Elasticity

PR409

Namal Bandaranayake
Learning Objectives

By the end of this session you would be able

to…
 Define, calculate, and explain the factors
that influence the price elasticity of
demand
 Describe other types of elasticity
 How do people react
when price of petrol
goes up?

 Do people react the

same way if price of
carrots go up?
 How Change in Supply
Changes Price and Quantity

Large Fall in Small Increase in Small Fall in Large Increase in

Price Quantity Price Quantity
Responsiveness of Quantity
Demanded to Price
Price Increase Quantity Demanded Decrease

 By how much?
 Should be comparable across different product
categories
 Price increase in cars may be in hundreds of thousands
rupees
 Price increase in vegetables may be in tens of rupees
 The measurement should be independent of units
Elasticity: A Units-Free Measure

Percentage change
Price elasticity of in quantity demanded
=
demand
Percentage change in
price
% Q

%P
Calculating the
Elasticity of Demand
Original
Price (dollars per chip)

point (P1, Q1)

410

ΔP= 20

400
Pave =
$400 New
point (P1, Q1)
Qave = 40
390
Da
ΔQ= 8
36 40 44
Quantity (millions of chips per year)
 Calculating Elasticity
Percentage change in quantity demanded
Price elasticity of demand =
Percentage change in price

% Q Q / Qave
 
% P P / Pave
(Q2 - Q1)/(Q2+Q1)/2
=
(P2 - P1)/(P1+P2)/2
8 / 40
 = 4
20 / 400
Price Elasticity of Demand
 Price elasticity of demand is a
measure of the responsiveness of the
quantity demanded of a good to a
change in its price (ceteris paribus)
 Elastic Demand - means demand is
sensitive to price
 Inelastic Demand - means demand is
insensitive to price
 Calculating Elasticity

 Negative sign is ignored for convenience.

 The changes in price and quantity are
expressed as percentages of the average price
and average quantity between the two prices
and quantities being compared.
 Avoids having two values for the price elasticity of
demand
Inelastic and Elastic Demand
Perfectly Inelastic Demand
D1 Q / Qave

Price

P / Pave
Elasticity = 0

12
 Quantity demanded
remains constant
when price changes
occur
6
 E.g. Elasticity for life
saving drugs (insulin)

Quantity
Inelastic and Elastic Demand
Perfectly Elastic Demand

Q / Qave
Price


Elasticity = ∞ P / Pave
12
 If price changes by any
percentage: quantity
demanded will fall to 0
 E.g. two shops / vending
6
machines selling
identical products side by
side. If the price of one is
lower the demand for
other will be zero
Quantity
Elasticity Along a Linear Curve
ELASTICITY OF DEMAND

30

25
B
Price (dollars per pizza)

20 A
12.5
15
C
10

5
25
0
0 10 20 Quantity (pizzas
30 per hour) 40 50 60

Calculate the Elasticity When

 At mid point (A) : when price changes from $15 to $10 and quantity demanded increases from 20
to 30
 Above mid point (B): When the price falls from $25 to $15 a pizza, the quantity demanded
increases from zero to 20
 Below mid point (C) : When the price falls from $10 to $0, the quantity demanded increases from
30 to 50
 Elasticity and Total Revenue

Inelastic Demand Elastic Demand

 Calculate Revenue at Point A  Calculate Revenue at Point A
 Calculate Revenue at Point B  Calculate Revenue at Point B

 Revenue @ A = $4 x 10 = $40 Million  Revenue @ A = $1000x1 = $1000 Million

 Revenue @ B = $2 x 15 = $30 Million  Revenue @ B = $500 x 3 = $1500 Million
Elasticity and Total Revenue

 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 inelastic, a 1 percent
price cut increases the quantity sold
by less than 1 percent and total
revenue decreases.
 If demand is unit elastic, a 1 percent
price cut increases the quantity sold
by 1 percent and total revenue does
not change
Elasticity and Total Revenue

 If a price cut increases total

revenue, demand is elastic
 If a price cut decreases total
revenue, demand is inelastic
 If a price cut leaves total
revenue unchanged demand is
unit elastic.
Inelastic and Elastic Demand
D3
Price

Elasticity = 1

12

Unit Elasticity
6

1 2 3 Quantity
 How do people react
when price of petrol
goes up?
Is the demand elastic or
inelastic?

 Do people react the

same way if price of
carrots go up?
Is the demand elastic or
inelastic?
The Factors that Influence the
Price Elasticity of Demand

 The closer the substitutes for a

good, the more elastic is demand.
 The higher the proportion of
income spent on a good, the more
elastic is demand.
 The greater the time elapsed since
a price change, the more elastic is
demand.
Price Elasticities of Demand
Other Commonly Used
Elasticities
 Income Elasticity of Demand
 Cross Price Elasticity of Demand
 Price Elasticity of Supply
Necessities and Luxuries
Income Elasticity of Demand for
Food
 In countries with high
income the income
elasticity of demand for
food is low
 As income increases, the
income elasticity of
demand for food
decreases
 Low-income consumers
spend a larger
percentage of any
increase in income on
food than do high-income
consumers
Exercise 1

 One of the gas stations in your town

begins selling gas at 5% below the
price of every other station. As a
result, you increase your purchase of
gas at that station by 25%. What is
your price elasticity of demand for
gas from this station? Is this demand
elastic or inelastic?
Exercise 2

Your price elasticity of demand for

bananas is 4. If the price of
bananas rises by 5 percent, what
is
 The percentage change in the
quantity of bananas you buy?
 The change in your expenditure on
bananas?
Exercise 3

 The world demand for crude oil is

estimated to have a short-run price
elasticity of 0.05. If the initial price of oil
were $100 per barrel, what would be the
effect on oil price and quantity of an
embargo that curbed world oil supply by 5
percent? (For this problem, assume that the
oil supply curve is completely inelastic.)