Elasticity

The Concept of Elasticity

• Elasticity is a measure of the responsiveness of one
variable to another.
• The greater the elasticity, the greater the
responsiveness.
• When price rises, what happens to quantity demanded?
• Quantity demanded falls.

BUT….

• How much does the quantity demanded fall?

 The Concept of Elasticity
• If price rises by 10% - what happens to quantity
demanded?

• We know quantity demanded will fall

• By more than 10%?
• By less than 10%?

• Elasticity measures the extent to which

quantity demanded will change
 Price Elasticity
• The price elasticity of demand is the percentage
change in quantity demanded divided by the percentage
change in price.

Percentage change in quantity demanded

ED =
Percentage change in price
Where % change in demand
is greater than % change in price – elastic

Where % change in demand is less than % change

in price - inelastic
UNDERSTANDING VALUES FOR PRICE ELASTICITY OF DEMAND

• If Ped = 0 then demand is said to be perfectly inelastic. This

means that demand does not change at all when the price changes
– the demand curve will be vertical.
• If Ped is between 0 and 1 (i.e. the percentage change in demand is
smaller than the percentage change in price), then demand is
inelastic. Producers know that the change in demand will be
proportionately smaller than the percentage change in price.
• If Ped = 1 (i.e. the percentage change in demand is exactly the
same as the percentage change in price), then demand is said to
unit elastic. A 15% rise in price would lead to a 15% contraction in
demand leaving total spending by the same at each price level.
• If Ped > 1, then demand responds more than proportionately to a
change in price i.e. demand is elastic. For example a 20% increase
in the price of a good might lead to a 30% drop in demand. The
price elasticity of demand for this price change is –1.5
 Perfectly Inelastic Demand
Qty demanded doesn’t respond to price
Elasticity=0
Price
Demand

1. An $5
increase
in price... 4

Quantity
100
2. ...leaves the quantity demanded unchanged.
 Inelastic Demand
A large percent change in price  A small percent
change in quantity demanded
Elasticity < 1
Price

1. A 25% $5
increase
in price... 4

Demand

90 100 Quantity
2. ...leads to a 10% decrease in quantity.
 Unit Elastic Demand
Each 1% increase in price  a 1% decrease in
quantity demanded
Elasticity = 1
Price

1. A 25% $5
increase
in price... 4

Demand

75 100 Quantity
2. ...leads to a 75% decrease in quantity.
 Elastic Demand
Small increase in price  big decrease in
quantity demanded
Elasticity > 1
Price

1. A 25% $5
increase
in price... 4

Demand

50 100 Quantity
2. ...leads to a 50% decrease in quantity.
 Perfectly Elastic Demand
The smallest change in price  Huge change in
quantity demanded
Elasticity is INFINITE
Price

$4 Demand

At exactly $4, consumers will buy any quantity

…and they won’t pay a cent more
…they’ll buy something else if price rises at all.
Demand facing a competitive firm.

Quantity
 Sign of Price Elasticity
• According to the law of demand, whenever the price
rises, the quantity demanded falls. Thus the price
elasticity of demand is always negative.

• Because it is always negative, economists usually state

the value without the sign.

• Elasticity does not have any units.

 Own Price Elasticity of Demand
• The price elasticity of demand is a measure of the
responsiveness of quantity demanded to a price change
• Own Price Elasticity of Demand: The percentage change
in the quantity demanded relative to a percentage change in
its own price.
Q P Q P
ED    
Q P P Q
• For a smooth (differentiable) demand curve, the price
elasticity of demand is given by
Q P
ED  
P Q
 Using Price Elasticity of Demand

• Elasticity is a pure ratio independent of units.

• Since price and quantity demanded generally

move in opposite direction, the sign of the
elasticity coefficient is generally negative.

