Elasticity and its Application

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Elasticity
• “Elasticity” is a (standard) measure of the degree of sensitivity
( or responsiveness) of one variable to changes in another
variable.
• The change in dependent variable due to change in the
independent variables.

Types of Elasticity
• Price Elasticity of Demand
• Cross price Elasticity of Demand
• Income Elasticity of Demand
• Price Elasticity of Supply 2
Price Elasticity of Demand
 Price elasticity of demand is the percentage change in quantity demanded given a
percent change in the price.

 It is a measure of how much the quantity demanded of a good responds to a change in

the price of that good.

Elasticity = Percentage change in Dep Var

Percen change in Indep Variable
Determining Price Elasticity
Ed = Percentage Change in Quantity Demand
Percentage Change in Price

Ed = Change in Quantity /Quantity

Change in Price/ Price

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• E=

4
 P Qd
10 200
9 240

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Categories of Ed
• There are 5 types of elasticity of demand:
• Relatively Elastic Demand (Ed> 1) ...
• Relatively Inelastic Demand (Ed< 1 ) ...
• Unitary Elastic Demand ( Ed = 1)
• Perfectly Elastic Demand (Ed = ∞) ...
• Perfectly Inelastic Demand (Ed = 0) ...

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Relatively Elastic Demand (Ed> 1)
• The demand is said to be relatively elastic if the percentage
change in demand is greater than the percentage change in
price i.e. if there is a greater change in demand there is a small
change in price.
• If the price falls by 5% and the demand rises by more than 5%
(say 10%), then it is a case of elastic demand. The demand for
luxurious goods such as car, television, furniture, etc. is
considered to be elastic.

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Relatively Inelastic Demand (Ed<
1• The
) demand is said to be relatively inelastic if the percentage
change in quantity demanded is less than the percentage
change in price i.e. if there is a small change in demand with a
greater change in price.
• For example: when the price falls by 10% and the demand
rises by less than 10% (say 5%), then it is the case of inelastic
demand. The demand for goods of daily consumption such as
rice, salt, kerosene, etc. is said to be inelastic.

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Unitary Elastic Demand ( Ed = 1)
• The demand is said to be unitary elastic if the percentage
change in quantity demanded is equal to the percentage
change in price. It is also called unitary elasticity.
• In such type of demand, 1% change in price leads to exactly
1% change in quantity demanded. This type of demand is an
imaginary one as it is rarely applicable in our practical life.

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Perfectly Elastic Demand (Ed = ∞)
• The demand is said to be perfectly elastic if the quantity
demanded increases infinitely (or by unlimited quantity) with
a small fall in price or quantity demanded falls to zero with a
small rise in price.
• Thus, it is also known as infinite elasticity. It does not have
practical importance as it is rarely found in real life.

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Perfectly Inelastic Demand (Ed =
0)
• The demand is said to be perfectly inelastic if the demand
remains constant whatever may be the price (i.e. price may
rise or fall). Thus it is also called zero elasticity.

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Mathematical Application of
Price Elasticity of Demand
• Demand Equation
Qd = a –bP
Where
Qd = Quantity Demand
P = Price
dQ P
Ed = ----- . -----
dp Q

Example: Qd = 8 – 0.5 P if P = 10
Calculate Price Elasticity of Demand 12
Rules of Derivatives
• 1. Constant Rule
The derivative of constant is zero.
dy/dx = 10 = 0
2. Variable Rule (Power 1)
The derivative of Power one variable is equal to 1
e.g : y=x or y = 10x
dy/dx = 1 dy/dx = 10
3. Power Rule
dy/dx = n x n-1
e.g: y = 4x2 or y = 10x3 = dy/dx = 30x2
dy/dx = 4*2 x2-1 = 8x 13
Example :
Q = 8 – 0.5 P if P = 10
Calculate Price Elasticity of Demand
dQ P
Ed = ----- . -----
dp Q
Put p= 10 in demand equation we get Q = 8 – 0.5(10) = 3
then
Ed = dQ/dp x 10/3
Now apply derivative on demand equation
dQ/dP = 0 – 0.5 (1) = - 0.5
Then
Ed = dQ/dp x 10/3
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= -0.5 x 10/3 = -1.67 (Elastic Demand)
• Q = 15 – 5P if P= 3 Rs

• Calculate Ed = -5 x 3/0 = infinity

Perfectly Elastic Demand

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 Determinants of
Price Elasticity of Demand

 Necessities versus Luxuries

 Availability of Close Substitutes
 How much of our income a good
takes
 Time Horizon
 Determinants of Price
Elasticity of Demand
Demand tends to be more inelastic
 If the good is a necessity.
 If the time period is shorter.
 The smaller the number of close substitutes.
 The lower the portion of income we spend
 Determinants of
Price Elasticity of Demand
Demand tends to be more elastic :

 if the good is a luxury.

