Elasticity of Demand 2015

Elasticity of Demand and
Supply
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Copyright 2003 South-Western

Thomson Learning. All rights reserved.
Definition
Elasticity of demand means responsiveness

of quantity demand to percentage change in
price.
Types of Elasticity of Demand
Price Elasticity of Demand

Income Elasticity of Demand
Arc Elasticity of Demand
Cross Elasticity of Demand
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Sign of Price Elasticity

According to the law of demand, whenever
the price rises, the quantity demanded falls.
Thus the price elasticity of demand is
always negative.
Because it is always negative, economists
usually state the value without the sign.
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Price elasticity reveals the responsiveness of

the Quantity Demand to % age change in
price.
Price Elasticity =
of demand
% Change in
quantity demanded
% Change in Price
% Q
% P
dQ P
Eld
*
dP Q
OR we can rewrite it
as follows
(Q0 Q1 ) (Q0 Q1 )
( P0 P1 ) ( P0 P1 )
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Classifying Demand and

Supply as Elastic or Inelastic
Demand is inelastic or Less Elastic if
the percentage change in quantity is
less than the percentage change in
price.
E<1
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After calculating the price elasticity of

demand, you can determine whether it is
elastic, inelastic, or unitary elastic with the
following chart:
If the absolute value of the elasticity term < 1,
then the demand is inelastic.
If the absolute value of the elasticity term > 1,
then the demand is elastic.
If the absolute value of the elasticity term = 1,
then the demand is unitary elastic.
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Elasticity of Demand
Price
Perfectly inelastic
demand
curve
(a)
Perfectly inelastic:
An increase in price results in no
Quantity
Relatively inelastic:
A percent increase in price results
in a smaller % reduction in sales.
The demand for cigarettes has
been estimated to be highly
inelastic or less elastic.
change in consumers purchases.

The vertical demand curve is
imaginary as the substitution and
income effects prevent this from
happening in the real world.
Price
Demand for
Cigarettes
(b)
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Quantity

Price
Demand curve of
unitary elasticity
(c)
Quantity
Unitary elasticity:
The percent change in quantity
demanded due to an increase in
price is equal to the % change in
price. A decreasing slope
results. Sales revenue (price
times quantity) is constant.
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Price
(d)
More Elastic
Demand
Quantity
More elastic:
A % increase in price leads to a
larger % reduction in purchases.
When good are substitutes
then quantity demand will be
highly sensitive to changes in
price.
Price
Perfectly Elastic
Demand
Perfectly elastic:
If price remains constant but
quantity demand is increasing with
the passage of time
(e)
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Quantity

(Q0 Q1 ) (Q0 Q1 )
Recall - ( P P ) ( P P )
0
1
0
1
With this straight-line (constant-slope)

demand curve, demand varies across
a range of prices.
Using the equation for elasticity, the
formula shows that, when price rises
from $1 to $2 while quantity
demanded falls from 110 to 100
the elasticity for that region of the
demand curve is ( - .14 ) inelastic.
Price
(110 - 100) (110 + 100)

($1 - $2) ($1 + $2)
= ( - ) 0.14
Elasticity = (-) 0.14
2
1
D
100 110
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Quantity
demanded

Recall A price increase of the same amount,
from $10 to $11, . . . leads to a decline
in quantity demanded from 20 to 10.
Note that this change in price was
smaller (as a %) than in the previous
slide but resulted in the same change
in quantity demanded.
Using the equation for elasticity, the
elasticity amounts to - 7.0 (greater
than - .14 from before).
The price-elasticity of a straight-line
demand curve increases as price rises.
(Q0 Q1 ) (Q0 Q1 )
( P0 P1 ) ( P0 P1 )
(20 - 10) (20 + 10)
Price
($10 - $11) ($10 + $11)
= (-) 7.0
Elasticity = (-) 7. 0
11
10
D
10 20
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Quantity
demanded

