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CHAPTER FOUR

ELASTICITY

We have seen in chapter three how a change in the price of the good results in
change in quantity demanded of that good in the opposite direction (movement
along the same demand curve); and how a change in income results in a
change in quantity demanded at every price. The same thing is said about the
changes in the price of related goods and other non-price determinants.
The question is now how to measure the magnitude of each change in quantity
demanded or supplied as a response to a change in one of the independent
variables. The same argument can be applied to the quantity supplied.
In order to have a better picture of the degree of responsiveness of quantity to a
change in one of the independent variable we have to understand the concept of
elasticity.

The Economic Concept of Elasticity


Elasticity is a measurement of the degree of responsiveness of the dependent
variable to changes in any of the independent variables.
In general elasticity is the percentage change in one variable in response to a
percentage change in another variable.
Elasticity =

% dependentVariable
% Y
=
= Elasticity Coefficient
% IndependentVariable % X

Elasticity coefficient includes a sign and a size. We need to interpret the sign
and the size of the coefficient.
Sign shows the direction of the relationship between the two variables. A
positive sign shows a direct relationship while a negative sign shows an inverse
relationship between the two variables.

Page 1 of 34

Size illustrates the magnitude of this relationship. In other words, it shows how
large the response of the dependent variable to the change in the independent
variable.
Large elasticity coefficient means that a small change in the independent
variable will result in a large change in the dependent variable (the opposite is
true).
Elasticity coefficient is a unit-free measure because in calculating the elasticity
we use the percentage change rather than the change to avoid the difficulty of
comparing different measurement units, and the percentages cancel out.
Changing the units of measurement of price or quantity leave the elasticity value
the same
Elasticity is an important concept in economic theory. It is used to measure the
response of different variables to changes in prices, incomes, costs, etc.
In addition to price and income elasticities of demand, you may estimate the
elasticity with respect to any of the other variables like advertisement and
weather conditions. You may even measure the elasticity of production to
various inputs or the elasticity of your grades in managerial economics to hours
of study.
This chapter covers some of the important types of elasticities.

Page 2 of 34

THE PRICE ELASTICITY OF DEMAND (Ed):


In the previous chapter we have discussed the movement of the quantity
demanded along a given demand curve as a result of change in the price of the
good. The direction of the movements reflects the law of demand that shows an
inverse (negative) relationship between P and Qd; the lower the price the greater
the quantity demanded.
When supply increases while demand stays

constant, the equilibrium price falls and the

P0

equilibrium quantity increases. But does

P2

the price fall by a large amount or a little?

P1

S0
S1

D2

And does the quantity increase by large


amount or a little? The answer depends on

Q0

Q2

D1
Q1

the responsiveness of quantity demanded to a change in price.


We are now going to discuss the question of how sensitive the change in
quantity demanded is to a change in price. The response of a change in quantity
demanded to a change in price is measured by the price elasticity of demand.
Price elasticity of demand (Ed) is an economic measure that is used to
measures the degree of responsiveness of the quantity demanded of a good to
a change in its price, when all other influences on buyers plans remain the
same.
The price elasticity of demand is calculated by dividing the percentage change
in quantity demanded by the percentage change in price.
Ed =

%Q d Q d / Q d
=
%P
P / P

Example:
Suppose P1 = 7, P2 = 8, Q1 = 11, Q2 = 10, then
If P from 8 to7, Ed = -0.8
If P from 7 to 8, Ed = -0.64
You can see that the value of Ed is different depending on direction of change in
P even with the same magnitude.
Page 3 of 34

To solve this problem we use Arc elasticity


The arc elasticity of demand is measured over a discrete interval of a demand
(or a supply) curve.
To calculate the price elasticity of demand (Ed): We express the change in price
as a percentage of the average pricethe average of the initial and new price,
and we express the change in the quantity demanded as a percentage of the
average quantity demandedthe average of the initial and new quantity.
By using the average price and average quantity, we get the same elasticity
value regardless of whether the price rises or falls.
Q d
Q 2 Q1
Q 2 Q1
%Q d Q avg
( Q 2 + Q1 ) / 2 Q 2 + Q 1
=
=
Ed =
=
P2 P1
P2 P1
P
%P
Pavg
P2 + P1
(P2 + P1 ) / 2
=

