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Academic Tutorials
•ELASTICITY
OF DEMAND

EC 115 NOTES

INTRODUCTION Concepts of Demand Elasticity

• So far we have studied the law of demand • There are basically three major
which states that there is an inverse
relationship between price per unit and types of demand elasticity:
quantity demanded. • Price elasticity of demand
• The concept of demand only tells us the
direction of the change in quantity demanded • Income elasticity of demand
and says nothing about the magnitude of
this change.
• Cross-price elasticity of
• It is Demand elasticity which explains not demand
only the direction but also the magnitude • Note: price elasticity is sometimes referred
of change in quantity demanded. to as elasticity of demand.

Part 1: Elasticity Of Demand Mathematically

• What is price elasticity of demand?
• 1. This is the responsiveness of quantity
demanded of a good to changes in its price,
given consumer income, tastes and price of all
other goods. • ep=(∆Q/Q)/(∆P/P)
• 2. The degree of responsiveness or sensitivity of
quantity demanded of a good to changes in its • This becomes:
price.
• 3. It is a measure of relative change in quantity
demanded or purchased of a good in response to
relative change in its price.
•ep = (∆Q/∆P) X (P/Q)
• 4. The proportionate change in quantity demanded
in response to a small change in the price divided
by a proportionate change in price.

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The meaning of Price

Interpretation: with minus sign
elasticity
• Mathematically speaking, price Elasticity Interpretation
elasticity is negative because the
change in quantity demanded is in Elasticity < -1 Elastic
opposite direction to change in price.
• However, it is sometimes helpful to Elasticity = -1 Unit elastic
ignore the minus sign in order to
make meaningful interpretations. Elasticity > -1 Inelastic

Interpretation: without minus sign Example

• 1. Suppose the price of a
Elasticity Interpretation commodity falls from k6 to k4 per
unit and due to this quantity
Elasticity < 1 Inelastic
demanded increases from 80 to
120 units. Find the price elasticity
Elasticity = 1 Unit elastic of demand using
• (a) the normal method
Elasticity > 1 Elastic • (b) the midpoint method

Price elasticity and total

solution
Expenditure/Revenue
• (a) elasticity = • It is always very important to
(120-80)/(4-6) x (6/80)= -1.5 know the effect of a change in
This means elastic demand. price on total revenue (PXQ)
• (b) elasticity= • This relationship can be
[(80-120)/100] / [(6-4)/5]= -1 summaries using price elasticity
This means unit elastic demand. of demand.

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Price elasticity and total Determinants of Price

expenditure Elasticity
• What are the factors which determine
Price elastic inelastic Unit whether the price elasticity of demand of a
good is elastic, unit elastic or inelastic?
change elastic • The main determinants are:
• 1. Availability of substitutes
Price falls Total Total Total
expenditure expenditure expenditure • 2. Single or group
increases decreases is constant • 3. Necessity or luxury
• 4. Proportion of income
Price rises Total Total Total • 5. Number of uses
expenditure expenditure expenditure
decreases increases is constant • 6. Complementarity between goods
• 7. Time for adjustment

1. Availability of Close
2. Single or Group
substitute
• A commodity without any close • The elasticity of demand for any
substitutes will have inelastic demand. particular brand (single) of any good
• This is because even though the price will be higher than the price elasticity
changes, consumers can not switch to
other goods due to lack of substitutes of all brands (group) together.
and hence will be forced to continue • This is closely linked to the availability
purchasing the same good. of substitutes: it is easier to substitute
• This means a large increase in price brands than goods.
will cause a very small decrease in
quantity demanded. • Example: BMW will have greater
• Example: the demand for common salt. elasticity than the Car industry.

3. Necessity or Luxury 4. Proportion of income

• Goods which are necessities have a • The proportion of consumer income
lower price elasticity as compared spent on a particular good also affects
to luxury goods. the elasticity of demand for it.
• This is because consumers can easily • The greater the proportion of consumer
do without luxury goods and can not income spent on a particular good the
do without necessities. higher the price elasticity.
• For example: the price of matches can
• For example, the price elasticity of
even double, but consumers may not
cars will be higher than that of food: even reduce quantity demanded because
e.g. Maize meal they spend a very small amount on it.

