COECA1 - Chapter 4 - Price Elasticity (1)

COECA1-B11
Chapter 4: Price Elasticity
By Joshua van Houten

Learning Outcomes:
1. Define price elasticity of demand and supply.
2. Define, calculate, and explain the factors influencing the price
elasticity of demand.
3. Define, calculate, and explain the factors influencing the cross-
price elasticity and income elasticity of demand.
4. Define, calculate, and explain the factors influencing the supply of
demand.
Introduction
As discussed in Chapter 3 we are aware that when the supply of a good decreases there is
subsequent increase in the price (equilibrium price) which will decrease the subsequent
equilibrium quantity, which will also decrease.
With this scenario we need to determine what effect a price increase or decrease will have on the
equilibrium quantity. with a relatively small decrease in the equilibrium quantity. The answer
depends on the responsiveness of the quantity demanded of a good to a change in its price. This
can be referred to as price elasticity.
Price Elasticity of Demand
Price Elasticity of Demand and Price Elasticity Definitions:
• The price elasticity of demand is a units-free measure of the responsiveness of the quantity
demanded of a good to a change in its price when all other influences on buying plans remain
the same (Ceteris paribus).
• Therefore, price elasticity can be seen as a measure of responsiveness or sensitivity. The price
elasticity of demand is concerned with the sensitivity or responsiveness of the quantity
demanded to a change in the price of the product.
1
Calculating Price Elasticity of Demand:
To calculate the price elasticity of demand, we need to know the quantity demanded at two different prices (Ceteris
paribus). Therefore, we need to know the two different price points and the corresponding quantity demanded at each
respective price point. Once we have this information you should follow the following steps:
Step 1: Calculate the difference in price points and the difference in quantity demanded at each respective price
point.
Step 2: Calculate the average price and the average quantity demanded
Step 3: Calculate the percentage change in price and the percentage change in quantity demanded
Step 4: Take your respective answers from step 3 and divide the percentage change in quantity demanded and
divide it by the percentage change in price as per the formula below:
2
Price Elasticity of Demand
Calculating Price Elasticity of Demand Example 1:
Initial Price of pizza = $20.50
Initial Demand = 9 pizzas an hour
New Price = $19.50
New Demand = 11 pizzas an hour
Step 1: Difference in Price & Difference in Quantity Demanded Step 2: Average Price & Average Quantity Demanded
• $20.50 - $19.50 = $1 • $20.50 + $19.50 is $40.00 divided by 2 = $20.00 is the
• 11 pizzas (an hour) – 9 pizzas (an hour) = 2 pizzas (an Average Price
hour)
• 9 pizzas (an hour) + 11 pizzas (an hour) is 20 pizzas (an
hour) divided by 2 = 10 pizzas (an hour) which is the
Average Quantity Demanded
Step 3: % Change in Price & % Change in Quantity Demanded Step 4: % Change in Quantity Demanded divided by the %
Change Price
• Difference in Price 1$ divided by the Average Price $20
times 100 = 5% (percentage change in price)
• Price elasticity of demand = 20% divided by 5%
• Difference in the quantity demanded 2 pizzas (an hour) • Price elasticity of demand is = 4
divided by the average quantity demanded 10 pizzas (an
hour) times 100 = 20% (percentage change in Q
demanded) 3
Price Elasticity of Demand Classifications:
Perfectly Inelastic Demand = 0
If the quantity demanded remains constant when the price changes, then the price elasticity of
demand is zero and the good is said to have a perfectly inelastic demand. An example of a good that
has a very low-price elasticity of demand or is perfectly inelastic is insulin.
Inelastic Demand between = 0 and 1
The percentage change quantity demanded is less than the percentage change in the price of the
product.
Unit Elastic Demand = 1
If the percentage change in the quantity demanded equals the percentage change in the price, then the
price elasticity equals 1 and the good is said to have a unit elastic demand.
4
Price Elasticity of Demand Classifications
Elastic Demand between 1 and ∞

