TOPIC 3
ELASTICITY
− Elasticity is a measure of the responsiveness or sensitivity
of one variable to a change in another.
− Formally, it is the percentage change in a dependent
variable as a result of a percentage change in the
independent variable.
− The formula for elasticity is:
Elasticity of Demand
− Elasticity of demand is a measure of the responsiveness
of demand to changes in the determinants of demand.
− It measures the extent to which demand changes
following a change in its determinants.
− These determinants include product’s own price, income
and price of related goods.
Basic Types of Elasticity of Demand
1. Price elasticity of demand:
–
Responsiveness of quantity demanded to a change in a product’s
price
2. Income elasticity of demand:
–
Responsiveness of quantity demanded to a change in income
3. Cross elasticity of demand:
–
Responsiveness of quantity demanded of one good to
in the price of another good.
changes
1. Price Elasticity of Demand (PED)
− PED is a measure of how much the quantity demanded of a good
responds to a change in the price of that good.
− PED is the percentage change in quantity demanded given a
percentage change in the price of the good.
− It is a comparison of the size of the change in quantity demanded
and the change in price that brought it.
− Formula for PED:
% change in quantity demanded
PED (ε p ) =
% change in price
Example of PED calculation:
• If the price of the product changes by 5% and this result in a 10%
change in the quantity demanded, ceteris paribus, then;
p
10%
=
=2
5%
• The ratio which is 2 is the elasticity coefficient which means that a
1% change in the price of the product will lead to a 2% change in
the quantity demanded.
Example 2:
− If the price of an ice cream cone increases from R2.00 to
R2.20 and the amount you buy falls from 10 to 8 cones,
then your elasticity of demand would be calculated as:
(8 − 10) 100
− 20%
10
=
= −2
(2.20 − 2.00) 100 10%
2.00
Point Elasticity Formula
in quantity
p = %%change
change in price
Q
 100
Q
=
P
 100
P
Q
Q P
Q
=
=

P
Q P
P
=
Q P

P Q
EXERCISE
1. Price increases by 10% and quantity decreases by 2%
2. Price increases by 10% and quantity decreases by 10%
3. Price increases by 10% and quantity decreases by 15%
4. Price increases by 10% and quantity remains the same
9
Categories of Price Elasticity of Demand
• Inelastic Demand (0 < ep<1) – Quantity demanded does not
respond strongly to price changes, i.e. PED is less than one.
• Elastic Demand (1 < ep<
) – Quantity demanded responds
strongly to changes in price, i.e. PED is greater than one.
• Unit Elastic (ep =1) – Quantity demanded changes by the same
percentage as the price.
• Perfectly Inelastic (ep = 0) – Quantity demanded does not
respond to price changes.
• Perfectly Elastic (ep = ) – Quantity demanded changes
infinitely with any change in price.
(a) Perfectly Inelastic Demand: Elasticity equals 0
Price
Demand
10%
1. . . . A 10 %
increase in price
0
Quantity
100
2. . . . leaves the quantity demanded unchanged.
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(b) Inelastic Demand: Elasticity is Less than 1
Price
10%
1. A 10 %
increase
in price . . .
2%
Demand
0
2. . . . leads to an 2 % decrease in quantity demanded.
Quantity
(c) Unit Elastic Demand: Elasticity equals 1
Price
10%
1. A 10 %
increase
in price . . .
Demand
10 %
0
Quantity
2. . . . leads to a 10 % decrease in quantity demanded.
Copyright©2003 Southwestern/Thomson Learning
(d) Elastic Demand: Elasticity is Greater than 1
Price
10%
1. A 10 %
increase
in price . . .
15%
Demand
0
2. . . . leads to an 15 % decrease in quantity demanded.
Quantity
(e) Perfectly Elastic Demand: Elasticity equals Infinity
Price
1. At any price
above R4, quantity
demanded is zero.
R4
Demand
2. At exactly R4,
consumers will
buy any quantity.
0
3. At a price below R4,
quantity demanded is infinite.
Quantity
The Determinants of Price Elasticity
1. Habit forming products – demand for products such as
cigarettes, alcohol, drugs is relatively inelastic.
2. The degree of necessity - demand for necessities tends to be
relatively inelastic whereas for luxury goods it tends to be
relatively elastic.
3. Availability of substitute - the more substitutes and the closer
they are, the more people will switch to alternatives when the
price of the good rises, i.e. elastic demand.
