Topic: Elasticity of Demand

Objective:
The learner will understand the importance of the concept of elasticity to the demand for
goods and services.
Learning Outcomes:
1. Using the appropriate elasticity formula, the learner will be able calculate the price
elasticity of demand of a good or service.
2. The learner will be able to interpret the meaning of the elasticity value derived from
the calculations performed.
3. The learner will be able to apply the knowledge of elasticity to practical uses.
Practical Illustration Exercise:
Decide on an item costing $1.00 that you and your class partner often purchase and write
it on a piece of paper (for example, Snickers Bar: $1.00). Now reduce the price by 40
cents and write down how many bars each of you will buy at the new price. Assume that
at $1.00 you normally will buy one Snicker Bar and when the price drops by 40 cents you
by four bars instead. Your friend reacts differently to the same reduction in price by
indicating that he/she will buy only two bars. (Note: if you both reacted the same, ask
another person how they will react to the change in price). Lets calculate the difference
in the response between you and your friend to the same change in price.
We will use the formula:
% change in quantity bought
----------------------------------% change in price
a) To calculate your change in quantity bought:
New quantity Original quantity (4 minus 1) = 3
b) % change in quantity bought is therefore:
(Change in quantity/Original quantity) x 100%
That is, 3/1 x 100% = 300%
c) To calculate the change in price:
New price Original price (1.00 minus .40) = .60
d) % change in price is therefore:
(Change in price/Original price) x 100%
That is, .60/1.00 x 100% = 60%

e) Now using the formula,

% change in quantity bought
----------------------------------% change in price
we can substitute the values we obtained above to get:
300%
-------- =
60%

Using the same procedure, we can calculate the extent of your friends reaction:
100%
-------- =
60%

1.6

From this, we see that you have a greater reaction than your friend to the same change in
price. Your reaction was measured at 5 compared to 1.6 from your friend. You both show
differing degrees of responsiveness in your buying to a change in the price of the
commodity. This degree of responsiveness to a change in price is known as the elasticity
of demand.
[Note: I have included a primer on calculating price elasticity at the end of this
lesson.]
In economics, the price elasticity of demand measures the responsiveness of the
quantity demanded of a good to change in its price. The formula used to calculate the
price elasticity of demand is

Unitary Elastic:

If the value obtained by the formula is equal to 1, demand is said to

be unitary elastic, because demand expands the same amount as
price.

Elastic:

If the value obtained by the formula is greater than 1, demand is said

to be elastic, because demand expands more than the price.

Inelasic:

If the value obtained by the formula is less than 1, demand is said to

be inelastic, because demand expands less than price.

From your calculations on the Snickers Bar, determine if your demand in unitary, elastic
or inelastic.

Graphical Illustration A: Unitary Elasticity

Notice the percentage change in the quantity denanded is the same as the percentage
change in price.

Graphical Illustration B: Elastic Demand

Graphical Illustration C: Inelastic Demand

Question:
Using the elasticity formula, can you calculate the elasticity values from graphs A, B and
C above?
Perfect Elasticity:
Sometimes demand might be totally unresponsive to a change in price, causing the
resulting elasticity value to be zero. This is known as perfectly inelastic demand.

So what do we do with these values?

