Lesson 03

Elasticity
1

After studying this chapter, you will be able
to:
Define and calculate the price elasticity of
demand
Use a total revenue test and an
expenditure test to estimate the price
elasticity of demand
Explain the factors that influence the
price elasticity of demand
Define and calculate the cross elasticity
of demand
Define and calculate the income elasticity
of demand
Define and calculate the elasticity of
supply
2
What is ELASTICITY?
3
Elasticity is a measure of responsiveness of
one variable to another

Price and quantity demanded
Income and quantity demanded
Price and quantity supplied, etc
4
Price Elasticity of Demand
Measures the sensitivity of quantity
demanded to price changes.
It measures the percentage change in the
quantity demanded for a good or service that
results from a one percent change in the price.
The price elasticity of demand is:
P) Q)/(% (% EP
Price elasticity of demand =
Percentage change in quantity demanded
Percentage change in price
5
Calculating Elasticities
Point Elasticity Approach:
price
elasticity of
demand
Q = (Q
a
Q
b
)
P = (P
a
P
b
)
P
a
Q
a
a
a a a
P Q Q P
Q P P Q

The subscript
a stands for after price change
b stands for before price change
$
Q
P
b
Q
b
Price
elasticity of
demand
Percentage change in quantity demanded (Q)
Percentage change in its own price (P)
=
6
Single point
on curve
% in Q
% in P
6
Challenge 01
1. The Nugegoda Kentucky Fried Chicken (KFC)
outlet typically sells 1,500 Chicken buckets per
month at $3.50 each

2. The price elasticity for the chicken bucket is
estimated to be 0.30

3. If the KFC outlet increases the price of the bucket
to $4.00:
a. How many chi.buckets will the KFC outlet sell
after the price change?__________
b. The KFC outlets revenue will change by
$__________
c. Will consumers be worse or better off as a
result of this price change?_________ 7
7
Calculating Elasticities
Percentage change in quantity
Percentage change in own price
=
where:
P

= (P
a
+ P
b
) 2
Q

= (Q
a
+ Q
b
) 2
Q = (Q
a
Q
b
)
P = (P
a
P
b
)
Arc Elasticity Approach:
Own price
elasticity of
demand
Q P Q P
Q P P Q

The subscript
a stands for after price change
b stands for before price change
Avg Price
Avg Quantity
P
a
P
b
Q
a
Q
b
Specific range
on curve
$
Q
P
Q
Price
elasticity of
demand
8
Challenge 02

Calculate the Arc elasticity of demand
for the following combinations;

1. P0 = $89; Q0 = 1000; P1 = $99; Q1 = 950
2. P0 = $89; Q0 = 1000; P1 = $99; Q1 = 700
9
Elasticity Along a Demand Curve
P
r
i
c
e

$10
9
8
7
6
5
4
3
2
1
0 1 2 3 4 5 6 7 8 9 10 Quantity
Elasticity declines along
demand curve as we move
toward the quantity axis
E
d
= 1
E
d
= 0
E
d
< 1
E
d
> 1
E
d
=
10
The Variety of Demand Curves
Inelastic Demand

Quantity demanded does not respond strongly to price
changes.
Price elasticity of demand is less than one.

Elastic Demand

Quantity demanded responds strongly to changes in
price.

Price elasticity of demand is greater than one.
11
The Variety of Demand Curves
Perfectly Inelastic (P
E
=0)

Quantity demanded does not respond to price
changes.

Perfectly Elastic (P
E
= )

Quantity demanded changes infinitely with any change
in price.

