Price Elasticity of Demand and Its Measurements

Peng Shen

October 13, 2021

Peng Shen Price Elasticity of Demand October 13, 2021 1 / 26

The Algebra of Supply and Demand

Recall from your high school mathematics knowledge, we can use algebraic
equations (or functions) to express the curves on a graph.
Therefore, we can use linear equations (or functions) of quantity
demanded (or quantity supplied) on price of the product (denote as P) to
describe the demand (or supply).
1 Demand equation (function): P = a + b · Q d
where b < 0 for most goods, and Q d is the quantity demanded.
2 Supply equation (function): P = c + d · Q s
where d > 0, and Qs is the quantity supplied.
3 Equilibrium condition: Q s = Q d = Q ∗ , and P = P ∗

Peng Shen Price Elasticity of Demand October 13, 2021 2 / 26

An example (from graph to equation) demand

Peng Shen Price Elasticity of Demand October 13, 2021 3 / 26

An example (from graph to equation) demand

Use the first 2 points in red: from the point (3, 2.5) to the point (4, 2)

Peng Shen Price Elasticity of Demand October 13, 2021 3 / 26

An example (from graph to equation) demand

Use the first 2 points in red: from the point (3, 2.5) to the point (4, 2)

P − 2.5 Qd − 3
=
2 − 2.5 4−3

Peng Shen Price Elasticity of Demand October 13, 2021 3 / 26

An example (from graph to equation) demand

Use the first 2 points in red: from the point (3, 2.5) to the point (4, 2)

P − 2.5 Qd − 3
=
2 − 2.5 4−3

Demand equation (function) is: P = − 12 Q d + 4

Peng Shen Price Elasticity of Demand October 13, 2021 3 / 26

An example (from graph to equation) supply

Peng Shen Price Elasticity of Demand October 13, 2021 4 / 26

An example (from graph to equation) supply

Use the first 2 points in red: from the point (6, 2) to the point (7, 2.5)

Peng Shen Price Elasticity of Demand October 13, 2021 4 / 26

An example (from graph to equation) supply

Use the first 2 points in red: from the point (6, 2) to the point (7, 2.5)

P −2 Qs − 6
=
2.5 − 2 7−6

Peng Shen Price Elasticity of Demand October 13, 2021 4 / 26

An example (from graph to equation) supply

Use the first 2 points in red: from the point (6, 2) to the point (7, 2.5)

P −2 Qs − 6
=
2.5 − 2 7−6

Supply equation (function) is: P = 12 Q s − 1

Peng Shen Price Elasticity of Demand October 13, 2021 4 / 26

An example (from graph to equation) equilibrium

Solve the system of two equations with Q s = Q d = Q ∗ , and P = P ∗ , so

1 1
P = Q − 1 , and P = − Q + 4 =⇒
2 2

Peng Shen Price Elasticity of Demand October 13, 2021 5 / 26

An example equilibrium (solve the equations)

Solve the above system of equations for the equilibrium quantity and price.

Equate the two functions and re-arrange items

1 1 1 1
Q−1 = − Q+4 =⇒ Q+ Q = 4+1
2 2 2 2

Peng Shen Price Elasticity of Demand October 13, 2021 6 / 26

An example equilibrium (solve the equations)

Solve the above system of equations for the equilibrium quantity and price.

Equate the two functions and re-arrange items

1 1 1 1
Q−1 = − Q+4 =⇒ Q+ Q = 4+1
2 2 2 2
So that the equilibrium quantity is Q ∗ = 5, plug this into supply function
(or demand function, whichever you like), we have (we use supply here)

Peng Shen Price Elasticity of Demand October 13, 2021 6 / 26

An example equilibrium (solve the equations)

Solve the above system of equations for the equilibrium quantity and price.

Equate the two functions and re-arrange items

1 1 1 1
Q−1 = − Q+4 =⇒ Q+ Q = 4+1
2 2 2 2
So that the equilibrium quantity is Q ∗ = 5, plug this into supply function
(or demand function, whichever you like), we have (we use supply here)

1
P∗ = ·5−1 =⇒ P ∗ = $1.5 , and Q ∗ = 5
2

Peng Shen Price Elasticity of Demand October 13, 2021 6 / 26

An Exercise

Solve for the equilibrium point for the following market:

Demand function: P = 16 − 2Q d
Supply function: P = 4 + 4Q s

Peng Shen Price Elasticity of Demand October 13, 2021 7 / 26

An Exercise

Solve for the equilibrium point for the following market:

