TOPIC 4: ELASTICITY

PRICE ELASTICITY OF DEMAND

The price elasticity of demand measures the
responsiveness of quantity demanded to changes
in price.
The price elasticity of demand is computed as the
percentage change in the quantity demanded
divided by the percentage change in price.
Formula for price elasticity of demand

%Q
Q2 Q1
( P1 P2 ) / 2
EP

%P (Q1 Q2 ) / 2
P2 P1

PRICE ELASTICITY OF DEMAND

Example: If the price of an ice cream cone

increases from $2.00 to $2.20 and the amount
you buy falls from 10 to 8 cones, then your
elasticity of demand, using the midpoint formula,
would be calculated as:
(10 8)
22%
(10 8) / 2

2.32
(2.00 2.20)
9.5%
(2.00 2.20) / 2

VARIOUS FORMS OF PRICE

ELASTICITY OF DEMAND

Elastic Demand: E P 1
Percentage

change in quantity demanded is greater than

percentage change in price.

Inelastic Demand: E P 1

Percentage change in quantity demanded is less than

percentage change in price.

Unit Elastic:

EP 1

Percentage

change in quantity demanded is equal to

percentage change in price.

Perfectly inelastic:
Quantity

demanded does not change as price changes.

Perfectly elastic:
A

EP 0

EP

small percentage change in price causes an extremely

large percentage change in quantity demanded.

PRICE ELASTICITY AND TOTAL

REVENUE
Total revenue is the amount of money that a
seller receives from the sale of a good.
Total revenue is computed as the price of the
good times the quantity sold.
TR = P Q

PRICE ELASTICITY AND TOTAL

REVENUE

When demand is elastic:

An

increase in price results in a decrease in total

revenue.
A decrease in price results in an increase in total
revenue.

When demand is inelastic:

An

increase in price results in an increase in total

revenue.
A decrease in price results in a decrease in total
revenue.

When demand is unit elastic:

A

change in price results in no change in total

revenue.

DETERMINANTS OF PRICE
ELASTICITY OF DEMAND

Number of substitutes

Necessities versus luxuries

Necessity is a good that is needed for life (a good that we cannot do

without) Necessity good has a low price elasticity of demand.
Luxury is a good that gives a lot of satisfaction but we can live
without it Luxury good has a high price elasticity of demand.

Percentage of ones budget spent on the good

The more substitutes a good has, the higher the price elasticity of
demand.
The fewer substitutes a good has, the lower the price elasticity of
demand.

The greater the percentage of ones budget that spent to purchase a

good, the higher the price elasticity of demand.
The smaller the percentage of ones budget that spent to purchase a
good, the lower the price elasticity of demand.

Time

The longer the time period, the higher the price elasticity of demand.
The shorter the time period, the lower the price elasticity of demand.

CROSS PRICE ELASTICITY OF

DEMAND
Cross price elasticity of demand is a measure of
the responsiveness in quantity demanded of one
good to changes in the price of another good.
It is computed as the percentage change in
quantity demanded of one good (X) divided by the
percentage change in the price of another good
(Y).
Formula for cross price elasticity of demand
%Q X
QX 2 QX 1
( PY 1 PY 2 ) / 2
E X ,Y

%PY
(Q X 1 Q X 2 ) / 2
PY 2 PY 1

CROSS PRICE ELASTICITY OF

DEMAND
Substitute

goods: If the cross price elasticity

of demand is positive then X and Y are
substitute goods.
If

EX,Y > 0 Goods are substitutes.

If

EX,Y < 0 Goods are complement.

If

EX,Y = 0 Goods are unrelated.

Complementary

goods: If the cross price

elasticity of demand is negative then X and Y
are complementary goods.

Unrelated

goods: If the cross price elasticity

of demand is zero then X and Y are
unrelated.

INCOME ELASTICITY OF DEMAND

Income elasticity of demand is a measure of the
responsiveness in quantity demanded to changes
in income.
It is computed as the percentage change in the
quantity demanded divided by the percentage
change in income.
Formula for income elasticity of demand

%Q
Q2 Q1
( I1 I 2 ) / 2
EI

%I (Q1 Q2 ) / 2
I 2 I1

INCOME ELASTICITY OF DEMAND

Normal goods: Those goods that have positive

income elasticity of demand.
If

EI > 0 Normal good

Higher

income raises the quantity demanded for

normal goods.

Inferior goods: Those goods that have negative

income elasticity of demand.
If

EI < 0 Inferior good

Higher

income lowers the quantity demanded for

inferior goods.

INCOME ELASTICITY OF DEMAND

If

EI > 1: Demand for the good is income

elastic.
If E < 1: Demand for the good is income
I
inelastic.
If E = 1: Demand for the good is income unit
I
elastic.

PRICE ELASTICITY OF SUPPLY

Price elasticity of supply is a measure of the
responsiveness of quantity supplied to changes in
price.
The price elasticity of supply is computed as the
percentage change in the quantity supplied
divided by the percentage change in price.
Formula for price elasticity of supply

%QS
QS 2 QS 1
( P1 P2 ) / 2
ES

%P (QS 1 QS 2 ) / 2
P2 P1

VARIOUS FORMS OF PRICE

ELASTICITY OF SUPPLY

Elastic Supply: ES > 1

Percentage

change in quantity supplied is greater than

percentage change in price.

Inelastic Supply: ES < 1

Percentage change in quantity supplied is less than

percentage change in price.

Unit Elastic: ES = 1

change in quantity supplied is equal to percentage

change in price.

Percentage

Perfectly inelastic: ES = 0
Quantity supplied does not change as price changes.
Perfectly elastic: ES =

small percentage change in price causes an extremely large

percentage change in quantity supplied.

PRICE ELASTICITY OF SUPPLY AND

TIME

The longer the period of adjustment is to a

change in price, the higher the price elasticity of
supply.
Producers

take time to adjust quantity produced

and sold in respond to a change in price.