Elasticity of Demand

Dr. Syed Irshad Hussain

 Outline
• Definition of Elasticity
• Price Elasticity of Demand
• Computing the Price Elasticity of Demand
• Type of Demand Curves
• Price Elasticity and Total Revenue
• Factors affect elasticity
• Other elasticities
 Focus questions

A. What is the meaning of price elasticity of demand?

B. What are the determinants of price elasticity of demand?
C. List and explain the types of demand curve?
D. How to calculate price elasticity of demand?
E. What is cross price elasticity?
F. What is income elasticity of demand?
 Speed of adjustment
• How quickly market respond to change in circumstances depend on
the elasticity of demand and supply
• In economics elasticity of demand and supply is quantifiable and it
tells us the speed of adjustment of demand and supply
 Elasticity
• Elasticity = responsiveness
• Price elasticity = responsiveness to price change
• Price elasticity of demand = responsiveness of demand to change in
price
• Price elasticity of supply = responsiveness of supply to change in price
• Cross price elasticity = responsiveness of the demand of one good to
change in the price of a related good
• Income elasticity of demand = responsiveness of demand to change in
consumers’ income
• Elasticity is a unitless number
 Definitions
• Elasticity is a measure/ rate of the responsiveness of one variable to changes in an
other variables.

• Elasticity is a measure of the responsiveness of quantity demanded or quantity

supplied to one of its determinants. It is a number that tells us the percentage
change that will occur in quantity demanded and quantity supplied with respect to
changes in one of its determinants

Elasticity of Demand: is the rate at which the quantity demanded changes with a
change in one of its determinants (Price, Income, Price of related goods, taste)

Elasticity of supply: is the rate at which the quantity supplied changes with a
change in one of its determinants (Price, Input prices)
 Price Elasticity of Demand
Price elasticity of demand: a measure of how much the quantity demanded
of a good responds to a change in the price of that good when all other things
are equal.

It is calculated as the percentage change in quantity demanded divided by the

percentage change in price
 Calculation of price elasticity of demand
• It is computed as the percentage change in quantity demanded divided
by the percentage change in price.

• Price elasticity of demand can be calculated using the following formula

% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 𝑑
Price elasticity of demand (𝐸𝑃) =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
Example: If the price of cigarettes increases by 20 percent and the quantity
demanded falls by 10 percent we have:
−10
𝐸𝑃 = = -0.5
20
• It means that a 1% increase in the price of cigarettes reduces demand by
half a percent.
 Computing the Price Elasticity of Demand
Price elasticity of demand: The percentage change in quantity demanded
caused by a 1 percent change in price.
%Δ Quantity
𝐸𝑝 =
ARC Elasticity %Δ Price

Elasticity which is measured over a discrete interval of a demand (or a supply)

curve.
𝑄2 − 𝑄1 𝑃2 − 𝑃1
𝐸𝑝 = ÷
(𝑄2 + 𝑄1 )/2 (𝑃2 + 𝑃1 )/2
 Computing Price Elasticity of demand
ARC Elasticity

The % change in P equals P

$250 – $200 $250

B
x 100% = 22.2%
$225 A
$200
▪ The % change in Q equals
8 – 12 D
x 100% = -40.0% Q
10 8 12
▪ The price elasticity of demand equals
40/22.2 = -1.8
 Computing the Price Elasticity of Demand
Point Elasticity

Point Elasticity: Elasticity measured at a given point of a demand (or a supply) curve.

Δ𝑄 𝑃1
𝜀𝑃 = 𝑥
Δ𝑃 𝑄1

The point elasticity of a linear demand function can be expressed as:

𝑑𝑄 𝑃1
𝜀𝑃 = 𝑥
𝑑𝑃 𝑄1
 Computing the Price Elasticity of Demand through calculus
Point Elasticity

Q = 36 – 2P

Where P= 12, Calculate the Edacity

Qd = 500 – 10 P + 2 I – 20 Pc
• If Income is I = Rs 20, Price of Pc = Rs.5
• Find the elasticity if the P=5
 Interpreting elasticity
• Elasticity > 1 means demand is elastic
– A one percent increase in price decreases demand by more than 1
percent
• Elasticity < 1 means demand is inelastic
– A one percent increase in price decreases demand by less than 1
percent
• Elasticity = 1 means demand is unit elastic
– A one percent increase in price decreases demand by 1 percent
 Categories of Elasticity
• Economists classify demand curves according to their elasticity.
• Demand can be inelastic, unit elastic, or elastic, and can range from zero to infinity ( perfe
ct inelastic, perfect elastic)
1. Relative elasticity of demand EP > 1
2. Relative inelasticity of demand EP < 1
3. Unitary elasticity of demand EP = 1
4. Perfect Elasticity EP = ∞
5. Perfect inelasticity EP = 0
• The price elasticity of demand is closely related to the slope of the demand curve.
• Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
 Perfectly inelastic demand
If the quantity demanded doesn’t change when the price changes, the price
elasticity of demand is zero and the good has perfectly inelastic demand.
When due to any change in price demand remains same.