• Interpretation: If ED = - 2.72: A one percent

increase in price results in a 2.72% decrease in
quantity demanded
The Midpoint Method: A Better Way to
Calculate Percentage Changes and
• The midpoint formula is preferable when
Elasticities
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]
• Example: If the price of an ice cream cone increases
from $2.00 to $2.20 and the amount you buy falls from
10 to 8 cones, then
Q2 = 8, Q1 = 10, P2 = $2.20, P1 = $2.00

elasticity of demand, using the midpoint formula, would be

calculated as:

(10  8)
(10  8) / 2 22%
  2.32
(2.20  2.00) 9.5%
(2.00  2.20) / 2
 Graphs of Elasticities
B
$26
24 C (midpoint)
22 A
20
18
D
16
14 Elasticity of demand
between A and B = 1.27
0 10 12 14
Quantity of software (in hundred thousands)
 Calculating Elasticities: Price
elasticity of Demand

P What is the price elasticity of

demand between A and B?
Q2–Q1
%ΔQ ½(Q2+Q1)
B
ED = %ΔP = P2–P1
$26 Midpoint
C ½(P2+P1)
$23
$20 A 10–14
½(10+14) -.33
= 26–20 = .26 = 1.27
D ½(26+20)
Q
10 12 14
7-17
 What Determines Price Elasticity of Demand?
• The number of close substitutes for a good /
uniqueness of the product – the more close
substitutes in the market, the more elastic is the
demand for a product because consumers can
more easily switch their demand if the price of
one product changes relative to others in the
market.
 What Determines Price Elasticity of Demand?

• The cost of switching between different

products – there may be significant
transactions costs involved in switching
between different goods and services. In this
case, demand tends to be relatively inelastic.
 What Determines Price Elasticity of Demand?
• The degree of necessity or whether the good is a
luxury – goods and services deemed by consumers to
be necessities tend to have an inelastic demand
whereas luxuries will tend to have a more elastic
demand because consumers can make do without
luxuries when their budgets are stretched. i.e. in an
economic recession we can cut back on discretionary
items of spending.
 What Determines Price Elasticity of Demand?
• The % of a consumer’s income allocated to
spending on the good – goods and services
that take up a high proportion of a household’s
income will tend to have a more elastic demand
than products where large price changes makes
little or no difference to someone’s ability to
purchase the product.
 What Determines Price Elasticity of Demand?
• The time period allowed following a price
change – demand tends to be more price
elastic, the longer that we allow consumers to
respond to a price change by varying their
purchasing decisions. In the short run, the
demand may be inelastic, because it takes time
for consumers both to notice and then to
respond to price fluctuations.
 What Determines Price Elasticity of Demand?
• Whether the good is subject to habitual
consumption – when this occurs, the consumer
becomes much less sensitive to the price of the
good in question. Examples such as cigarettes
and alcohol and other drugs come into this
category.
 What Determines Price Elasticity of Demand?
• Peak and off-peak demand - demand tends to
be price inelastic at peak times – a feature that
suppliers can take advantage of when setting
higher prices. Demand is more elastic at off-
peak times, leading to lower prices for
consumers.
 What Determines Price Elasticity of Demand?
• The breadth of definition of a good or service
– if a good is broadly defined, i.e. the demand
for cars or shirts, is fairly inelastic. But specific
brands of cars or shirts are likely to be more
elastic following a price change.
 Demand Curves Show How Sensitive
Consumers are to Price Changes
Relatively inelastic
P
1. Quantity demanded is not affected very
much by price changes.

2. Therefore not very sensitive to price changes.

3. Not many substitutes, short period of time,

and small proportion of budget.

4.  Q is not as great as theP.

Demand

Quantity Demanded/unit time

 Demand Curves Show How Sensitive
Consumers are to Price Changes
Relatively elastic
P
1. Quantity demanded is affected very
Demand much by price changes.

2. Therefore very sensitive to price changes.

3. Many substitutes, long period

of time, and large proportion
of budget.

4.  Q is greater than theP.

Quantity Demanded/unit time

 Price Elasticity and Total Revenue
Total revenue is the price of a good multiplied by
the quantity sold.

