ECO101: Introduction to

Microeconomics
Lectures 6-7
Elasticity
• Analyzes how much buyers and sellers respond to
changes in a market
• For some goods, when price changes, quantity demanded
changes drastically
• For others, when price changes, quantity demanded
barely changes
• Can you think of some examples?
 Price Elasticity of Demand

Price
• Law of demand: when price of a good/service rises,
there is a decrease in the quantity demanded for the
good/service (direction: inverse relationship)
30
• By how much does the quantity demanded decrease
(magnitude)? 25

• This depends on the responsiveness/elasticity of the

quantity demanded to a change in price.
D1

150 200 Quantity

Price Elasticity of Demand

Price
Price

Slope of the demand curve is an

indication of the degree of
responsiveness

Quantity Quantity

Slope of Demand Curve: Steep Slope of Demand Curve: Flat

If price changes, quantity demanded If price changes, quantity demanded
barely changes changes by a lot
A case of inelastic demand A case of highly elastic demand
Price Elasticity of Demand
 Price elasticity of demand is a units-free measure of the responsiveness of the quantity demanded
of a good to a change in its price, all other things remaining the same.

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 Δ𝑄/𝑄𝐴𝑉𝐸

𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑡𝑖𝑐𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 (ε) = =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 Δ𝑃/𝑃𝐴𝑉𝐸

 Epsilon (ε) is used to represent price elasticity of demand.

 We express the changes in price and quantity as percentages of the average price and average
quantity. By using the average price and average quantity, we calculate the elasticity at a point on
the demand curve midway between the original point and the new point. This means we get the
same elasticity regardless of whether price falls from P1 to P2 or rises from P2 to P1.
 Since price and quantity demanded have an inverse relationship, the PED is always a negative
number. Since we are only interested in the magnitude of the PED, we ignore the minus sign.
Calculating PED
Calculate the PED for smoothies when price falls
from £3.10 per smoothie to £2.90 per smoothie
and quantity demanded rises from 9 to 11
smoothies an hour.

%Δ𝑄 Δ𝑄/𝑄𝐴𝑉𝐸
PED = =
%Δ𝑃 Δ𝑃/𝑃𝐴𝑉𝐸
2/10
=
0.20/3.00
=3
 Different types of demand curves
1. PED = 0 : Perfectly Inelastic Demand
If quantity demanded remains unchanged when the price changes, the good is said to have a perfectly
inelastic demand.
e.g. insulin (essential goods)

2. PED = - 1 : Unit Elastic Demand

If the percentage change in the quantity demanded equals the percentage change in price, the good is
said to have a unit elastic demand.

3. 0 > PED > - 1 : Inelastic Demand

Quantity demanded does not respond strongly to changes in price so the percentage change in quantity
demanded is less than the percentage change in price.
e.g. food and housing
Different types of demand curves
4. PED < - 1 : Elastic Demand
Quantity demanded responds strongly to changes in price so the percentage
change in quantity demanded is greater than the percentage change in
price.
e.g. cars and furniture

5. PED = - ∞ : Perfectly Elastic Demand

If the quantity demanded changes by an infinitely large percentage in
response to a tiny price change, the good is said to have a perfectly inelastic
demand.
e.g. brands of cereal (goods that have perfect substitutes)
Different types of demand curves
Factors influencing Price Elasticity of Demand

1. The closeness of substitutes

The closer the substitutes for a good/service, the more elastic the
demand for it.
Necessities such as food and insulin have poor alternatives and thus
have an inelastic demand. Luxurious goods such as cars and vacations
have an elastic demand.

2. Proportion of income spent on the good

Other things remaining the same, the greater the proportion of
income spent on a good, the more elastic is the demand for it.
For goods that use up a large proportion of our income and budget, a
small price change can make them unaffordable e.g. housing rent
Factors influencing Price Elasticity of Demand

3. The time elapsed since a price change

The longer the time that has elapsed since a price change, the
more elastic is demand. The more time consumers have to adjust
to a price change, the more elastic is the demand for that good.
Elasticity along a linear demand curve

Figure shows how the elasticity of demand

changes along a linear demand curve.
 Demand is unit elastic at the mid-point
of the demand curve i.e. elasticity = 1
 At prices above the mid-point, demand
is elastic
i.e. elasticity > 1
 At prices below the mid-point, demand
is inelastic
i.e. elasticity < 1
Why do firms care about PED?
 A rise in price causes quantity demanded to decrease ( law of demand)
 Does a rise in price cause total revenue earned by a firm to increase?
 Total Revenue = Price X Quantity Sold
 Change in revenue depends on the elasticity of demand

Suppose a hair stylist is considering increasing the price of haircuts from $25
to $35. At $25 per haircut, the stylist usually sells 15 haircuts in one day.
With the new price, she will end up losing a few clients – but will she still be
earning more?
Why do firms care about PED?
Change in total revenue due to a change in price depends on the elasticity
of demand
If demand is elastic, a 1 percent price increase reduces quantity demanded
(and thus the quantity sold) by more than 1 percent, and total revenue
decreases.
If demand is inelastic, a 1 percent price increase reduces quantity
demanded ( and thus the quantity sold) by less than 1 percent, and total
revenue increases.
If demand is unit elastic, a 1 percent price increase changes the quantity
sold by 1 percent and the revenue remains unchanged.
Why do firms care about PED?
Changes in total revenue as a rest of changes in price, when all other
influences on quantity sold remains unchanged, can be used to estimate the
price elasticity of demand – this is known as the total revenue test.

