Elasticity of Demand

Price Elasticity of Demand

A measure of the responsiveness of quantity
demanded to changes in price.
Measured by dividing the percentage change in
the quantity demanded of a good by the
percentage change in its price.
Economists compute price elasticity of demand
using midpoints as the base values of changes in
prices and quantities demanded.
Computing Elasticity of Demand
We divide the change
in quantity demanded
by the average
quantity demanded, all
of which is then
divided by the change
in price divided by the
average price.

Computing the Price Elasticity of
Demand
price in change Percentage
demanded quatity in change Percentage
demand of elasticity Price =
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 your elasticity of demand would be
calculated as:
2
percent 10
percent 20
100
00 2
00 2 20 2
100
10
8 10
= =

.
) . . (
) (
Computing the Arc Price Elasticity of Demand
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.
)/2] P )/[(P P (P
)/2] Q )/[(Q Q (Q
= Demand of Elasticity Price
1 2 1 2
1 2 1 2
+
+
Computing the Arc Price Elasticity of
Demand
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 the your
elasticity of demand, using the midpoint formula, would be
calculated as:
32 . 2
5 . 9
22
2 / ) 20 . 2 00 . 2 (
) 00 . 2 20 . 2 (
2 / ) 8 10 (
) 8 10 (
= =
+

percent
percent
)/2] P )/[(P P (P
)/2] Q )/[(Q Q (Q
= Demand of Elasticity Price
1 2 1 2
1 2 1 2
+
+
Ranges of Elasticity
I nelastic Demand
Percentage change in price is greater than
percentage change in quantity demand.
Price elasticity of demand is less than one.
Elastic Demand
Percentage change in quantity demand is greater
than percentage change in price.
Price elasticity of demand is greater than one.

Perfectly Inelastic Demand
- Elasticity equals 0
Quantity
Price
4
$5
Demand
100
2. ...leaves the quantity demanded unchanged.
1. An
increase
in price...
Inelastic Demand
- Elasticity is less than 1
Quantity
Price
4
$5
1. A 25%
increase
in price...
Demand
100 90
2. ...leads to a 10% decrease in quantity.
Unit Elastic Demand
- Elasticity equals 1
Quantity
Price
4
$5
1. A 25%
increase
in price...
Demand
100 75
2. ...leads to a 25% decrease in quantity.
Elastic Demand
- Elasticity is greater than 1
Quantity
Price
4
$5
1. A 25%
increase
in price...
Demand
100 50
2. ...leads to a 50% decrease in quantity.
Perfectly Elastic Demand
- Elasticity equals infinity
Quantity
Price
Demand
$4
1. At any price
above $4, quantity
demanded is zero.
2. At exactly $4,
consumers will
buy any quantity.
3. At a price below $4,
quantity demanded is infinite.
Q & A
On Tuesday, price and quantity demanded are INR 7
and 120 units, respectively. Ten days later, price and
quantity are INR 5 and 150 units, respectively. What is
the price elasticity of demand between the price of INR 5
and INR 7?

What does the price elasticity of demand calculated
figure indicate?

Determinants of Price Elasticity
on Demand
Number of Substitutes: The more substitutes for
a good, the higher the price elasticity of demand;
the fewer substitutes for a good, the lower the
price elasticity of demand. The more broadly
defined the good, the fewer the substitutes; the
more narrowly defined the good, the greater the
substitutes.
Necessities Versus Luxuries: The more that a
good is considered a luxury rather than a
necessity, the higher the price elasticity of
demand.
Determinants of Price Elasticity
on Demand
Percentage of Ones Budget Spent on the Good:
The greater the percentage of ones budget that
goes to purchase a good, the higher the price
elasticity of demand; the smaller the percentage
of ones budget that goes to purchase a good, the
lower the elasticity of demand.
Time: The more time that passes, the higher the
price elasticity of demand for the good; the less
time that passes, the lower the price elasticity of
demand for the good.
Determinants of Price Elasticity
of Demand
Demand tends to be more inelastic
If the good is a necessity.
If the time period is shorter.
Lesser the impact on the budget of the
individual.
The more broadly defined the market.

Determinants of
Price Elasticity of Demand
Demand tends to be more elastic :
if the good is a luxury.
the longer the time period.
Higher the impact on the budget of the
individual.
the more narrowly defined the market.
Elasticity and Total Revenue
Total revenue is the amount paid by
buyers and received by sellers of a good.
Computed as the price of the good times
the quantity sold.

