Elasticity of

Demand

by
Balaji K
 Overview
 Elastic Vs Inelastic Demand
 Difference between elastic, inelastic, and unitary
elastic demand/supply
 Types of Elasticity of Demand
 Determinants of price elasticity of demand
 Income elasticity
 Cross price elasticity of demand

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Elasticity of Demand

 If price rises by 10% - what happens to demand?

 We know demand will fall
 By more than 10%?
 By less than 10%?
 Elasticity measures the extent to which
demand will change

3
Elasticity - Concept

 According to Marshall “The elasticity of

demand in a market D
η is great or small
according as the amount demanded
increases much or little for a given fall
in the price and diminishes much or
little for a given rise in Price”

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Elastic Demand

 “A small change in price may lead to a

great change in quantity
η demanded.In
D

this case ,demand is elastic”

Price in Rs Quantity Demanded
Demand is elastic if the of milk
percentage change in
quantity is greater than the 25 1 litre
percentage change in price.
24 2 litre
E>1 27 0.5 litre

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InElastic Demand

“A big change in price followed by

small change in quantity
ηD
demanded.In
this case ,demand is inelastic”
E<1
Price in Rs Quantity Demanded of milk

25 1 litre

14 1.2 litre

20 1.5 litre

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Types of Elasticity

 1.Price Elasticity
η
a)Perfectly Elastic
D

b)Perfectly Inelastic
c)Relatively Elastic
d)Relatively Inelastic
e)Unit Elasticity of Demand

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Types of Elasticity

 2.Income Elasticity
a)Zero IncomeηElasticity
D

b)Negative Income Elasticity

c)Unit Income Elasticity
d)Income Elasticity greater than unity
e)Income Elasticity less than unity
3.Cross Elasticity of Demand
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Price Elasticity

 The price elasticity of demand is the

percentage changeη in quantity
D

demanded divided by the percentage

change in price.

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Part 1: Price Elasticity of Demand
- Calculation
 Base value for percentage changes in price or quantity is always
midway between initial value and new value
 Denominator

- Define the percentage change in price from any value P0 to any other
value P1 as ( P 1 −P 0 )
% Change in Price =
( P1 +P 0 )
• Numerator: 2

When quantity demanded changes from Q0 to Q1,

percentage change is calculated as
(Q _ Q )
% Change in Quantity Demanded = 1 0

Q + Q 
1
 0

 2 

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 Figure 1: Calculating Price Elasticity of Demand
-- laptop computer demand
Price per
Laptop
D
$3,500
C
3,000
2,500
2,000
B
1,500
A
1,000
D

100,000 200,000 300,000 400,000 500,000 600,000 Quantity of

Laptops
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 Calculating Price Elasticity of Demand
-- An Example
 Now let’s calculate an elasticity of demand for laptop
computers using data in Figure 1 from point A to point B
(500,000 − 600,000) − 100,000
%∆Q = = = −0.182, or − 18.2 %
 (500,000 + 600,000)  550,000
 2 
($1,500 − $1,000) $500
% ∆P = = = 0.400, or 40.0 %
 ($1,500 + $ 1, 000 )  $1,250
 2 
• Use percentage changes for price and quantity to
calculate price elasticity of demand (η D )
− 0.182
η D
=
0.400
= −0.46

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Calculating Price Elasticity of Demand
-- by Total Outlay Method
Price in Rs Quantity Total Outlay
Demanded
4.50 4 18

4 4.5 18

3 6 18

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Price Elasticity of Demand
-- Categorize Goods
 Inelastic Demand
 Price elasticity of demand between 0 and -1
% ∆Q
Inelastic Demand ⇒ < 1.0
%∆P
|% Change in Quantity Demanded| < |% Change in Price|

• Extreme Case: Perfectly Inelastic Demand

– Price elasticity of demand equal to 0

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Categorizing Goods by Elasticity
• Elastic Demand
– Price elasticity of demand with absolute value > 1
% ∆Q
Elastic Demand ⇒ >1
%∆ P
|% Change in Quantity Demanded| > |% Change in Price|

• Extreme Case: Perfectly (infinitely) Elastic Demand

– Price elasticity of demand approaching minus infinity
• Another Special Case: Unitary Elastic Demand
– Price elasticity of demand equal to -1

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 Figure 2: Extreme Cases of Demand
(a) (b)
Price Price
per per
Unit Unit
D
$4 $4
Perfectly Elastic
3 3 Demand
Perfectly Inelastic
Demand
2 2 D

1 1

20 40 60 80 100 20 40 60 80 100
Quantity Quantity

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Perfectly Elastic Demand Curve
The demand curve is horizontal, any change in price can and
will cause consumers to change their consumption.

Perfectly Inelastic Demand Curve

The demand curve is vertical, the quantity demanded is totally
unresponsive to the price. Changes in price have no effect on
consumer demand.