If the number of haircuts sold in a day decreases from 15 to 10 when the

hair stylist increases prices per haircut from $25 to $35, then the demand
for haircuts must be:
a. Elastic
b. Inelastic
Income Elasticity of Demand
If income increases, demand for some goods & services goes up. By how much?

Depends on income elasticity of demand

Income elasticity of demand is a measure of the responsiveness of the demand for a good
or service to a change in income, other things remaining the same.

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 Δ𝑄/𝑄𝐴𝑉𝐸

𝐼𝑛𝑐𝑜𝑚𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑡𝑖𝑐𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒 Δ𝐼/𝐼𝐴𝑉𝐸

If income elasticity of demand is positive: good is normal

If income elasticity of demand is negative: good is inferior
Income Elasticity of Demand
If normal goods have
Income elasticity of demand > 1: As income increases, the quantity demanded increases
faster than income i.e. luxury goods such as international travel, jewelry
Income elasticity of demand < 1: As income increases, the quantity demanded increases
slower than income i.e. necessity goods such as newspapers, clothing

As you get richer, you spend a larger proportion of your income on luxury goods and a
smaller proportion of your income on necessary goods.
Cross Elasticity of Demand
Cross price elasticity of demand is a measure of the responsiveness of the demand for a
good or service to a change in the price of a substitute or complement, other things
remaining the same.

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑋

𝐶𝑟𝑜𝑠𝑠 𝑒𝑙𝑎𝑠𝑡𝑖𝑡𝑖𝑐𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑌
Δ𝑄𝑋 /𝑄𝑋𝐴𝑉𝐸
=
Δ𝑃𝑌 /𝑃𝑌𝐴𝑉𝐸

If cross elasticity of demand is positive: goods are substitutes

If cross elasticity of demand is negative: good are complements
Cross Elasticity of Demand
The magnitude of cross elasticity of demand depends on the strength of the relationship between the
two goods.

In case of substitutes:
If XED > 1: high elasticity because the two goods are very close substitutes e.g. coke and pepsi
If XED < 1: low elasticity the two goods are weak substitutes e.g. burgers and pizzas

In case of complements:
If XED < - 1: high elasticity because the two goods are very close complements e.g. pencil and
sharpener
If XED > - 1: low elasticity because the two goods are weak complements e.g. tea and milk

If goods are unrelated: XED = 0 e.g. TVs and shirts

Price Elasticity of Supply
Price elasticity of supply is a measure of the responsiveness of the quantity supplied to a
change in the price of a good when all other influences on selling plans remain the same.

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑 Δ𝑄/𝑄𝐴𝑉𝐸

𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑡𝑖𝑐𝑦 𝑜𝑓 𝑠𝑢𝑝𝑝𝑙𝑦 = =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 Δ𝑃/𝑃𝐴𝑉𝐸

Since price and quantity supplied have a positive relationship (law of supply), the PES is
always a positive number.
Factors affecting PES

1. Resource Substitutability
If a good can only be produced by using rare or unique resources or resources that are not
easily available, it will have a low elasticity of supply i.e. the good will have a low
responsiveness to price changes.

2. Time frame
Goods that take a long time to produce have a very low price elasticity of supply. On the
other hand, goods that can be quickly and easily made have high elasticity of supply.
In the long run, supply is more elastic.
 Example
1. Good weather brings a bumper tomato crop. The price falls from £7 to £5
a load, and the quantity demanded increases from 300 to 500 loads a day.
Over this price range,
a. What is the price elasticity of demand?
b. Describe the demand for tomatoes.

2. Judy’s income has increased from £13,000 to £17,000. Judy increased her
demand for concert tickets by 15 per cent and decreased her demand for
bus rides by 10 per cent. Calculate Judy’s income elasticity of demand for
a. concert tickets
b. bus rides
 Example
3. A fall in the price of X from $12 to $8 causes an increase in the
quantity demanded of X from 500 to 700 units and quantity
demanded of Y from 900 to 1,100 units.
a. What is the cross elasticity of demand between X and Y?
b. What is the relationship between goods X and Y?
 Example
4. The demand function for an energy drink on an exam day is given by

𝑃 = 130 − 2𝑄𝑑

a. Assume you sell one litre of the drink at Tk 50. What is your total revenue earned?
b. Hoping to make more profits, you decide to increase the price to TK 60 per litre.
How does your total revenue change?
c. Over this price range, what is the PED for the energy drink?