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ELASTICITY
We have seen in chapter three how a change in the price of the good results in
change in quantity demanded of that good in the opposite direction (movement
along the same demand curve); and how a change in income results in a
change in quantity demanded at every price. The same thing is said about the
changes in the price of related goods and other non-price determinants.
The question is now how to measure the magnitude of each change in quantity
demanded or supplied as a response to a change in one of the independent
variables. The same argument can be applied to the quantity supplied.
In order to have a better picture of the degree of responsiveness of quantity to a
change in one of the independent variable we have to understand the concept of
elasticity.
% dependentVariable
% Y
=
= Elasticity Coefficient
% IndependentVariable % X
Elasticity coefficient includes a sign and a size. We need to interpret the sign
and the size of the coefficient.
Sign shows the direction of the relationship between the two variables. A
positive sign shows a direct relationship while a negative sign shows an inverse
relationship between the two variables.
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Size illustrates the magnitude of this relationship. In other words, it shows how
large the response of the dependent variable to the change in the independent
variable.
Large elasticity coefficient means that a small change in the independent
variable will result in a large change in the dependent variable (the opposite is
true).
Elasticity coefficient is a unit-free measure because in calculating the elasticity
we use the percentage change rather than the change to avoid the difficulty of
comparing different measurement units, and the percentages cancel out.
Changing the units of measurement of price or quantity leave the elasticity value
the same
Elasticity is an important concept in economic theory. It is used to measure the
response of different variables to changes in prices, incomes, costs, etc.
In addition to price and income elasticities of demand, you may estimate the
elasticity with respect to any of the other variables like advertisement and
weather conditions. You may even measure the elasticity of production to
various inputs or the elasticity of your grades in managerial economics to hours
of study.
This chapter covers some of the important types of elasticities.
Page 2 of 34
P0
P2
P1
S0
S1
D2
Q0
Q2
D1
Q1
%Q d Q d / Q d
=
%P
P / P
Example:
Suppose P1 = 7, P2 = 8, Q1 = 11, Q2 = 10, then
If P from 8 to7, Ed = -0.8
If P from 7 to 8, Ed = -0.64
You can see that the value of Ed is different depending on direction of change in
P even with the same magnitude.
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Q 2 Q1 P2 + P1 Q 2 Q1 P2 + P1
=
Q 2 + Q1 P2 P1
P2 P1 Q 2 + Q1
Where,
Q1 = the original (the old) quantity demanded, Q2 = the new quantity demanded
P1 = the original (the old) price, P2 = the new price
Qavg = the average quantity, Pavg = the average price
The formula yields a negative value, because price and quantity move in
opposite directions (law of demand). But it is the magnitude, or absolute value,
of the measure that reveals how responsive the quantity change has been to a
price change. Thus, we ignore the minus (negative) sign and use the absolute
value because it simply represents the negative relationship between P and Qd
Example:
Suppose P1 = 7, P2 = 8, Q1 = 11, Q2 = 10, then
Ed =
10 11 8 7
= 0.71
10 + 11 8 + 7
2
2
Now how to interpret the elasticity coefficient? What Ed= - 0.71 means?
Page 4 of 34
It means that if the price of the good increases (decreases) by 1% the quantity
demanded of the good decreases (increases) by 0.71%
Example:
Price($)
Qd(bushels of Wheat)
8
20
7
40
6
60
5
80
What is the Ed if P increases from 6 to 7?
Ed =
40 60 7 + 6
= 2.6
60 + 40 7 6
%Q d 10
=
= 2
%P
5
b. Interpret Ed
Ed = 2 means that a decrease in P by 1% results in an increase in Qd by 2%
c. What would be the increase in Qd if P decreases by 4%?
Since E d =
%Q d
, then %Q d = ( E d ) ( %P ) = (-2) (-4%) = + 8 %,
%P
%Q d 6%
%Q d
, then % P =
=
= 3% ,
%P
Ed
2
Page 5 of 34
supply) curve. It is the price elasticity for small changes in the price or for
changes around a point on the demand curve.
dQ d
%Q d
dQ P
d =
= Q =
dP
%P
dP Q
P
Q P
P Q
Notice that the first term of the last formula is nothing but the slope of the
1. The value of the elasticity; varies along a linear demand curve, as P/Q
change even though, the slope is constant.
