Price elasticity,

income elasticity
and cross
elasticity of
demand
BY Shamiso and Oteng
CONTENTS
What does elasticity
mean?
Price elasticity of demand

Special PED values

Factors affecting price elasticity of demand

 What does elasticity
mean?
Both the demand for and the supply of a good or service can be
expected to depend on its price as well as other factors. It is often
important to know just how sensitive demand and/or supply will be to
a change in either price or one of the other determinants – for
example, in predicting how consumers, firms and the government may
be affected by a change in the market environment. The sensitivity of
demand or supply to a change in one of its determining factors can be
measured by its elasticity.

Elasticity: a numerical measure of responsiveness of one variable

following a change in another variable, ceteris paribus.
● Elasticity therefore measures the responsiveness of
one variable (such as quantity demanded for a
product) after a change in another variable (such as
the price of that product), ceteris paribus. The
elasticity is a coefficient/number.
● The extent of any change is important.
● When there is a small change in the price of a product
or income of customers causes a bigger change in the
quantity demanded, then the relationship between
price/income and quantity demanded is said to be
elastic.
● Contrary to this, if a large change in price or income
results in only a small change in the quantity
demanded then the relationship between price/income
and quantity demanded is said to be inelastic.
● The distinction is important as firms respond to a
range of changing circumstances in their markets.
● These circumstances include understanding how much
QD for a good responds not only to a change in its
price but also to change in income of customers or the
prices of substitutes and complements.
 Price Elasticity of
Demand (PED)
The most common elasticity measure is the price elasticity of demand
(PED).

PED measures the responsiveness of the quantity demanded for a

product following a change in the price of the product.

This is the only thing that changes, ceteris paribus or other things
equal.

If demand is price elastic, then a small change in price will result in a

relatively larger change in quantity demanded.

On the other hand, if there is a large change in price and a far smaller
change in quantity demanded, then demand is price inelastic.
 Price Elasticity of
Demand (PED)
PED is calculated as the percentage change in quantity demanded
divided by the percentage change in price of the product:

Where:
 Price Elasticity of
Demand (PED)
We define the percentage change in price as 100 ×
ΔP/P (where Δ means ‘change in’ and P stands for
‘price’).

Similarly, the percentage change in quantity

demanded is 100 × ΔQ/Q.
 Example 1

Price Change

Scenario: Product A and B are currently priced at $100 and demand for them is
1000 units per month. Consider what might happen to the demand for A and B if the
price rises to $105. The quantity demanded of Product A only falls from 1000 to
990, whereas QD for Product B falls from 1000 to 900. By putting these values into
the PED equation we can calculate the prices elasticity of demand.
 Step-by-step solution

Step 1: calculate percentage change in quantity demand

● % change in quantity demanded = New quantity demanded –

Old quantity demanded x 100/Old quantity demanded
● % change in quantity demanded =
1 PRODUCT A PRODUCT B
990-1000 x 100/1000 900-1000 x
= -1% 100/1000
= -10%
 Step-by-step solution

Step 2: calculate the the change in price by using the change in price
formula

● % change in Price = New Price – Old Price x 100/Old

Price
● % change in Price =
2
PRODUCT A PRODUCT B
105-100 x 100/100 105-100 x 100/100
= 5% = 5%
 Step-by-step solution

Step 3: calculate the Price Elasticity of Demand

Price Elasticity of Demand = Percentage change in Quantity

Demanded/Percentage change in Price
Price Elasticity of Product
Demand = B
3
Product A
-1%/5% = -0.2 -10%/5% = -
2.0
So, the price elasticity of demand is -0.2 and -2.0.
In both cases the result is a negative figure.

Economics usually refer to PED in absolute terms, ignoring the negative sign.

When demand is not very sensitive to price, the percentage change in

quantity demanded will be smaller than the original percentage change in
price, and the elasticity will then be between 0 and −1. Hence, in the case of
product A, a change in price of 5% led to a -1% change in QD resulting in
PED being -0.2, less than 1. In this case, we say that demand for this
product is price inelastic or unresponsive to price changes.

When the demand is highly price sensitive, the percentage change in quantity
demanded following a price change will be large relative to the percentage
change in price. In this case, the PED will take on a value that is smaller
than −1.Hence, in the case of product B, a change in price of 5% led to a -
10% change in QD resulting in PED being -2%. Therefore, we say that the
demand is price elastic or responsive to price changes.
TWO THINGS TO NOTICE

First, because the demand curve is downward

sloping, the elasticity will always be negative.
This is because the changes in price and
quantity are always in the opposite
direction.This is because of the
negative/inverse relationship between price
and quality demanded; as the price goes up,
the QD goes down and as the price
decreases, the QD increases.

Second, you should try to calculate the

elasticity only for a relatively small change in
price, as it becomes unreliable for very large
changes.
 SPECIAL PED VALUES
PED values can range from 0 to infinity. These values need
explanation.
UNIT ELASTICITY
03
Where the change in
PERFECTLY price is relatively the
INELASTIC same as the change in
the quantity demanded.
Where change in price
has no effect on the
quantity demanded
PERFECTLY
ELASTIC
01 02
Where all that is
produced is sold at a
given price.
PERFECTLY INELASTIC
Regardless of the price charged, consumers are willing and able
to buy the same amount hence demand is described as perfectly
inelastic.

FOR EXAMPLE

PED when there is an increase from $10 to $11.

