Elasticity of Demand

Macroeconomics Elasticity: an economics concept that

measures responsiveness of one variable to
changes in another variable.
Module 5: Elasticity
Types of elasticity
• price elasticity of demand
• price elasticity of supply
• income elasticity of demand
• cross-price elasticity of demand

Elasticity of Demand (cont.) Elastic and Inelastic Demand Analysis

Elastic and Inelastic Demand Factors helping to predict

Inelastic Demand: a low
product demand as more or less
Elastic Demand: a high
responsiveness of quantity responsiveness by consumers to elastic:
demanded or supplied to price changes. • Substitutes
changes in price. • Example: Cigarette taxes and • Necessities vs. luxuries
• Example: A store owner raises smoking rates. The greater the • Share of the consumer’s budget
prices, she can expect that amount of the tax increase, the • Short run versus long run
the quantity demanded will fewer cigarettes are bought • Competitive dynamics
drop, but she might not know and consumed.
how sensitive customers will be
to the change.
 Calculating Elasticity and Percentage Changes:
Examples of Elastic and Inelastic Demand
Definitions
Which of the following products have elastic demand and which have inelastic • Elastic Demand: when the • Inelastic Demand: when the
demand? calculated elasticity of demand calculated elasticity of demand is less
is greater than one, indicating a than one, indicating a 1 percent
• Gasoline increase in price paid by the consumer
high responsiveness of quantity
• College textbooks demanded or supplied to leads to less than a 1 percent change in
• Coffee changes in price. purchases (and vice versa); this indicates
• Airline tickets a low responsiveness by consumers to
price changes.
• Concert tickets • Elastic Supply: when the
• Soft drinks calculated elasticity of either
• Inelastic Supply: when the
calculated elasticity of supply is less than
• Medical procedures supply is greater than one, one, indicating a 1 percent increase in
indicating a high responsiveness price paid to the firm will result in a less
of quantity demanded or than 1 percent increase in production by
supplied to changes in price. the firm; this indicates a low
responsiveness of the firm to price
increases (and vice versa if prices drop).

Calculating Elasticity and Percentage Changes: Calculating Elasticity and Percentage Changes:
Definitions (cont.) Calculations
• Midpoint Elasticity Approach: most • Unitary Elasticity: when Calculating Elasticity Example: For every
accurate approach to solving for the calculated elasticity is equal to 10 percent increase in the
elasticity in which the growth rate, or one indicating that a change in the The formula for calculating
percentage change in quantity price of the good or service results in elasticity is: price of a pack of
demanded, is divided by the a proportional change in the quantity cigarettes, the smoking rates
average of the two quantities demanded or supplied.
demanded.
drop about 7 percent. Using
• Point Elasticity Approach:
the formula, we get:
approximate method for solving for
elasticity in which the initial quantity
demanded is subtracted from the
new quantity demanded, then
divided by the initial price
Calculating Elasticity and Percentage Changes: Calculating Elasticity and Percentage Changes:
Inelastic Elastic / Unitary

What does the number -0.7 tell us about the elasticity of Different Products, Different Price Elasticities of Demand
demand?
• Negative sign reflects the law of demand: at a higher price, • If the absolute value of the • If elasticity is equal to one, it
the quantity demanded for cigarettes declines. elasticity of a product is means that the change in the
greater than one, the quantity demanded is
• The result of less than one says the size of the quantity change exactly equal to the change
change in the quantity in price, so the demand
is less than the size of the price change.
demanded is greater than response is exactly
• It would take a relatively large price change to cause a the change in price. proportional to the change in
relatively small change in quantity demanded. • Greater than one indicates a price.
• Consumer responsiveness to a change in price is relatively larger reaction to price change, • We call this unitary
which we describe as elastic. elasticity, because unitary means
small. When the elasticity is less than 1, demand is inelastic. one.

