1.

2 Elasticities Unit Overview

Price Elasticity of Demand (PED) Elasticities Online:

• PED and its determinants Elasticity
Substitutes
• The total revenue test of PED Inferior goods
• Applications of PED
Elasticities Video
Cross Price Elasticity of Demand (XED) Lessons
• XED and its determinants
• Applications of XED Practice Activities

Income Elasticity of Demand (YED) Microeconomics

• YED and its determinants Glossary
• Applications of YED
Price Elasticity of Supply (PES)
• PES and its determinants
• Applications of PES
 Introduction to
1.2 Elasticities Elasticities

Introduction to Elasticities
Elasticity is an economic concept which refers to the responsiveness among consumers or
producers to a change in a variable which affects either the market demand or the market
supply. There are four types of elasticity that we will study in this unit:

• Price Elasticity of Demand (PED): Measures the responsiveness of consumers of a particular

good to a change in the good’s price.

• Cross-price elasticity of Demand (XED): Measures the responsiveness of consumers of one

good to a change in the price of a related good (either a substitute or a complement).

• Income Elasticity of Demand (YED): Measures the responsiveness of consumers of a

particular good to a change in their income.

• Price elasticity of Supply (PES): Measures the responsiveness of producers of a particular

good to a change in the price of that good.
1.2 Elasticities PED

Price Elasticity of Demand – definition and formula

Price Elasticity of Demand (PED) is a measurement of how much the quantity demanded for a
good will change as a result of a particular change in the good’s price. PED can range from a
value of 0 to infinity, and is calculated using the following formula:
݄ܶ݁ ‫݀݁݀݊ܽ݉݁݀ ݀݋݋݃ ܽ ݂݋ ݕݐ݅ݐ݊ܽݑݍ ݄݁ݐ ݊݅ ݄݁݃݊ܽܿ ݁݃ܽݐ݊݁ܿݎ݁݌‬
ܲ‫= ܦܧ‬
݄ܶ݁ ‫݀݋݋݃ ݄݁ݐ ݂݋ ݁ܿ݅ݎ݌ ݄݁ݐ ݊݅ ݄݁݃݊ܽܿ ݁݃ܽݐ݊݁ܿݎ݁݌‬
%∆ࡽࢊ
‫… ݎ݋‬
%∆ࡼ
If, for example, we know that an increase in the price of bananas from $4 to $6 caused the
quantity demanded to fall from 1,000 bananas to 800 bananas, we can calculate the PED for
bananas.
800 − 1000 Notice that since we did not KNOW the
%∆ܳ݀ = = −0.2 × 100 = −20%
1000 percentage changes in P and Q, we had to
6−4 calculate them. The full PED formula is
%∆ܲ = = 0.5 × 100 = 50%
4
−૛૙ ࡽ૛ − ࡽ૚ ࡼ૛ − ࡼ૚
ࡼࡱࡰ = = −૙. ૝ ࡼࡱࡰ = ÷
૞૙ ࡽ૚ ࡼ૚
1.2 Elasticities PED

Price Elasticity of Demand – definition and formula

Notice from the previous slide that our PED was a negative value.
• This reflects the law of demand
• Whichever direction the price of good moves in, the quantity will always move in the other
direction
• Since PED will always be negative, we can refer to it in its absolute value. So, the PED for
bananas is 0.4
Interpretation of the PED coefficient:
If PED is less We say demand is inelastic. This means that the percentage change in the quantity is less than the
than 1: percentage change in the price.

If PED is greater We say that demand is elastic. The percentage change in the quantity is greater than the percentage
than 1 change in the price.
If PED=0: Demand is perfectly inelastic. There was no change in quantity resulting from the price change.
Demand is unit elastic. The percentage change in the quantity was identical to the percentage change in
If PED=1:
the price.
Demand is perfectly elastic. The smallest increase in price causes the quantity demanded to fall to
If PED = infinity:
ZERO.
1.2 Elasticities PED Video Lesson