Well, they are more useful to sellers than for us really. If a seller knows how we respond
to different prices for its product, it is able to adjust the price in order to get the most
sales revenue. Knowing elasticity helps because it tells the seller whether the total sales
revenue will stay the same or go up or down when he changes the price. Lets look at
some examples.
Unitary Elasticity: No Change in Revenue
Suppose the Starbucks in your area doubles the price of its basic house coffee from $1.50
to $3.00. As a response, people don't buy as much coffee as they used to. As a matter of
fact, Starbucks finds that it sells only half as much coffee as it used to. Now, instead of
selling 60 cups per hour at $1.50 each, Starbucks sells 30 cups per hour at $3.00 each.
Question 1: How much revenue (total sales) does Starbucks make per hour on its house
coffee when it sells 60 cups at $1.50 each?
Question 2: How much revenue (total sales) does Starbucks make per hour on its house
coffee when it sells 30 cups at $3.00 each?
If you answered questions one and two correctly, they should have the same answer for
each question, which is $90.00. So, even though Starbucks doubled its price and now
sells half as much coffee, it is still making the same amount of revenue (money sales) that
it always did. Economists say that the demand for Starbucks coffee is UNITARY
ELASTIC, meaning, if the price doubles, the quantity sold gets cut in half. Similarly, if
the price triples, quantity sold is only one-third as much. If the price gets cut in half
($1.50 to $.75), the quantity sold doubles. Remember, unitary elasticity means an
equal change in price and quantity sold, which results in sales revenue
remaining the same.
Elastic: Change in Revenue
Sometimes you can change your selling price a little, and demand for your product will
respond tremendously. For example, suppose you own a video rental store. Your basic

video rental fee is $3.00. You decide to raise your rental price by 25 cents. You figure
maybe you will rent a few less videos, but customers won't really get too upset. To your
surprise, you start losing a lot of customers! "Hey, wait a minute," you think. "I only
raised my price by a measly quarter. What's going on? I used to rent 40 videos an hour at
$3.00. Now, at $3.25, I'm only renting 10 videos. I used to make $3.00 x 40 = $120 per
hour. Now I'm only making 10 x $3.25 = $32.50 an hour. My total revenue has dropped a
lot."
When customers respond really strongly to a price hike, the demand for your product
(video rentals) drops tremendously, causing you to lose revenue. Demand for this product
is said to be HIGHLY ELASTIC.
But, don't worry, it works both ways. If demand is highly elastic, guess what happens if
you DROP your price, say from $3.00 to $2.75? That's right. Customers will flock to your
business and rent a lot more videos. So actually, you wind up making a lot more revenue
if you drop your price. So, if you rent videos for $2.75, you will probably rent 60 videos
an hour. 60 x $2.75 = $165. You make more revenue ($165) at $2.75 than you did at
$3.00 ($120). You should definitely rent for $2.75, or maybe even lowermaybe $2.50 or
$2.25.
Sometimes, you may sell a product whose demand is HIGHLY INELASTIC. When this
happens, you can raise your price a lot, but customers will keep coming to you for your
product. If you drop your price a lot, you don't get many additional customers. In other
words, customer demand doesn't change very much even when your price does.
For example, suppose you own a gas station in a great location. There are no other gas
stations near yours. You sell gas for $1.80 a gallon regular. One day you decide to raise
your price to $2.20 a gallon regular. The price that you pay your supplier for your gas
hasn't gone up; you just want to make more revenue. You're afraid that customers might
stop coming to your station once they see the new $2.20 price, but they still buy gas from
you. You haven't lost any customers, or maybe you've lost just a few. But your new $2.50
per gallon price is making you a lot more revenue. You don't worry about the few
customers you have lost.
Now you start feeling guilty because you feel you are "ripping off" (gouging) your
customers. You decide to drop your price to $1.60 a gallon. Of course you will keep all of
your old customersthey will be very happy with you, but you hope you're going to get a
lot of brand new customers as well. To your surprise, you get about the same number of
customers you always did, maybe just a few more. Why? Because demand for your
product, gasoline, is HIGHLY INELASTIC.
Question 3: Suppose you run a car detailing business. You detail 12 cars a week and
charge $100 per car. What is your total revenue per week?
Question 4: You decide to cut your price in half, to $50 per car. Now you are getting 30
cars a week. Is the demand for your service unitary elastic or highly elastic? Hint:

Figure out if your total revenue now is the same or higher. If demand is unitary elastic,
then your total revenue stays the same.
The table below summarizes the relationship between elasticity and revenue:

Elasticity and Revenue

When elasticity is
>1
>1
=1
=1
<1
<1

And price
increases
decreases
increases
decreases
increases
decreases

Then revenue
decreases
increases
doesn't change
doesn't change
increases
decreases

To further illustrate the relationship between elasticity and revenue you can visit this
website:
http://www.missouri.edu/~econ5ed/ch5/sld018.htm
Determinants of Elasticity:
From the illustrations so far, you probably will have noticed that the elasticity of demand
will be different for different goods and services. What determines the demand for a
particular good or service?
The most important thing in determining whether the demand will be elastic or inelastic
is the availability of substitutes. For example, we have reason to believe that the demand
for public transportation is less elastic in New York City than it is in some other cities.
The reason could be that there are fewer good substitutes for public transportation in New
York City than in some smaller cities. The private car is the most important substitute for
public transportation for most local traffic, and it is more expensive to keep a car in New
York than it is most other places. Insurance is more costly and parking places are harder
to get. For these and other reasons, there are a larger proportion of the population in New
York than in most cities who do not have cars. In all cities, in increase in the price of a
ride on public transportation will cause some riders to switch to cars. In New York the
proportion that make this substitutioncar instead of subwayis smaller than in most
American cities, for the reasons we have seen. Thus, a 1% increase in the fare in New
York causes a smaller (percent) cut in the number of riders; in other words, elasticity is
smaller.

In general, the more substitutes there are for the good, and the better substitutes, the more
elastic demand will be. The more substitutes, the more people switch, and so, the more
elastic demand is.
Another important thing that affects the elasticity of demand is the proportion of income
spent on the good. An increase in the price of a good or service reduces the purchasing
power of income, and with less income (in purchasing power terms) people will cut back
on purchases of all goods. If people spend a large part of their income on a particular
good or service, then an increase in the price of that good or service reduces the
purchasing power be a relatively great deal, causing a greater cutback than might
otherwise occur. This means a bigger cutback when the price goes upmore elastic
demand.
It will also make a difference how much time people have to adjust to the change in
price, but this can work out in several different ways. For cigarettes, for examplea good
for which habit formation is importantthe elasticity will probably be greater in the long
run, since it will take a long time for people to break their habits and not be replaced by
new smokers. For cars it would work the other way. In a short period of time, if car prices
go up, people can just keep driving their old clunkers. That is, the cars already on the
road are substitutes for new cars. But in a longer period of time the old cars wear out and
the elasticity of demand is less.
Even after all these things are considered, there is still a lot of variation in the elasticity of
demand from good or service to good or service. The only way to answer the question is
to look at the numbers, do the statistics, and let the evidence tell us what the elasticity of
demand is for a particular good.

PRACTICE QUESTIONS
With your assigned class partner, answer the questions below:
1. When orange growers have a good harvest, they are faced with an oversupply of
oranges. The growers want to sell them quickly, so they drop their price of oranges, say
from 20 cents a pound to 10 cents a pound. Farmers figure that they will get a lot of new
customers. People who normally don't drink orange juice will switch to OJ when they see
how low the prices are. But, to the farmers' surprise, they don't get a lot more customers
(not much increased demand for oranges).
In fact, the farmers find out that, if they just destroy most of the oranges instead of selling
them on the open market, the supply of oranges becomes scarce (limited). Farmers can
then actually raise the price of oranges, say from 20 cents a pound to 40 cents a pound.
The farmers may lose a few customers, but most of the customers still buy at the higher
price, and farmers make more total revenue.

