LECTURE OUTLINES

Chapter 5:
Elasticity
Slides integrated by Mariana Moses
 Outline

• Definition of Elasticity
• Different types of elasticity
– 1. Price elasticity of demand
• Calculating the price elasticity of demand:
at a point – point elasticity; or between two points –
arc or midpoint elasticity
• Price elasticity of demand and revenue
– 2. Income elasticity of demand
– 3. Cross elasticity of demand
– 4. Price elasticity of supply

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 A general definition of elasticity

• Elasticity – a measure of responsiveness or

sensitivity

• Elasticity coefficient – the percentage change

in a dependent variable if the relevant
independent variable changes by one per cent

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 Elasticity

Elasticity = % change in dependent variable

% change in independent variable

Examples…
DV= Size of maize crop, IV= Rainfall
DV=Investment, IV= Interest Rate
DV=Qd of Rice, IV= Price of Rice
DV=Q of labour supplied, IV= Wage
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 Types of elasticity

• The price elasticity of demand

• The income elasticity of demand

• The cross elasticity of demand

• The price elasticity of supply

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 The price elasticity of demand

• The price elasticity of demand – the

percentage change in the quantity demanded if
the price of the product changes by one per
cent, ceteris paribus

– Shows how responsive quantity demanded is to

changes in price

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 • The impact of different demand elasticities on
the equilibrium price and quantity

Figure 5-1: The impact of different

demand elasticities on the
equilibrium price and quantity
(Textbook page 112)

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Important aspects and implications:
• Units do not affect the result

• Can compare different goods and services

• Consider the absolute value

Two formulas:
• Point elasticity (use for small price changes)

• Arc elasticity (use for larger price fluctuations)

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 Elasticity

• Important – it uses percentage changes and not

units, i.e. relative changes, not absolute.
• Absolute – price expressed in monetary terms
(rands, pounds, euros), quantity expressed in
terms of physical units (kilos, boxes, bags).

• Price elasticity of demand is the ratio of the

percentage change in quantity demanded to the
percentage change in price – this ratio is called
the ELASTICITY COEFFICIENT. 10
 Elasticity

• ELASTICITY COEFFICIENT shows how people

react to changes in prices of different goods and
services.
• Because it is in percentage terms, we can
compare them to each other.

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 Elasticity

• E.g. because we use percentage changes, we

can compare how people react to price changes
of meat, bread, petrol, cars, pens….etc.
• Would not be possible if used ‘absolute numbers’
e.g. a R1 change in price of these products would
have very different effects on the quantity
demanded.
• Can compare a 1 per cent change in the price
of the product.
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 Elasticity

• E.g. Consider two products; cars and bread.

• If the price of cars and bread increased by R1,
the effect on quantity demanded would be very
different.
• Because the price of a car of approximately
R100,000 is far greater compared to the price of
a bread that is under R10.
• Percentage change in car price would be <1%,
percentage change in price of bread (R10 each)
would be 10%.
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 Elasticity

• Different types of elasticity

– 1. Price elasticity of demand
– Calculating the price elasticity of demand
(at a point – point elasticity)

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 Calculating the price elasticity of
demand
• Price elasticity of demand (ep) =
% change in quantity demanded of a product
% change in the price of the product
• ep = ∆Q/Q x100 (can cancel out the 100s)
∆P/P x 100

= ∆Q/Q
∆P/P

= ∆Q/Q x P/∆P

ep = ∆Q/∆P x P/Q

(elasticity at a POINT)
(Derive this for yourself to check if you fully understand how we got to this final equation!!!!) 15
Calculating the price elasticity of
demand

• The slope of the linear demand curve

= ∆P/ ∆Q
• So the one part of the equation is ∆Q/ ∆P which
is the inverse of the slope of the linear
demand curve.
• Second part of the equation is P/Q which is the
ratio of price to quantity at any point on the
line (therefore known as POINT
ELASTICITY… ELASTICITY AT A POINT).

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Calculating the price elasticity of
demand

• Since the ratio is

different at any point
on the demand curve,
the price elasticity of
demand will be
different at any point
on the curve, since the
slope (or inverse of the
slope) is constant.

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 Calculating the price elasticity of
demand
• Calculating elasticity
coefficient
• ep = ∆Q/∆P x P/Q
• ∆Q/∆P is fixed = - 20/10
=-2

• At A, ep = ∆Q/∆P x P/Q
= -2 x 10/0
(anything divided by 0 … infinity)
= -2 x ∞
=∞ 18
 Calculating the price elasticity of
demand
• As we move downward and to
the right, the elasticity
coefficient falls.

• In the middle of the line, the

elasticity coefficient = -1
At C …- 2 x 5/10= - 2 x ½ = -1
• To the left of this, the coefficient
is greater than (-)1 and to the
right the coefficient is less than
(-)1.