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6. Complementarity between
5. Number of uses
goods
• The greater the number of uses to which a • Complementary goods usually have inelastic
commodity can be put, the greater the price demand because they are not consumed
elasticity of demand. alone.
• When the price increases, the good will be • Consumers tend to focus on the price of
put to only the most important uses and
hence demand will fall. If price reduces the the main good they are consuming and not
demand will increase because the good will the complement good and hence react less to
now be put to some less important uses. changes in the price of the complement good.
• For example: milk will only be used to feed • For example, the demand for salt and car oil
babies if it becomes too expensive but can be are inelastic because they are complements
used for cakes, bread and general drinking if to food and fuel respectively.
it is too cheap.

Part 2: Cross-Price Elasticity

7. Time for Adjustment
of Demand
• Demand for almost all goods tends to be • Cross-price elasticity of demand is
more elastic the longer the time period the change in the quantity demanded
involved.
of a particular good as a result of a
• For example, if the price of fuel
change in the price of a related good
increased, the consumers will need some
time to make all adjustments by (complement or substitute)
switching to substitute goods. • Due to the fact that there are two
• The more time they are given, the less of types of related goods; we have two
fuel they will consume because they will kinds of cross-price elasticity.
discover alternative commodities.

Mathematically (a) For substitute goods

• Cross price elasticity for goods X and • The Cross price elasticity for substitute
goods is positive. This is because when
Y respectively is given by: the price of the substitute good falls the
consumers will reduce Quantity demand
• epx = (∆Qx/∆Py) X (Py/Qx) for the good in question in order to
purchase more of the substitute.
• When the price of the substitute
• epy = (∆Qy/∆Px) X (Px/Qy) increases, consumer demand will
increase because they will purchase less
of the substitute and more of the good in
question.

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(a) For complement goods Example

• The Cross price elasticity for complement • If the quantity demanded of Good X
goods is negative. This is because when
the price of the complement good falls falls from 120 units to 100 units
the consumers will increase Quantity due to a change in the price of good
demand for the good in question in order Y from k 500 to k 750.
to purchase more of the complement.
• When the price of the complement • (a) Calculate the cross price
increases, consumer demand will elasticity for good X.
reduce because they will purchase less
of the complement and less of the good • (b) Is good Y a complement or a
in question. substitute.

Part 3: Income Elasticity of

Solution
Demand
• This measures the degree of
• (a) epx = (∆Qx/∆Py) X (Py/Qx) responsiveness of quantity demanded
• Hence, for a particular good to changes in
consumer income.
• epx = (-20/250) X (500/120)= -0.33 • When the income of consumers
• (b) Since the cross price elasticity is increases, they increase the
negative, good Y is a complement consumption of normal goods and
good. reduce their consumption of inferior
goods.

Mathematically Interpretation
• Income elasticity of demand is given • Income elasticity of demand is positive
by: for normal goods. This is because when
income increase consumers demand
• eI= (∆Qx/∆I) X (I/Qx) more of normal goods like meat.
• Some books use M and not I. • Income elasticity of demand is negative
• It is the change in the quantity for inferior goods. This is because
consumers demand less of inferior goods
demanded of good X as a result of a
like ‘kapenta’ when their income is
change in consumer income.
increased.

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Example Solution
• Mr. Banda’s income was increased • (a) eI= (∆Qx/∆I) X (I/Qx)
from K 250,000 to K 700,000 and
because of this he decided to • eI= (-15/450000) X (250000/20)
reduce his purchase of good X = -0.41667
from 20 kg to only 5 Kg.
• (b) Good X is an inferior good
• (a) Calculate the income elasticity because of negative income
for good X elasticity. It is also not a griffin
• (b) What type of good is good X? good.

•The End!!