ECO0006 Economics for Managers: Lecture 2

Elasticity of Demand: Price, Income & Cross Elasticity of Demand

Price Elasticity of Demand (PED) =

________________________________________________________
________________________________________________________
(PED) = % Change in Qty Demanded =
% Change in Price

Price Elasticity: Demand is price elastic (consumers are sensitive to

PRICE changes)
Find the PED if a rise in the price of
chocolates from $0.90 to $1.10 causes
quantity demanded to fall from 105 to 55.

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Factors that result in elastic demand (with respect to price):
1) High share of budget spent on product
2) Many substitutes
3) More time to find substitutes

Demand is price inelastic: Consumers are NOT sensitive to PRICE

changes

Find the PED if a rise in the price of

chocolates from $0.90 to $1.10 causes
quantity demanded to fall from 105 to 95.

Factors that result in inelastic demand (with respect to price):

1) Low share of budget spent on product
2) Few substitutes
3) No time to find substitutes

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Fast facts
• Formula for PED = %  Q =  Q/Q = Q2-Q1 ÷ P2-P1 OR
%  P  P/P Q1 P1

= Q2-Q1 ÷ P2-P1
Q1+Q2 P1+P2
• PED is always negative
• Price elastic: IPEDI >1
• Price inelastic: IPEDI < 1
• PED = ∞, demand is perfectly price elastic

• PED = 0, demand is perfectly price inelastic

• PED = 1, demand is unitary elastic

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 • Application: Predict effect of price changes on Total Revenue

If demand is price elastic:

1) A ________ in price causes a _______________________________

rise in quantity demanded and total revenue ________.

2) Price strategy is to ______________ price.

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If demand is price inelastic:

1) A ________ in price causes a ____________________________

fall in quantity demanded and total revenue _______.

2) Price strategy is to __________ price.

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Income Elasticity of Demand (YED)
________________________________________________________
________________________________________________________

= %  Q =  Q/Q = Q2-Q1 ÷ Y2-Y1 OR Q2-Q1 ÷ Y2-Y1

%  Y  Y/Y Q1 Y1 Q1+Q2 Y1+Y2

Income Demand for Bus

($) Rides (a week)
500 10
750 12

Income Demand for Taxi

($) Rides (a week)
500 2
750 5

Income Demand for

($) “Dumb
phone”
500 100
750 50

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• YED > 0: ________ good 0 < YED < 1:___________ good;
YED > 1: ____________ good.
• A normal good:
______________________________________________________

• YED < 0: ________ good

• An inferior good:
______________________________________________________

• Application of YED: Predict changes in demand/improve

products/taxation

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Cross Elasticity of Demand (CED) =
________________________________________________________
________________________________________________________

CED = % Change in Quantity of Good A = QA2-QA1 ÷ PB2-PB1 OR

% Change in Price of Good B QA1 PB1

= QA2-QA1 ÷ PB2-PB1
QA1+QA2 PB1+PB2

Starbucks Vs Spinelli Coffee Bread & Nutella

Price of Demand for Price of Demand for

Starbucks Spinelli Coffee Bread Nutella
Coffee
$6 5 cups $5 1 bottle
$9 10 cups $2 2 bottles

Substitutes in demand:

CED for ____________with respect to ______________

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Complements in demand:

CED for ___________ with respect to __________

• Sign of CED indicates TYPE of relationship.

• Magnitude of CED indicates closeness of relationship.
Large magnitude:
______________________________________________________

Small magnitude:
______________________________________________________

Zero magnitude:
______________________________________________________

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Discussion Questions

1. According to a study of the price elasticities of products sold in

common supermarkets, the price elasticity of demand for
toothbrushes is estimated at -0.22. Which of the following could
most suitably explain why the price elasticity of demand for
toothbrushes is so low?

(A) Toothbrushes are heavily endorsed by dentists.

(B) The toothbrush industry is highly competitive.
(C) There are few close substitutes for toothbrushes.
(D) Toothbrushes are relatively cheap compared to other
goods sold in the supermarkets.

2. Which of the following group of people are likely to have the

highest price elasticity of demand for travel via the Mass Rapid
Transit (MRT)?

(A) Retirees who use it to travel to meet their friends for

coffee.
(B) Workers who can only reach their workplace via MRT.
(C) Business executives who work in the city central where car
parking charges are very high.
(D) High income earners.

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3. If a 4% decrease in price leads to an increase in the quantity
demanded of 8%:

(A) Supply is price elastic.

(B) Demand is income elastic.
(C) Price elasticity of demand is -2.
(D) Demand is price inelastic.

4. The demand for Nike running shoes is more price elastic than
the demand for running shoes as a whole. This is best explained
by:

(A) Nike running shoes are a luxury and not a necessity.

(B) Nike running shoes are the best made.
(C) There are more complements for Nike running shoes than
running shoes in general.
(D) There are more substitutes for Nike running shoes than
running shoes in general.

5. Air-conditioners and electricity are complementary goods and

have a cross elasticity demand of -2.5. If the government wants
to reduce electricity consumption by 5%, it should place a tax on
air-conditioners such that the unit price of air-conditioners:

(A) rise from $1000 to $1,200

(B) rise from $1000 to $1,020
(C) fall from $1,020 to $1,000
(D) fall from $1,200 to $1,000

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6 Suppose the demand schedule for soft toys is as follows:

Quantity
Price
Demanded
$8 40
$10 32
$12 24

(a) Use the point method to calculate the price elasticity of

demand for soft toys as the price of soft toys increases from
$8 to $10.

(b) The seller of Good X feels that the number of units sold for
Good X is somehow affected by the price of Good Y. By
experimenting with the price, he realises that when price of
Good Y is $50, he can sell 12,000 units of Good X. However,
when the price of Good Y becomes $60, he can now sell
10,000 units of Good X. Calculate the cross elasticity of
demand between Good X and Y. Analyse the effect on the
seller’s revenue when price of Good Y falls.

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7. You are given the following information for two goods Alpha
and Omega

Good Percentage Change in:

Price Quantity Income
Alpha 1.2 -3.3 2.2
Omega -2.1 1.82 4.68

(a) Calculate the price elasticity of demand for Good Alpha and
comment on your result.

(b) Calculate the cross elasticity of demand between Good

Alpha with respect to Good Omega and comment on your
result.

(c) Calculate the income elasticity of demand for Good Omega

and comment on your result.

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