Price, Income and Cross

Elasticity
Elasticity – the concept

 The responsiveness of one variable to

changes in another
 When price rises what happens to
demand?
 Demand falls
 BUT!
 How much does demand fall?
Elasticity – the concept

 If price rises by 10% - what happens to

demand?
 We know demand will fall
 By more than 10%?
 By less than 10%?
 Elasticity measures the extent to which
demand will change
Elasticity

 3 basic types used:

 Price elasticity of demand
 Income elasticity of demand
 Cross elasticity
Elasticity

 Price Elasticity of Demand

The responsiveness of demand to changes in
price
Where % change in demand is greater than %
change in price – elastic
Where % change in demand is less than %
change in price - inelastic
 The Formula:
% Change in Quantity Demanded
___________________________
P_ed =
% Change in Price

If answer is less than 1: the relationship is inelastic

If the answer is more than 1: the relationship is elastic

Note: PED has – sign in front of it; because as price rises

demand falls and vice-versa (inverse relationship between
price and demand)
 Ranges of Elasticity
Inelastic Demand
 Percentage change in price is greater than
percentage change in quantity demand.
 Price elasticity of demand is less than one.
Elastic Demand
 Percentage change in quantity demand is
greater than percentage change in price.
 Price elasticity of demand is greater than one.
 Perfectly Inelastic Demand
- Elasticity equals 0
Price Demand

1. An $5
increase
in price... 4

100 Quantity
2. ...leaves the quantity demanded unchanged.
 Inelastic Demand
- Elasticity is less than 1
Price

1. A 25% $5
increase
in price... 4

Demand

90 100 Quantity
2. ...leads to a 10% decrease in quantity.
 Unit Elastic Demand
- Elasticity equals 1
Price

1. A 25% $5
increase
in price... 4

Demand

75 100 Quantity
2. ...leads to a 25% decrease in quantity.
 Elastic Demand
- Elasticity is greater than 1
Price

1. A 25% $5
increase
in price... 4

Demand

50 100 Quantity
2. ...leads to a 50% decrease in quantity.
 Perfectly Elastic Demand
- Elasticity equals infinity
Price
1. At any price
above $4, quantity
demanded is zero.

$4 Demand

2. At exactly $4,
consumers will
buy any quantity.

3. At a price below $4, Quantity

quantity demanded is infinite.
 Elasticity
Price
Total revenue is price x
The importance of elasticity
quantity sold. In this
is the information it
example, TR = £5 x 100,000
provides on the effect on
= £500,000.
total revenue of changes in
price.
This value is represented by
the grey shaded rectangle.
£5

Total Revenue

100 Quantity Demanded (000s)

 Elasticity
Price If the firm decides to
decrease price to (say) £3,
the degree of price elasticity
of the demand curve would
determine the extent of the
increase in demand and the
change therefore in total
£5 revenue.

£3

Total Revenue
D
100 140 Quantity Demanded (000s)
Elasticity
Price (£)
Producer decides to lower price to attract sales

10 % Δ Price = -50%
% Δ Quantity Demanded = +20%
Ped = -0.4 (Inelastic)
5 Total Revenue would fall
Not a good move!

D
5 6
Quantity Demanded
 Elasticity
Price (£)
Producer decides to reduce price to increase sales
% Δ in Price = - 30%
% Δ in Demand = + 300%
Ped = - 10 (Elastic)
Total Revenue rises
10
Good Move!
7
D

5 Quantity Demanded 20
Elasticity
 If demand is price  If demand is price
elastic: inelastic:
 Increasing price  Increasing price
would reduce TR would increase TR
(%Δ Qd > % Δ P)
 Reducing price would (%Δ Qd < % Δ P)
increase TR  Reducing price would
(%Δ Qd > % Δ P) reduce TR (%Δ Qd <
% Δ P)
Elasticity

 Income Elasticity of Demand:

The responsiveness of demand to changes in
incomes
 Normal Good – demand rises as income
rises and vice versa
 Inferior Good – demand falls as income
rises and vice versa
Elasticity

 Income Elasticity of Demand:

 A positive sign denotes a normal good

 A negative sign denotes an inferior good
 For example:
 Yed = - 0.6: Good is an inferior good but
inelastic – a rise in income of 3% would lead to
demand falling by 1.8%
 Yed = + 0.4: Good is a normal good but
inelastic – a rise in incomes of 3% would lead to
demand rising by 1.2%
 Yed = + 1.6: Good is a normal good and
elastic – a rise in incomes of 3% would lead to
demand rising by 4.8%
 Yed = - 2.1: Good is an inferior good and
elastic – a rise in incomes of 3% would lead to a
fall in demand of 6.3%
Elasticity

 Cross Elasticity:
 The responsiveness of demand of one
good to changes in the price of a related
good – either a substitute or a complement

% Δ Qd of good t
__________________
Xed =
% Δ Price of good y
Elasticity

 Goods which are complements:

Cross Elasticity will have negative sign (inverse
relationship between the two)
 Goods which are substitutes:
Cross Elasticity will have a positive sign
(positive relationship between the two)
Elasticity
 Price Elasticity of Supply:
 The responsiveness of supply to changes in price
 If Pes is inelastic - it will be difficult for suppliers to
react swiftly to changes in price
 If Pes is elastic – supply can react quickly to changes in
price

% Δ Quantity Supplied
____________________
Pes =
% Δ Price
Determinants of Elasticity
 Time period – the longer the time under consideration
the more elastic a good is likely to be
 Number and closeness of substitutes – the greater
the number of substitutes the more will be the elasticity.
 The proportion of income taken up by the product –
the larger the proportion the more will be the elasticity.
 Luxury or Necessity – tends to have elastic demand,
while necessity goods have an inelastic demand.
Importance of Elasticity

 Relationship between changes in price

and total revenue
 Importance in determining what goods to
tax (tax revenue)
 Importance in analysing time lags in
production
 Influences the behaviour of a firm
Examples of Supply Elasticities
 When the price of DaVinci paintings
increases by 1% the quantity supplied
doesn’t change at all, so the quantity
supplied of DaVinci paintings is
completely insensitive to the price.
Price elasticity of supply is 0.
 When the price of beef increases by 1%
the quantity supplied increases by 5%,
so beef supply is very price sensitive.
Price elasticity of supply is 5.
Business Uses of Elasticity of demand
An elasticity is a unit-free measure.
By comparing markets using
elasticities it does not matter how we
measure the price or the quantity in the
two markets.
Elasticities allow businessman to
quantify the differences among
markets without standardizing the units
of measurement.
 Examples of Unit-free Comparisons
 Gasoline and jewelry
It doesn’t matter that gas is sold by the gallon for
about $1.09 and gold is sold by the ounce for
about $290.
We compare the demand elasticities of -0.2 (gas)
and -2.6 (gold jewelry).
Gold jewelry demand is more price sensitive.