Chapter 6: Elasticity

Section I.1 General Definition of elasticity

1) Elasticity is a measure of responsiveness or sensitivity

a) How sensitive the dependent variable is to changes in independent variable

2) Formally defined as: percentage change in a dependent variable if the relevant

independent variable changes by one percent
Percentage change ∈dependent variable
Elasticity=
Percentage change ∈independent variable

Section I.2 Price elasticity of demand

1) The price elasticity of demand is the percentage change in quantity demanded if price
of the product changes by one per cent, ceteris paribus.
∆ percentage Q( demanded)
ep =
∆ percentage Price of product

2) The sensitivity of quantity demanded to a change in price will depend on the slope of
the demand curve

(ii) Aspects and implications of price elasticity

1) It is calculated on percentage changes which are Relative changes not absolute

changes

a) Cannot use absolute changes since quantity and price expressed in different units.

2) Price elasticity of demand is the rato of percentage change in either variable. The
ratio is called elasticity coefficient THEREFORE THERE ARE NO UNITS

3) Elasticity coefficient enables us to compare how consumers react to changes in price

of different goods.

a) We cannot compare a R1 change in price of a car as a opposed to a change of R1 in

prices of matches. But we can compare elasticity coefficient of these products.

4) Price elasticity of demand has a negative sign since an increase in price (+ve) has a
decrease in quantity demanded (-ve)law of demand. But we simply look at the
absolute value of the price elasticity coefficient.

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 (iii) Calculating price elasticity of demand:

∆Q
1) is simply the inverse
∆P
of the demand curve
slope. Note that when
equation of demand
curve is given as Q=aP+c;
then the ‘a’ represents
dQ
but if the equation is
dP
given in the form of
P=aQ+c then ‘a’
dP
represents ; therefore
dQ
invert it to get the correct
value

1) Use arc-elasticity if there are large fluctuations in

price and use point-elasticity if

price change is relatively small

(Q 2−Q 1) /(Q1+Q 2)
using the arc elasticity formula: ep= note that your are diving the midpoint
(P 2−P 1) /( P1+ P 2)

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 (iv) Price elasticity of demand and total revenue (total expenditure)

1) Total revenue is simply the product of quantity purchased and the price paid by
consumers.

2) If ep >1 : If relatively elastic

a) The change in price leads to a proportionately greater change in quantity demanded.

TR (total revenue) changes in opposite direction

3) If ep=1: Unitarily elastic

a) The change in price leads to an equi-proportional change in quantity demanded.

Total revenue remains unchanged.

4) If 0<ep < 1: Relatively inelastic

a) The change in price leads to proportionally smaller change in quantity demanded. TR

change in the same direction as price changes.

 TR increases as long as price

elasticity is greater than one.
 TR reaches maximum when
price elasticity is one
 TR falls when price elasticity
is less than one

The elasticity is dependent on point and inverse slope; therefore the

elasticity on a linear demand curve varies at each point

the steepness of the graph alone cannot tell you the elasticity of the graph.

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(v) Different categories of price elasticity of demand

1) Perfectly inelastic demand (ep=0):

a) This shows that the consumer plans to purchase a fixed amount of product
irrespective of price.

b) Thus TR can increase with price and suppliers can exploit the consumers

2) Inelastic demand (0<ep <1)[since ep is the inverse of slope of demand curve, a low
price elasticity means a steep graph]

a) Although the elasticity coefficient varies from point to point, we can draw a
relatively steep graph to indicate RELATIVELY inelastic demand.

b) An increase in price will cause the TR to increase. There is no incentive for the price to
drop since a drop in price will cause a proportionally smaller increase in quantity

3) Unitarily elastic demand (ep =1)

a) TR remains constant regardless of price or quantity changes.

b) It is a rectangular hyperbola since y=k/x  k=xy… where x is price and y is quantity

demanded.

i) Thus an increase in price (x) will cause a decrease in quantity demanded (y) and
their product (xy=TR) must be constant, k.

4) Elastic demand (ep >1):

a) The slope of the demand curve is relatively flat.

b) An increase in price will result in a proportionally bigger decrease in quantity. Thus

TR decreases with price increase.

5) Perfectly elastic demand (ep=∞):

a) Graph is horizontal

b) An increase in price results no revenue.

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(vi) Determinants of price elasticity of demand

In discussing each determinant, we assume ceteris paribus. This means that one
determinant can neutralise another determinant

1) Substitution possibilities

a) The larger the number of substitutes, the closer (or better) the substitutes are, the
greater the price elasticity of demand.

b) If a good does not have close substitutes (like salt and petrol and electricity), the more
inelastic it will be.