PED = %change in QD/%change in price = 0%/10% = 0

When the PED = 0, demand is perfectly inelastic, it is completely

unresponsive to price changes.
Perfectly Inelastic Demand Curve
PERFECTLY ELASTIC
Perfectly elastic demand occurs when a change in price causes a
complete change in the quantity demanded.

A firm can sell any quantity at the going market price, for
example Q or Q1 , but nothing above this price.

For example
At a price of $10 per unit consumers are not prepared to buy any
of this product; however, if the price falls to $9, they will buy all
that is available. The relative change in quantity demanded here
is infinite, since the original demand was zero.

Therefore

PED = %change in quantity demanded/%change in price

= ∞/-10%
= (-) ∞
Perfectly Elastic Demand Curve
 UNIT ELASTICITY

Unit elasticity of demand is found when a percentage

change in price results in an equal percentage change in
quantity demanded, giving a PED of one (unity).

When PED is unity, the area under the demand curve stays
the same as price changes, showing that total revenue and
total spending remain unchanged as price changes.

In other words a percentage change in price will be equal to

the percentage change in QD.

If we were to increase a price by 10%, unit price elasticity

will mean that Δ QD is also 10% , which could be an
increase or decrease in quantity.
Unit Elastic Demand Curve
HOW ELASTICITY VARIES ALONG THE
DEMAND CURVE
● Elasticity varies along the demand curve.
● The key is to be aware that elasticity is defined in
terms of the percentage changes in price and
quantity.
● When price is relatively high, a small change in price
is a small percentage change, and the percentage
change in quantity is relatively large – because when
price is relatively high, the initial quantity is
relatively low.
● The reverse is the case when price is relatively low.
PRICE ELASTICITY OF DEMAND AND TOTAL
REVENUE
One reason why firms may have an interest in the price
elasticity of demand is that if they are considering changing
their prices, they will be eager to know the extent to which
demand will be affected.

For example, they may want to know how a change in price

will affect their total revenue. As it happens there is a
consistent relationship between the price elasticity of
demand and total revenue.

Total revenue before and after the price change can be

calculated.
Total revenue is equal to price multiplied by quantity.

For instance Product A has been priced at $40 and the quantity
demanded was 20.

Following a change in price from $40 to $35, the QD then rose

from 20 to 30.
So at the original price revenue was 40 × 20 = 800.

At the new lower price, total revenue is 35 × 30 = 1,050.

We can therefore see that when the price elasticity of demand is

elastic, a fall in price leads to a rise in revenue.
When the price of a Product B falls from 10 to 9, and quantity
demanded rises from 80 to 82, demand is inelastic (−0.25).

At the original price, revenue was 10 × 80 = 800

And at the lower price it was 9 × 82 = 738.

This time, total revenue has fallen with a fall in price and
inelastic demand.
Demand is price elastic when price is relatively
high.

This is the range of the demand curve in which

total revenue rises as price falls.

This makes sense, as in this range the quantity

demanded is sensitive to a change in price and
increases by more (in percentage terms) than the
price falls.

This implies that, as you move to the right in this

segment, total revenue rises.

The increase in quantity sold more than

compensates for the fall in price. However, when
the mid-point is reached and demand becomes
unit elastic, total revenue stops rising – it is at its
maximum at this point.

The remaining part of the curve is inelastic: that

is, the increase in quantity demanded is no
longer sufficient to compensate for the decrease
 Total revenue, elasticity and a price
change
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FACTORS AFFECTING PRICE
The availability & attractiveness of substitutes
The greater the number of substitute products and the more closely substitutable those products
are, the more it can be expected that consumers will switch away from a particular product when
its price goes up or towards that product if its price falls.

For example, canned drinks where there are many types of colas, iced teas and fruit juices etc.
so a small change in price could see quite large changes in what consumers purchase.

It is important to distinguish between the substitutability of products within the same group and
substitutability with goods from other product groupings.

For example, different types of orange juices are a group of products in their own right.
The types of orange juice are also part of a larger group of fruit juices and part of the even bigger
category of products that we could label as 'drinks'.

If we are concerned with the price elasticity of demand for a particular type of orange juice
produced by a specific manufacturer, then it will probably have a fairly high PED because of the
range of substitutes. As we classify products into groupings - such as 'fruit juices' or 'all soft
drinks' demand will start to become more price inelastic.

So, the narrower the definition of the market, the likelihood is that the PED will be greater.
 The relative expense of the product
A rise in price reduces the purchasing power of a person's income and
their ability to pay for products.

You may not notice small changes in the price of an inexpensive item
that is a small part of overall expenditure, such as salt. This tends to
mean that demand for that good is relatively inelastic.

On the other hand, an item that figures large in the household budget
will be seen very differently, and consumers will tend to be much
more sensitive to price when a significant proportion of their income
is involved

For example, a 10% increase in the price of a flight to Pakistan will

have a bigger impact than a 10% rise in the price of a bus trip into
town. So, the greater the relative proportion of income accounted for
by the product, the higher the PED.
 The time period
Consumers may respond more strongly to a price
change in the long run than to one in the short run.

An increase in the price of petrol may have limited

effects in the short run; however, in the long run,
consumers may buy smaller cars or switch to diesel.

Thus, the elasticity of demand tends to be more elastic

in the long run than in the short run. Habit or
commitment to a certain pattern of consumption may
dictate the short-run pattern of consumption, but
people do eventually adjust to price changes.
 Thanks!
Do you have
any questions?

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