PRICE ELASTICITY OF DEMAND

Think About It...

THE LAW OF DEMAND SAYS...
Consumers will buy more when prices go
down and less when prices go up
HOW MUCH MORE OR LESS?
DOES IT MATTER?
to whom?
Price Elasticity Provides an Answer
 Elasticity . . .

• … is a measure of how much

buyers and sellers respond to
changes in market conditions

• … allows us to analyze supply and

demand with greater precision.
 Price Elasticity of Demand
• Price elasticity of demand is the
percentage change in quantity
demanded given a percent change in
the price.

• It is a measure of how much the

quantity demanded of a good
responds to a change in the price of
that good.
 Determinants of
Price Elasticity of Demand

• Necessities versus Luxuries

• Availability of Close Substitutes
• Definition of the Market
• Time Horizon
 Determinants of
Price Elasticity of Demand
Demand tends to be more elastic:
• if the good is a luxury.
• the longer the time period.
• the larger the number of close
substitutes.
• the more narrowly defined the
market.
 PRICE ELASTICITY OF DEMAND
Measures Responsiveness to Price
Changes
P The percentage change in quantity
The percentage change in price

.01
P2 .02
P1

D Elasticity is .5
Q2 Q1 Q
PRICE ELASTICITY OF DEMAND
Commonly Expressed as…
P The percentage change in quantity
The percentage change in price

% Q d
P2 % P
P1

D Elasticity is .5
Q2 Q1 Q
 PRICE ELASTICITY OF DEMAND
A demand curve is elastic when an increase in
price reduces the quantity demanded a lot (and
vice versa).
When the same increase in price reduces quantity
demanded just a little, then the demand curve
is inelastic.

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 ELASTICITY RULE

Elasticity slope BUT:

If two linear demand curves run through a
common point, then at any given quantity, the
curve that is FLATTER is MORE ELASTIC.

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 DEFINING AND MEASURING
ELASTICITY
Price elasticity of demand = the percentage
change in quantity demanded divided by the
percentage change in price.

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 DEFINING AND MEASURING
ELASTICITY
Example:
If the price of oil increases by 10% and the quantity
demanded falls by 5%, then the price elasticity of
demand for oil is:

Note: since we know that price and quantity demanded

will always move in opposite directions (law of demand)
we usually drop the minus sign (for price elasticity of
demand ONLY).
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USING THE MIDPOINT FORMULA

There is a problem: Our percent change

calculation depends on our choice of starting point.
To solve this problem, we calculate the price
elasticity of demand using the midpoint formula for
percentage changes. Back to Ta
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 Refinement –
The Midpoint Formula
Change in Change in
quantity price
Ed =
Sum of
 Sum of
Quantities/2 prices/2

The midpoint formula is preferable when

calculating the price elasticity of demand
because it gives the same answer regardless of
the direction of the price change. Back to Ta
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6. In calculating price elasticity of demand, we use
average price and average quantity as our base value
because
a. it reduces the complexity of the formula and
makes the calculation easier
b. the resulting measure is then not influenced by
whether price is rising or falling
c. we would get the same answer if we use the initial
price and quantity

B. Instead of measuring elasticity as the

difference between two numbers divided by
the original number, we take the difference
between the two numbers divided by the
average of the two numbers.
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MATHEMATICS OF DEMAND ELASTICITY
Example: At the initial price of $10, the quantity
demanded is 100. When the price rises to $20,
the quantity demanded is 90.

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 ESTIMATING ELASTICITIES
Economists (and many others) are interested in price
elasticity of demand (Houthakker and Taylor)

Estimating elasticity is crucial to understanding and

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 INTERPRETING THE PRICE
ELASTICITY OF DEMAND
Classification of price elasticity of demand:
A good can have a price elasticity as low as zero or
as high as infinity.

If the |Ed| < 1, the demand curve is inelastic.

If the |Ed| > 1, the demand curve is elastic.
If the |Ed| = 1, the demand curve is unit elastic.

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 Ranges of Elasticity
Perfectly Inelastic
Quantity demanded does not respond to price
changes.

Perfectly Elastic
Quantity demanded changes infinitely with any
change in price.

