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Price, Income and Cross

Elasticity

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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?

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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

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Elasticity
• 4 basic types used:
• Price elasticity of demand
• Price elasticity of supply
• Income elasticity of demand
• Cross elasticity

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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

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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)

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Price (£)
Elasticity
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

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Elasticity
Price
Total revenue is price x
The importance of elasticity
quantity sold. In this
is 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)

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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)

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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

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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

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Elasticity
• If demand is • If demand is
price elastic: price inelastic:
• Increasing price • Increasing price
would reduce TR would increase
(%Δ Qd > % Δ P) TR
• Reducing price (%Δ Qd < % Δ P)
would increase • Reducing price
TR would reduce TR
(%Δ Qd > % Δ P) (%Δ Qd < % Δ P)

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Price

P1
Inelastic Demand
Elasticity less than 1

P2

Q1 Q2 Quantity
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Price

P1
Perfectly Inelastic Demand
Elasticity equals 0

P2

Q1 = Q2 Quantity
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Price

Elastic Demand
Elasticity greater than 1

P1
P2
D

Q1 Q2 Quantity
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Price

Perfectly Elastic Demand

Elasticity equals infinity

P1 = P2
D

Q1 Q2 Quantity
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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

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Elasticity
• Income Elasticity of Demand:

• A positive sign denotes a normal good

• A negative sign denotes an inferior good

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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%

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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

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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)

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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

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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

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What are the implications of the

concept of elasticity of demand?
• For the producer
• For the consumer
• For the government

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