Elasticity

Microeconomics
Objectives

By the end of the topic students should be

able to understand
Application of demand and supply.
 Define elasticity and explain elasticity of
demand.
The numerical interpretation of the
elasticity of demand.
Elasticity

Elasticity is a general
concept that can be used to
quantify the response in one
variable when another variable
changes.
% ∆A
e la s tic ity o f A w ith re s p e c t to B =
% ∆B
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?
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
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
Price Elasticity of Demand

To calculate the price elasticity of demand:

We express the change in price as a
percentage of the average price—the average
of the initial and new price,
and we express the change in the quantity
demanded as a percentage of the average
quantity demanded—the average of the initial
and new quantity.
Price Elasticity of Demand
Figure 4.2 calculates the price elasticity of
demand for pizza.
The price initially is $20.50 and the quantity
demanded is 9 pizzas an hour.
Price Elasticity of Demand
The price falls to $19.50 and the quantity
demanded increases to 11 pizzas an hour.
The price falls by $1
and the quantity
demanded increases
by 2 pizzas an hour.
Price Elasticity of Demand
The average price is $20 and the average
quantity demanded is 10 pizzas an hour.
Price Elasticity of Demand
The percentage change in quantity demanded,
%∆Q, is calculated as ∆Q/Q ave, which is 2/10 = 1/5.
The percentage change in price, %∆P, is calculated
as ∆P/Pave, which is $1/$20 = 1/20.
Price Elasticity of Demand

The price elasticity of

demand is
%∆Q/ %∆P = (1/5)/
(1/20)
 = 20/5
 = 4.
 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)
Price Elasticity of Demand

A popular measure of elasticity is price

elasticity of demand measures how
responsive consumers are to changes in
the price of a product.

% c h a n g e in q u a n tity d e m a n d e d
p ric e e la s tic ity o f d e m a n d =
% c h a n g e in p ric e

• The value of demand elasticity is

always negative, but it is stated in
absolute terms.
Calculating Elasticities

Calculating percentage changes:

P2 − P1
% c h a n g e in p ric e = x 100%
P1

Q2 − Q
% c h a n g e in q u a n tity d e m a n d e d = 1
x 100%
Q1
Activity: Calculate the Elasticity of beans

Price of baked beans Market demand per

per tin week

40 pence 1000
30 pence 1500
 Figure 1: Calculating Price Elasticity of Demand
-- laptop computer demand
Price per
Laptop
D
$3,500
C
3,000
2,500
2,000
B
1,500
A
1,000
D

100,000 200,000 300,000 400,000 500,000 600,000 Quantity of

Laptops
 Calculating Price Elasticity of Demand
-- An Example

 Now let’s calculate an elasticity of demand for laptop

computers using data in Figure 1 from point A to point B
(500,000 − 600,000) − 100,000
%∆ Q = = = − 0.182, or − 18.2 %
 (500,000 + 600,000)  550,000
 2 
($1,500 − $1,000) $500
% ∆P = = = 0.400, or 40.0 %
 ($1,500 + $1,000)  $1,250
 2 
• Use percentage changes for price and quantity to
calculate price elasticity of demand (η D )
− 0.182
η D
=
0.400
= −0.46
Calculating Elasticities

Elasticity is a ratio of
percentages.
• Using the values on the
graph to compute
elasticity, using
percentage changes
yields the following
result:
+ 100%
p ric e e la s tic ity o f d e m a n d = = − 3 .0
− 3 3 .3 %
Calculating Elasticities

 A more accurate way of

computing elasticity than
percentage changes is the
midpoint formula:
Q2 − Q1
x 100%
% ∆Qd (Q 1 + Q 2 ) / 2
=
% ∆P P2 − P1
x 100%
( P1 + P2 ) / 2

10 − 5 5
x 100% x 100%
% ∆Qd (5 + 1 0 ) / 2 6 6 .7 %
= = 7 .5 = = − 1 .6 7
% ∆P 2 − 3 -1 - 4 0 .0 %
x 100% x 100%
(3 + 2 ) / 2 2 .5
Calculating Elasticities