2. The value of the elasticity varies along a nonlinear demand curve as both
terms in the above equation varies from as we move along a nonlinear
demand curve.
3. The value of the elasticity is constant along the demand curve only in the
case of an exponential function in the form:
Qd = aP-b,
where the price elasticity of demand equals b, which can be proved as
follows:
d =
dQ P
P
= baP b1
= b
dP Q
aP b
This type of nonlinear equations can be expressed in linear form using logarithm
d =
dQ P
P
150 P P 3 150 P 4
= 150(P 4 )
=
=
4 = 3
dP Q
50
50
50P 3
P4
P
Example:
70
dQ P
= ( 20)
= 2.33
600
dP Q
Example:
2250 2550
11 + 10
= 1.31
11 10
2250 + 2550
10
dQ P
= ( 300 )
= 1.2
2550
dP Q
Example:
Q 2 Q1 P2 + P1
= 2
P2 P1 Q 2 + Q1
Page 7 of 34
P2 + 100
(10,000 8,000 )(P2 + 100 )
10,000 8,000
=
P2 100
10,000 + 8,000 (P2 100 )(10,000 + 8,000 )
2,000(P2 + 100 )
2,000P2 + 200,000
=
(P2 100 )(18,000 ) 18,000P2 1,800,000
2P2 + 200
18P2 1,800
A 50% decrease in the price of salt caused the quantity demanded to increase
by10%. Calculate the price elasticity of demand for salt, explain the meaning of
your result and tell if the demand for salt is elastic or inelastic?
Ed = 10/50 = 0.20 which means a10% change in price results in a 2% Change in
the quantity demanded in the opposite direction.
Example:
Qd = 50 P3, is the demand curve equation for apple, calculate the price
elasticity of demand when P =3 and Q = 9.
d =
dQ P
3
1
= 3(3 2 ) = 27 = 9
dP Q
9
3
Page 8 of 34
%Q d
> 1 % Qd > % P demand is elastic.
%P
%Q d
< 1 % Qd < % P demand
%P
is inelastic.
Consumers are not very responsive to changes
in P. Demand Curve is steeper 1% (or ) in P results in a less than 1%
(or) in Qd (if Ed = 0.70 that means if P by 1% Qd by 0.7%.) or (if P by
10% Qd by 7%.)
Examples of inelastic goods: medicine, food, etc.
If the price elasticity is between 0 and 1, demand is inelastic.
P
More Elastic
More Inelastic
Qd
Page 9 of 34
%Q d
= 1 % Qd = % P demand is
%P
unit-elastic
1% in P results in a 1% in Qd
Qd
S1
S2
D
%Q d
= 0 demand is perfectly inelastic
%P
S1
S2
Qd
Qd
curve the more elastic is the demand and the more steeper is the demand curve
the more inelastic is the demand
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Slope =
P
,
Q d
Elasticity: E d =
%Q d
%P
For a straight-line (linear) demand curve the slope is constant (i.e., the slope is
the same at every point along the curve). It is equal to the change in price over
the change in quantity demanded.
Although the slope is constant, price elasticity varies along a linear demand
curve.
Ed =
Ed > 1
Ed=1
Ed < 1
Ed = 0
The following equation shows the relationship between the elasticity and the
Q d P
%Q d Q d / Q d Q d P
1
P
=
=
=
%P
Qd
P Q d slope Q d
P / P
P
1
is also
slope
P
; i.e. straight-line
Qd
Page 11 of 34
high, inelastic when price is low and unit-elastic at the midpoint of the demand
curve.
strategy.
There is a relationship between the price elasticity of demand and revenue
received.
Total revenue (TR) equals the total amount of money a firm receives from the
which effect is the largest, price effect or the effect of quantity demanded.
The size of the price elasticity of demand coefficient, tells us which of these two
effects is largest.
o If demand is elastic (Ed >1) % Qd > % P
10 % in P results in more than 10 % in sales TR
10 % in P results in more than 10 % in sales TR
o If demand is inelastic (Ed <1) % Qd < % P
10 % in P results in less than 10 % in sales TR
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TR
E>1
E<1
E=1
The rises or falls in TR as price increases (or decreases) depend on Ed. Hence,
products that have inelastic demands, and should reduce prices of products that
have elastic demands.
