Chapter 6

Elasticity
 Objectives
• Define elasticity
• Explain the meaning and significance of price
elasticity of demand
• Distinguish between five categories of price
elasticity of demand
• Explain the determinants of price elasticity of
demand
• Define income elasticity and cross elasticity of
demand
• Explain the meaning and significance of price
elasticity of supply
 An introductory overview
• Qd = f(Px, Pg, Y, T, N, …)
– Qd = dependent variable
– Independent variables

• Qs = f(Px, Pg, Pf, Pe, Ty, N, …)

– Qs =dependent variable
– Independent variables

• Equilibrium price and quantity respond to

changes in demand and supply
 Elasticity
• Elasticity is the measure of responsiveness or
sensitivity
• How responsive a dependent variable (Qd or Qs) is to
changes in an independent variable
• Meaning how responsive are quantity demanded
and quantity supplied to price changes?
% change in dependent variable
Elasticity =
% change in independent variable

• Types of elasticity:
a) Price elasticity of demand
b) Income elasticity of demand
c) Cross elasticity of demand
d) Price elasticity of supply
 Price elasticity of demand
• Investigate the relationship between
quantity demanded and price of the
product: Qd = f(Px)
• The percentage change in the quantity
demanded if the price of the product
changes by 1%
• Formula:
% change in quantity demanded of a product
eP =
% change in price of the product
 Price elasticity of demand
• Calculated using percentage changes, which
are relative changes and not absolute changes
• Elasticity coefficients – compare how consumers
react to changes in the prices of different goods
and services
• Determine how consumers react to a change in
the price of a product
• Use absolute values – NO NEGATIVE SIGN
 Calculating price elasticity of
demand
ca

• Example:
– SHOP car-sales decreased the price of the
car from R15 000 to R10 000. The quantity
demanded for the car increased from 8 to 10
due to the change in price

– Old quantity = 8
– New quantity = 10
– Old price = R15 000
– New price = R10 000
 STEP 1
• Percentage change in quantity demanded

= New Qd – Old Qd x 100

Old Qd

= 10 – 8 x 100
8
= 25%
 STEP 2
• Percentage change in the price of the
product

= New P – Old P x 100

Old P

=
R10 000 – R15 000 x 100
R15 000
= -33% (ignore negative sign)
 STEP 3
% change in quantity demanded
eP =
% change in price of the product

= 25%
-33%
= |0,76|
A 1% decrease in the price of motorcars
will lead to 0,76% increase in the quantity
demanded
 Class Activity
• Calculate Tshepo’s price elasticity for
demand if he decides to decrease the
price of his cars from R40 000 to
R30 000, and this leads to an
increase in the quantity demanded
from 50 cars to 80 cars?
 Price Elasticity of Demand

12

Q
18 24

12
1. Quantity demanded originally is 100 at a
price of R2. There is a rise in price to R3
resulting in a fall in demand to 75.
Calculate the price elasticity of demand.

2. Quantity demanded originally is 20 units

at a price of R5 000. There is a fall in
price to R4 000 resulting in a rise in
demand to 32 units. Calculate the price
elasticity of demand.
 Price elasticity of demand
• Point elasticity formula
– Changes in the price are relatively small

• Arc elasticity formula

– There are large fluctuations in the price
– Average of two quantities and prices

= (Q2 – Q1)/[(Q2 + Q1)/2]

(P2 – P1) / [(P2 + P1)/2]
 Price Elasticity of Demand

• Categories of price elasticity of demand

– Perfectly inelastic → eP = 0
– Inelastic → 0 < eP <1
– Unit elastic → eP = 1
– Elastic → 1 < eP < 
– Perfectly elastic → eP = 

15
 Price elasticity of demand
Category Meaning
Perfectly inelastic eP = 0 Qd does not change
demand when P changes
Inelastic demand 0 < eP <1 %ΔQd < %ΔP

Unitary eP = 1 %ΔQd = %ΔP

Elastic demand 1 < eP <  %ΔQd > %ΔP
Perfectly elastic eP =  Indeterminate quantity
demand
 Price elasticity of demand and
total revenue
• Determine total expenditure by consumers and
total revenue for producers

• Producers are interested in two things:

– How much they expect to sell at each price
– How much total revenue would be at different prices

• Total Revenue (TR) = Price x Quantity sold

• Relationship between eP and TR

 Price elasticity of demand and
total revenue
• A negative relationship between quantity
demanded and the price of a product

– If the eP > 1: TR will change in the opposite

direction to the price change
– If the eP = 1: TR will remain unchanged

– If the eP < 1: TR will change in the same

direction as the price change
 PRICE, QUANTITY AND TOTAL REVENUE
Price Quant TR = P %ΔP %ΔQ eP
ity xQ
7 2 14 - - ED = 
6 4 24 -|14.2| 100 ED > 1 Elastic
5 6 30 -|16.6| 50 ED > 1 Elastic
4 8 32 -|20| 33.3 ED > 1 Elastic
3 10 30 -|25| 25 ED = 1 Unit
2 12 24 -|33.3| 20 0 < ED < 1 Inelasti
c
1 14 14 -50 16.6 0 < ED < 1 Inelasti
c
0 16 0 -100 14.2 0 < ED < 1 Inelasti
19
PRICE, QUANTITY AND TOTAL REVENUE
Price Quantity TR = P x Q ELASTICITY VALUE
Ep = %∆Qd ÷ %∆P
8 0 8x0=0 -
7 1000 7000
6 2000 12 000
5 3000 15 000
4 4000 16 000
3 5000 15 000
2 6000 12 000
1 7000 7000
0 8000 0
20
 Linear Demand Curve And Elasticity Values