Elasticity Along a Demand

Curve
Ed =
$10
9
8
7
6
5
4
3
2
1
Elasticity declines along

demand curve as we move
toward the quantity axis
Price
Ed > 1
Ed = 1
Ed < 1
Ed = 0
1
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9 10 Quantity
Determinants of
Availability of substitutes
When good substitutes for a product are

available, a rise in price induces many
consumers to switch to another product.
The greater the availability of substitutes,
the more elastic demand will be.
Share of total budget expended on product

As the share of the total budget expended on
the product rises, demand is more elastic.
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Elastic
and InelasticPrice
Demand
Price
$1.50
$1.50
$1.00
$1.00
D
25
100
90 100
(a) Ballpoint pens per week (in thousands)
(b) Cigarette packs per week (in millions)
As the price of ballpoint pens (a) rises from $1.00 to $1.50 . . . the
quantity demanded plunges from 100,000 to 25,000 per week.
The % reduction in quantity demanded is larger than the % increase in
price, hence the demand for ballpoint pens is relatively elastic.
As the price of cigarettes (b) rises from $1.00 to $1.50 . . . quantity
demanded plunges from 100 million to 90 million packs per week.
The % reduction in quantity demanded is smaller than the % increase
in price, hence the demand for cigarettes is relatively inelastic.
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Income Elasticity of Demand
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Income Elasticity of demand
Income elasticity indicates responsiveness of

a products demand to a change in income.
% Change in
Income Elasticity
quantity demanded
=
of demand
% Change in Income
A normal good is a good with a positive

income elasticity of demand.
As income expands, the demand for normal
goods will rise.
Goods with a negative income elasticity are

inferior goods.
As income expands, the demand for inferior
goods will decline.
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Arc Elasticity of Demand

Arc Elasticity of demand is used to find an
average of two point elasticities on the
demand curve.
p
p
a
b
Qd
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Formula for Arc Elasticity

The formula for Arc elasticity of demand is
as follows
E=
dQ P1 P2
dP Q1 Q2
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Cross Elasticity of demand

If the objective is to check the
responsiveness of quantity demand to
percentage change in the price of substitute
goods then cross elasticity of demand
would be used.
dQ1 P2
Elc
*
dP2 Q1
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Inelastic
Salt
Matches
Toothpicks
Airline travel (short run)
Gasoline (short run)
Gasoline (long run)
Natural gas, home (short run)
Natural gas, home (long run)
Coffee
Fish (cod), at home
Tobacco products (short run)
Legal services (short run)
Physician services
Taxi (short run)
Automobiles (long run)
0.1
0.1
0.1
0.1
0.2
0.7
0.1
0.5
0.3
0.5
0.5
0.4
0.6
0.6
0.2
Approximately Unitary Elasticity

Movies
Homes, owner occupied (long run)
Shellfish (consumed at home)
Oysters (consumed at home)
Private education
Tires (short run
Tires (long run)
Radio and television receivers
0.9
1.2
0.9
1.1
1.1
0.9
1.2
1.2
Elastic
Restaurant meals
Foreign travel (long run)
Airline travel (long run)
Fresh green peas
Automobiles (short run
Chevrolet automobiles
Fresh tomatoes
2.3
4.0
2.4
2.8
1.4
4.0
4.6
Can you explain why the demand for some goods

is highly inelastic while that for others is elastic.
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Relationship between Total

Revenue and Price
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Total Expenditures
and Demand Elasticity
Price elasticity
of demand
More Elastic
Unitary Elastic
Less elastic
Elasticity
coefficient
(in absolute value)
1 to
1
0 to 1
Impact of higher price

on total consumer
expenditures or a
firms total revenue
decrease
-- unchanged-increase
Impact of lower price

on total consumer
expenditures or a
firms total revenue
increase
-- unchanged-decrease
The table above summarizes the relationship

between changes in price and total expenditures
for demand curves of varying elasticity.
When the total revenue is maximized , marginal

