ECO 1003: Microeconomics

Chapter 4: Elasticity 1
The Basics

Markets
Supply and Demand

Increasing
Scarcity Comparative
Cost – Benefit Incentive Opportunity Efficiency Equilibrium
Advantage
Costs

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Learning Objectives

1. Define price elasticity of demand and explain what determines

whether demand is elastic or inelastic
2. Calculate the price elasticity of demand using information from the
demand curve
3. Understand how changes in the price of a good affect total
revenue and total expenditure depending on the price elasticity of
demand for the good
4. Explain the cross-price elasticity of demand and income elasticity
of demand
5. Discuss the price elasticity of supply, explain what determines
whether supply is elastic or inelastic, and calculate the price
elasticity of supply using information from a supply curve
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Price Elasticity of Demand
 The law of demand (see Chapter 3) says:
An increase in price causes a decrease in
quantity demanded (and vice-versa)
 But how much does quantity demanded change
in response to a change in price?
 Price elasticity of demand is defined as the
percentage change in quantity demanded from a
1% change in price
Elasticity gives us a measure of responsiveness
of quantity demanded to changes in price 4
Price Elasticity of Demand

• Example:
Suppose the price of beef decreases by 1% and the quantity of beef
demanded increases 2%
 Thus, we say that the price elasticity of demand for beef is – 2

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Calculate Price Elasticity
• Symbol for elasticity is ε (lower case Greek epsilon)
Percentage change in quantity demanded [(Qnew-Qold)/Qold]x100
ε= =
Percentage change in price [(Pnew-Pold)/Pold]x100
• Price elasticity of demand is always negative
 Ignore the sign
• Example: A movie ticket in Ruwais mall costs AED 40.25. At this price, 1000
persons visit the movie theatre. If the manager reduces the price to AED 35,
1250 visit the movie theatre. Using the formula above we have Pold=40.25 AED,
Qold=1000, and Pnew=35 AED, Qnew=1250. So
[(Qnew-Qold)/Qold]x100 [(1250-1000)/1000]x100 0.25 = -1.92
=
ε= =
[(Pnew-Pold)/Pold]x100 -0.13 Education. All rights reserved.
[(35-40.25)/40.25]x100 ©McGraw-Hill
• ε=-1.92 means if the price decreases by 1%, the quantity demanded
increases by more than 1%.
Elastic Demand

• If price elasticity is greater than 1 (i.e, ε>1), demand is elastic

• Percentage change in quantity is greater than percentage change in price
• Demand is responsive to price

Price Elasticity of Demand

Unit elastic

Inelastic Elastic

0 1 2 3

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Inelastic Demand
• If price elasticity is less than 1 (i.e, ε<1), demand is inelastic
• Percentage change in quantity is less than percentage change in price
• Quantity demanded is not very responsive to price

Price Elasticity of Demand

Unit elastic

Inelastic Elastic

0 1 2 3

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Unit Elastic Demand
• If price elasticity is 1 (i.e, ε=1), demand is unit elastic
• Price and quantity change by the same percentage

Price Elasticity of Demand

Unit elastic

Inelastic Elastic

0 1 2 3

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Example: Demand for Pizza

Old New % Change

Price AED 4.00 AED 3.77 -5.75%
Quantity 400 404 1%

Percentage change in quantity demanded = [(Qnew-Qold)/Qold]x100

ε=
Percentage change in price [(Pnew-Pold)/Pold]x100

1%
ε= = -0.17 Demand is inelastic since |ε|<1
-5,75%

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Determinants of Price Elasticity of Demand

• More options, more elastic

Substitution • Salt
Options • Morton's salt

• Large share, more elastic

Budget Share • New car
• Salt

• Long time to adjust, more elastic

Time • Air conditioner
• Gasoline

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Examples of Elasticities

Green peas 2.80

Restaurant meals 1.63
Beer 1.19
Coffee 0.25

Automobiles 1.35
Foreign air travel 0.77

Movies 0.87
Theater, opera 0.18
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Price Elasticity Notation

Percentage change in quantity demanded

ε=
Percentage change in price

• ΔQ is the change in quantity

• ΔQ / Q is percentage change in quantity
• ΔP is change in price
• ΔP / P is percentage change in price
ΔQ / Q
ε=
ΔP / P