INTRODUCTION TO PRICE ELASTICITY OF DEMAND – CALCULATING PED

USING DATA FROM A DEMAND DIAGRAM
1.2 Elasticities PED

Inelastic Approximately Unitary

Interpretation of PED Salt 0.1 Elasticity
Demand for bananas was 0.4. Based on our Matches 0.1 Movies 0.9
interpretations of PED from the table on Toothpicks 0.1 Housing, owner occupied, 1.2
the previous slide, we know that demand Gasoline, short-run 0.2 long-run
for bananas is inelastic. Gasoline, long-run 0.7 Shellfish, consumed at 0.9
• For every 1% increase in the price of Residential natural gas, 0.1 home
bananas between $4 and $6, the short-run Oysters, consumed at 1.1
Residential natural gas, 0.5 home
quantity demanded fell by 0.4%.
long-run Private education 1.1
• Since price increased by a total of 50%,
Coffee 0.25 Tires, short-run 0.9
the quantity fell by a total of just 20%. Tires, long-run 1.2
Fish (cod) consumed at 0.5
• Consumers are relatively unresponsive home Radio and television 1.2
to the price of bananas. Tobacco products, 0.45 receivers
short-run Highly Elastic
Study the tables on the right and try to Legal services, short- 0.4 Restaurant meals 2.3
determine what the goods in each run Foreign travel, long-run 4.0
Physician services 0.6 Fresh green peas 2.8
category have in common.
Taxi, short-run 0.6 Chevrolet automobiles 4.0
Automobiles, long-run 0.2 Fresh tomatoes 4.6
1.2 Elasticities PED

Interpretation of PED
Answer the following questions based on the goods in the table on the previous slide.
1. Which products are the most inelastic?
2. What factors would most likely explain why salt is very inelastic?
3. Why would the demand for tooth picks be inelastic?
4. Although both short-run and long-run gasoline are both inelastic, why is short-run gasoline more
inelastic than long-run gasoline?
5. What factors would likely explain why Chevrolet cars are very elastic?
6. Why would tires have unitary elasticity while gasoline is inelastic?
1. [Inelastic goods = salt, matches, toothpicks, short-run airline travel, gasoline, residential natural gas, coffee, fish, tobacco, legal services, physician
services, taxi service, automobiles]
2. [Salt is inelastic because there are no good substitutes, it is a necessity to most people, and it represents a small proportion of most people's
budget.]
3. [Toothpicks are inelastic because they cost very little and represent a small percentage of a typical grocery budget and have few substitutes.]
4. [Short-run gasoline is more inelastic than long-run because in the short run, we have to buy gas to keep our car going. In the long run, we can switch
to more fuel-efficient cars (including hybrid), ride the bus or walk more. But the short-run, those options are not available.]
5. [Chevrolet cars would be very elastic because we don't have to buy that brand of car - we have lots of substitutes.]
6. [Even though tires are a want if we drive a car, the decision to buy them is not as immediate as buying gas (unless we have a flat and must buy one
to get back on the road). You can shop around for the best price as there are a number of brands and stores that sell tires. You can buy new or used
tires so you have some substitutes. So even though we think of tires as wants, there is a greater flexibility in buying tires than in buying gasoline. This
contributes to the higher elasticity of tires over gasoline.]
1.2 Elasticities PED

The Determinants of PED

Whether demand for a good at a particular price is elastic or inelastic depends on several
characteristics of the good itself. Just how much will consumers respond to a price change for
the good? The following table presents some of the primary determinants of PED
The number of substitutes available. The more substitutes, more elastic demand, as
S Substitutes consumers can replace a good whose price has gone up with one of its now relatively
cheaper substitutes.

Proportion of The proportion of income the purchase of a good represents. If a good represent a higher
P income proportion of a consumer's income, his demand tends to be more elastic.

Luxury or necessity? If a good is a necessity, changes in price tend not to affect quantity
Luxury or
L necessity?
demand, i.e. demand is inelastic. If it's a luxury that a consumer can go without,
consumers tend to be more responsive.

A Addictive? If a product is addictive or habit forming, demand tends to be inelastic.

