Principles of

Economics

Module No. 005

Elasticity and its Applications Quantitative Demand
Analysis

By Muhammad
Shahid Iqbal
 Elasticity of Demand
Today’s market economies rely mainly on the activities of
consumers, businesses, and resource suppliers to
allocate resources efficiently.
Now we will discuss demand and supply by explaining
significant ideas that help us answer such questions as:
Why do buyers of some products (restaurant meals)
respond to price increases by substantially reducing their
purchases while buyers of other products (toothpaste)
respond by only slightly cutting back their purchases?
Why do higher market prices for some products (chicken)
cause producers to greatly increase their output while
price rises for other products ( gold) cause only limited
increases in output?
Why does demand for some products rise when HH
income increases while demand for other products rises
just a little?
 Elasticity of Demand
We know, from the Law of Demand, that price and
quantity demanded are inversely related.
Now, we are going to get more specific in defining
that relationship. We want to know just how much
will quantity demanded change when price changes?
That is what elasticity of demand measures.
It is a measure of how much buyers and sellers
respond to changes in market conditions
Price elasticity of demand is a measure of how much
the quantity demanded of a good responds to a
change in the price of that good.
Price elasticity of demand is the percentage change
in quantity demanded given a percent change in the
price.
 Elasticity of Demand
Percentage change in quantity demanded
Price elasticity of demand =
Percentage change in price
The Ed usually yields a negative
value, due to the inverse nature
of the relationship between
price and quantity demanded.
How Do We Interpret the Price
Elasticity of Demand?

In the case of price elasticity of demand it is used

to see how sensitive the demand for a good is to
a price change.
The higher the price elasticity, the more sensitive
consumers are to price changes.
A very low price elasticity implies just the
opposite, that changes in price have little
 Calculating Percentage Changes
if the price of milk
increases by 10% (from
P
$2 to $2.20) and the
quantity demanded
decreases by 15%
(from 100 to 85), the B
price elasticity $
of2.20
demand is: A
$2.00
D

85 10 Q
end value – start value 0
x 100%
start value
 Elasticity of Demand

(Q1 − Q 2 )(P1 + P 2 ) / 2
Ed =
(P1 − P 2 )(Q1 + Q 2 ) / 2
Sale price of single family home in March is
$1,27,100 and at this price 4890000 homes were
sold. One month later the sale price increases to
$1,28,200 and demand of single family homes
becomes 4770,000.
What is the own price elasticity of demand.
 Price Elasticity of Demand
We can read it as the percentage change in
quantity for a 1% change in price
Thus, if Ed = 2, that means in that part of the
demand curve, a 1% change in price will cause a
2% change in quantity demanded. Or if we
extrapolate, a 2% change in price will cause a 4%
change in quantity demanded, and so on.
Suppose the government wants to reduce teenage
smoking by 30%. Suppose further that the
government knows that the teenage elasticity of
demand for a pack of cigarettes is 2. By what
percentage would the government have to increase
the price of a pack of cigarettes (through a tax) in
order to cut teenage smoking by 30%?
 Price Elasticity of Demand
Relatively elastic or
elastic Demand
Ed = % Δ in Qd
% Δ in P
Ed > 1 (in absolute
value)
% Δ in Qd > % Δ in P
Suppose that a 2 percent
decline in the price of cut
flowers results in a 4
percent increase in
quantity demanded.
Then demand for cut
flowers is elastic
 Price Elasticity of Demand
Relatively Inelastic or
Inelastic
Ed = % Δ in Qd
% Δ in P
Ed < 1 (in absolute
value)
% Δ in Qd < % Δ in P
Suppose that a 2 percent
decline in the price of
coffee leads to only a 1
percent increase in
quantity demanded. Then
demand is inelastic
 Price Elasticity of Demand

Unitary Elastic Demand

Ed = % Δ in Qd
% Δ in P
Ed = 1 (in absolute
value)
% Δ in Qd = % Δ in P
Suppose that a 2 percent
drop in the price of
chocolate causes a 2
percent increase in
quantity demanded. This
special case is termed unit
elasticity because E d is
exactly 1, or unity
 Price Elasticity of Demand

Perfectly Inelastic: The first extreme limit is

when demand is perfectly inelastic. It means that
howsoever great the rise or fall in the price of the
commodity in question, its demand remains
absolutely unchanged. In Figure the vertical line
shows a perfectly inelastic demand. In other
words, in this case elasticity of demand is zero.
No amount of change in price induces a change in
demand.
Approximate examples include
an acute diabetic’s demand for
insulin or an addict’s demand
for heroin.
 Price Elasticity of Demand
Perfectly elastic demand: The other extreme case
of elasticity of demand, viz., when it is infinite or
perfect. Elasticity of demand is infinity when even
a negligible fall in the price of the commodity leads
to an infinite extension in the demand for it. In Fig.
the horizontal straight line shows infinite elasticity
of demand. Even when the price remains the
same, the demand goes on changing.

