Principles of Economics

ECN30305
Lecture 5

1. Price Theory: Price Elasticity

When you have completed your
study of this chapter, you will be able to

1 Define the price elasticity of demand.

2 Explain the factors that influence it.
3 Calculate the price elasticity of demand.
4 Explain the relationship between total revenue
and the price elasticity of demand.

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 The Concept of Price Elasticity
 Elasticity is a measure of the responsiveness of
people’s demand to changes in price.
 We would like to explore how large is the response
of consumers to changes in price?
 In other words, we are measuring the magnitude of
response.
Price Price
Pencils Bread
P2
P1
Q2 Q1 Q2 Q1
3
Popular Elasticity Measures

Popular measures of elasticity include:

 Price elasticity of demand ( Ed )

 Price elasticity of supply ( Es )

Next
 Income elasticity of demand
week
 Cross elasticity of demand for related
goods

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Price Elasticity of Demand
 Price elasticity of demand ( Ed )
measures the response of consumers to
changes in price, ceteris paribus.

Two general types of elasticity

 Elastic demand
 Large change in demand with given price

change (∆D > ∆P)

 Inelastic demand
 Small change in demand with given price

change (∆D < ∆P)

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Computing Price Elasticity of Demand

Elasticity % Change in Quantity

Demand
of = Ed = % Change in Price
Demand

Midpoint %∆D
formula =
%∆P
%∆P
%∆D Note: elasticity does NOT
measure the slope of the curve

Price rise results in fall in

quantity demanded 6
 Price Elasticity of Demand

Milk 1.7 > 1 Relatively Price Elastic

Rice 0.68 < 1 Relatively Price Inelastic

$ $

2.20 21

9.5% 15.4%
2.00 18

16.2% D 10.5%
D
85 100 Quantity of 9 10 Quantity of Rice
milk 7
 Using the Midpoint Formula to Compute
Price Elasticity
% Change in ÷ % Change in
Demand Price
(Q1 – Q0) (P1 – P0)
------------------- ÷ ------------------
(Q1 + Q0) / 2 (P1 + P0) / 2

85 – 100 2.20 – 2.00 = – 0.1667

(85 + 100)/2 ÷ (2.20 + 2.00)/2 0.09524

= – 1.7 = |1.7| > 1 “Negative” sign not

crucial in price
Milk is relatively price elastic elasticity of demand

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Using the Midpoint Formula to Compute
Price Elasticity
 By using the average price and average quantity,
we get the same elasticity value regardless of
whether the price rises or falls.

 The formula yields a negative value, because price

and quantity move in opposite directions.

 But it is the magnitude, or absolute value, of the

measure that reveals how responsive the quantity
change has been to a price change.

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 Using the Midpoint Formula to Compute
Price Elasticity
 The price of rice initially is $21.00/kg and Price

the quantity demanded is 9 kg.

21.00
 The price falls to $18.00/kg and the
18.00
quantity demanded increases to 10 kg.

9 10 Rice

10 – 9 ÷ 18.00 – 21.00 = 0.105

(10 + 9) / 2 (18.00 + 21.00) /2 – 0.154

= – 0.68 = |0.68| < 1 “Negative” sign not

crucial in price
Rice is relatively price inelastic elasticity of demand
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 Price Elasticity Versus Slope of Curve

Price Elasticity = %∆ Demand

%∆ Price

= 1.7

Slope of curve = ∆Y = ∆ Price

∆X ∆Demand

= 2.20 – 2.00
85 – 100

= – 0.013
© 2015 Pearson
Elasticity and Total Revenue are related
b) Total revenue when P=$2.00
$
TR = P X Q
= 2 X 100
= $200
2.20
9.5%
Total revenue when P=$2.20
TR = P1 x Q1
2.00 = 2.20 x 85
16.2% D = $187

85 100 Quantity of
milk

Remember Milk is price elastic. i.e. the %∆ in demand > % ∆ in price.

Thus as price increases, the % loss in demand being greater, results in a fall in total
revenue
© 2015 Pearson
Elasticity and Total Revenue are related
Total revenue when P=$21
$ TR = P X Q
= 21 x 9
= $189
21

15.4% Total revenue when P=$18

18
TR = P1 x Q1
= 18 x 10
10.5% = $180
D
9 10 Quantity of Rice

Recall that rice is price inelastic, i.e. the %∆ in demand < % ∆ in price.
Thus as price falls, the % gain in demand being smaller, results in a fall in
total revenue

© 2015 Pearson
 More Exercises Using the Midpoint
Formula to Compute Price Elasticity
 %∆Q is calculated as ∆Q/Qave, which is :
(11 – 9) / (11+9)/2 = 2/10 = 1/5 = 0.2

 %∆P, is calculated as ∆P/Pave, which is:

19.5 – 20.5 / (19.5+20.5)/2 = 1/20 = 0.05

 Therefore, the price elasticity of demand is

(1/5)/(1/20) = 4
= 0.2 = 4
0.05

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Mid-Point

Qave =10

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Price Elasticity of Demand
 Demand can be inelastic, unit elastic, or
elastic, and can range from zero to
infinity.
 5 degrees of price elasticity of demand

 Ed > 1 Relatively Elastic

 Ed < 1 Relatively Inelastic
 Ed = 1 Unit Elastic
 Ed = ∞ Perfectly Elastic
 Ed = 0 Perfectly Inelastic

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Relatively Elastic Demand
 Ed > 1 P

 A change in price
causes a larger
7
change in the 6
quantity demanded. D2

 %∆D > %∆P O 50 100 Q

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 Relatively Inelastic Demand

P  Ed < 1

 A change in price
10
causes a
proportionately
6
smaller change in
the quantity
D1
demanded.
O 90100 Q
 %∆D < %∆P

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 Unitary Elastic Demand

 Ed = 1 P
This demand curve
 the percentage change in has unitary elasticity
the quantity demanded
equals the percentage
change in price

 %∆D = %∆P
D2

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 Perfectly Elastic Demand

 Ed = ∞ This demand curve

has infinite elasticity

 the percentage
change in the
quantity demanded
is infinitely large
when the price
barely changes

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 Perfectly Inelastic Demand

 Ed = 0

 the quantity
demanded doesn’t
change when the
price changes

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Price Elasticity of Demand
The Factors That Influence the Elasticity

of Demand

 The elasticity of demand for a good depends

on:
 The closeness of substitutes

 Luxuries versus necessities

 The proportion of income spent on the good

 The time elapsed since a price change

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 Price Elasticity of Demand
 The closeness of substitutes
 The closer the substitutes for a good or service,

the more elastic are the demand for it.

 Luxuries versus necessities

 Necessities, such as food or

housing, generally have

inelastic demand.
 Luxuries, such as exotic

vacations, generally have

elastic demand.
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Price Elasticity of Demand
 The time elapsed since a price change
 The more time consumers have to adjust to a

price change, or the longer that a good can be

stored without losing its value, the more
elastic is the demand for that good.

 The proportion of income spent on the good.

 The greater the proportion of income

consumers spent on a good, the larger is its

elasticity of demand.

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Price Elasticity of Demand
Estimated price elasticities of demand for selected products
Product Price elasticity of demand
Salt 0.1
Water 0.2
Coffee 0.3
Cigarettes Inelastic 0.3
Shoes and footwear 0.7
Housing 1.0
Automobiles Unit elastic 1.2
Foreign travel 1.8
Restaurant meals 2.3
Air travel 2.4
Motion pictures 3.7
Specific brands of coffee 5.6

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