Calculating Elasticity and Percentage Changes

Calculating Elasticity and Percentage Changes
(cont.)
Calculating Percentage Changes/Growth Rates Midpoint Elasticity
• Solve for elasticity using the Midpoint (or arc) elasticity approach: • Solve for elasticity using
Formula for computing growth rate: growth rate of the quantity uses the average price and average the midpoint (or arc)
demanded and the quantity over the price and quantity elasticity approach
percentage change in price change.
in order to to examine how with product quantity
these two variables are demanded at 100 then
related. Same Example: A job pays $10 per moved to 103.
hour. At some point, the individual
Example: A job pays $10 per hour. At some point, the • Use the point elasticity doing the job is given a $2-per-hour
individual doing the job is given a $2-per-hour raise. The approach with product raise. The percentage change (or
percentage change (or growth rate) in pay is: quantity demanded at 100 growth rate) in pay is:
then moved to 103.
Calculating Price Elasticities Using the Midpoint Calculating Price Elasticities Using the Midpoint
Formula Formula (cont.)
The Midpoint Method : using the average percentage change in both quantity Calculate elasticity from points B to A: Step 4. Then, those values can be used to
Step 1. Use price elasticity of demand formula determine the price elasticity of demand:
and price.
• There are two formulas used for the midpoint method; the percent change in
quantity, and the percent change in price.
• The advantage of the midpoint method is that one obtains the same Step 2. From the midpoint formula we know:
elasticity between two price points whether there is a price increase or
decrease.

Step 3. Use the values provided in the figure (as price

decreases from $70 at point B to $60 at point A) in each
equation:

Calculating Price Elasticities Using the Midpoint

Categories of Elasticity: Definitions
Formula (cont. II)
Elasticity Is Not Slope • (Relatively) Elastic: the percentage change in
• Common mistake to confuse the slope quantity demanded is greater than the
of either the supply or demand curve percentage change in price; measured price
with its elasticity. elasticity of demand is greater than one (in
absolute value)(relatively).
• The slope is the rate of change in units
along the curve, or the rise/run • (Relatively) Inelastic: the percentage change in
(change in y over the change in x). quantity demanded is less than the percentage
change in price; measure price elasticity of
• The price elasticity, however, changes demand is less than one (in absolute value).
along the curve.
• Elasticity is the percentage change—
which is a different calculation from
the slope, and it has a different
meaning.
Categories of Elasticity: Definitions (cont.) Categories of Elasticity

• Unitary Elastic: when a given percent price change in price leads to an • Demand is described • Unitary elasticities indicate
equal percentage change in quantity demanded. as elastic when the computed proportional responsiveness
elasticity is greater than 1, of demand. In other words, the
• Perfectly (or infinitely) Elastic: the extremely elastic situation of demand or percent change in
supply where quantity changes by an infinite amount in response to any indicating a high responsiveness to
changes in price. quantity demanded is equal to
change in price; horizontal in appearance.
the percent change in price, so
• Perfectly Inelastic: the highly inelastic case of demand in which a • Computed elasticities that are less the elasticity equals 1.
percentage change in price, no matter how large, results in zero change in than 1 indicate low responsiveness
the quantity; thus, the price elasticity of demand is zero; vertical in to price changes and are
appearance(relatively). described as inelastic demand.

Table 1. Three Categories of Elasticity: Elastic,

Categories of Elasticity (cont.)
Inelastic, and Unitary

If… Then… And it’s called… • Both elastic and inelastic are relative terms, as
shown in Figure 1.
% change in quantity Computed elasticity is Elastic
is greater than % greater than 1 • As one moves down the demand curve from top
change in price left to bottom right, the measured elasticity is much
greater than one (very elastic), then just greater
% change in quantity Computed elasticity is Unitary than one (somewhat elastic), then equal to one
is equal to % change equal to 1 (unitary elastic, then less than one (somewhat
in price inelastic), and finally much less than one (very
% change in quantity Computed elasticity is Inelastic inelastic).
is less than % change less than 1 • Note that the epsilon symbol, ε, is often used to
in price represent elasticity.
Categories of Elasticity: Polar Cases Categories of Elasticity: Polar Cases (cont.)

Polar Cases of Elasticity Perfectly (or infinitely) elastic demand curve refers to the
• Two extreme cases of elasticity: extreme case in which the quantity demanded (Qd)
• When computed elasticity equals zero.
increases by an infinite amount in response to any
• When computed elasticity is infinite.
decrease in price at all.
Note: Even though perfectly elastic and perfectly inelastic curves correspond • Similarly, quantity demanded drops to zero for any
to horizontal and vertical curves, remember that, in general, elasticity is not increase in the price.
the same as the slope. • A perfectly elastic demand curve is horizontal, as shown
in Figure 2 to the right.
• Perfectly elastic demand is an “all or nothing” thing!