Ed = % Δ in Qd
% Δ in P
Ed = % Δ in Qd
0
Ed = ∞
 Price Elasticity of Demand

Even though the slope of a linear demand curve is

constant, the elasticity is not. At points with a low
price and high quantity, the demand curve is
inelastic. At points with a high price and low
quantity, the demand curve is elastic.
Elasticity of Demand and Its
Determinants
Availability of Close Substitutes
Definition of the Market
Amount of Consumers Budget
Necessities versus Luxuries
Time Horizon
Availability of information concerning
substitute goods
Joint Demand
Several Uses of Commodity
Range of Prices
Elasticity of Demand and Its
Determinants
Availability of Substitutes
The more substitutes for a good, the higher
the price elasticity of demand; the fewer
substitutes for a good, the lower the price
elasticity of demand.
For example, butter and margarine are easily
substitutable. A small increase in the price of
butter, assuming the price of margarine is
held fixed, causes the quantity of butter sold
to fall by a large amount. By contrast, because
eggs are a food without a close substitute, the
demand for eggs is probably less elastic than
the demand for butter.
Elasticity of Demand and Its
Determinants
Definition of the Market: Narrowly defined
markets tend to have more elastic demand
than broadly defined markets, because it is
easier to find close substitutes for narrowly
defined goods. For example, food, a broad
category, has a fairly inelastic demand
because there are no good substitutes for
food. Ice cream, a more narrow category, has
a more elastic demand because it is easy to
substitute other desserts for ice cream.
Vanilla ice cream, a very narrow category, has
a very elastic demand because other flavors
of ice cream are almost perfect substitutes for
vanilla.
 Elasticity of Demand and Its
Determinants
Amount of Consumers Budget: The percentage of the
consumer’s budget that is spent on the commodity is
also important in the determination of price elasticity.
The greater the percentage of one’s budget that goes to
purchase a good, the higher the price elasticity of
demand; the smaller the percentage of one’s budget
that goes to purchase a good, the lower the elasticity of
demand.
Most consumers have both the willingness and ability to
postpone the purchase of big ticket items.
If an item constitutes a significant portion of one's
income, it is worth one's time to search for substitutes.
A consumer will give more time and thought to the
purchase of a $3000 television than a $1 candy bar, so
demand for the former will be more elastic than demand
for the latter.
Elasticity of Demand and Its
Determinants
Time Horizons (Time Period of
Adjustment): The length of the time period
used in measuring the price elasticity affects
the magnitude of price elasticity. Goods tend
to have more elastic demand over longer time
Horizons and vive versa. When the price of
gasoline rises, the quantity of gasoline
demanded falls only slightly in the first few
months. Over time, however, people buy
more fuel efficient cars, switch to public
transportation, and move closer to where they
work. Within several years, the quantity of
gasoline demanded falls substantially..
Elasticity of Demand and Its
Determinants
Necessities vs. Luxuries
Necessities tend to have inelastic demands,
whereas luxuries have elastic demands..
With a true necessity a consumer has neither
the willingness nor the ability to postpone
consumption. Insulin is the ultimate necessity,
so the demand for it is inelastic.
The demand for luxuries is relatively more
elastic, i.e. when the price of sailboats rises,
the quantity of sailboats demanded falls
substantially
Elasticity of Demand and Its
Determinants
Availability of information concerning substitute
goods: The easier it is for a consumer to locate the
substitute goods, the more willing he will be to undertake
the search, and the more elastic demand will be.
an attachment to a certain brand—either out of tradition
or because of proprietary barriers—can override
sensitivity to price changes, resulting in more inelastic
demand.
KEY QUESTION: Using these determinants and your own
reasoning in judging whether demand for each of the
following products is probably elastic or inelastic:
1. bottled water 2. toothpaste; 3. Colgate toothpaste
4. Ketchup 5. diamond bracelets
6. Microsoft Windows operating system

.
 Total Revenue and Elasticity of
Demand
Price of Pen Quantity
Demanded (Q)
T. Price Elasticity
of Demand
(P) Expenditures
or Revenue
(PxQ)
5.00 30 150 -
4.75 40 190 E >1
4.50 50 225 E>1
4.25 60 255 E>1
4.00 75 300 E>1
3.75 80 300 E=1
3.50 84 294 E<1
3.25 87 282.75 E<1
 Total Revenue and Elasticity of
Demand
When the price elasticity of
demand for a good is
relatively elastic Ed > 1,
the when the price is
raised, the total revenue
falls, and vice versa.
When the price elasticity of
demand for a good is
relatively inelastic Ed < 1,
when the price is raised,
the total revenue rises, and
vice versa.
When the price elasticity of
demand for a good is
unitary elastic (Ed = 1), the
so a change in price will
not affect total revenue.
 Income Elasticity of Demand

