Unit 4 Lecture : 9 and 10

ELASTICITY OF DEMAND

CONTENTS
Introduction
Objectives
Price Elasticity of Demand
Determinants of Demand Elasticity
Cross price elasticity
Income elasticity of demand
References

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Introduction:Elasticity of Demand
Example : Do people care about the price of
petrol?

▪ The effects of high

oil prices are felt
throughout the
economy.
Households attempt
to reallocate their
budgets and change
their consumption
patterns.
 Introduction
The law of demand states that the higher the price the lower
the quantity consumers will purchased. However, the response
of the quantity supply or demanded to changes in price is
unknown. Therefore, we tend to ask the question of how much
will the quantities demanded react to price? This question is
answered by elasticity. Elasticity is a concept that is used to
quantify the response in one variable when there is change in
another variable. Knowing the size and magnitude of this
reaction is very imperative.

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 OBJECTIVES
• At the end of this unit, you should be able to:

• define elasticity in relation to demand

• state different types of elasticity of demand
• calculate elasticity
• explain the determinants of demand elasticity.
 Demand and Price Elasticity
According to law of demand when prices rise, quantity
demanded is expected to fall ceteris paribus (all things
been equal). This shows that there is a negative
relationship between price and demand. The negative
relationship is replicated in the downward slope of the
demand curve. Though slope of a demand curve may
reflect the responsiveness of quantity demanded to price
change but is not a good measure of responsiveness.
 Price Elasticity
Price elasticity of demand can be described as
proportional or percentage change in quantity demanded
as a result of proportional or percentage change in that
commodity’s price.

How price elasticity is measured: Divide the percentage

change in the quantity demanded of a product by the
percentage change in the product’s price.
 The price elasticity of demand and its
measurement

▪ Note: The price elasticity of demand is not the same

as the slope of a demand curve.
 The price elasticity of demand is the percentage
change in quantity demanded divided by the
percentage change in price. Symbolically we may
write

Ed = % Q
% P
Q / Q Q P
Or Ed = or Ed = 
P / P P Q

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 Calculation of Percentage change in Quantity
Demanded

Let assume that quantity demanded of chicken increased from

6kg (Q0) to 12kg (Q1) due to decrease in price from $10 to
$7. To calculate the percentage change in quantity demanded
using the above formula, we have:
 Calculation of Percentage change in Price

Percentage change in price can also be calculate using a

similar formula as shown above using the Chicken change in
price from $10 (P0) to $7 (P1) as an example:
 Computing the Price Elasticity of Demand
From the above calculation on Chicken:
• % change in quantity demanded is 100%
• % change in price is 42.89 percent (42.89 will carry a
minus sign due to decrease in price) .
Hence we have

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 The Midpoint Method: A Better Way to Calculate
Percentage Changes and Elasticities

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. Using the midpoint formula to calculate
percentage change has been recommended by Case
and Fair (1999).

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 Midpoint formula
Midpoint formula describes more accurately the
percentage change. It can be define as a way of
calculating percentage change in demand and price
using the halfway values between Q1 and Q2 and P1
and P2.
 Midpoint formula - Example
% change in quantity
demanded

% change in price
 Example
Now that we know that:
% change in quantity demanded = 66.7%
% change in price = -35.3%

Price elasticity of demand

 Calculate price elasticity of demand with
extreme cases
Introduction : The price elasticity of demand
coefficient can range from a value of zero to a value
that is infinitely large, but economists typically divide
elasticity coefficients into three broad categories:
Elastic demand:
When Ed > 1 means that a 1 percent change in price
calls forth more than a 1 percent change in quantity
demanded, the good has price-elastic demand. Example
: luxury goods.

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• Inelastic demand:
When Ed < 1 means that a 1 percent change in price
evokes less than a 1 percent change in quantity
demanded, the good has price inelastic demand.
Example : necessary goods
• Unitary elastic
When Ed = 1 means that the percentage change in
quantity demanded is exactly the same as the percentage
change in price, the good has unit elastic demand.
For instance, if 5 per cent increase in price of petrol
drives down the quantity of petrol demanded by 5 per
cent. Then elasticity is calculated as follow:

-5 / 5 = -1
Summary of the price elasticities of demand
Perfectly Elastic Demand

Perfectly elastic demand occurs when the quantity

demanded dropped to zero with a little price change. This
usually occurs when producers can only sell their product at
a market predetermined price. Any attempt to increase the
price by a small amount will drive quantity demanded to
zero because consumers can easily buy from other producers
who complied with the market regulated price.
• Example:
If the price of a bushel of wheat is fixed in the world
market at $40, any attempt by Russian government to
raise its own price by $1 may lead to zero demand for
Wheat from Russia as consumers can get from other
suppliers in the world market. Perfect elastic demand
curve is a horizontal line (because producers can only
sell at a fixed price).
Perfectly In- elastic Demand
This is a case where quantity demanded does not
respond to increase in price i.e. the percentage change in
quantity demanded is zero then the elasticity of such
commodity is also zero. For instance if quantity
demanded of needle remain the same despite changes in
price then the demand curve for needle will be a vertical
line. Then we say needle has inelastic demand.
Therefore perfectly inelastic demand is a demand
wherein quantity demanded does not respond at all
to price change.
For example if 20 percent increase in price of needle
occurred but the quantity demanded remains the same i.e.
there is no responsiveness at all to change in price. Then the
elasticity of needle will be:
0 / 20 = 0
Figure : Perfectly elastic and inelastic
 Measuring elasticity of demand – Problem