Demand function: P = 16 − 2Q d
Supply function: P = 4 + 4Q s

16 − 2Q = 4 + 4Q =⇒ Q∗ = 2 =⇒
P ∗ = 16 − 2 · 2 = $12

Peng Shen Price Elasticity of Demand October 13, 2021 7 / 26

An Exercise

Solve for the equilibrium point for the following market:

Demand function: P = 16 − 2Q d
Supply function: P = 4 + 4Q s

16 − 2Q = 4 + 4Q =⇒ Q∗ = 2 =⇒
P ∗ = 16 − 2 · 2 = $12

So that the equilibrium point is (Q ∗ , P ∗ ) = (2, $12)

Peng Shen Price Elasticity of Demand October 13, 2021 7 / 26

Price elasticity of demand and supply

Recall that if the demand (resp. supply) curve is more “steep”, then the
consumers (resp. producers) will take more tax burden.
This is related to the responsiveness of the quantity demanded (resp.
supplied) to a change in price.

Peng Shen Price Elasticity of Demand October 13, 2021 8 / 26

Price elasticity of demand and supply

Recall that if the demand (resp. supply) curve is more “steep”, then the
consumers (resp. producers) will take more tax burden.
This is related to the responsiveness of the quantity demanded (resp.
supplied) to a change in price.

Price elasticity of demand (resp. supply): the responsiveness of the

quantity demanded (resp. supplied) to a change in price.

Peng Shen Price Elasticity of Demand October 13, 2021 8 / 26

Price elasticity of demand and supply

Recall that if the demand (resp. supply) curve is more “steep”, then the
consumers (resp. producers) will take more tax burden.
This is related to the responsiveness of the quantity demanded (resp.
supplied) to a change in price.

Price elasticity of demand (resp. supply): the responsiveness of the

quantity demanded (resp. supplied) to a change in price.
% change in quantity demanded (supplied)
Price elasticity of demand (supply ) = % change in price ,

∆Q d /Q d × 100%
εdp =
∆P/P × 100%

Peng Shen Price Elasticity of Demand October 13, 2021 8 / 26

Price elasticity of demand and supply

Recall that if the demand (resp. supply) curve is more “steep”, then the
consumers (resp. producers) will take more tax burden.
This is related to the responsiveness of the quantity demanded (resp.
supplied) to a change in price.

Price elasticity of demand (resp. supply): the responsiveness of the

quantity demanded (resp. supplied) to a change in price.
% change in quantity demanded (supplied)
Price elasticity of demand (supply ) = % change in price ,

∆Q d /Q d × 100% ∆Q d /Q d
εdp = = ,
∆P/P × 100% ∆P/P

Peng Shen Price Elasticity of Demand October 13, 2021 8 / 26

Price elasticity of demand and supply

Recall that if the demand (resp. supply) curve is more “steep”, then the
consumers (resp. producers) will take more tax burden.
This is related to the responsiveness of the quantity demanded (resp.
supplied) to a change in price.

Price elasticity of demand (resp. supply): the responsiveness of the

quantity demanded (resp. supplied) to a change in price.
% change in quantity demanded (supplied)
Price elasticity of demand (supply ) = % change in price ,

∆Q d /Q d × 100% ∆Q d /Q d ∆Q s /Q s
εdp = = , εsp =
∆P/P × 100% ∆P/P ∆P/P

Why do we use percentage change in quantity (resp. price) instead of

change in quantity (resp. price)?

Peng Shen Price Elasticity of Demand October 13, 2021 8 / 26

Why percentage change?

Here after, we will talk about the price elasticity of demand (i.e. εdp ) only

A → B.
If we use change in quantity over
change in price...
When the unit of price is
8−4
dollar: 16−18 = −2.
Figure 1: Demand curve of apple When the unit of price is cent:
8−4
1600−1800 = −0.02.

Price Quantity The value is sensitive to the unit of

A 18 4 measure. It is difficult to compare
B 16 8 the responsiveness.

Peng Shen Price Elasticity of Demand October 13, 2021 9 / 26

Midpoint formula

And, here after, we will use an “unconventional” method to calculate

percentage change, i.e., the midpoint formula.

(Q −Q ) d d
Percentage change in quantity: ∆Q d % =  2d d1 × 100%
Q +Q
2 1
2

(P2 −P1 )
Percentage change in price: ∆P% = P2 +P1

× 100%
2

Price elasticity of demand (midpoint formula):

∆Q d % (Q d − Q d ) (P2 − P1 ) ∆Q d ∆P
dp = =  2 d d 1 ÷   = ÷
∆P% Q2 +Q1 P2 +P1 Q2 + Q1d
d P2 + P1
2 2

Peng Shen Price Elasticity of Demand October 13, 2021 10 / 26

Why use midpoint?

