞ < Ed < - 1 Elastic or relatively elastic demand

Ed = - ∞ Perfectly elastic demand
 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