The price change leads to a proportionally greater change in the quantity demanded.
Perfectly Elastic Demand = less than ∞
If the quantity demanded changes by an infinitely large percentage in response to a tiny price change,
then the price elasticity of demand is infinity and the good is said to have a perfectly elastic demand.
Note: Refer to pages 93 in your textbook
5
Price Elasticity of Demand Classifications
Price Elasticity of Demand Classifications Represented Graphically:
Perfectly Inelastic Demand Unit Elastic Demand Perfectly Elastic

Demand
6
Rules for Calculating Price Elasticity of
Demand
1. Average Price and Quantity
• We use the average price and average quantity as it gives the most precise measurement of
elasticity.
• We focus on the average such that the change is the same regardless of whether one is moving up
or down by the same magnitude.
2. Percentages and Proportions
• Elasticity is the ratio of two percentage changes, so when we divide one percentage change by
another, the 100s cancel.
7
Rules for Calculating Price Elasticity of
Demand
3. A Units-Free Measure
• Elasticity is a units-free measure as the percentage change in each variable is independent of the
units in which the variable is measured.
4. Minus Signs and Elasticity
• Due to the law of demand, changes in prices will result in an inverse change in quantity (negative
relationship) thus the price elasticity of demand is a negative number. However, we use the
magnitude of the elasticity and ignore the minus sign.
8
Factors that Influence the Elasticity of
Demand
The elasticity of demand is dependant on the following factors:
1. The closeness of substitutes - The closer the substitutes for a good, the more elastic is the demand for
it.
2. The proportion of income spent on the good - Ceteris paribus, the larger the proportion of income
spent on a good, the more elastic or less inelastic the demand is for that good.
3. The time elapsed since the price change - The longer the time that has elapsed since a price change,
the more elastic is demand.
• In essence the price elasticity of demand depends on how easily one good serves as a substitute for
another, the proportion of income spent on the good, and the length of time elapsed since the price change.
9
Price Elasticity of Demand Practical
Example:
1. Calculate the price elasticity of demand for pizza and interpret your results.
• Original price of a pizza = $15 per pizza
• New price of a pizza = $25 per pizza
• Original quantity of pizza demanded when the price of a pizza is $15 per pizza = 20 pizzas per
hour
• New quantity demanded for pizzas when the price changed to $25 per pizza = 0 pizzas per hour
10
Answer
Step 1: Difference in price & difference in quantity Step 2: Average Price & Average Quantity Demanded
• $25-$15 • ($15+$25) ÷ 2
 Price Difference = $10  Average Price = $20
• 20 pizzas per hour – 0 pizzas per hour • (20 pizzas per hour + 0 pizzas per hour) ÷ 2
 Difference in Quantity Demanded= 20 pizzas per hour  Average demand = 10 pizzas per hour
Step 3: % Change in Price & % Change in Quantity Step 4: Price Elasticity of Demand Formula
Demanded
• $10 ÷ $20 × 100
 Percentage change in price = 50%  PED =
• 20 pizzas per hour ÷ 10 pizzas per hour × 100  Price elasticity of demand = 4
 Percentage change in quantity demanded = 200%
 The price elasticity of demand is elastic
11
Example:
hour
• New quantity demanded for pizzas when the price changed to $15 per pizza = 20 pizzas per
hour
12
Answer
• $15 – $10 • ($10+$15) ÷ 2
 Price Difference = $5  Average Price = $12.5
Demanded
• $5 ÷ $12.5 × 100
• 10 pizzas per hour ÷ 25 pizzas per hour × 100  Price elasticity of demand = 1
 The price elasticity of demand is unit elastic
13
Example:
hour
• New quantity demanded for pizzas when the price changed to $25 per pizza = 30 pizzas per
hour
14
Answer
• $10-$0 • ($10+$0) ÷ 2
 Price Difference = $10  Average Price = $5
Demanded
• $10 ÷ $5 × 100
• 20 pizzas per hour ÷ 40 pizzas per hour × 100  Price elasticity of demand = 0.25
 The price elasticity of demand is inelastic
15
Elasticity Along a Linear Demand Curve
Question 1 Question 2 Question 3
• Original prices: $15 per pizza • Original prices: $10 per pizza • Original prices: $0 per pizza
• New Price: $25 per pizza • New Price: $15 per pizza • New Price: $10 per pizza
• Original demand: 20 pizzas per hour • Original demand: 30 pizzas per hour • Original demand: 50 pizzas per hour
• New Demand: 0 pizzas per hour • New Demand: 20 pizzas per hour • New Demand: 30 pizzas per hour
• Average Price: $20 • Average Price: $12.5 • Average Price: $5
• Average Quantity: 10 pizzas per hour • Average Quantity: 25 pizzas per hour • Average Quantity: 40 pizzas per hour
16
• Elasticity and slope are not the same. A linear demand

