Chapter 7

MARKET DEMAND AND

ELASTICITY

MICROECONOMIC THEORY
BASIC PRINCIPLES AND EXTENSIONS
EIGHTH EDITION
WALTER NICHOLSON
Copyright 2002 by South-Western, a division of Thomson Learning. All rights reserved.
 Elasticity
Suppose that a particular variable (B)
depends on another variable (A)
B = f(A)
We define the elasticity of B with respect
to A as
% change in B B / B B A
eB,A
% change in A A / A A B
The elasticity shows how B responds (ceteris
paribus) to a 1 percent change in A
 Price Elasticity of Demand
The most important elasticity is the price
elasticity of demand
measures the change in quantity demanded
caused by a change in the price of the good
% change in Q Q / Q Q P
eQ,P
% change in P P / P P Q
eQ,P will generally be negative
except in cases of Giffens paradox
 Distinguishing Values of eQ,P

Value of eQ,P at a Point Classification of

Elasticity at This Point

eQ,P < -1 Elastic

eQ,P = -1 Unit Elastic

eQ,P > -1 Inelastic

 Price Elasticity and Total
Expenditure
Total expenditure on any good is equal to
total expenditure = PQ
Using elasticity, we can determine how
total expenditure changes when the price
of a good changes
 Price Elasticity and Total
Expenditure
Differentiating total expenditure with
respect to P yields
PQ Q
QP
P P
Dividing both sides by Q, we get
PQ / P Q P
1 1 eQ,P
Q P Q
 Price Elasticity and Total
Expenditure
PQ / P Q P
1 1 eQ,P
Q P Q
Note that the sign of PQ/P depends on
whether eQ,P is greater or less than -1
If eQ,P > -1, demand is inelastic and price and
total expenditures move in the same direction
If eQ,P < -1, demand is elastic and price and
total expenditures move in opposite directions
 Price Elasticity and Total
Expenditure
Responses of PQ

Demand Price Increase Price Decrease

Elastic Falls Rises

Unit Elastic No Change No Change

Inelastic Rises Falls

Income Elasticity of Demand
The income elasticity of demand (eQ,I)
measures the relationship between
income changes and quantity changes
% change in Q Q I
eQ,I
% change in I I Q
Normal goods eQ,I > 0
Luxury goods eQ,I > 1
Inferior goods eQ,I < 0
 Cross-Price Elasticity of
Demand
The cross-price elasticity of demand (eQ,P) measures
the relationship between changes in the price of one
good and and quantity changes in another

% change in Q Q P'
eQ,P '
% change in P' P' Q

Gross substitutes eQ,P > 0

Gross complements eQ,P < 0
 Relationships Among
Elasticities
Suppose that there are only two goods
(X and Y) so that the budget constraint
is given by
PXX + PYY = I
The individuals demand functions are
X = dX(PX,PY,I)
Y = dY(PX,PY,I)
 Relationships Among
Elasticities
Differentiation of the budget constraint
with respect to I yields
X Y
PX PY 1
I I
Multiplying each item by 1
PX X X I PY Y Y I
1
I I X I I Y
 Relationships Among
Elasticities
Since (PX X)/I is the proportion of income
spent on X and (PY Y)/I is the proportion of
income spent on Y,
sXeX,I + sYeY,I = 1
For every good that has an income elasticity
of demand less than 1, there must be goods
that have income elasticities greater than 1
Slutsky Equation in Elasticities
The Slutsky equation shows how an
individuals demand for a good responds to
a change in price
X X X
X
PX PX U constant
I
Multiplying by PX /X yields
X PX X PX X 1
PX X
PX X PX X U constant
I X
Slutsky Equation in Elasticities

Multiplying the final term by I/I yields

X PX X PX PX X X I

PX X PX X U constant
I I X
Slutsky Equation in Elasticities
A substitution elasticity shows how the
compensated demand for X responds to
proportional compensated price changes
it is the price elasticity of demand for
movement along the compensated demand
curve