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Price Elasticity Pattern

• Price elasticity changes systematically as price goes down

• At high P and low Q, P / Q is large
• Demand is elastic
• At the midpoint, a
demand is unit elastic

Price
• At low P and high Q, a/2
P / Q is small
• Demand is
inelastic b/2 b
Quantity

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Two Special Cases

Perfectly Elastic Demand Perfectly Inelastic Demand

• Infinite price elasticity of demand • Zero price elasticity of demand

Price Price
D

Quantity Quantity

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Elasticity and Total Expenditure
• When price increases, total expenditure can increase, decrease or
remain the same
• The change in expenditure depends on elasticity
• Terminology: total expenditure = total revenue
• Calculate as P x Q
Price
• Graphing idea: total
expenditure is the area Expenditure = 8
of a rectangle with height P
and width Q
• Example: P = 2 and 2
Q=4 D
4
Quantity
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Price Elasticity and Total Expenditure

• Price of bunch of Fresh Moroccan mint increases from AED 2 to AED 4

• A and B are both below the midpoint of the curve
• Inelastic portion of the demand curve
• Total revenue increases when price increases
Price (AED/ bunch of mint)

Price (AED/ bunch of mint)

12 D Expenditure = 12 D Expenditure =
AED 10,000/day AED 16,000/day

B
4
2
A

5 6 4 6
Quantity (000s bunches of Quantity (000s bunches of
mint/day) mint/day)

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Price Elasticity and Total Expenditure

• Price of Fresh Moroccan mint bunch increases from AED 8 to AED10

• Prices are both above the midpoint of the curve
• Elastic portion of the demand curve
• Total revenue decreases
Price (AED/ bunch of mint)

Price (AED/ bunch of mint)

12 12 Expenditure =
Z
Y Expenditure = 10 AED 10,000/day
8 AED 16,000/day

D D

2 6 1 6
Quantity (000s bunches of Quantity (000s bunches of
mint/day) mint/day)

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The Effect of a Price Change on Total Expenditure
Price AED 12 AED 10 AED 8 AED 6 AED 4 AED 2 AED 0
Quantity 0 1,000 2,000 3,000 4,000 5,000 6,000
Expenditure AED 0 AED 10,000 AED 16,000 AED 18,000 AED 16,000 AED 10,000 AED 0

Total expenditure (AED /day)

Price (AED/ bunch of mint)

12 18,000
10 16,000

8
10,000
6

1 2 3 4 5 6 2 6 10
Quantity (000s bunches of Price (AED/ bunch of mint) 4-19
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mint/day)
Elasticity, Price Change, and Expenditure

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 Cross-Price Elasticity of Demand
• Substitutes and complements affect demand
• Cross-price elasticity of demand is defined as the percentage change
in quantity demanded of good A from a 1 percent change in the price of
good B
• Sign of cross-price elasticity shows relationship between the goods
• Complements have negative cross-price elasticity
Example: Good A is a Right shoe; good B is a Left shoe. If the price of Right shoe goes up, the
quantity demanded of Left show will go down. Right and Left shoe are Complementary goods
because Right (Left) shoes are always used in conjunction with Left (right) shoes. Cross-price
elasticity of these 2 goods is negative.
• Substitutes have positive cross-price elasticity
Example: Good A is a can of Vimto; good B is a can of Shani. If the price of Vimto goes up, the
quantity demanded of Shani will go up. Vimto and Shani are two alternative drinks that could be
used for the same purpose. Cross-price elasticity of these 2 goods is positive.

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 Income Elasticity of Demand
• Income elasticity of demand is defined as the percentage change in
quantity demanded from a 1 percent change in income
• Income elasticity of demand can be positive or negative
• Positive income elasticity is a normal good
Example: An example of such good is Mercedes S-Class cars. Suppose that due to substantial
economic growth in the country, everyone’s income rises to AED 300,000/month. Because
everybody has extra money, the quantity demanded of Mercedes S-Class cars increases by
15%. The income-elasticity of Mercedes S-Class cars is positive as it is a normal good.
• Negative income elasticity is an inferior good
Example: An example of such good is cheap cars. Suppose that due to substantial economic
growth in the country, everyone’s income rises to AED 300,000/month. Because everybody has
extra money and buy costly cars, the quantity demanded of cheap cars decreases by 15%.
The income-elasticity of cheap cars is negative as it is an inferior good.

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