The amount of time a consumer has to respond to the price change. If prices remain high
T Time over a longer period of time, consumers can find substitutes or learn to live without, so
demand is more elastic over time.
1.2 Elasticities PED

The Determinants of PED

Based on the determinants of PED, organize the items below along the spectrum of elasticity,
from those which you believe have relatively inelastic demand to highly elastic demand.
Relatively inelastic……………………………………………………………………………………….Relatively Elastic
1.2 Elasticities PED

Applications of PED
The PED formula is useful for more than just telling us how much consumers respond to price
changes. It can be very useful to businesses and government decision making.
Applications of PED for
Businesses benefit from knowing how responsive their consumers are to price changes
at any given time.
• If a seller knows demand is HIGHLY elastic, he may wish to lower the price and
Businesses capture many new customers.
• If a seller knows demand is highly inelastic, he may wish to raise his price as he will
not lose many sellers but will enjoy higher revenues.

The government needs to know how consumers will respond to taxes imposed on
particular goods. For example, if the government wishes to raise revenues from taxing
goods, it should know that:
Government • A tax on restaurant meals (relatively elastic) will not raise much revenue because
people will just stop going to restaurants.
• A tax on cigarettes (relatively inelastic) will raise lots of revenue because most people
will continue smoking and thus have to pay the tax.
1.2 Elasticities PED

The Total Revenue Test of PED

A quick way to determine whether a demand is elastic or inelastic is to consider whether the
revenues of sellers raises or falls as a result of a price change.
Consider the good whose demand is shown on the left: Calculate
the total revenues at each of the prices shown. (Total
Revenue=Price x Quantity)
• At $10: ܴܶ = 10 × 0 = ૙
• At $8: ܴܶ = 8 × 10 = ૡ૙ PED>1
• At $6: ܴܶ = 6 × 20 = ૚૛૙
• At $4: ܴܶ = 4 × 30 = ૚૛૙ PED=1
• At $2: ܴܶ = 2 × 40 = ૡ૙ PED<1
• At $0: ܴܶ = 0 × 50 = ૙
The Total Revenue Test of Elasticity:
• If a decrease in price causes TR to rise, demand is elastic.
• If a decrease in price causes TR to fall, demand is inelastic
• If an increase in price causes TR to rise, demand is inelastic
• If an increase in price causes TR to fall, demand is elastic
1.2 Elasticities PED Video Lesson

PRICE ELASTICITY OF DEMAND AND THE TOTAL

REVENUE TEST
1.2 Elasticities PED

PED and the slope of the Demand Curve P

PED and slope are different concepts. Cigarettes (D1) and

iPhones (D2)
• Slope of a line measures the rise over the run, or in the
demand curve the change in price over the change in P1
quantity. P2
D2
• PED measures the percentage change in quantity over the
percentage change in price.
• However, by comparing the relative slopes of demand
D1
curves plotted on the same axis, we can determine the
Q1 Q2 Q3 Q4 Q
relative elasticity of different goods. P
D3 Heart transplants (D3),
Questions: Watermelons (D4),
1. For which product is demand perfectly inelastic? Perfectly elastic? P2 Movie Tickets (D5)
Closes to unit elastic? Heart Transplants, Watermelons, Movie Tickets
2. What relationship exists between relative slopes of demand curves
P1 D4
and elasticity? Steeper= Less Elastic Flatter= More Elastic
3. What are two characteristics of cigarettes that make demand for
them inelastic? Addictive and Substitutes
4. What are two characteristics of heart transplants that make demand
perfectly inelastic? Substitutes and Necessity
D5
5. What are the characteristics of a good for which demand is perfectly
elastic? Many Substitutes, Luxury, High Proportion of Income Q2 Q1 Q
1.2 Elasticities PED

PED Discussion Questions

Discuss the following question about PED with your class.

1. Why do buyers of some products respond to price increases by reducing their

purchases more than the buyers of other products?
2. Why do higher market prices for some products cause producers to greatly increase
their output while price rises for other products cause only limited increase in
output?
3. Why does the demand for some products rise a great deal when household income
increases while the demand for other products rises just a little?
4. Is PED for a particular good the same at all prices? Yes or no. If no, then why would
PED change as the price changes?
5. Illustrate the concept of changing PED along a straight line demand curve.
6. How does the PED for a good affect the producer's decisions on how to set prices?
1.2 Elasticities XED

Cross Price Elasticity of Demand (XED)

Another type of elasticity measures the responsiveness of consumers of one good to a change in
the price of a related good.
For Example: Consider apples and pears, two fruits that are close substitutes for one another.
• How will demand for pears be affected by an increase in the price of apples?
• XED tells us the percentage by which quantity of pears will change following a particular
percentage change in the price of apples.