Q 2 Q1 P2 + P1 Q 2 Q1 P2 + P1

=
Q 2 + Q1 P2 P1
P2 P1 Q 2 + Q1

Where,
Q1 = the original (the old) quantity demanded, Q2 = the new quantity demanded
P1 = the original (the old) price, P2 = the new price
Qavg = the average quantity, Pavg = the average price
The formula yields a negative value, because price and quantity move in
opposite directions (law of demand). But it is the magnitude, or absolute value,
of the measure that reveals how responsive the quantity change has been to a
price change. Thus, we ignore the minus (negative) sign and use the absolute
value because it simply represents the negative relationship between P and Qd
Example:
Suppose P1 = 7, P2 = 8, Q1 = 11, Q2 = 10, then
Ed =

10 11 8 7

= 0.71
10 + 11 8 + 7
2
2

Now how to interpret the elasticity coefficient? What Ed= - 0.71 means?

Page 4 of 34

It means that if the price of the good increases (decreases) by 1% the quantity
demanded of the good decreases (increases) by 0.71%
Example:
Price($)

Qd(bushels of Wheat)

8
20
7
40
6
60
5
80
What is the Ed if P increases from 6 to 7?
Ed =

40 60 7 + 6

= 2.6
60 + 40 7 6

A 1% increase in P would result in a 2.6% decrease in Qd


Example:
If a rightward shift in the supply curve leads to an increase in Qd by 10 % as a
result of a decrease in P by 5%.
a. Calculate Ed.
Ed =

%Q d 10
=
= 2
%P
5

b. Interpret Ed
Ed = 2 means that a decrease in P by 1% results in an increase in Qd by 2%
c. What would be the increase in Qd if P decreases by 4%?
Since E d =

%Q d
, then %Q d = ( E d ) ( %P ) = (-2) (-4%) = + 8 %,
%P

Thus, a decrease in P by 4% results in an increase in Qd by 8%


d. What would be the decrease in P if Qd increases by 6%
Since E d =

%Q d 6%
%Q d
, then % P =
=
= 3% ,
%P
Ed
2

Thus, if Qd increases by 6%, P decreases by 2%


However, if we want to measure Ed at a single point rather than between two

points we should use point elasticity of demand

Page 5 of 34

The point elasticity of demand measured at a given point of a demand (or a

supply) curve. It is the price elasticity for small changes in the price or for
changes around a point on the demand curve.
dQ d
%Q d
dQ P
d =
= Q =

dP
%P
dP Q
P

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


d =

Q P

P Q

Notice that the first term of the last formula is nothing but the slope of the

demand function with respect to the price.


Having this fact in mind you will easily remember that:

1. The value of the elasticity; varies along a linear demand curve, as P/Q
change even though, the slope is constant.
2. The value of the elasticity varies along a nonlinear demand curve as both
terms in the above equation varies from as we move along a nonlinear
demand curve.
3. The value of the elasticity is constant along the demand curve only in the
case of an exponential function in the form:
Qd = aP-b,
where the price elasticity of demand equals b, which can be proved as
follows:
d =

dQ P
P
= baP b1
= b
dP Q
aP b

This type of nonlinear equations can be expressed in linear form using logarithm

log Q = log a b (log P)


Example:

Calculate the elasticity of demand using the following equation:


Qd = 50P-3,
Page 6 of 34

d =

dQ P
P
150 P P 3 150 P 4
= 150(P 4 )
=

=
4 = 3
dP Q
50
50
50P 3
P4
P

Example:

Given Qd = 2000 - 20P, Find d when P=70


At P=70, Qd = 2000 20(70) = 2000 1400 = 600
d =

70
dQ P
= ( 20)
= 2.33
600
dP Q

Example:

If Qd =200 - 300P + 120I + 65T 250Pc + 400Ps,


and if I=10, T=60, Pc =15, Ps j=10, Find:
a. Ed for the price range $10 and $11
b. d at P =$10
Qd = 200 - 300P + 120(10) + 65(60) 250(15) + 400(10)
= 200 - 300P + 1200 + 3900 3750 + 4000
Qd = 5550 300P
a. Ed for the price range $10 and $11 (Arc Elasticity)
At P=10, Qd = 5550 300(10) = 2550
At P=11, Qd = 5550 300(11) = 2250
Ed =

2250 2550
11 + 10

= 1.31
11 10
2250 + 2550

b. d at P =$10 (Point Elasticity)


d =

10
dQ P
= ( 300 )
= 1.2
2550
dP Q

Example:

Assume a company sells 10,000 units of its output at price of $100.


