ELASTICITY

SOME CONTEXT AND BACKGROUND

• The concept of elasticity is important in economics. Sadly, the CORE text does
not cover it well. Fortunately, the concepts are not difficult to grasp. Once you
understand the formula for the price elasticity of demand, it is easy to apply it to
the price elasticity of supply, and the cross elasticity and income elasticity of
demand.
• I have not prescribed any textbook for the three lectures that will cover this
work. I will work through it carefully and thoroughly in class, and the work will
be covered in the whiteboard session. If you do not understand what is
happening in class, please watch the podcasts again. If that is not helpful, please
search for “price elasticity” on YouTube. Elasticity is taught in a very standardized
way in a standard microeconomics curriculum, so watching YouTube videos
should be very beneficial, if you need that.
 AIM OF THESE LECTURES

• Define and calculate the price elasticity of demand and explain the factors that
influence it

• Define and explain the price elasticity of supply

• Define the cross elasticity of demand and the income elasticity of demand and
explain the factors that influence them
 WHAT IS PRICE ELASTICITY?

• Elasticity = responsiveness
• By how much does the quantity demanded change if the price
increases by 1%? 10%? 50%?
 CALCULATING THE PRICE ELASTICITY OF DEMAND

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑

• Price elasticity =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒

• Price elasticity is always negative (why?)

• But we typically present it as a positive number
 AN EXAMPLE (AND ITS IMPLICATIONS)
• If the price of coffee increases from R15 to R25 a cup, and the quantity demanded decreases from
4 cups to 2 cups per day, calculate the
• Percentage increase in the price
• Percentage decrease in the quantity
• Price elasticity of demand
• If the price of coffee decreases from R25 to R15 a cup, and the quantity demanded increases from
2 cups to 4 cups per day, calculate the
• Percentage increase in the price
• Percentage decrease in the quantity
• Price elasticity of demand
 RESOLVING THE PROBLEM OF GETTING DIFFERENT PRICE
ELASTICITIES WHEN THE PRICE INCREASES OR DECREASES

• Calculate the price change based on the average of the initial price
and the final price
• Calculate the quantity change based on the average of the initial
quantity and the final quantity
∆𝑄 𝑃1 + 𝑃2
• The formula simplifies to the following: PED = .
∆𝑃 𝑄1 + 𝑄2
 LET’S REPEAT THE EXERCISE

• If the price of coffee increases from R15 to R25 a cup, and the quantity demanded decreases from
4 cups to 2 cups per day, calculate the
• Percentage increase in the price, using the average of the old and new prices
• Percentage decrease in the quantity, using the average of the old and new quantities
• Price elasticity of demand
∆𝑄 𝑃1 + 𝑃2
• Price elasticity of demand using the formula PED = .
∆𝑃 𝑄1 + 𝑄2

• If the price of coffee decreases from R25 to R15 a cup, and the quantity demanded increases from
2 cups to 4 cups per day, calculate the
• Percentage decrease in the price, using the average of the old and new prices
• Percentage increase in the quantity, using average of the old and new quantities
• Price elasticity of demand
 GIVING MEANING TO THE NUMBERS
• Distinguish between
• Elastic demand
• Unit elastic demand
• Inelastic demand

•
 PRICE ELASTICITY ALONG A LINEAR DEMAND
CURVE

• Given a demand curve: Qd = 70 – 10 P

• Complete the table on the next slide using the following formula:
∆𝑄 𝑃1 + 𝑃2
• PED = .
∆𝑃 𝑄1 + 𝑄2
Price Quantity Price elasticity
0 70
1/13 = 0.08
1 60
3/11 = 0.27
2 50
5/9 = 0.56
3 40
1
4 30
9/5 = 1.8
5 20
11/3 = 3.67
6 10
13
7 0
PRESENTING THIS GRAPHICALLY

• See the board

• Important: the midpoint of a linear demand curve is where the price

elasticity is one
• At higher prices, the price elasticity is greater than one (demand is
relatively elastic)
• At lower prices, the price elasticity is less than one (demand is relatively
inelastic)
 SLOPE OF THE DEMAND CURVE AND PRICE
ELASTICITY

• Remember: Slope is not the same as elasticity

• BUT the two are related
• On the same set of axes, for the same quantity and price combinations, the
flatter demand curve corresponds to the more price elastic demand, while the
steeper demand curve corresponds to the less price elastic (more price
inelastic) demand

• Showing this graphically: see the board

 DISTINGUISHING BETWEEN DIFFERENT
SITUATIONS

• Follow the diagrams on the board

• Relatively elastic demand
• Unit elastic demand
• Relatively inelastic demand
• Perfectly elastic demand
• Perfectly inelastic demand
WHAT FACTORS INFLUENCE THE PRICE ELASTICITY
OF DEMAND?

