Elasticity of Demand

Elasticity of demand measures the responsiveness of quantity demanded to changes in either price of the product or
income or price of another product. There are three main types of elasticity:
 Price elasticity of demand
 Income elasticity of demand
 Cross elasticity of demand

Price Elasticity of Demand (PED)

Price elasticity of demand is a measure of the responsiveness of quantity demanded to changes in price. More
specifically, it addresses the percentage change in quantity demanded for a given percentage change in price.

PED = % change in quantity demanded

% change in price

Ex: The price of a product increased from $100 to $115 resulting in a decrease in quantity demanded from 400 units to
300 units. Calculate PED.

The coefficient for PED is always negative because of the inverse relationship between price and quantity demanded. For
interpretation purposes the negative sign is ignored.

PED can take values between zero and infinity. A value less than one (PED<1) means that demand is price inelastic. A
change in price will lead to a less than proportionate change in quantity demanded. A value greater than one (PED>1)
means that demand is price elastic; a change in price will result in a more than proportionate change in quantity
demanded.

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Responses of PED
Coefficient Responsiveness of Quantity Terminology
of PED Demanded to a Change in
Price
PED = 0 Quantity demanded does Perfectly /
not change as price changes. Absolutely inelastic

0<PED<1 Quantity demanded changes Fairly inelastic

proportionately less than
price changes: %Qd < %P.

PED = 1 Quantity demanded changes Unitary elastic

proportionately to price
change: %Qd =%P.

1<PED<& Quantity demanded changes Fairly elastic

proportionately more than
price changes: %Qd > %P.

PED = & Quantity demanded is Perfectly elastic

extremely responsive to
even very small changes in
price

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Factors influencing Price Elasticity of Demand
 Whether Close Substitutes Are Available: The price elasticity of demand tends to be high if there are other goods
that consumers regard as similar and would willing to consume instead. The price elasticity of demand tends to be
low if there are no close substitutes.

 Whether the Good is a Necessity or a Luxury: The price elasticity of demand tends to be low if a good is something
you must have, like a life -saving medicine. The price elasticity of demand tends to be high if the good is a luxury—
something you can easily live without.

 Share of Income Spent on the Good: The price elasticity of demand tends to be low when spending on a good
account for a small share of a consumer’s income. In that case, a significant change in the price of the good has little
impact on how much the consumer spends. In contrast, when a good account for a significant share of a consumer’s
spending, the consumer is likely to be very responsive to a change in price. In this case, the price elasticity of
demand is high.

 Time: The price elasticity of demand tends to increase as consumers have more time to adjust to a price change.
This means that the long -run price elasticity of demand is often higher than the short run elasticity.

 Degree of addiction: The greater the degree of addiction for the product, the more inelastic demand will be.
Quantity demanded will be fairly unresponsive to changes in price. An example would be cigarette smoking. Changes
in the price of cigarette do not lead to significant change in its quantity demanded.

Uses of Price Elasticity of Demand

1. PED and Total Revenue
Total revenue is the amount of money received by firms when they sell a product. It is equal to the price (P) of the
product times the quantity (Q) of goods sold.
TR = P X Q
Changes in price will affect quantity demanded inversely. The impact on total revenue will depend on PED. The following
three possibilities may arise:
a) Elastic Demand (PED >1)

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 b) Inelastic demand (PED<1)

c) Unitary elastic demand (PED=1)

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The above can be summarized as follows:
 Elastic demand: price and total revenue change in opposite direction
 Inelastic demand: price and total revenue change in the same direction
 Unit elastic demand: as price changes, total revenue remains unchanged

Relationship between Quantity and Total Revenue

Fairly inelastic demand (0<PED<1)

Fairly elastic demand (1<PED<&)

Unitary Elastic Demand (PED =1)

Total Revenue and Perfectly Inelastic Demand Total Revenue and Perfectly Elastic Demand

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2. PED and Price Discrimination
Price discrimination occurs when firms charge distinct groups of buyers different prices for the same product. This can
occur because each group of buyers has a different PED for the product. Therefore firms can increase their revenue by
charging a higher price to those buyers whose demand for the product is inelastic and a lower price to those buyers
whose demand for the product is elastic.

3. PED and indirect taxes

Indirect taxes are taxes on goods and services. Governments must consider the PED for the products to be taxed if they
are interested in increasing tax revenues. The lower the PED for the product being taxed, the larger the tax revenues for
the government.

4. PED and Indirect Taxes burden

PED allows the firm to decide how much of an indirect tax to pass on consumers. Normally, when an indirect tax is
imposed on a product, its price does not increase by the full amount of the tax. This means that the burden of the tax is
shared between consumers and the producers. Producers will be able to pass a bigger burden of the indirect tax on
consumers the more inelastic demand for the product is. This is because the resulting decrease in quantity demanded
following the increase in price will be less than proportionate. Infact when demand is perfectly inelastic the whole
burden of the tax is passed onto consumers whereas when demand is perfectly elastic producers absorb the tax
completely.

