Unit 1: Microeconomics

Subtopic 1.2: ELASTICITIES

LEARNING OUTCOMES
1.2 Elasticities Introduction to
Elasticities

Introduction to Elasticities
Elasticity is an economic concept which refers to the responsiveness among consumers or
producers to a change in a variable which affects either the market demand or the market
supply. There are three types of elasticity that we will study in this unit:

• Price Elasticity of Demand (PED): Measures the responsiveness of consumers of a particular

good to a change in the good’s price.

• Income Elasticity of Demand (YED): Measures the responsiveness of consumers of a

particular good to a change in their income.

• Price elasticity of Supply (PES): Measures the responsiveness of producers of a particular

good to a change in the price of that good.
1.2 Elasticities PED

Price Elasticity of Demand – definition and formula

Price Elasticity of Demand (PED) is a measurement of how much the quantity demanded for a
good will change as a result of a particular change in the good’s price. PED can range from a
value of 0 to infinity, and is calculated using the following formula:

If, for example, we know that an increase in the price of bananas from $4 to $6 caused the
quantity demanded to fall from 1,000 bananas to 800 bananas, we can calculate the PED for
bananas.

Notice that since we did not KNOW the

percentage changes in P and Q, we had to
calculate them. The full PED formula is

𝑸 𝟐− 𝑸 𝟏 𝑷 𝟐− 𝑷 𝟏
𝑷𝑬𝑫= ÷
𝑸𝟏 𝑷𝟏
1.2 Elasticities PED

Price Elasticity of Demand – definition and formula

Price Elasticity of Demand (PED) is a measurement of how much the quantity demanded for a
good will change as a result of a particular change in the good’s price. PED can range from a
value of 0 to infinity, and is calculated using the following formula:

P0= 4 P1=3
Q0= 60 Q1= 105

P0=10 P1=12
Q0=200 Q1=180

𝑸 𝟐− 𝑸 𝟏 𝑷 𝟐− 𝑷 𝟏
𝑷𝑬𝑫= ÷
𝑸𝟏 𝑷𝟏
1.2 Elasticities PED

Price Elasticity of Demand – definition and formula

Notice from the previous slide that our PED was a negative value.
• This reflects the law of demand
• Whichever direction the price of good moves in, the quantity will always move in the other direction
• Since PED will always be negative, we can refer to it in its absolute value. So, the PED for bananas is 0.4
• PED is calculated along a given demand curve

Interpretation of the PED coefficient:

If PED is less We say demand is inelastic. This means that the percentage change in the quantity is
than 1: less than the percentage change in the price.

If PED is
greater than We say that demand is elastic. The percentage change in the quantity is greater than
the percentage change in the price.
1
Demand is perfectly inelastic. There was no change in quantity resulting from the
If PED=0:
price change.

If PED=1: Demand is unit elastic. The percentage change in the quantity was identical to the
percentage change in the price.
If PED = Demand is perfectly elastic. The smallest increase in price causes the quantity
infinity: demanded to fall to ZERO.
DEMAND CURVES & PED
1.2 Elasticities PED

Inelastic Approximately Unitary

Elasticity
Interpretation of PED Salt 0.1
Movies 0.9
Demand for bananas was 0.4. Based on our Matches 0.1
interpretations of PED from the table on Housing, owner 1.2
Toothpicks 0.1 occupied, long-run
the previous slide, we know that demand Gasoline, short- 0.2 Shellfish, 0.9
for bananas is inelastic. run consumed at home
• For every 1% increase in the price of Gasoline, long- 0.7 Oysters, consumed 1.1
bananas, the quantity demanded fell by run at home
0.4%. Residential 0.1 Private education 1.1
natural gas,
• Since price increased by a total of 50%, Tires, short-run 0.9
short-run
the quantity fell by a total of just 20%. Residential 0.5 Tires, long-run 1.2
• Consumers are relatively unresponsive to natural gas,
the price of bananas. long-run Radio and 1.2
Coffee 0.25 television receivers
Highly Elastic
Study the tables on the right and try to Fish (cod) 0.5
Restaurant meals 2.3
determine what the goods in each consumed at
home Foreign travel, 4.0
category have in common. Tobacco 0.45 long-run
products, short- Fresh green peas 2.8
run
Legal services, 0.4 Chevrolet 4.0
short-run automobiles
Fresh tomatoes 4.6
Physician 0.6
1.2 Elasticities PED

Interpretation of PED
Answer the following questions based on the goods in the table on the previous slide.

