Chapter 6: Elasticity and

Demand

McGraw-Hill/Irwin

Copyright 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

Elasticity
% in dependent variable
% in independent variable
Price elasticity of demand
% in quantity demanded
% in price
6-2

Price Elasticity of Demand (E)

Measures responsiveness or sensitivity of
consumers to changes in the price of a
good
Q
E
P
P & Q are inversely related by the law of
demand so E is always negative
The larger the absolute value of E, the more
sensitive buyers are to a change in price
6-3

Sign of Price Elasticity of Demand

The coefficient of the price elasticity of
demand is always negative
It is intuitively more appealing to talk about
price elasticity in terms of its absolute
value.

6-4

6-4

Price Elasticity of Demand (E)

Table 6.1
Elasticity

Responsiveness

Elastic

%Q > %P

E > 1

Unitary Elastic

%Q = %P

E = 1

Inelastic

%Q < %P

E < 1
6-5

Elastic Demand

6-6

6-6

Inelastic Demand
Demand becomes less elastic as
price declines along a linear
demand curve.

6-7

6-7

Price Elasticity of Demand (E)

Percentage change in quantity demanded
can be predicted for a given percentage
change in price as:

%Qd = %P x E
Percentage change in price required for a
given change in quantity demanded can be
predicted as:

%P = %Qd E
6-8

Price Elasticity & Total Revenue

Table 6.2
Elastic

Unitary elastic

Inelastic

%Q > %P %Q = %P %Q < %P
Quantity-effect
dominates

No dominant
effect

Price-effect
dominates

Price
rises

TR falls

No change in TR

TR rises

Price
falls

TR rises

No change in TR

TR falls

6-9

Factors Affecting
Price Elasticity of Demand
Availability of substitutes
The better & more numerous the substitutes for a
good, the more elastic is demand

Percentage of consumers budget

The greater the percentage of the consumers
budget spent on the good, the more elastic is
demand

Time period of adjustment

The longer the time period consumers have to
adjust to price changes, the more elastic is demand
6-10

Factors Affecting Price Elasticity

of Demand
Necessities versus Luxuries
Luxuries have a more elastic demand

Definition of the market

The more finely defined the market the more
elastic the demand. The more aggregate the
definition of the market the more inelastic the
demand
hamburger < beef <all meat products

6-

6-11

Calculating
Price Elasticity of Demand
Price elasticity can be calculated by
multiplying the slope of demand ( Q/ P)
times the ratio of price to quantity (P/Q)

Q
100
Q P
Q
Q

E
P
P
P Q
100
P
6-12

Calculating
Price Elasticity of Demand
Price elasticity can be measured at an
interval (or arc) along demand, or at a
specific point on the demand curve
If the price change is relatively small, a point
calculation is suitable
If the price change spans a sizable arc along
the demand curve, the interval calculation
provides a better measure
6-13

Calculating Price Elasticity of

Demand
Regression analysis provides a point estimate
Arc elasticity is typically only used for teaching
purposes

6-

6-14

Computation of Elasticity
Over an Interval
When calculating price elasticity of
demand over an interval of demand, use
the interval or arc elasticity formula
Q Average P
E

P Average Q

6-15

Computation of Elasticity at a Point

When calculating price elasticity at a point on
demand, multiply the slope of demand
( Q/ P), computed at the point of measure,
times the ratio P/Q, using the values of P and
Q at the point of measure
Method of measuring point elasticity depends
on whether demand is linear or curvilinear

6-16

Price Elasticity for Linear

Demand
Q / Q Q p

.
p / p p Q
Q a bp
p
b
Q
617

6-17

Point Elasticity When

Demand is Linear

Given Q = a + bP + cM + dPR, let income

& price of the related good take specific
values M and PR , respectively

Then express demand as Q = a + bP ,

where a = a + cM + dPR and the slope
parameter is b = Q P

6-18

Point Elasticity When

Demand is Linear
Compute elasticity using either of the two
formulas below which give the same value for E

P
P
Eb
or E
Q
PA
Where P and Q are values of price and quantity demanded
at the point of measure along demand, and A ( = a b) is
the price-intercept of demand

