ELASTICITY OF

DEMAND

PRISCILLA T BAFFOUR, PHD

Preview
 What is it about elasticity?
 Types of Elasticity of Demand (Own-Price, Cross Price and Income)
 Own Price Elasticity of Demand
 Types

 Measurement

 Degrees of own PED

 Cross Price Elasticity of Demand
 Income Elasticity of Demand
 Own PED and Sales Revenue
 Is there a relationship?
Concepts of elasticity

 Itmeasures the degree of responsiveness of quantity

demanded to a change in the price of the product in
question, the price of a related product or the income of
the consumer.

 Itmeasures the rate of change in consumer demand in

response to changes it its determinants
Concepts of elasticity

 Recall the Demand function:

Qd  f  P0 , Ps , Pc , Aa,b...z , Yd , T , E, POP

 The focus here is to measure how changes in the P’s and Yd affects Qd
Coefficient of elasticity = Percentage change in quantity demanded
Percentage change in the relevant variable
Concepts of elasticity

 PRICE ELASTICITY OF DEMAND.

 Thismeasures the responsiveness of quantity demanded of a
product to changes in its ‘ own price. For example, if the
price of alcohol increases, what happens to the quantity of
alcohol demanded?
Concepts of elasticity

 CROSS-PRICE ELASTICITY OF DEMAND.

 Thismeasures the responsiveness of quantity demanded
to changes in the prices of other goods (both
complements and substitutes).For example, If the price
of one brand of coffee rises, what happens to the
demand for another coffee brand Or, if the price of
petrol falls, what happens to the demand for cars?
Concepts of elasticity

 INCOME ELASTICITY OF DEMAND

 Thismeasures the responsiveness of demand to a
change in the income of consumers. For example, if
incomes are rising, on average, by $50 per month, what
will happen to the demand for housing?
Price Elasticity of demand

PED = Percentage change in quantity demanded

Percentage change in the price of the product

Two different types of price elasticity (PED )can be calculated, as

follows:
 Arc elasticity of demand.
 Point elasticity of demand.
Arc elasticity of demand
1
Q 2  Q1  / Q 2  Q 1 
2
Arc Ed =
 P 2  P1  / 1  P 2  P1 
2


Q 2  Q1 
x
 P 2  P1 
 P2  P1  Q 2  Q 1 

Figure 2.5 Arc elasticity of demand

Point elasticity of demand

Point Ed 
 Q2  Q1  / Q1  Q2  Q1  P1
 x
 P2  P1  / P1  P2  P1  Q1
Degrees of elasticity: Price Inelastic

  Products with a price elasticity of demand of less than 1 are said to have
a relatively inelastic demand with respect to price
 They are said to be PRICE INELASTIC .
 Examples include;
 Fuel products and other necessities
 Alcoholic beverages
 Cigarettes
Degrees of elasticity: Price Elastic


  Products with a price elasticity of demand greater than 1 are said to
have a relatively elastic demand they are said to be PRICE
ELASTIC .

 Examples include;
 Luxuries
Degrees of elasticity: Unitary Elastic


  Products with a price elasticity of demand exactly equal to 1 are
said to have a unit (OR UNITARY)ELASTICITY OF
DEMAND.
Degrees of elasticity: Perfectly Elastic


  Products with a price elasticity of demand exactly equal to infinity
are said to have a PERFECTLY ELASTICITY OF DEMAND.

 Here at the same price different quantities can be demanded

 Examples include
Visit to a tourist site that you have been to a number of times
Degrees of elasticity: Perfectly Inelastic


  Products with a price elasticity of demand exactly equal to zero are
said to have a PERFECTLY INELASTIC DEMAND.

