Chapter 4 – Price Elasticity of Demand

Things to Consider
- That restaurant has been slow lately. Why did they raise their prices?
- Tim’s has just raised the price of coffee again. I’m mad but I’m still going to buy one
every morning. Am I being irrational?

Elasticity
- Elasticity: measures how responsive Qd or Qs is to changes in P and other determinants.

- If, say, P changes, will Qd change by a little or by a lot?

- This knowledge would be very useful to firms and policymakers whose decisions may
affect price and therefore, affect Qd.

- A firm wants to maximize its profit. Other things being equal, it will want to maximize its
total revenue.

- Here’s where knowing the price elasticity of demand for its good is handy for a firm.

- It can tell a firm whether it should raise or lower its price (assuming it has the ability to
set price
Price Elasticity of Demand
- Price elasticity of demand is a measure of how much the quantity demanded of a good
respond to a change in the price of that good.
- Will a small price change result in a proportionately bigger or smaller change in quantity
demanded?

- The price elasticity of demand is computed as the percentage change in the quantity
demanded divided by the percentage change in price.

- We’ll denote price elasticity by Ep.

- Ep = percentage change in Qd
percentage change in P
= % change in Qd
% Change in P

- The number we get from our calculations is called the coefficient of elasticity.
- The size of the coefficient, Ep, will tell us how elastic the good is – how responsive
demand is to a change in price.
- The larger the coefficient, the more responsive is demand to a change in the price of the
good.
- Elasticity will vary because how people respond to price changes will vary so we can
define different types of elasticity.

Types of Price Elasticity of Demand

Inelastic Demand: a change in P leads to a proportionately smaller change in Qd.
- Demand is not very responsive to a price change.
- Percentage change in P > percentage change in Qd.
- Ep < 1
- Demand curve will be steep.

Example: dentist visit

Perfectly Inelastic Demand: a change in P does not change Qd whatsoever.
- Demand is not at all responsive to a price change.
- Percentage change in P = zero change in Qd.
- Ep = 0
- Demand curve will be perfectly vertical.

Example: heart medicine

Elastic Demand: a change in P leads to a proportionately larger change in Qd.

- Demand is very responsive to a price change.
- Percentage change in Qd > percentage change in P.
- Ep > 1
- Demand curve will be fairly flat.

Example: most manufacture

Perfectly Elastic Demand: a change in P leads to an infinitely great change in Qd.
- Demand is extremely responsive to a price change.
- Percentage change in Qd approaches infinity.
- Ep = infinity
- Demand curve will be horizontal.

Example: There is no real-world example. A good with perfectly elastic demand would be one
with an infinite number of substitutes so that any change in price would create an infinite change
in demand

Unit Elastic: a change in P leads to a proportionately equal change in Qd.

- Percentage change in P = percentage change in Qd.
- Ep = 1
- Demand curve will be non-linear. It will be a rectangular hyperbola. It has to be non-
linear so that no matter where you are on the curve, TR will always be the same,
maximum value.

Example: wine in the US

Price Elasticity of Demand: Analysis
Calculating Elasticity
- If we are given percentage changes in price and the corresponding changes in Qd, we use
the formula
Ep = % Change in Qd
% Change in P
- For example, the price of milk increases by 2% and Qd decreases by .5% Ep = -.5/2 =
-.25

- When we are given two prices and their corresponding Qd values, we must calculate
percentage changes in P and Qd.

o A percentage change in Qd = (Qd2 – Qd1)/Qd1

o A percentage change in P = (P2 – P1)/P1

- Note that we will get a different value for our percentage changes depending on whether
we go from Point A to Point B or from Point B to Point A.

Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you
buy falls from 10 to 8 cones, then your elasticity of demand would be calculated as follows:
Qd1 = 10
Qd2 = 8
P1 = 2.00
P2 = 2.20
Percentage change in Qd = (8 – 10)/10 = -.2
Percentage change in P = (2.20 – 2.00)/2.00 = .1
Ep = -.2/.1 = -2.0

- The other formula we use is the formula for point elasticity.

- It measures the impact of a marginal change in price on quantity demanded.
- The formula for point elasticity is Ep = dQ/dP * P/Q
- This is easy to compute, since dQ/dP is just the slope of a linear demand curve when
demand is in the form Q = f(P).
- Let’s do an example

- Demand is given by the equation Qd = 200 – 3P.

- What is the point elasticity of demand when price is $15?

o Slope = -3
o When P = 15, Qd = 155
o Ep = -3 * 15/155 = -.29

- In all three examples, we have an elasticity coefficient that has a negative sign.
- But remember the law of demand: as P goes up, Qd goes down. The coefficient will
always be a negative number.
 - Since we’re smart economists and know this, when we calculate price elasticity, we drop
the negative sign (we know it will always be negative).