In between the two extreme shapes of demand curves

are the demand curves for most products

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Figure 3: Relationship between demand
slope and elasticity
Elasticity = |(1/slope)*(P/Q)|

PRICE Perfectly inelastic

Perfectly elastic

Relatively Elastic Demand

Relatively Inelastic Demand

Quantity

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 Elasticity Along a Demand Curve
Elasticity declines
Ed = ∞ Perfectly Elastic along demand curve
$10 as we move toward
9 the quantity axis
8 Ed > 1 Relatively
Elastic
7
6
Price

Unit Elastic
Ed = 1
5
4 Relatively Inelastic
3 Ed < 1
2 Perfectly Inelastic

1 Ed = 0
0 1 2 3 4 5 6 7 8 9 10 Quantity
Elasticity and Total Revenue
 Total revenue (TR) of all firms is defined as
 TR = P x Q
 Rule: when two numbers are both changing, percentage
change in their product is (approximately) the sum of their
individual percentage changes
 Applying this to total revenue


%∆TR = %∆Q + %∆P
Example: assume demand is unitary elastic and Q rises by
10%
 % Change in TR = 10% + (-10%) = 0

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Figure 4(a): When does it pay to raise the
price?
Price increases from P0 to P1 and quantity
demanded decreases from Q0 to Q1
PRICE

P1

P0

Demand
Quantity
Q1 Q0
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Figure 4(b): When does it pay to raise the
price?
 How about revenue change?
Change in total revenue =
PRICE
P1Q1-P0Q0

P1

P0

Demand
Quantity
Q1 Q0
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Figure 4(c): When does it pay to raise the
price?
 How much is the change in total revenue?
Change in total revenue =
PRICE
P1Q1-P0Q0

Gain = Q1(P1 – P0)

P1
= Q1ΔP

Loss = P0*(Q0 - Q1)

P0
= P0 ΔQ

Demand
Quantity
Q1 Q0
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Figure 5 Effects of Price Changes on Expenditure

W h e r e d e m A ap nr i d c e i si n : c r eA pa sr i e c e w di l el : c r e

I n e l (a | s | t< i1 c ) i n c r e xa ps e n d d i t eu cr er e a s e e
u n i et a l a r y( s | t i | c= 1 ) c a u s e n o c ch a a un n so g e e c h i n a n g
e x p e n d i t u r e e x p e n d i t
e l a ( s| t i| c> 1 ) d e c r e a s e e i nx cp re e n a d s i et u er e x

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Elasticity & Straight-Line Demand Curves
 Look at percentage change in P
 Look at percentage change in Q
 As we move upward and leftward by equal distances,
percentage change in quantity rises
 Percentage change in price falls
Elasticity of demand varies along a straight-line demand
curve
 Demand becomes more elastic as we move upward
and leftward

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 10

PRICE
| ED | > 1
ED = 1 ( 
• P 
slope  Q 

)
elastic (1/ slope) = 5 = fixed
8
As P increases, Q falls,
elasticity gets bigger
6
| ED | = 1
Unit elastic
45
| ED | < 1

2 inelastic

0
0 10 20 30 40 50
QUANTITY

25
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 Small Summary
Inelastic Unitary Elastic Elastic Demand
Demand Demand

Definition |ED| <1 |ED| =1 |ED| >1

Total Revenue Same direction Does not change Opposite direction

as price change with price change from price

Straight Line Lower segment Middle point Upper segment

Demand Curve

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What Affects Elasticity?
-- 1. Availability of Substitutes
 Demand is more elastic
 Ifclose substitutes are easy to find and buyers
can cut back on purchases of the good in
question
 Demand is less elastic
 If
close substitutes are difficult to find and
buyers can not cut back on purchases of the
good in question

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What Affects Elasticity?
-- 2. Narrowness of Market
 More narrowly we define a good, easier it
is to find substitutes
 More elastic is demand for the good
 More broadly we define a good
 Harder it is to find substitutes and the less
elastic is demand for the good
 Different things are assumed constant
when we use a narrow definition
compared with a broader definition
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What Affects Elasticity?
-- 3.Necessities vs. Luxuries
 The more “necessary” we regard an item, the
harder it is to find a substitute
 Expect it to be less price elastic
 The less “necessary” (luxurious) we regard an
item, the easier it can be substituted
 Expect it to be more price elastic
 Example?

