Economics and

Management

Elasticity
 Lecture Outline

• Price elasticity of demand

• Elasticity and total revenue
• Determinants of price elasticity
• Income and cross elasticity
• Price elasticity of supply
 Elasticity – the Concept
• The responsiveness of one variable
to changes in another
• When price rises, what happens
to demand?
• Demand falls
• BUT!
• How much does demand fall?
Elasticity – the concept
• If price rises by 10% - what happens
to demand?

We know demand will fall

• By more than 10%?
• By less than 10%?

Elasticity measures the extent to which demand

will change
 Elasticity
• 4 basic types used:

• Price elasticity of demand

• Price elasticity of supply
• Income elasticity of demand
• Cross elasticity
 Elasticity of Demand
Elasticity of demand: a measure of the extent to which the
quantity demanded of a good responds to changes in one of
the influencing factors
• Price elasticity of demand - measures the responsiveness
of quantity demanded to a change in price (ceteris paribus)
• Income elasticity of demand - measures the
responsiveness of quantity demanded to a change in
income
• cross elasticity of demand - measures the responsiveness
of quantity demanded to a change in the price of some
related commodities
Price elasticity is the most commonly used to ‘measure’ the
elasticity of demand
 Elasticity
• Price Elasticity of Demand
– The responsiveness of demand
to changes in price
– Where % change in Qty demanded
is greater than % change in price –
elastic
– Where % change in Qty demanded is less
than % change in price - inelastic
– Where % change in Qty demanded is
equal to % change in price - unitary
 Price Elasticity of Demand
% Change in Quantity Demanded
___________________________
Ped =
% Change in Price

Ped is almost always negative, analysts tend to ignore the sign

• If the elasticity is greater than 1 (in absolute value): , the condition is
known as elastic (i.e. the quantity demanded changes more than
proportionately in response to a given change in price)
• If the elasticity is less than 1 (in absolute value): , the condition is known as
inelastic (i.e. the quantity demanded changes less than proportionately in
response to a given change in price)
• If the elasticity is exactly 1, the condition is known as unitary (i.e. it is
the boundary between elastic and inelastic, the quantity demanded
changes in proportion with the change in price)
Price Elasticity of Demand
The demand curve
Price (£)
can be a range of
slopes each of
which is
associated with a
different
relationship
between price and
the quantity
demanded.

Quantity Demanded
 Ped & Total Revenue
Total revenue is
Price The importance of elasticity is price x quantity
the information it provides on
the effect of changes in price sold.
on total revenue
In this example, TR
= £5 x 100,000 =
£5 £500,000.
This value is
represented by the
grey shaded
Total Revenue
rectangle.

100 Quantity (000s)

 Price Elasticity of Demand
If the firm
decides to
Price decrease price
to (say) £3, the
degree of price
elasticity of the
£5
demand curve
would determine
the extent of the
£3
increase in
demand and
therefore the
Total Revenue change in total
revenue.
D
100 140 Quantity (000s)
 Price Elasticity of Demand
Price (£)
Producer decides to lower price to attract sales

P1= 10 % Δ Price = 50%

% Δ Quantity Demanded = 20%
Ped = 20/50= 0.4 (Inelastic)

P2= 5 Total Revenue would fall

Not a good move!

D
5 6
Quantity

%Change in P = % ΔQ=
((P2 - P1) / P1)100 ((Q2 - Q1) / Q1)100
 Price Elasticity of Demand
Price (£)
Producer decides to reduce price to increase sales
% Δ in Price = 30%
% Δ in Quantity Demand = 300%
Ped = 300/30 = 10 (Elastic)
Total Revenue rises
10
Good Move!
7
D

5 Quantity 20
 Price Elasticity of Demand
• Two Extreme cases of price elasticity of demand
• a) An increase in price leaves the quantity demanded unchanged
• b) At price £7 - consumers will buy any quantity
• An increase in price - quantity demanded zero
• A decrease in price - quantity demanded is infinite

a) Perfectly inelastic demand: b) Perfectly elastic demand:

Price
Ped = 0 Price
Ped = Infinity
D1

P2 £7 D2
P1

6 Quantity Quantity
 Exercise 1
Price Quantity % change in % change in Price
Initial New Initial New quantity price Elasticity of
P1 P2 Q1 Q2 demanded Demand
1. 25 30 100 40 -60% 20% (-)3
___________
2. 40 70 120 90
___________
3. 200 220 80 64
___________
4. 50 75 150 135
In each case identify whether you ___________

would describe it as elastic / unit %Change in Q =

elastic / inelastic ((Q2 - Q1) / Q1)100
1. _ Elastic _________________
E.G. % Change in quantity for
2. _________________________ case 1. =
(-60/100) 100
3. _________________________
4. _________________________ %Change in P =
((P2 - P1) / P1)100
 Exercise 1