Graphical Illustration of the relationship between TR, P, MR, and Ed
When the price is equal to zero, as it is where demand intersects the quantity
axis, or when the quantity demanded equals zero, as it is when the demand
intersects the price axis, total revenue must equal zero. Thus, when a firm either
sells none of its goods or sells its good for a zero price, they bring in zero
revenue.
If the firm moves away from either of these intersection points then their total
revenue must increase. Total revenue continues to rise as the firm moves away
from the intersections until it reaches a maximum at the midpoint.
For a price increase, total revenue rises when demand is inelastic and falls
P decreases)
To max TR, set price at unitary elastic price
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Marginal revenue is the revenue generated by selling one additional unit of the
product
It is the change in total revenue resulting from changing quantity by one unit.
MR =
TR
Q
For a straight-line demand curve the marginal revenue curve is twice as steep
as the demand.
To sell more, often price must decline, so MR is often less than the price.
When EP = -. MR = P.
At the point where marginal revenue crosses the X-axis, the demand curve is
produced adds more to TR than adding to TC; i.e., expand production as long
as MR > MC and M is positive.
The optimal production reached when MR = MC and M = 0
Units produced over and above the optimal level will have negative M because
than MR.
The conclusion here is that if the manager maximizes TR the firm will make less
Demand
MR
TR
Ed >1
Elastic
MR >0
Ed < 1
Inelastic
MR < 0
Ed = 1
Unit elastic
MR = 0
Max.
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Ed> 1
Ed = 1
P*
Ed< 1
0
MR
TR
E = 1;
E > 1;
MR=0
MR > 0
E < 1;
MR< 0
TR
0
Q*
Example:
Given Qd = 20 2P,
Find the price range for which
a. D is elastic
b. D is inelastic
c. D is unit elastic
d. If the firm increases P to $7, is TR increasing or decreasing?
Answer:
Qd = 20 2P P = 10 0.5Q
TR = 10Q 0.5Q2
MR = 10 Q
When MR = 0, 10 Q =0 Q = 10 and P = 10 0.5(10) = 5
At this P and Q, Ed = 1
a. D is elastic for price range above 5 (or Q less than 10)
b. D is inelastic for price range below 5 (or Q above 10)
c. D is unit elastic at P = 5 and Q = 10
d. If the firm chooses to increase the price to $7 and 7 is in the elastic part,
TR will be decreasing
Example:
dQ P
7.5 75
= ( 10 )
= 1 TR is maximized
=
dP Q
75
75
TR MR
Ed
10
10
---
--
18
6.33
24
3.40
28
2.14
30
1.44
30
1.00
Ed = 1 (unitary elastic), TR is
28
-2
0.69
24
-4
0.47
18
-6
0.29
10 10
-8
0.16
Exercise:
Page 17 of 34
a
b
4
0
D
2
MR and Elasticity
The relationship between Marginal Revenue (MR), price (P), and price the
Clearly the equation shows that if Ed < -1, MR must be positive: if Ed > -1, MR
We know that TR = P X Q
dP
dP
dQ
dTR
d
=
+Q
=P+Q
(PXQ) = PX
dQ
dQ
dQ
dQ
dQ
Multiply the second term by P/P
P
dP
1
dP
Q dP
= P(1 + XQ
MR = p + XQ
) = P(1 + X
)
P
dQ
P
dQ
P dQ
But
dQ P
d =
X
dP Q
1 dP Q
=
X
So,
d dQ P
MR =
Thus, MR = P (1 +
1
)
d
If P = 20 and d = -4 find MR
1
MR = 20 1 +
MR = 20 (1 - 0.25)
= 20 (0.75) = 15
Page 18 of 34
services is inelastic.
Elasticity does not only differ from one good to another but also it may differ for
higher price of a good by buying more of the substitute goods and less of the
relatively more expensive one. So, we would expect a relatively high price
elasticity of demand for goods or services with many close substitutes, but
would expect a relatively inelastic demand for goods with few close substitutes.
