Elasticity & its

Application
5
Abu Naser Mohammad Saif
Assistant Professor
Faculty of Business Studies
University of Dhaka
 Elasticity
Elasticity measures how much one
variable responds to changes in another
variable.

Elasticity is a numerical measure of the

responsiveness of Qd or Qs to one of its
determinants.
 Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P

▪ Price elasticity of demand measures

how much Qd responds to a change in
P.

▪ Loosely speaking, it measures the

price-sensitivity of buyers’ demand.
Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
P
Example:
P rises
Price elasticity P2
by 10%
of demand P1
equals D
15% Q
= 1.5 Q2 Q1
10%
Q falls
by 15%
Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
Along a D curve, P and Q P
move in opposite directions,
which would make price P2
elasticity negative. P1
We will drop the minus sign D
and report all price
Q
elasticities as positive Q2 Q1
numbers.
You design websites for local businesses.
You charge $200 per website,
and currently sell 12 websites per month.
Your costs are rising
(including the opportunity cost of your time),
so you consider raising the price to $250.
The law of demand says that you won’t sell
as many websites if you raise your price.
How many fewer websites? How much will
your revenue fall, or might it increase?

6
Calculating Percentage Changes
Standard method
of computing the
Demand for percentage (%) change:
your websites
P end value – start value
x 100%
start value
B
$250
A Going from A to B,
$200 the % change in P equals
D
($250–$200)/$200 = 25%
Q
8 12
Calculating Percentage Changes
Problem:
The standard method gives
Demand for different answers depending
your websites on where you start.
P
From A to B,
B P rises 25%, Q falls 33%,
$250
A elasticity = 33/25 = 1.33
$200
From B to A,
D
P falls 20%, Q rises 50%,
Q elasticity = 50/20 = 2.50
8 12
Calculating Percentage Changes
▪ So, we instead use the midpoint method:

end value – start value

x 100%
midpoint

▪ The midpoint is the number halfway

between the start and end values, the
average of those values.
Calculating Percentage Changes
▪ Using the midpoint method, the % change
in P equals
$250 – $200
x 100% = 22.2%
$225
▪ The % change in Q equals
12 – 8
x 100% = 40.0%
10
▪ The price elasticity of demand equals
40/22.2 = 1.8
ACTIVE LEARNING 1
Calculate an elasticity
Use the following
information to
calculate the
price elasticity
of demand
for hotel rooms:
if P = $70, Qd = 5000
if P = $90, Qd = 3000
ACTIVE LEARNING 1
Answers
Use midpoint method to calculate
% change in Qd
(5000 – 3000)/4000 = 50%

% change in P
($90 – $70)/$80 = 25%

The price elasticity of demand equals

50%
= 2.0
25%
 Determinants of Price Elasticity
The price elasticity of demand depends on:
▪ the extent to which close substitutes are
available
▪ whether the good is a necessity or a luxury
▪ how broadly or narrowly the good is
defined
▪ the time horizon—elasticity is higher in the
long run than the short run
 Variety of Demand Curves
▪ The price elasticity of demand is closely
related to the slope of the demand curve.
The flatter the curve, the bigger the
elasticity.
The steeper the curve, the smaller the
elasticity.
▪ Five different classifications of D
curves.…
 “Perfectly inelastic demand”
Price elasticity % change in Q 0%
= = =0
of demand % change in P 10%

D curve: P
D
vertical
P1
Consumers’
price sensitivity: P2
none
P falls Q
Elasticity: by 10% Q1
0 Q changes
by 0%
“Inelastic demand”
Price elasticity % change in Q < 10%
= = <1
of demand % change in P 10%

D curve: P
relatively steep
P1
Consumers’
price sensitivity: P2
relatively low D
P falls Q
Elasticity: by 10% Q1 Q2
<1
Q rises less
than 10%
“Unit elastic demand”
Price elasticity % change in Q 10%
= = =1
of demand % change in P 10%

D curve: P
intermediate slope
P1
Consumers’
price sensitivity: P2
intermediate D

P falls Q
Elasticity: by 10% Q1 Q2
1
Q rises by 10%
“Elastic demand”
Price elasticity % change in Q > 10%
= = >1
of demand % change in P 10%

D curve: P
relatively flat
P1
Consumers’
price sensitivity: P2 D
relatively high
P falls Q
Elasticity: by 10% Q1 Q2
>1
Q rises more
than 10%
 “Perfectly elastic demand”
Price elasticity % change in Q any %
= = = infinity
of demand % change in P 0%

D curve: P
horizontal
P2 = P1 D
Consumers’
price sensitivity:
extreme
P changes Q
Elasticity: by 0% Q1 Q2
infinity
Q changes
by any %
 Price Elasticity and Total Revenue
▪ If you raise your price from $200 to $250,
would your revenue rise or fall?
Revenue = P x Q
▪ A price increase has two effects on revenue:
▪ Higher P means more revenue on each unit
you sell.
▪ But you sell fewer units (lower Q),
due to law of demand.
▪ Which of these two effects is bigger?
It depends on the price elasticity of demand.
 Price Elasticity and Total Revenue

Price elasticity Percentage change in Q

=
of demand Percentage change in P

Revenue = P x Q
▪ If demand is elastic, then
price elast. of demand > 1
% change in Q > % change in P
▪ The fall in revenue from lower Q is greater
than the increase in revenue from higher P,
so revenue falls.
Price Elasticity and Total Revenue
increased
Demand for
P revenue due
your websiteslost
to higher P
If P = $200, revenue
due to
Q = 12 and lower Q
$250
revenue = $2400.
$200
If P = $250, D
Q = 8 and
revenue = $2000.
When D is elastic, Q
8 12
a price increase
causes revenue to fall.
Price Elasticity and Total Revenue
Price elasticity Percentage change in Q
=
of demand Percentage change in P