Unit Elastic
Quantity demanded changes by the same percentage
as the price.
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 Perfectly Inelastic Demand
- Elasticity equals 0
Price Demand

1. An $5
increase
in price... 4

100 Quantity
2. ...leaves the quantity demanded unchanged. Back to Ta
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 Inelastic Demand
- Elasticity is less than 1
Price

1. A 22% $5
increase
in price... 4

Demand

90 100 Quantity
2. ...leads to a 11% decrease in quantity. Back to Ta
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 Unit Elastic Demand
- Elasticity equals 1
Price

1. A 22% $5
increase
in price... 4

Demand

80 100 Quantity
2. ...leads to a 22% decrease in quantity. Back to Ta
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 Elastic Demand
- Elasticity is greater than 1
Price

1. A 22% $5
increase
in price... 4

Demand

50 100 Quantity
2. ...leads to a 67% decrease in quantity. Back to Ta
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 Perfectly Elastic Demand
- Elasticity equals infinity
Price
1. At any price
above $4, quantity
demanded is zero.

$4 Demand

2. At exactly $4,
consumers will
buy any quantity.

3. At a price below $4, Quantity

quantity demanded is infinite. Back to Ta
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 Price Elasticity is...
Inelastic when Ed < 1
Typical of necessities one must have

Elastic when Ed > 1

Typical of luxuries one wants

Unit elastic when Ed = 1

Price change does not change total
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Elastic, Inelastic, or
Unit Elastic

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Elastic, Inelastic, or Unit Elastic

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Elastic, Inelastic, or Unit Elastic

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Elastic, Inelastic, or Unit Elastic

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Elastic, Inelastic, or Unit Elastic

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ELASTICITY AND TOTAL REVENUE
Total revenue: price times quantity demanded
(sold).
TR = P × Q
Sellers need to know how elastic their good is so
they can plan.

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 Elasticity and Total Revenue
Price

$4

P x Q = $400
P (total revenue)
Demand

0 100 Quantity
Q
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Elasticity and Total Revenue

With an inelastic demand

curve, an increase in price
leads to a decrease in quantity
that is proportionately
smaller. Thus, total revenue
increases.

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 Elasticity and Total Revenue: Inelastic Demand

Price Price …leads to an increase in total

An increase in price from $1 revenue from$100 to $240
to $3...

$3

Revenue = $240
$1 Demand Demand
Revenue = $100
0 100 Quantity 0 80 Quantity
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Elasticity and Total Revenue

With an elastic demand curve,

an increase in the price leads to
a decrease in quantity demanded
that is proportionately larger.
Thus, total revenue decreases.

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 Elasticity and Total Revenue: Elastic Demand

Price Price …leads to a decrease in total

An increase in price from $4 revenue from$200 to $100
to $5...

$5
$4

Demand Demand
Revenue = $200 Revenue = $100

0 50 Quantity 0 20 Quantity

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 DEMAND SCHEDULE AND TOTAL
REVENUE
Price
$10 Elastic
9 Unit-elastic
8
7
6 Inelastic
5 Demand Schedule and Total Revenue for
4 a Linear Demand Curve
3 Quantity Total
2 Price demanded
1 revenue
D $0 10 $0
0 1 2 3 4 5 6 7 8 9 10 1 9 9
Quantity 2 8 16
3 7 21
Total 4 6 24
revenue 5 5 25
$25 6 4 24
24 7 3 21
21 8 2 16
9 1 9
16
10 0 0

The price elasticity of demand

0
0 1 2 3 4 5 6 7 8 9 10
Quantity
changes along the demand
Demand is elastic: a Demand is inelastic: a
curve.
higher price reduces total higher price increase total Back to Ta
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 Total revenue rises then declines
with price to a
P point... TR

Inelastic
Demand D Inelastic
Demand
Q Quantity Demanded Back to Ta
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 Total revenue rises then declines
with price to a
P point... TR

Elastic
Demand

Inelastic
Demand D Elastic Inelastic
Demand Demand
Q Quantity Demanded
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 Total revenue rises then declines
with price to a
P point... TR

Elastic Unit
Demand Elastic

Inelastic
Demand D Elastic Inelastic
Demand Demand
Q Quantity Demanded Back to Ta
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WHAT FACTORS DETERMINE THE
PRICE ELASTICITY OF DEMAND?
1. The availability of close substitutes is very
important.
Fewer substitutes makes it harder for
consumers to adjust Q when P changes, so
demand is inelastic.
Many substitutes? Switching brands when
prices change is EASY, so demand is elastic.

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WHAT FACTORS DETERMINE THE
PRICE ELASTICITY OF DEMAND?