1. Which products are the most inelastic?

2. What factors would most likely explain why salt is very inelastic?
3. Why would the demand for tooth picks be inelastic?
4. Although both short-run and long-run gasoline are both inelastic, why is short-run gasoline more
inelastic than long-run gasoline?
5. What factors would likely explain why Chevrolet cars are very elastic?
6. Why would tires have unitary elasticity while gasoline is inelastic?

1. [Inelastic goods = salt, matches, toothpicks, short-run airline travel, gasoline, residential natural gas, coffee, fish,
tobacco, legal services, physician services, taxi service, automobiles]
2. [Salt is inelastic because there are no good substitutes, it is a necessity to most people, and it represents a small
proportion of most people's budget.]
3. [Toothpicks are inelastic because they cost very little and represent a small percentage of a typical grocery budget and
have few substitutes.]
4. [Short-run gasoline is more inelastic than long-run because in the short run, we have to buy gas to keep our car going. In
the long run, we can switch to more fuel-efficient cars (including hybrid), ride the bus or walk more. But the short-run, those
options are not available.]
5. [Chevrolet cars would be very elastic because we don't have to buy that brand of car - we have lots of substitutes.]
6. [Even though tires are a want if we drive a car, the decision to buy them is not as immediate as buying gas (unless we
have a flat and must buy one to get back on the road). You can shop around for the best price as there are a number of
1.2 Elasticities PED

The Determinants of PED

Whether demand for a good at a particular price is elastic or inelastic depends on several
characteristics of the good itself. Just how much will consumers respond to a price change for
the good? The following table presents some of the primary determinants of PED

The number of substitutes available. The more substitutes, more elastic

S Substitutes demand, as consumers can replace a good whose price has gone up with
one of its now relatively cheaper substitutes.

The proportion of income the purchase of a good represents. If a good

P Proportion of
income
represent a higher proportion of a consumer's income, his demand tends
to be more elastic.

Luxury or necessity? If a good is a necessity, changes in price tend not to

L Luxury or
necessity?
affect quantity demand, i.e. demand is inelastic. If it's a luxury that a
consumer can go without, consumers tend to be more responsive.

A Addictive? If a product is addictive or habit forming, demand tends to be inelastic.

The amount of time a consumer has to respond to the price change. If

T Time prices remain high over a longer period of time, consumers can find
substitutes or learn to live without, so demand is more elastic over time.
1.2 Elasticities PED

The Determinants of PED

Based on the determinants of PED, organize the items below along the spectrum of elasticity,
from those which you believe have relatively inelastic demand to highly elastic demand.

Relatively inelastic………………………………………………………………………………………
Elastic
Variable PED along a demand curve (HL Topic)
Why does PED vary across the
demand curve?
Along any downward sloping demand
curve, PED varies as we move along
the curve.
P $10 to $ 9 =

P $9 to $ 8 =

P $5 to $4 =

P $2 to $ 1 =

P $0 to $ 1 =
Variable PED along a demand curve (HL Topic)
Why does PED vary across the
demand curve?
Along any downward sloping demand
curve, PED varies as we move along
the curve.
P $10 to $ 9 = (1-0)/0 = ∞ = - ∞
( 9-10)/10 -10%