curve has a constant slope but a varying elasticity.
• Elasticity of demand is not the same as slope. And a

good way to see this fact is by studying a demand
curve that has a constant slope but a varying elasticity.
17
Elasticity Along a Linear Demand Curve Example 1 Answers:
1. The price elasticity of demand at an average price of $20 a

pizza is 4 at this point the demand is elastic.
2. At the midpoint of a linear demand curve, the price elasticity

of demand is 1 at this point there is a unit elastic demand. At
prices above the midpoint, the price elasticity of demand is
greater than 1: Demand is elastic.
3. The price elasticity of demand at an average price of $5 a

pizza is ¼ at this point there is an inelastic demand.
18
Total Revenue and Demand
The total revenue from the sale of a good equals the price of the good multiplied by the quantity sold.
When a price changes, total revenue also changes. But a cut in the price does not always decrease total
revenue.
The change in total revenue depends on the elasticity of demand:
• If a price cut increases total revenue demand is elastic.

• If a price cut leaves revenue unchanged demand is unit elastic.
• If a price cut leaves decreases total revenue demand inelastic.
19
The change in total revenue depends on the elasticity of demand in the

following way:
• If demand is elastic, a 1 percent price cut increases the quantity sold by

more than 1 percent and total revenue increases.
• If demand is unit elastic, a 1 percent price cut increases the quantity

sold by 1 percent and total revenue does not change.
• If demand is inelastic, a 1 percent price cut increases the quantity sold

by less than 1 percent and total revenue decreases.
20
• When demand is elastic, in the price range from $25 to $12.50, a

decrease in price (part a) brings an increase in total revenue (part b).
• When demand is unit elastic, at a price of $12.50 (part a), total

revenue is at a maximum (part b).
• When demand is inelastic, in the price range from $12.50 to zero, a

decrease in price (part a) brings a decrease in total revenue (part b).
21
Income Elasticity of Demand
Income elasticity of demand - is a measure of the responsiveness of the demand for a good or
service when there is a change in income, other things remaining the same (Ceteris Paribus).
Income elasticity of demand is calculated by using the formula below:
22
Income Elasticity of Demand
Using the income elasticity of demand formula the result can either be positive or negative.
Income elasticities fall into three interesting ranges:
• Positive and greater than 1 = normal good, income elastic
• Positive and less than 1 = normal good, income inelastic
• Negative = inferior good
*Note:
A normal good is a luxury good, whereas inferior good is an essential good
23
Income Elasticity of Demand Practical
Question:
Suppose that the price of pizza is constant and 9 pizzas an hour are bought. Then incomes rise from
$975 to $1,025 a week. No other influence on buying plans changes and the quantity of pizzas sold
increases to 11 pizzas an hour.
Therefore:
Original Demand = 9 pizzas per hour

Original Income = $975
New Demand = 11 pizzas per hour
New income = $1 025
*Hint: follow the steps but replace price with income

