Unit 2: Demand and Consumer

Preferences - Elasticity

Session 2 (Source: Sloman, J. 2006, Economics, FT Pearson,

Harlow) Chapter 3
 Learning Objectives
At the end of the lesson, students will be able to:
1. Discuss the determinants of price elasticity of demand.
2. Apply the price elasticity of demand in the industry.
3. Explain the concept of income elasticity of demand.
4. Interpret the coefficient of income elasticity of demand.
5. Explain briefly the concept of cross elasticity of demand.
6. Interpret the coefficient of cross elasticity of demand.
 A measure of the sensitivity or responsiveness of
quantity demanded to changes in price of the good
itself, income or the price of other goods.

3 types of demand elasticities:

1) Price elasticity of demand;
2) Income elasticity of demand; and
3) Cross price elasticity of demand
 A measure of the responsiveness of a
change in the quantity demanded to a
change in the price of the good itself.

Price elasticity of demand looks at a

movement along a given demand curve.
 Formula:
The mid-point formula for price elasticity of demand
is:
P Ed = %
Qd
%
P

Q 2 − Q1
(Q 2 + Q1)
=
P 2 − P1
( P 2 + P1)
 Note:
Price Elasticity is always negative because of the
law of demand. According to the law, price and
quantity demanded are inversely related.

Since the denominator and numerator of the

equation moves in opposite directions, hence the
coefficient of P Ed is always negative.
It is difficult to work with the negative sign, hence
drop the negative sign. To change it into a positive
figure, economists take its absolute value.
Normally, we use the simple formula below when
calculating percentage changes
EP = %
Q
%
P

∆Q / Q
=
∆P / P
∆Q P
= x
∆P Q
 Problem:
The use of the
simple formula will
result in different
answers for EP even
30 B
though we are
moving along the
same points, e.g. Pt 25 A
A  B, & from B 
A. D

10,000 20,000
Example:
Suppose ticket prices for Stefanie Sun’s concert is
raised from $25 to $30. Calculate the P Ed given
that the number of seats sold falls from 20,000 to
10,000
[movement from point A to B].
10,000 − 20,000
20,000 50%
EP = = = 2.5
30 − 25 20%
25
 Example:
Observe what happens if ticket prices for her
concert is lowered from $30 to $25
[movement from point B to A]

20,000 − 10,000
10,000 100%
EP = = = 5.9
25 − 30 17%
30
Simple formula - weakness: 2 different answers
because different bases used for each computation
Why use the mid-point formula?
The coefficient of EP remains the same (3.7)
whether we move up [point A to B] or move down
[point B to A] the demand curve.

Using the mid-point formula:

10,000 − 20,000
(20,000 + 10,000) 33
EP = = = 3.7
30 − 25 9
(25 + 30)
Why use the mid-point formula?

Reason:
Base did not change regardless of whether P
rose or fell, since we are moving along the same
range.

Bases in the mid-point formula are made up of

AVERAGE quantities and prices.
The coefficients of price elasticity of
demand can range from zero to infinity.

Elasticity is always measured

with respect to the value 1.
Elastic demand is a ‘condition in which the
percentage change in quantity demanded is
greater than the percentage change in price’.

%∆Q
EP = >1
%∆P
⇒ %∆Q > %∆P
Quantity demanded changes MORE than
proportionately to a change in price
Graphically, the demand curve is relatively
flat
P

Q
Inelastic demand is a ‘condition in which the
percentage change in quantity demanded is
less than the percentage change in price’.

% ∆Q
EP = <1
% ∆P
⇒ % ∆Q < % ∆P
Quantity demanded changes LESS than
proportionately to a change in price
Graphically, the demand curve is relatively steep

D
Q
Unitary demand is a ‘condition in which the
percentage change in quantity demanded is equal
to the percentage change in price’.

% ∆Q
EP = =1
% ∆P
⇒ % ∆Q = % ∆P

Quantity demanded and price changes

proportionately
Graphically, a demand curve that is unit elastic is
shaped like a rectangular hyperbola.

D
Q
Perfectly elastic demand is a ‘condition in which a
small percentage change in price brings about an
infinite percentage change in quantity demanded.’

% ∆Q
EP = =∞
% ∆P
Demand is perfectly elastic
when an unlimited amount
of good is demanded at
that one price. P
Any change in price
causes quantity demanded
to fall to zero.
P D
Graphically, a perfectly
elastic demand curve is
horizontal.