Here is how to interpret two different values

of elasticity:
When ε = 0.2, a 10% increase in price
leads to a 2% decrease in quantity
demanded.
When ε = 2.0, a 10% increase in price
leads to a 20% decrease in quantity
demanded.
 10
| ED | > 1 As P increases, Q falls,
PRICE
elastic elasticity gets bigger

| ED | = 1
6
Unit elastic
5
| ED | < 1
4
inelastic

QUANTITY
0
0 10 20 25 30 40 50
Slope and Elasticity

The value of the slope of the

demand curve and the value of
elasticity are not the same.
Unlike the value of the slope, the
value of elasticity is a useful
measure of responsiveness.
Slope and Elasticity
2−3 1 2−3 1
slope = =− slope = =−
10 − 5 5 160 − 80 80

 Changing the units of measure yields a very

different value of the slope, yet the behavior of
buyers in both diagrams is identical.
Elasticity Changes along a
Straight-Line Demand Curve
− 6.4 Along the elastic
range, elasticity
values are greater
than one.
− .29 • Along the inelastic
range, elasticity
values are less than
one.
Types of Elasticity

Hypothetical Demand Elasticities for Four Products

%
% CHANGE IN
CHANGE
QUANTITY ELASTICITY
IN PRICE
PRODUCT DEMANDED (%∆QD) (%∆QD  %∆P)
(%∆P)
Insulin +10% 0% 0.0 Perfectly
inelastic
Basic telephone +10% -1% -0.1 Inelastic
service
Beef +10% -10% -1.0 Unitarily elastic
Bananas +10% -30% -3.0 Elastic
Price Elasticity of Demand
-- Categorize Goods
Inelastic Demand
Price elasticity of demand between 0 and -1
% ∆Q
Inelastic Demand ⇒ < 1.0
%∆P
|% Change in Quantity Demanded| < |% Change in Price|

• Extreme Case: Perfectly Inelastic Demand

– Price elasticity of demand equal to 0
Price Elasticity of Demand
Elasticity Along
a Straight-Line
Demand Curve
Figure 4.4
shows how
demand
becomes less
elastic as the
price falls along
a linear demand
curve.
Price Elasticity of Demand
At prices above the mid-point of the
demand curve, demand is elastic.

At prices below the

mid-point of the
demand curve,
demand is inelastic.
Price Elasticity of
For example, if the
Demand
price falls from $25
to $15, the quantity
demanded
increases from 0 to
20 pizzas an hour.
The average price
is $20 and the
average quantity
is 10 pizzas.
The price elasticity
of demand is
(20/10)/(10/20),
which equals 4.
Price Elasticity of Demand
If the price falls
from
$10 to $0, the
quantity demanded
increases from 30
to 50 pizzas an
hour.
The average price
is $5 and the
average quantity is
40 pizzas.
The price elasticity
is (20/40)/(10/5),
which equals 1/4.
Price Elasticity of Demand
If the price falls
from
$15 to $10, the
quantity
demanded
increases from 20
to 30 pizzas an
hour.
The average price
is $12.50 and the
average quantity is
25 pizzas.
The price elasticity
is (10/25)/(5/12.5),
which equals 1.
Categorizing Goods by Elasticity

• Elastic Demand
– Price elasticity of demand with absolute value > 1
% ∆Q
Elastic Demand ⇒ >1
%∆ P
|% Change in Quantity Demanded| > |% Change in Price|

• Extreme Case: Perfectly (infinitely) Elastic Demand

– Price elasticity of demand approaching minus infinity
• Another Special Case: Unitary Elastic Demand
– Price elasticity of demand equal to -1
Pricing strategies for substitutes:
If a competitor cuts the price of a rival product,
firms use estimates of cross-price elasticity to
predict the effect on the quantity demanded and
total revenue of their own product. For example,
two or more airlines competing with each other
on a given route will have to consider how one
airline might react to its competitor’s price
change. Will many consumers switch? Will they
have the capacity to meet an expected rise in
demand? Will the other firm match a price rise?
Will it follow a price fall?
Pricing strategies for complementary goods:

For example, popcorn, soft drinks and cinema

tickets have a high negative value for cross
elasticity– they are strong complements.
Popcorn has a high mark up i.e. pop corn costs
pennies to make but sells for more than a
pound. If firms have a reliable estimate for C ped
they can estimate the effect, say, of a two-for-
one cinema ticket offer on the demand for
popcorn. The additional profit from extra popcorn
sales may more than compensate for the lower
cost of entry into the cinema.
Advertising and marketing:
 In highly competitive markets where brand names carry
substantial value, many businesses spend huge
amounts of money every year on persuasive
advertising and marketing. There are many aims behind
this, including attempting to shift out the demand curve
for a product (or product range) and also build
consumer loyalty to a brand. When consumers become
habitual purchasers of a product, the cross price
elasticity of demand against rival products will decrease.
This reduces the size of the substitution effect
following a price change and makes demand less
sensitive to price. The result is that firms may be able to
charge a higher price, increase their total revenue and
turn consumer surplus into higher profit.
income elasticity of demand

Income elasticity of demand measures

the relationship between a change in
quantity demanded for good X and a
change in real income.
The formula for calculating income
elasticity: % change in demand divided by
the % change in income
Normal necessities vs Luxuries
 Normal necessities have an income elasticity of
demand of between 0 and +1 for example, if income
increases by 10% and the demand for fresh fruit
increases by 4% then the income elasticity is +0.4.
Demand is rising less than proportionately to income.
 Luxuries have an income elasticity of demand > +1 i.e.
the demand rises more than proportionate to a change in
income – for example a 8% increase in income might
lead to a 16% rise in the demand for restaurant meals.
The income elasticity of demand in this example is +2.0.
Demand is highly sensitive to (increases or decreases
in) income.
Inferior Goods

Inferior goods have a negative income

elasticity of demand. Demand falls as
income rises. Typically inferior goods or
services tend to be products where there
are superior goods available if the
consumer has the money to be able to
buy it. Examples include the demand for
cigarettes, low-priced own label foods in
supermarkets and the demand for council-
owned properties.
 Figure 2: Extreme Cases of Demand

(a) (b)
Price Price
per per
Unit Unit
D
$4 $4
Perfectly Elastic
3 3 Demand
Perfectly Inelastic
Demand
2 2 D

1 1

20 40 60 80 100 20 40 60 80 100
Quantity Quantity
What Affects Elasticity?
-- 1. Availability of Substitutes

Demand is more elastic

If close substitutes are easy to find and buyers
can cut back on purchases of the good in
question
Demand is less elastic
If close substitutes are difficult to find and
buyers can not cut back on purchases of the
good in question
What Affects Elasticity?
-- 3.Necessities vs. Luxuries

The more “necessary” we regard an item,

the harder it is to find a substitute
Expect it to be less price elastic
The less “necessary” (luxurious) we
regard an item, the easier it can be
substituted
Expect it to be more price elastic
Example?
What Affects Elasticity?
-- 4. Time Horizon
Short-run elasticity
 Measured a short time after a price change
Long-run elasticity
 Measured a year or more after a price change
Usually easier to find substitutes for an item in
the long run than in the short run
 Therefore, demand tends to be more elastic in the long
run than in the short run
What Affects Elasticity?
-- 5. Importance in the Buyer’s Budget

The more of their total budgets that

households spend on an item
The more elastic is demand for that item
The less of their total budgets that
households spend on an item
The less elastic is demand for that item
 Figure 6 Some Short-Run Price Elasticities of
Demand elastic

S p e c ific B r a n d s N a r r o w C a te g o r ie s B r o a d C a te g o r ie s

T id e D e te r g e n t – 2 .7 9 T r a n s a t la n t ic A ir T r a v e l – 1 .3 0 R e c r e a tio n – 1 .0 9
T o u r is m in T h a ila n d – 1 .2 0
P epsi – 2 .0 8 G ro u n d B e e f – 1 .0 2 C lo th in g – 0 .8 9
C oke – 1 .7 1 P o rk – 0 .7 8 Food – 0 .6 7
M ilk – 0 .5 4 Im p o rts – 0 .5 8
C ig a r e t te s – 0 .4 5 T r a n s p o r ta tio n – 0 .5 6
E le c tr ic ity – 0 .4 0 to – 0 .5 0
Beer – 0 .2 6
Eggs – 0 .2 6
G a s o lin e – 0 .2 0
O il – 0 .1 5

inelastic