24
Income Elasticity of Demand Practical Answer:
Step 1: Difference in income & difference in quantity Step 2: Average Price & Average Quantity Demanded
• $1 025 - $975 • ($1 025 + $975) ÷ 2
 Price Difference = $50  Average Income = $1 000
Step3:%Change in Income & %Change in Quantity Step 4: Income Elasticity of Demand Formula
Demanded
• $50 ÷ $1 000 × 100
 IED =
 Percentage change in income = 5%
• 2 pizzas per hour ÷ 10 pizzas per hour × 100  Income elasticity of demand = 4
 Percentage change in quantity demanded = 20%  The income elasticity of demand is elastic, and the
pizza is a normal good
25
Cross Elasticity of Demand
Cross elasticity of demand - is a measure of the responsiveness of the demand for a good to a
change in the price of a substitute or complement, other things remaining the same. We calculate
the cross elasticity of demand by using the formula:
• Substitute goods - is a product or service that can be easily replaced with another by consumers.
• Complementary goods - are two goods that need to be used in conjunction with each other. In
other words they are two goods that only work together. For example printers and printer ink.
26
Cross Elasticity of Demand
Using the cross elasticity of demand formula the result can either be positive or negative.
• If the cross elasticity of demand is positive, demand and the price of the other good change in
the same direction, so the two goods are substitutes.
• If the cross elasticity of demand is negative, demand and the price of the other good change in
opposite directions, so the two goods are complements.
27
Cross Elasticity of Demand Practical
Question:
Suppose that the price of pizza is constant, and people buy 9 pizzas an hour. Then the price of a burger
rises from $1.50 to $2.50. No other influence on buying plans changes and the quantity of pizzas
bought increases to 11 an hour.
Therefore:
Original Price of Burgers = $1.50
New Price of Burgers = $2.50

28
Cross Elasticity of Demand Practical Answer:
• $2.50 - $1.50 • ($1.50 + $2.50) ÷ 2
 Price Difference = - $1  Average Price of burgers = $2
Step 3: % Change in Price & % Change in Quantity Step 4: Income Elasticity of Demand Formula
Demanded
• $1 ÷ $2 × 100
 CED =
• 2 pizzas per hour ÷ 10 pizzas per hour × 100  Cross elasticity of demand = 0.4
 Percentage change in quantity demanded = 20%  The cross elasticity of demand is positive. Therefore,
the two good are substitutes.
29
Cross Elasticity of Demand Practical
Question:
Suppose that the price of pizza is constant, and people buy 11 pizzas an hour. Then the price of a
cooldrink rises from $0.60 to $1.00. No other influence on buying plans changes and the quantity of
pizzas bought increases to 9 an hour.
Therefore:
Original Price of a Cooldrinks = $0.60
New Price of a Cooldrink = $1.00

30
Cross Elasticity of Demand Practical Answer:
• $1.00 - $0.60 • ($1.00 + $0.60) ÷ 2
 Price Difference = $0.40  Average Price of pizza = $0.80
 Difference in Quantity Demanded= - 2 pizzas per hour  Average demand = 10 pizzas per hour
Step 3: % Change in Price & % Change in Quantity Step 4: Income Elasticity of Demand Formula
Demanded
• $0.40 ÷ $0.80 × 100
 CED =
• -2 pizzas per hour ÷ 10 pizzas per hour × 100  Cross elasticity of demand = - 0.4
 Percentage change in quantity demanded = -20%  The cross elasticity of demand is negative. Therefore,
the two good are compliments.
31
Cross Elasticity of Demand Represented
Graphically:
*Tip:
If you are asked to illustrate Cross

Elasticity graphically be cognisant of
which product you select to illustrate.
32
Price Elasticity of Supply
You know that when demand increases, the equilibrium price rises and the equilibrium quantity
increases. But does the price rise by a large amount and the quantity increase by a little? Or does the
price barely rise and the quantity increase by a large amount?
• The answer depends on the responsiveness of the quantity supplied to a change in the price. If the
quantity supplied is not very responsive to price, then an increase in demand brings a large rise
in the price and a small increase in the equilibrium quantity. If the quantity supplied is highly
responsive to price, then an increase in demand brings a small rise in the price and a large
increase in the equilibrium quantity.
• We use a units-free measure—the elasticity of supply.