Categories of Elasticity: Polar Cases (cont. II) Price Elasticity of Supply

Perfectly inelastic demand is an extreme case, Price elasticity of supply is the percentage change in the quantity of
necessities with no close substitutes are likely to
have highly inelastic demand curves. a good or service supplied divided by the percentage change in the
• This is the case with life-saving prescription price.
drugs, like insulin. • Measures how much quantity supplied changes in response to a
• A specific quantity of insulin is prescribed to the change in the price.
patient. Regardless of a price increase or
decrease, the same quantity is needed to stay • Looks at how producers respond to a change in the price instead
alive. of how consumers respond.
• Perfectly inelastic demand means that
quantity demanded remains the same when
price increases or decreases.
• Consumers are completely unresponsive to
changes in price.
Price Elasticity of Supply (cont.) Calculating Price Elasticities of Supply

Calculate the price elasticity of supply Step 1. Use price elasticity of demand formula Step 3. Use the values provided in the in each
equation:
from point A to B.
• Assume that an apartment rents for $650
per month and at that price 10,000 units
are offered for rent, as shown in Figure 2,
left. Step 2. From the midpoint formula we know:
• When the price increases to $700 per
month, 13,000 units are offered for rent.
• By what percentage does apartment Step 4. Then, those values can be used to determine
the price elasticity of demand:
supply increase?
• What is the price sensitivity?

Income Elasticity, Cross-Price Elasticity & Other

Income Elasticity
Types of Elasticities
• Quantity supplied (Qs) depends on the cost of production, changes in Income Elasticity of Demand
weather (and natural conditions), new technologies, and government
policies. • For most products, most of • Formula:
the time, the income
• Elasticity can be measured for any determinant of supply and demand, not elasticity of demand is
just the price.
positive.
Elasticity
• How a percentage change in one variable causes a percentage
change in another variable. • The percentage change in
• Elasticity does not just apply to the responsiveness of supply and quantity demanded
demand to changes in the price of a product.
• Quantity demanded (Qd) depends on income, tastes and divided by the percentage
preferences, population, expectations about future prices, and the change in income.
prices of related goods.
Income Elasticity (cont.) Cross-Price Elasticity

Income Elasticity of Demand • If good A is a complement for

Cross-Price Elasticity of
• A rise in income will cause an increase in the quantity demanded good B, like coffee and sugar, then
• These goods are referred to as normal goods. Demand
• For a few goods, an increase in income means that one might purchase less • Refers to the idea that a higher price for B will mean a
of the good. the price of one good lower quantity of A consumed.
• When the income elasticity of demand is negative, the good is called an inferior good.
is affecting the • Substitute goods have positive
quantity demanded of cross-price elasticities of demand.
a different good. • If good A is a substitute for good B,
• Complement goods like coffee and tea, then a higher
have negative cross- price for B will mean a greater
price elasticities. quantity of A consumed.

Cross-Price Elasticity (cont.) Elasticity in Labor and Financial Capital Markets

Calculating Cross-Price Elasticity of Demand Wage Elasticity of Labor Interest Elasticity of

• The cross-price elasticity of demand is the percentage Supply: the percentage Savings: the percentage
change in the quantity of good A that is demanded as a change in hours worked change in the quantity of
result of a percentage change in the price of good B. divided by the percentage savings divided by the
• Formula: change in wages. percentage change in
interest rates.
The formula is as follows:
The formula is as follows:
Expanding the Concept of Elasticity Table 1. Formulas for Calculating Elasticity

• The elasticity concept does not • The idea is almost always a

Elasticity Type Formula
need to relate to a typical supply price or money variable, and
Income elasticity of demand = % change in Qd / % change in income
or demand curve at all. how it causes a percentage
Cross-price elasticity of demand = % change of Qd in A / % change of price in
• Whatever context elasticity is change in another variable, good B
invoked, the idea always refers to typically a quantity variable of Wage elasticity of labor supply = % change in quantity of labor supplied / %
percentage change in one some kind. change in wage
variable. Wage elasticity of labor demand = % change of labor demanded / % change
in wage
Interest rate elasticity of savings = % change in quantity of savings / % change
in interest rate
Interest rate elasticity of borrowing = % change in quantity of borrowing / %
change in interest rate

