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ELASTICITY
This basically refers to the degree of responsiveness of a dependent variable to an
independent variable (price, income, price of other commodities, tastes and
preferences etc). There are many elasticities of demand as its determinants. The three
important elasticities relevant for discussion are:-
(i) Price elasticity of demand
(ii) Income elasticity of demand
(iii) Cross elasticity of demand.
(i) Price elasticity of demand -- measure of the responsiveness of quantity demanded to
a change in price.
(ii) Income elasticity of demand -- measures the responsiveness of quantity demanded
to a change in income.
(iii) Cross elasticity of demand. -- measures the responsiveness of quantity demanded to
a change in the price of some related good.
Price elasticity is the most commonly used. The general formula is as follows:
eD = Proportionate change in quantity demanded
Proportionate change in price
If, for example, the price of good X should rise by 10% (or ).1) and the quantity
demanded should fall in consequence by less than 10%, say 5% (or 0.05), then the price
elasticity of demand would be 0.05/0.1 = 0.5. Since the elasticity is less than 1, we say
that the demand for X is inelastic:
Meaning: a given percentage change in price gives rise to a smaller percentage
change in quantity demanded
Now, If the price of X increases by 10%, the quantity demanded falls by more than 10%,
say 20% (or 0.2), then the price elasticity of demand will be
0.2
0.1 = 2.
Since the elasticity is greater than 1, we say that the demand for X is elastic
Meaning: a given percentage in price gives rise to a bigger percentage change in
quantity demanded.
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On the other hand, if, when the price of X increases by 10%, the quantity demanded
should fall by exactly 10%, the price elasticity of demand would exactly equal to 1. This
is called unitary elasticity.
READ USEFUL CONCEPTS IN HARDWICK et al, pages 59 - 64.
PRICE ELASTICITY OF DEMAND
This is a measure of responsiveness of demand to changes in the commodity’s own
price.
It may also be defined as a proportionate change in quantity demanded due to a
proportionate change in price.
It can otherwise be defined as a percentage change in quantity demanded resulting
from a 1 percentage change in price
If the changes in price are very small, we compute the point elasticity of demand and
when the changes in price are not small, we use arch elasticity of demand.
Point Elasticity of Demand
Symbolically, Point Elasticity of demand is given by
ep = dQ / dp = dQ P ……………………….(1)
Q P dP Q
for a linear demand curve,
Q = bo - b,P,
dQ = -b, ……………………….(2)
dp
Substituting in equation (1), we get ep = -b P
Q
This implies that the elasticity changes at various points of the linear demand curve.
The price elasticity of demand is always negative because of the negative relationship
between price and quantity.
Thus we can multiply -1 to our elasticity functions.
Price elasticity of demand always ranges between 0 and infinity
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Arch Elasticity of Demand
When changes are big, then it is usually better to define elasticity in terms of arc
elasticity of demand other than point elasticity of demand. It can thus be defined
symbolically as,
eac =
Arc elasticity between A and B.
Determinants of Price Elasticity of Demand
I. The availability of substitutes; The demand will be more elastic if there are
substitute commodities. Implying a small change in price will lead to a big
change in quantity consumed because of the alternative available.
II. The importance of the commodity or degree of necessity of the commodity. This
depends on the nature of the need that the commodity satisfies. Luxurious
commodities are price elastic and necessities are price inelastic in nature. This
means that even if there is a big increase in price, the fall in quantity consumed
is very small.
III. The time period; in the longrun, demand is more elastic.
IV. The alternative uses to which the commodity can be put. The more the uses of a
commodity, the greater its price elasticity will be.
V. The proportion of income spent on the particular commodities.
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INCOME ELASTICITY OF DEMAND
Definition
This is thus defined as a proportionate change in quantity demanded resulting from a
proportionate change in income. Symbolically it can be defined as;
If ey>0, the commodity is a normal good.
If however, ey < 1, the commodity is an inferior good.
Luxurious items are assumed to have very high income elasticities of demand. While
necessities are goods with low income elasticity of demand.
Determinants of Income elasticity of demand
(i) The degree of necessity of the commodity
(ii) The initial level of income. For example, a car is a luxury in the LDC’s. While it is a
necessity in a developed country.
(iii) The time period, because consumption patterns adjust with a time-lag to changes
in income.
CROSS ELASTICITY OF DEMAND
It was mentioned earlier that the price of substitutes and complimentary commodities
would affect demand for a certain commodity.
Thus considering two goods X and Y, suppose the price of good Y goes up, what would
be the effect on the quantity of good X that is bought?