P $9 to $ 8 = (2-1)/1 = 100% = - 9
( 9-8)/9 -11.8%

P $5 to $4 = (6-5)/5 = +20% = - 1
( 4-5)/4 -20%

P $2 to $ 1 = (9-8)/8 = 12.5 = - 0.25

( 1-2)/2 -50%

P $0 to $ 1 = (9-10)/10 = -10% = 0
( 1-0)/0 ∞
 Why does PED vary across the
demand curve?
• Percentage change in quantity
demanded will always be greater than
the percentage changes in price, that is
why we get elastic figures for the top
half of the curve
PED > 1
• The middle part of the demand curve
will always be unit elastic

• Percentage change in quantity

demanded will always be less than the
1 percentage change in price, that is why
PED= we get inelastic figures for the bottom
half of the curve
PED<1
Conclusion
Elastic and Inelastic should not be
used to refer to an entire demand
curve (with the exception of three
special cases where PED remains
constant) but only to a portion of the
demand curve corresponding to a
particular price or price range
1.2 Elasticities PED

PED and the slope of the Demand Curve P

PED and slope are different concepts. Cigarettes (D1) and

• Slope of a line measures the rise over the run, or in the iPhones (D2)
demand curve the change in price over the change in
P1
quantity.
• PED measures the percentage change in quantity over the P2
D2
percentage change in price.
• However, by comparing the relative slopes of demand
curves plotted on the same axis, we can determine the
relative elasticity of different goods. D1

Q1 Q2 Q3 Q4 Q
P
D3 Heart transplants (D3),
Questions: Watermelons (D4),
1. For which product is demand perfectly inelastic? Perfectly elastic? P2 Movie Tickets (D5)
Closes to unit elastic?
2. What relationship exists between relative slopes of demand curves
and elasticity? P1 D4
3. What are two characteristics of cigarettes that make demand for
them inelastic?
4. What are two characteristics of heart transplants that make demand
perfectly inelastic?
5. What are the characteristics of a good for which demand is perfectly
elastic? D5

Q2 Q1 Q
1.2 Elasticities PED

Importance of PED for firms P

Knowledge of PED is crucial for firms when making Inelastic
pricing decisions to increase total revenue Demand
P2
• Total revenue, amount of money received by firms when
P1
they sell their goods
Formulae to calculate TR
TR= P*Q

What will happen to the firms TR when there is a D1

change in the price of that good? Q2 Q1 Q

P

We know P & Q are negatively related. Increase in P Elastic

P1
leads to a decrease in Q and vice versa. So what Demand
P2
happens to TR? Depends on PED.
There are 3 scenarios:
1. PED>1 ELASTIC
2. PED<1 INELASTIC
3. PED=1 UNIT ELASTIC D2

Q1 Q2 Q
1.2 Elasticities PED

Importance of PED for firms Elastic Demand

P
What will happen to the firms TR when there is a
change in the price of that good? P1

P2
“Elastic Only Irritate Skin”

Elastic Opposite Inelastic Same

D2
PED>1 ELASTIC
If PED is elastic, price and total revenue move in the
opposite direction. Q1 Q2 Q

A reduction in price will increase revenue as

demand will increase more than price.

Fall in price will lead to a greater percentage

increase in the quantity demanded.

Firm should reduce the price to increase total

revenue
1.2 Elasticities PED

Importance of PED for firms P

Inelastic
What will happen to the firms TR when there is a Demand
change in the price of that good? P2
P1
“Elastic Only Irritate Skin”

Elastic Opposite Inelastic Same

D1
PED<1 INELASTIC
Q2 Q1 Q
If PED is inelastic price and revenue move in the
same direction.

An increase in price will increase revenue as

demand will fall by less than price.

Rise in price will lead to a smaller percentage fall in

the quantity demanded.

Firm should increase the price to increase total

revenue
1.2 Elasticities PED

Importance of PED for firms

Unit elastic
What will happen to the firms TR when there is a Demand
change in the price of that good?

PED=1 Unit ELASTIC

Percentage change in quantity demand is equal to

percentage change in price

Total revenue remains the same

1.2 Elasticities PED

The Total Revenue Test of PED & Firms Pricing decision

A quick way to determine whether a demand is elastic or inelastic is to consider whether the
revenues of sellers raises or falls as a result of a price change.