Price elasticity % change in Q 0%

= = =0
of demand % change in P 10%
P D
P1
The demand curve is vertical.
P2
P falls
by 10%
Q
Q1
Q changes
by 0%
 Inelastic demand
If the percentage change in the quantity demanded is smaller than the p
ercentage change in price. The price elasticity of demand is less than 1
and the good has inelastic demand.
Price elasticity % change in Q 9%
= = <1
of demand % change in P 10%
P
D curve:
P falls P1
Relatively steep
by 10%
Elasticity: P2
<1
D
Q
Q1 Q2
Q rises by 9%
 Unit elastic demand
When quantity demanded changes by exactly the same percentage as price. T
he price elasticity of demand equals 1 and the good has unit elastic demand.

Price elasticity % change in Q 10%

= = =1
of demand % change in P 10%
P
D curve: P1
intermediate slope P falls
Elasticity = 1 by 10% P2
D

Q
Q1 Q2
Q rises by 10 %
 Elastic demand
If the percentage change in the quantity demanded is greater than the percentage
change in price. The price elasticity of demand is greater than 1 and the good has
elastic demand.

Price elasticity % change in Q 11 %

= = >1
of demand % change in P 10%
P
D curve:
P1
Relatively flat
P falls
Elasticity: > 1 by 10% P2 D

Q
Q1 Q
Q rises by 11%2
 Perfectly Elastic demand
When there is small or no change in price but quantity demanded changes to
reasonable extent . If the percentage change in the quantity demanded is
infinitely large when the price barely changes. The price elasticity of demand
is infinite and the good has a perfectly elastic demand.

Price elasticity % change in Q any %

= = = infinity P
of demand % change in P 0%
P2 = P1 D
D curve:
horizontal P changes
by 0%
Elasticity = infinity
Q
Q1 Q2
Q changes by any %
 Elasticity differs along a linear demand curve.
• The slope of a linear demand curve is constant, but the elasticity is not

– At points with a low price and a high quantity demanded, demand is

inelastic or at prices below the mid-point of the demand curve, demand
is inelastic.

– At points with a high price and a low quantity demanded, demand is

elastic or at prices above the mid-point of the demand curve, demand is
elastic.
Elasticity differs along a linear demand curve.

P
$30 200%
E = = -5.0
-40%
20 67%
E = = -1.
-67%
0
10 40%
E = = -0.2
-200%
$0 Q
0 20 40 60
 Price Elasticity and Total Revenue
The total revenue is amount received by sellers from selling good or service, computed as the
price of the good and service times the quantity sold.
Revenue = P x Q

When the price changes, total revenue also changes. But a rise in price doesn’t always increase
total revenue.
• 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.
• Price elasticity of demand tells us the strength of relationship between price and quantity
demanded
 Price Elasticity and Total Revenue
• If price goes up a little , and quantity demanded goes down a lot, what
happens to PQ = Total Revenue?
• If price goes up a lot but quantity demanded does not change much, w
hat happens to PQ = Total Revenue?
• If price goes up 2 percent and quantity demanded goes down by more
than 2 percent, what happens to TR?
 Price Elasticity and Total Revenue (cont.)
The change in total revenue due to a change in price depends on the elasticity of
demand:
– For a firm price increase leads to an increase in revenue when demand for its
product is inelastic. In the case of inelastic demand, a 1 percent price increase,
decreases the quantity sold by less than 1 percent, and total revenue increases.
– For a firm, price increase leads to decrease in revenue when the demand for its
product is elastic. In the case of elastic demand, a 1 percent price increase,
decreases the quantity sold by more than 1 percent, and total revenue
decreases
– In the case of unitary elastic demand, a 1 percent price increase, decreases
the quantity sold by exactly1 percent, and total revenue remains unchanged.
 Price Elasticity and Total Revenue (cont.)

▪ When demand is inelastic (a price elasticity less than 1), price and total
revenue move in the same direction.
• When demand is elastic (a price elasticity greater than 1), price and total
revenue move in opposite directions.
• If demand is unit elastic (a price elasticity exactly equal to 1), total revenue
remains constant when the price changes.
The Factors That Influence the Elasticity of Demand

The elasticity of demand for a good depends on:

• Availability of substitutes
• Nature of the good (necessity vs luxury)
• Definition of the market (broad vs narrow)
• Time horizon
 The Factors That Influence the Elasticity of Demand
Goods with close substitutes tend to have more elastic demand because it is easier
for consumers to switch from that good to others. Example: Pepsi;

Necessities tend to have inelastic demands, whereas luxuries have elastic demands.

