Elasticity Concepts

➢Price Elasticity of Demand

➢Income Elasticity
➢Cross-Price Elasticity
➢Price elasticity of Supply
 The Elasticity Concept
• Elasticity is a measure of responsiveness of
one variable to another variable.
• Also defined as the percentage change in a
dependent variable resulting from a % change
in an independent variable.
Elasticity as a measure of
responsiveness
◼ The “law of demand” tells us that
as the price of a good increases the
quantity that will be bought
decreases but does not tell us by
how much.
◼ “If you change price by 5%, by
what percent will the quantity
purchased change?
 Elasticity Coefficient

◼ ep, h, e are common symbols used to

represent price elasticity
◼ Ei is used to represent income elasticity
◼ Exy is for cross elasticity
 Elasticity Coefficient
▪ Elasticity Coefficient = %Change in Qdx
% Change in V

▪ Price elasticity = %Change in Qdx

% Change in the price of X
▪ Income elasticity = %Change in Qdx
% Change in income
▪ Cross elasticity = %Change in Qdx
% Change in the price of Y
 Two Measurements of Elasticity

• Point Elasticity – elasticity at a given point on a

function. Point for small scale (marginal)
changes.
• Arc Elasticity – average elasticity over a given
range of a function. Arc for large scale changes.
Calculating Price Elasticity of Demand From
Two Points on a Demand Curve

◼ The midpoint formula is preferable

when calculating the price elasticity of
demand because it gives the same
answer regardless of the direction of
the change.
(Q2 - Q1) / [(Q2 + Q1) / 2]
Price elasticity of demand =
(P2 - P1) / [(P2 + P1) / 2]
 % change in quantity demanded
ep

% change in price
%DQ At a point on a demand function this can be
or, ep  calculated by:
%DP
Q
Q22 -
-QQ11 = D Q DQ
Q1 Q1
ep = =
P2 P-2 P
-1 P=1 D P DP
P1 P1
Calculating Price Elasticity of Demand From
Two Points on a Demand Curve

·Point A: Price = P4 Quantity = 120

·Point B: Price = P6 Quantity = 80

◼ From Point A to Point B: Price rise = 50% and

Quantity fall = -33%
◼ From Point B to Point A: Price fall = -33% and
Quantity rise = 50%

(80 - 120) / [(80 + 120)/ 2]

Price elasticity of demand =
(6 - 4) / [(6 + 4)/ 2]

Mid point method = 1

 An easier way! By rearranging terms
DQ this is a point on
DQ P1 DQ P1 the demand
ep = Q1
DQ
P1
=
Q1 * D P
= * function
DP Q1
P1 this is the
slope of the
Given that when: demand function
P1 = $7, Q1 = 3
DQ P71
P2 = $5, Q2= 5 ep = -1
DP
* Q
31
= -2.33
P2- P1 = 5 - 7 = D P = -2
P1 = $7, Q1 = 3
Q2 - Q1 = 5 - 3 = D Q = +2
On linear demand functions the
Then, slope remains constant so you
DQ +2 just put in P and Q
= = -1
DP -2
This is the slope of the demand Q = f(P)
 An application of price elasticity.
The price elasticity of demand for milk is estimated between -.35 and -.5.
Using -.5 as a reasonable figure, there are several important observations that
can be made.
%DQ
What effect does a
Since ep = -.5
ep 
10% increase in the Pmilk %DP
have on the quantity that
individuals are willing to buy?
To solve for % D Q
%DQ
Multiply both sides by +10% -5%(-.5
(+10%)x = p e
) =% D Q x (+10%)
A 10% increase in the price of milk would % +10%
DP
reduce the quantity demanded by about Pmilk
5%.
P2
If price were decreased by 5%, what +10%
P1
would be the effect on quantity Dmilk
demanded? A 10% increase -5%
in P reduces Q
by 5% Q2 Q1 Qmilk
 %DQ
ep  The price elasticity of demand is a measure of
%DP the % D Q that will be “caused” by a % D P.

If the price elasticity of demand for air travel was estimated at -2.5, what
effect would a 5% decrease in price have on quantity demanded ?
%DQ
-2.5 = = +12.5% change in quantity demanded
% DP
- 5%

If the price elasticity of demand for wine was estimated at -.8, what
effect would a 6% increase in price have on quantity demanded ?

%DQ
-.8 = = -4.8% decrease in quantity demanded
%+6%
DP
 Price Elasticities of Selected Goods
(Wall Street Journal)
• Apples (US) = -1.159
• Lettuce (US) = -2.58
• 1% Milk (US) = -0.50
• Cheese (UK) = -1.36
• Cheese (US) = -0.595 Do these
make sense given
• Meat (China) = -0.06 the factors that
influence price
• Beer (US) = -2.83 elasticity?

