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Elasticity

BEEB1013 Principles of Economics

CHAPTER OUTLINE

Price Elasticity of Demand

Slope and Elasticity
Types of Elasticity

Ch. 5: Elasticity

Calculating Elasticities
Calculating Percentage Changes
Elasticity Is a Ratio of Percentages
The Midpoint Formula
Elasticity Changes Along a Straight-Line
Demand Curve
Elasticity and Total Revenue

Dr. Mohd Razani Mohd Jali

Room 0.55 Economic Building
School of Economics, Finance and Banking
UUM College of Business
razani@uum.edu.my
04-928 6792

The Determinants of Demand Elasticity

Availability of Substitutes
The Importance of Being Unimportant
The Time Dimension

Other Important Elasticities

Income Elasticity of Demand
Cross-Price Elasticity of Demand
Elasticity of Supply

Looking Ahead

Price Elasticity of Demand

Slope and Elasticity

elasticity A general concept used to quantify the response in one variable

when another variable changes.

elasticity of A with respect to B

%A
%B
FIGURE 5.1 Slope Is Not a Useful Measure of Responsiveness

Changing the unit of measure from pounds to ounces changes the numerical value of the
demand slope dramatically, but the behavior of buyers in the two diagrams is identical.

Types of Elasticity

price elasticity of demand The ratio of the percentage of change in quantity

demanded to the percentage of change in price; measures the responsiveness
of quantity demanded to changes in price.

perfectly inelastic demand Demand in which quantity demanded does not

respond at all to a change in price.

perfectly elastic demand Demand in which quantity drops to zero at the

slightest increase in price.

A good way to remember the difference between the two perfect elasticities is

% change in quantity demanded

price elasticity of demand
% change in price

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elastic demand A demand relationship in which the percentage change in

quantity demanded is larger than the percentage change in price in absolute
value (a demand elasticity with an absolute value greater than 1).

inelastic demand Demand that responds somewhat, but not a great deal, to
changes in price. Inelastic demand always has a numerical value between zero
and 1.

unitary elasticity A demand relationship in which the percentage change in

quantity of a product demanded is the same as the percentage change in price
in absolute value (a demand elasticity of 1).
FIGURE 5.2 Perfectly Inelastic and Perfectly Elastic Demand Curves

Figure 5.2(a) shows a perfectly inelastic demand curve for insulin.

Price elasticity of demand is zero.
Quantity demanded is fixed; it does not change at all when price changes.
Figure 5.2(b) shows a perfectly elastic demand curve facing a wheat farmer.
A tiny price increase drives the quantity demanded to zero.
In essence, perfectly elastic demand implies that individual producers can sell all they want
at the going market price but cannot charge a higher price.

A warning:
You must be very careful about signs. Because it is generally understood that
demand elasticities are negative (demand curves have a negative slope), they
are often reported and discussed without the negative sign.

Calculating Elasticities
Calculating Percentage Changes

To calculate percentage change in quantity demanded using the initial value as

the base, the following formula is used:

change in quantity demanded

100%
Q1
Q2 Q1

100%
Q1

% change in quantity demanded

Elasticity Is a Ratio of Percentages

Once the changes in quantity demanded and price have been converted to
percentages, calculating elasticity is a matter of simple division. Recall the
formal definition of elasticity:

price elasticity of demand

% change in quantity demanded

% change in price

We can calculate the percentage change in price in a similar way. Once again,
let us use the initial value of Pthat is, P1as the base for calculating the
percentage. By using P1 as the base, the formula for calculating the percentage
of change in P is

change in price
100%
P1
P2 P1

100%
P1

% change in price

The Midpoint Formula

midpoint formula A more precise way of calculating percentages using the

value halfway between P1 and P2 for the base in calculating the percentage
change in price and the value halfway between Q1 and Q2 as the base for
calculating the percentage change in quantity demanded.

% change in quantity demanded

change in quantity demanded

100%
Q1

Q2 Q1
100%
Q1

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Elasticity Changes Along a Straight-Line Demand Curve

Point Elasticity
point elasticity A measure of elasticity that uses the slope measurement.
We have defined elasticity as the percentage change in quantity demanded
divided by the percentage change in price. We can write this as

Q
Q1
P
P1
Where denotes a small change and Q1 and P1 refer to the original price and
quantity demanded.
This can be rearranged and written as

Q P1

P Q1
Notice that Q/P is the reciprocal of the slope.