Price Elasticity of demand along a straight line demand curve

Although the slope of a straight line demand curve has a
constant slope (gradient), the PED along the straight line
varies. Calculate the PEDs between the following points:
i) A ($10, 80 units) and B ($15, 70 units)

ii) C ($25, 50 units) and D ($30, 40 units)

iii) E ($40, 20 units) and F ($45, 10 units)

Hence it can be said that on any straight line demand

curve, there is an elastic portion of the curve at high prices
and low quantities and an inelastic portion at low prices
and high quantities. At the midpoint of the demand curve
there is unit elasticity of demand.
The relationship between the straight line demand curve
and total revenue is illustrated in the second diagram.
Along the elastic portion, as price falls, total revenue
increases whereas along the inelastic portion decreases in
price will result in a decrease in total revenue. Total
revenue is maximized when PED = 1.

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How can a firm alter its price elasticity of demand

Make it more inelastic Make it more elastic

- Advertising to change the mindset of people
about the product. A successful advertisng
campaign will make them believe that the
product is a necessity.
- Mergers with other firms to remove rivals from
the market. Number of substitutes will
decrease
- Advertising in order to show that the product
is a viable substitute for an existing product.
Objective is make a less competitive market
more competitive
- Introduction of a new brand in the market to
increase number of substitutes.

Income Elasticity of Demand

The income elasticity of demand is a measure of the responsiveness of demand to changes in income. It provides
information on the direction of change of demand, given a change in income, and on the magnitude of the change (by
how much the demand curve will shift).

YED = % change in demand

% change in income

EX: The income of a consumer increases from $100 to $150 resulting in an increase in demand from 200 units to 225
units. Calculate YED.

Interpreting the income elasticity of demand

The income elasticity of demand provides two kinds of important information:
 its sign (whether it is positive or negative)
 its numerical value: whether it is greater or smaller than one

The sign of the income elasticity of demand (normal good or inferior good)
 YED>0: The income elasticity of demand is positive (YED>O) when demand and income change in the same direction
(that is, both increase or both decrease). A positive YED indicates that the good in question is normal. Most goods
are normal goods.

 YED<0: A negative income elasticity of demand (YED<O) indicates that the good is inferior: demand for the good and
income move in opposite directions (as one increases the other decreases). Examples include bus rides, used clothes
and used cars; in these cases, as income increases, the demand for these goods fall as consumers switch to
consumption of normal goods (new cars, new clothes and so on).

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The value of the income elasticity of demand
 YED > 1: If a good has a YED that is greater than one, it is said to be income elastic. This means that a percentage
change in income will give rise to a larger percentage change in demand (in the formula for the YED, the
numerator is larger than the denominator). The good is also said to be a luxury product/superior good.

 YED < 1: If on the other hand a good has an YED that is less than one, it is said to be income inelastic: the percentage
change in income produces a smaller percentage change in demand (the numerator is smaller than the
denominator). Necessities such as food usually have YED<1.

 YED = 1: If a product has a YED equals to one, then an increase in income will lead to an equivalent percentage
increase in demand.

Special Case: YED = 0

If YED for a product is zero, then it means that a change in income will have no effect on the demand for the product.
Demand is said to be income absolutely inelastic.

Uses of Income Elasticity of Demand

Income elasticity of demand is an important concept to firms considering the future size of the market for their product.
If the product has a high income elasticity of demand, sales are likely to expand rapidly as national income rises, but may
also fall significantly if the economy moves into recession.

During rising income periods, demand for goods with YED>1 will increase significantly. Firms have all to gain by
expanding production of luxury products or joining such markets.

On the other hand, demand goods with 0<YED<1, such as food, will not increase significantly, but it can be expected that
demand for better quality of such goods will increase. So firms in such markets will have to move into the up market if
they want to increase revenue and profit.

However, during period of falling incomes, demand for inferior goods will rise whereas demand for normal goods will
fall. The opposite of the above will occur.

It should be noted that as income changes overtime, what are perceived to be superior, normal and inferior goods may
change. What was previously perceived to be a normal may now be considered as an inferior good. In addition,
technological advances may also affect how goods are perceived and so their income elasticity of demand. An example
would be black and white TV and colour TV.

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 Cross Elasticity of Demand
The cross-elasticity of demand is a measure of the responsiveness of the demand for one good (say X) to a change in the
price of another good (say Y). It provides us with information on the direction of change of demand (whether it increases
or decreases), and on the magnitude of the demand shift (by how much demand shifts).

XED = % change in demand for X

% change in price of Y

Ex: An increase in the price of good Y from $5 to $8 results in an increase in the demand for X from 100 units to 150
units. Calculate the XED for X.

Interpreting the cross-elasticity of demand

1. Positive XED: substitutes
The cross-elasticity of demand is positive (XED>O) when the change in the demand for the one good is in the same
direction as the change in the price of the other good, in other words, when the price of Y increases the demand for X
also increases; and when the price of Y falls, the demand for X also falls. This occurs when the two goods, X and Y, are
substitutes for each other.
The larger the value of the cross-elasticity of demand, the greater is the substitutability between two goods (strong
substitutes).