• Childcare (US) = -0.57

Suppose Price Rises 10% What will be the
Response?
Rank from 1 (most inelastic good) to 10
(most elastic good)
Good Rank Good Rank
Legal Services Motor Vehicles
Electricity Restaurant Meals
Movies Food
Lamb Beer
Bread Gasoline
Suppose Price Rises 10% What will be the
Response?
Rank from 1 (most inelastic good) to 10
(most elastic good)
Good Rank Good Rank
Legal Services 4 Motor Vehicles 8
Electricity 2 Restaurant Meals 9
Movies 6 Food 1
Lamb 10 Beer 7
Bread 3 Gasoline 5
 Categorizing Elasticity of Demand as
Elastic or Inelastic
• Perfectly Inelastic
– Quantity demanded does not respond to price
changes.
• Infinitely Elastic
– Quantity demanded changes infinitely with any
change in price.
• Unitary Elastic
– Quantity demanded changes by the same
percentage as the price.
Categorizing Elasticity of Demand as Elastic
or Inelastic
◼ Inelastic Demand
➢ Quantity demanded does not respond
strongly to price changes.
➢ Price elasticity of demand is less than
one.
◼ Elastic Demand
➢ Quantity demanded responds
strongly to changes in price.
➢ Price elasticity of demand is greater
than one.
 Figure 1: Perfectly Inelastic Demand

Price
Demand
E=0

P5.00

P4.00
1. An increase
in price…

0 100 Quantity

2. …leaves the quantity demanded unchanged.

 Figure 1: Infinitely or Perfectly Elastic Supply

We say that supply

is perfectly or Price
infinitely elastic
when a 1% change
in the price would
result in an infinite Perfectly Elastic
change in quantity Supply (elasticity
supplied. = )

Quantity
 Figure 2: Relatively Inelastic Demand

Price
Demand E<1

P5.00

P4.00

1. A 22%
increase in
price…

0 90 100 Quantity

2. … Leads to a 11% decrease in quantity demanded.

 Figure 3: Unit Elastic Demand

Price E=1
Demand

P5.00

P4.00
1. A 22%
increase in
price…

0 80 100 Quantity

2. … Leads to a 22% decrease in quantity demanded.

 Figure 4: Relatively Elastic Demand

Price E>1
Demand

P5.00

P4.00
1. A 22%
increase in
price…

0 50 100 Quantity

2. … Leads to a 67% decrease in quantity demanded.

 Figure 5: Perfectly Elastic Demand

Price

1. At any price above P4,

quantity demanded is zero.

P4.00 Demand
2. At exactly $4, consumers
will buy any quantity.

3. At any price below P4,

quantity demanded is infinite.
0
Quantity
 Perfectly Inelastic Supply

We say that supply

is perfectly
Price
inelastic when a
1% change in the
price would result
in no change in
quantity supplied. Perfectly
Inelastic Supply
(elasticity = 0)

Quantity
 Price Elasticity and Revenues
Price elasticity [Ep] is related to revenue
“How will a change in price effect the total
revenue?” is an important question.
TR = P x Q
Elastic Demand (|ep|>1): %DQ>%DP
❑ for a price increase, revenue decreases
❑ for a price decrease, revenue increases
Unitary Demand (|ep|=1): % DQ=%DP
❑ no change in revenue
Inelastic Demand (|ep|<1): % DQ<%DP
❑ for a price increase, revenue increases
❑ for a price decrease, revenue decreases
Determinants of Price
Elasticity
◼ Availability of substitutes
Greater availability of substitutes makes a
good relatively more elastic (Ep > 1).
– Necessity versus luxury
– Broadly-defined versus narrowly-defined goods

◼ Portion of the expenditures on the good

to the total budget
Lower portion tends to decrease relative
elasticity (Ep < 1).
.
◼ Time to adjust to the price changes

Longer time period means there are

more adjustment possible and
increases relative elasticity
(Ep > 1).
 Income Elasticity
[normal goods] Income elasticity is a measure of the change in
demand [a “shift” of the demand function] that is
“caused” by a change in income.
% D Qx
ey  The increase in income, DY, increases demand
% DY to D2. The increase in demand results in a
[Where Y = income] larger quantity being purchased at the
same Price [P1]..
P Due to increase
For a “normal good” an increase in income,
in income to Y2 will “shift” the
demand
demand to the right. This is an increases
increase in demand to D2. P1 D2
% D Y > 0; % D Q> 0; D
therefore,
ey >0 [it is positive] Q1 Q2 Q/ut

.
When income elasticity is positive, the good is considered
a “normal good.”
For both increases
The greater the value of Ey, and decreases in
the more responsive buyers income, Ey is positive
are to a change in their incomes.
+-
%%D%
DQDxxQx
+ e
Q
Eeyy  %DY
+- %%D YD Y
When the value of Ey is greater than 1, it is called a “superior good.”

The |% D Qx| is greater than the |% D Y|.

Buyers are very responsive to changes in Ey  % D Qx
income. Sometimes “superior goods” are %DY
called “luxury goods.”