Price Quantity % change % change Price

in in price Elasticity
Initial New Initial New
quantity of
demanded Demand
25 30 100 40 -60% 20% (-)3
40 70 120 90 -25% 75% (-)0.33
200 220 80 64 -20% 10% (-)2
50 75 150 135 -10% 50% (-)0.2
In each case identify whether you would describe it as elastic / unit
elastic / inelastic
1. Elastic
2. Inelastic
3. Elastic
4. Inelastic
 Income Elasticity of Demand
• Income Elasticity of Demand (Yed)
– The responsiveness of demand
to changes in incomes

% Change in Quantity Demanded

___________________________
Yed =
% Change in Income

• Normal Good – demand rises

as income rises and vice versa (Yed positive)
• Inferior Good – demand falls (-)
as income rises and vice versa (Yed negative)
 Cross Elasticity of Demand
• Cross Elasticity of demand:
• The responsiveness of demand
of one good (A) to changes in the price
of a related good (B) – either
a substitute or a complement
• How much the demand for good A will
change when the price of B changes

% Δ Qd of good A
_________________
Xed =
% Δ Price of good B
 Cross Elasticity of Demand
• Goods which are substitutes:
– The demand for A will rise as the
price of good B rises (positive
relationship between the two)
• Goods which are complements:
– The demand for A will fall as the price
of good B rises (inverse relationship
between the two)
 Importance of Elasticity
• Relationship between changes
in price and total revenue
• Importance in determining
what goods to tax (tax revenue)
• Influences the behaviour of a firm
 % Δ Qd
________
Exercise 2 Ped =
% Δ Price

Price Quantity Revenue Price

Initial New Initial New Before After Elasticity
price price of
change change Demand
1. 25 30 100 40 £2,500 £1,200 Elastic
2. 40 70 120 90 Inelastic
3. 200 220 80 64 Elastic
4. 50 75 150 135 Inelastic

Has revenue increased or decreased in each case?

1.
2.
3.
4.
 Exercise 2
Price Quantity Revenue Price
Initial New Initial New Before After price Elasticity
price change of Demand
change
25 30 100 40 £2,500 £1,200 Elastic
40 70 120 90 £4,800 £6,300 Inelastic
200 220 80 64 £16,000 £14,080 Elastic
50 75 150 135 £7,500 £10,125 Inelastic

Has revenue increased or decreased in each case?

1. Decrease
2. Increase
3. Decrease
4. Increase
 Exercise 2 continued
In the table below put a tick in the box that associates the
appropriate elasticity value with the appropriate effect on total
revenue when price rises (as in the previous examples):

Effect of a price increase on total Elastic Inelastic Unit

revenue elastic

Increase
Decrease
Stay same
 Exercise 2 continued
In the table below put a tick in the box that associates the
appropriate elasticity value with the appropriate effect on total
revenue when price rises (as in the previous examples):

Effect of a price increase on total Elastic Inelastic Unit

revenue elastic

Increase ****
Decrease ****
Stay same ****
 Determinants of Elasticity
If the company wants to estimate the value of the price elasticity of
their product, then they need to judge it against the following criteria:

• Proportion of income spent on the good - the lower the proportion

of income spent, the more inelastic the good will tend to be
• Time period – the longer the time under consideration the more
elastic a good is likely to be – takes time to adjust consumption
patterns
• The number of substitutes - the more substitutes a good has the
easier it is for consumers to switch to another product if the price
goes up (elastic)
• The strength of the brand - the stronger the brand, the more
inelastic the product will be
• The level of necessity or addiction - the more necessary or addictive
something is, the more inelastic it will be
 Elastic / Inelastic?
1. Eggs 1. Inelastic
2. Luxury Holiday 2. Elastic
3. Building 3. Inelastic
Materials
4. Petrol 4. Inelastic
5. Bread 5. Inelastic
6. Restaurant Meal 6. Elastic
7. Airline Travel 7. Elastic
Elasticity of Supply
 The Supply Curve

• The supply curve is

Price the graphical
£ representation of the
S law of supply
• The supply curve
£20
indicates a positive
relationship between
supply and price.
• when the price rises,
£10
producers offer more
for sale
• when price falls less
100 500 quantity is supplied
Quantity
 Price Elasticity of Supply