 the longer the time period.
 the larger the number of close substitutes.
 The larger the income portion we spend
Price Elasticity of Demand
and Revenue
• Total revenue is by definition equal to price times
quantity (or TR = P x Q)
• Ed and Revenue
1. When demand is price-inelastic, a price decrease
reduces total revenue.
2. When demand is price-elastic, a price decrease
increases total revenue.
3. In the borderline case of unit-elastic demand,
a price decrease leads to no change in total
revenue.
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Elasticity: Summary of
Crucial Concepts

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Cross Price Elasticity of
DemandB
• ...measures the responsiveness of buyers
to the purchase of one good in response
to changes in the price of another good
Types of other Goods
• Substitutes
• Complements
Ec = ΔQdA/ΔpB x PB / QdA

Ec = ΔQdC /ΔpP x Pp / Qdc

Example 1
PB QdA
10 20
15 30

Example 2

Pc QdF
5 40
8 30

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 Cross-price elasticity of demand
• How quantity demanded of one good responds to a change in
price of another good
% ∆ in Qty Dgood B
Cross-price Ea,b =
% ∆ in Pgood A
• 1. Ec = Positive

• Substitutes have positive cross-price elasticity Ea,b > 0

• Example: Price soda ↑ => Qty D other drinks ↑
• 2. Ec = Negative

• Complements have negative cross-price elasticity Ea,b < 0

• Example: Price gas ↑ => Qty D large SUV’s ↓
 Income Elasticity of Demand
• Income elasticity of demand- percentage change in demand due
to some percentage change in Income.
• EY = % ∆ in Qty Demanded
% ∆ in Income
EY = ΔD /Δy x Y /D
• 1.
Y Qd
500 15
1000 20
Example 2:
D = 200 + 50 Y if Y= 100 Rs
Calculate Income Elasticity of Demand
dD Y
Ed = ----- . -----
dY D
Put p= 100 in demand eq. we get D = 200 + 50(100) = 5200
then
Ey = dD/dY x 100/5200
Now apply derivative on demand equation
dD/dY = 0 + 50(1) = 50
Then
Ey = dD/dy x 100/5200 25
= 50 x 100/5200 Ey = 0.96
Categories of EY
• 1. Ey = Positive (Income Increase, Demand Increase)
• Normal Goods have positive Income elasticity (normal good
= Income ↑, Qty D ↑)
• Income elastic: Ey >1 (considered a luxury)
• Income inelastic: Ey < 1 (considered a necessity)

• 2. Ey = Negative (Income Increase, Demand Decrease)

• Inferior Goods: Ey < 0 (negative income elasticity)

• e,.g Secondhand sales

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Price Elasticity of Supply
• …measures the responsiveness of quantity supplied (QS) by
business firms to changes in the price of a good (P).
• The percentage change in the quantity supplied that occurs in
response to a 1 percent change in price

Q Q
Price elasticity of supply 
P P
Example 1:
P Qs
10 20
20 40

• Calculate Es ?
ΔQ P
Es = ----- . -----
Δp Q
• Example 2:
Qs = 5 +2P if P= 10 Rs
Calculate Es ?
dQ P
Es = ----- . ----- 28

dp Q
Categories of Es
• Elastic Supply (Es> 1)
• Inelastic Supply (Es < 1 )
• Unitary Elastic Supply (Es  = 1)
• Perfectly Elastic Supply (Es  = ∞)
• Perfectly Inelastic Supply (Es  = 0)

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Price Price
S
S
P2 P2

P1 P1

Q1 Q2 Quantity Q1 Q2 Quantity
Elastic Supply: Inelastic Supply:
the % change in QS is greater than the % change in QS is less than the %
the % change in P that caused it. change in P that caused it.
Indicates that Firms are very Indicates that Firms are not very
responsive or sensitive to price responsive or sensitive to price
changes and are willing and able to changes and are either not able or
make a lot more of the product willing to make more of this product
available with small price increases. available without a large price
increase.
Price Price Price

Quantity Quantity Quantity

Perfectly Inelastic Supply Perfectly Elastic Supply Unitary Elastic Supply
Ps = 0 PS = Ps = 1

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Any change is price will the % change in QS is
Quantity supplied does cause QS to go to zero
not change at all no matter the same as the %
Practical application: change in P
how much price changes A firm is willing to make
that caused it.
as much of this product
Example: Fixed seating at available at a constant
a theater or arena. price
(Could happen if costs do
not change)
Determinants of Elasticity of Supply
How much does the cost per unit of output rise as
quantity supplied increases?
The more it (costs /output) increases the
more inelastic supply will be.
If costs don’t rise at all as QS increases then
supply is perfectly elastic.
• Ability to increase quantity produced
• Beach front property is inelastic (hard to increase quantity)
• Books, cars are elastic

• Time Period
• Supply is more elastic in long run vs. short run
• Time allows companies to produce more
 Questions
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