ELASTICITY OF DEMAND

• When we discussed the determinants of demand

in last session, we noted that buyers usually
demand more of a good when its price is lower,
when their incomes are higher, when the prices
of substitutes or the goods are higher, or when
the prices of complements of the goods are
lower
• Our discussion of demand was qualitative, not
quantitative. That is, we discussed the direction
in which the quantity demanded moves, but not
the size of the change.
• To measure how much demand responds to
changes in its determinants, economists use the
concept of elasticity.
• To measure how much demand
responds to changes in its
determinants, economists use the
concept of elasticity.
• 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, computed as the percentage change
in quantity demanded divided by the
percentage change in price.
THE PRICE ELASTICITY OF DEMAND
AND ITS DETERMINANTS

• The law of demand states that a fall in the

price of a good raises the quantity demanded.
• The price elasticity of demand measures how
much the quantity demanded responds to a
change in price.
• Demand for a good is said to be
elastic if the quantity demanded
responds substantially to changes
in the price.
• Demand is said to be inelastic if
the quantity demanded responds
only slightly to changes in the
price.
• What determines whether the demand
for a good is elastic or inelastic?
Because the demand for any good
depends on consumer preferences, the
price elasticity of demand depends on
the many economic, social, and
psychological forces that shape
individual desires.
• Based on experience, however, we can state some
general rules about what determines the price
elasticity of demand
• Necessities versus Luxuries
• Necessities tend to have inelastic demands, whereas luxuries
have elastic demands
• When the price of a visit to the doctor rises, people will not
dramatically alter the number of times they go to the doctor,
although they might go somewhat less often.
• By contrast, when the price of sailboats rises, the
quantity of sailboats demanded falls substantially
• The reason is that most people view doctor visits as
a necessity and sailboats as a luxury
• Of course, whether a good is a necessity or a
luxury depends not on the intrinsic properties
of the good but on the preferences of the buyer.
• For an avid sailor with little concern over his
health, sailboats might be a necessity with
inelastic demand and doctor visits a luxury
with elastic demand
• Availability of Close Substitutes
• Goods with close substitutes tends to have more
elastic demand because it is easier for
consumers to switch from that good to others
• 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.
• Definition of the Market
• The elasticity of demand in any market
depends on how we draw the boundaries 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 narrower 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.
• Time Horizon
• Goods tend to have more elastic demand over
longer time horizons. 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.
COMPUTING THE PRICE ELASTICITY
OF DEMAND