Example:
Dell computer, for example, has many substitutes. So its price elasticity of
demand is highly elastic because the consumers can easily shift to the other
substitutes if the price of Dell computer increases
Example:
Pepsi and Coke are very close substitutes. So, the availability of Pepsi makes
the price elasticity of demand of Coke very high. Any increase in the price of
Coke will result in a huge shift of consumers to Pepsis purchase.
Furthermore, the broader the definition of the good, the lower the elasticity since
there is less opportunity for substitutes. The narrower the definition of the good
the higher the elasticity, since there are more substitutes.
Page 19 of 34
Example:
A buyer who likes Japanese cars and has relative preference for Toyota
products may have higher price elasticity of demand for Camry than the price
elasticity of demand for Toyota cars. His price elasticity of demand for Toyota
cars is higher than the price elasticity of demand for Japanese cars. And his
price elasticity of demand for Japanese cars is higher than the price elasticity of
demand for cars in general. Why?
Example:
Consider the relative price elasticity of demand for a good such as apples
compared to a good such as fruits. What is the difference between apples and
fruits? Apples are, of course, a fruit but so are lots of other goods as well.
Hence, more substitutes exist for apples than exist for the broader category of
fruits. We have already determined that as the number of substitutes increase
then so does that goods relative price elasticity of demand.
2. Proportion of total expenditures to Income
The higher the proportion of income spent on the good, the higher the elasticity
Consider the price elasticity of demand for a good such as a pen compared to
that for a good such as a car. One of the big differences between these two
types of goods is that the price of a pen is small as a proportion of the income
while the price of a car is typically a large percentage of income. Doubling the
price of pens will not, therefore, have a big impact on ones income. However,
doubling the price of cars will have a large impact on ones income.
Thus, the demand for high-priced goods such as cars tends to be more price
elastic than the demand for low-priced good such as bread or salt.
Page 20 of 34
Consider what happens as the price of a good such as gasoline doubles. People
respond to the higher price by decreasing their use of gas. However, in just a
short time period it is more difficult to do this than in a longer period. Essentially,
the longer the time period people have to adjust, the more alternatives they can
find to reduce their consumption of gas. For example, they might be able to
move closer to work, buy a more fuel-efficient car, use public transportation,
arrange with friends to go in on car, etc.
Thus, in short run, the response is very limited demand is less elastic; over
time, demand tends to be more elastic because time is available to search for
substitutes and adjust to the new situation
4. Necessary vs. Luxury goods
Demand for necessary goods, goods that are critical to our everyday life and
have but are not likely to buy unless our income jumps or the price declines
sharply, is relatively elastic (cars, traveling to foreign countries for vacation).
Nevertheless, what is one person's luxury is another person's necessity
5. Durability of the product:
The demand for durable goods (such as cars) tends to be more price elastic
have the possibility of repairing the existing ones, and the possibility of buying
used ones.
Page 21 of 34
called a derived demand, since the demand for these goods is directly
associated with the demand for the final good. The derived demand for a
specific intermediate good will be more inelastic:
1. The more essential is that good to the production of the final good.
2. The more inelastic the demand for the final good.
3. The smaller the share of that good in the cost of producing the final good.
4. The shorter the time passes after the price changes.
Page 22 of 34
following formula:
EY =
%Q d O 2 Q1 y 2 Y1 O 2 Q1 Y2 Y1 O 2 Q1 Y2 + Y1
=
Q 2 + Q1 Y2 + Y1 Q 2 + Q1 Y2 + Y1 Q 2 + Q1 Y2 Y1
%Y
2
2
%Q d Q d dQ d
Y
EY =
=
X
=
%Y
dY Q d
dY
EY > 1 Demand is income elastic and the good is normal and luxury. % Qd
Q A
4
Y
= 1.5 X = 1.5 > 1 Normal (luxury) good
X
Y
4
QA
Page 23 of 34
Example:
The manager of Global Food Inc heard the news that government plans to give
a 15% raise to all its employees who represent 70% of the labor force of the
country. If the estimated income elasticity of demand for global food products is
0.85, find the expected change in the demand for the firm products.