Unit Elastic (P
E
=1)

Quantity demanded changes by the same percentage
as the price.
12
The Variety of Demand Curves
Inelastic demand
Elastic demand
Unity demand
Perfectly inelastic
Perfectly elastic
P
Q
P
P
P
P
Q
Q
Q Q
13
Description Numerical
value
Total Outlay/Revenue
Infinitely elastic ED = Zero for a price rise, infinite for a
price fall
Elastic ED> 1 Decreases for a price rise, increases
for a price fall
Unitary elastic ED=1 Remains the same whether price
rises or falls
Inelastic ED<1 Increases for a price rise, decreases
for a price fall
Zero elastic ED=0 Increases for a price rise, decreases
for a price fall
14
The primary determinant of price
elasticity of demand
The availability of substitutes
Many substitutes demand is price elastic
Few substitutes demand is price inelastic
Nature of commodity
Luxuries goods more elastic
Necessities goods less elastic
Proportion of income spent
Proportion is small inelastic
Proportion is high more elastic
15
Income Elasticity of Demand
Income elasticity of demand measures how much the
quantity demanded of a good responds to a change in
consumers income.

It is computed as the percentage change in the
quantity demanded divided by the percentage change
in income.
Income elasticity of demand =
Percentage change
in quantity demanded
Percentage change
in income
Y
Q
Q
Y
Y Y
Q Q
Ey
x
x
x x

16
When the income
elasticity is:
The good is classified as:
Greater than 0.0 A normal good
Greater than 1.0
A luxury (and a normal)
good
Less than 1.0 but
greater than 0.0
A necessity (and a
normal) good
Less than 0.0
An inferior good
Interpreting the Income
Elasticity of Demand
Page 75
17
Challenge 03
18
The quantity demanded for tea increases
from 200kgs per week to 250kgs per week
due to an increase in income of the buyer
from Rs. 6000/- per week to Rs. 6500/- per
week.
Calculate the income elasticity of demand.
Cross elasticity of demand
Cross elasticity of demand measures the percentage
change in the quantity demanded of one good that
results from a one percent change in the price of
another good.
For example consider the substitute goods, butter and
margarine.
m
b
b
m
m m
b b
P Q
P
Q
Q
P
/P P
/Q Q
E m b

The cross elasticity for substitutes is positive, while
that for complements is negative.
19
If the Cross-Price
Elasticity is:
The Good is
Classified as a:
Positive Substitute
Negative Complement
Zero Independent
Interpreting the Cross
Price Elasticity of
Demand
Page 76
20
Challenge 04
21
The quantity demanded for tea increases
from 200kgs per week to 250kgs per week
due to an increase in price of coffee from
Rs. 60/- per week to Rs. 65/- per week.
Calculate the cross elasticity of demand.

Price elasticity of supply
Price elasticity of supply measures the percentage
change in quantity supplied resulting from a 1 percent
change in price.
The elasticity is usually positive because price and
quantity supplied are directly related.


22
The Variety of supply Curves
Inelastic Supply

Quantity supplied does not respond strongly to price
changes.
Price elasticity of supply is less than one.

Elastic Supply

Quantity supplied responds strongly to changes in
price.

Price elasticity of Supply is greater than one.
23
The Variety of Supply Curves
Perfectly Inelastic (P
E
=0)

Quantity supplied does not respond to price changes.

Perfectly Elastic (P
E
= )

Quantity supplied changes infinitely with any change
in price.

Unit Elastic (P
E
=1)

Quantity supplied changes by the same percentage as
the price.
24
The Variety of Supply Curves
Inelastic Supply
Elastic Supply
Unity Supply
Perfectly inelastic
Perfectly elastic
P
Q
P
P
P
P
Q
Q
Q Q
25
Challenge 05
26
The quantity supplied of tea increases from
200kgs per week to 300kgs per week due
to an increase in price of tea from Rs. 60/-
per week to Rs. 70/- per week.
Calculate the elasticity of supply.

NOW YOU CAN;

Define and calculate the price elasticity of
demand
Use a total revenue test and an
expenditure test to estimate the price
elasticity of demand
Explain the factors that influence the
price elasticity of demand
Define and calculate the cross elasticity
of demand
Define and calculate the income elasticity
of demand
Define and calculate the elasticity of
supply
27
28