a) a) Is the above example of changing orange prices an example of highly elastic or

highly inelastic demand for oranges?
b) b) If you have a lot of competitors in your area, selling the same product as you are,
will demand for that product probably be highly elastic or highly inelastic? Why?
How are competition and elasticity related?
2. You own the only building materials store in town. One night the news weather report
indicates that your town will probably be flooded by heavy rains tomorrow night. The
next morning, you notice that a lot of your customers are buying sand bags; you have lots
of bags in inventory. Your price is $2.00 a bag, and you're selling 200 an hour. You decide
to double your price at noon time to $4.00 a bag. You figure that customers will pay this
high price because they absolutely need the bags, and you have no competition. No other
stores in your area sell sand bags. Even though you double your price, you are still selling
200 bags an hour.
(a) Is the demand for sand bags unitary elastic, highly elastic, or highly inelastic?
(b) Name two other products (besides video rentals) that you believe are highly elastic.
(c) Name two other products (besides gasoline and sand bags during a flood) that you
believe are highly inelastic.
3. Two driversTom and Jerryeach drive up to a gas station. Before looking at the price,
each places an order. Tom says, Id like 10 gallons of gas. Jerry says, Id like $10 of
gas. Pick the correct answer from below:
(a) Tom has higher price elasticity of demand than Jerry.
(b) Tom has higher income elasticity of demand than Jerry.
(c) Its hard to figure out from the information given.
(d) Toms price elasticity of demand is zero.
4. The price elasticity of demand of a good is 1.25. Pick the correct answer below:
(a) the demand for the good is elastic.
(b) the demand for the good is inelastic.
(c) the good is a necessity
(d) the good is a luxury
5. The demand for a good is highly inelastic if
(a) the price elasticity of the good is close to zero.
(b) the income elasticity of the good is close to one
(c) if it is a necessity
(d) both a and c.
6. The demand for a particular brand of tooth paste
(a) can be more elastic than the demand for tooth paste, because tooth paste is a necessity.
(b) can be less elastic than the demand for tooth paste, because tooth paste is a necessity.
(c) more elastic than the demand for tooth paste, because a particular brand always have
close substitutes.
(d) none of the above.

7. A perfectly inelastic demand curve

(a) is a vertical line parallel to Y-axis.
(b) is a vertical line parallel to X-axis.
(c) indicates a good with no close substitutes.
(d) a and c.
(e) b and c.
8. If the price of steaks rises from $6 to $10 per pound, and the quantity purchased falls
from 90 to 70 pounds, the price elasticity of demand (in absolute value) is
a) 0.333
b) 0.5
c) 2.0
d) 3.0
9. The price elasticity of demand for automobiles measures the responsiveness of
(a) consumer purchases to a change in the price of automobiles
(b) consumer purchases to a change in the quality of automobiles
(c) supplier production levels to a change in the price of automobiles
(d) consumer purchases of automobiles to a change in their income
10. Because of unseasonably cold weather, Florida orange growers expect (1) fewer
bushels of oranges to be harvested, (2) a higher market price for oranges, and (3) larger
total revenues from this years crop. This statement would most likely be correct if the
(a) demand for Florida oranges was elastic
(b) demand for Florida oranges was inelastic
(c) demand for Florida oranges was unitary elastic
(d) income elasticity of Florida oranges was negative
11. The price of a newspaper increases by 10% and quantity demanded of newspapers
falls by 10%. The demand for newspapers is
(a) perfectly elastic
(b) unitary elastic
(c) elastic
(d) inelastic
12. The ABC Computer Company wants to increase the quantity of computers it sells by
5%. If the price elasticity of demand is 2.5 the company must
(a) increase price by 2.0%
(b) decrease price by 2.0%
(c) decrease price by .5%
(d) decrease price by .5%

13. As you move down a straight-line-downward-sloping demand curve, the price

elasticity of demand
(a) becomes more elastic.
(b) becomes more inelastic.
(c) remains constant because the slope is constant.
(d) may become more or less elastic depending on the slope of the demand curve.
14. A new fertilizer has led to an increase in the number of tomatoes harvested and a
decrease in the income of tomato growers. Therefore, the demand for tomatoes must be
(a) elastic.
(b) inelastic.
(c) unitarily elastic.
(d) perfectly inelastic.
15. Fill in the blanks in the table below. Use the midpoint formula to compute elasticity
values.
Price