Elasticity and Total Revenue Table 1. Price, Elasticity, and Demand

If Then… Therefore…
Total Revenue and Elasticity of Demand demand
• Studying elasticities is useful for a is…
number of reasons, pricing being the Elastic % change • A given % rise in P will be more than offset by a larger % fall in Q
most important. in Qd is so that total revenue (P times Q) falls
• The key concept in thinking about greater • A given % fall in P will be more than offset than a larger % rise in Q
than % so that total revenue (P times Q) rises
collecting the most revenue is the price
change in P
elasticity of demand.
Unitary % change • A given % rise or fall in P will be exactly offset by an equal % fall in
• Total revenue is price times the quantity in Qd is Q so that total revenue (P times Q) is unchanged
of tickets sold. equal to %
(TR = P x Qd) change in P
Inelastic % change • A given % rise in P will cause a smaller % fall in Q so that total
in Qd is less revenue (P times Q) rises
than % • A given % fall in P will cause a smaller % rise in Q so that total
change in P revenue (P times Q) falls
Elasticity, Costs, and Customers Elasticity, Costs, and Customers (cont.)

Customers and Changing Costs • If new and less expensive ways of

• What happens if the firm’s production producing are invented, can the • How would a technological
costs change? firm keep the benefits in the form breakthrough in aspirin
of higher profits, or will the market
• What is the impact on customers? pressure them to pass along the production impact the market
• If the cost of a key input rises, can the firm gains to consumers in the form of if it were inelastic?
pass along those higher costs to lower prices? • How would a technological
consumers in the form of higher prices?
• The price elasticity of demand breakthrough in aspirin
plays a key role in answering these production impact the market
questions.
if it were elastic?

Elasticity, Costs, and Customers (cont. II) Elasticity, Costs, and Customers (cont. III)

Applying elasticity in the real world Long-Run vs. Short-Run Impact -

Demand
• What happens to the housing rental market there is a big • Elasticities are often lower in the
boom in apartment production in your community? short run than in the long run.
• What happens if demand is elastic? • On the demand side of the
market, it can sometimes be
• What happens if demand is inelastic? difficult to change Qd in the
short run but easier in the long
run.
• The elasticity of demand for
energy is somewhat inelastic in
the short run, but much more
elastic in the long run.
Elasticity, Costs, and Customers (cont. IV) Tax Incidence

Long-Run vs. Short-Run Impact - Supply • In most markets for goods and Elasticity and Tax Incidence
services, prices bounce up and
• For supply side of markets, down more than quantities in the • The analysis of how a tax burden is divided between consumers and
producers of goods and services short run, but quantities often move producers is called tax incidence.
more than prices in the long run.
typically find it easier to expand • Tax incidence depends on the price elasticities of supply and demand.
production in the long term of • The underlying reason for this pattern
is that supply and demand are often • Typically, the tax incidence, or burden, falls both on the consumers and
several years rather than in the short inelastic in the short run, so that shifts
run of a few months. in either demand or supply can producers of the taxed good.
cause a relatively greater change in
• In the short run it can be costly or prices. • To predict which group will bear most of the burden, examine the elasticity
of demand and supply.
difficult to build a new factory, hire • Since supply and demand are more
many new workers, or open new elastic in the long run, the long-run
stores. But over a few years, all of movements in prices are more
muted, while quantity adjusts more
these are possible. easily in the long run.

Tax Incidence (cont.) Quick Review

• When the demand is inelastic, consumers are not very responsive to price • What is elasticity and give a few • What is the difference between a
changes, and the quantity demanded reduces only modestly when the examples? midpoint elasticity approach and the
tax is introduced. • Why is the demand for some goods point elasticity approach in
either elastic or inelastic? calculating elasticity?
• When a tax is
added in a market • How do you mathematically • What is the difference between slope
differentiate between elastic, and elasticity?
with an inelastic
inelastic, and unitary elasticities of • Explain and compare graphs for the
supply, and sellers
demand? following types of elasticities: elastic,
have no alternative
than to accept • What is are percentage changes, or inelastic, unitary, infinite, and zero.
growth rates?
lower prices for their
business, taxes do • How do you calculate price
elasticity using the midpoint
not greatly affect method?
the equilibrium
quantity.
Quick Review (cont.)

• How do you calculate the price • How do you evaluate how

elasticity of supply? elasticity can cause shifts in
• How do you calculate the income demand and supply?
elasticity of demand? • How can you predict how
• What is cross-price elasticity of elasticity affects equilibrium in the
demand and how do you calculate long-run and the short-run?
it? • How do the price elasticities of
• What is elasticity in labor and demand and supply determine
financial capital markets? the incidence of a tax on buyers
• How do differences in elasticity and sellers?
affect total revenue?