TR = P x Q
 Total Revenue: A Picture
Price

$4

P x Q = $400
P (total revenue)
Demand

0 100 Quantity
Q
 Elasticity and Total Revenue:
Elastic Demand

Price Price …leads to a decrease in

An increase in price from total revenue from$200 to
$4 to $5... $100

$5
$4

Demand Demand
Revenue = $200 Revenue = $100

0 50 Quantity 0 20 Quantity
 Elasticity and Total Revenue
• With inelastic demand, an increase in price leads to a small
decrease in quantity demanded. Total revenue increases when
price rises. P x Q Increases when P rises.

•With elastic demand, a small increase in price leads to a big

decrease in quantity demanded. Total revenue decreases when
price rises. P x Q decreases when P rises.

•When demand is inelastic – a rise in price leads to a rise in total

revenue – for example a 20% rise in price might cause demand to
contract by only 5% (Ped = -0.25)

•When demand is elastic – a fall in price leads to a rise in total

revenue - for example a 10% fall in price might cause demand to
expand by only 25% (Ped = +2.5)
 As we move down the demand curve, total
revenue first increases, reaches a maximum (or
peak), and then decreases.

TR

Qd
 Elasticity Along a Demand Curve
Ed = ∞
Elasticity declines along
$10 demand curve as we move
9 toward the quantity axis
8 Ed > 1
7
6
Price

Ed = 1
5
4
3 Ed < 1
2
1 Ed = 0
0 1 2 3 4 5 6 7 8 9 10 Quantity
 P Ed > 1  Elastic Section

Ed = 1  Unitary Elastic

Section

Ed < 1  Inelastic

Section

Qd

TR

Qd
 Price Changes:
If a price change causes TR to move in the
opposite direction from the price change,
we are in the elastic portion of the demand
curve.
 Price Changes:
Therefore,

if P TR
or
ifP TR

Elastic Section of Demand Curve

 Price Changes:
If a price change causes TR to move in the
same direction as the price change, we
are in the inelastic portion of the demand
curve.
 Price Changes:
Therefore,

if P TR
or
ifP TR

Inelastic Section of Demand Curve

 Remember:

P P
Relatively
Relatively elastic
inelastic

Q Q
The two demand curves have the 3
sections of elasticity

We use the terms relatively inelastic or

elastic here as a means of saying
that over the whole range (3 sections)
the average elasticity of demand is
either inelastic or elastic.
 Remember:

P P
Relatively
- 1.10
elastic
- 5.50

Relatively - .95
inelastic

- .15

Q Q
Avg. = - .625 Avg. = - 3.225
 AND,

When:

Ed > 1elastic demand  TR  with a P 

Ed = 1  unitary demand  TR is maximized.

Ed < 1  inelastic demand  TR  with P 

 Practical Use:
Would a producer facing a negatively
sloped demand curve for the
commodity he/she sells ever want to
operate in the inelastic range of the
demand curve ?

Generally, NO!!
 P

P0

P1

Qd
Q0 Q1
TR

TR1 = TR0

Qd
Q0 and Q1 yield the same total revenue.

Now Some Common Sense:

Don't you think the total cost (TC)of

producing Q0 is < the TC of producing
Q1?
ELASTICITY AND TOTAL REVENUE: AT A
GLIMPSE
 Price Elasticity of Supply

Quantity supplied responds to price.

Price elasticity of supply
the percentage change in quantity
supplied resulting from a percent
change in price.
 Computing the Price Elasticity of
Supply

The percentage change in

quantity supplied divided by the
percentage change in price.

Percentage Change in
Quantity Supplied
Elasticity of Supply =
Percentage Change
in Price
 Perfectly Inelastic Supply
Elasticity equals 0
Price Supply

1. An $5
increase
in price... 4

100 Quantity
2. ...leaves the quantity supplied unchanged.
 Inelastic Supply
Elasticity < 1
Price
Supply

1. A 22% $5
increase
in price... 4

100 110 Quantity

2. ...leads to a 9 ½ % increase in quantity supplied.
 Unit Elastic Supply
Elasticity equals 1
Price
Supply

1. A 22% $5
increase
in price... 4

100 125 Quantity

2. ...leads to a 22% increase in quantity.
 Elastic Supply
Elasticity > 1
Price

Supply
1. A 22% $5
increase
in price...
4

100 200 Quantity

2. ...leads to a 67% increase in quantity.
 Perfectly Elastic Supply
Elasticity equals infinity
Price

$4 Supply

At exactly $4,
producers will
supply any quantity.