%UY = 15% X 70% =10.5%
%Q d
=
%Y
%Q d
0.85 =
10.5
EY =
1. If peoples average income increased from BD300 to BD350 per month and
as a result their purchase of orange juice increased from 5000 liters to 5800
liters per month, Calculate EY
EY = 0.96.
The increase in income by 10% results in an increase in the Qd of orange
juice by 9.6% .Orange juice is a normal, necessary good. People buy more of
it when their income increases.
2. If peoples average income increased from BD300 to BD350 per month and
as a result their purchase of used mobiles decreased from 400 units to 300
units per month, Calculate EY
EY = - 1.86.
The increase in income by 10% results in a decrease in the Qd of used
mobiles by 18.6%. Since the sign is negative this means the mobile is an
inferior good. People buy less of it when their income increases.
3. If income by 5% and Qd by 10% EY = +2 normal, luxury good
4. If income by 5% and Qd by 10% EY = -2 inferior good
Page 24 of 34
the price of the related good changes. That is, how elastic is the demand curve
in response to changes in prices of related goods.
Cross elasticity measures the responsiveness of Qd of a particular good to
=
Q 2 x + Q1x P2 y + P1y Q 2 x + Q1x P2 y P1y
%Py
2
2
For small price changes, the cross elasticity may be calculated as a point
%Q x Q x dQ x Py
ER =
=
=
X
%Py
dPy dPy Q x
P
y
When the cross elasticity of demand has a positive sign, the two goods are
substitute goods.
When the cross elasticity of demand has a negative sign, the two goods are
complementary goods
When ER=0 no relation between PX and DY
The size of cross elasticity of demand coefficient is primarily used to indicate the
Page 25 of 34
If
P1x = 20,
P2x= 30
Q1y = 200
Q2y = 250
Q1z = 150
Q2z = 140
P
dQ A
2 .5
= 0.5 Strong Substitutes
X B = 0 .8 X
4
QA
dPB
b. E R =
P
dQ A
1
X C = 3 X = 0.75 Strong Complements
4
QA
dPC
Example:
Nissan Maxima and Toyota Camry are competing substitutes in the market for
small passenger cars. The Nissan Manager would like to predict the negative
effect of Toyotas 15% discount on Camry during Ramadhan. From previous
years, Nissan manager has an estimate of the cross elasticity of 2.0 between
these two brands.
Page 26 of 34
Given this information, calculate the expected effect on Nissan sales of Maxima
cars.
Solution
ER =
2=
%QMamima
=
%PCamry
%QMaxima
15%
Find the point price elasticity, the point income elasticity, and the point cross
elasticity at P=10, Y=20, and PR=9, if the demand function were estimated to be:
Qd= 90 - 8P + 2Y + 2PR
Is the demand for this product elastic or inelastic? Is it a luxury or a necessity?
Does this product have a close substitute or complement? Find the point
elasticities of demand.
Solution
First find the quantity at these prices and income:
Qd= 90 - 8P + 2Y + 2PR = 90 -8(10) + 2(20) + 2(9) =90 -80 +40 +18 = 68
Ed = (Q/P)(P/Q) = (-8)(10/68)= -1.17 which is elastic
EY = (Q/ Y)(Y/Q) = (2)(20/68) = +.59 which is a normal good, but a necessity
ER = (Qx/ PR)(PR /Qx) = (2)(9/68) = +.26 which is a mild substitute
Page 27 of 34
have:
%Q = Ed (%P) + EY (%Y) + ER (%PR)
Where, P is price, Y is income, and PR is the price of a related good.
Example:
LTC has a price elasticity of -2, and an income elasticity of 1.5 for its laptops.
The cross elasticity with another brand is +.50
a. What will happen to the quantity sold if LTC raises price 3%, income rises
2%, and the other brand companies raises its price 1%?
b. Will Total Revenue for this product rise or fall?
Solution
a. %Q = Ed (%P) + EY (%Y) + ER (%PR)
= -2 (3%) + 1.5 (2%) +0.50 (1%) = -6% + 3% + 0.5% = -2.5%.
We expect sales to decline.
b. Total revenue will rise slightly (about + 0.5%), as the price went up 3%
and the quantity of laptops sold falls 2.5%.
Page 28 of 34