Consider the good whose demand is shown on the left: Calculate

the total revenues at each of the prices shown. (Total
Revenue=Price x Quantity)
• At $10:
• At $8:
• At $6: PED>1
• At $4:
• At $2: PED=1
• At $0:
The Total Revenue Test of Elasticity: PED<1
• If a decrease in price causes TR to rise, demand is elastic.
• If a decrease in price causes TR to fall, demand is inelastic
• If an increase in price causes TR to rise, demand is inelastic
• If an increase in price causes TR to fall, demand is elastic
• TR is at the maximum where price is at a point where demand
is unit elastic
1.2 Elasticities PED

Applications of PED
The PED formula is useful for more than just telling us how much consumers respond to price
changes. It can be very useful to businesses and government decision making.

Applications of PED for

• Gives guidance to the firm if it is thinking about changing the price of its
product.

• If PED is elastic, price and revenue move in the opposite direction. A

reduction in price will increase revenue as demand will increase more than
price. Fall in price will lead to a greater percentage extension in the
Businesses quantity demanded.

• If PED is inelastic, price and revenue move in the same direction. An

increase in price will increase revenue as demand will fall by less than price.
Rise in price will lead to a smaller percentage contraction in the quantity
demanded.
 PED & Indirect taxes
• If the government wants to increase tax revenue it should tax goods with
inelastic demand.
• Tax has the effect of shifting the supply curve upward by the amount of
tax.
• Tax revenue is the shaded area.
1.2 Elasticities PED

Applications of PED
The PED formula is useful for more than just telling us how much consumers respond to price
changes. It can be very useful to businesses and government decision making.

Applications of PED for

If a government wants to raise revenue, it should tax products with inelastic

demand. This is because the quantity sold won’t fall by much because a rise a
price will cause a smaller percentage contraction in the quantity demanded.
• A tax on restaurant meals (relatively elastic) will not raise much revenue
because people will just stop going to restaurants.
Governme • A tax on cigarettes (relatively inelastic) will raise lots of revenue because
nt most people will continue smoking and thus have to pay the tax.

If the government’s aim is to discourage the consumption of a product it will

be more successful if demand is elastic. This is because a rise in price will
cause a greater percentage contraction in the quantity demanded.
 PED in relation to Primary commodities and Manufactured products (HL Topic)

• Primary commodities: is a good sold for production or consumption just as it was
found in nature e.g. agriculture, fishing, forests as well as products of extractive
industries (oil, coal, minerals).

• Agricultural products include food and non-edible commodities like cotton and rubber

• Many primary commodities have a low PED as compared to manufacturing & services
products.

• Food has a high price inelastic demand—necessity and no substitutes

• Manufacturing products are more elastic. They may in some cases be necessities but
they usually have substitutes
Consequence of a low PED for primary commodities(HL
TOPIC)

• Low PED and fluctuations in supply over short periods of

time create large fluctuations in commodity prices and in
farmers income

• From the diagrams(next slide) we can see that shifts in the

supply curve result in large price fluctuations when demand
is inelastic and milder ones when demand is elastic.

• Large price fluctuations over short periods of time are

referred to as price volatility.
 Consequence of low PED for primary commodities (HL
TOPIC)
• Two results follow from this:
1. Commodity prices fluctuate widely, so do producers income which
depends on total revenue=p*Q
2. A fall in supply of a primary commodity with inelastic demand leads to
an increase in TR for producers because the % increase in price is larger
than % decrease in Qt.
3. Unexpected conclusion: a poor harvest benefits the farmer while a
bumper crop reduces a farmers TR.
1.2 Elasticities YED

Income Elasticity of Demand (YED)

Another type of elasticity measures the responsiveness of quantity demanded of a good to a
change in the income and involved demand curve shifts.
For Example: Imagine a country is going into recession, so incomes of the average household are
falling. Demand for new cars is falling, but demand for bicycles is rising. YED is a measure of how
responsive consumers’ demand for bicycles and cars is to changes in their incomes.