Narrow and board markets

The longer the time period involved, the more elastic the demand will tend to be.
The more time consumers have to adjust to a price change Example: Gasoline
Elasticity is higher in the long run than the short run.

The higher the fraction of income spent on the good, the more elastic the demand will
tend to be.
 Cross price elasticity
The cross-price elasticity of demand measures the response of demand
for one good to changes in the price of another good.

• Example: If there is a change in the price of coffee, how much the

demand for tea change?
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑑 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑋
• EPx=
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑌
• Substitutes have positive cross-price elasticities,
• while complements have negative cross-price elasticities
 Example
• The price of grapes rises from 200 to 300 per kilogram. As a result the quantity of
apples demanded rises from 8000 per week to 10,000. Find cross price elasticity.

𝑄2𝑥 − 𝑄1𝑥 𝑃2𝑦 − 𝑃1𝑦

𝐸𝑃𝑥,𝑦 = ÷
(𝑄1𝑥 + 𝑄2𝑥 )/2 (𝑃2𝑦 + 𝑃1𝑦 )/2

Solution:
10000−8000
• % change in the Qd of apples = 9000
= 0.22 𝑜𝑟 22.2%
300−200
• % change in price of grapes = = 0.40 𝑜𝑟 40%
250
22.2
• Cross price Elasticity = 40
= 0.55→ substitutes
 Income elasticity of demand
The income elasticity of demand measures the response of quantity
demanded to a change in consumer income.
The formula for calculating the income elasticity of demand is
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑑 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑋
• 𝐼𝑛𝑐𝑜𝑚𝑒 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑡𝑦 𝑜𝑓 𝐷𝑒𝑚𝑎𝑛𝑑 (𝐸𝐼) =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒
• Normal goods have positive income elasticities, while inferior goods
have negative income elasticities
• Necessities tend to have small income elasticities, while luxuries
tend to have large income elasticities
 Example
• Jamal’s income rises from Rs.20K to Rs.22K, and the quantity of potatoes
he purchases each week falls from 2Kg to 1Kg. Calculate income elasticity

𝑄2 − 𝑄1 𝐼2 − 𝐼1
𝐸𝐼 = ÷
(𝑄1 + 𝑄2 )/2 (𝐼1 + 𝐼2 )/2
1−2
• Solution: % change in Qd = × 100 = −66.7%
1.5
22000−20000
• % change in income = × 100 = 9.5%
21000
−66.7
• Income Elasticity (EI) = = -7 → potato is an inferior good for Jamal
9.5
 Income and Cross Price Elasticity through calculus!

Smooth Sailing, Inc., has estimated the demand function for its sailboats (quantity purchased
annually) as follows:

Where,
QD = quantity purchased,
PS = the price of smooth sailing sailboats,
PX = the price of Company X’s sailboat, P
Y = the price of Company Y’s motorboat, I
= per capita income in dollars,
A = dollars spent on advertising, and
W = number of favorable days of weather in the southern region of the United States.

Suppose that PS = $9,000, PX = $9,500, PY = $10,000, I = $15,000, A = $170,000, and W = 160.

Find the price elasticity of demand at that point.
 Income and Cross Price Elasticity through calculus!

a. Find income elasticity of demand

b. Find cross-price elasticity of demand for motorboat and sailing boat
c. Find cross-price elasticity of demand for sailing boats by different
companies.
 Qd= 89,830-40(9,000) +20(9500) +15(10,000) +2(15,000) +0.001(170,000) +10(160)

Qd=101,600

TAKE derivate w.r.t to ONE economic variable only, the derivate of constant and other
variable(s) would be equal to ZERO, ALWAYS!!!

E= dQd/dPs *Ps/Qd=-40(9000/101,600)=-3.54
E= dQd/dPX *PX/Qd=+20 (9500/101,600)=1.87
E= dQd/dPY *PY/Qd=+15(10,000/101,600)=1.47
E= dQd/dPA *PA/Qd=0.001(170,000/101,600)= 0.0016
E= dQd/dPI *PI/Qd=+10(160/101,600)=0.01
E= dQd/dPW *PW/Qd=+2(15,000/101,600)=0.296
For PS: 461,600-40Ps
For PX: -88,400+20Px
For PY: 48,400+15Py
For A: 101,430+0.001
A For I: 71,600+2I
For W: 100,000+10W
 References
N. Gregory Mankiw, Principles of Microeconomics: eight Edition,, Chapter 5

Managerial Economics, Chapter-4: Demand Elasticity, Seventh Edition,

Paul G. Keat, (2013)