ELASTICITY OF DEMAND

SUMEETHA M
ELASTICITY
Elasticity is a concept borrowed from physics
Elasticity is a measure of how responsive a
dependent variable is to a small change in an
independent variable(s)
Elasticity is defined as a ratio of the percentage
change in the dependent variable to the
percentage change in the independent variable
Elasticity can be computed for any two related
variables
ELASTICITY
Elasticity can be computed to show the effects of:
a change in price on the quantity demanded [ a change in quantity
demanded is a movement on a demand function]
a change in income on the demand function for a good
a change in the price of a related good on the demand function for a
good
a change in the price on the quantity supplied
a change of any independent variable on a dependent variable
Responsiveness
The law of demand tells us that as the price
of a good increases the quantity that will be
bought decreases but does not tell us by how
much.
ep [ownprice elasticity] is a measure of that
information]
If you change price by 5%, by what percent
will the quantity purchased change?
Determinants of Elasticity
Availability of substitutes [greater availability of
substitutes makes a good relatively more elastic]
Portion of the expenditures on the good to the
total budget .
Time to adjust to the price changes [longer time
period means there are more adjustment
possible and increases relative elasticity
Price elasticity for brands is tends to be more
elastic than for the category of goods
Determinants
Nature of Goods
Different Uses of the Commodity
Time Period
Changes in Income
Habits
Joint DD
Distribution of Income
ELASTICITY AND ITS
APPLICATION
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Price Elasticity and Total Revenue
If demand is elastic, then
price elast. of demand > 1
% 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.
Revenue = P x Q
Price elasticity
of demand
=
Percentage change in Q

Percentage change in P

ELASTICITY AND ITS
APPLICATION
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Price Elasticity of Demand
Price elasticity of demand measures how
much Q
d
responds to a change in P.
Price elasticity
of demand
=
Percentage change in Q
d
Percentage change in P

Loosely speaking, it measures the price-sensitivity of
buyers demand.
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?
A C T I V E L E A R N I N G
Elasticity and expenditure/revenue
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Elasticity Is Independent of Units
Percentages allow us to have a measure of
responsiveness that is independent of units.
This makes comparisons of responsiveness of
different goods easier.
Demand Curve
Shapes and Elasticity
Elasticity Along a Demand Curve
P
r
i
c
e

$10
9
8
7
6
5
4
3
2
1
0 1 2 3 4 5 6 7 8 9 10 Quantity
Elasticity declines along demand
curve as we move toward the
quantity axis
E
d
= 1
E
d
= 0
E
d
< 1
E
d
> 1
E
d
=
The Price Elasticity of Demand Along a
Straight-line Demand Curve
Elasticity of Demand and
Total Revenue
A firms revenues are equal to price per unit
times quantity sold.
Revenue = Price x Quantity
The elasticity of demand directly influences
revenues when the price of the good
changes.

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ELASTICITY AND ITS
APPLICATION
15
Price Elasticity and Total Revenue
Continuing our scenario, if you raise your price
from Rs200 to Rs250, would your revenue rise or fall?
Revenue = P x Q
A price increase has two effects on revenue:
Higher P means more revenue on each unit
you sell.
But you sell fewer units (lower Q),
due to Law of Demand.
Which of these two effects is bigger?
It depends on the price elasticity of demand.
Elasticity of Demand and
Total Revenue

16
Revenues Fall as Price Rises with Elastic Demand Curves
Q
P
D
$10
250
R=$10x250
=$2,500
$20
50
R=$20x50
=$1,000
R=$10x250
=$2,500
Elasticity of Demand and
Total Revenue

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Summary of Relationship between Elasticity of Demand and Revenues
Absolute Value of
Elasticity
Name Price and Revenue
Inelastic P and R Move Together
Elastic P and R Move Opposite
Unit Elastic P Moves but R Stays the Same
1
D
E
1
D
E
1
D
E
Mathematics of
Demand Elasticity
Example:
If the price of oil increases by 10% and over a
period of several years, the quantity demanded
falls by 5%, then the long run elasticity of demand
for oil is:

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terms) absolute (in 0.5 or
0.5
10%
5%

Mathematics of Demand Elasticity

Elasticity of demand is always negative, so we
typically drop the negative sign and use
absolute value instead.

If the |Ed| < 1, the demand curve is inelastic.
If the |Ed| > 1, the demand curve is elastic.
If the |Ed| = 1, the demand curve is unit elastic.

