Module 3:

Price elasticity of demand

 Ped measures the responsiveness of demand for a product following a change in its

own price.
 Price elasticity of demand measures the responsiveness of quantity demanded for a
product to a change in price.
 The shape of demand and supply depends on these elasticities.

 =
 Demand equation: Q= a-bP
 Q=8-2P (find the elasticity when price is Rs.2)
 Ep= -2(P/Q) Thus Ep= -2(2/4)= -1
 Q=8-2P (find the elasticity when price is Rs.2)
 SLOPE=-1/2= CHG IN P/ CHG IN Q
 Ep= CHG IN Q/CHG IN P * P/Q
 =-2* 2/4= -1
A
2
B

4
Measurement of Elasticity of Demand-
point vs. arc elasticity
 1. Point elasticity of demand is defined as the -proportionate change in the quantity
demanded resulting from a very small proportionate change in price.
 Ep= P/Q * chg in Q/chg in P or
 1/slope* P/Q
 2. Arc elasticity of demand- When price changes are large or we have to measure elasticity
over an arc of the demand curve rather than at a specific point on the demand curve, the
point elasticity method does not provide a true measure of price elasticity of demand .
 Accurate measure of price elasticity can be obtained by taking the average of original price
and new price as well as average of the old quantity and new quantity as the basis of
measurement of percentage changes in price and quantity. 
  E p = {∆q/(q1+q2)/2} /{∆p/(p1+p2)/2} 
point vs. arc elasticity

 Suppose price increase from 500 to 600 and quantity falls from 100 to 80
units. Calculate Ep.
 Chg in Q/Chg in P * avg P/avg Q
 = -20/100* 550/90= - 11/9
600 A

500 B

80 100
 Point method: -20/100* 500/100= -1
Degrees of elasticity
 Ep at point B= -0.5* 50/0= infinity
B, P= 50
50

D Slope= chg in P/Chg in Q

Ep= 1/slope * P/Q
Slope=-0.5, Ep at point A= 0.5*0= 0
A
Degrees of elasticity

 1.If Ped = 0 demand is said to be perfectly inelastic. This means that demand does
not change at all when the price changes – the demand curve will be drawn as vertical.
 If PeD= infinity, demand is perfectly elastic.
 2.If Ped is between 0 and 1 (i.e. the percentage change in demand from A to B is
smaller than the percentage change in price), then demand is inelastic.
 3.If Ped = 1 (i.e. the percentage change in demand is exactly the same as the
percentage change in price), then demand is said to unit elastic. A 15% rise in price
would lead to a 15% contraction in demand leaving total spending by the same at each
price level.
 4.If Ped > 1, then demand responds more than proportionately to a change in price
i.e. demand is elastic. For example a 20% increase in the price of a good might lead to
a 30% drop in demand. The price elasticity of demand for this price change is –1.5.
 If Q=a-bP P=100-5Q, Q=20-1/5P
 Slope=-1/b slope=-5
 e= 1/slope* P/Q e=-1/5* 90/2=- -9
 = -b*P/Q
Numerical problems
 1. The price of a good falls from Rs. 6 to Rs. 4 per unit and due to this quantity demanded of the good increase from 80 to 120
units. Find Ep.
 2. A consumer purchases 80 units of a commodity when its price is Re. 1 / unit and purchases 48 units when its price is
2Rs/unit. What is the Arc price elasticity of demand?
 3. Calculate price elasticity of demand curve, P=100-5Q at each of the following price and quantity levels:
 P=90, Q=2
 P=50, Q=10
 P=5, Q=19:
 4. Studies in the United States indicate that price elasticity of demand for cigarettes is 0.4. If a pack of cigarettes currently
costs $2 and the government want to reduce smoking by 20 percent, by how much should it increase the price?
 5. Suppose a seller of a textile cloth wants to lower the price of its cloth from Rs. 150 per metre to Rs. 142.5 per metre. If its
present sales are 2000 m per month and further it is estimated that its elasticity of demand for the product equals -0.7 . Show
 A) whether or not his total revenue will increase as a result of his decision to lower the price; and
 B) calculate the exact magnitude of its new total revenue.
 0.7= diff in Q/7.5 * 150/2000
 Diff in Q= 0.7*7.5*2000/150
 = 70
Answers
 1. % chg in quantity demanded=diff in Q/avg Q * 100= 40/100*100= 40
% chg in price=diff in P/avg P* 100= -2/5 * 100=-40
Ep= 40/-40=-1
 2. proportionate chg in P= 1/1.5
 Proportionate chg in Q= 32/64
 Ep=32/64*1.5= 0.75
 3. Ep= -1/5*90/2= -9
 4. .4= 20/x Thus x= 50%
 5. a) Ep=0.7= diffin Q/diff in P * p/q
 =diff in q/7.5* 150/2000=0.7
 Diff in q= 0.7*7.5*2000/150= 70
 New quantity= 2000+70=2070
 B) total revenue before reduction in price= 2000*150=300000
 Total revenue after price reduction=2070*142.50= 294975.
 Thus total revenue has decreased.
 Total revenue and price elasticity of demand
 Total revenue is the amount received by the seller from the sale of the quantity of the
goods sold in the market. TR=PXQ
 Change in total revenue following a change in price depends on price elasticity of demand
 When demand is elastic (ep>1)
 DECREASE IN PRICE CAUSES INCREASE IN TR
 INCREASE IN PRICE CAUSES DECREASE IN TR
P A
When demand is Inelastic (ep<1)
 DECREASE IN PRICE CAUSES DECREASE IN TR
 INCREASE IN PRICE CAUSES INCREASE IN TR PxQ= TR