Suppose competitors decrease their price and as a result the companys sale
decrease to 8,000 units. Ed in this price-quantity range is -2. What must be the
price if the company wants to sell the same number of units before its
competitors decrease their price?
Using E d =

Q 2 Q1 P2 + P1

= 2
P2 P1 Q 2 + Q1
Page 7 of 34

Q1=8000, Q2= 10000, P1= 100, P2=?


2=
=

P2 + 100
(10,000 8,000 )(P2 + 100 )
10,000 8,000

=
P2 100
10,000 + 8,000 (P2 100 )(10,000 + 8,000 )

2,000(P2 + 100 )
2,000P2 + 200,000
=
(P2 100 )(18,000 ) 18,000P2 1,800,000

For simplification, divide numerator and denominator of left-hand side by 1000


2=

2P2 + 200
18P2 1,800

2(18P2 1800 ) = 2P2 + 200

-36P2 + 3600 = 2P2 + 200


-38P2 = -3400
P2 = -3400/-38 = 89.5
TR1 = 100 X 8,000 = 800,000
TR2 = 89.5 X 10,000 = 895,000
Since TR2 > TR1 TR  it is good to cut price but is not known since we do
not the TC
Example:

A 50% decrease in the price of salt caused the quantity demanded to increase
by10%. Calculate the price elasticity of demand for salt, explain the meaning of
your result and tell if the demand for salt is elastic or inelastic?
Ed = 10/50 = 0.20 which means a10% change in price results in a 2% Change in
the quantity demanded in the opposite direction.
Example:

Qd = 50 P3, is the demand curve equation for apple, calculate the price
elasticity of demand when P =3 and Q = 9.
d =

dQ P
3
1
= 3(3 2 ) = 27 = 9
dP Q
9
3

Page 8 of 34

Categories of Demand Elasticity


Using absolute value of Ed, we differentiate between five categories of elasticity

that range between zero and infinity.


1. Relatively Elastic Demand (Ed > 1)
If E d =

%Q d
> 1 % Qd > % P demand is elastic.
%P

Consumers are very responsive to changes in P. Demand curve is flatter 1%


change in P results in a more than 1% change in Qd (in the opposite direction).
(if Ed = 2 that means if P  by 1% Qd  by 2%.)
Examples of elastic goods: cars, furniture, vacations, etc.
2. Relatively Inelastic Demand (Ed < 1)
If E d =

%Q d
< 1 % Qd < % P demand
%P

is inelastic.
Consumers are not very responsive to changes
in P. Demand Curve is steeper 1%  (or ) in P results in a less than 1% 
(or) in Qd (if Ed = 0.70 that means if P  by 1% Qd  by 0.7%.) or (if P  by
10% Qd  by 7%.)
Examples of inelastic goods: medicine, food, etc.
If the price elasticity is between 0 and 1, demand is inelastic.
P

More Elastic

More Inelastic
Qd

Page 9 of 34

3. Unitary Elastic Demand (Ed = 1)


If E d =

%Q d
= 1 % Qd = % P demand is
%P

unit-elastic
1%  in P results in a 1%  in Qd

4. Perfectly Elastic Demand (Ed = )


%Q d
= demand is perfectly elastic
If E d =
%P

Qd

S1
S2
D

horizontal demand curve the same price is

charged regardless of Qd (perfect competition).


Qd

Any price increase would cause demand

to fall to zero. Shifts in supply curve results in no change in price. Examples:


identical products sold side by side, agricultural products.

5. Perfectly Inelastic Demand (Ed = 0)


If E d =

%Q d
= 0 demand is perfectly inelastic
%P

S1
S2

a vertical demand curve demand is

completely inelastic. Qd remains the same


regardless of any change in price. Shifts in supply

Qd
Qd

curve results in no change in Qd. Examples: medicine of heart diseases or


diabetes such as insulin A good with a vertical demand curve has a demand
with zero elasticity.
We conclude from the five categories above that the more flatter is the demand

curve the more elastic is the demand and the more steeper is the demand curve
the more inelastic is the demand
Page 10 of 34

Elasticity along straight line demand curve


Elasticity of demand (Ed) is not the slope of the demand curve.