Quantity
 Determinants of
Elasticity of Supply

Ability of sellers to change the amount they

produce
• Beach-front land is inelastic.
• Books, cars, or manufactured goods are elastic.
Time period
• Supply is more elastic in the long run
than in the short run.
 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, In

An Increase in Supply in the Market

for Wheat
Price of
Wheat

S1

$3

Demand

0 100 Quantity of Wheat

 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, In

An Increase in Supply in the Market

for Wheat
Price of
1. When demand is inelastic,
Wheat an increase in supply...

S1 S2

2. ...leads $3
to a large
fall in
price... 2

Demand

0 100 110 Quantity of Wheat

3. ...and a proportionately smaller
increase in quantity sold. As a result,
revenue falls from $300 to $220.
Calculating Elasticity of Supply
Between Two Points
$6.00
5.50 Elasticity of supply
5.00 B between A and B: E  %Q
4.50
A
C % P
4.00 485  475 10
3.50 2 ( 485  475)
1
480 .021
ES     .2
3.00 5  4.50 .50 .105
2 (5  4.50)
1
4.75

0
470 480 490
Quantity of workers
FACTORS THAT AFFECT PRICE ELASTICITY OF
SUPPLY

• (1) Spare production capacity

If there is plenty of spare capacity then a business should be able to
increase its output without a rise in costs and therefore supply will be
elastic in response to a change in demand. The supply of goods and
services is often most elastic in a recession, when there is plenty of spare
labour and capital resources available to step up output as the economy
recovers.

• (2) Stocks of finished products and components

If stocks of raw materials and finished products are at a high level then a
firm is able to respond to a change in demand quickly by supplying these
stocks onto the market - supply will be elastic. Conversely when stocks
are low, dwindling supplies force prices higher and unless stocks can be
replenished, supply will be inelastic in response to a change in demand.
 FACTORS THAT AFFECT PRICE ELASTICITY OF
SUPPLY

• (3) The ease and cost of factor substitution

• If both capital and labour resources are occupationally
mobile then the elasticity of supply for a product is
higher than if capital and labour cannot easily and
quickly be switched
• (4) Time period involved in the production process
• Supply is more price elastic the longer the time period
that a firm is allowed to adjust its production levels. In
some agricultural markets for example, the momentary
supply is fixed and is determined mainly by planting
decisions made months before, and also climatic
conditions, which affect the overall production yield.
 Income Elasticity of Demand

EI = %  Qd / %  Id

Measures the sensitivity of DEMAND to

changes in disposable income.
 Luxury Goods
Luxury Goods are Normal Goods but
they have an

EI >= 1
Quantity demanded is very senistive to
changes in disposable income
 “Necessities”
“Necessities” are Normal Goods but

0 < EI < 1
Quantity demand is not very sensitive to
changes in disposable income
• Normal Goods (EI >0)
–Luxury Goods (EI >= 1)
–Necessitites (0 < EI < 1)

• Inferior Goods (EI < 0)

 Cross-Price Elasticity
Measures how sensitive DEMAND for a
commodity is to changes in the price of
a substitute or compliment commodity
 Cross-Price Elasticity

Ecp of x,y =

%  Qx / %  Py
 Cross-Price Elasticity

Ecp > 0  Substitute

Ecp < 0  Compliment

Ecp = 0  Independent
 Example:
The Cross-Price Elasticity of tea and
coffee would be calculated as:

Ecp, tea, coffee =

%  Qtea / %  Pcoffee
 Interpretation?

If the
Ecp, tea,coffee = + .65

Then for every 1% increase in the price of

tea, the Qd of coffee would increase
.65%. We also would know that tea and
coffee are substitutes