A study conducted by the Australian Medical

Association suggests that every 10 per cent
increase in the price of cigarettes is associated
with a 5 per cent decrease in the quantity of
cigarettes demanded.
a) Use the figures from this study to calculate
the price elasticity of demand for cigarettes.
b) On the basis of your findings, does this suggest
that increasing the price of cigarettes will
substantially decrease smoking.
Measuring elasticity of demand : Solving the
problem
Answer (a) : using the following formula:
Measuring elasticity of demand : Solving the
problem

Insert the percentage changes from the question into the

formula:

0.05
Elasticity = = 0.5
0.10
Measuring elasticity of demand : Solving
the problem
Answer (b) on the basis of the answer to (a).

We find that price elasticity of demand for cigarettes

is less than one, or inelastic. This is not
unexpected. Cigarette smoking is a difficult habit to
give up. An increase in price alone is insufficient to
induce people to break this habit.
 SELF-ASSESSMENT EXERCISE

➢ What is elasticity? Mention and define its different

types.
 The Price Elasticity of Demand and Its
Determinants

• Availability of Close Substitutes : Goods with

close substitutes tend to have more elastic demand
because it is easier for consumers to switch from that
good . For example if price of close-up tooth paste
went up, if the prices of other tooth pastes like Dabur
herbal, oral B, Pepsodent tooth pastes remain the
same;

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then they are cheaper than close-up. Consumer will shift
easily to any of the other tooth pastes. Hence the
demand elasticity of close-up will be very elastic such
that a little increase in price will drive down the quantity
demanded for it rapidly.

Time Horizon: Goods tend to have more elastic demand

over longer time horizons.
• Necessities versus Luxuries: Necessities tend to have
inelastic demands, whereas luxuries have elastic
demands.
• Definition of the Market: The elasticity of demand in
any market depends on how we draw the boundaries of
the market. Narrowly defined markets tend to have more
elastic demand than broadly defined markets, because it is
easier to find close substitutes for narrowly defined
goods.

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• Addict or habit
People that are addicted to some product consumed out
of their habit which ‘die hard’ are another factor that can
determine demand elasticity. Smokers and drunkards
who consume cigarette and alcohols out of habit will
not budge from buying their brands despite increase in
price. As such, elasticity of demand for these products
will be inelastic.
• Importance of a commodity
The greater the uses of a product the more its price
elasticity. For example, ginger powder is not only use
for soup seasoning, but can be included in, fried rice,
beans porridge, oat meal, and can even be added to
black tea, green tea or used to make pure ginger tea. For
these alternative uses it can be put to, its demand
becomes very elastic. Increase in price of ginger may
lead to decrease in quantity demanded.
 SELF-ASSESSMENT EXERCISE

➢List the determinants of elasticity of demand.

Explain them with examples.
What determines price elasticity of demand?

Total revenue: the total amount of funds received by

a seller of a good or service.

Total revenue is found by multiplying price per unit

by the number of units sold.

TR = P x Q
 The relationship between price
elasticity and total revenue
When demand is price elastic:
A decrease in price leads to an increase in total revenue.
An increase in price leads to a decrease in total revenue.

When demand is price inelastic:

A decrease in price leads to a decrease in total revenue.
An increase in price leads to an increase in total revenue.
 The relationship between price elasticity and
total revenue

Price
Reducing the Price when
demand is elastic increases
total revenue.

30 𝑇𝑅1 = 30𝑋16 = $480

𝑇𝑅2 = 20𝑋28 = $560
20

Demand Curve
16 28
0 Quantity Demanded
The relationship between price elasticity and
total revenue

Price Reducing the Price when

demand is inelastic
30 A reduces total revenue.
𝑇𝑅1 = 30𝑋16 = $480
20 B
𝑇𝑅2 = 20𝑋20 = $400

Demand Curve
0 16 20
Quantity Demanded
The relationship between price elasticity and total
revenue

If demand is … Then … Because …

elastic an increase in price the decrease in

reduces revenue quantity demanded is
proportionally greater
than the increase in
price

elastic a decrease in price the increase in

increases revenue quantity demanded is
proportionally greater
than the decrease in
price
The relationship between price elasticity and total
revenue: continued

If demand is … Then … Because …

inelastic An increase in price the increase in
increases revenue quantity demanded
is proportionally
greater than the
increase in price

inelastic a decrease in price the decrease in

reduces revenue quantity demanded
is proportionally
smaller than the
increase in price
The relationship between price elasticity and total
revenue: continued

If demand is … Then … Because …

unit-elastic an increase in price the decrease in
does not affect quantity demanded is
revenue proportionally the
same as the increase
in price

unit-elastic a decrease in price the increase in quantity

does not affect demanded is
revenue proportionally the
same as the decrease
in price
 Other demand elasticities
Cross price elasticity of demand: the percentage change in
the quantity demanded of one good divided by the percentage
change in the price of another good.
Cross price elasticity
 Cross price elasticity

Cross price elasticity will be positive when the two

goods are substitutes in consumption.