Cross elasticity of demand is thus defined as the proportionate change in the quantity
demanded of X resulting from a proportionate change in the price of Y.
Thus,
exy =
If exy < 1 then X and Y are
complimentary commodities.
exy > 0 then X and Y are substitute
commodities.
exy = 0 then X and Y are not related.
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The higher the value of the cross elasticity, the stronger the degree of substitutability or
complementarity of X and Y. The main determinant of cross elasticity is the nature of the
commodities relative to their uses.
REFLECTION QUESTIONS AND ANSWERS
[Link] is the main difference between the law of demand and the price elasticity of
demand?
The law of demand tells you that quantity demanded will increase as price falls,
or conversely, that quantity demanded will decrease as price rises. So, the law of
demand says there is an inverse relationship between price and quantity
demanded. By contrast, the price elasticity of demand tells you “how much”
quantity demanded changes when price changes. It shows the responsiveness
of a change in quantity demanded to a change in price. [text: E p. 356; MI p.
112]
2. Why do economists use percentages rather than absolute amounts in
measuring the responsiveness of consumers to changes in price?
There are two basic reasons. First, the choice of units when absolute changes
are used will have an arbitrary effect on the interpretation of responsiveness.
For example, if price is calculated in dollars, then a one-unit drop in price (from $5 to $4)
might be associated with a 10-unit increase in quantity. If, however, the price
was calculated in cents, then a 100-unit drop in price would be associated with
a 10-unit increase in quantity. In the first case, it would appear the demand is
inelastic and in the second case it would appear to be elastic. Second, the use
of percentages allows comparisons to be made across products. You can
compare the percentage change in quantity demanded to a percentage
change in price across all products for which you have data on changes in
price and quantity demanded. [text: E p. 357; MI p. 113]
3. How do you interpret the coefficient of the price elasticity of demand? Explain
when Ed is 1.5, 0.7, and 1.0.
The interpretation is based on the elasticity formula. The formula has the
percentage change in quantity demanded in the numerator and the
percentage change in price in the denominator. A coefficient of 1.5 indicates
that demand is elastic because the percentage change in quantity demanded
(the numerator) is greater than the percentage change in price (the
denominator). A coefficient of 0.7 indicates that demand is inelastic because
the percentage change in quantity demanded (the numerator) is less than the
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percentage change in price (the denominator). A coefficient of 1.0 indicates
that demand is unit elastic because the percentage change in quantity
demanded (the numerator) is the same as the percentage change in price (the
denominator). [text: E p. 357; MI p. 113]
4. What is the meaning of perfectly inelastic demand and perfectly elastic
demand? How would each be graphed?
Perfectly inelastic demand indicates that there is no change in quantity
demanded for a percentage change in price. The elasticity of demand is zero
in this case. The graph, with price on the vertical axis and quantity on the
horizontal axis, would be a vertical line at the level of quantity demanded.
Perfectly elastic demand indicates that a very small change in price results in a
zero to infinite change in quantity demanded. The elasticity of demand is
infinite in this case. The graph, with price on the vertical axis and quantity on
the horizontal axis, would be a horizontal line across quantity at one price level.
[text: E pp. 357-358; MI pp. 113-114]
5. (Consider This) Use an ACE bandage and a rubber tie-down to make an
analogy for explaining the price elasticity of demand.
The ACE bandage has a high amount of potential stretch, so it would be
relatively elastic or responsive to a movement. A rubber tie-down has only a
limited amount of stretch, so it would be relatively inelastic or unresponsive to
the same movement. [text: E p. 358; MI p. 114]
6. The president of a toy company asks you for advice about whether the
company should cut the price of its best-selling doll this year based on the
following information: last year the company cut the price of its best-selling doll
by 10% and the total revenues from doll sales increased by 10%.
The total revenue test indicates that the price elasticity of demand for the doll in
last year’s price range was unit elastic, or 1. If the firm cuts the doll’s price this
year, then it will most likely put the price of the doll in the inelastic range of
demand, and thus a percentage change in price will lead to a greater
percentage change in quantity in this range, causing total revenues to fall. You
should advise the president not to cut the price because the firm is maximizing
its total revenue. [text: E pp. 359-362; MI pp. 115-118]
7. The owner of a health club asks you for advice about whether the company should raise
or lower the price of its membership this year based on the following information: last
year the club raised the price of its membership by 5% and the number of members
paying the same fee fell by 7%.
The formula for the price elasticity of demand indicates the demand for
memberships is price elastic or 1.4 in this case (7 divided by 5). This result
suggests that total revenues for the club should have decreased last year.