Why do we use the midpoint?

Price Quantity
A 18 4
B 16 8

If we use the conventional way to

calculate percentage change...
Figure 2: Demand curve of apple 8−4 16−18
A → B: 4 ÷ 18 = −9.
4−8 18−16
B → A: 8 ÷ 16 = −4.

The two cases gives different values.

To ensure that we have only one value of the price elasticity of demand
between the same two points on a demand curve, we use the midpoint
formula.

Peng Shen Price Elasticity of Demand October 13, 2021 11 / 26

Apply the midpoint formula

Percentage change in quantity

demanded: (8−4) × 100% ≈ 66.67%
( 8+4
2 )

Percentage change in price:

(16−18)
Figure 3: Demand curve of apple × 100% ≈ −11.76%
( 16+18
2 )

Price Quantity
A 18 4 The price elasticity between point A
66.67%
B 16 8 and point B is −11.76% ≈ −5.67

Peng Shen Price Elasticity of Demand October 13, 2021 12 / 26

Apply the midpoint formula

There is no need to write the

percentage change in percent. It is
enough to write it in decimal.
And no need to calculate exactly
the midpoint, just use the sum. So
dp between point A and point B is

8 − 4 16 − 18 0.3333 Figure 4: Demand curve of apple

÷ ≈ ≈ −5.67
8 + 4 16 + 18 −0.0588
And further, we can rewrite the price elasticity as below

∆Q d ∆P ∆Q d P2 + P1
dp = d d
÷ = d d
×
Q2 + Q1 P2 + P1 Q2 + Q1 ∆P

Peng Shen Price Elasticity of Demand October 13, 2021 13 / 26

Connect Elasticity with Slope

For Demand Curve given by: P = a + b · Q d , we have Slope = b

∆Q d P2 + P1
dp = d d
×
Q2 + Q1 ∆P

P2 + P1 ∆Q d
dp = ×
Q2d + Q1d ∆P

Figure 5: Demand curve of apple

Peng Shen Price Elasticity of Demand October 13, 2021 14 / 26

Connect Elasticity with Slope

For Demand Curve given by: P = a + b · Q d , we have Slope = b

∆Q d P2 + P1
dp = d d
×
Q2 + Q1 ∆P

P2 + P1 ∆Q d
dp = ×
Q2d + Q1d ∆P

P2 + P1 1
dp = ×
Q2d + Q1d Slope
Figure 5: Demand curve of apple
P2 + P1 1
= d d
×
Q2 + Q1 b

Peng Shen Price Elasticity of Demand October 13, 2021 14 / 26

Compare elasticity

Price elasticity of demand is always negative.

Law of demand:
price ↓, quantity demanded ↑
price ↑, quantity demanded ↓

We compare elasticities by comparing their absolute value.

Although -3 is actually a smaller number than -2, we say that a price
elasticity of -3 is larger than a price elasticity of -2.

Peng Shen Price Elasticity of Demand October 13, 2021 15 / 26

Elastic, Unit elastic, and inelastic
The demand between point A and B is
Elastic: the percentage change in quantity demanded is greater than the
percentage change in price, so the elasticity is greater than -1 (e.g. -2).
Unit elastic: the percentage change in quantity demanded is equal to the
percentage change in price, so the elasticity is equal to -1.
Inelastic: the percentage change in quantity demanded is less than the
percentage change in price, so the elasticity is smaller than -1 (e.g. -0.5).

Figure 6: Here we drop the minus sign in front of the Price Elasticity of Demand

Peng Shen Price Elasticity of Demand October 13, 2021 16 / 26

Price elasticity along a demand curve

The price elasticity

between point A and point B is

−5.67.

between point C and point D is

Figure 7: Demand curve of apple −1.
Price Quantity between point E and point F is
A 18 4
−0.18.
B 16 8
C 11 18
D 9 22
E 4 32
F 2 36

Peng Shen Price Elasticity of Demand October 13, 2021 17 / 26

Price elasticity along a demand curve

The price elasticity

between point A and point B is

−5.67.

between point C and point D is

Figure 7: Demand curve of apple −1.
Price Quantity between point E and point F is
A 18 4
−0.18.
B 16 8
C 11 18
D 9 22 As we move down along the
E 4 32 demand curve, the demand changes
F 2 36 from being elastic to being inelastic.

Peng Shen Price Elasticity of Demand October 13, 2021 17 / 26

Elasticity of two demand curves
If two demand curves intersect, on the intervals close to the intersection,
the flatter demand curve is more elastic.

Price elasticity of D1 between A and B is -1.6.