Y
Assume the following:
• Incomes in America have fallen by 4%
• Bike sales have risen by 8%
• Car sales have fallen by 3% 8
• Calculate the YED for bicycles and cars 𝑌𝐸𝐷 𝑏𝑖𝑘𝑒𝑠 = =− 2 Notice that YED can
−4
be negative (bikes) OR
−3 positive (cars)
𝑌𝐸𝐷 𝑐𝑎𝑟𝑠 = =0.75
−4
Demand for bikes is income elastic
Demand for cars is income inelastic
1.2 Elasticities YED

Income Elasticity of Demand (YED)

Calculations

Q. Suppose your income increases from $800 per month to $1000 per month, and your purchase
of clothes increase from $100 to $140 per month. What is your income elasticity of demand for
clothes?

(140 − 100)/100
𝑌𝐸𝐷 𝑐𝑙𝑜𝑡h𝑒𝑠 =
(1000 − 800)/ 800

0.40
𝑌𝐸𝐷 𝑐𝑙𝑜𝑡h𝑒𝑠 = =1.6
0.25

Demand for clothes is income elastic

1.2 Elasticities YED

Income Elasticity of Demand (YED)

Income elasticity of demand provides two kinds of information
The sign of YED: positive or negative
The numerical value of YED: whether it is smaller or greater than 1
1.2 Elasticities YED

Income Elasticity of Demand (YED)

As with PED, the absolute value of YED can be:
The sign of YED: positive or negative
The numerical value of YED: whether it is smaller or greater than 1
1.2 Elasticities YED

Income Elasticity of Demand (YED): Engel Curve

1.2 Elasticities YED

Importance of YED for firms (HL ONLY)

Firms which wish to produce in expanding markets may wish to know YEDs of various goods and
services

• During economic growth, firms which are producing goods and services that have an income
elastic demand (YED>1) will experience a rise in the demand of those products
For e.g. Restaurants, movies, healthcare

 Higher the YED greater the expansion of the market of the good/service

 Lower the YED smaller the expansion of the market of the good/service
For e.g. clothing, food, furniture

• During a recession goods with

YED>1 experience the largest decline in sales
YED<1 avoid large fall in sales
YED<0 experience a rise in sales
1.2 Elasticities YED

Importance of YED for firms (HL ONLY)

Firms which wish to produce in expanding markets may wish to know YEDs of various goods and
services

As countries experience economic growth, incomes increase.

If total income in the economy increase by 3%

If goods and services have income elastic demand YED>1, this means that the demand for these
goods increase at a higher rate than 3% e.g. restaurants, movies, healthcare and foreign travel

Other G&S have income inelastic demand, would grow by less than 3% e.g. food, clothing and
furniture

Higher the YED of a good or service, greater the expansion of its market in the future

Lower the YED, smaller is the expansion

In a recession, goods and services with a high YED are the hardest hit, experiencing the largest
declines in sales. Products with low YED’s can avoid large falls in sales while inferior goods can
experience a rise in sales.
1.2 Elasticities YED

Importance of YED in explaining changes in the sectoral structure of the

economy (HL ONLY)

Every economy has three sectors:

1. Primary sector: agriculture, forestry, fishing and extractive industries
2. Manufacturing sector
3. Services sector: entertainment, travel, banking, insurance,
healthcare, education

With economic growth, the relative size of these sectors change and
these changes can be explained in terms of YED.
1.2 Elasticities YED

Importance of YED in explaining changes in the sectoral structure of the

economy (HL ONLY)

 Agriculture has a YED which is positive but <1 income inelastic.

 As society’s income grows, demand for agriculture grows more slowly than growth
in income.

 Manufacturing and service sectors usually have income elastic demand >1.
therefore, as income increases, their demand increases by a greater % as compared
to the growth in income.

 Overtime, the share of agriculture output in total output shrinks, while

manufacturing grows. Overtime, the services grows more rapidly at the expense of
both agriculture and manufacturing

 If total output is increasing overtime, a falling share for the primary sector does not
mean that output is falling, it simply means its output is growing more slowly than
total output.