X PX
e S
X ,PX
PX X U constant
Slutsky Equation in Elasticities
Thus, the Slutsky relationship can be
shown in elasticity form
e X ,PX e SX ,PX s X e X ,I
It shows how the price elasticity of
demand can be disaggregated into
substitution and income components
Note that the relative size of the income
component depends on the proportion of total
expenditures devoted to the good (sX)
 Homogeneity
Remember that demand functions are
homogeneous of degree zero in all
prices and income
Eulers theorem for homogenous
functions shows that
X X X
PX PY I 0
PX PY I
 Homogeneity
Dividing by X, we get
X PX X PY X I
0
PX X PY X I X
Using our definitions, this means that
e X ,PX e X ,PY e X ,I 0

An equal percentage change in all prices

and income will leave the quantity of X
demanded unchanged
 Cobb-Douglas Elasticities
The Cobb-Douglas utility function is
U(X,Y) = XY
The demand functions for X and Y are
I I
X Y
PX PY
The elasticities can be calculated
X PX I PX I 1
e X ,PX 2 1
PX X PX X PX I

PX
 Cobb-Douglas Elasticities
Similar calculations show
e X ,I 1 e X ,PY 0

eY ,PY 1 eY ,I 1 eY ,PY 1

Note that
PX X PYY
sX sY
I I
 Cobb-Douglas Elasticities
Homogeneity can be shown for these elasticities

e X ,PX e X ,PY e X ,I 1 0 1 0
The elasticity version of the Slutsky equation can
also be used

e X ,PX e SX ,PX s X e X ,I
1 e SX ,PX (1)
e SX ,PX (1 - )
 Cobb-Douglas Elasticities
The price elasticity of demand for this
compensated demand function is equal
to (minus) the expenditure share of the
other good
More generally
e S
X ,PX (1 - s X )
where is the elasticity of substitution
 Linear Demand
Q = a + bP + cI + dP
where:
Q = quantity demanded
P = price of the good
I = income
P = price of other goods
a, b, c, d = various demand parameters
 Linear Demand
Q = a + bP + cI + dP
Assume that:
Q/P = b 0 (no Giffens paradox)
Q/I = c 0 (the good is a normal good)
Q/P = d 0 (depending on whether
the other good is a gross substitute or
gross complement)
 Linear Demand
If I and P are held constant at I* and
P*, the demand function can be written
Q = a + bP
where a = a + cI* + dP*
Note that this implies a linear demand
curve
Changes in I or P will alter a and shift the
demand curve
 Linear Demand
Along a linear demand curve, the slope
(Q/P) is constant
the price elasticity of demand will not be
constant along the demand curve
Q P P
eQ,P b
P Q Q
As price rises and quantity falls, the
elasticity will become a larger negative
number (b < 0)
 Linear Demand
P Demand becomes more
elastic at higher prices
-a/b eQ,P < -1

eQ,P = -1

eQ,P > -1

Q
a
Constant Elasticity Functions
If one wanted elasticities that were
constant over a range of prices, this
demand function can be used
Q = aPbIcPd
where a > 0, b 0, c 0, and d 0.
For particular values of I and P,
Q = aPb
where a = aIcPd
Constant Elasticity Functions
This equation can also be written as
ln Q = ln a + b ln P
Applying the definition of elasticity,
b 1
Q P ba' P P
eQ,P b
P Q a' P b

The price elasticity of demand is equal

to the exponent on P
 Important Points to Note:
The market demand curve is negatively
sloped on the assumption that most
individuals will buy more of a good when the
price falls
it is assumed that Giffens paradox does not
occur
Effects of movements along the demand
curve are measured by the price elasticity of
demand (eQ,P)
% change in quantity from a 1% change in price
 Important Points to Note:
Changes in total expenditures on a good
caused by changes in price can be
predicted from the price elasticity of demand
if demand is inelastic (0 > eQ,P > -1) , price and
total expenditures move in the same direction
if demand is elastic (eQ,P < -1) , price and total
expenditures move in opposite directions
 Important Points to Note:
If other factors that enter the demand
function (prices of other goods, income,
preferences) change, the market demand
curve will shift
the income elasticity (eQ,I) measures the effect
of changes in income on quantity demanded
the cross-price elasticity (eQ,P) measures the
effect of changes in another goods price on
quantity demanded
 Important Points to Note:
There are a number of relationships among
the various demand elasticities
the Slutsky equation shows the relationship
between uncompensated and compensated
price elasticities
homogeneity is reflected in the fact that the sum
of the elasticities of demand for all of the
arguments in the demand function is zero