Slope =

P
,
Q d

Elasticity: E d =

%Q d
%P

For a straight-line (linear) demand curve the slope is constant (i.e., the slope is

the same at every point along the curve). It is equal to the change in price over
the change in quantity demanded.
Although the slope is constant, price elasticity varies along a linear demand

curve.

Ed =

Ed > 1
Ed=1
Ed < 1
Ed = 0

The following equation shows the relationship between the elasticity and the

slope of a straight line demand curve


Ed =

Q d P
%Q d Q d / Q d Q d P
1
P

=
=

=
%P
Qd
P Q d slope Q d
P / P
P

Since the slope of straight-line demand curve is constant,


constant elasticity varies as a result of variation of

1
is also
slope

P
; i.e. straight-line
Qd

demand curve elasticity depends on the values of Qd and P

Page 11 of 34

1. When P = 0, Ed = 0 (perfectly inelastic)


2. When Q = 0, Ed = (perfectly elastic)
3. Ed increases as we move upward along a straight-line demand curve (from
the inelastic range to the elastic one) (as P and Q)
4. Ed decreases as we move downward along the straight-line demand curve
(as P and Q).
Thus, along downward sloping demand curve, demand is elastic when price is

high, inelastic when price is low and unit-elastic at the midpoint of the demand
curve.

Pricing Strategy: The Relationship between P, Ed, and TR


Managers of profit maximizing firms are usually concern with the best pricing

strategy.
There is a relationship between the price elasticity of demand and revenue

received.
Total revenue (TR) equals the total amount of money a firm receives from the

sales of its product


TR = P X Q.
TR is affected by changes in both P and Qd. But as we know by now the law of

demand implies that an increase in P will result in a decrease in Qd.


Thus, an increase in P may or may not lead to greater TR. This depends on

which effect is the largest, price effect or the effect of quantity demanded.
The size of the price elasticity of demand coefficient, tells us which of these two

effects is largest.
o If demand is elastic (Ed >1) % Qd > % P
10 % in P results in more than 10 % in sales TR
10 % in P results in more than 10 % in sales TR
o If demand is inelastic (Ed <1) % Qd < % P
10 % in P results in less than 10 % in sales TR
Page 12 of 34

10 % in P results in less than 10 % in sales TR


o If demand is unit elastic (Ed =1) % Qd = % P
10 % in P results in 10 % in sales TR does not change
10 % in P results in 10 % in sales TR does not change

TR
E>1

E<1

E=1

The rises or falls in TR as price increases (or decreases) depend on Ed. Hence,

TR varies along a linear downward sloping demand curve.


In order to increase total revenues, the manager should increase prices of

products that have inelastic demands, and should reduce prices of products that
have elastic demands.
Graphical Illustration of the relationship between TR, P, MR, and Ed
When the price is equal to zero, as it is where demand intersects the quantity

axis, or when the quantity demanded equals zero, as it is when the demand
intersects the price axis, total revenue must equal zero. Thus, when a firm either
sells none of its goods or sells its good for a zero price, they bring in zero
revenue.
If the firm moves away from either of these intersection points then their total

revenue must increase. Total revenue continues to rise as the firm moves away
from the intersections until it reaches a maximum at the midpoint.
For a price increase, total revenue rises when demand is inelastic and falls

when demand is elastic.


With a linear DC, TR increases and then decreases when P increases (or when

P decreases)
To max TR, set price at unitary elastic price
Page 13 of 34

Marginal revenue is the revenue generated by selling one additional unit of the

product
It is the change in total revenue resulting from changing quantity by one unit.
MR =

TR
Q

For a straight-line demand curve the marginal revenue curve is twice as steep

as the demand.
To sell more, often price must decline, so MR is often less than the price.
When EP = -. MR = P.
At the point where marginal revenue crosses the X-axis, the demand curve is

unitary elastic and total revenue reaches a maximum.


A product maximizing manager will expand product as long as the additional unit

produced adds more to TR than adding to TC; i.e., expand production as long
as MR > MC and M is positive.
The optimal production reached when MR = MC and M = 0
Units produced over and above the optimal level will have negative M because

for these units MR < MC


When TR is maximized, MR = 0 and MC (positive value) is definitely greater

than MR.
The conclusion here is that if the manager maximizes TR the firm will make less

than max profit.