Elasticity Changes Along a Straight-Line Demand Curve

TABLE 5.1 Demand Schedule
for Office Dining
Room Lunches

FIGURE 5.3 Demand Curve for Lunch at the Office

Dining Room

TABLE 5.1 Demand Schedule

for Office Dining
Room Lunches
Price
(per
Lunch)

Quantity
Demanded
(Lunches per Month)

$11
10
9
8
7
6
5
4
3
2
1
0

0
2
4
6
8
10
12
14
16
18
20
22

To calculate price elasticity of demand between points A and B on the demand curve, first
calculate the percentage change in quantity demanded:

% change in quantity demanded

TABLE 5.1 Demand Schedule

for Office Dining
Room Lunches

Quantity
Demanded
(Lunches per Month)

Price
(per
Lunch)

Quantity
Demanded
(Lunches per Month)

$11
10
9
8
7
6
5
4
3
2
1
0

0
2
4
6
8
10
12
14
16
18
20
22

$11
10
9
8
7
6
5
4
3
2
1
0

0
2
4
6
8
10
12
14
16
18
20
22

% change in price

9 10
1
100 %
100 % 10.5%
(10 9) / 2
9.5

Elasticity Changes Along a Straight-Line Demand Curve

TABLE 5.1 Demand Schedule
for Office Dining
Room Lunches
Price
(per
Lunch)

Quantity
Demanded
(Lunches per Month)

$11
10
9
8
7
6
5
4
3
2
1
0

0
2
4
6
8
10
12
14
16
18
20
22

42
2
100 % 100 % 66.7%
(2 4) / 2
3

Elasticity Changes Along a Straight-Line Demand Curve

Price
(per
Lunch)

Next, calculate the percentage change in price:

FIGURE 5.3 Demand Curve for Lunch at the Office

Dining Room

FIGURE 5.3 Demand Curve for Lunch at the Office

Dining Room

Finally, calculate elasticity:

elasticity of demand

66.7%
6.33
10.5%

FIGURE 5.4 Point Elasticity Changes Along a Demand Curve

FIGURE 5.3 Demand Curve for Lunch at the Office

Dining Room

Between points A and B, demand is quite elastic at 6.33.

Between points C and D, demand is quite inelastic at .294. (You can work this number
out for yourself using the midpoint formula.)

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Elasticity and Total Revenue

In any market, P Q is total revenue (TR) received by producers:

TR = P Q
total revenue = price quantity

When price (P) declines, quantity demanded (QD) increases. The two factors, P
and QD, move in opposite directions:

effects of price changes

on quantity demanded:

Because total revenue is the product of P and Q, whether TR rises or falls in

response to a price increase depends on which is bigger: the percentage
increase in price or the percentage decrease in quantity demanded.

effect of price increase on

a product with inelastic demand:

P QD TR

If the percentage decline in quantity demanded following a price increase is

larger than the percentage increase in price, total revenue will fall.

P QD
and
P QD

effect of price increase on

a product with elastic demand:

P QD TR

The Determinants of Demand Elasticity

The opposite is true for a price cut. When demand is elastic, a cut in price
increases total revenues:

Availability of Substitutes
Perhaps the most obvious factor affecting demand elasticity is the availability of
substitutes.

effect of price cut on a product

with elastic demand:

P QD TR

The Importance of Being Unimportant

When an item represents a relatively small part of our total budget, we tend to
pay little attention to its price.

When demand is inelastic, a cut in price reduces total revenues:

The Time Dimension

effect of price cut on a product
with inelastic demand:

P QD TR

E C O NO M I C S I N PRACTI C E
Elasticities at a Delicatessen in the Short Run and Long Run
The graph shows the expected
relationship between long-run
and short-run demand for
Franks sandwiches.
Notice if you raise prices above
the current level, the expected
quantity change read off the
short-run curve is less than that
from the long-run curve.

The elasticity of demand in the short run may be very different from the
elasticity of demand in the long run. In the longer run, demand is likely to
become more elastic, or responsive, simply because households make
adjustments over time and producers develop substitute goods.

Other Important Elasticities

Income Elasticity of Demand
income elasticity of demand A measure of the responsiveness of demand to
changes in income.

income elasticity of demand

% change in quantity demanded

% change in income

Cross-Price Elasticity of Demand

cross-price elasticity of demand A measure of the response of the quantity
of one good demanded to a change in the price of another good.

THINKING PRACTICALLY
1. Provide an example of a purchasing situation in which you think your own short and
long run elasticities differ a lot and a second in which they are similar.
What drives those differences?

cross - price elasticity of demand

% change in quantity of Y demanded

% change in price of X

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Looking Ahead

Elasticity of Supply

elasticity of supply A measure of the response of quantity of a good supplied

to a change in price of that good. Likely to be positive in output markets.

elasticity of supply

% change in quantity supplied

% change in price

The purpose of this chapter was to convince you that measurement is

important. If all we can say is that a change in one economic factor causes
another to change, we cannot say whether the change is important or whether
a particular policy is likely to work. The most commonly used tool of
measurement is elasticity, and the term will recur as we explore economics in
more depth.

elasticity of labor supply A measure of the response of labor supplied to a

change in the price of labor.

elasticity of labor supply

% change in quantity of labor supplied

% change in the wage rate

End of todays lesson

Questions or comments?

Reference:
Case, Fair & Oster (2014), Ch. 5

There are those who make things happen,

those who let things happen, and
those who wonder what happened.