Some Generalities About Demand Elasticities and Their Determinants

1. Goods that are necessities tend to have inelastic demand.
- Example: the demand for insulin would be perfectly inelastic (no matter how much price
changes, if you must have insulin, you’ll buy it).
- Example: the demand for textbooks would be inelastic (if price went up, you may try to find a
used copy, but you’ll still end up getting a new one if it means passing the course)

2. Goods that are luxuries tend to have elastic demand.

- Example: the demand for plasma TVs (if the price is right, you may buy one, but you likely
won’t buy one if the price is too high for your budget).
- Example: vacations abroad (same reason as above).

3. Goods that have close substitutes tend to have elastic demand.

- Example: Coke and Pepsi (if the price of Coke goes up, many consumers will switch to Pepsi).
-Example: Eggs don’t really have a close substitute (their demand is inelastic).

4. Goods tend to have more elastic demand over longer time horizons.
- You can find substitutes in the long run where you can’t in the short run.

5. How you define the market makes a difference.

- Example: food – inelastic
vegetables – more elastic
broccoli – even more elastic

- The more narrowly defined the market, the more elastic the demand for that good.

6. How much of your budget you spend on a good determines elasticity.

- If you spend a large proportion of your budget on a good, demand for that good will tend to be
elastic.
- If you only spend a small proportion of your budget on a good, demand will tend to be inelastic

- Elasticity is not constant along a linear demand curve.

- Elasticity is not the same as slope.
- Slope measures rates of change.
- Elasticity measures percentage changes.
- We can illustrate different elasticities along the demand curve:
 - Why does elasticity change along the curve the way it does?
- Recall that our point elasticity formula for a demand curve specified as Q = f(p) is
o Ep = dQ/dP * P/Q
- Slope dQ/dP is constant for a linear demand curve.
- But P and Q are different combinations at different points on the demand curve, so
elasticity changes along the demand curve.
- Since dQ/dP is the slope of the demand curve, that’s why we can “see” elasticity by the
steepness (slope) of the curve.

Price Elasticity and Total Revenue

- With an inelastic demand curve, an increase in price leads to a decrease in quantity that is
proportionately smaller.
- A firm would only lose a few sales but make up for it by getting a higher price for the
sales it does make.
- The gain to TR from the P increase will outweigh the loss to TR from a decrease in Q.
- TR will increase if P goes up if demand is inelastic.
- So, if a firm wants to increase TR and demand for its good is inelastic, it should increase
P.

- With an elastic demand curve, a decrease in the price leads to an increase in quantity
demanded that is proportionately larger.
- A firm would gain so many sales that even with a lower price, it ends up with greater
total revenue.
- The gain to TR from the Q increase will outweigh the loss in TR from the lower price.
- TR will increase if P goes down if demand is elastic.
 - So, if a firm wants to h TR and demand for its good is elastic, it should decrease P.
- If demand is unit elastic, the gain to TR from a P increase (or decrease) will be exactly
offset by the decrease (or increase) in Q.
- TR will not increase if P goes up and demand is unit elastic.
- TR will not increase if P goes down and demand is unit elastic.
- No change in P will increase TR, so
- TR must be at a maximum when Ep = 1.

Some Estimated Elasticities of Demand:

- Bread .15 inelastic
- Clothing.49 inelastic
- Motor vehicles 1.14 elastic (just)
- Restaurant meals 2.27 elastic

Other Elasticities of Demand

Things to Consider
- I just got a raise. Why would that make me want to eat less frozen pizza and go out for
fresh pizza?
- The price of salmon went up. Why do I buy more tuna instead?

Income Elasticity of Demand

- Income elasticity of demand: measures how much the quantity demanded of a good
respond to a change in consumers’ income.
- It is computed as the percentage change in the quantity demanded divided by the
percentage change in income.
- Income elasticity is denoted EN

- If we are given percentage changes in income and the corresponding changes in Qd, we
use the formula
EI = % Change in Qd
% Change in N
- If we are given 2 levels of income and their corresponding Qd, we must calculate the
percentage changes in Qd and Income.

Here, the plus, or minus sign matters.

- If EN> 0
o the good is a normal good
o as N goes up, Qd goes up

- If EN < 0
o the good is an inferior good
o as N goes down, Qd goes up

- If EN is between -1 and 1, the good is income inelastic.

- If EN is greater than 1 or less than -1, the good is income elastic.
Goods consumers regard as necessities tend to be income inelastic.
- Examples: food, clothes, housing

Goods consumers regard as luxuries tend to be income elastic.

- Examples: vacations, sports cars, jewelry

Example: Consumer incomes decrease from $45000 to $40000. Demand for canned beans
increases from 100 cans to 102 cans per year.
• Q1 = 100
• Q2 = 102
• N1 = $45 000
• N2 = $40 000

- EN = (102-100) / 100
(40000 - 45000) / 45000)
= .02 /- .11
= -.18

Canned beans are income inelastic (elasticity is a fraction) and inferior (elasticity is negative).