Ed

Demand

MR

TR

Ed >1

Elastic

MR >0

Ed < 1

Inelastic

MR < 0

Ed = 1

Unit elastic

MR = 0

Max.

Page 14 of 34

Ed> 1

Ed = 1

P*

Ed< 1
0

MR
TR
E = 1;
E > 1;

MR=0

MR > 0

E < 1;
MR< 0

TR
0

Q*

The above graph shows that:


o Ed >1 Demand elastic MR>0 P and TR move in the opposite

direction (negative relationship)


o Ed < 1 Demand inelastic MR < 0 P and TR move in the same

direction (positive relationship)


o Ed = 1 Demand unit elastic MR = 0 TR is maximum
Example:

If a company wants to its TR when Ed = 0.75, it should P


Example:

If a company wants to its TR when Ed = 1.5, it should P


Page 15 of 34

Example:

If Ed = 1, an in P by 15%, Qd by 15%, TR will not change


Example:

Given Qd = 20 2P,
Find the price range for which
a. D is elastic
b. D is inelastic
c. D is unit elastic
d. If the firm increases P to $7, is TR increasing or decreasing?
Answer:
Qd = 20 2P P = 10 0.5Q
TR = 10Q 0.5Q2
MR = 10 Q
When MR = 0, 10 Q =0 Q = 10 and P = 10 0.5(10) = 5
At this P and Q, Ed = 1
a. D is elastic for price range above 5 (or Q less than 10)
b. D is inelastic for price range below 5 (or Q above 10)
c. D is unit elastic at P = 5 and Q = 10
d. If the firm chooses to increase the price to $7 and 7 is in the elastic part,
TR will be decreasing
Example:

Given Qd = 150 10P, find Q and P at which d = -1


Since Qd = 150 10P P = (150/10) (1/10) Q = 15 0.1Q
TR = 15Q 0.1Q2
MR = dTR/dQ = 15 0.2Q
(Note that the slope of MR equation is twice the slope of the inverse demand
equation).
TR reaches maximum when MR = 0 (Q that max TR is the same as Q that
makes MR= 0
Set MR =0 15 0.2Q = 0 Q =15/0.2= 75 and P = 15 0.1(75) = 7.5
Page 16 of 34

So, at Q=75 and P=7.5


MR = 0 and d =

dQ P
7.5 75
= ( 10 )
= 1 TR is maximized
=
dP Q
75
75

Find P and Q at which Ed >1 and Ed <1

Ed >1 at P > 7.5, and Q < 75


Ed <1 at P < 7.5, and Q > 75
Example:
P

TR MR

Ed

10

10

---

--

18

6.33

24

3.40

28

2.14

30

1.44

30

1.00

Ed = 1 (unitary elastic), TR is

28

-2

0.69

max and MR is zero

24

-4

0.47

18

-6

0.29

10 10

-8

0.16

Ed > 1 (elastic demand

Ed < 1 (inelastic demand

Exercise:

From the graph to the right


a. calculate Ed
b. When P increases what would happen to TR?
Ed = 1 and TR remains the same.
The area (0-5-a-20) = the area (0-4-b-25)

Page 17 of 34

a
b

4
0

D
2

MR and Elasticity
The relationship between Marginal Revenue (MR), price (P), and price the

elasticity of demand (Ed), can be stated using the formula:


1
MR = P 1 +
d

Clearly the equation shows that if Ed < -1, MR must be positive: if Ed > -1, MR

must be negative; and if Ed = -1, MR must be zero.


To proof the relationship between MR and Ed, (for your information only)

We know that TR = P X Q
dP
dP
dQ
dTR
d
=
+Q
=P+Q
(PXQ) = PX
dQ
dQ
dQ
dQ
dQ
Multiply the second term by P/P
P
dP
1
dP
Q dP
= P(1 + XQ
MR = p + XQ
) = P(1 + X
)
P
dQ
P
dQ
P dQ
But
dQ P
d =
X
dP Q
1 dP Q
=
X
So,
d dQ P
MR =

Thus, MR = P (1 +

1
)
d

If P = 20 and d = -4 find MR
1
MR = 20 1 +

MR = 20 (1 - 0.25)
= 20 (0.75) = 15

Page 18 of 34

Factors Affecting Demand Elasticity


Demand for some goods and services is elastic whereas for other goods and

services is inelastic.
Elasticity does not only differ from one good to another but also it may differ for

a particular product at different prices.


