Lesson 3: Elasticity

According to the law of demand:

 Side Effect: P increases Q decreases
 Magnitude Effect: E DP How many units does the quantity demanded decrease?
Example: when the price of vegetable (broconi) increases by 10% and the price of electricity
increases by 10%? The quantity demanded will change by the same amount?
Ans: NO but HOW
Questions: what characteristics of goods/market can determine the response sensitivity of
customers to changes in price?

Explain the notation: E XY : how the percentage change in Y will cause Exy percentage change in
X. Y is the determinant.

Definition: E DP A measure of how much the quantity demanded of a good respond to a change in

the price of that good, computed as the percentage change.

% ∆ Q D ∆ Q D /Q D ∆ QD P
E❑DP= = = .
%∆ P ∆ P/ P ∆P Q
∆ QD
(Explanation:% ∆ QD = ∗100)
QD

Properties:
 E DP is a relative number (without unit)
 E DP always takes the negative value because of the law of demand (a negative association
between price and quantity demanded):
❑ ∆ QD P
E DP= . <0
∆P Q

P ∆ QD
o is always positive because P>0; Q>0 The sign of E DP depends on the .
Q ∆P
Because of the law demand (
∆ P> 0 ( imply price increases ) → ∆ Q D <0(imply quantity demanded decreases))
∆ QD
< 0.
∆P
How do we compute the E DP???
∆ QD P
E❑DP= .
∆P Q

The mid-point method The poind method

Condition If you have two different point, such The change from A to B is very small,
that A ( P A , Q A ) and B ( P B ,Q B ). like one point on the demand curve.
We have A ( P A , Q A ) and the
information about the demand
function.

Formulation (Q A −Q B) (P A + PB ) d QD P P 1 P
E DP= E❑DP= . =Q' ( P ) =
( P A −P B) ( Q A +QB ) dP Q Q P '(Q) Q

Example Demand function: P=¿70-0,02Q

A ( P A =30 , Q A=2000 )

1 P 1 30
E❑DP= = =−0.75
P' (Q) Q −0.02 2000
Intepretation: EDP=-0.75. means that at
price P=30, 1-percentage change in price
causes quantity demanded to change by
0.75%.
E.g., A ( P A =60 , Q A=10 ) and B
10-percentage change in price causes
( P B=40 ,Q B=15 ) . quantity demanded to change by 7.5%.
10−15 60+ 40  Change in quantity demanded is
E DP= =−1
60−40 10+15 smaller the change in price.
Intepretation: When the price  The level of response response
increases (decreases) by 1%, 10% the less to the change in price
quantity demanded decreases
(increases) by 1%, 10%, holing other
factors constant.

Types of Elasticity:
 Perfect Elasticity: ¿ E DP∨¿ ∞
 Perfect Inelasticity: ¿ E DP∨¿ 0
 Unit Elasticity: ¿ E DP∨¿ 1
 Elasticity: ¿ E DP∨¿ 1 (co gian nhiều)
 Inelasticity: ¿ E DP∨¿ 1 (co giãn ít)
The relationship between the elasticity level and the slope of demand curve:
 More elastic  the flatter demand curve is
  More inelastic the steeper demand curve is

Inelastic Elastic
A significant change in price only cause a A small change in price cause a significant
small change in quantity demanded. change in quantity demanded.

Determinants of ¿ E DP∨¿ level: (Important)

 Availability of Close Substitutes:

o More close substitutes the market is more competitiveCustomers is more
sensitive to any change in price (Customers have many options) E DP increases
o E.g.,: Electricity versus Broconi:
 Electricity has no close substitutes Customers have no option rather
than the electricity The market for electricity is less eslastic.
 Broconi: there are many types of vegtable in the market The market for
broconi is more eslastic
 Proportion of Income spent on:
o A large proportion (e.g., travelling package, diamond rings…) more elastic.
o A small proportion (e.g., salt, toothbrush…) more inelastic.

 5M/month, a package of salt (price 5k/unit)

 Definition of Market
o E.g., Food (the general market, including drinking, eating, meat,…) Inelastic

o Chicken meat (a specific meat in the food market face the competition from other
meat like beef, porlk…) Elastic
o Food (have no option)MeatChicken meat (other substituted goods: beef,
pork,...) Chicken leg: Following this way to define the food market, the
elasticity increase
o Conclusion: The more specific market is, the higher level of elasticity is
  The time frame: the time duration after the price change: 1 day, 1 month, 10 months, 1
year
o The longer time after the price change, the more elastic demand is.