 Here at different prices quantity demanded remains the same

 Examples include
Saltor products on which we spend an infinitesimal portion of our
income
Figure 2.6 Degrees of elasticity of demand
Cross-price elasticity of demand
  

The terminology regarding the degree of cross-price elasticity (ignoring

the sign)is the same as for price elasticity, namely:
1 =unit cross-price elasticity.
Less than 1 =inelastic cross-price elasticity.
Greater than 1 =elastic cross-price elasticity
 Income elasticity of demand
Income Ed (YED)= Percentage change in demand
Percentage change in real income
Inferior goods
 These are goods of which consumers buy less when real incomes
rise. The value of income elasticity is, therefore, negative. Examples
might be Gari, unbranded clothing, cheap package holidays, etc.
Normal goods
 These are the most common goods with demand generally rising as
real income rises. They can themselves be further subdivided into
two categories: Necessities and Luxuries
Income elasticity of demand
Necessities .
These are goods and services which exhibit a positive income elasticity
of demand, though the value will tend to be less than 1. Articles such as
basic foodstuffs and ordinary day-to-day clothing fall into this category.
Consumers will purchase a certain amount of these goods at very low
levels of income, but they will tend for any given percentage increase in
real income to increase their spending on the goods by a smaller
proportion.
Income elasticity of demand

Necessities .These are goods and services which exhibit a positive income elasticity
of demand, though the value will tend to be less than 1. Articles such as basic
foodstuffs and ordinary day-to-day clothing fall into this category. Consumers will
purchase a certain amount of these goods at very low levels of income, but they will
tend for any given percentage increase in real income to increase their spending on
the goods by a smaller proportion.

Luxuries . At very low income levels, nothing will be spent on these but, once a
certain threshold income level is reached, the proportionate rise in demand for luxury
goods is greater than the proportionate rise in real income, e.g. foreign holidays,
dining out and DVD players.
 Calculation of Two Demand Elasticities

Good A Original New % Change Elasticity

Quantity 100 95 -5%

-5%/10% = -0.5%
Price £1 £1.10 10%

Good B

Quantity 200 140 -30%

-30%/20%=-1.5%
Price £5 £6 20%
 The determinants of price elasticity of demand

• The availability of substitutes

• The proportion of income spent on a good

• Time
 
The relationship between price
elasticity and sales revenue
Total revenue = price x quantity sold
TR = P x Q

Figure 2.7 Demand and total revenue

 Price Elasticity and Total Revenue
Price elasticity of Percentage change in Q
=
demand Percentage change in P

Revenue = P x Q
 If demand is elastic, then

% 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
Price elasticity of Percentage change in Q
=
demand Percentage change in P

Revenue = P x Q
 If demand is inelastic,
% 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.
Price elasticity and total revenue

 With a price inelastic demand:

 an increase in price causes a reduction in quantity demanded, but total
revenue increases;
 a fall in price causes an increase in quantity demanded, but total revenue earned
declines.
 With a price elastic demand:
 an increase in price causes such a large fall in quantity demanded that total revenue
falls;
 a reduction in price causes such a large increase in the quantity demanded that the total
revenue rises.
Marginal revenue

Marginal
   revenue (MR) is defined as the change in () total revenue (TR) as a firm
sells one more or one less unit of its output (Q ).

Average revenue (AR)is the total revenue (TR)

divided by output (Q )or the revenue earned on
average for each unit sold.
A
Figure 2.8 Elasticity, marginal revenue and total revenue
Elasticity, marginal revenue and
total revenue - key relationships
 Marginal revenue falls as output rises. Since the demand curve slopes downwards,
the addition to total revenue from producing and selling extra units declines.
 Average revenue exceeds marginal revenue. When the demand curve is downward
sloping, the marginal revenue from selling one more unit falls faster than the
average revenue from selling the total output.
Elasticity, marginal revenue and
total revenue - key relationships
 When total revenue is increasing, marginal revenue is positive. This results from
the fact that demand is elastic between points A and B on the demand curve DD in
Figure 2.8.
 When total revenue is falling, marginal revenue is negative. A negative marginal
revenue results from demand being inelastic between points B and C in Figure
2.8.
 Total revenue is maximised when marginal revenue is zero which occurs when the
price elasticity is unitary. Therefore,further attempts to increase total revenue by
lowering price below P *will fail because the sales volume will not increase
sufficiently to compensate for the price fall.
PRACTICE EXAMPLE:

1/16/22
A. Pharmacies raise the price of insulin by 10%. Does total
expenditure on insulin rise or fall?
B. As a result of a fare war, the price of a luxury cruise falls 20%.