The elasticity of demand is computed between points on a given demand curve.

Hence, the price elasticity of demand is influenced by all determinants of


demand.
We can summarize the main factors that affect Ed as:
1. Availability and closeness of Substitutes
When a large number of substitutes are available, consumers respond to a

higher price of a good by buying more of the substitute goods and less of the
relatively more expensive one. So, we would expect a relatively high price
elasticity of demand for goods or services with many close substitutes, but
would expect a relatively inelastic demand for goods with few close substitutes.
Example:

Dell computer, for example, has many substitutes. So its price elasticity of
demand is highly elastic because the consumers can easily shift to the other
substitutes if the price of Dell computer increases
Example:

Pepsi and Coke are very close substitutes. So, the availability of Pepsi makes
the price elasticity of demand of Coke very high. Any increase in the price of
Coke will result in a huge shift of consumers to Pepsis purchase.
Furthermore, the broader the definition of the good, the lower the elasticity since

there is less opportunity for substitutes. The narrower the definition of the good
the higher the elasticity, since there are more substitutes.

Page 19 of 34

Example:

A buyer who likes Japanese cars and has relative preference for Toyota
products may have higher price elasticity of demand for Camry than the price
elasticity of demand for Toyota cars. His price elasticity of demand for Toyota
cars is higher than the price elasticity of demand for Japanese cars. And his
price elasticity of demand for Japanese cars is higher than the price elasticity of
demand for cars in general. Why?
Example:

Consider the relative price elasticity of demand for a good such as apples
compared to a good such as fruits. What is the difference between apples and
fruits? Apples are, of course, a fruit but so are lots of other goods as well.
Hence, more substitutes exist for apples than exist for the broader category of
fruits. We have already determined that as the number of substitutes increase
then so does that goods relative price elasticity of demand.
2. Proportion of total expenditures to Income
The higher the proportion of income spent on the good, the higher the elasticity

of demand. Expensive good take a greater proportion of an individuals income


and expenditures than the inexpensive goods; so expensive good are more
elastic.
Example:

Consider the price elasticity of demand for a good such as a pen compared to
that for a good such as a car. One of the big differences between these two
types of goods is that the price of a pen is small as a proportion of the income
while the price of a car is typically a large percentage of income. Doubling the
price of pens will not, therefore, have a big impact on ones income. However,
doubling the price of cars will have a large impact on ones income.
Thus, the demand for high-priced goods such as cars tends to be more price
elastic than the demand for low-priced good such as bread or salt.

Page 20 of 34

3. The Time Elapsed Since Price Change (Length of Time)


Over time, demand tends to be more elastic because time is available to search

for substitutes for a good when a longer time period is considered.


Example:

Consider what happens as the price of a good such as gasoline doubles. People
respond to the higher price by decreasing their use of gas. However, in just a
short time period it is more difficult to do this than in a longer period. Essentially,
the longer the time period people have to adjust, the more alternatives they can
find to reduce their consumption of gas. For example, they might be able to
move closer to work, buy a more fuel-efficient car, use public transportation,
arrange with friends to go in on car, etc.
Thus, in short run, the response is very limited demand is less elastic; over

time, demand tends to be more elastic because time is available to search for
substitutes and adjust to the new situation
4. Necessary vs. Luxury goods
Demand for necessary goods, goods that are critical to our everyday life and

have no close substitute, is relatively inelastic (food, medicine).


Demand for luxury goods, goods with many substitutes and we would like to

have but are not likely to buy unless our income jumps or the price declines
sharply, is relatively elastic (cars, traveling to foreign countries for vacation).
Nevertheless, what is one person's luxury is another person's necessity
5. Durability of the product:
The demand for durable goods (such as cars) tends to be more price elastic

than the demand for non-durable goods, such as foods.


This is because durable goods have the possibility of postponing purchase,

have the possibility of repairing the existing ones, and the possibility of buying
used ones.

Page 21 of 34

As a result a small percentage change in the prices of durable goods cause

larger percentage change in the quantity demanded.