33
Elasticity of Supply
The elasticity of supply - measures the responsiveness of the quantity supplied to a change in the
price of a good when all other influences on selling plans remain the same. It is calculated by using
the formula:
Interpreting the elasticity of Supply Result:
• If the elasticity of supply is greater than 1, we say that supply is elastic.
• if the elasticity of supply is less than 1, we say that supply is inelastic.

34
Elasticity of Supply Practical Question:
Suppose that when the price rises from $20 to $21, the quantity supplied increases from 10 to 20
pizzas per hour.
Therefore:
Original Supply = 10 pizzas per hour
Original Price of a Pizza = $20
New Supply = 20 pizzas per hour
New Price of a Pizza = $21
*Hint: follow the steps and use the supply of pizzas

35
Elasticity of Supply Practical Answer:
Step 1: Difference in price & difference in quantity Step 2: Average Price & Average Quantity Supplied
• $21.00 - $20.00 • ($21.00 + $20) ÷ 2
 Price Difference = $1  Average Price of pizza = $20.50
 Difference in Quantity Supplied = 10 pizzas per hour  Average Supply = 15 pizzas per hour
Step 3: % Change in Price & % Change in Quantity Step 4: Elasticity of Supply Formula
Supplied
• $1 ÷ $20.50 × 100
 ES =
 Percentage change in price = 4.88%
• 10 pizzas per hour ÷ 15 pizzas per hour × 100  Elasticity of Supply = 13.73
 Percentage change in quantity demanded = 67%  The elasticity of supply is greater than 1. Therefore,
the supply is elastic
36
Factors that Influence the Elasticity of Supply
The elasticity of supply of a good depends on:
1. Resource substitution possibilities
• Some goods and services can be produced only by using unique or rare productive resources. These
items have a low, perhaps even a zero, elasticity of supply.
• Other goods and services can be produced by using commonly available resources that could be
allocated to a wide variety of alternative tasks. Such items have a high elasticity of supply.
The supply of most goods and services lies between these two extremes. Therefore, the supply of goods
and services have an elasticity of supply between zero and infinity.
37
Elasticity of Supply
38
Factors that Influence the Elasticity of Supply
The elasticity of supply of a good depends on:
2. Time Frame for the Supply Decision
To study the influence of the amount of time elapsed since a price change, we distinguish three-time
frames of supply:
• Momentary supply - When the price of a good changes, there is an immediate response of the
quantity supplied.
• Short-run supply - when only some of the possible adjustments to production can be made
• Long-run supply - after all the technologically possible ways of adjusting supply have been
exploited is determined 39
Practical Questions
1. Calculate and interpret Amelia’s elasticity of demand for tickets as the price for tickets increases from
R100 to R150. Show all formulas and calculations.
2. Calculate and interpret Amelia's income elasticity of demand for tickets as her income increases from
R10 000 to R15 000. Show all formulas and calculations.
*Note – the formulas will not be provided in the exam, so know them! 40
Price Elasticity of Demand Practical Answer:
• R150 – R100 • (R100 + R150) ÷ 2
 Price Difference = R50  Average Price of tickets =R125
• 5 tickets – 3 tickets • (5 tickets + 3 tickets) ÷ 2
 Difference in Quantity Demanded = 2 tickets  Average Demand = 4 tickets
Demanded
• R50 ÷ R125 × 100
 PED =
 Percentage change in price = 40%
• 2 tickets ÷ 4 tickets × 100  Price elasticity of Demand = 1.25
 Percentage change in quantity demanded = 50%  The price elasticity of demand is greater than 1.
Therefore, the demand is elastic.
41
Income Elasticity of Demand Practical Answer:
Step 1: Difference in income & difference in quantity Step 2: Average Price & Average Quantity Demanded
• R10 000 – R15 000 • (R10 000 + R15 000) ÷ 2
 Income Difference = R5 000  Average Income = R12 500
• 15 tickets – 10 tickets • (15 tickets + 10 tickets) ÷ 2
 Difference in Quantity Demanded = 5 tickets  Average Demand = 12.5 tickets
Step 3: % Change in Income & % Change in Quantity Step 4: Price Elasticity of Demand Formula
Demanded
• R5 000 ÷ R12 500 × 100
 PED =
 Percentage change in price = 40%
• 5 tickets ÷ 12.5 tickets × 40%  Price elasticity of Demand = 1
 Percentage change in quantity demanded = 50%  The price elasticity of demand is equal to1. Therefore,
the demand is unit elastic.
42
Practical Questions
1. Tea and Sugar are:
a) Substitutes
b) Substitutes in production
c) Complements
d) Complements in production
43
Practical Questions
2. If No Name Brand Rusks is a normal good, then a decrease in consumers’ income will cause:
a) An increase in the demand for milk
b) An increase in the supply of milk
c) A decrease in the demand for milk
d) A decrease in the supply of milk
44
Practical Answers
1. C
2. C
45

