Elasticity of Demand
• How does a firm go about determining the
price at which they should sell their product
in order to maximize total revenue?
• Total Revenue = Price  Quantity
• You are a marketing manager for Intel
• A new computer chip has been developed
• Decision to Be Made
• Do you sell the new chip at a high price ($400)?
• Do you sell the new chip at a low price ($200)?
Price (dollars per chip)
Demand and Total Revenue
400
300
200
Da
100
40
80
120
Quantity (millions of chips per year)
Price (dollars per chip)
Demand and Total Revenue
400
300
200
Da
100
40
80
120
Quantity (millions of chips per year)
Price (dollars per chip)
Demand and Total Revenue
Total revenue
loss
400
300
200
100
Da
Total
revenue
gain
40
80
120
Quantity (millions of chips per year)
Price (dollars per chip)
Demand and Total Revenue
400
300
200
100
Db
40
60
80
120
Quantity (millions of chips per year)
Price (dollars per chip)
Demand and Total Revenue
400
300
200
100
Db
40
60
80
120
Quantity (millions of chips per year)
Price (dollars per chip)
Demand and Total Revenue
Total revenue
loss
400
300
200
100
Total
revenue
gain
Db
40
60
80
120
Quantity (millions of chips per year)
Price (dollars per chip)
Price (dollars per chip)
Demand and Total Revenue
Da
Db
Quantity (millions of chips per year)
Quantity (millions of chips per year)
Slope Depends on
Units of Measurement
• In these two examples, we can compare the
slopes of the demand curves
• We cannot do so if we are dealing with
different goods and services.
• Elasticity is independent of the units of
measurement.
• Price elasticity of demand
• A measure of the responsiveness of the quantity
demanded of a good to a change in its price
(ceteris paribus).
Elasticity: A Units-Free Measure
Price elasticity of
=
demand
Percentage change
in quantity demanded
Percentage change in price
Calculating Elasticity
• The changes in price and quantity are
expressed as percentages of the average
price and average quantity.
• Avoids having two values for the price
elasticity of demand
Price (dollars per chip)
Calculating the
Elasticity of Demand
Original
point
410
400
390
Da
36
40
44
Quantity (millions of chips per year)
Price (dollars per chip)
Calculating the
Elasticity of Demand
Original
point
410
400
New
point
390
Da
36
40
44
Quantity (millions of chips per year)
Price (dollars per chip)
Calculating the
Elasticity of Demand
Original
point
410
 P = -$20
400
New
point
390
Da
36
Q = 8
40
44
Quantity (millions of chips per year)
Price (dollars per chip)
Original
point
410
P=
-$20
400
Pave = $400
New
point
390
Da
36
Q = 8
40
44
Quantity (millions of chips per year)
Price (dollars per chip)
Calculating the
Elasticity of Demand
Original
point
410
 P=
400
-$20
Pave =$400
New
point
Qave = 40
390
Da
36
Q = 8
40
44
Quantity (millions of chips per year)
Calculating Elasticity
Percentage change in quantity demanded
Price elasticity of demand =
Percentage change in price
%Q

%P
Q / Qave

P / Pave
Calculating Elasticity
Percentage change in quantity demanded
Price elasticity of demand =
Percentage change in price
%Q

%P

Q / Qave

P / Pave
8 / 40
= -4
 20 / 400
Inelastic and Elastic Demand
• Three demand curves that cover the entire
range of possible elasticities of demand:
• Perfectly inelastic
• Unit elastic
• Perfectly elastic
Inelastic and Elastic Demand
• Perfectly inelastic demand
• Implies that quantity demanded remains
•
constant when price changes occur.
Price elasticity of demand = 0
Price
D1
Elasticity = 0
12
Perfectly Inelastic
6
Quantity
Inelastic and Elastic Demand
Unit elastic demand
Implies that the percentage change in
quantity demanded equals the percentage
change in price.
Price elasticity of demand = -1
Price
Inelastic and Elastic Demand
Elasticity = -1
12
Unit Elasticity
6
D2
1
2
3
Quantity
Inelastic and Elastic Demand
• Perfectly elastic demand
• Implies that if price increases by any
percentage, quantity demanded will fall to 0
and if price decreases by any percentage,
quatity will rise to infinity.
• Price elasticity of demand =