4. The Proportion of Income spent on the product - the
higher the proportion of our income we spent on a good, the
more elastic will be demand. We spend a tiny fraction of our
income on salt. Its PED is very low.
5. Advertising - producers use advertising to convince consumers
that their products have no real substitutes thereby reducing the
elasticity of demand for their products.
Determinants (continued)
6. Durability - the more durable the good, the more elastic the
demand will tend to be, ceteris paribus.
7. The time horizon - demand is more elastic in the long run but
relatively inelastic in the short run.
8. The degree of complementarity of the product –
demand is relatively inelastic for goods that tend to be used
jointly with other goods.
Price Elasticity of Demand & Total Revenue
1. Inelastic Demand
–
quantity demanded changes by a percentage which is less than
the percentage change in the price.
–
There`s an incentive for producers to raise the price of the
product since percentage fall in quantity demanded is smaller
than the percentage increase in the price.
–
However, there`s no incentive for producers to drop the price of
the product since percentage increase in quantity will be smaller
than the percentage decrease in the price.
–
Therefore, producers can raise revenue by increasing the price of
the good.
2. Elastic Demand
–
When the percentage change in quantity demanded is greater
than the percentage change in price.
–
Producers can increase total revenue by lowering the price of
the product.
–
However, there are no incentive to increase their prices since,
the resulting decrease in the quantity demanded will be
proportionately greater than the increase in the price.
3. Unit Elastic Demand
–
Producers cannot raise total revenue by either decreasing or
increasing the price.
–
Because the percentage change in price will be exactly offset by a
corresponding percentage change in the quantity demanded.
–
Total revenue will remain unchanged.
Relationship between PED & Total Revenue
− When price is changed, the impact on a firm’s total
revenue (TR) will depend upon the price elasticity of
demand
Elasticity
Elastic demand
Unit elastic demand
Inelastic demand
For a price
increase
TR decreases
For a price
decrease
TR increases
TR does not change TR does not change
TR increases
TR decreases
2. Income Elasticity of Demand
− Income elasticity of demand measures how much the
demand of a good responds to a change in consumers’
income (Y).
− It enables us to predict how much the demand curve will
shift for a given change in income.
− It is computed as the percentage change in the quantity
demanded divided by the percentage change in income.
Computing Income Elasticity
Percentage change
in quantity demanded
Income elasticity of demand =
Percentage change
in income
Example: A 2% rise in income causing an 8% rise in the
demand for a product.
y ED
+ 8%
=
= +4
+ 2%
Determinants of Income Elasticity
1. Type of Goods
- Normal Goods (positive income elasticity)
- Inferior Goods (negative income elasticity)
• Higher income raises the quantity demanded for normal
goods but lowers the quantity demanded for inferior goods.
2. The degree of “necessity” of the good.
− Goods consumers regard as necessities tend to be income
inelastic (examples include food, fuel, clothing, utilities, and
medical services).
− Goods consumers regard as luxuries tend to be income elastic
(examples include sports cars, expensive clothes or foods).
3. Cross Price Elasticity
– It measures the responsiveness of demand for one
product to a change in the price of another (either
substitute or a complement)
– It enables us to predict how much the demand curve for
the first product will shift when the price of the second
product changes.
– Calculated as:
CED AB
%  Q DA
=
%  PB
Cross elasticity for substitutes and complementary goods
• If good B is a substitute for good A, A`s demand will rise
as B`s price rises. Hence CED will be positive.
• If good B is complementary to good A, A`s demand will
fall as B`s price rises. Hence CED will be negative.
Price (dollars per pizza)
25.00
Elastic
demand
20.00
15.00
Unit
elastic
12.50
10.00
Inelastic
demand
When demand
is elastic,
price cut
increases
total revenue
Total Revenue (billions of dollars)
5.00
0
350.00
312.50
300.00
Maximum
total revenue
250.00
When demand
is inelastic,
price cut decreases
total revenue
200.00
150.00
100.00
50.00
0
25
50
Quantity (pizza per hour)
QUESTIONS
*Question 1 (Tutorial III)
a. Explain five categories of price elasticity of demand
with the aid of appropriate diagrams.
(15)
b. Discuss how the knowledge of price elasticity of
demand can assist producers to increase their total
revenue.
(9)
c. Discuss the various factors that influence/determine
elasticity of demand.
(10)