Q
Perfectly inelastic demand is a ‘condition in which
quantity demanded does not change as the price
changes.’

% ∆Q
EP = =0
% ∆P
Demand is perfectly
inelastic when a change in
price results in NO change
in quantity demanded. P
D
Graphically, a perfectly
inelastic demand curve is
represented by a vertical
straight line.

Q0 Q
 Elasticity need NOT be constant along a given
demand curve.

Elasticity is constant only if:

demand is unit elastic [P Ed = 1]; or
demand is perfectly elastic [P Ed = ∞]; or
demand is perfectly inelastic [P Ed = 0].
Constant elasticity?

It means that the coefficient of P Ed

calculated remains the same regardless of
where you are on the demand curve.
 Elasticity CHANGES along a LINEAR negatively
sloped demand curve.

Demand is elastic above the mid-point of a linear

negatively sloped demand curve, unit elastic at the
mid-point and inelastic below the mid-point.

Elasticity falls as we move down the demand curve.

The concept of price elasticity of demand is
closely linked to a firm’s total revenue.

Definition of total revenue (TR):

The total number of dollars a firm earns from
the sale of a good or service, which is equal
to its price multiplied by the quantity sold’.
 Total revenue (TR):
Formula:
TR = P x Q

where P = price at which the good is sold

Q = quantity of the good sold
Total revenue (TR): TR = P x Q
From the formula above, observe that:
Since price and quantity change in opposite
directions, what happens to TR will depend on
which variable changes more.
How much price and quantity change in turn
depends on price elasticity of demand.
Knowledge of P Ed assist the producer / firm in
deciding whether to raise or lower its price (which
affects Q and hence TR) in order to maximise its
profit (Profit = TR – TC)
 Summary:
Inelastic Unit elastic Elastic
(0 < Ed < 1) (Ed = 1) (Ed > 1)

When P ↑ When P ↑ When P ↑

% ∆Q < % ∆ P % ∆Q = % ∆ P % ∆Q > % ∆ P
 TR ↑  TR unchanged  TR ↓
When P ↓ When P ↓ When P ↓
% ∆Q < % ∆ P % ∆Q = % ∆ P % ∆Q > % ∆ P
 TR ↓  TR unchanged  TR ↑
Key points:
Elastic demand: TR & P are inversely related,
i.e. TR  when P  and vice-
versa.
Inelastic demand: TR & P are directly related,
i.e. TR  when P  & vice-versa.

Unitary demand: TR remains unchanged no

matter whether P /.
Recall that elasticity is not
constant along a linear Px P Ed >1
negatively sloped demand P Ed =1
curve.
As we move down the P Ed <1
demand curve (i.e. P ),
observe that demand is Qx
elastic above the mid-point
TR
of the demand curve, unit ($)
elastic at the midpoint and
inelastic below the
midpoint.
TR
Qx
Elastic dd:
Px P Ed >1
%Q>%P
 TR  P Ed =1

Inelastic dd: P Ed <1

%Q<%P
 TR  Qx

TR
Unitary dd:
($)
%Q=%P
 TR is at its max.

TR
Qx
Why is TR at its maximum when demand is unit
elastic?
Unit elasticity occurs at the mid-point of the
demand curve.
The mid-point (unit elasticity) separates elastic
from inelastic portion of demand curve.
Since TR rises along the elastic portion of the
demand curve and falls along the inelastic portion
of the demand curve when P falls,
TR must be at its maximum when demand is unit
elastic.
i. Availability of substitutes
The more & closer the substitutes, the more
elastic is demand.

Why?
When the price of a good increases
[i.e. becomes relatively more expensive],
it is easier to switch to consuming the substitute.
Demand for a good or service is price inelastic if
the good has no close substitutes.
i. Availability of substitutes

Example:
If the price of beans increase, consumers can
switch to peas.
Example:
If the price of electricity increase, households
have few or no substitutes because electricity
are usually provided by a state-owned company
which has no competitor usually.
i. Availability of substitutes
The availability of substitutes depends on how
the good is defined.

The narrower the definition, the more substitutes

there are.

Demand for the good is elastic.
The broader the definition, the less substitutes
there are.

Demand for the good is inelastic.
i. Availability of substitutes
The availability of substitutes depends on how
the good is defined.

Example 1: Demand for PCs is inelastic in

general, but the demand for specific brands of
PC e.g. Apple, IBM, Dell computers is elastic.
Example 2 : Demand for Food is inelastic in
general but the demand for specific type of food
e.g. burgers, chicken rice, noodles is elastic.
ii. Share of budget spent on the product

Demand for a good that takes up a small

proportion of the consumer’s budget tends to
be inelastic.