The Elasticity of Derived Demand:
The demand for intermediate goods (goods used in producing the final good) is

called a derived demand, since the demand for these goods is directly
associated with the demand for the final good. The derived demand for a
specific intermediate good will be more inelastic:
1. The more essential is that good to the production of the final good.
2. The more inelastic the demand for the final good.
3. The smaller the share of that good in the cost of producing the final good.
4. The shorter the time passes after the price changes.

Page 22 of 34

INCOME ELASTICITY OF DEMAND


The income has an impact upon demand.
Recall that the relationship between income and demand may be direct or

inverse, depending on whether the good is a normal good or an inferior good.


Income Elasticity of Demand (EY) measures the responsiveness of Qd of a good

to a change in income. It is the percentage change in quantity demanded


divided by percentage change in income.
It may be calculated across and arc for big changes in income using the

following formula:
EY =

%Q d O 2 Q1 y 2 Y1 O 2 Q1 Y2 Y1 O 2 Q1 Y2 + Y1

=
Q 2 + Q1 Y2 + Y1 Q 2 + Q1 Y2 + Y1 Q 2 + Q1 Y2 Y1
%Y
2
2

For small changes in income using the point elasticity:


dQ d

%Q d Q d dQ d
Y
EY =
=
X
=
%Y
dY Q d
dY

EY > 1 Demand is income elastic and the good is normal and luxury. % Qd

> % Y (A small percentage change in income results in a large percentage


change in Qd)
0 < EY < 1 Demand is income inelastic and the good is normal and

necessary. % Qd < % Y (A large percentage change in income results in a


small percentage change in Qd)
EY < 0 (negative) the good is an inferior good.
Examples:

Given QA = 3 2PA +1.5Y + 0.8PB 3PC


If PA= 2, Y=4, PB=2.5, PC=1
Calculate EY
dQA/dY = 1.5, QA = 3 2(2) +1.5(4) + 0.8(2.5) 3(1) = 4
EY =

Q A
4
Y
= 1.5 X = 1.5 > 1 Normal (luxury) good
X
Y
4
QA
Page 23 of 34

Example:

The manager of Global Food Inc heard the news that government plans to give
a 15% raise to all its employees who represent 70% of the labor force of the
country. If the estimated income elasticity of demand for global food products is
0.85, find the expected change in the demand for the firm products.
%UY = 15% X 70% =10.5%
%Q d
=
%Y
%Q d
0.85 =
10.5

EY =

%UQd = 10.5 X 0.85 = 8.9%


Examples:

1. If peoples average income increased from BD300 to BD350 per month and
as a result their purchase of orange juice increased from 5000 liters to 5800
liters per month, Calculate EY
EY = 0.96.
The increase in income by 10% results in an increase in the Qd of orange
juice by 9.6% .Orange juice is a normal, necessary good. People buy more of
it when their income increases.
2. If peoples average income increased from BD300 to BD350 per month and
as a result their purchase of used mobiles decreased from 400 units to 300
units per month, Calculate EY
EY = - 1.86.
The increase in income by 10% results in a decrease in the Qd of used
mobiles by 18.6%. Since the sign is negative this means the mobile is an
inferior good. People buy less of it when their income increases.
3. If income by 5% and Qd by 10% EY = +2 normal, luxury good
4. If income by 5% and Qd by 10% EY = -2 inferior good

Page 24 of 34

CROSS ELASTICITY OF DEMAND


The decision to buy a good depends not only on its price but also on the price

and availability of other goods (substitutes or complements).


We know that as the price of related good changes, the demand for the good

will also change.


What we want to know here is how much will quantity demanded rise or fall as

the price of the related good changes. That is, how elastic is the demand curve
in response to changes in prices of related goods.
Cross elasticity measures the responsiveness of Qd of a particular good to

changes in the prices of its substitutes and its complements.


If X and Y are two goods, the cross elasticity of demand is the percentage

change in Qd of good X to the percentage change in price of good Y


The arc elasticity formula:
ER =

%Q x Q 2 x Q1x P2 y P1y Q 2 x Q1x P2 y + P1y


=

=
Q 2 x + Q1x P2 y + P1y Q 2 x + Q1x P2 y P1y
%Py
2
2

For small price changes, the cross elasticity may be calculated as a point

elasticity using the following formula:


dQ x

%Q x Q x dQ x Py
ER =
=
=
X
%Py
dPy dPy Q x

P
y

When the cross elasticity of demand has a positive sign, the two goods are

substitute goods.
When the cross elasticity of demand has a negative sign, the two goods are

complementary goods
When ER=0 no relation between PX and DY
The size of cross elasticity of demand coefficient is primarily used to indicate the

strength of the relationship between the two goods in question.