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COECA1-B11

Chapter 4: Price Elasticity

By Joshua van Houten

Price Elasticity of Demand and Price Elasticity Definitions:

Elastic Demand between 1 and ∞

Note: Refer to pages 93 in your textbook

Price Elasticity of Demand Classifications Represented Graphically:

Perfectly Inelastic Demand Unit Elastic Demand Perfectly Elastic

Question 1 Question 2 Question 3

• Average Price: $20 • Average Price: $12.5 • Average Price: $5

Elasticity Along a Linear Demand Curve

• Elasticity and slope are not the same. A linear demand

• Elasticity of demand is not the same as slope. And a

Elasticity Along a Linear Demand Curve Example 1 Answers:

1. The price elasticity of demand at an average price of $20 a

2. At the midpoint of a linear demand curve, the price elasticity

3. The price elasticity of demand at an average price of $5 a

The change in total revenue depends on the elasticity of demand:

• If a price cut increases total revenue demand is elastic.

The change in total revenue depends on the elasticity of demand in the

• If demand is elastic, a 1 percent price cut increases the quantity sold by

• If demand is unit elastic, a 1 percent price cut increases the quantity

• If demand is inelastic, a 1 percent price cut increases the quantity sold

• When demand is elastic, in the price range from $25 to $12.50, a

• When demand is unit elastic, at a price of $12.50 (part a), total

• When demand is inelastic, in the price range from $12.50 to zero, a

Income elasticity of demand is calculated by using the formula below:

Income elasticities fall into three interesting ranges:

• Positive and greater than 1 = normal good, income elastic

• Positive and less than 1 = normal good, income inelastic

• Negative = inferior good

A normal good is a luxury good, whereas inferior good is an essential good

Original Demand = 9 pizzas per hour

*Hint: follow the steps but replace price with income

Original Demand = 9 pizzas per hour

Original Price of Burgers = $1.50

New Demand = 11 pizzas per hour

New Price of Burgers = $2.50

Original Demand = 11 pizzas per hour

Original Price of a Cooldrinks = $0.60

New Demand = 9 pizzas per hour

New Price of a Cooldrink = $1.00

If you are asked to illustrate Cross

• We use a units-free measure—the elasticity of supply.

Interpreting the elasticity of Supply Result:

• If the elasticity of supply is greater than 1, we say that supply is elastic.

• if the elasticity of supply is less than 1, we say that supply is inelastic.

Original Supply = 10 pizzas per hour

Original Price of a Pizza = $20

New Supply = 20 pizzas per hour

New Price of a Pizza = $21

*Hint: follow the steps and use the supply of pizzas

1. Resource substitution possibilities

2. Time Frame for the Supply Decision

a) An increase in the demand for milk

b) An increase in the supply of milk

c) A decrease in the demand for milk

d) A decrease in the supply of milk

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