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What Affects Elasticity?
-- 4. Time Horizon
 Short-run elasticity
 Measured a short time after a price change
 Long-run elasticity
 Measured a year or more after a price change
 Usually easier to find substitutes for an item in
the long run than in the short run
 Therefore, demand tends to be more elastic in the
long run than in the short run

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What Affects Elasticity?
-- 5. Importance in the Buyer’s Budget
 The more of their total budgets that
households spend on an item
 The more elastic is demand for that item
 The less of their total budgets that
households spend on an item
 The less elastic is demand for that item

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Importance of Elasticity of Demand

 Price Fixation
 Production
 Distribution
 International Trade
 Public Finance

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 Figure 6 Some Short-Run Price Elasticities of
Demand elastic

S p e cB i fr i a c n d s N a r rC o aw t e g o r i e s B r o C a ad t e g o r i e

T i d De e t e r g – 2e .9n 7 t T r a n s a t l a n t i –c 1 .0A 3 i r RT r e a c v r ee l a – 1t i o. 0 n 9
T o u r i s m in T – 1 h .0a 2 i la n d
Pe p s i –2 . 0 8 G r o Bu ne de f –1 . 0 2 C l o t h i n – g0 . 8 9
C o k e – 1 .1 7 Po r k – 0 .8 7 Fo o d – 0 .7 6
M ilk – 0 .4 5 I m p o r t s – 0 .8 5
C ig a r e t t e s –0 . 4 5 T r a n s p –o 0 r .6 t 5 a t i o
E l e c t r i c i t y – 0 . 4t o 0– 0 .0 5
B e e r – 0 .6 2
E g g s – 0 .6 2
G a s o li n e – 0 .0 2
O il – 0 .5 1

inelastic

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Part 2: Income Elasticity of Demand
 Percentage change in quantity demanded
divided by the percentage change in income
 With all other influences on demand with the price of
the good kept constant
% change in Quantity Demanded
ηY = % Change in Income
% ∆Q
=
% ∆Y

• Interpretation: percentage increase in quantity

demanded for each 1% rise in income
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Income Elasticity of Demand vs.
Price Elasticity of Demand
 Price elasticity measures sensitivity of demand to price as
we move along a demand curve from one point to another
 Income elasticity tells us relative shift in demand curve—
increase in quantity demanded at a given price
 While a price elasticity is virtually always negative,
income elasticity can be positive or negative
 Normal goods
 Inferior goods

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Income Elasticity of Demand
 Economic necessity
 Good with an income elasticity of demand between 0 and 1
 Economic luxury
 Good with an income elasticity of demand greater than 1
 An implication
 As income rises, proportion of income spent on economic
necessities will fall
 While proportion of income spent on economic luxuries will rise
 But, it is important to remember that economic
necessities and luxuries are categorized by actual
consumer behavior
 Not by our judgment of a good’s importance to human survival

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Income Elasticity of Demand
Zero Income Elasticity
Quantity demanded remains the same, even though money income increases. E=0

Negative Income Elasticity

When income increases,quantity demanded falls(E<0)

Unit Elasticity
When an increase in income brings about a proportionate increase in quantity demanded
,then income elasticity of demand is equal to 1(E=1)

Income Elasticity Greater Than Unity

In this case,an increase in income brings about a more than Proportionate increase in
quantity demanded.(E>1)

Income Elasticity Less Than Unity

When income increases quantity demanded also increases but less than
Proportionately(E <1)

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 Figure 9 Some Income Elasticities

I n c o m e I n c o m e
G o o d o r S e r v Ei c l ea s t i c i t y G o oo rSd e r v i c e E l a s t i c i t y

Fr e sF r hu i t 1 . 9 9 I m p o r t s 2 .3 7
C o m p u t e r s 1 .1 7
T r a n s a t l a n t ic A 1 i r. 4 T 0 r a v eT l r a n s p o r t a t i o 1 n .9 7
C o l l Ee gd eu c a t io n 0 .5 5
C ig a r e t t e s 0 .0 5 R e c r e a t io n 1 .7 0
C h ic k e n 0 . 4 2 C lo t h in g 1 . 0 2
P o r k 0 .4 3 Fo o d 0 . 6 t o 00 . 8 5
F r e s h V e g e t a b 0 l e .6 2s
T o o t h E x t r a c –t 0i o .3 1nt o 0 .7 4
G r o u n d B e e f – 0 .0 2
B r e a d –0 . 4 2
P o t a t o e s – 0 .1 8 Luxury (>1), Necessity (0<EY <1),
Normal (>0) and Inferior (<0)
Goods defined by Income
elasticties
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Part 3: Cross-Price Elasticity of Demand
 Cross-price elasticity of demand
 Percentage change in quantity demanded of one good (x)
caused by a 1% change in price of another good (z)
 While all other influences on demand remain unchanged
% ∆Qx
η XZ = %∆Pz
• % Change in Quantity of Prod X / %Change in Price of
Prod Y
• Substitutes (+)
• Complements (-)
ηxztwo goods are related
• Its size tells us how closely the
– A large absolute value for suggests that the two goods
are close substitutes or complements
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 k Y ou
Th a n

Complements (-) vs Substitutes (+)

defined by sign of cross price elasticity

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