Elasticity and Its

Applications
3
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 Elasticity . . .

• Discuss the weaknesses of shifts: DD and SS.

• … is a measure of how much buyers and sellers
respond to changes in market conditions

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 THE ELASTICITY OF DEMAND
Price elasticity of demand (PED)
• measure of how much the
quantity demanded of a good
responds to a change in
the price of that good.

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Computing the Price Elasticity of Demand

• Point formula.

Percentage change in quantity demanded

Price elasticity of demand =
Percentage change in price

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Example

• If the price of bread increases from $2.00 to

$2.20 and the amount you buy falls from 10 to
8 loaves, then your elasticity of demand would
be calculated as:

(10 − 8)
× 100 20%
10 = =2
(2.20 − 2.00)
× 100 10%
2.00

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The Midpoint Method: A Better Way to
Calculate Percentage Changes and
Elasticities
• 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.
(Q 2 − Q1 ) / [(Q 2 + Q1 ) / 2]
Price elasticity of demand =
(P2 − P1 ) / [(P2 + P1 ) / 2]

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The Midpoint Method: A Better Way to
Calculate Percentage Changes and
Elasticities
• 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.
(Q 2 − Q1 ) / [(Q 2 + Q1 ) / 2]
Price elasticity of demand =
(P2 − P1 ) / [(P2 + P1 ) / 2]

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Example Using The Midpoint Method:

• If the price of bread increases from $2.00 to

$2.20 and the amount you buy falls from 10 to
8 loaves, then your 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
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Interpreting numerical elasticities

• Ranges 0 <η < ∞

• Extreme cases
η = 0: Perfectly Inelastic
• Price change no effect on quantity demanded.
• Vertical demand curve.
η = ∞: Perfectly Elastic
• A tiny change in price will lead to an indefinitely
large change in quantity demanded.
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The Variety of Demand Curves

• Realistic ranges
• η < 1: Inelastic Demand
• % change in quantity demanded is less than the %
change in price..
• η > 1: Elastic Demand
• % change in quantity demanded is greater than the
% change in price.
• η = 1: Unit Elastic
• N.B. Negative sign is ignored, only the
absolute value is considered.
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Figure 1 The Price Elasticity of Demand

(a) Perfectly Inelastic Demand: Elasticity Equals 0

Price
Demand

$5

4
1. An
increase
in price . . .

0 100 Quantity

2. . . . leaves the quantity demanded unchanged.

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Learning
 Figure 1 The Price Elasticity of Demand

(b) Inelastic Demand: Elasticity Is Less Than 1

Price

$5

4
1. A 22% Demand
increase
in price . . .

0 90 100 Quantity

2. . . . leads to an 11% decrease in quantity demanded.

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Figure 1 The Price Elasticity of Demand

(c) Unit Elastic Demand: Elasticity Equals 1

Price

$5

4
1. A 22% Demand
increase
in price . . .

0 80 100 Quantity

2. . . . leads to a 22% decrease in quantity demanded.

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 Figure 1 The Price Elasticity of Demand

(d) Elastic Demand: Elasticity Is Greater Than 1

Price

$5

4 Demand
1. A 22%
increase
in price . . .

0 50 100 Quantity

2. . . . leads to a 67% decrease in quantity demanded.

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 Figure 1 The Price Elasticity of Demand

(e) Perfectly Elastic Demand: Elasticity Equals Infinity

Price

1. At any price
above $4, quantity
demanded is zero.
$4 Demand

2. At exactly $4,
consumers will
buy any quantity.

0 Quantity
3. At a price below $4,
quantity demanded is infinite.

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 Elasticity and total revenue
• Negatively sloped demand curve does not have
a constant elasticity, even though it does have a
constant slope.
• Elasticity varies along a linear demand curve.
• Total revenue

TR = P x Q

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Example: Assume a demand curve has the equation
Qd = 22 - 2P

Price($) Qd Ε Total revenue($)

0 22 0 0

5.50 11 -1 60.50

11 0 infinity 0

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 Example: Assume a demand curve has the equation
Qd = 22 - 2P

Price($) Qd Edp Total revenue($)

0 22 0 0
1 20 -0.1 20
Ε<1 2 18 -0.22 36
3 16 -0.38 48
4 14 -0.57 56
5 12 -0.83 60
5.50 11 -1 60.50
6 10 -1.2 60
7 8 -1.75 56
Ε>1 8 6 -2.67 48
9 4 -4.5 36
10 2 -10 20
11 0 infinity 0

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 Note: elasticity varies over
the length of a ‘straight line’
Price
demand curve. Why tend to
be elastic in the high price
$11 Elastic >1 range and inelastic in low
price range?