TR = P x Q
Marginal Revenue and Price
Elasticity of Demand
1
1
P
MR P
E
| |
= +
|
\ .
Marginal Revenue and Price
Elasticity of Demand
P
X
Q
X
MR
X
1
P
E >
1
P
E <
1
P
E =
Marginal Revenue, Total Revenue, and
Price Elasticity
TR

Q
X
1
P
E <
MR<0

MR>0

1
P
E >
1
P
E =
MR=0

Price Elasticity of Demand and
Total Revenue
Total revenue may increase, decrease or remain
constant.
If demand is elastic, a price rise decreases total
revenue.
If demand is elastic, a price fall increases total revenue.
If demand is inelastic, a price fall decreases total
revenue.
If demand is unit elastic, a price fall will sell more
goods while total revenue remains constant.
Elasticities,
Price Changes
and Total
Revenue
Bridge Toll Example
Current toll for the George Washington
Bridge is $2.00/trip.
Suppose the quantity demanded at
$2.00/trip is 100,000 trips/hour.
If the price elasticity of demand for bridge
trips is 2.0, what is the effect of a 10% toll
increase?
Bridge Toll: Elastic Demand
Price elasticity of demand = 2.0
Toll increase of 10% implies a 20% decline
in the quantity demanded.
Trips fall to 80,000/hour.
Total expenditure falls to $176,000/hour (=
80,000 x $2.20).
$176,000 < $200,000, the revenue from a
$2.00 toll.
Bridge Toll Example, Part 2
Now suppose the elasticity of demand for
bridge trips is 0.5.
How would the number of trips and the
expenditure on tolls be affected by a 10%
increase in the toll?
Bridge Toll: Inelastic Demand
Price elasticity of demand = 0.5
Toll increase of 10% implies a 5% decline
in the quantity demanded.
Trips fall to 95,000/hour.
Total expenditure rises to $209,000/hour (=
95,000 x $2.20).
$209,000 > $200,000, the revenue from a
$2.00 toll.
Cross Elasticity of Demand
Measures the responsiveness in the quantity
demanded of one good to changes in the price of
another good.
Defined as the percentage change in the quantity
demanded of one good divided by the percentage
change in the price of another good.
This concept is often used to determine whether
two goods are substitutes or complements and the
degree to which one good is a complement to or
substitute for another.
Cross Price Elasticity of Demand
Elasticity measure that looks at the impact a
change in the price of one good has on the
demand of another good.
% change in demand Q1/% change in price of
Q2.
Positive-Substitutes
Negative-Complements.
Income Elasticity of Demand
Measures the responsiveness of quantity
demanded to changes in income.
Define as the percentage change in quantity
demanded of a good divided by the percentage
change in income.
Income elasticity of demand is positive (E
y
> 0)
for a normal good.
The demand for an inferior good decreases as
income increases.
Computing Income Elasticity
Income Elasticity
of Demand
Percentage Change
in Quantity Demanded
Percentage Change
in Income
=

Income Elasticity
- Types of Goods -
Normal Goods
Income Elasticity is positive.
I nferior Goods
Income Elasticity is negative.

Higher income raises the quantity
demanded for normal goods but lowers the
quantity demanded for inferior goods.


Price Elasticity of Supply
Measures the responsiveness of quantity
supplied to changes in price.
Defined as the percentage change in
quantity supplied of a good divided by the
percentage change in the price of the good.
Supply can be classified as elastic, inelastic,
unit elastic, perfectly elastic, or perfectly
inelastic.
Price Elasticity of Supply
CAPACITY

How much spare capacity a firm has - if there is plenty of spare
capacity, the firm should be able to increase output quite quickly
without a rise in costs and therefore supply will be elastic

STOCKS

The level of stocks or inventories - if stocks of raw materials,
components and finished products are high then the firm is able to
respond to a change in demand quickly by supplying these stocks
onto the market - supply will be elastic

FACTORS THAT DETERMINE ELASTICITY OF SUPPLY

FACTOR SUBSTITUTION

If capital and labour resources are occupationally mobile and
substitutable then the elasticity of supply for a product is likely
to be higher than if capital equipment and labour cannot easily
be switched and the production process is fairly inflexible in
response to changes in the pattern of demand for goods and
services.

TIME PERIOD

Supply is likely to be more elastic, the longer the time period a
firm has to adjust its production. In the short run, the firm
may not be able to change its factor inputs.
FACTORS THAT DETERMINE ELASTICITY OF SUPPLY
Summary of the Four Elasticity
Concepts
Who Pays the Tax?
A tax placed on the
sellers of VCR tapes
shifts the supply curve
from S1 to S2 and raises
the equilibrium price
from $8 to $8.50. Part of
the tax is paid by buyers
through a higher price
paid, and part of the tax
is paid by sellers through
a lower price kept.
Tax revenues are
maximized by placing
the tax on the seller who
faces the more inelastic
demand curve.
Different Elasticities and Who Pays the Tax
Q & A
Why will government raise more tax
revenue if it applies a tax to a good with
inelastic demand than if it applies the tax to
a good with elastic demand?

Under what condition would a per-unit tax
placed on the sellers of computers be fully
paid by the buyers of computers?