2. Negative XED: complements

The cross-elasticity of demand is negative (XED<O) when the demand for one good and the price of another good
change in opposite directions; this occurs when the two goods are complements. The larger the numerical value of the
negative cross-elasticity of demand, the greater is the complementarity between two goods (strong complements).

3. Zero XED: unrelated products

If the cross-elasticity of demand is zero (XED = 0) or close to zero, this means that two products are unrelated or
independent of each other. For example: potatoes and telephones are unrelated to each other: a change in the price of
one is unlikely to have an impact on demand for the other.

Uses of XED
Firms have to be aware of the extent to which their products have close substitutes. The existence of close substitutes
provides both a threat and a challenge for a firm. It has to be aware that raising its price may lose some of its customers.
It may, however, be able to attract customers away from rivals by lowering price. The closer the substitutes are, the
bigger will be the response to a change in price.

Knowledge about the existence of complements can help a firm to increase its revenue. A firm may offer one product at
a lower price if it is purchased with a more expensive complement. For example, a firm may seek to sell more TVs by
offering to sell a CD player at a reduced price with every TV purchased.

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Limitations of elasticity concepts
 Elasticity coefficients are calculated using past data meaning at the time the elasticity coefficients are being used,
they may no longer be relevant. There could have been changes in market conditions thus altering the present
elasticities.
 There may be irrelevancies or omissions in the data collected to compute elasticity. The data are not reliable
implying that the elasticity coefficients will not provide an accurate picture.
 Demand is affected by other factors apart from price, income and prices of related products. This means that
changes in demand different from those predicted by the elasticity concepts can occur because of changes in the
other factors affecting demand.

Price Elasticity of Supply

Price elasticity of supply refers to the responsiveness of supply to changes in the price level. The concept of price
elasticity of supply looks at how much supply will change as prices change.

PES =

The coefficient of PES will always be positive because of the direct relationship between price and quantity supplied.
The coefficient indicates the degree to which supply is responsive to changes in price. Coefficients below 1 are said to be
price inelastic supply and coefficients above 1 indicate supply is more price elastic.

Ex: Price of a product increased from $10 to $12 resulting in an increase in quantity supplied from 100 units to 110 units.
Calculate PES

Responses of PES
1. Absolutely or Perfectly inelastic (PES = 0): Supply is totally unresponsive to changes in price. Quantity supplied
remains constant whatever the price of the product.

2. Fairly inelastic (0<PES<1): Supply is relatively unresponsive to changes in price. A change in price leads to a smaller
proportionate change in quantity supplied. If price is increased by 10%, quantity supplied will increase by less that
10%.

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3. Fairly elastic (1<PES<α): Supply is relatively responsive to changes in price. A change in price will lead to a more than
proportionate change in quantity supplied. For example, if price is reduced by 25%, quantity supplied will decrease
by more than 25%.

4. Perfectly elastic (PES = α): Supply is totally responsive to changes in price. A change in price leads to an infinite
change in quantity supplied.

5. Unitary elastic (PES=1): A change in price leads to an equivalent percentage change in quantity supplied.

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 Factors influencing PES
1. Time lag in production: Time is a key factor in determining price elasticity of supply. If a producer sees prices rising in
the market they would ordinarily want to take advantage of this and sell more output. However, it may take time to
produce extra output and so in the short term they cannot meet the additional demand. Increases in the price of
wheat on the world market would see farmers wanting to respond, but it might take six months or a year until they
can harvest a new crop. The supply of many raw materials is often price inelastic because mining firms need to
explore and find new resources before they can increase supply. Even if they did know about reserves they might
need to dig new mines or drill new wells to exploit them, all of which takes time.

2. The availability of stocks or stock-piling: Firms that hold stock of finished goods are likely to have a more elastic
supply curve in the short term. When prices increase they are already in a position to increase supply. This is part of
the reason why firms will often keep stocks available so that they can react to unforeseen surges in demand

3. The ease of switching between alternative production: if firms can switch between production of different goods
relatively easily then it may be able to expand production of one product quite quickly should its price rise. Take a
textile manufacturer producing replica shirts! if one team’s shirt is selling very well and a shortage has driven up the
price, if the manufacturer makes a variety of different shirts for different teams they could switch production from
less popular teams and increase supply of the most popular shirts quickly.

4. The availability of spare capacity: firms with spare capacity have the capacity to expand output relatively quickly in
response to changes in the price. Firms at full capacity would find it very difficult to respond in the same way; they
would be unable to respond if prices rose.

5. The number of firms in the market and ease with which firms can enter a market: Supply is determined by all firms
in the market, if it is easy to enter a market then resources not currently involved in the supply of a particular good
might enter a market if they see prices rising and an opportunity to generate profits. If there are little or no barriers
to entry and exit from a market then it is likely that firms will move into a market swiftly, increasingly the supply
when prices in that market rise.

6. The ability to alter production methods might also be a factor influencing price elasticity of supply. If a firm can
transfer quickly to alternative methods of production, for example more capital intensive production, then the
supply curve will become more elastic.

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