Price elasticity of D2 between A and C is -0.3.
Peng Shen Price Elasticity of Demand October 13, 2021 18 / 26
Two extreme cases

Perfectly elastic: Perfectly inelastic:

price elasticity = 0
price elasticity = infinity

Peng Shen Price Elasticity of Demand October 13, 2021 19 / 26

Price elasticity of demand

Figure 8: Perfectly elastic Figure 9: Elastic Figure 10: Unit elastic

Figure 11: Inelastic Figure 12: Perfectly inelastic

Peng Shen Price Elasticity of Demand October 13, 2021 20 / 26

Total expenditure and total revenue
When price ↑, total expenditure can ↑, or ↓, or remain the same
the change in expenditure depends on elasticity

Peng Shen Price Elasticity of Demand October 13, 2021 21 / 26

Total expenditure and total revenue
When price ↑, total expenditure can ↑, or ↓, or remain the same
the change in expenditure depends on elasticity

Terminology: Total Expenditure = Total Revenue = P × Q

Total revenue: amount of money a firm receives from selling a good or
service, calculated by price times the number of units sold (P × Q).

Peng Shen Price Elasticity of Demand October 13, 2021 21 / 26

Price elasticity of demand and total expenditure
Effect of a price cut on total expenditure, or equivalently, total revenue
two parts of the effect: a. price per unit ↓, b. number of units sold ↑

Figure 13: Price elasticity: -0.46, total

expenditure (or revenue) decreases Figure 14: Price elasticity: -1.73, total
expenditure (or revenue) increases

Peng Shen Price Elasticity of Demand October 13, 2021 22 / 26

Price elasticity of demand and total expenditure

If demand is elastic (|| > 1), then changes in quantity demanded is

greater than changes in price; and if demand is inelastic (|| < 1), then
changes in quantity demanded is smaller than changes in price.

Figure 15: Elasticity, Price Change, and Expenditure

Peng Shen Price Elasticity of Demand October 13, 2021 23 / 26

Price elasticity of demand and total expenditure

Why are price elasticity and total expenditure (or total revenue) related?

Percentage change in quantity demanded

Price elasticity of demand =
Percentage change in price
If it is greater than -1, in a price cut, the quantity demanded goes up by a
higher percentage than price, raising the expenditure (or revenue).

Peng Shen Price Elasticity of Demand October 13, 2021 24 / 26

Price elasticity of demand and total expenditure

Why are price elasticity and total expenditure (or total revenue) related?

Percentage change in quantity demanded

Price elasticity of demand =
Percentage change in price
If it is greater than -1, in a price cut, the quantity demanded goes up by a
higher percentage than price, raising the expenditure (or revenue).

Effect of a price cut on expenditure depends on price elasticity of demand

if demand is elastic, expenditure (or revenue) increases
if demand is unit elastic, expenditure (or revenue) does not change
if demand is inelastic, expenditure (or revenue) decreases

Peng Shen Price Elasticity of Demand October 13, 2021 24 / 26

Total revenue

Previously we learned about perfectly competitive market. In a perfectly

competitive market, firms are price takers.
Here, let’s consider a firm that
chooses a price
sells each unit of product at almost no cost
Example: Amazon’s digital book

Peng Shen Price Elasticity of Demand October 13, 2021 25 / 26

Total revenue

Previously we learned about perfectly competitive market. In a perfectly

competitive market, firms are price takers.
Here, let’s consider a firm that
chooses a price
sells each unit of product at almost no cost
Example: Amazon’s digital book
The firm wants to maximize its profits (total revenue - total cost). Since
the total cost is zero, it is the same as maximizing the total revenue.
You will learn more about producer’s theory later.

Peng Shen Price Elasticity of Demand October 13, 2021 25 / 26

Price elasticity of demand and total revenue

On a straight line demand curve

shown in the left figure. As quantity
demanded increases, the elasticity
decreases (from > 1 to < 1).

Peng Shen Price Elasticity of Demand October 13, 2021 26 / 26

Price elasticity of demand and total revenue

On a straight line demand curve

shown in the left figure. As quantity
demanded increases, the elasticity
decreases (from > 1 to < 1).

Hence, as the quantity demanded

increases, the total revenue first
increases, then decreases.

Peng Shen Price Elasticity of Demand October 13, 2021 26 / 26

Price elasticity of demand and total revenue

On a straight line demand curve

shown in the left figure. As quantity
demanded increases, the elasticity
decreases (from > 1 to < 1).

Hence, as the quantity demanded

increases, the total revenue first
increases, then decreases.

The maximizing point is at which

the price elasticity of demand is
equal to 1 (unit elastic).

Peng Shen Price Elasticity of Demand October 13, 2021 26 / 26