Revenue = P x Q
▪ If demand is inelastic, then
price elast. of demand < 1
% change in Q < % change in P
▪ The fall in revenue from lower Q is smaller
than the increase in revenue from higher P,
so revenue rises.
▪ In our example, suppose that Q only falls to 10
(instead of 8) when you raise your price to $250.
Price Elasticity and Total Revenue
increased
Demand for
revenue due
your websites
P to higher P lost
If P = $200, revenue
Q = 12 and due to
$250 lower Q
revenue = $2400.
If P = $250, $200
Q = 10 and D
revenue = $2500.
When D is inelastic, Q
10 12
a price increase
causes revenue to rise.
ACTIVE LEARNING 2
Elasticity and expenditure/revenue

A. Pharmacies raise the price of

insulin by 10%. Does total
expenditure on insulin rise or
fall?
ACTIVE LEARNING 2
Answer

A. Pharmacies raise the price of

insulin by 10%. Does total
expenditure on insulin rise or fall?
Expenditure = P x Q
Since demand is inelastic, Q will
fall less than 10%, so expenditure
rises.
 Price Elasticity of Supply
Price elasticity Percentage change in Qs
=
of supply Percentage change in P

▪ Price elasticity of supply measures how

much Qs responds to a change in P.
▪ Loosely speaking, it measures sellers’
price-sensitivity.
▪ Again, use the midpoint method to
compute the percentage changes.
 Price Elasticity of Supply
Price elasticity Percentage change in Qs
=
of supply Percentage change in P
P
Example: S
P rises
Price P2
by 8%
elasticity P1
of supply
equals
Q
16% Q1 Q2
= 2.0
8% Q rises
by 16%
 The Variety of Supply Curves

▪ The slope of the supply curve is closely

related to price elasticity of supply.
▪ Rule of thumb:
The flatter the curve, the bigger the
elasticity.
The steeper the curve, the smaller the
elasticity.
▪ Five different classifications…
“Perfectly inelastic”
Price elasticity % change in Q 0%
= = =0
of supply % change in P 10%

S curve: P
S
vertical
P2
Sellers’
price sensitivity: P1
none
P rises Q
Elasticity: by 10% Q1
0
Q changes
by 0%
“Inelastic”
Price elasticity % change in Q < 10%
= = <1
of supply % change in P 10%

S curve: P
S
relatively steep
P2
Sellers’
price sensitivity: P1
relatively low
P rises Q
Elasticity: by 10% Q1 Q2
<1
Q rises less
than 10%
“Unit elastic”
Price elasticity % change in Q 10%
= = =1
of supply % change in P 10%

S curve: P
intermediate slope S
P2
Sellers’
price sensitivity: P1
intermediate
P rises Q
Elasticity: by 10% Q1 Q2
=1
Q rises
by 10%
“Elastic”
Price elasticity % change in Q > 10%
= = >1
of supply % change in P 10%

S curve: P
relatively flat S
P2
Sellers’
price sensitivity: P1
relatively high
P rises Q
Elasticity: by 10% Q1 Q2
>1
Q rises more
than 10%
“Perfectly elastic”
Price elasticity % change in Q any %
= = = infinity
of supply % change in P 0%

S curve: P
horizontal
P2 = P1 S
Sellers’
price sensitivity:
extreme
P changes Q
Elasticity: by 0% Q1 Q2
infinity
Q changes
by any %
 Determinants of Supply Elasticity
▪ The more easily sellers can change
the quantity they produce, the greater
the price elasticity of supply.
▪ For many goods, price elasticity of
supply is greater in the long run than in
the short run, because firms can build
new factories, or new firms may be
able to enter the market.
 Other Elasticities
▪ Income elasticity of demand: measures the
response of Qd to a change in consumer income

Income elasticity Percent change in Qd

=
of demand Percent change in income

▪ For normal goods, income elasticity > 0.

▪ For inferior goods, income elasticity < 0.
 Other Elasticities
▪ Cross-price elasticity of demand:
measures the response of demand for one good to
changes in the price of another good

Cross-price elast. % change in Qd for good 1

=
of demand % change in price of good 2

▪ For substitutes, cross-price elasticity > 0

(e.g., an increase in price of beef causes an
increase in demand for chicken)
▪ For complements, cross-price elasticity < 0
(e.g., an increase in price of computers causes
decrease in demand for software)
SU MMA RY
• Elasticity measures the responsiveness of
Qd or Qs to one of its determinants.
• Price elasticity of demand equals
percentage change in Qd divided by
percentage change in P.
When it’s less than one, demand is
“inelastic.” When greater than one, demand
is “elastic.”
• When demand is inelastic, total revenue
rises when price rises. When demand is
elastic, total revenue falls when price rises.
SU MMA RY
• Demand is less elastic: in the short run;
for necessities; for broadly defined goods;
and for goods with few close substitutes.
• Price elasticity of supply equals percentage
change in Qs divided by percentage change
in P.
When it’s less than one, supply is “inelastic.”
When greater than one, supply is “elastic.”
• Price elasticity of supply is greater in the
long run than in the short run.
S U M M A RY
• The income elasticity of demand
measures how much quantity
demanded responds to changes in
buyers’ incomes.
• The cross-price elasticity of demand
measures how much demand for
one good responds to changes in
the price of another good.