R8 Ep=  (Perfectly Elastic)

Ep>1 (Elastic)

R4 Ep=1 → TR MAXIMISED

0< Ed<1 (Inelastic)

Ep= 0
0 1000 2000 3000 4000 5000 6000 7000 8000
21
 Price elasticity and TR
• Figure 5-2:
– If eP > 1: TR increases as the quantity sold
increases

– If eP = 1: TR is at its maximum

– If eP < 1: TR decreases as quantity sold

increases
 Determinants of eP
• Availability of substitutes
– Price elastic demand

• Price as proportion of income

– Higher priced goods are more price elastic in demand
than lower priced goods
– Luxuries are price elastic in demand unlike
necessities

• Brand loyalty and advertising

– Price inelastic (those who are brand loyal)
• Addiction
• Time
 Income elasticity of demand
• Sensitivity of the quantity demanded if the
income changes
– Qd = f(Y)
% change in quantity demanded
eY =
% change in consumers’ income

• Normal goods vs Inferior goods

• Positive or negative
 Income elasticity of demand
• Inferior products
– Negative income elasticity (eY < 0)

• Normal products
– Positive income elasticity (eY > 0)

• Normal products can be divided in two

categories:
• Necessities 0 < eY < 1
• Luxury products eY > 1
 Income Elasticity of Demand
• Normal goods:
– EY greater than 1
• %ΔQd > % ΔY
• Demand is income elastic
• Luxuries (superior goods with inferior substitutes)

– EY greater than 0 but less than 1

• %ΔQd < % ΔY
• Demand is income inelastic
• Necessities

– EY equal than 1
– EY less than 1
• Inferior goods
• Negative relationship between income and Qd
 Income Elasticity of Demand

• Goods consumers regard as necessities

tend to be income inelastic
– Examples: food, fuel, clothing

• Goods consumers regard as luxuries tend

to be income elastic
– Examples: sports car, expensive food
 Cross-price Elasticity of Demand
• eC = sensitivity of the quantity demanded
to a change in the price of a related
product

eC = % change in quantity demanded of product A

% change in the price of product B

– Complementary goods – Negative cross elasticity

(eC < 0)

– Substitutes – Positive cross elasticity (eC > 0)

29
Cross price elasticity of demand
Relationship Cross elasticity Example
between goods of demand
Washing soap
Unrelated Zero and books
Coffee and milk
Complements Negative
Hamburger vs
Substitutes Positive Pizza
 Price Elasticity of Supply
• eS = measures how much the quantity
supplied responds to changes in the price
of the good
– Perfectly Inelastic Supply: eS = 0
– Inelastic Supply: 0 < eS < 1
– Unit Elastic Supply: eS = 1
– Elastic Supply: eS > 1
– Perfectly Elastic Supply: eS = 
 Determinants of price elasticity
of supply
• Time
– Short run (inelastic) and elastic in the long run

• Expectations
• Stockpiling
• Excess capacity
• Availability of inputs
PRICE, QUANTITY AND TOTAL REVENUE
Price Quantity TR = P x Q ELASTICITY VALUE
Ep = %∆Qd ÷ %∆P
8 0 8x0=0 -
7 1000 7000
6 2000 12 000
5 3000 15 000
4 4000 16 000
3 5000 15 000
2 6000 12 000
1 7000 7000
0 8000 0
33
 Exercise 1: Elasticity

• If the coefficient of the price elasticity of demand is

7, then a 15% increase in price will result in a
________% decrease in the quantity demanded?

• Suppose the coefficient of the price elasticity of beer

is 0.3. If government through sin taxes want to
reduce the drinking of beer by 15%, by how much
should the price of beer be raised?

• The value of the percentage change in quantity

demanded owing to a percentage change in income
is calculated to be equal to -2. This good is a/an ….
 Question relating to the calculation of elasticity

A local pizzeria raised its price from R90 to R110 for each
pizza and the sales of its pizza decreased from 150 per day
to 100 per day. What is the price elasticity of demand in
this case if we use the arc elasticity method to calculate
the price elasticity?

[1] 2/3
[2] –2,5
[3] 2
[4] 3/2
45
40
35
30
25
20
15
10
5
0
0 25 50 75 100

36
 QUESTIONS RELATING TO SLIDE 35

• At which prices is the price elasticity larger than one?

• At which of the provided prices is the elasticity value

smaller than one?

• At which price level is the price elasticity equal to 1?

• Suppose the price is R10. What must happen to prices

in order to increase the total revenue?

• Suppose the price is R30. What must happen to prices

in order to increase the total revenue?
37
 S1
P
S0
50 D S2

40 S3

30

25

20

0
Q

38
 QUESTIONS RELATING TO SLIDE 37

• Suppose the supply of maize increases from S 0

to S2? What happens to total revenue?

• Suppose the supply of maize decreases from S 3

to S2? What happens to total revenue?

• At which price will total revenue be maximised?

39
 Number of
Month Tickets Price

January 5,500 110

February 4,500 90

March 3,500 80

April 5,000 100

May 15,000 50
 QUESTION RELATING TO SLIDE 40

• CALCULATE THE PRICE ELASTICITY

OF DEMAND,BETWEEN JANUARY AND
FEBRUARY.