Unit Elastic = 1

$5.50

Inelastic < 1

D
0
11 22 Quantity Demanded
 elastic • Change in TR
unit of a product in
P
inelastic response to a
price change
depends on
elasticity of
Total revenue DD.
• Elastic range
decrease in
price will
TR
increase TR
• Inelastic range,
a decrease in
Quantity price will
reduce TR
 Price elasticity of demand and total revenue

Total Revenue (TR) = Price X Quantity sold

When Ƞ > 1 a rise in price leads to fall in TR

When Ƞ < 1 a rise in p - rise in TR

When Ƞ > 1 a fall in p - rise in TR

When Ƞ < 1 a fall in p - fall in TR

When Ƞ = 1 a rise/fall in p - no change in TR

What Determines The Price Elasticity of
Demand?
• Availability of Close Substitutes
- Products with close substitutes tend to have more
elastic demand. Reverse is true
• Definition of the Market or product
- Any one of a group of related products will have a
more elastic demand than the group as a whole.
- Narrowly defined products eg salt (broad –
inelastic) but brands of salt (red seal, victoria,
probrands – narrow - elastic)

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 What Determines The Price
Elasticity of Demand?
• Time Horizon
• Necessities versus Luxuries
• the good or service is a large share of the
consumer's budget

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The Price Elasticity of Demand and Its
Determinants
• Demand tends to be more elastic :
• the larger the number of close substitutes.
• if the good is a luxury.
• the more narrowly defined the market.
• the longer the time period.

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 Application of price elasticity of
demand

Who is vitally concerned with the

concept?
• retail businesses especially those
selling/holding
–perishable goods
–fashion trend items
–large stock variations seasonally
• budgeting governments
• nations specialising in primary resource
exports
 Application of price elasticity of demand

Why is it an important concept?

• Influences resource allocation

• Impacts on marketing strategies
• Affects governments policies
– protection of international trade
– social impact of pricing policy
• Affects cultural / tourism attractions etc
 Other demand elasticities

Income and
Cross price

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 Income elasticity of demand (ȠY)

Income elasticity of demand [is] a measure of how

much the quantity demanded of a good responds
to a change in consumers’ income

Formula:
ȠY = percentage change in quantity demanded /
percentage change in income
 Percentage change
in quantity demanded
Income elasticity of demand =
Percentage change
in income
 Income elasticity of demand

• Response to a ‘normal good’ - ȠY > 1.

- quantity demanded increases as income increases.
– the direction is positive, but the size of the increase
in quantity demanded is extremely variable from
good to good.
– ȠY for normal goods can be > or < 1.

– 0< ȠY < 1; income – inelastic necessities

- Examples include food, fuel, clothing, utilities, and

medical services
 Income elasticity of demand

• ȠY > 1; income – elastic luxuries

• Examples include sports cars and expensive

foods.
• The more necessary an item is in the
consumption pattern of consumers, the lower
is its income elasticity.
 Income elasticity of demand

For ‘inferior goods’ - ȠY < 1.

- the quantity demanded will move in the opposite
direction.
• Higher income can lead to a reduced demand for
cheaper cuts of meat, second hand clothing and
furniture.
• Inferior goods have negative income elasticities
• Income increases and the quantity demanded
decreases
 Cross-price elasticity of demand ( ȠXY)

• This measure of elasticity allows us to determine whether

two goods are substitutes or compliments
“Cross-price elasticity of demand [is] a measure of how much
the quantity demanded of one good responds to a change
in the price of another good” (Mankiw, (2007) p. 96).
It is measured by:
percentage change in quantity demanded of good 1 divided
by the percentage change in the price of good 2.
- -∞ < ȠXY < ∞
- ȠXY > 0
A positive cross-price elasticity indicates the two goods are
substitutes
 Cross price elasticity of demand

• ȠXY < 0

• A negative cross-price elasticity indicates the two

goods are compliments.

• Knowledge of cross elasticity can be important in

matters of competition pricing
 Price elasticity of supply (Ƞ
Ƞs)

Price elasticity of supply [is] a measure of how

much the quantity supplied of a good responds to
a change in the price of that good” (Mankiw,
(2007) p. 100).
 Computing the Price Elasticity of
Supply
Formula:
Point and Midpoint

Percentage change
in quantity supplied
Price elasticity of supply =
Percentage change in price
 Interpretation of price elasticity of
supply

- Ƞs > 1; elastic
Realistic
- Ƞs < 1; inelastic range

- Ƞs =1; unit

- Ƞs =0; perfectly inelastic Extreme

cases
- Ƞs = ∞; perfectly elastic
 Determinants of Elasticity of Supply

• Responsiveness of quantity supplied ‘ will

depend on Substitution and Production costs
Substitution
depends on how easy it is for firms to shift from
the production of other products to the one
whose price has risen. (discuss – agric – land vs
labour transfer)
Production costs
- Ƞs also depends on how costs behave as
output vary.
- if rising output lowers unit cost of production,
more will be produced → elastic supply
.
 Determinants of Elasticity of Supply

- if rising output increases cost of production, less

will be produced → inelastic supply.

Time frame
- It is difficult to change quantity supplied in the
short run but easy in the long run.

- Supply tends to be more elastic in the long run

than short run because it usually takes time for
producers to alter productive capacity in
response to price change.
• Example : the planting cycle of crops - maize in
Zimbabwe.
• Zim government usually increase the price during
tussling stage.
• This has no influence on how much maize will
get planted for this year’s crop.
• If the price persist, it will influence the amount get
planted next season.
• Note: The supply of some goods is totally
inelastic even in the long run.
 Application of price elasticity of
demand: Impact on government
policies
Why do governments in developed economies target
the following when imposing taxes?

• tobacco products, ( cigarettes)

• alcoholic beverages, beer, spirits (brandy, whisky,
gin)
• table wines red and white, casks and bottles
• petrol and petrol products
• motor vehicles, passenger and commercial