Why?
The good is likely to be rather cheap.
Any percentage increase in the price of the
good is likely to affect our budget only
marginally.
ii. Share of budget spent on the product

Example:
Price of salt/kg  by 10% from $1 to
$1.10/kg.
Negligible increase in price by only
10cents/kg.
ii. Share of budget spent on the product

However, demand for a good that takes up

a large proportion of the consumer’s
budget tends to be elastic.
Why?
The good is likely to be expensive.
Any percentage increase in the price of
the good will dent our budget significantly.
 iii. Time

With time, demand for a good tends to become

more elastic because:

 more substitutes become available over time;

 given more time, consumers become more
willing to substitute / switch to other goods.
iii. Time

Example:
When you want to buy something in a hurry,
you usually end up paying a premium on the
price.
However, if you have time to shop around and
compare prices, you end up paying a lower
price.
iv. Luxury or necessity

Demand for a luxury tends to be

price elastic.

Demand for a necessity tends to be

price inelastic.
 Summary:
Inelastic demand Elastic demand

Few substitutes
Many substitutes

Small % of the budget
Large % of the budget

Shorter time period
Longer time period

Necessity
Luxury
This measures the responsiveness of
change in demand to changes in income

EY = % Change in Demand for Good

% Change in Income
= %∆DD / %∆Y
Sign Type of Good
Positive Normal
(As Y↑=> Necessities EY < 1 Inelastic
DD↑) Luxury EY > 1 Elastic

Negative Inferior
(As Y↑=>
DD↓)
 Income ($) Demand for Good X
100 20
120 25
140 32

Income increases from $100 to $120

EY = +25% / +20% = +1.25
Income increases from $120 to $140
EY = +28% / +16.7% = +1.67
 Income ($) Demand for Good X
100 20
120 18
140 16

Income increases from $100 to $120

EY = -10% / +20% = -0.5
 Application of Income Elasticity
Be able to forecast accurately changes in
consumer demand as well as develop new
products to meet changes in consumer
preferences as income changes.
For governments, such information is
important where taxation is concerned. To
tax products with high income elasticity of
demand to raise revenue
Measures the responsiveness of demand
for one good to changes in the price of
another good

EX = % Change in Quantity of Good A

% Change in Price of Good B
= %∆QA / %∆PB
Price of Butter Demand for Margarine
$1.00 100 kg
$1.20 150 kg

If price of butter increases from $1.00 to

$1.20
Cross elasticity coefficient = +50%/+20%
= +2.5
 Price of Butter Demand for Bread
$1.00 100 kg
$1.20 90 kg

If price of butter increases from $1.00 to

$1.20
Cross elasticity coefficient = -10%/+20%
= -0.5
Sign of the Relationship between the 2
coefficient goods
Positive Substitutes

Negative Complements

Zero Independent
The size of the
coefficient indicates the
closeness of the
relationship of the two
goods.
 Application of Cross Elasticity
It is important to know what effect a change in
the price of its competitor’s product will have
on a firm’s sales.
This information may be useful in the
formulation of the firm’s own pricing and
marketing strategies.
 Price
Definition Responsiveness of a
change in quantity
demanded to a change
in the price of the
good
Income Cross
Responsiveness of a Responsiveness of a
change in quantity to a change in quantity for
change in income a good to a change in
the price of another
good

Formula (Q1 − Q 0) EY = ∆Q
%∆ Ex = ∆QB
%∆
(Q1 + Q 0) ∆Y
%∆ ∆ PA
%∆
( P1 − P 0)
( P1 + P 0)

Sign Always Negative EY>0 (+) normal goods EX>0 (+) substitutes
↑ → Qd↓
P↑ EY<0 (-) inferior goods EX<0 (-) complements

Size EP=0 perfectly inelastic Positive EY Size of coefficient

EP<1 inelastic EY>1 luxury shows the closeness of
EP=1 unitary EY<1 necessity the substitutes or the
EP>1 elastic complements
∞ perfectly elastic
EP=∞

Factors Availability of Income NA

substitute
Proportion of Y spent
on the good
Time

Others EP>1 elastic NA NA

↑ → TR↓
P↑ ↓
EP<1 inelastic
↑ → TR↑
P↑ ↑
 Price
A

Demand

C Quantity