Elasticity

Price Elasticity of Demand
 The response of consumers to a change in price is measured
by the price elasticity of demand.
 Price Elasticity of Demand – the percentage
change in quantity demanded divided by the percentage change in price.
 Formula:
percent
change
in quantity demanded
price elasticity (E) =

percent change in price
 The law of demand implies that the price elasticity of
demand will always be greater than zero.
 Since quantity demanded decreases when prices increase (law
of demand), E is always negative.
 Elastic vs. Inelastic.
 If E > 1, demand is called elastic in
the immediate price range.
 If E < 1, demand is called inelastic
 note: the numbers are in absolute values
 Elasticity Extremes
 A horizontal demand curve means that demand is perfectly
elastic. Any price increase would cause demand to fall to zero
 A vertical demand curve means that demand is completely
inelastic.
Demand will not change regardless of any change in price.

Determinants of Elasticity
 The elasticity of demand is computed between points on a
given
demand curve. Hence, the price elasticity of demand is influenced
by
all of the determinants of demand.
 Four factors are particularly worth noting:
 Necessities vs. Luxuries
 Demand for necessities, goods that are critical to our
everyday life, is relatively inelastic.
 Demand for luxury goods, goods we would like to have
but
are not likely to buy unless our income jumps or the ice declines
sharply,
is relatively elastic.
 Availability of Substitutes
 The greater the availability of substitutes, the higher
the price elasticity of demand.
 Time
 The longrun price elasticity of demand is higher than
the shortrun elasticity
 Relative Price:
 The higher the price in relation to a consumer's
income, the higher the elasticity of demand

Price Elasticity and Total Revenue
 A price hike increases total revenue only if demand is
inelastic (E < 1)
 A price hike reduces total revenue if demand is elastic (E
> 1)
 A price hike does not change total revenue if demand is
unitary elastic (E = 1)
 The reverse applies for price decreases

Income Elasticity of Demand
 Income Elasticity of demand – Percentage
change in quantity demanded divided by percentage change in income
 Formula:
percentage
change in quantity demanded
elasticity of demand =

percentage change in income
 Normal Good  good for which demand rises
when income rises.
 A normal good has an income elasticity of demand greater
than zero.
 Inferior Good  good for which demand
decreases when income rises.
 An inferior good has an income elasticity of demand less
than zero

Cross Price Elasticity
 exists when the change in the price of one good affects the
demand for another good.
 Formula:
percentage change in quantity
demanded of good X
cross elasticity =

percent change in price of good Y
 when the crossprice elasticity of demand has a negative
sign the two goods are complementary goods
 when the crossprice elasticity of demand has a positive
sign the two goods are substitute goods