6-19

Point Elasticity When

Demand is Curvilinear
Compute elasticity using either of two equivalent
formulas below

Q P
P
E

P Q P A
Where Q P is the slope of the curved demand at the
point of measure, P and Q are values of price and quantity
demanded at the point of measure, and A is the priceintercept of the tangent line extended to cross the price axis

6-20

Elasticity (Generally) Varies Along a

Demand Curve
For linear demand, price and E vary directly
The higher the price, the more elastic is demand
The lower the price, the less elastic is demand

For curvilinear demand, no general rule about

the relation between price and quantity
Special case of Q = aPb which has a constant
price elasticity (equal to b) for all prices

6-21

Constant elasticity demand

function

1. Q P
log Q log log P
2. Q / P ( ) P 1

3. ( Q / P )( P / Q ) ( ) P

P
P

6-22

Constant Elasticity of Demand

(Figure 6.3)

6-23

Constant elasticity demand

function

6-

6-24

Marginal Revenue
Marginal revenue (MR) is the change in
total revenue per unit change in output
Since MR measures the rate of change in
total revenue as quantity changes, MR is
the slope of the total revenue (TR) curve

TR
MR
Q
6-25

Demand & Marginal Revenue

(Table 6.3)
TR = P Q

MR = TR/ Q

Unit sales (Q)

Price

$4.50

4.00

$4.00

$4.00

3.50

$7.00

$3.00

3.10

$9.30

$2.30

2.80

$11.20

$1.90

2.40

$12.00

$0.80

2.00

$12.00

$0

1.50

$10.50

$-1.50

--

6-26

Demand, MR, & TR

Panel A

(Figure 6.4)

Panel B
6-27

Demand & Marginal Revenue

When inverse demand is linear,
P = A + BQ (A > 0, B < 0)
Marginal revenue is also linear, intersects the
vertical (price) axis at the same point as
demand, & is twice as steep as demand

MR = A + 2BQ

6-28

Proof
P A BQ
TR PQ ( A BQ)Q AQ BQ
MR TR / Q A 2 BQ

6-

6-29

Marginal Revenue

6-

6-30

Total Revenue

6-

6-31

Linear Demand, MR, & Elasticity

(Figure 6.5)

6-32

MR, TR, & Price Elasticity

(Table 6.4)
Marginal
revenue
MR > 0

Total revenue
TR increases as
Q increases
(P decreases)

Price elasticity
of demand
Elastic
(E> 1)

MR = 0

TR is maximized

Unit Elastic
(E= 1)

MR < 0

TR decreases as
Q increases

Inelastic
(E< 1)

(P decreases)

6-33

Marginal Revenue & Price Elasticity

For all demand & marginal revenue
curves, the relation between marginal
revenue, price, & elasticity can be
expressed as

1
MR P 1
E

6-34

Proof
MR TR / Q
TR P Q P (Q) Q

P Q
TR / Q P (P / Q) Q P 1

Q P

Q P

P Q

1
MR P 1

6-

6-35

Marginal Revenue & Price Elasticity

Note that as E -
that MRP

1
MR P 1
E

6-

6-36

Income Elasticity
Income elasticity (EM) measures the
responsiveness of quantity demanded to
changes in income, holding the price of the
good & all other demand determinants
constant
Positive for a normal good
Negative for an inferior good

Qd Qd M
EM

M M Qd

6-37

Normal Good

6-

6-38

Inferior Good

6-

6-39

Cross-Price Elasticity
Cross-price elasticity (EXR) measures the
responsiveness of quantity demanded of good X
to changes in the price of related good R,
holding the price of good X & all other demand
determinants for good X constant
Positive when the two goods are substitutes
Negative when the two goods are complements

E XR

QX QX PR

PR
PR Q X
6-40

Substitute Good

6-

6-41

Interval Elasticity Measures

To calculate interval measures of income &
cross-price elasticities, the following formulas
can be employed

Q Average M
EM

M Average Q
E XR

Q Average PR

PR Average Q
6-42

Point Elasticity Measures

For the linear demand function
Q = a + bP + cM + dPR, point measures of
income & cross-price elasticities can be
calculated as

M
EM c
Q
E XR

PR
d
Q
6-43

6-

6-44

6-

6-45