Income elasticity of demand (EdY)

measures how much the quantity demanded
of a good responds to a change in consumers’
income.
It is computed as the percentage change in
the quantity demanded divided by the
percentage change % change in quantity demanded
in income.
Income elasticity of demand =
% change in the income
 Income Elasticity of Demand

Typically, if our income rises, we buy more and visa

versa. These types of goods are called normal goods.
EdY > 0
If a good’s elasticity is 0 < EdY < 1 then it is a necessity
good.
If a good’s elasticity is EdY > 1, then it is a luxury good.
If a goods elasticity is EdY < 0 it is an inferior good.
Example: Genovia has experienced exceptional growth
in recent years. Its GDP per capita has increased from
around $30,000 to $50,000 in last 5 years. Over the
period quantity demanded of personal cars has
increased from 450,000 units per year to 600,000
units. Quantity demanded of public transport, however,
has declined from 10,000 buses to 7,000 buses.
Calculate income elasticity of demand and tell which
product is a normal good and which one is inferior.
 Cross Price Elasticity of Demand

Another type of elasticity is the Cross Price

Elasticity. This gets at how changes in price of
one good can effect the demand of another
Cross price elasticity of demand measures the
percentage change in demand for a particular
good caused by a percent change in the price of
another good.
% change in quantity demanded of good 1
Cross price elasticity of demand (E1,2 ) =
% change in the price of good 2

∂Qx Pyo
Ex , y = .
∂Py Qxo
 Cross Price Elasticity of Demand

The cross price elasticity of demand for

substitute goods is positively correlated-- as
the price of good A increases so does the demand
for substitute good B i.e. E1,2 > 0.
The cross price elasticity of demand for
complementary goods is negatively
correlated-- as the price of good A increases the
demand for complementary good B decreases i.e.
E1,2 < 0
For example, if, in response to a 10% increase in the
price of fuel, the demand of new cars that are fuel
inefficient decreased by 20%, the cross elasticity of
demand would be: -20%/10% = -2
 Cross Price Elasticity of Demand

Selected cross price elasticities of demand

Good Good with price change XED

Butter Margarine +0.81

Beef Chicken +0.28

Entertainment Food -0.72

 Cross Price Elasticity of Demand

Mathematical representations of demand curves

1. The demand for company X’s product is given by.
Qx = 12 – 3Px + 4Py
Where Px = Rs. 3.00 per unit and Py = Rs. 1.50
per unit
Calculate the cross price elasticity of demand
b/w Good X and Good Y at the given prices.
Are Goods X and Y substitutes or
Compliments, Explain?

2. Suppose Qdx= 10000 - 2Px + 3Py - 4.5M

where Px = $100, Py = $50 and M = $2000

What is the own price elasticity of demand?
 Price Elasticity of Demand

Suppose the own price elasticity of demand for

good X is -2, its income elasticity is 3, its advertising
elasticity is 4 and cross price elasticity of demand
between it and good Y is -6, determine how much
the consumption of this good will change if
1. The price of good X increases by 5 percent

2. The price of good Y increases by 10 percent

3. Advertising decreases by 2 percent

4. Income falls by 3 percent

Two drivers—Tom and Jerry—each drive up to a gas

station. Before looking at the price, each places an
order. Tom says, “I’d like 10 gallons of gas.” Jerry
says, “I’d like $10 worth of gas.” What is each
driver’s price elasticity of demand?
 The Elasticity of Supply
Price elasticity of supply: a measure of how much
the quantity supplied of a good responds to a change
in the price of that good,
It is computed as the percentage change in quantity
supplied divided by the percentage change in price.
The price elasticity of supply depends on the flexibility
of sellers to change the amount of the good they
produce. For example, beachfront land has an
inelastic supply because it is almost impossible to
produce more of it. By contrast, manufactured goods,
such as books, cars, and televisions, have elastic
supplies because the firms that produce them can run
their factories longer in response to a higher price.
a key determinant of the price elasticity of supply is
the time period being considered
Computing the price elasticity of supply
 Applications of Supply,
Demand, and Elasticity

a. Use the midpoint method to calculate your price

elasticity of demand as the price of compact discs
increases from $8 to $10 if (i) your income is
$10,000, and (ii) your income is $12,000.
b. Calculate your income elasticity of demand as your
income increases from $10,000 to $12,000 if (i) the
price is $12, and (ii) the price is $16.
Elasticity and Demand, Applied Problem
Assume that the demand for cosmetic or plastic
surgery is price inelastic. Are the following
statements true or false? Explain.
a. When the price of plastic surgery increases, the
number of operations decreases.
b. The percentage change in the price of plastic
surgery is less than the percentage change in
quantity demanded.
c. Changes in the price of plastic surgery do not
affect the number of operations.
d. Quantity demanded is quite responsive to
changes in price.
e. If more plastic surgery is performed,
expenditures on plastic surgery will decrease.
f. The marginal revenue of another operation is
negative.