revenue is Zero and elasticity of demand would be elastic.
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Total Revenues
and
Demand
Elasticity
The Firms Demand Curve, Total Revenue, and Elasticity
Price
$9
$8
$7
$6
$5
$4
$3
$2
$1
$0
Here demand is More elastic so

lower prices result in more
Price
revenue and higher prices result in
elasticity
P X Q = TR
less revenue
e = 17.00
$9 x 0 = $0
Total revenue unchanged by price
e = 5.00
$8 x 1 = $8
when demand is unitary elastic
e = 2.60
$7 x 2 = $14
e = 1.57
$6 x 3 = $18
e = 1.00
$5 x 4 = $20
e = 0.64
$4 x 5 = $20
e = 0.38
$3 x 6 = $18
e = 0.20
$2 x 7 = $14
$1 x 8 = $8
e = 0.06
$0 x 9 = $0
0 1 2 3 4 5 6 7 8 9
Qty Total
Price sold revenue Price elasticity of demand
$9
$8
$7
$6
$5
$4
$3
$2
$1
$0
x
x
x
x
x
x
x
x
x
x
0
1
2
3
4
5
6
7
8
9
=
=
=
=
=
=
=
=
=
=
$0
$8
$14
$18
$20
$20
$18
$14
$8
$0
((0-1) / (0+1)) / ((9-8) / (9+8)) = 17.00

((1-2) / (1+2)) / ((8-7) / (8+7)) = 5.00
((2-3) / (2+3)) / ((7-6) / (7+6)) = 2.60
((3-4) / (3+4)) / ((6-5) / (6+5)) = 1.57
((4-5) / (4+5)) / ((5-4) / (5+4)) = 1.00
((5-6) / (5+6)) / ((4-3) / (4+3)) = 0.64
((6-7) / (6+7)) / ((3-2) / (3+2)) = 0.38
((7-8) / (7+8)) / ((2-1) / (2+1)) = 0.20
((8-9) / (8+9)) / ((1-0) / (1+0)) = 0.06
Here demand is less elastic

so lower prices result in less
revenue and higher prices
result in more revenue
Quantity
By tracing out the demand curve, one

can see how changes in price (through
changes in quantity demanded) change
revenue collected.
total
By calculating
the price elasticity of
demand at different points along the
demand curve, one can follow how
and where total revenue is maximized.
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Total Revenues and Demand Elasticity
The firm maximizes its revenue at the price (or quantity)

where demand is unitary elastic.
Total Revenue is maximized

somewhere between 4 and 5 units
Total Revenue is maximized

somewhere between $4 and $5
(where demand is unitary elastic).
(again, where demand is unitary elastic).
Quantity Total
Price sold revenue Elasticity
Price
$9
$8
$7
$6
$5
$4
$3
$2
$1
$0
Total
$0 $5 $10 $15 $20 revenue
(c) Price versus Total Revenue
$9
$8
$7
$6
$5
$4
$3
$2
$1
$0
x
x
x
x
x
x
x
x
x
x
0
1
2
3
4
5
6
7
8
9
=
=
=
=
=
=
=
=
=
=
$0
$8
$14
$18
$20
$20
$18
$14
$8
$0
17.00
5.00
2.60
1.57
1.00
.64
.38
.20
.06
Total
revenue
$20
$15
$10
$5
Qty
$0
0 1 2 3 4 5 6 7 8 9
(d) Quantity versus Total Revenue
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Price Elasticity of Supply
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Price Elasticity of Supply
The price elasticity of supply is the percent

change in quantity supplied divided by the
percent change of the price causing the
supply response.
Analogous to the price elasticity of demand.
However, the price elasticity of supply will
be positive because the quantity producers
are willing to supply is directly related to
price.
Formula for finding Price Elasticity of supply
is same as price elasticity of demand. To
calculate elasticity of supply, derivative of
supply equation is taken
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Concepts of Consumer
Surplus and Producer Surplus
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Consumer Surplus
Consumer surplus is the difference between
the amount consumers are willing to pay and
the amount they have to pay for a good.
Lower market prices increase the amount of

consumer surplus in the market.
Consumer Surplus:
the area below the demand curve but above the actual
price paid.
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Market Demand Schedule

