3.

Elasticity of demand
 Definition
• The responsiveness of quantity demanded to
a changes in the determinants of
demand/supply is measured by the elasticity
of demand/supply.
• Elasticity refers to sensitivity to change or
responsiveness. For example, the response of
consumers to a change in price is measured by
the price elasticity of demand.
 Price elasticity of demand
• The price elasticity of demand is given by
percentage change in quantity demanded
divided by the percentage change in price.
• The price elasticity of demand is a relative
measure. It measures the responsiveness of
quantity demanded (as a percentage) of a
good to a one percent change in price.
• Formula
 Characteristics
• Demand can be elastic, inelastic, or unitary
elastic.
• And these are the five characteristics of price
elasticity of demand
• Five because there is perfectly elastic and
perfectly inelastic
Price elastic
• Demand is price elastic if the absolute value of
Ep is greater than 1.
• Consumer response is large relative to the
change in price.
Price inelastic and unitary elastic
• Demand is price inelastic if the absolute value
of Ep is less than 1.
• Consumer response is smaller relative to the
change in price.
• Demand is unitary elastic if the absolute value
of Ep equals 1.
• The percentage change in quantity demanded
is equal to the percentage change in price.
Perfectly price elastic and inelastic
Five characteristics
Examples of price elasticity of demand
 Point elasticity vs arc elasticity
• Arc elasticity is when the whole demand curve
has one characteristic
• For example the whole demand curve is price
elastic or price inelastic
• Point elasticity is when each point has its own
price elasticity
• Each combination of price and quantity has its
own elasticity
Point elasticity
• The gradient of the curve is not changing.
• What changes is price and quantity responses
• So point elasticity is depending on the price
and quantity because the gradient is constant.
• Price elasticity decreases from left to right.
• The upper part is elastic and the lower part is
inelastic.
An example
 Homework
• 1. given that Q = 200 -0.5P and the price of
the good is 100. calculate the price elasticity
of demand at this point.
• 2. the quantity purchased at a price of 12
dollars is 134 units and at a price 24 is 84
units. Calculate the price elasticity of demand.
• 3. the price elasticity of demand is 2 on a
demand curve Q=90-1.2P. Calculate the price
and quantity
 Application of price elasticity of
demand
• Price elasticity explains why producers cannot
charge the highest possible price.
• Although one would think otherwise, higher
prices may actually reduce total sales revenue.
• Total revenue - the price of a product
multiplied by the quantity sold in a given time
period.
• Total revenue = price x quantity sold
• Price elasticity also explains why the government
does not charge a tax or give a subside on all the
goods
• A tax or a subsidy changes the price of the good
and therefore change the expenditure on that
good.
• Total expenditure- the price of a product
multiplied by the quantity bought in a given time
period.
• Total expenditure = price x quantity sold
• Revenue of the firms = expenditure of the
households
• From topic 1 the expenditure of households is
the revenue of the firms
• The firms want revenues to increase so as to
maximize profit
• The government wants expenditure on luxury
and basic goods to decrease to maximise
welfare (satisfaction)
Price determination
 This a graph of y=a/x