The price elasticity of supply measures the

responsiveness of quantity supplied to a
change in the commodity’s own price (ceteris
paribus)
• Price Elasticity of Supply:
% Δ Quantity Supplied
____________________
Pes =
% Δ Price
• If the elasticity is less than 1, the condition is known as
inelastic (i.e. the quantity supplied changes less than
proportionately in response to a given change in price)
• If the elasticity is exactly 1, the condition is known as
unitary (i.e. it is the boundary between elastic and inelastic,
the quantity supplied changes in proportion with the change
in price)
• If the elasticity is greater than 1, the condition is known as
elastic (the quantity supplied changes more than
proportionately in response to a given change in price)
 Price Elasticity of Supply
Price

Price
S2
S1
P2 P2
P1
P1

Q1 Q2 Quantity Q1 Q2 Quantity
a) Elastic supply b) Inelastic supply

• a) Supply is elastic since the percentage change in

the quantity supplied is > percentage change in price
(%ΔQS > %ΔP). PES = >1
• b) Supply is inelastic since the percentage change in
the quantity supplied is < percentage change in price
(%ΔQS < %ΔP). PES = <1
 Price Elasticity of Supply
– In other words:

– If PES is inelastic (less than 1) - it will be

difficult for suppliers to react swiftly to
changes in price

– If PES is elastic (greater than 1) – supply

can react quickly to changes in price
Determinants of Elasticity
of Supply
The main determinants of elasticity of
supply are:

• Time
• Excess capacity and unsold stocks
• The ease with which resources can shift
from one industry to another
 Determinants of Elasticity
of Supply
• Time: Since it takes time for firms to adjust the
quantities they produce, the supply of a commodity
is likely to be more elastic the longer the period of
time under consideration.
- In the momentary period ,supply is limited to the
quantities already available in the market and can not
be increased even if a substantial rise in price occurs.
- In the short run, supply can be increased by
increasing the use of some factors of production.
- In the long run, the quantities of all factors of
production can be increased
 Determinants of Elasticity
of Supply
• Excess capacity and unsold stocks:
- Supply will be more elastic the greater the excess
capacity in the industry and the higher the level of
unsold stocks.
- In the short run, it may be possible to increase
supplies considerably if there is a pool of
unemployed labour and unused machinery (excess
capacity) in the industry.
- Similarly, if the industry has accumulated a large
stocks of unsold commodities, supplies can quickly
be increased.
Determinants of Elasticity
of Supply
• The ease with which resources can be
shifted from one industry to another:
- In both the short and the long run, in the
absence of excess capacity and unsold stocks,
an increase in supply requires the shifting of
factors of production from one use to another.
- Heterogeneity of labour (location moving and
re-training) and capital (equipment unsuitable,
need to acquire new ones) may restrict their
mobility in certain industries (supply can be
inelastic)
 Practice

In a local housing market, the average

price of a 2-bedroom terrace house
increases from £100,000 to £150,000,
and the number of such houses
available in the estates agents increases
from 100 to 125 houses. Plot the supply
curve and calculate the elasticity of
supply
 Practice - Answer
Price1 Price2 Quantity Quantity %ΔQS %ΔP
Supply1 Supply2

100.000 150.000 100 125 25% 50%

% Δ QS = 25/100 X 100
% Δ QS = 25%

% Δ P = 50.000/100.000 X 100
% Δ P = 50%

Price
S2

150000

PES = _______
% Δ QS 100000
%ΔP

100 125 Quantity

PES = 25% / 50% = 0.5% (Inelastic)

 Exercise
Complete the following graph by showing what is likely to happen to
the equilibrium price and the equilibrium quantity in the owner-
occupied housing market if there is a rise in demand (shift of D) when
supply is relatively elastic (%ΔQS > %ΔP)
Price
(£)

S
- Small
P2
E2 changes in
P1 price
E1
- Large
changes in
quantity
D D1
0 supplied
Q1 Q2 Quantity
 Exercise
Complete the following graph by showing what is likely to happen to
the equilibrium price and the equilibrium quantity in the owner-
occupied housing market if there is a rise in demand (shift of D) and
supply is inelastic.
Price
(£) S

P2 E2
- Large changes
in price
P1
E1
- Small changes
in quantity
supplied
D D1
0
Q1 Q2 Quantity
 Some Interesting Papers

Barker K. (2003) Review of housing supply: securing our future

needs – interim report
Barker, K. (2004) Review of Housing Supply Final Report -
Delivering Stability: Securing our Future Housing Needs
Niemietz K (2012), Abundance of land, shortage of housing.
IEA Discussion Paper No. 38

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