Price
Consider the market for cellular

phones service . This time we
will assume that the demand
for cell service is more linear
and that the market price is $100.
140
If the market price is $100, then

the 30th unit will not sell
because those who demand it are
only willing to pay $60 for
cellular phone service.
100
At $100, the 17th unit will sell

willing to pay up to $100 for
At $100, the 5th unit will sell
willing to pay up to $133 for
(monthly bill)
120
Market price = $100
80
60
Demand
5
10 15 20 25 30
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Quantity
(millions of
subscribers)

Market Demand Schedule

Price
(monthly bill)
For all those goods under 17

units, people are willing to
pay more than $100 for service.
The area, represented by the
distance above the actual price
paid and below the demand
curve, is called consumer
surplus.
This area represents the net
gains to buyers from market
exchange.
Consumer
surplus
140
120
Market price = $100
100
80
60
Demand
5
10 15 20 25 30
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Quantity
(millions of
subscribers)

Producer Surplus
It means the difference between the
minimum amount required to induce
producers to supply a good and the amount
they actually receive.
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Market Supply Schedule

Consider the market for cellular
phones service again. This time
we will assume that the supply
for cell phones is more linear
and that the market price is $100.
Price
(monthly bill)
Supply
140
120
If the market price is $100, then

the 30th unit will not be produced
100
because the cost of supplying it
exceeds the market price of $140.
At $100, the 17th unit will be
80
produced because those who
supply it are willing to do so for
at least $100.
60
At $100, the 5th unit will be
produced because those who
supply it are willing to do so for
at least $60.
Market price = $100
10 15 20 25 30
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Quantity
(millions of
subscribers)

Market Supply Schedule

Price
(monthly bill)
For market outputs of less then

17 units, producers are willing
to supply the good for $100.
The area represented by the
distance above the supply
curve but below the actual sales
price is called producer surplus.
This area is the difference
between the minimum amount
required to induce producers to
supply a good and the amount
they actually receive.
Supply
140
120
Market price = $100
100
80
Producer
surplus
60
10 15 20 25 30
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Quantity
(millions of
subscribers)

Demand Estimation
The most common method for demand estimation
is Regression Analysis in which average
relationship between dependent and independent
variables have been analyzed.
Qd P
Where is an error term or Random Term which

captures any shock event that may effect the
dependent variable.
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Demand Estimation
There are two types of Regression

equation
Simple Regression Equation
Multiple Regression Equation
If there is only one independent variable
then it a simple regression equation and if
more than one independent variables, then it
is Multiple Regression Equation
HOW TO ESTIMATE THE REGRESSION EQUATION
With the help of Ordinary Least Square

(OLS) Method, we can estimate the
regression equation
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Elasticity of Demand and

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Elasticity of demand means responsiveness

Price Elasticity of Demand

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Sign of Price Elasticity

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Price Elasticity of Demand

Price elasticity reveals the responsiveness of

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Classifying Demand and

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Price Elasticity of Demand

After calculating the price elasticity of

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change in consumers purchases.

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Copyright 2003 South-Western

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With this straight-line (constant-slope)

(110 - 100) (110 + 100)

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(20 - 10) (20 + 10)

($10 - $11) ($10 + $11)

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Elasticity Along a Demand

Elasticity declines along

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When good substitutes for a product are

Share of total budget expended on product

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(a) Ballpoint pens per week (in thousands)

(b) Cigarette packs per week (in millions)

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Income Elasticity of Demand

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Income Elasticity of demand

Income elasticity indicates responsiveness of

A normal good is a good with a positive

Goods with a negative income elasticity are

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Arc Elasticity of Demand

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Formula for Arc Elasticity

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Cross Elasticity of demand

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Approximately Unitary Elasticity