Q
 When demand is unit-elastic (ep=1)
 NO CHANGE IN TR
P Q TR
10 10 100
15 9 135
E<1
10 10 100
15 5 75
E>1

10 10
TR and elasticity

p Q TR Ep
5 30 150 -
4.75 40 190 >1
4.5 50 225 >1
4.25 60 255 >1
4 75 300 >1
3.75 80 300 =1
3.5 84 294 <1
Price elasticity and total revenue along
a linear demand curve
 When demand is inelastic – a rise in price leads to a rise in total revenue – a
20% rise in price might cause demand to contract by only 5% (Ped = -0.25)
 When demand is elastic – a fall in price leads to a rise in total revenue - for
example a 10% fall in price might cause demand to expand by only 25% (Ped =
+2.5)
 When demand is perfectly inelastic (i.e. Ped = zero), a given price change
will result in the same revenue change, e.g. a 5 % increase in a firm's prices
results in a 5 % increase in its total revenue
Finding elasticity using changes in TR-
Expenditure method

 1. Suppose price of a good falls from Rs. 10 to Rs.8 per unit. As a result, its quantity
demanded increases from 80 units to 100 units. Tell whether demand for a good is
elastic, inelastic or unit elastic. WILL TR increase or decrease?
 2. Suppose price of a good rises from Rs. 15 to Rs. 16 per unit. As a result, its quantity
demanded falls from 100 units to 80 units. Find out whether price elasticity of demand is
more than one or less than one.
 3. Q=200+15Y-5.5P
 A) when P=Rs.150 and Y=135, determine the Ep
 B) Determine what effect a rise in price will have on total revenue.
 1. TR1= 800
TR2= 800
No chg, hence Ep= 1
 2. TR at price 15= 1500
TR at price 16=16*80=1280
TR2 < TR1, thus Ep>1.
 3. Ep=-5.5*150/Q
Q=1400, Ep=5.5*150/1400=0.59
B) Since Ep<1, a rise in price will cause increase in revenue.
use

 Firms can use PED estimates to predict:

 The effect of a change in price on the total revenue & expenditure on a product
 The likely price volatility in a market following changes in supply – this is important for commodity
producers who may suffer big price movements from time to time
 The effect of a change in an indirect tax (e..g VAT, fuel or other duties) on price and quantity
demanded and also whether the business is able to pass on some or all of the tax onto the consumer
 Information on the PED can be used by a business as part of a policy of price discrimination (also
known as 'yield management'). This is where a business decides to charge different prices for the
same product to different segments of the market e.g. peak and off peak rail travel or prices
charged by many of our domestic and international airlines
 A business contemplating a tactical price-war or planning a promotional discount based on price
(e.g. 50% off for a limited period) will want to know how responsive customer demand will be to the
pricing tactics used
Factors affecting Ped

 The following factors affect Ped:

 1.The number of close substitutes for a good 
 2.The degree of necessity or whether the good is a luxury 
 3.The % of a consumer's income allocated to spending on the good 
 4.The time period allowed following a price change 
 5.Whether the good is subject to habitual consumption 
 6. The breadth of definition of a good or service
 7. Complementarity between goods
 Income elasticity of demand
 Income elasticity of demand measures the responsiveness of the quantity demanded
for a good or service to a change in income.
 It is calculated as the ratio of the percentage change in quantity demanded to the
percentage change in income.
 A negative income elasticity of demand is associated with inferior goods; an increase
in income will lead to a fall in the demand and may lead to changes to more luxurious
substitutes.
 A positive income elasticity of demand is associated with normal goods; an increase in
income will lead to a rise in demand.
 If income elasticity of demand of a commodity is less than 1, it is a necessity good. If
the elasticity of demand is greater than 1, it is a luxury good or a superior good.
 A zero income elasticity of demand occurs when an increase in income is not
associated with a change in the demand of a good.
MEASUREMENT OF INCOME ELASTICITY

 The formula for calculating income elasticity is:

 % Change in demand divided by the % change in income
 For example, if in response to a 10% increase in income, the quantity
Clickthe
demanded for a good increased by 20%, to income
add textelasticity of demand
would be 20%/10% = 2.0.
 Greater than 1, hence luxury good.
Y
 Q=50+.5Y,
 Ei= Chg in Q/Chg in Income * Income/quantity
 =1/slope * Income/quantity
Q
 = coefficient of I * income/quantity= 4* 50/320= 0.62
'Cross Elasticity Of Demand'
 Definition: The measure of responsiveness of the demand for a good towards the change
in the price of a related good is called cross price elasticity of demand. It is always
measured in percentage terms.
 If A and B are related goods, cross elasticity of A= Proportionate change in demand for A
divided by proportionate change in Price of B.

Pb

=chg in Qa/chg in Pb * Pb/Qa

=1/slope * Pb/Qa
Qa

For example: if there is an increase in the price of tea by 10%. and the quantity
demanded for coffee increases by 2%, then the cross elasticity of demand = 2/10 
Cross elasticity
 In case the two goods are not related, the Coefficient of Cross Elasticity is zero.
 In case the two goods are substitutes for each other like tea and coffee, the cross price
elasticity will be positive,
 In case the goods are complementary in nature like pen and ink, then the cross elasticity
will be negative, i.e. demand for ink will decrease if prices of pen increase or vice-versa.
 Weak substitutes like tea and coffee will have a low cross elasticity of demand. If the price
of tea increases, it will encourage some people to switch to coffee. But for most people,
their preference for a particular drink is more important than a small difference in price
 For two alternative brands, for example, Starbucks Coffee and Costa Coffee, these goods
are closer substitutes as the difference is much smaller. If the price of Costa Coffee
increases, more consumers will switch to an alternative brand such as Starbucks. WIth
close substitutes, the XED will be higher.
 Classification of various types of market structures is made on the basis of cross elasticity
of demand.
 Many firms are multi-product firms or inter-related with other firms,
 Qx=1200-3Px-0.1Pz, Where Pz=300
 Find the Ep when Px=140

 1/slope=-3 Pz
 Ep= -3* 140/750= -0.56

 What is the cross elasticity when Px=140

Cross elasticisity= 1/slope* Pz/Qx=
-0.1*300/750=- 0.04 Qx
If Pz changes by 10%, by how much will Qx change?
Advertising or Promotional Elasticity of
Demand
 Advertising or promotional elasticity of demand (EA) measures the expected
changes in demand as a result of change in other promotional expenses. 

 EA = ΔQ/ΔA x A/Q

 The higher the value of this elasticity, the greater will be the inducement of
the firm to advertise that product.
 It is on the basis of advertising elasticity that a firm decides how much to
spend on advertising a product.
applications
Practise ques.
 1. Suppose the cross price elasticity of demand between goods X and Y is 4. How much
would the price of good Y have to change in order to increase the consumption of good X
by 20 percent?
 2. Suppose the own price elasticity of demand for good X is -3, its income elasticity is 1,
its advertising elasticity is 2, and the cross price elasticity of between it and good Y is
-4. Determine how much the consumption of this good will change if:
 The price of the good X decreases by 5 percent
 The price of good Y increases by 8 percent
 Advertising decreases by 4 percent
 Income increases by 4 percent
Q10. The demand curve for a product is given by