ܲ݁‫ܣ ݀݋݋ܩ ݂݋ ݕݐ݅ݐ݊ܽݑݍ ݄݁ݐ ݊݅ ݄݁݃݊ܽܿ ݁݃ܽݐ݊݁ܿݎ‬ %∆ܳ஺

ܺ‫= ܦܧ‬ ‫ݎ݋‬. .
ܲ݁‫ܤ ݀݋݋ܩ ݂݋ ݁ܿ݅ݎ݌ ݄݁ݐ ݊݅ ݄݁݃݊ܽܿ ݁݃ܽݐ݊݁ܿݎ‬ %∆ܲ஻
Assume the following: 50 − 30 2.5 − 2 0.67
• Apples go from $2 to $2.50 ܺ‫ܦܧ‬஺௉ = ÷ = = 2.7

P1=$2, P2=$2.50 30 2 0.25
• The quantity of pears rises from 30 to 50

Q1=30, Q2=50 Demand for pears is cross price elastic
with apples (i.e. XED>1)
1.2 Elasticities XED

Cross Price Elasticity of Demand (XED)

Just like PED, the absolute value of XED can be:
• 0-1: Inelastic – Consumers of Good A are relatively unresponsive to a change in the price of
Good B (the % change in QA will be smaller than the % change in PB)
• 1: Unit Elastic – Consumers of Good A will respond proportionally to a change in the price of
Good B (the % change in QA will be the same as the % change in PB)
• >1: Elastic – Consumers of Good A will be relatively responsive to a change in the price of
Good B (the % change in QA will be greater than the % change in PB)

Complementary goods: The XED for complementary goods will always be NEGATIVE, because when the
price of one complement goes up, the demand for the other will FALL.
• Example: Price of hot dogs rises, the demand for hot dog buns will decrease. XED coefficient will be
negative, reflecting the inverse relationship
Substitute goods: The XED for substitutes will always be POSITIVE, because when the price of one substitute
goes up, the demand for the other will RISE.
• Example: The price of beef rises, the demand for pork will rise. XED coefficient will be positive, reflecting
the direct relationship
Blog post: A cross-price elasticity example – gasoline and obesity
1.2 Elasticities YED

Income Elasticity of Demand (YED)

Another type of elasticity measures the responsiveness of consumers of a good to a change in
the income.
For Example: Imagine a country is going into recession, so incomes of the average household
are falling. Demand for new cars is falling, but demand for bicycles is rising. YED is a measure of
how responsive consumers’ demand for bicycles and cars is to changes in their incomes.

ܲ݁‫݀݋݋݃ ܽ ݂݋ ݕݐ݅ݐ݊ܽݑݍ ݄݁ݐ ݊݅ ݄݁݃݊ܽܿ ݁݃ܽݐ݊݁ܿݎ‬ %∆ܳ

ܻ‫= ܦܧ‬ ᇱ
‫ݎ݋‬. .
ܲ݁‫݁݉݋ܿ݊݅ ݏݎ݁݉ݑݏ݊݋ܿ ݊݅ ݄݁݃݊ܽܿ ݁݃ܽݐ݊݁ܿݎ‬ %∆ܻ
Assume the following: 8
ܻ‫ܦܧ‬௕௜௞௘௦ = = −2 Notice that YED can
• Incomes in America have fallen by 4% −4
• Bike sales have risen by 8% be negative (bikes) OR
−3 positive (cars)
• Car sales have fallen by 3% ܻ‫ܦܧ‬௖௔௥௦ = = 0.75
• Calculate the YED for bicycles and cars
−4
Demand for bikes is income elastic
Demand for cars is income inelastic
1.2 Elasticities YED

Income Elasticity of Demand (YED)

As with PED and XED, the absolute value of YED can be:
• 0-1: Inelastic – Demand for the good is relatively unresponsive to changes in consumer
income (quantity will change by a smaller percentage than the change in income)
• 1: Unit Elastic – Demand for the good is proportionally responsive to income changes
(quantity will change by the same percentage as the change in income)
• >1: Elastic – Demand for the good is relatively responsive to changes in income (quantity will
change by a larger percentage than consumers’ income)