unitary elastic
12

10

6
y

0
0 5 10 15 20 25
• So elasticity is used to determine if prices are to
increase or decrease.
• A price cut decreases total revenue/expenditure
if demand is price inelastic.
• A price cut increases total revenue/expenditure if
demand is price elastic.
• A price cut does not change total
revenue/expenditure if demand is unitary elastic.
• Elasticity and revenue have the following
relationship; expressed also on point elasticity
form
• The following graph illustrates the concept of
revenue against prices.
• Average revenue=demand curve
• Marginal revenue=absolute change in revenue
due changes in quantity/prices
• The firms would rather reduce the price when
the demand curve is price elastic so as to
maximize profits (luxury goods)
• The firms would rather increase the price
when the demand curve is price inelastic so as
to maximize profits (beer, basic goods)
• The government would rather reduce the
price when the demand curve is price inelastic
so as to reduce expenditure on such goods
• Inelastic goods are basic commodities (most
cases)
• Therefore reducing expenditure and increase
welfare for the society
• The government would rather increase the
price when the demand curve is price elastic
so as to reduce expenditure on such goods
• elastic goods are not basic commodities (most
cases)
• therefore reduce expenditure and increase
welfare for the society.
 Determinants of price elasticity of
demand
• Differences in price elasticity are explained by
several factors:
– Whether the Good is a Necessity or Luxury
– The Availability of Substitutes
– The Price Relative to Income
– Habit forming goods
• Some goods are so critical to our everyday life
that we regard them as necessities (needs).
For example salt.
• Demand for necessities is relatively inelastic.
For example salt.
• A luxury good (wants) enhance the
satisfaction and one can live without them.
Such as cell phones.
• Demand for luxury goods is relatively elastic.
• The greater the availability of substitutes, the
higher the price elasticity of demand. For an
example beef
• The smaller the availability of substitutes or
no sbstitutes, the lower the price elasticity of
demand. For example sugar and salt
• If the price of a product is very high relative to
the consumer’s income, (proportion of income
spend on a good) the demand will tend to be
elastic. For example milk, meat.
• If the price of a product is very low relative to
the consumer’s income, (proportion of income
spend on a good) the demand will tend to be
inelastic. For example razor, needles, shoe
polish, pens
• Habit forming goods; these are good that are
addictive such as alcohol or cigarettes
• There consumption is a habit and habits are
hard to kill.
• Such goods are price inelastic because a
change in price does not change the amount
to be purchased to significantly
 Income elasticity of demand
• This is the responsiveness of quantity
demanded to changes in the household’s
income.
• It is a relative change because it determine
the percentage change of quantity demanded
to a on percent change in the price of the
good.
• The formula
 Income elasticity
• Just like from the determinants of demand,
the concept of income brings in two goods
• Inferior goods
• Normal goods

• The third one will be; Necessities (basic

commodities)
• Inferior goods have a negative income
elasticity.
• It is usually high but in the negative. For
example soya mince
• It also measures the degree of inferiority; for
example soya mince is more inferior as
compare to Matemba. So soya mince will have
a bigger but negative income elasticity than
Matemba.
• normal goods have a positive income
elasticity.
• It is usually high but in the positive. For
example cell phones
• It also measures the degree of normal(ity); for
example ice cream is more normal as compare
to air time. So ice cream will have a bigger but
positive income elasticity than air time.
• Basic goods (necessities) have a very small
income elasticity which can be either negative
or positive. Such as sugar and salt.
• Changes in income does not change the
quantity demanded significantly
• People do not change their demand for salt
because the income has changes
 Cross elasticity of demand
• This is the responsiveness of quantity
demanded to changes in the price of other
goods
• It is a relative change because it determine
the percentage change of quantity demanded
of one good to a one percent change in the
price of other good.
• The formular
• Just like from the determinants of demand,
the concept of price of other goods brings in
two goods to mind
• substitutes goods

• compliments goods
 Cross elasticity
• substitute goods have a positive cross elasticity.
• For example beef and chicken
• It also measures the degree of substitutability;
• Strong substitutes are those that can completely
replace each other in consumption and have a
high positive cross elasticity e.g. Beef and chicken
• weak substitutes are those that can not
completely replace each other in consumption
and have a high low positive cross elasticity e.g.
Fire wood and electricity
• complimentary goods have a negative cross elasticity.
• For example tea and sugar
• It also measures the degree of complimentarity;
• Strong compliments are those that can not be
consumed in isolation and have a high negative cross
elasticity e.g. Guns and bullets; left shoe and a right
shoe.
• weak compliments are those that can be consumed
individually but together they enhance satisfaction
have a high low cross elasticity but negative e.g. Butter
and bread;
• Goods that are not related in consumption
have a zero cross elasticity.
• For example petrol and chicken
• The cross elasticity will be low (close to zero).
It can be negative or positive but very close to
zero.