 E.g., the price of gasoline: 20k/1litere of gasoline--> 40k/litre of gasoline.

After one day, you still aceept to use your motorcycle to go to school.
After one month, you can make the change to use the public
transportation--> sensitive

Why is ¿ E DP important??? It can help us determine the price strategy ( when we raise/reduce the
price of goods in the market).
Consider the situation that the firm want to raise the price (P), there are two effects in the market:
 Price Effects on Revenue (TR): P increases TR increases
 Quantity Effects on Revenue (TR): P increases Q decreases TR decreases
 Finally, whether TR increases or decreases??? The answer will depend on the fact
that the price effect is greater or smaller than the quanity effect.
Price Strategy:
 If the market is elastic, the firm should reduce the price because TR increases due to
an expansion of market share.
 If the market is inelastic, the firm should raise the price because the customer will
accept to continue to consume at the higher price.
In other word, if firms want to raise the price:
 Elastic: Price Effect< Quantity Effect TR decreases
 Inelastic: Price Effect> Quantity Effect TR increases

EDP P increase P decrease

EDP > 1 TR decrease TR increase

EDP = 1 TR not change TR not change

 EDP < 1 TR increase TR decrease

The relationship between the elasticity level and the slope of demand curve:
 More elastic  the flatter demand curve is
 More inelastic the steeper demand curve is
The Slope and Elasticity are two different concepts:
Slope Elasticity
Demand Function (D): P= a-bQ
Slope of demand function= -b ❑ 1 P 1 P
Elasticity: E DP= =
 Slope is constant P' (Q) Q −b Q
❑
Thus, E DP is conditional on the point
on the demand curve (Depend on the
P
value of ).Elasticity change along
Q
the demand curve

How does the elasticity change along the demand curve?

The slope of linear demand curve is constant.

The price elasticity of demand decreases from the

left hand side to the right hand side.

Alternatively, the demand is more elastic at a high

price.

❑ 1 PA
At point A: E DP , A = =∞
−b 0
❑ 1 0
At point B: E DP , B= =0
−b Q
❑ ❑
Similarly, w can prove that: E DP ,C > E DP , D
E❑DP decreases when moving from A to B.
% ∆ Q Dx ∆ Q DxAt
/Qthe ∆ QDx price,
Dx higher P the demand is more elastic.
Price elastic of demand: E❑DP= = = x x
% ∆ Px ∆ P x / Px ∆ P x Q Dx
 ❑ % ∆ QDx ∆ Q Dx /Q Dx ∆Q Dx PY
Cross-price elasticity of demand: E XY = = = x
% ∆ PY ∆ PY /PY ∆ PY QDx

How to calculate the cross-price elasticity of demand: mid-point method and point method.
Example:
When the price of orange is 16k/kg and the price of tangerine is 14k/kg, the quantity demanded
of tangerine is 30 kg. When the price of orange decreases to 12k/kg, then the quantity demanded
of tangerine is 22 kg. What is the cross-price elasticity of demand for tangerine?
Solution:
Pc ,1=16 → QT , 1=30

Pc ,2=12 → QT ,1 =22

30−22 16+12
E XY = =14 /13
16−12 30+22

❑ % ∆ QDx ∆ Q Dx /Q Dx ∆Q Dx PY
E XY = = = x
% ∆ PY ∆ PY /PY ∆ PY QDx
❑
The sign of E XY depends on the association between X and Y.

❑ % ∆ QDx ∆ Q Dx /Q Dx ∆Q Dx PY
E XY = = = x
% ∆ PY ∆ PY /PY ∆ PY QDx
❑
 X and Y are substitued: E XY > 0
❑
o PY ↑ →Q DY ↓ →Q Dx ↑ → ∆Q Dx > 0 while ∆ PY > 0 → E XY >0
❑
o PY ↓ →Q DY ↑ →Q Dx ↓ → ∆Q Dx < 0 while ∆ PY < 0 → E XY >0
❑
 X and Y and complemetary: E XY < 0
o PY ↑ →Q DY ↓ →Q Dx ↓ → ∆Q Dx < 0 while ∆ PY > 0 → E❑XY <0

❑ % ∆ Q D ∆ Q D / Q D ∆ QD I
3. The income elasticity of demand: E DI = = = x
%∆I ∆I/I ∆ I QD
❑
The sign of E DI depends on the type of goods.
❑
 The normal goods: E DI >0: Higher income make people to consume more.
❑
o Necessities: 0< E DI <1
❑
o Luxuries: E DI >1
❑
 The inferior: E DI <0: Higher income make people to consume less.