Normal goods: A normal good is one with a POSITIVE YED coefficient. There is a direct relationship between
income and demand.
Example: As incomes fell, car sales fell as well. If incomes were to rise, car sales would begin to rise. Cars are
a normal good.
Inferior goods: An inferior good is one with a NEGATIVE YED coefficient. This is a good that people will buy
more of as income falls, and less of as income rises.
Example: Bicycle transportation is an inferior good, because Americans demanded MORE bicycles as their
incomes fell. If income were to rise, bicycle sales would begin to fall.
Blog post: Is bicycle transportation an “inferior good”?
1.2 Elasticities PES

Price Elasticity of Supply (PES)

This is a measure of the responsiveness of producers to price changes. Since there is always a
direct relationship between price and quantity supplied, the PES coefficient will always be
positive. PES can be calculated using the same formula as the other types of elasticity:
ܲ݁‫݈݀݁݅݌݌ݑݏ ݕݐ݅ݐ݊ܽݑݍ ݄݁ݐ ݊݅ ݄݁݃݊ܽܿ ݁݃ܽݐ݊݁ܿݎ‬ %∆ܳௌ
ܲ‫= ܵܧ‬ ‫ݎ݋‬. .
ܲ݁‫݁ܿ݅ݎ݌ ݄݁ݐ ݊݅ ݄݁݃݊ܽܿ ݁݃ܽݐ݊݁ܿݎ‬ %∆ܲ
PES will always be positive, since there is a PES in the short-run (1 week after price change)
direct relationship between the price of a good 1.1 − 1 500 − 400
ܲ‫ܵܧ‬ௌோ = ÷
and the quantity firms wish to supply. 1 400
Consider the following: 0.1
= = ૙. ૝
• The price of tablet computers rises from 0.25
$400 to $500 PES in the long-run (3 months after price change)
• In the week that follows, the quantity rises 2 − 1 500 − 400
ܲ‫ܵܧ‬௅ோ = ÷
from 1 million to 1.1 million 1 400
• In the three months that follow, the 1
= =૝
quantity rise from 1 million to 2 million 0.25
1.2 Elasticities PES

The Determinants of PES

The primary determinant of PES is the amount of time producers have to respond to a price
change.
• In the tablet computer market (previous slide), producers were relatively unresponsive to the rise in price
in the one week following the price increase (PES equaled only 0.4)
• After three months, producers had the time to increase their production to meet the higher demand,
thus they were much more responsive (PES equaled 4)
P Sm
Three time periods help determine PES: Ssr
MARKET PERIOD
Immediately after a change in price. Supply is highly inelastic, because
firms cannot immediately produce more of a good. Sm in the graph.
SHORT-RUN Slr
Firms can use their fixed capital more or less intensively, so supply is more
slightly more elastic.. Ssr in the graph.
LONG-RUN
Firms have time to vary the amount of capital they use, so supply is highly
elastic. In the long-run an increase in price will result in a much greater
increase in Qs than in the market period or the short-run. Slr in the graph. Q
1.2 Elasticities PES

The Determinants of PES and Applications of PES

In addition to the amount of time following a price change, the following help determine PES:
• The mobility of resources: If resources (labor and capital) can be quickly put into or taken out of the
production, supply tends to be more elastic. Generally, this applies to low-skilled manufactured goods, the
supply of which is more elastic than high-tech, capital-intensive manufactured goods.
• The ability to store stocks: If large inventories can be kept, producers can respond to price rises by drawing on
those inventories to meet rising demand and to price declines by adding to inventories in response to falling
demand. Goods which can be stored tend to have more elastic supply than perishable, non-storable goods.
Applications of PES: Similar to PED, a knowledge of PES can help businesses and the
government better plan for the anticipated price changes to particular goods.
• Business firms: If a producer expects the price of his product to change in the future, he will want to adjust his
output accordingly. Being able to adjust output in a timely manner to price changes is key to maximizing a
firm’s profits.
• Government: A government must consider the PES for a good if it is considering intervening in the market for
that good in any way. For example, if a government is considering imposing price controls (maximum or
minimum prices) on an agricultural commodity, the PES should be considered so any changes in output
resulting from the government controlled price can be anticipated.

Blog post: The problem with price controls in Blog post: Calculating the price elasticity of
Europe’s agricultural markets supply of natural gas