Elasticity

Microeconomics
17th July, 2019
Prof. Ashutosh Tripathi
Price Elasticity of Demand
• Price elasticity of demand measures the
percentage change in the quantity
demanded resulting from a 1-percent
change in price.

Q/Q Q / P
EP  
P/P Q/P
 Price Elasticity and
Consumer Expenditure

Demand If Price Increases, If Price Decreases,

Expenditures: Expenditures:

Inelastic (Ep <1) Increase Decrease

Unit Elastic (Ep = 1) Unchanged Unchanged

Elastic (Ep >1) Decrease Increase

Point Elasticity of Demand

– Point elasticity measures elasticity at a

point on the demand curve.
– Its formula is:

EP  (P/Q)(1/slope)
 Variation in Point Elasticity
over a Linear Demand Curve

e=∞

What is relation
between AR & MR
curves? How to e=1
draw MR curve?

e=0
 Elasticity, Total Revenue
and Linear Demand
P TR
100
Elastic Unit elastic
80 Unit elastic

60 1200
Inelastic
40

20 800

0 10 20 30 40 50 Q 0 10 20 30 40 50 Q

Elastic Inelastic
Demand, Marginal Revenue
(MR) and Elasticity
P • For a linear
100
Elastic
inverse demand
80 Unit elastic function, MR(Q)
60
= a + 2bQ, where
Inelastic b < 0.
40
• When
20 – MR > 0, demand is
elastic;
– MR = 0, demand is
0 10 20 40 50 Q unit elastic;
– MR < 0, demand is
MR inelastic.
 Factors Affecting
Own Price Elasticity
– Available Substitutes
• The more substitutes available for the good,
the more elastic the demand.
– Time
• Demand tends to be more inelastic in the short
term than in the long term.
• Time allows consumers to seek out available
substitutes.
– Expenditure Share
• Goods that comprise a small share of
consumer’s budgets tend to be more inelastic
than goods for which consumers spend a large
portion of their incomes.
Elastic vs. Inelastic Demand
Curves
 Problems Using Point
Elasticity

– We may need to calculate price

elasticity over portion of the demand
curve rather than at a single point.
– The price and quantity used as the base
will alter the price elasticity of demand
(point elasticity of demand is not
symmetric).
Arc Elasticity of Demand

– Arc elasticity calculates elasticity over

a range of prices
– Its formula is:

EP  ( Q/P)( P / Q)
P  the average price
Q  the average quantity
Income Elasticity of Demand
• Income elasticity of demand measures
the percentage change in the quantity
demanded resulting from a 1-percent
change in income.
– Its formula is:

Q I
EI  
I Q
Income Elasticity of Demand
and Type of Good

• Income Elasticity • Type of Good

– Positive – Normal Good

•0<e<1
• Necessity

•e>1
• Luxury

– Negative
– Inferior Good
 Cross-price Elasticity of
Demand
• Cross-price elasticity of demand
measures the percentage change in the
quantity demanded of good Y resulting
from a 1-percent change in price of good
X.
– Its formula is:

QY PX
EC  
PX QY
 Cross-Price Elasticity of
Demand and type of Good

• Cross-price • Type of good

Elasticity

– Positive – Substitutes

– Negative – Complements
 Food for thought
• Is long run supply elasticity always
higher? If not, why? What about
demand elasticity?
• Will a monopolist ever choose to
operate on a range of a demand curve
where e<=1? If not, why?
Relationship between MR, AR & Ep
• MR = AR ( 1 + 1/│Ep│), which can be
derived from R = P.Q by
differentiating both sides by Q
• AR = P
• │Ep│= │(dQ/dp).(P/Q)│
• This formula also explains why a
monopolist chooses an elastic range
to fix his price
Example 1: Pricing and Cash Flows
• According to an FTC Report by
Michael Ward, AT&T’s own price
elasticity of demand for long distance
services is -8.64.
• AT&T needs to boost revenues in
order to meet it’s marketing goals.
• To accomplish this goal, should AT&T
raise or lower it’s price?
 Answer: Lower price!
• Since demand is elastic, a reduction in
price will increase quantity demanded
by a greater percentage than the
price decline, resulting in more
revenues for AT&T.
 Example 2: Quantifying the
Change
• If AT&T lowered price by 3 percent,
what would happen to the volume of
long distance telephone calls routed
through AT&T?
 Answer
• Calls would increase by 25.92 percent!
% QX
d
EQX , PX  8.64 
%PX
% Q X
d
 8.64 
 3%
 3%   8.64   %QX
d

%QX  25.92%
d
Example 3: Impact of a change in a
competitor’s price

• According to an FTC Report by

Michael Ward, AT&T’s cross price
elasticity of demand for long
distance services is 9.06.
• If competitors reduced their prices
by 4 percent, what would happen to
the demand for AT&T services?
 Interpreting Demand Functions
• Example:

QX  10  2 PX  3PY  2M
d

– Law of demand holds (coefficient of PX is

negative).
– X and Y are substitutes (coefficient of PY is
positive).
– X is an inferior good (coefficient of M is
negative).
Linear Demand Functions and
Elasticities

• General Linear Demand Function and

Elasticities:

QX  0   X PX  Y PY   M M   H H
d

PY M
EQX , PX
P
X X EQ X , PY  Y EQX , M  M
QX QX QX
Own Price Cross Price Income
Elasticity Elasticity Elasticity
 Example of Linear Demand

• Qd = 10 - 2P.
• Own-Price Elasticity: (-2)P/Q.
• If P=1, Q=8 (since 10 - 2 = 8).
• Own price elasticity at P=1, Q=8:
(-2)(1)/8= - 0.25.
 Log-Linear Demand

• General Log-Linear Demand Function:

ln QX d   0   X ln PX  Y ln PY   M ln M   H ln H

Own Price Elasticity : X

Cross Price Elasticity :  Y
Income Elasticity : M
 Example of Log-Linear
Demand

• ln(Qd) = 10 - 2 ln(P).
• Own Price Elasticity: -2.
 Graphical Representation of
Linear and Log-Linear Demand
P P

D D

Q Q
Linear Log Linear