Page 25 of 34

Two products are considered good substitutes or complements when the

coefficient is larger than 0.5 (in absolute terms)


Example:

If

P1x = 20,

P2x= 30

Q1y = 200

Q2y = 250

Q1z = 150

Q2z = 140

Determine the relationship between X and Y, and the relationship between X


and Z
ER(xy) = 0.556 X and Y are strong substitutes
ER(xz) = - 0.172 X and Z are mild complements
Example:

Given QA = 3 2PA +1.5Y + 0.8PB 3PC


If PA= 2, Y=4, PB=2.5, PC=1
Calculate
a. ER between A and B
b. ER between A and C
Solution,
dQA/dPB = 0.8, dQA/dPC = -3,
QA = 3 2(2) +1.5(4) + 0.8(2.5) 3(1) = 4
a. E R =

P
dQ A
2 .5
= 0.5 Strong Substitutes
X B = 0 .8 X
4
QA
dPB

b. E R =

P
dQ A
1
X C = 3 X = 0.75 Strong Complements
4
QA
dPC

Example:

Nissan Maxima and Toyota Camry are competing substitutes in the market for
small passenger cars. The Nissan Manager would like to predict the negative
effect of Toyotas 15% discount on Camry during Ramadhan. From previous
years, Nissan manager has an estimate of the cross elasticity of 2.0 between
these two brands.

Page 26 of 34

Given this information, calculate the expected effect on Nissan sales of Maxima
cars.
Solution
ER =
2=

%QMamima
=
%PCamry

%QMaxima
15%

%UQMaxima = 2 X (-15%) = -30%


Maxima sales are expected to drop by 30% as a result of Toyota discounts
during Ramadhan.
Exercise

Find the point price elasticity, the point income elasticity, and the point cross
elasticity at P=10, Y=20, and PR=9, if the demand function were estimated to be:
Qd= 90 - 8P + 2Y + 2PR
Is the demand for this product elastic or inelastic? Is it a luxury or a necessity?
Does this product have a close substitute or complement? Find the point
elasticities of demand.
Solution
First find the quantity at these prices and income:
Qd= 90 - 8P + 2Y + 2PR = 90 -8(10) + 2(20) + 2(9) =90 -80 +40 +18 = 68
Ed = (Q/P)(P/Q) = (-8)(10/68)= -1.17 which is elastic
EY = (Q/ Y)(Y/Q) = (2)(20/68) = +.59 which is a normal good, but a necessity
ER = (Qx/ PR)(PR /Qx) = (2)(9/68) = +.26 which is a mild substitute

Page 27 of 34

NET OR COMBINED EFFECT OF ELASTICITY


To find the total effect of change in more than one variable on the quantity

demanded, we may combine the effect of price elasticity of demand (Ed),


income elasticity of demand (EY), and cross elasticity of demand (ER), and or
any other elasticity, thus calculating the net effect of theses changes.
Most managers find that prices and income change every year.
By definition we know that:
o Ed = %Q/ %P %Q = Ed (%P)
o EY = %Q/ %Y %Q = EY (%Y)
o ER = %Q/ % PR %Q = ER (%PR)
If you knew the price, income, and cross price elasticities, then you can forecast

the percentage changes in quantity.


Combining these effects (assuming independent and additive functions) we

have:
%Q = Ed (%P) + EY (%Y) + ER (%PR)
Where, P is price, Y is income, and PR is the price of a related good.
Example:

LTC has a price elasticity of -2, and an income elasticity of 1.5 for its laptops.
The cross elasticity with another brand is +.50
a. What will happen to the quantity sold if LTC raises price 3%, income rises
2%, and the other brand companies raises its price 1%?
b. Will Total Revenue for this product rise or fall?
Solution
a. %Q = Ed (%P) + EY (%Y) + ER (%PR)
= -2 (3%) + 1.5 (2%) +0.50 (1%) = -6% + 3% + 0.5% = -2.5%.
We expect sales to decline.
b. Total revenue will rise slightly (about + 0.5%), as the price went up 3%
and the quantity of laptops sold falls 2.5%.

Page 28 of 34