. .
Income Elasticity
[inferior goods]

There is another classification of goods where changes in income

shift the demand function in the “opposite” direction.
An increase in income [+DY] reduces demand.
-%%DQ
DQ x

eyy =
x
An increase in income reduces -E %+DY
DY
the amount that individuals P
are willing to buy at each price
of the good. Income elasticity
decreases
is negative: - Ey demand
P1
The greater the absolute value
of - Ey, the more responsive buyers D1
- %DQ x
D2
are to changes in income

Q2 Q1 Q/ut
.
.
Income Elasticity
[inferior goods]

Decreases in income increase the demand for inferior goods.

A decrease in income [-DY] increases demand.

+%DQ
% D Q
A decrease in income [-D Y]
results in an increase in demand, P - Eey y  xx

%DY
the income elasticity of demand -DY
is negative

For both increases and decreases in

P1 D2
income the income elasticity is negative
for inferior goods. The greater the D1
absolute value of ey, the more responsive
+%DQ x

buyers are to changes in income

Q1 Q2 Q/ut
. .
Income Elasticity (eI) Interpretation
• Value of eI determines type of good.
• Sign indicates normal or inferior
+eI implies normal good.
- eI implies inferior good.
• Normal goods may be necessity
(noncyclical) or luxury (cyclical).
– If eI >1 then luxury (responsive to
income).
– If eI < 1 then necessity (unresponsive to
income).
 Examples of Ey
◼ normal goods, [0 < ey < 1 ],
(between 0 and 1)
coffee, beef, Coca-Cola, food, Physicians’
services, hamburgers, . . .

◼ Superior goods, [ ey > 1], (greater

than 1)
movie tickets, foreign travel, wine, new
cars, . . .
◼ Inferior goods, [ey < 0], (negative)
Noodles, ordinary bus service, sardines. .
.
Cross-price elasticity of demand , [Exy]
[substitutes]

When the price of pork increases, it will tend to increase the

demand for beef. People will substitute beef, which is
relatively cheaper, for pork, which is relatively more
expensive.
When beef is $2, Qb beef
[price of pork]

When pork is $1.50, Qp pork

[price of beef]
is purchased. Pb is purchased.
Pp price of pork increases at Pb = $2 more
increase beef will be bought
The quantity demanded
demand to substitute for
2 of pork decreases.
2 the smaller
for an increase quantity of
1.50
in Ppork, pork.
Dp
demand for
beef increases
Db Db ’
-DQp

Qp’ Qp pork/ut Qb Qb’ beef/ut

.
Cross-price elasticity of demand , [exy]
[substitutes]

The cross elasticity of the demand for beef with respect to the
price of pork, ebeef-pork or ebp can be calculated:
+Q
%D DQ
ofb beef An increase in the price of pork,
+ebp
ebp = “causes” an increase in the demand
positive %DP+of
DPpork
p for beef.
cross elasticity is positive

%D -Q Dof
Qbeef
b A decrease in the price of pork,
+eebpbp = “causes” a decrease in the demand
positive %DP of pork for beef.
- DPp
If goods are substitutes, exy will be positive. The greater the
coefficient, the more likely they are good substitutes.
Cross-price elasticity of demand , [exy]
[compliments]
as more crayons are
purchased, the
demand for colour
Pc a decrease in the price
Pc books increases.
increase
of crayons, demand At the same
P1 price a larger
$3 quantity will
-DPc Dp be bought
Po
Dc Dc’
Q1 Q2 crayons 2000 2500 colour books
increases the quantity demanded + DQb
of crayons
DQ for complements, the cross
- ebc %D+ Q ofbb
ebc =
negative
elasticity is negative for price
increase or decrease.
-
%DP of c
DPc
 Cross-Price Elasticity
Interpretation
◼ Exy > 0 [positive], suggests substitutes,
the higher the coefficient the better the
substitute
◼ Exy < 0 [negative], suggests the goods
are complements, the greater the
absolute value the more
complementary the goods are
◼ Exy = 0, suggests the goods are not
related
➢ exy can be used to define markets in
legal proceedings
Elasticity of Supply

◼ Elasticity of supply is a
measure of how responsive
sellers are to changes in the
price of the good.
◼ Elasticity of supply [ep] is
defined:
% D Quantity Supplied
e =
s
% D price
Elasticity of supply
%DQsupplied
es =
%DP
Given a supply function, at a price [P1], Q1 is produced and offered
for sale.
P At a higher price [P2], a larger
quantity, Q2, will be produced
and offered for sale.

P2 The increase in price [ DP ], induces

+DP a larger quantity goods [ DQ]for
P1 sale.
The more responsive sellers are to
DP, the greater the absolute value of es.
+DQ
[The supply function is “flatter”or
Q1 Q2 Q /ut more elastic]
The supply function is a P
model of sellers behavior.
Si a perfectly inelastic
supply, es = 0
Sellers behavior is influenced by:
1. technology Se
2. prices of inputs
a perfectly
3. time for adjustment elastic supply
market period
short run
[es is undefined.]
long run
very long run
Q /ut
4. expectations
5. anything that influences costs of production
taxes
regulations, . . .