• At E… ep = -2 x 0/20
(zero divided by anything is zero)
= -2 x 0
=0 19
Calculating the price elasticity of
demand

• Although this is technically correct, in

practice only a part of the demand curves
are encountered; it’s unlikely you’ll ever
find the situation prices fall to zero or rises
so high that quantity demanded is zero .

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 Calculating the price elasticity of
demand
Example

Section between:
A. P1=48,Q1=2 and B. P2=36,Q2=4.

Using our formula now, calculate.

ep = ∆Q/∆P x P/Q
∆Q/∆P = - 2/12 = -1/6
P/Q = ?? Which point do we use?
1. -1/6 x 48/2 = -4
2. -1/6 x 36/4 = -1½

Two different answers for the same

question… the answer will depend on the
direction of the change -- to calculate
elasticity of this section of the demand curve.

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Calculating the price elasticity of
demand

• The answer depends on which point we

use as a basis for calculation.

• How can we ensure that the answer is

independent of the starting point??

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 Calculating the price
elasticity of demand

• How do we ensure that the answer is

independent of the starting point
– use an average of the two points

• The elasticity coefficient calculated by

comparing two points on a demand curve
is called ARC ELASTICITY

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Calculating the price elasticity of
demand

• ep = ∆Q/∆P x P/Q is the point elasticity

formula.
• Instead of just using P and Q values,
now use the average of the two P and
Q value that is being looked at.
• ep = ∆Q/∆P x AveP/AveQ

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 Calculating the price
elasticity of demand
Example

1. P1=10,Q1=17 and 2. P2=8,Q2=19

ep = (Q2-Q1)/[(Q1+Q2)/2]
(P2-P1)/[(P1+P2)/2]

= 2/[(17+19)/2]
-2/ [(10+8)/2]

= 2/(36/2)
-2/(18/2)

= 2/18 x -9/2

= -1/2
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 Price elasticity of demand and
total revenue

• Can determine by how much total expenditure by

consumers on a product changes (as a result of the
change in quantity demanded) when the price of the
product changes.
• This is probably the most important reason why e.g.
business people or policy makers are interested in
information concerning the price elasticity of demand.

• Remember -
Total expenditure by consumers on a product
equals total revenue of firms for that product.
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• The price elasticity of demand can be used to
determine by how much the total expenditure by
consumers on a product changes when the price
of the product changes

 Price elasticity of demand > 1

TR increases as Q increases

 Price elasticity of demand = 1

TR reaches a maximum

 Price elasticity of demand < 1

TR falls as Q increases
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Figure 5-2: The relationship between price elasticity of demand and total
revenue (Textbook page 116)

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Different categories of price elasticity of
demand:
• Perfectly inelastic demand (ep = 0) Only consider
the absolute
• Inelastic demand (0 < ep < 1) value of the
elasticity
• Unitary elastic demand (ep = 1) coefficient
when
• Elastic demand (1 < ep < ∞) identifying the
categories of
price elasticity
• Perfectly elastic demand (ep = ∞)
of demand.

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Table 5-2: Price elasticity of demand: a summary (Textbook page 117)

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 Figure 5-3: The different categories of price elasticity of demand
(Textbook page 118)

• Price has no effect Qd.

• Qd is independent of price.
• Consumers plan to
purchase a fixed amount of
the good irrespective of the
price.
• ep = 0.
• Vertical line parallel to the
price axis.

Types of goods
• Insulin, very addictive
substances.

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• Qd responds to price
change but not greatly.
• % ∆ P > % ∆ Qd.
• 10% increase in P, 2%
decrease in Qd.
• 10 % > 2%.

• Elasticity coefficient:
0 < eP < 1.

Types of Goods:
• Examples, necessities: food,
housing, electricity, health
care, education, petrol.

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• % ∆ P = % ∆ Qd
• Price decreases
by 10% then Qd
increases by 10%
• Elasticity
coefficient:
ep = 1

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• Elastic: Highly responsive
• When price changes; Qd
responds greater than the
change in price
• P increase by 10%, Qd
decreases by 15%
• 15 % > 10%
• % ∆ Qd > % ∆ P
• 1 < ep < ∞

Types of goods:
• Examples, luxury goods :
Cars, CDs, magazines, fast foods.

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• Perfectly responsive.
• Consumers are willing to
purchase any quantity at a
certain price, but if the price
changes up only slightly the
Qd falls to zero.
• Elasticity coefficient: ∞
• Horizontal demand curve.

• Example, two vending

machines side by side. If the
price of goods are the same,
people buy from any. If the
price of one machine’s goods
is higher than the other, only
buy from the cheaper one.