Q xd  1200  3Px  0.1Pz

where Pz=$300.
a. What is the own price elasticity of demand when Px=$140? Is demand elastic or inelastic at
this price? What would happen to the firm’s revenue if it decided to charge a price below
$140?
-3*140/750=-0.56
-3*240/450=-1.6
b. What is the own price elasticity of demand when Px=$240? Is demand elastic or inelastic at
this price? What would happen to the firm’s revenue if it decided to charge a price above
$240? 1/slope*
c. What is the cross-price elasticity of demand between good X and good Z when Px=$140? Are Pz/Qx=.1*300/75
the goods X and Z substitutes or complements?
0=-0.04
Ei= 1/slope*Y/Q=
15*15000/226850
= 0.99
Q=2000+15Y-P, If Y=15000. Find the income elasticity when price is 150?
Points to ponder
 How to determine price elasticity from demand equation?
 Why is Price elascticity negative?
 Is it always negative?
 What is the relation between price elasticity and slope
 What is the difference between point and arc elasticity?
 How to determine TR and MR from demand equation
 Why does MR of a luxury good decrease when price is increased
 Why does MR of a necessity good increase when price is decreased
 How should a seller decide about increasing the price of his good?
Elasticity of supply

 The price elasticity of supply is the measure of the responsiveness in quantity

supplied to a change in price for a specific good.
 The elasticity of supply for a good depends on number of producers, time period,
storage capacity, factor mobility and spare capacity.
 The price elasticity of supply has a range of values:
 PES > 1: Supply is elastic.
 PES < 1: Supply is inelastic.
 PES = 0: The supply curve is vertical; there is no response of demand to prices.
Supply is “perfectly inelastic.”
 PES = ∞∞ (i.e., infinity): The supply curve is horizontal; there is extreme change in
demand in response to very small change in prices. Supply is “perfectly elastic.”
Elasticity and tax incidence
1. Tax incidence refers to how the burden of a tax is distributed between firms and
consumers (or between employer and employee). 
2. The tax incidence depends upon the relative elasticity of demand and supply.
 If demand is more inelastic than supply, consumers bear most of the tax burden.
 If supply is more Inelastic than demand, sellers bear most of the tax burden.

1.

https://courses.lumenlearning.com/wmopen-microeconomics/chapter/tax-incidence/
 Demand fn: P=252-2Q
Supply fn: P=2Q
Suppose tax imposed is Rs. 50 per unit on sellers, find the incidence of tax

 New supply eqn: P=2Q+50

 P= 126, Q= 63
 P=152, Q=51
Case study

 Can good news for farming be bad news for farmers?

 Why did OPEC fail to keep the price of oil high?

Test questions(solved)

   The demand and supply for juices are given by Qd = 120-8P and Qs = -6+4P. Suppose now the
government imposes a per-unit tax of 4.5 on the sellers. What would be the new quantity and the
net price received by the sellers .

 Qd=120-8P
 Qs=-6+4(P-4.5)
 At equilibrium Qs=Qd
 120-8P=-6+4(P-4.5)
 120-8P=-6+4P-18
 12P=144, P=12
 Q=120-8(12), Q=24
 Net price received by the seller=12-4.5=7.5
 Qd = 66-3P          Qs = -4+2P   

 Determine the dead weight loss if a price ceiling of Rs. 10 is imposed in  this
market.

 Qs=-4+2P, Put P=10, Q=16

16.67
 Dwl=1/2*base*height dwl
14
 =1/2*(16.67-10)*(24-16)
10
 =1/2*6.67*8=26.68

24
 Suppose the market for cotton is characterized by the market demand and
supply

 equations of P = 100 – Q/100 and P = Q/100. If Govt. impose a price ceiling of

P=40 per unit, what will be the loss in producer surplus?

 100-q/100=q/100, q=5000, P=50

 Initial PS= ½*5000*50=125000 50

 New PS=1/2*4000*40=80000 40
 Difference= 45000
4000 5000
 Demand and supply in a market are described by the equations
                  Qd = 66-3P

                  Qs = -4+2P
 What would be the producer surplus and tax revenue after a per unit tax  t=5
is imposed.
 Qs’= -4+2(P-5). At Eq: Qd=Qs’
16
 66-3P=-4+2(P-5), P=16, Q=24 14
14
11
 PS=1/2*18*9=81 2
 Tax revenue= 18*5=90
18 24
 If the demand equation is;    5 Qd=365-15P+Y and supply equation is Qs =
-7+2P, What would be the     consumer and producer surplus if income was
50. (Y stands for income)
27.66
 Eq P= 18, Q=29

 CS=1/2*29*(27.66-18)
 Cs=140.17 18

 PS=1/2*29*(18-3.5) 3.5
 PS=210.25

29