2) The degree of complementarity of the product

a) In the case of highly complementary goods (e.g. sugar, tea, coffee, motorcar tyres,
petrol etc), price elasticity tends to be low

b) It is argued that it is the absence of good substitutes rather than the degree of
complementarity which is responsible for inelastic demand of highly complementary
goods.

3) Type of want satisfied by the product

a) Price elasticity of necessities tend to be lower than price elasticity of luxury goods.

4) Time period under consideration:

a) Demand tends to be more price elastic in the long run than in short run.

b) When the price of a product changes, consumers need time to adjust to the change in
relative prices.

i) In the short run: If price of petrol increased, then consumers could do nothing since
they needed petrol.

ii) In the long run: they will tend to purchase cars that don’t use petrol (e.g. hybrid)

iii) Another example is when airticket fares in short notice are generally high priced
while airtickets in long run may be cheaper.

c) The practice of charging different prices to different sets of customers according to

differences in price elasticity is called price discrimination.

5) Proportion of income spent on the product

a) The greater the proportion of the income spent on a product, the greater the price
elasticity of demand will be and vice versa.

b) Low price elasticity could also be explained by the lack of substitutes, the degree of
complementarity and type of want that is satisfied.

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 i) Look at price of cars (which takes a large proportion of income) is fairly elastic since
consumer will purchase something else should the price increase.

6) Definition of the product

a) The broader the definition of the product, the smaller the measured price elasticity of
demand will tend to be.

i) This is a result of the lack of substitutes due to the broad definitions.

ii) Food is relative inelastic. Price elasticity of demand of a specific car brand will tend
to be more elastic than cars in general.

7) Advertising

a) Price elasticity of demand for a particular brand will be greater than the price
elasticity of the product. The reason is that one brand may be substituted by another

b) Therefore the suppliers try to convince consumers that their particular product has
no real substitutes to such an extent that price elasticity becomes zero (which is rarely
the case)

8) Durability:

a) The more durable the product, the more elastic the demand will be.

b) If price of washing machines increase, the consumer may decide to keep their existing
washing machine for a longer period of time than they originally intended.

c) Non-durable goods like cleaning materials tend to have a more inelastic demand
curve.

9) Number of uses of the product:

a) The greater the number of uses of a particular product, the greater the price elasticity
of demand.

b) The argument is that there are more substitutes available. E.g. a rise in electricity
prices may cause consumers to switch to other means of cooking

10) Addiction:

a) Products that are addictive tend to be inelastic of demand. For consumers who are
totally addicted, the demand may be perfectly inelastic.

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 Elasticity and slope:
The only valid graphical comparison of price elasticity of
demand to compare two demand curves for the same
product at the point where they intersect. This is since; the
p/q is constant for both curves at that given point. The
more elastic curve is the graph with the smaller slope (or
when the inverse of the slope is greatest.
 Another reason why we cannot check elasticity of
different products ON THE SAME GRAPH is that
there are different measurements

(vii) Combined effect of determinants

1) In many cases, various determinants counteract each other and the final result is
therefore uncertain.

Section I.3 Income elasticity of demand

1) Normal goods have a positive

income elasticity since an increase
in income leads to increase in
quantity demanded. Vice versa for
inferior goods.

2) Normal goods are further

classified into 2 categories:

a)
If ey (income elasticity of demand)
is greater than one (ey >1); then
the good is a luxury good. This
means that when the percentage change in quantity demanded is greater than the
percentage change in income.

b) If 0<ey <1 then it is a necessity (or essential good)

3) Low income elasticity of demand of basic foodstuffs is one of the reasons why
developing countries which export agricultural products fared relatively badly
during post-world war 2 economic boom

a) Since consumer income increased by quantity did not increase to the same extent.

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Section I.4 Cross elasticity of demand
1) It measures the responsiveness of the quantity demanded of a particular good to
changes in price of a related good.

2) When two products are unrelated

then cross elasticity (ec=0) will be
zero

3) For substitutes, cross elasticity is

positive since an increase in price
of substitutes will cause increase
in demand of the other product.

4) For complements, an increase in

price of one good will lead to a
decrease in quantity purchased of
the other good.

Section I.5 Price elasticity of supply

1) It measures the responsiveness of the quantity supplied of a product to changes in
price.

2) It is always positive since an increase in price will lead to an increase in quantity

supplied by the producer

(ii) Different categories of

supply elasticity

1) If supply curve passes through origin then P=aQ. a = P/Q

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