19
ELASTICITY AND ITS
APPLICATION
20
Q
1
P
1
D
Perfectly inelastic demand (one extreme case)
P
Q
P
2
P falls
by 10%
Q changes
by 0%
0%

10%

= 0
Price elasticity
of demand
=
% change in Q

% change in P

=
Consumers
price sensitivity:
D curve:
Elasticity:
vertical
none
0
ELASTICITY AND ITS
APPLICATION
21
D
Inelastic demand
P
Q
Q
1
P
1
Q
2
P
2
Q rises less
than 10%
< 10%

10%

< 1
Price elasticity
of demand
=
% change in Q

% change in P

=
P falls
by 10%
Consumers
price sensitivity:
D curve:
Elasticity:
relatively steep
relatively low
< 1
ELASTICITY AND ITS
APPLICATION
22
D
Unit elastic demand
P
Q
Q
1
P
1
Q
2
P
2
Q rises by 10%
10%

10%

= 1
Price elasticity
of demand
=
% change in Q

% change in P

=
P falls
by 10%
Consumers
price sensitivity:
Elasticity:
intermediate
1
D curve:
intermediate slope
ELASTICITY AND ITS
APPLICATION
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D
Elastic demand
P
Q
Q
1
P
1
Q
2
P
2
Q rises more
than 10%
> 10%

10%

> 1
Price elasticity
of demand
=
% change in Q

% change in P

=
P falls
by 10%
Consumers
price sensitivity:
D curve:
Elasticity:
relatively flat
relatively high
> 1
ELASTICITY AND ITS
APPLICATION
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D
Perfectly elastic demand (the other extreme)
P
Q
P
1
Q
1
P changes
by 0%
Q changes
by any %
any %

0%

= infinity
Q
2
P
2
=

Consumers
price sensitivity:
D curve:
Elasticity:
infinity
horizontal
extreme
Price elasticity
of demand
=
% change in Q

% change in P

=
ELASTICITY AND ITS
APPLICATION
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Other Elasticities
Income elasticity of demand: measures the response
of Q
d
to a change in consumer income
Income elasticity
of demand
=
Percent change in Q
d
Percent change in income

Recall from the earlier class: An increase in income
causes an increase in demand for a normal good.
Hence, for normal goods, income elasticity > 0.
For inferior goods, income elasticity < 0.
ELASTICITY AND ITS
APPLICATION
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Other Elasticities
Cross-price elasticity of demand:
measures the response of demand for one good to
changes in the price of another good
Cross-price elast.
of demand
=
% change in Q
d
for good 1
% change in price of good 2

For substitutes, cross-price elasticity > 0
(e.g., an increase in price of beef causes an increase in
demand for chicken)
For complements, cross-price elasticity < 0
(e.g., an increase in price of computers causes
decrease in demand for software)
Applications of
Elasticity of Demand
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How the farmers in India has Worked themselves Out of a Job:
Increased agricultural productivity has the supply of
food BUT the supply of farmers.
And their revenues because the demand for most
agricultural products is inelastic.
Applications of
Elasticity of Demand
Why the War on Drugs is Hard to Win:
Because demand for most illegal drugs is inelastic,
drug dealers earn greater revenue and gain more
power as the drug war becomes more effective.

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Solve This
The elasticity of demand for
eggs has been estimated to be
0.1. If egg producers raised
their prices by 10 percent,
what will happen to their total
revenue?
a) It will increase
b) It will decrease
c) It wont change
To next
Try it!
Solve This
If a fashionable clothing store raised its prices
by 25 percent, what does that tell you about
the stores estimate of the elasticity of demand
for its products?
a) They think its elastic
b) They think its inelastic
To next
Try it!
Solve This
When the patent expires on a
brand-name drug and 5
generic drugs come on the
market, what happens to
elasticity of demand?
a) It rises
b) It falls

To next
Try it!
Demand is less elastic in the short run,
for necessities, for broadly defined goods,
or for goods with few close substitutes.
Price elasticity of supply equals percentage
change in Q
s
divided by percentage change in P.
When its less than one, supply is inelastic.
When greater than one, supply is elastic.
Price elasticity of supply is greater in the long run
than in the short run.
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Summary
CHAPTER SUMMARY
The income elasticity of demand measures
how much quantity demanded responds to
changes in buyers incomes.
The cross-price elasticity of demand measures
how much demand for one good responds to
changes in the price of another good.
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