Does luxury cruise companies’ total revenue

rise or fall?
Answers 36

1/16/22
A. Pharmacies raise the price of insulin by 10%. Does total expenditure on
insulin rise or fall?
Expenditure = P x Q

Dr. S Coleman
For diabetics, Insulin is a necessity.
Since demand is inelastic, THEN…
Q will fall less than 10%,

BUSI12082
…..so expenditure rises.
Answers

B. As a result of a fare war, the price of a luxury cruise falls 20%.

Do luxury cruise companies’ total revenue
rise or fall?
Revenue = P x Q
A luxury cruise is considered a luxury, not a necessity
Since demand is elastic, THEN…..
Q will increase more than 20%,
……so revenue rises.
 Price Elasticity of Supply
Percentage change in Qs

1/16/22
Price elasticity of
=
supply Percentage change in P

 Most everything in the “price elasticity of supply” section corresponds to

similar concepts from the “price elasticity of demand” section.
 Loosely speaking, it measures sellers’ price-sensitivity.
 Again, use the midpoint method can be used to compute the percentage
changes.
 The 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.
PRACTICE EXAMPLE:

 The supply of (new) original paintings by Picasso is inelastic. The

supply of new cars is more elastic.
 Suppose population growth causes demand for both goods to double
(i.e., at each price, Qd doubles).
 For which product will P change the most?
 For which product will Q change the most?
 Answers

Paintings by Picasso (inelastic

When supply is inelastic, supply):
an increase in demand has P
a bigger impact on price
S
than on quantity. D1 D2

P2 B

P1 A

Q1 Q2
Q
Answers 42

New cars
When supply (elastic supply):
is elastic, an increase P
in demand has a bigger
impact on quantity D1 D2
than on price. S

B
P2
A
P1

Q1 Q2
Q
Key learning points

 The
  (own) price elasticity of demand for a product may be defined in
general terms as:
Ed = Percentage change in quantity demanded
Percentage change in the price of the product
 The value of Ed may be calculated on the basis of a movement along a
section of the demand curve, giving rise to a value of the arc elasticity
.This is expressed on the basis of the average quantity and average price,
as follows:

 Q2 Q1 x  P2  P1
 P2  P1  Q2 Q1
Key learning points

For  very
 small price changes, elasticity may be calculated with reference to a single
point on the demand curve, giving rise to a value of the point elasticity ,as follows:
Q 2  Q 1  P1
x
Point  P2  P1  Q 1

Products with a price elasticity of demand of less than 1 (in absolute terms)are said to
have a relatively inelastic demand with respect to price 釦 hey are said to be price
inelastic .In this case, total sales revenue will tend to rise (fall)as price rises (falls).
Products with a price elasticity of demand greater than 1 (in absolute terms)are said
to have a relatively elastic demand 釦 they are said to be price elastic. In this case,
total sales revenue will tend to fall (rise)as price rises (falls).
Key learning points

  
Products with a price elasticity of demand equal to 1 (in absolute terms)are said to
have a unit or unitary elasticity of demand. In this case, total sales revenue will
remain unchanged as price rises or falls.
 The value of price elasticity of demand can range from infinity (in absolute
terms)to 0. A product with a perfectly inelastic demand will have a value of Ed
equal to 0 at every price, while a product with a perfectly elastic demand will
have a value of Ed equal to infinity at a particular price.
 Cross-price elasticity of demand indicates the responsiveness of the demand for
one product to changes in the prices of other goods and services and may be
calculated as:
Key learning points

 Substitutes will tend to have a positive value for cross-price Ed ,while

complements will tend to have a negative value.
 Income elasticity of demand measures the responsiveness of quantity demanded
with respect to (real) income variations as follows:
Income Ed = Percentage change in demand
Percentage change in real income
 Necessities exhibit a positive income elasticity of demand though the value
will tend to be less than 1. In contrast, luxuries will tend to have an income
elasticity of demand greater than 1.
 Marginal revenue is defined as the incremental change in total revenue and is
usually measured as a firm sells one more or one less unit of its output.
Key learning points

 The marginal revenue curve declines at twice the rate of the demand (average
revenue)curve.
 When total revenue is increasing (decreasing),marginal revenue is positive
(negative)such that total revenue is maximised when marginal revenue is zero
.This occurs when the price elasticity of demand is equal to 1.