Toothpaste is an example of a substitute good; if the

price of one brand of toothpaste increases, the demand
for a competitor's brand of toothpaste increases in turn.
Cross price elasticity will be negative when the two
goods are complements in consumption.

A negative cross elasticity of demand indicates that the

demand for good A will decrease as the price of B
goes up. This suggests that A and B are complementary
goods, such as a printer and printer toner. If the price of
the printer goes up, demand for it will drop.
 Summary of cross-price elasticities of demand

If the products are Then the cross-price Example

… elasticity of demand
will be …
substitutes positive two brands of
printers

complements negative printers and toner

cartridges

unrelated zero printers and

peanut butter
 Cross price elasticities - Problem

Would you expect the cross price elasticity between the following
pairs of goods to be positive or negative? Explain your answers.
a) Coke and Pepsi.
b) DVD players and DVDs.
c) Gucci sunglasses and vegemite.
 Cross price elasticities – Solving the Problem
(a) Coke and Pepsi are the classic example of two goods which are
substitutes in consumption. An increase in the price of Coke
would, therefore, lead to an increase in demand for Pepsi, so the
cross-price elasticity would be positive.
(b) DVD players and DVDs are complements in consumption. An
increase in the price of DVD players would see a decrease in
demand for DVD players, and hence a decrease in demand for
the complement DVDs. The cross-price elasticity between the
two goods would, therefore, be negative.
(c) Gucci sunglasses and vegemite are completely unrelated goods,
therefore, we would expect the cross price elasticity to equal
zero.
 Income elasticity of demand

Income elasticity of demand: A measure of the

responsiveness of quantity demanded to a change in income.
Measured by the percentage change in quantity demanded
divided by the percentage change in income. For a certain
product, the income elasticity of demand can be positive
or negative, or non-responsive.
Where:
• % Change in Demand Quantity = Change in
Demand Quantity / Original Demand Quantity

• % Change in Income of Consumer = Change in

Income of Consumer / Original Income of Consumer
 Income elasticity of demand
When the income elasticity of a product is less than one,
it is an indication that household consumption of the
product does not increase despite the increase in
households’ income. The higher the income elasticity of
demand for a particular good, the more demand for that
good is tied to fluctuations in consumers' income.
Businesses use the measure to help predict the impact of
a business cycle on sales.
 Summary of income elasticity of demand
If the income Then the good is Example
elasticity of demand
is
Positive, but less Normal goods Milk, staple like rice
than 1 or bread etc.

Positive and greater Luxury goods Rolex watches, high-

than 1 end sports cars, and
Louis Vuitton
handbags, diamonds
etc.
Zero essential goods salt
Negative an inferior good High fat meat
 References
Samuelson, P. A. & Nordhaus, W. D. (2010).
Economics. (9th ed.). New York: McGraw Hill
Companies.
 Quiz
Q1. If you know the value of the price elasticity of
demand, then which of the following can you
compute?
a. The effect of a price change on the quantity
demanded.
b. The responsiveness of the quantity supplied of a
good to a change in its price.
c. The price elasticity of supply.
d. All of the above
 Quiz
Q1. If you know the value of the price elasticity of
demand, then which of the following can you
compute?
a. The effect of a price change on the quantity
demanded.
b. The responsiveness of the quantity supplied of a
good to a change in its price.
c. The price elasticity of supply.
d. All of the above
 Quiz
Q2. How do economists avoid confusion over
different units of measurement in the
computation of elasticities?
a. By using aggregate values rather than single
values.
b. By using whole numbers rather than fractions.
c. By using percentage changes.
d. By using computer software packages.
 Quiz
Q2. How do economists avoid confusion over
different units of measurement in the
computation of elasticities?
a. By using aggregate values rather than single
values.
b. By using whole numbers rather than fractions.
c. By using percentage changes.
d. By using computer software packages.
 Quiz
Q3. When demand is price inelastic, what is the
relationship between price and total revenue?
a. They move in the same direction.
b. They move in opposite directions.
c. When price changes, total revenue remains the
same.
d. They are unrelated.
 Quiz
Q3. When demand is price inelastic, what is the
relationship between price and total revenue?
a. They move in the same direction.
b. They move in opposite directions.
c. When price changes, total revenue remains the
same.
d. They are unrelated.
 Quiz
Q4. Fill in the blanks: If an increase in the price of a
substitute leads to ________ in quantity
demanded, the cross price elasticity of demand is
________ .
a. an increase; positive.
b. an increase; negative.
c. a decrease; positive.
d. a decrease; negative.
 Quiz
Q4. Fill in the blanks: If an increase in the price of a
substitute leads to ________ in quantity
demanded, the cross price elasticity of demand is
________ .
a. an increase; positive.
b. an increase; negative.
c. a decrease; positive.
d. a decrease; negative.