Elasticity
PR409
Namal Bandaranayake
Learning Objectives
By the end of this session you would be able
to…
Define, calculate, and explain the factors
that influence the price elasticity of
demand
Describe other types of elasticity
How do people react
when price of petrol
goes up?
Do people react the
same way if price of
carrots go up?
How Change in Supply
Changes Price and Quantity
Large Fall in Small Increase in Small Fall in Large Increase in
Price Quantity Price Quantity
Responsiveness of Quantity
Demanded to Price
Price Increase Quantity Demanded Decrease
By how much?
Should be comparable across different product
categories
Price increase in cars may be in hundreds of thousands
rupees
Price increase in vegetables may be in tens of rupees
The measurement should be independent of units
Elasticity: A Units-Free Measure
Percentage change
Price elasticity of in quantity demanded
=
demand
Percentage change in
price
% Q
%P
Calculating the
Elasticity of Demand
Original
Price (dollars per chip)
point (P1, Q1)
410
ΔP= 20
400
Pave =
$400 New
point (P1, Q1)
Qave = 40
390
Da
ΔQ= 8
36 40 44
Quantity (millions of chips per year)
Calculating Elasticity
Percentage change in quantity demanded
Price elasticity of demand =
Percentage change in price
% Q Q / Qave
% P P / Pave
(Q2 - Q1)/(Q2+Q1)/2
=
(P2 - P1)/(P1+P2)/2
8 / 40
= 4
20 / 400
Price Elasticity of Demand
Price elasticity of demand is a
measure of the responsiveness of the
quantity demanded of a good to a
change in its price (ceteris paribus)
Elastic Demand - means demand is
sensitive to price
Inelastic Demand - means demand is
insensitive to price
Calculating Elasticity
Negative sign is ignored for convenience.
The changes in price and quantity are
expressed as percentages of the average price
and average quantity between the two prices
and quantities being compared.
Avoids having two values for the price elasticity of
demand
Inelastic and Elastic Demand
Perfectly Inelastic Demand
D1 Q / Qave
Price
P / Pave
Elasticity = 0
12
Quantity demanded
remains constant
when price changes
occur
6
E.g. Elasticity for life
saving drugs (insulin)
Quantity
Inelastic and Elastic Demand
Perfectly Elastic Demand
Q / Qave
Price
Elasticity = ∞ P / Pave
12
If price changes by any
percentage: quantity
demanded will fall to 0
E.g. two shops / vending
6
machines selling
identical products side by
side. If the price of one is
lower the demand for
other will be zero
Quantity
Elasticity Along a Linear Curve
ELASTICITY OF DEMAND
30
25
B
Price (dollars per pizza)
20 A
12.5
15
C
10
5
25
0
0 10 20 Quantity (pizzas
30 per hour) 40 50 60
Calculate the Elasticity When
At mid point (A) : when price changes from $15 to $10 and quantity demanded increases from 20
to 30
Above mid point (B): When the price falls from $25 to $15 a pizza, the quantity demanded
increases from zero to 20
Below mid point (C) : When the price falls from $10 to $0, the quantity demanded increases from
30 to 50
Elasticity and Total Revenue
Inelastic Demand Elastic Demand
Calculate Revenue at Point A Calculate Revenue at Point A
Calculate Revenue at Point B Calculate Revenue at Point B
Revenue @ A = $4 x 10 = $40 Million Revenue @ A = $1000x1 = $1000 Million
Revenue @ B = $2 x 15 = $30 Million Revenue @ B = $500 x 3 = $1500 Million
Elasticity and Total Revenue
If demand is elastic, a 1 percent
price cut increases the quantity sold
by more than 1 percent and total
revenue increases.
If demand is inelastic, a 1 percent
price cut increases the quantity sold
by less than 1 percent and total
revenue decreases.
If demand is unit elastic, a 1 percent
price cut increases the quantity sold
by 1 percent and total revenue does
not change
Elasticity and Total Revenue
If a price cut increases total
revenue, demand is elastic
If a price cut decreases total
revenue, demand is inelastic
If a price cut leaves total
revenue unchanged demand is
unit elastic.
Inelastic and Elastic Demand
D3
Price
Elasticity = 1
12
Unit Elasticity
6
1 2 3 Quantity
How do people react
when price of petrol
goes up?
Is the demand elastic or
inelastic?
Do people react the
same way if price of
carrots go up?
Is the demand elastic or
inelastic?
The Factors that Influence the
Price Elasticity of Demand
The closer the substitutes for a
good, the more elastic is demand.
The higher the proportion of
income spent on a good, the more
elastic is demand.
The greater the time elapsed since
a price change, the more elastic is
demand.
Price Elasticities of Demand
Other Commonly Used
Elasticities
Income Elasticity of Demand
Cross Price Elasticity of Demand
Price Elasticity of Supply
Necessities and Luxuries
Income Elasticity of Demand for
Food
In countries with high
income the income
elasticity of demand for
food is low
As income increases, the
income elasticity of
demand for food
decreases
Low-income consumers
spend a larger
percentage of any
increase in income on
food than do high-income
consumers
Exercise 1
One of the gas stations in your town
begins selling gas at 5% below the
price of every other station. As a
result, you increase your purchase of
gas at that station by 25%. What is
your price elasticity of demand for
gas from this station? Is this demand
elastic or inelastic?
Exercise 2
Your price elasticity of demand for
bananas is 4. If the price of
bananas rises by 5 percent, what
is
The percentage change in the
quantity of bananas you buy?
The change in your expenditure on
bananas?
Exercise 3
The world demand for crude oil is
estimated to have a short-run price
elasticity of 0.05. If the initial price of oil
were $100 per barrel, what would be the
effect on oil price and quantity of an
embargo that curbed world oil supply by 5
percent? (For this problem, assume that the
oil supply curve is completely inelastic.)