Another increase in price this year would only decrease total revenues. You
should advise the owner to lower membership prices because it should increase
Introduction to Microeconomics ECO 1010 – Prof. David Nerubucha
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total revenue given that the membership price is in the elastic range. [text: E
pp. 359-362; MI pp. 115-118]
8. A gasoline station very near a professional football stadium parks car on its lot to
make money on game days. Last year it charged $4.00 per car and parked
1,000 cars. This year it raised the parking price to $5.00 and parked 850 cars.
Did the station owner make a good economic decision in raising the parking
prices from one year to the next? Explain.
The owner made a good decision in raising price. The total revenue test
indicates that total revenue increased with the increase in price. The $4.00
price times 1,000 cars produced $4,000 in revenue, but the $5.00 price times the
850 cars produced $4,250 in revenue, for a gain of $250. These results indicate
that demand for parking is inelastic in this price range. The midpoints formula
also shows that demand is inelastic in the price range because the coefficient is
0.73. [text: E pp. 359-362; MI pp. 115-118]
9. The president of the Micro Brewing Corporation asks you, as the company
economist, to forecast changes in consumer beer purchases associated with a
proposed price change. You conduct a survey and find that if the price of a six-
pack increases from $5.50 to $7.50, the quantity demanded will decrease from
2,200 units to 1,800 units a month. Should the Micro Brewing Corporation raise its
price? Explain the economic basis for this recommendation to the president.
Yes, the corporation should increase the price of a six-pack. Over the price
range considered, the price elasticity of demand coefficient is 0.65, or inelastic,
using the midpoints formula. An increase in price when demand is inelastic will
increase total revenue. This increase in total revenue also can be shown by
multiplication. With a price of $5.50 times a quantity of 2,200 per month, the
total revenue was $12,100. With the higher price of $7.50 times a lower quantity
of 1,800, the total revenue is $13,500. Thus, there is a gain of $1,400 in total
revenue from raising the price. [text: E pp. 359-362; MI pp. 115-118]
10. On the below demand curve, indicate the character of the price elasticity of
demand across all prices.
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11. Based on the determinants of elasticity as discussed in the text, explain what the
price elasticity of demand of the following products would be: (a) ballpoint
pens; (b) Crest toothpaste; (c) diamond rings; (d) sugar; and (e) refrigerators.
(a) Ballpoint pens: Demand should be slightly elastic because there are
substitutes, and they are not a complete necessity. However, they are not very
durable and the price is small relative to most incomes, and the substitutes are
not quite the same so the elasticity will not be high.
(b) Crest toothpaste: Demand should be very elastic because there are very
many other brand-name substitutes, and this brand is not a necessity.
(c) Diamond rings: Demand should be elastic because there are other types
of rings, the price is high relative to most incomes, they are durable, and they
are a luxury item.
(d) Sugar: Demand should be inelastic because there are few close
substitutes, the price is small relative to most incomes, it is not a durable good,
and not usually viewed as a luxury.
(e) Refrigerators: Demand is probably somewhat elastic because the price is
large relative to most incomes and they are durable so an old refrigerator can
last until “the price is right.” However, refrigerators are not luxuries and there are
no good substitutes, so the demand is probably not very elastic with respect to
price. [text: E pp. 362-363; MI pp. 118-119]
12. Explain how each of four different factors can affect the price elasticity of
demand. Give an example for each determinant.
First, the price elasticity of demand can be affected by the number of
substitutes. In general, the larger the number of substitutes for a product, the
greater will be the elasticity of demand. The price elasticity of demand for beef
tends to be relatively high because there are many possible substitute sources
of protein (e.g., chicken, turkey, or fish). Second, elasticity is also affected by
the proportion of income spent on a product. Other things equal, the higher
the price of a product relative to people’s incomes (and budgets), the greater
the product’s elasticity of demand. Sugar has a relatively low price elasticity of
demand because the cost of sugar is a minor part of a consumer’s budget. By
contrast, the price elasticity of demand for computers and other consumer
appliances such as washing machines is relatively high because they require a
large outlay from a consumer’s budget. Third, luxuries will tend to be price-
elastic while necessities are price-inelastic. Bread will have a low price elasticity
of demand coefficient relative to that for a luxury auto. Fourth, time will
influence the elasticity of demand. The greater the amount of time considered,
the greater the elasticity of demand. In the short-run the demand for travel to a
warm location during the winter will be less price-elastic than the demand for
Introduction to Microeconomics ECO 1010 – Prof. David Nerubucha
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travel to a warm location at other times of the year. [text: E pp. 362-363; MI pp.
118-119]
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