• Now that we have discussed the price elasticity

of demand in general terms, let’s be more
precise about how it is measured.
• Economists compute the price elasticity of
demand as the percentage change in the
quantity demanded divided by the percentage
change in the price. That is,
• For example, suppose that a 10-percent
increase in the price of an ice-cream cone
causes the amount of ice cream you buy to fall
by 20 percent
• By using the above formula, price elasticity of
demand is obviously 2.
• In this example, the elasticity is 2, reflecting
that the change in the quantity demanded is
proportionately twice as large as the change in
the price
• Because the quantity demanded of a good is
negatively related to its price, the percentage
change in quantity will always have the
opposite sign as the percentage change in
price.
• In this example, the percentage change in price
is a positive 10 percent (reflecting an increase),
and the percentage change in quantity
demanded is a negative 20 percent (reflecting a
decrease).
• For this reason, price elasticities of demand are
sometimes reported as negative numbers. Here
we follow the common practice of dropping the
minus sign and reporting all price elasticities as
positive numbers.
• (Mathematicians call this the absolute value.)
With this convention, larger price elasticity
implies a greater responsiveness of quantity
demanded to price.
• If you try calculating the price elasticity of
demand between two points on a demand
curve, you will quickly notice an annoying
problem:
• The elasticity from point A to point B seems
different from the elasticity from point B to point
A. For example, consider these numbers:
• Going from point A to point B, the price rises by
50 percent, and the quantity falls by 33 percent,
indicating that the price elasticity of demand is
33/50, or 0.66.
• By contrast, going from point B to point A, the
price falls by 33 percent, and the quantity rises by
50 percent, indicating that the price elasticity of
demand is 50/33, or 1.5.
• One way to avoid this problem is to use the
midpoint method for calculating elasticities.
Rather than computing a percentage change
using the standard way (by dividing the change
by the initial level), the midpoint method
computes a percentage change by dividing the
change by the midpoint of the initial and final
levels.
• For instance, $5 is the midpoint of $4 and $6.
Therefore, according to the midpoint method, a
change from $4 to $6 is considered a 40
percent rise, because (6 -4)/5 -100 =40.
Similarly, a change from $6 to $4 is considered
a 40 percent fall
• Because the midpoint method gives the same
answer regardless of the direction of change, it is
often used when calculating the price elasticity of
demand between two points. In our example, the
midpoint between point A and point B is:
•
• Midpoint: Price = $5 Quantity = 100
• According to the midpoint method, when
going from point A to point B, the price rises
by 40 percent, and the quantity falls by 40
percent. Similarly, when going from point B to
point A, the price falls by 40 percent, and the
quantity rises by 40 percent. In both directions,
the price elasticity of demand equals 1
• We can express the midpoint method with the
following formula for the price elasticity of
demand between two points, denoted (Q1, P1)
and (Q2, P2):
• Demand is elastic when the elasticity is
greater than 1, so that quantity moves
proportionately more than the price.
• Demand is inelastic when the elasticity is
less than 1, so that quantity moves
proportionately less than the price.
• If the elasticity is exactly 1, so that quantity
moves the same amount proportionately as
price, demand is said to have unit elasticity.
•Because the price elasticity of
demand measures how much quantity
demanded responds to changes in the
price, it is closely related to the slope
of the demand curve
•The following rule of thumb is a
useful guide:
The flatter is the demand
curve that passes through
a given point, the greater is
the price elasticity of
demand.
• The steeper is the demand
curve that passes through a
given point, the smaller is
the price elasticity of
demand.
GRAPHICAL ILLUSTRATION
OF TYPES OF ELASTICITIES
OF DEMAND
 TOTAL REVENUE AND THE PRICE
ELASTICITY OF DEMAND
• When studying changes in supply or demand in a market,
one variable we often want to study is total revenue, the
amount paid by buyers and received by sellers for the good
• In any market, total revenue is P x Q, the price of the
good times the quantity of the good sold.
• We can show total revenue graphically, as in Figure
below. The height of the box under the demand curve is
P, and the width is Q. The area of this box, P x Q, equals
the total revenue in this market. In Figure below, where P
= $4 and Q =100, total revenue is $4 x 100, or $400.
 • How does total revenue change as one moves along the
demand curve?
• The answer depends on the price elasticity of demand. If
demand is inelastic, as in the figure below, then an increase
in the price causes an increase in total revenue
• Here an increase in price from $1 to $3 causes the quantity
demanded to fall only from 100 to 80, and so total revenue
rises from $100 to $240.
• An increase in price raises P x Q because the fall in Q is
proportionately smaller than the rise in P.
• If demand is elastic: An increase in the price
causes a decrease in total revenue
• In Figure below, for instance, when the price
rises from $4 to $5, the quantity demanded
falls from 50 to 20, and so total revenue falls
from $200 to $100.
• Because demand is elastic, the reduction in the
quantity demanded is so great that it more than
offsets the increase in the price.
• That is, an increase in price reduces P x Q
because the fall in Q is proportionately
greater than the rise in P.
 • Generally
❖When a demand curve is inelastic (a price elasticity less
than 1), a price increase raises total revenue, and a price
decrease reduces total revenue.

❖ When a demand curve is elastic (a price elasticity

greater than 1), a price increase reduces total revenue,
and a price decrease raises total revenue.

❖ In the special case of unit elastic demand (a price

elasticity exactly equal to 1), a change in the price does
not affect total revenue
 The Cross-Price Elasticity of Demand

• Economists use the cross-price elasticity of demand to

measure how the quantity demanded of one good
changes as the price of another good changes. It is
calculated as the percentage change in quantity
demanded of good 1 divided by the percentage change
in the price of good 2.
•Whether the cross-price elasticity is a
positive or negative number depends
on whether the two goods are
substitutes or complements
•As we discussed in previous sessions,
substitutes are goods that are typically
used in place of one another, such as
hamburgers and hot dogs
 OTHER DEMAND ELASTICITIES
• In addition to the price elasticity of demand,
economists also use other elasticities to
describe the behavior of buyers
 INCOME ELASTICITY OF DEMAND
• A measure of how much the quantity
demanded of a good responds to a change in
consumers’ income, computed as the
percentage change in quantity demanded
divided by the percentage change in income
• Most goods are normal goods: Higher income raises
quantity demanded. Because quantity demanded
and income move in the same direction, normal
goods have positive income elasticities. A few
goods, such as bus rides, are inferior goods: Higher
income lowers the quantity demanded. Because
quantity demanded and income move in opposite
directions, inferior goods have negative income
elasticities
• . Even among normal goods, income elasticities vary
substantially in size. Necessities, such as food and
clothing, tend to have small income elasticities
because consumers, regardless of how low their
incomes, choose to buy some of these goods.
Luxuries, such as caviar and furs, tend to have large
income elasticities because consumers feel that
they can do without these goods altogether if their
income is too low.
• An increase in hot dog prices induces
people to grill hamburgers instead. Because
the price of hot dogs and the quantity of
hamburgers demanded move in the same
direction, the cross-price elasticity is
positive
• Conversely, complements are goods that are
typically used together, such as computers
and software. In this case, the cross-price
elasticity is negative, indicating that an
increase in the price of computers reduces
the quantity of software demanded.