Cross-Price Elasticity of Demand

- Denoted Eab, cross-price elasticity measures the response of Qd of a good “a” to a change
in price of a related good “b”.
- Eab = % change in Qd of good “a”
% change in P of good “b”

- The percentage change formula is: Eab = (Q2a – Q1a) / Q1a

(P2b – P1b) / P1b)

- The plus, or minus sign matters.

- If elasticity is > 0, an increase in P of “b” will lead to an increase in Qd of “a”
o - the goods are substitutes
- If elasticity is < 0, an increase in P of “b” will lead to a decrease in Qd of “a”
o - the goods are complements

- If cross-price elasticity equals 0, the goods are not related

- The larger the cross-price elasticity coefficient, the stronger the relationship between the
two goods.

- Example: The price of a soft drink increases from $1.99 to $2.49 per 2-litre bottle.
Demand for a fruit juice increases from 500 to 1000 bottles.

Q1a = 500
Q2a = 1000
P1b = 1.99
P2b = 2.49
Eab = (1000 - 500) / 500)
(2.49 -1.99) / 1.99)
= 1 / .25
= 4.0
- Elasticity is positive so the goods are substitutes.

Some Notes About Demand Elasticity

- The larger the price elasticity coefficient, the more elastic is the demand for the good.
- The more price elastic is demand, the flatter will be the demand curve.
- In first year, we don’t use point elasticity for income elasticity or cross-price elasticity

Elasticity of Supply
Things to Consider
- How does the quantity supplied of a good react to a change in the selling price of a good?
- Why does the type of good make a difference to supply price elasticity?

Elasticity of Supply
- Price elasticity of supply, Es, is a measure of how much the quantity supplied of a good
respond to a change in the price of that good.
- Price elasticity of supply is the percentage change in quantity supplied resulting from a
percentage change in price.
- Since P and Qs always move in the same direction, Es will always be > 0

- Es = % change in Qs
% change in P
- The percentage change formula is:
Es = (Q2 – Q1) / Q1
(P2 – P1) / P1

- where Q = quantity supplied.

- The point elasticity formula is Es = dQ/dP * P/Q
- where Q = quantity supplies

- Just as we did for price elasticity of demand, we can categorize types of elasticity of
supply:
- Perfectly Inelastic Supply:
o Es = 0
o Qs will not change for any change in P.
o Supply curve is vertical.
- Example: rare art
Inelastic Supply:
- Es between 0 and 1 (a fraction).
- Supply curve is steep.
- Supply does not respond greatly to a change in P.

Example: lakefront property

Elastic Supply:
- Es > 1
- Supply curve is flat.
- Supply is responsive to changes in P.

Example: most manufacture

Perfectly Elastic Supply:
- Es => infinity
- Supply curve is horizontal.
- Any price change will affect Qs infinitely.

- Example: There is no real-world example. It would be a good that had many perfect
substitutes in production and one that the unit cost of production didn’t change regardless
of how many were produced.

Unit elastic supply:

- Es = 1.
- A percentage change in P is exactly offset by a percentage change in Qs.

Example: There isn’t really one. Think of unit elasticity as the cut-off point between elastic and
inelastic supply
some Generalities about Supply Elasticities and their Determinants
1. A key determinant of supply elasticity is time.
- Supply is usually more elastic in the long run than in the short run.
- Firms can respond more easily in the longer term than they can in the short run.

2. Goods whose factors of production are readily available have more elastic supply.
- You can easily obtain more resources to produce more goods if the selling price rises and you
want to increase output.

3. Goods whose factors of production are mobile tend to have more elastic supply.
- You can move resources to other tasks to adjust quantity produced.

4. Goods with non-complicated production processes tend to have elastic supply.

- If price changes, the production plan can be easily changed to accommodate the firm’s
changing output decision.

5. Goods that can be easily stored tend to have more elastic supply.
-A firm can significantly increase production if it has a place to store its output.
Note: just like demand, the flatter the supply curve, the more elastic is the supply of the
good

Examples
- The price of aluminum rises from $20 to $25 per tonne. Quantity supplied increases from
8 tonnes to 9 tonnes.
- Using the percentage change formula:
Q1 = 8
Q2 = 9
P1= 20
P2 = 25
Es = (9 – 8) / 8
(25 – 20) / 20
= .50 inelastic
- The supply of grapes is given by Qs = P + 30. What is the elasticity of supply at a price
of $90?
- Using the point elasticity method:
o The slope of the supply curve is 1.
o When P = 90, Qs = 120.
- Es = 1 * (90/120) = .75 inelastic