Quantity
Demanded

$0
1
2
3
4
5
6
7

14
12
10
8
6
4
2
0

Total
Revenue

Percent
Change in
Price
---

Percent
Change in
Quantity
---

Elasticity
---

ASSIGNMENT QUESTIONS
1) Finally we will have a chance to apply the price elasticity concept to real world
situations. Discuss the following questions with your partner and submit your written
answers to the instructor for evaluation. Each answer earns a maximum of 10 points.
2) If the managers of a sports stadium plan to increase ticket prices in order to increase
revenue, they must believe that demand is inelastic. Explain.
3) After Hurricane Andrew inflicted millions of dollars of damage on Southern Florida,
the prices of construction materials (such as plywood) doubled in price. In an effort to
protect consumers, the government considered imposing price regulations that would
require construction materials to be sold at the same prices that prevailed prior to the

hurricane. Do you think this would have been a sound economic idea? Why or why
not?
4) At an urban college where most students commute to classes, there are 8,000 parking
spaces for students. All students pay $20 a quarter for a pass that allows them to park
in any one of those 8,000 spaces. Between 8 am and 1 pm there are always students
waiting in parking lots for spaces to open up. Students attending classes during this
time are always complaining about how difficult it is to find a place to park. Between
5 pm and 9 pm there are always a large number of empty spaces in the parking lots.
Students who attend classes at night never have a problem parking. Illustrate the
parking situation for these two different times of day using supply and demand
curves. Draw separate graphs for the day and night students. Are these markets in
equilibrium? Explain. The Director of Parking Services has asked you to help him
solve this problem. What would you suggest?
5) The university you attend needs to increase total revenue. The president suggests that
by raising tuition by 5%, total revenue will increase. However, after the tuition
increase, total revenue actually fell. What can you infer about the price elasticity of
demand for an education at your university? Why is this likely to be true? What did
your university president assume to be true about the price elasticity of demand for an
education at your university?
6) Economist David Romer found that in introductory economics classes a 10-percent
increase in class attendance is associated with a 4-percent increase in course grade.
What is the elasticity of course grade with respect to class attendance? Do you think it
is worth it to go to class or not?

Primer on Calculating the Price Elasticity of Demand

You may be asked the question "Given the following data, calculate the price elasticity of
demand when the price changes from $9.00 to $10.00"
Here is a demand schedule data:
Price
$7
$8
$9
$10
$11

Quantity
Demanded
200
180
150
110
60

To calculate the price elasticity, we need to know what the percentage change in quantity
demand is and what the percentage change in price is. It's best to calculate these one at a
time.
Calculating the Percentage Change in Quantity Demanded
The formula used to calculate the percentage change in quantity demanded is:
[QDemand(NEW) - QDemand(OLD)] / QDemand(OLD)
By filling in the values we wrote down, we get:
[110 - 150] / 150 = (-40/150) = -0.2667
We note that % Change in Quantity Demanded = -0.2667 (We leave this in decimal
terms. In percentage terms this would be -26.67%). Now we need to calculate the
percentage change in price.
Calculating the Percentage Change in Price
Similar to before, the formula used to calculate the percentage change in price is:
[Price(NEW) - Price(OLD)] / Price(OLD)
By filling in the values we wrote down, we get:
[10 - 9] / 9 = (1/9) = 0.1111
We have both the percentage change in quantity demand and the percentage change in
price, so we can calculate the price elasticity of demand.

Final Step of Calculating the Price Elasticity of Demand

We go back to our formula of:
PEoD = (% Change in Quantity Demanded)/(% Change in Price)
We can now fill in the two percentages in this equation using the figures we calculated
earlier.
PEoD = (-0.2667)/(0.1111) = -2.40
When we analyze price elasticities we're concerned with their absolute value, so we
ignore the negative value. We conclude that the price elasticity of demand when the price
increases from $9 to $10 is 2.40.