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Determinants of the price elasticity of
demand:
• Substitution possibilities
• The degree of complementarity of the product
• The type of want satisfied by the product
• The time period under consideration
• The proportion of income spent on the product
• The definition of the product
• Advertising
• Durability
• The number of uses for the product
• Addiction

The combined effect of the determinants

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 Determinants of Price
Elasticity of Demand
1. Substitution Possibilities

• If there is a larger number of close substitutes; demand is ELASTIC.

• ↑Price – leads to Substitution Effect – Consumers switch to
relatively cheaper substitute goods.
• Example, if the price of train tickets go up, substitute by now taking a
taxi. The easier it is to swap, the more elastic the demand for train
tickets are.

• The broader the product, the less substitution possibilities

there are – and the less price elastic it becomes; e.g. meat and beef
or branded products like Colgate and Aquafresh vs toothpaste and
Colgate

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 Determinants of Price
Elasticity of Demand
2. Degree of complementarity

• With highly complementary goods, the price

elasticity of demand tends to be low – demand is
INELASTIC.
• Example, cars and tyres, petrol and cars, CDs and
CD players.
• Often argued that it is the lack of substitute rather
than the complementarity that is responsible for
the inelasticity of the product.
• You also have to consider the other product.
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 Determinants of Price
Elasticity of Demand
3. Type of Want Satisfied By The Product

• Necessities (e.g. basic food stuffs, medical

care, petrol, electricity) are inelastic – they don’t
respond much to changes in price.

• Luxuries (e.g. swimming pools, entertainment)

are elastic – they can respond to changes in
price.
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 Determinants of Price
Elasticity of Demand
4. Time period under consideration
• Demand tends to be more price elastic in the long
run than in the short run, ceteris paribus.
• More time to respond.
• Example, with the increase in price of crude oil in the
1970s, people could do little in the short term. But in the
longer term could, for example, develop fuel efficient cars
to decrease the demand for petrol.

• Also products that last longer (more durable) tend to be

more elastic since they can be used again – e.g. can put
off buying new products for longer period if the price of
the product has increased.
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 Determinants of Price
Elasticity of Demand
5. The proportion of income spent on the product
• It is argued that the greater the proportion of
income spent on the product, the greater the price
elasticity of demand.
• For example, changes in prices of products like salt or
matches may not change the quantity demanded of
these products much, because they only constitute a
small proportion of the consumers’ income. But goods
such as rent or insurance payments that take up a
larger proportion of income may be more elastic.

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 Determinants of Price
Elasticity of Demand
• Other:
• Number of uses for the product – the more
uses (e.g. electricity for heating, lighting, cooking)
– the more price elastic the product; can always
eliminate some of the uses.
• Addiction – very addictive products will have low
price elasticities (inelastic). For completely
addicted consumers it may be perfectly price
inelastic.
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 Income elasticity of demand

• The income elasticity of demand – measures

the responsiveness of the quantity demanded to
changes in income
0 < ey < 1
normal good, essential good
1 < ey
normal good, luxury good

ey < 0
inferior good
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 Cross elasticity of demand
• Cross elasticity of demand – measures the
responsiveness of the quantity demanded for a
particular good when the price of another good
changes
0 < ec
substitutes
ec < 0
complements
ec = 0
unrelated goods 45
 The price elasticity of supply

• Price elasticity of supply – the ratio between

the percentage change in the quantity supplied
of a product and the percentage change in the
price of the product

• By how much will the quantity supplied change if

the price changes by one per cent?

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Different categories of price elasticity of
supply:

• Perfectly inelastic supply (es = 0)

• Inelastic supply (0 < es < 1)

• Unitary elastic supply (es = 1)

• Elastic supply (1 < es < ∞)

• Perfectly elastic supply (es = ∞)

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Figure 5-4: The different categories of price elasticity of supply
(Textbook page 128)

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Determinants of the price elasticity of
supply:
• Time

• Expectations

• Stockpiling

• Excess capacity

• Availability of inputs

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 Price elasticity of supply
Determinants of price elasticity of supply
1. Time that elapsed since price change –
Short run – inelastic… since suppliers don’t have sufficient time to respond to price
change
Long run – elastic… since suppliers have had the time to respond to price changes.

2. Price expectations – if expected price changes are seen as a longer term

phenomenon, suppliers will be more likely to adjust production.

3. Stockpiling or excess capacity –

The supply of products that can be stockpiled is more elastic than that of perishable
goods.
If suppliers have excess capacity they can respond much faster to changes e.g. price
increases.

4. Availability of inputs - If essential inputs are not available, firms cannot increase their
output in reaction to an increase in the price of a product -- if they can’t respond,
supply is inelastic.
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