2. The share of income spent on the good matters.

We are less sensitive to price changes when the
good feels cheap.
We are more sensitive to price changes when
the good feels expensive.

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 WHAT FACTORS DETERMINE THE
PRICE ELASTICITY OF DEMAND?

3. The length of time elapsed since the price

change matters.
Less time to adjust means lower elasticity.
Over time consumers can adjust their behavior by
finding substitutes (making demand more elastic).

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INCOME ELASTICITY OF
DEMAND
The income elasticity of demand measures how
sensitive the quantity demanded of a good is to
changes in income.
Income elasticity of demand =

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INCOME ELASTICITY OF
DEMAND
The income elasticity of demand can be used to
distinguish normal from inferior goods.
For normal goods, income elasticity is positive.
For inferior goods, income elasticity is
negative.

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INCOME ELASTICITY OF
DEMAND
Normal goods can be income-elastic or not.

For income-elastic goods, income elasticity is greater

than 1 (luxury goods, i.e. second homes and
international travels).

For income-inelastic goods, income elasticity is

positive but less than 1 (necessities such as food and
clothing).
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Why Did OPEC Fail to Keep the Price of Oil High?

Demand can behave differently in the short run

and the long run

In the short run, demand for oil is relatively inelastic

But in the long run, elastic

Production outside of OPEC
More conservation by consumers

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Why the war on drugs is hard to win:

Because demand for most illegal drugs is inelastic, drug

dealers earn greater revenue and gain more power as the
drug war becomes more effective.

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1. In general, “elasticity” can measure
a. whether a price increase causes quantity
demanded to increase or decrease
b. the strength of an economy’s tendency to recover
from recession
c. the responsiveness of decision makers to economic
changes in prices

C. You can think of elasticity as a rubber

band. Elastic means it can stretch, the easier
it stretches the more elastic the rubber band.
When price changes for a good and the
quantity demanded changes a lot, the
demand curve is very elastic. When price
changes and the quantity demanded changes
a little, the demand curve is inelastic. 49 Back to Ta
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 2. More “elastic” means
a. less desirable
b. less desirable
c. less responsive
d. more responsive
D. For example, in a perfectly competitive
market, if a firm (let’s say a farmer) charges a
price higher than the market price its sales will
drop to zero. Why would anyone buy from a
higher priced firm if they can buy exactly the
same thing from a multitude of other firms? In
this case the responsiveness is absolute, the
demand curve is perfectly elastic.
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3. Edith buys 9 magazines per week when the
price is $3. She buys 11 magazines per week
when their price is $2. Edith’s price elasticity of
demand is
a. -1/2 = -0.5
b. -2/3 = -0.667
c. -1.0
A. The difference between 9 and 11 units is 2
and the average quantity is 10. The
difference between $3 and $2 is 1 and the
average price is 2.5.
2/10 / 1/2.5 = 2/10 x 2.5/1 = 5/10 = 1/2 = .5.
* most authors drop the negative sign,
McEachern does not in his book.
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4. Matt bought 6 CDs last month, when the
price was $14. This month, when the price of
CDs increased to $16, Matt bought only 4 CDs.
Matt’s price elasticity of demand is
a. -1/3 = -0.333
b. -3/7 = -0.429
c. -7/3 = -2.333
d. -3
D. The difference between the quantities
demanded is 2 and the average quantity is 5.
The difference between the prices is 2 and the
average price is 15. So:
2/5 divided by 2/15 = 2/5 x 15/2 = 30/10 = 3
* Again, McEachern uses the negative sign. 52 Back to Ta
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5. If a 5% increase in price leads to an 8%
decrease in quantity demanded, demand is
a. perfectly elastic
b. elastic
c. unit elastic
d. inelastic

B. When price increases and a sellers total

revenue increases, the demand is inelastic.
When the price increases and the sellers total
revenue decreases, the demand is elastic. In
this case total revenue will decrease because
the quantity demanded is decreasing at a
greater percentage than the increase in price.
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6. If price elasticity of demand is -0.5,
a. a 1% decrease in quantity demanded leads
to a 0.5% decrease in price
b. a 1% decrease in price leads to a 0.5%
increase in quantity demanded
c. a 50% decrease in price leads to a 1%
increase in quantity demanded
d. demand is elastic