Price
Inelastic and Elastic Demand
12
6
Elasticity = 
D3
Perfectly Elastic
Quantity
Inelastic and Elastic Demand
• Inelastic demand
• Implies the percentage change in quantity
•
demanded is less than the percentage change in
price.
In absolute sense, price elasticity of demand > 0
and < 1
• Elastic demand
• Implies the percentage change in quantity
•
demanded is greater than the percentage change
in price.
In absolute sense, price elasticity of demand > 1
Price (dollars per chip)
Elasticity Along a Straight-Line
Demand Curve
500
400
300
250
200
100
0
40
80 100 120 160
200
Quantity (millions of chips per year)
Price (dollars per chip)
Elasticity Along a Straight-Line
Demand Curve
Elasticity = -4
500
Elastic
400
Lowering the price
from $500 to $300
results in a price
elasticity of demand of -4.
300
250
200
100
0
40
80 100 120 160
200
Quantity (millions of chips per year)
Price (dollars per chip)
Elasticity Along a Straight-Line
Demand Curve
500
Lowering the price
from $200 to $0
results in a price
elasticity of demand of -1/ 4.
400
Inelastic
300
250
200
Elasticity = -1/4
100
0
40
80 100 120 160
200
Quantity (millions of chips per year)
Price (dollars per chip)
Elasticity Along a Straight-Line
Demand Curve
500
|Elasticity| > 1
400
Lowering the price
from $500 to $0
results in a price
elasticity of demand of -1.
|Elasticity| = 1
300
250
200
|Elasticity| < 1
100
0
40
80 100 120 160
200
Quantity (millions of chips per year)
Elasticity, Total Revenue
and Expenditure
• Elastic demand — a 1 percent decrease in
price will result in a greater than 1 percent
increase in quantity demanded.
• Total revenue will increase
• Unit elastic demand — a 1 percent decrease
in price will result in a 1 percent increase in
quantity demanded
• Total revenue will not change
Elasticity, Total Revenue
and Expenditure
• Inelastic demand — a 1 percent decrease in
price will result in a less than 1 percent
increase in quantity demanded.
• Total revenue will decrease
Elasticity, Total Revenue
and Expenditure
• Total Revenue Test
• Price elasticity of demand can be estimated by
observing the change in total revenue that
results from a price change (ceteris paribus).
Elasticity, Total Revenue
and Expenditure
• Total Revenue Test
• Price cut and total revenue increases — demand
is elastic.
• Price cut and total revenue decreases —
demand is inelastic
• Price cut and total revenue does not change —
demand is unit elastic
Price (dollars per chip)
500
400
300
250
200
100
0
D
100
200
Price (dollars per chip)
500
400
300
250
200
Total Revenue (billions of dollars)
100
0
25
D
100
200
20
15
10
TR
5
0
100
200
Quantity (millions of chips per year)
Price (dollars per chip)
500
Elastic
demand
400
Unit
elastic
300
250
200
Inelastic
demand
When demand
is elastic,
price cut
increases
total revenue
Total Revenue (billions of dollars)
100
0
25
100
200
Maximum
total revenue
20
15
When demand
is inelastic,
price cut decreases
total revenue
10
5
0
100
200
Quantity (millions of chips per year)
More Elasticities of Demand
• Cross elasticity of demand
• Measures the responsiveness of the demand for
a good to a change in the price of a substitute or
complement good.
Cross elasticity
of demand
=
Percentage change
in quantity demanded
Percentage change in price of
a substitute or complement
Price of Walkmans
Cross Elasticity of Demand
D0
Quantity of Walkmans
Price of Walkmans
Cross Elasticity of Demand
Price of a CD player,
a substitute, rises.
Positive cross elasticity
D0
Quantity of Walkmans
D1
Price of Walkmans
Cross Elasticity of Demand
Price of a CD player,
a substitute, rises.
Positive cross elasticity
Price of a tape,
a complement,
rises. Negative
cross elasticity
D2
D0
Quantity of Walkmans
D1
Income Elasticity of Demand
• Income elasticity
• Measures the responsiveness of the demand to a
change in income.
Income elasticity
of demand
=
Percentage change
in quantity demanded
Percentage change in income
Income Elasticity of Demand
• Income elasticity (in absolute sense) can be:
1 ) Greater than 1 (normal good, income elastic)
• luxury goods - ocean cruises, jewelry
2 ) Between zero and 1 (normal good, income
inelastic)
• necessities - food, clothing
3 ) Less than zero (inferior good)
• potatoes, rice
Income
Income
elastic
elastic
Income
Income
inelastic
inelastic
Quantity demanded
Quantity demanded
Quantity demanded
Income Elasticity of Demand
Positive
income
elasticity
Income
Income
Negative
income
elasticity
m Income