Chapter 4

Demand
Elasticity

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Overview
The economic concept of
elasticity
The price elasticity of demand
The cross-elasticity of demand
Income elasticity
Other elasticity measures
Elasticity of supply
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Learning objectives

define and measure elasticity

apply concepts of price elasticity, crosselasticity, and income elasticity

understand determinants of elasticity

show how elasticity affects business

revenue
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The economic concept of

elasticity

Elasticity: the percentage change in one

variable relative to a percentage change in
another.

percent change in A
Coefficient of Elasticity
percent change in B

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Price elasticity of demand

Price elasticity of demand: the

percentage change in quantity demanded
caused by a 1 percent change in price

% Quantity
Ep
% Price
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Price elasticity of demand

Arc elasticity: elasticity which is

measured over a discrete interval of a
curve

Q2 Q1
P2 P1
Ep

(Q1 Q2 ) / 2 ( P1 P2 ) / 2
Ep = coefficient of arc price elasticity
Q1 = original quantity demanded
Q2 = new quantity demanded
P1 = original price
P2 = new price
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Price elasticity of demand

Point elasticity: elasticity measured at a

given point of a demand (or a supply)
curve

dQ P1
P =
x
dP Q1
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Price elasticity of demand

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

Q P1
p

P Q1
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Price elasticity of demand

Elasticity varies
along a linear
demand curve

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Price elasticity of demand

Some demand curves have constant

elasticity
such a curve has a nonlinear equation:
Q = aP-b

where b is the elasticity coefficient

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Price elasticity of demand

Categories of elasticity

Relative elasticity of demand: Ep > 1

Relative inelasticity of demand: 0 < Ep <

1
Unitary elasticity of demand: Ep = 1

Perfect elasticity: Ep =

Perfect inelasticity: Ep = 0

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Price elasticity of demand

Factors affecting demand elasticity

ease of substitution
proportion of total expenditures
durability of product
possibility of postponing purchase
possibility of repair
used product market
length of time period
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Price elasticity of demand

Derived demand: the demand for

products or factors that are not directly
consumed, but go into the production of a
another (final) product
The demand for such a product or factor
exists because there is demand for the
final product

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Price elasticity of demand

The derived demand curve will be more

inelastic:
the more essential is the component
the more inelastic is the demand curve
for the final product
the smaller is the fraction of total cost
going to this component
the more inelastic is the supply curve of
cooperating factors
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Price elasticity of demand

A long-run demand
curve will generally be
more elastic than a
short-run curve
As the time period
lengthens consumers
find ways to adjust to
the price change, via
substitution or shifting
consumption

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Price elasticity of demand

The relationship between price and

revenue depends on elasticity
Why? By itself, a price fall will reduce
receipts BUT because the demand curve
is downward sloping, the drop in price will
also increase quantity demanded

Q: which effect will be stronger?

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Price elasticity of demand

As price decreases
revenue rises when
demand is elastic
revenue falls when
it is inelastic
revenue reaches it
peak if elasticity =1
the lower chart
shows the effect of
elasticity on total
revenue
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Price elasticity of demand

Marginal revenue: the change in total

revenue resulting from changing quantity
by one unit

Total Revenue
MR
Quantity

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Price elasticity of demand

marginal revenue
curve is twice as
steep as the
demand
curve

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Price elasticity of demand

at the point where

marginal revenue
crosses the X-axis,
the demand curve
is unitary elastic
and total revenue
reaches a
maximum

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Price elasticity of demand

Examples: some real world elasticities

coffee: short run -0.2, long run -0.33
kitchen and household appliances:
-0.63
meals at restaurants: -2.27
airline travel in U.S.: -1.98
beer: -0.84, Wine: -0.55

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Price elasticity of demand

Examples: some real world elasticities

white pan bread:-0.69
cigarettes: short run -0.4, long run -0.6
wine imports: -0.15
crude oil: -0.06
internet services: -0.6/-0.7

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Cross-elasticity of demand

Cross-elasticity of demand: the

percentage change in quantity consumed
of one product as a result of a 1 percent
change in the price of a related product

%QA
Ex
%PB
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Cross-elasticity of demand

Arc cross-elasticity

Q2 A Q1 A
P2 B P1B
EX

(Q1 A Q2 A ) / 2 ( P1B P2 B ) / 2

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Cross-elasticity of demand

Point cross-elasticity

QA PB
EX

QA
PB

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Cross-elasticity of demand

The sign of cross-elasticity for substitutes

is positive
The sign of cross-elasticity for
complements is negative
Two products are considered good
substitutes or complements when the
coefficient is larger than 0.5 (in ab. value)
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Income elasticity

Income elasticity of demand: the

percentage change in quantity demanded
caused by a 1 percent change in income

%Q
EY
%Y
Y is shorthand for income
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Income elasticity

Arc income elasticity

Q2 Q1
Y2 Y1
EY

(Q1 Q2 ) / 2 (Y1 Y2 ) / 2

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Income elasticity

Categories of income
elasticity

superior goods:
EY > 1

normal goods: 0 EY
1

inferior goods:
EY < 0
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Other demand elasticities

Examples: elasticity is encountered every

time a change in some variable affects
demand
advertising expenditure
interest rates
population size

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Elasticity of supply

Price elasticity of supply: the

percentage change in quantity supplied as
a result of a 1 percent change in price

% Quantity Supplied
ES
% Price
The coefficient of supply elasticity is a
normally a positive number
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Elasticity of supply

Arc elasticity of supply

Q2 Q1
P2 P1
Es

(Q1 Q2 ) / 2 ( P1 P2 ) / 2

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Elasticity of supply

When the supply curve is more elastic, the

effect of a change in demand will be
greater on quantity than on the price of
the product
When the supply curve is less elastic, a
change in demand will have a greater
effect on price than on quantity

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Global application

Example: price elasticities in Asia

imports almost always price inelastic
if exports price inelastic, export earnings
will rise as prices rise
if exports price elastic, export earnings
will rise with world incomes

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