B. The percent change in quantity divided by

the percent change in price is equal to the
price elasticity of demand. So in this case, the
percent change in quantity is equal to .5 and
the percent change in price is 1, so .5 / 1 = .5
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7. Unit elastic demand occurs when
a. a one-unit increase in price leads to a one-
unit decrease in quantity demanded
b. a 1% increase in price leads to a one-unit
decrease in quantity demanded
c. price elasticity of demand is positive
d. price elasticity of demand is exactly -1

D. The price elasticity of demand is unitary

elastic when the percent change in quantity
demanded divided by the percent change in
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8. Total revenue is defined as
a. the net profit after the opportunity cost of
all resources used has been deducted
b. the change in quantity sold divided by the
change in price
c. price elasticity of demand times quantity
sold
d. price times quantity sold

D. If you own a business and the price for your

product is $2 and you sell 3 units, your total
revenue is $6.
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9. If a firm raises the price of its product, its
total revenue will
a. always increase
b. increase only if demand is price inelastic
c. increase only if demand is price elastic
d. remain constant, regardless of price
elasticity of demand

B. In this case total revenue increases because

the percent change in quantity sold is more
than the percent change in price.
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10. If a price reduction leads to greater total
revenue, demand is
a. perfectly inelastic
b. inelastic
c. unit elastic
d. elastic
D. In this example price is decreasing instead
of increasing. If a firm lowers its price and its
total revenue increases as a result, this means
that the percent change in quantity
demanded is greater than the percent change
in the price. Because the quantity demanded
is changing more than the change in price,
the demand curve is elastic. 58 Back to Ta
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11. John spends exactly the same dollar amount
of candy bars each week, regardless of their
price. John’s demand curve for candy bars is
a. upward-sloping
b. backward-bending
c. perfectly inelastic
d. unit elastic

C. A perfectly inelastic demand curve is

perfectly vertical. This means that a change
in price has no effect on the quantity
demanded.
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12. Along a linear, downward-sloping demand
curve, price elasticity of demand
a. is impossible to calculate
b. is constant and is equal to the slope
c. is constant and is equal to the inverse of the
slope
d. becomes more elastic as price increases

D. Linear means a straight line. Consumers

will have a greater response to a change in
price at higher prices than they will at lower
prices.
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13. A linear, downward-sloping demand curve
has
a. constant slope and constant elasticity
b. constant slope and varying elasticity
c. varying slope and constant elasticity
d. varying slope and varying elasticity

B. The slope all along a straight line is the

same. This is what makes a straight line a
straight line. Elasticity along this straight line
demand curve varies. The reason is the same
as explained in question 20.
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14. A perfectly elastic demand curve is
a. a vertical straight line
b. a horizontal straight line
c. a downward-sloping straight line
d. an upward-sloping straight line

B. A perfectly horizontal demand curve shows

that any increase in price beyond the price
at which the demand curve is at will lead to
zero sales.

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15. A perfectly inelastic demand curve is
a. a vertical straight line
b. a horizontal straight line
c. a downward-sloping straight line
d. an upward-sloping straight line

A. The vertical line is at the quantity that

will be demanded regardless of the
product’s price.

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16. If a firm facing a perfectly inelastic demand
curve raises its price,
a. it will still sell exactly the same amount of
output as it did at the lower price
b. it will lose some, but not all, of its sales
c. its sales will decrease to zero
d. its sales will increase

A. In this case, a change in price has no effect

on the quantity demanded.

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17. Which of the following is likely to have the
most elastic demand?
a. beef steak
b. beef (including steak, ribs, burgers, etc.)
c. meat (including beef, pork, chicken, etc.)
d. protein foods (including meat, cheese, eggs,
etc.)

A. The more broad the market the less elastic

is the demand curve. Beef steak is a market
that is much less broad than beef, meat, and
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18. Economists distinguish between normal and
inferior goods using
a. price elasticity of demand
b. price elasticity of supply
c. income elasticity of demand
d. tax incidence
C. A normal good is one that consumers will
purchase more of as their incomes increase.
An inferior good is one that consumers will
buy less of as their incomes increase.

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19. An inferior good is defined as one for which
demand increases as
a. price decreases
b. price increases
c. income increases
d. income decreases

D. New cars are an example of a normal good

and used cars is an example of an inferior
good. As consumer’s income decreases they
will tend to purchase more used cars and
fewer new cars.
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20. Luxury goods are usually
a. price inelastic
b. income inelastic
c. income elastic
d. goods with negative income elasticity

C. A luxury good is one that consumers can

live without. So as the price of luxury goods
increase, there is a large effect on the
quantity demanded as consumers choose to
buy less of the good.
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