Elasticity of demand

S&N, Ch. 4
Mw, Ch. 5
Sr, pp. 85-95
Elasticity of Demand
 When price rises, what happens
to demand?
 Demand falls
 BUT!
 How much does demand fall
 Elasticity measures the extent to which

demand will change

Types of Elasticity

Types of Elasticity

Income
Price elasticity Price elasticity Cross
elasticity of
of demand of supply elasticity
demand
Price elasticity of demand

Price elasticity of demand (EDP ) measures how much the

quantity demanded responds to a change in price

Percentage change in quantity

EDP is normally negative, but we can ignore the negative sign
EDP = demanded
Percentage change in price
Price elasticity of demand – Ex.
 At P1 = $90, Q1 =240 units are demanded
 At P2 = $110, Q2 = 160 units are demanded
 % change in quantity is (ΔQ/Qave) × 100%
 ΔQ = Q2 - Q1 = 160 – 240 = - 80
 Qave = (Q1 + Q2) / 2 = (240 + 160 ) / 2 = 200
 % change in Q = (-80 / 200) × 100% = - 40%
Price elasticity of demand – Ex.
 % change in price is (ΔP/Pave) × 100%
 ΔP = P2 - P1 = 110 – 90 = 20
 Pave = (P1 + P2) / 2 = (90 + 110 ) / 2 = 100
 % change in price is (20/100) × 100% = 20%
 E
DP = - 40 / 20 = - 2
 (We can ignore the minus sign)
Elastic vs. Inelastic demand
P P D

D’
D’
Q Q

When EDP is greater than 1, demand When EDP is lesser than 1, demand is
is elastic (flatter demand curve) inelastic (steeper demand curve)
Relative change in demand is larger Relative change in demand is lesser

than the relative change in the price than the relative change in the price
With elastic demand raising prices With inelastic demand raising prices

lowers total revenue (revenue = P × increases total revenue (revenue = P

Q) × Q)
Special cases
P D P D P

D D’

D’ D’

Q Q Q

EDP = 0 is perfectly  EDP = 1 is unit  EDP =∞ is perfectly

inelastic demand (a elastic demand elastic demand (a
vertical demand curve (raising prices does horizontal demand
– demand does not not change curve )
change with price) revenues)
Income elasticity of demand

Income elasticity of demand (EDI )measures how much the quantity

demanded responds to a change in consumers’ income.

EDI is positive for normal good

Percentage change in quantity

E =
EDI DI
is negative for inferior good demanded
Percentage change in income
Income elasticity of demand

Normal goods have positive EDI,

e.g. as income rises people go for

more vacations
Cross-price elasticity of demand

Cross-price elasticity of demand (EDC

DC
) measures how much the
quantity demanded in one good responds to a change in the price
of another good

Percentage change in quantity

EDC demanded of good 1
can have either sign
EDC

DC =
Percentage change in price of
good 2
Cross-price elasticity of demand

If the two goods are substitutes EDC

is positive

E.g. hot dogs and hamburgers are substitutes. If

the price of hot dogs goes up, people buy
hamburgers instead
Substitutes
Substitutes are rice, potatoes and pasta
●

goods that can tape players, CD players, MP3 players

●

ballpoint pens, fountain pens, felt-tip pens

replace others
●

With substitutes an increase

in the price of one leads to
an increase in the demand
for the other

Where substitutes exist demand

will be more elastic-If the price of
potatoes rises and the price of
pasta does not, people switch from
eating potatoes to eating pasta
Complements
Complements ●
trousers and belts
are goods ●
computers, software & internet
that are used connections
gin and tonic water
together
●

With complements
an increase in the
price of one leads
to a decrease in
demand for the
other
Determinants of Elasticity

Time period

the longer the time under consideration the more elastic a good is likely to be
Price Elasticity of Supply
Price elasticity of supply (ESP
SP
) measures how much the quantity
supplied responds to a change in price

If ESP
SP
is inelastic - it will be difficult for suppliers to react swiftly to
changes in price

If ESP
SP
is elastic – supply can react quickly to changes in price

Percentage change in quantity

ESP = supplied
Percentage change in price
Importance of Elasticity
Relationship between changes in price and total revenue

Importance in determining what goods to tax (tax revenue)

Importance in analysing time lags in production

Influences the behaviour of a firm

Next week
 Theory of the consumer
◦ S&N, Ch 5, Appendix 5
◦ Mw, pp.137-142