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Lesson 06
ELASTICITIES
ELASTICITY
Elasticity is a term widely used in economics to denote the “responsiveness of one variable to
changes in another.” In proper words, it is the relative response of one variable to changes in
another variable. The phrase "relative response" is best interpreted as the percentage change.
TYPES OF ELASTICITY
There are four major types of elasticity:
• Price Elasticity of Demand
• Price Elasticity of Supply
• Income Elasticity of Demand
• Cross-Price Elasticity of Demand
Price Elasticity of Demand:
Price elasticity of demand is the percentage change in quantity demanded with respect to the
percentage change in price.
Price elasticity of demand can be illustrated by the following formula:
If a 15% rise in the price of a product causes a 15% rise in the quantity supplied, the price
elasticity of supply will be:
PЄs = 15 % = 1
15 %
If a 2% rise in the consumer’s incomes causes an 8% rise in product’s demand, then the
income elasticity of demand for the product will be:
YЄd = 8% =4
2%
Cross-Price Elasticity of Demand:
Cross price elasticity of demand is the percentage change in quantity demanded of a specific
good, with respect to the percentage change in the price of another related good.
If, for example, the demand for butter rose by 2% when the price of margarine rose by 8%,
then the cross price elasticity of demand of butter with respect to the price of margarine will be.
PbЄda = 2% = 0.25
8%
If, on the other hand, the price of bread (a compliment) rose, the demand for butter would fall.
If a 4% rise in the price of bread led to a 3% fall in the demand for butter, the cross-price
elasticity of demand for butter with respect to bread would be:
PbЄda = - 3% = - 0.75
4%
EXAMPLE OF 2 FIRMS
Firm 1: (Inelastic demand curve)
For inelastic demand curve, firm increases its prices but quantity demanded does not change
as much. Increase in price is greater while the decrease in quantity is smaller. So firm will earn
more revenues by increasing prices. So TR increases as the price increases.
Price
10 F
Inelastic demand
curve
6 T
6
0 90 100 Quantity
Demanded
Є = percentage change in Qd
Percentage change in P
= 90 – 100 ÷ 10 – 6
100 6
= - 0.15
In the above figure, Elasticity for firm 1 is equal to -0.15; it is less than 1 (ignoring minus sign)
which shows that the demand curve is inelastic.
Price
10
0 40 100 Quantity
Demanded
Є = percentage change in Qd
Percentage change in P
= 40 – 100 ÷ 7 – 6
100 6
= - 3. 6
In the above figure elasticity for firm 2 is -3.6; it is greater than 1 (ignoring minus sign) which
shows that the demand curve is elastic.
Price
10
8 K
6
L
6
0 8 16 Quantity
Demanded
P 60 -15P P2 Qd = 60 – 15P + P2
0 60 0 0 60
1 60 -15 1 46
2 60 -30 4 34
3 60 -45 9 24
Then draw a figure, plot prices on vertical axis and quantity on horizontal axis. The resulting
curve will be downward sloping curve.
7
6
5
4
3
2
1
0
0 20 40 60 80
To find the point elasticity of demand from this quadratic equation, differentiate it with respect
to price,
Qd = 60 – 15P + P2
dQ/dP = -15 + 2P
IF P=3 then