• Availability of substitutes
• Whether the product is a necessity or a luxury
• The narrowness or broadness of the definition of the product
• The amount of time that elapses
• Proportion of income spent on the product
• E.g. toothpaste vs. rent of property
TOTAL REVENUE AND THE PRICE ELASTICITY OF
DEMAND

• Total revenue = price x quantity

• If a company could increase the price of a product, should it do so?
• It depends on the price elasticity of demand
• If the demand is price elastic:
• A given percentage price increase will cause a more than proportional decrease in the quantity
demanded, and revenue would decrease

• If the demand is price inelastic:

• A given percentage price increase will cause a less than proportional decrease in the quantity
demanded, and revenue would increase
 Price Quantity Total revenue Price elasticity
PRESENTING 0 70 0
THIS 1/13 = 0.08
1 60 60
GRAPHICALLY
3/11 = 0.27
2 50 100
5/9 = 0.56
3 40 120
See the board 1
4 30 120
9/5 = 1.8
5 20 100
11/3 = 3.67
6 10 60
13
7 0 0
 AN EXAMPLE
• You are the market strategist for British American Tobacco.You know
that BAT has much market power. Do you advise that BAT should
increase the price of cigarettes or decrease the price of cigarettes, if
they want to increase their revenue?
• Has this happened in South Africa?
• Are there risks associated with this strategy?
• What can BAT do to mitigate these risks?
 ANOTHER EXAMPLE

• Is a bumper harvest good or bad for farmers?

• Questions to answer:
• What happens to produce prices when there is a bumper crop?
• What happens to farmers’ total revenue when there is a bumper crop?
• Are crop failures good or bad for farmers?
PRICE ELASTICITY OF SUPPLY

• To what extent can suppliers change the quantity

supplied in response to a change in the price of the
product?
• This is the price elasticity of supply
∆𝑄 𝑃1 + 𝑃2
• PES = .
∆𝑃 𝑄1 + 𝑄2
WHAT FACTORS INFLUENCE THE PRICE ELASTICITY
OF SUPPLY?

• TIME
• Supply is less elastic in the short run (producers cannot change their production
overnight)
• Supply is more elastic in the long run (producers can change their production
processes)

• Examples and applications

• The supply of genuine antique art/furniture vs. “made to look old” modern
art/furniture
• The volatility of the gold price
CROSS-PRICE ELASTICITY OF DEMAND

• What happens to the demand for my product if a company that sells a

substitute or complementary product reduces the price for their product?
• Examples:
• What happens to the demand for pizzas if hamburger prices drop by 20%?
• What happens to the demand for e-cigarettes if the price of regular
cigarettes increases by 25%?
• What happens to the demand for cars if the price of petrol doubles?
 CALCULATING THE CROSS ELASTICITY OF
DEMAND
• Cross elasticity of demand =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑜𝑑𝑢𝑐𝑡
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑎 𝑠𝑢𝑏𝑠𝑡𝑖𝑡𝑢𝑡𝑒 𝑜𝑟 𝑐𝑜𝑚𝑝𝑙𝑒𝑚𝑒𝑛𝑡
∆ 𝑄𝑋 𝑃𝑌1 + 𝑃𝑌2
• The formula that we typically use: Cross elasticity = .
∆𝑃𝑌 𝑄𝑋1 + 𝑄𝑋2

• The sign of the cross elasticity is very important (we do not throw the negative
sign away)
• Positive sign: substitutes
• Negative sign: complements
• Note: no need to remember this; work it out!
EXAMPLE

• If the price of Pepsi increases from R9 to R11 per litre, the

quantity demand of Coca-Cola purchased on UCT campus
increases from 145 litres per day to 155 litres per day, ceteris
paribus. (What does this expression mean?)
• Calculate the cross elasticity of demand
• Are the two products complements or substitutes?
 INCOME ELASTICITY OF DEMAND

• By what percentage does the demand for a product change in response to

a 1% change in income?
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
• Income elasticity of demand =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑐𝑜𝑛𝑠𝑢𝑚𝑒𝑟 ′ 𝑠 𝑖𝑛𝑐𝑜𝑚𝑒

∆𝑄 𝑌1 + 𝑌2
• IED = . , where Y indicates (average) income
∆𝑌 𝑄1 + 𝑄2
HOW TO INTERPRET THE INCOME ELASTICITY OF
DEMAND

• Less than zero (i.e. negative): inferior product

• More than zero (i.e. positive): normal product
• Less than one: necessity
• More than one: luxury
INCOME ELASTICITY AND THE SHARE OF TOTAL
INCOME
• If the income elasticity for product X is less than one, and incomes
increase, the share of total expenditure of product X decreases
• Example: food
• If the income elasticity for product Y is more than one, and incomes
increase, the share of total expenditure of product Y increases
• Example: jewelry, overseas holidays
SOME APPLICATIONS OF ELASTICITY

• They help us understand how people respond to changes in prices

and income
• They quantify the law of demand:
• E.g. rather than saying: “when the price of rice decreases, consumers will
purchase more rice” we can be more precise: “when the price of rice
increases by 10%, people will increase their purchases of rice by 3%”
• Helpful for guiding government policy, e.g. the impact of excise taxes
END OF
DISCUSSION ON
ELASTICITY