Price Elasticity of Demand

 According to the law of demand,

when price goes up, consumers
demand fewer quantities of a
product. If the price of a product
falls, quantity demanded will rise.

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Price Elasticity of Demand
 For some products, consumers are highly
responsive to price changes. Demand for
such products is relatively elastic or simply
elastic.
 For other products, consumers’
responsiveness is only slight, or in rare cases
non-existent. Demand is said to be relatively
inelastic, or simply inelastic.

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 The Price-Elasticity Coefficient
 Economist measure the degree of price
elasticity or inelasticity of demand with the
coefficient Ed.

 Ed is defined as the percentage change in

quantity demanded of good X divided by the
percentage change in price of X.

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 The Ed Formula
percentage change in quantity demanded of X
Ed = percentage change in price of X

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Using Averages: An Example
 Consider the following example:
 Suppose that at a price of P10, quantity
demanded is 200 units. When the price
drops to P5, quantity demanded rises to 300
units.
Price
P10

Demand
P5

200 300 Quantity

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Using Averages: An Example
 The percentage change in quantity demanded
from 200 to 300 is a 50 percent (=100/200)
increase, while the opposing change in quantity
demanded from 300 to 200 is a 33 percent
(=100/300) decrease.
 Likewise, the percentage change in price from
P10 to P5 is a 50 percent (=P5/P10) decrease,
while the opposing change in price from P5 to
P10 is a 100 percent (=P5/P5) increase.

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Using Averages: An Example
 Using averages eliminates the “up versus
down” problem.
change in quantity change in price
Ed =
sum of quantities/2 sum of prices/2
For the quantity range 200-300, the quantity
reference is 250 units [=(200+300)/2].
For the same price range P5-P10, the price
reference is P7.50 [=(P5 + P10)/2]

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Using Averages: An Example
 The percentage change in quantity
demanded is now 100/250, or a 40
percent increase, and the percentage
change in price is now -P5/P7.50, or
about a 67 percent decrease.
 Ed = 0.4/-.67 = -0.597

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Elimination of the Minus
Sign
Because the demand curve slopes
downward, Ed will always be a negative
number. Therefore, we take the
absolute value and ignore the minus
sign.

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Interpretations of Ed
The coefficient of price elasticity of
demand can be interpreted as follows:
 Elastic Demand: Product demand for
which price changes cause relatively
larger changes in quantity demanded; Ed >
1
 Inelastic Demand: Product demand for
which price changes cause relatively
smaller changes in quantity demanded; Ed
<1
 Unit Elasticity: Product demand for which
price changes and changes in quantity
demanded are equal; Ed = 1

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Interpretations of Ed
Extreme Cases
 Perfectly Inelastic: Product demand for
which quantity demanded does not
respond to a change in price.
 Perfectly Elastic: Product demand for
which quantity demanded can be any
amount at a particular price.

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Interpretations of Ed

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 The Total-Revenue Test
 Elasticity is important to firms because
when the price of their products change, so
does their profit (total revenue minus total
costs).

Total revenue (TR) = price x quantity = P x Q

 This represents the total number of dollars
received by a firm from the sale of a
product in a particular period.

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 The Total-Revenue Test
Total revenue and the price elasticity
of demand are related. The total-
revenue test can determine elasticity
by examining what happens to total
revenue when price changes.

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 The Total-Revenue Test
 If demand is elastic, a decrease in price
will increase total revenue, and an
increase in price will reduce total revenue.
 If demand is inelastic, a price decrease
will decrease total revenue, while an
increase in price will increase total
revenue.
 If demand is unit elastic, total revenue
remains constant when prices rise or fall.

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 The Total-Revenue Test

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Price Elasticity along a
Linear Demand Curve
 Along a linear demand curve, elasticity
varies over the different price ranges.
 Because elasticity involves relative or
percentage changes in price and
quantity, as you move along a demand
curve, the percentage changes in price
and quantity will vary.

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Determinants of Price
Elasticity of Demand
 In general, there are four determinants
that can affect the price elasticity of
demand:
 Substitutability
 Proportion of Income
 Luxuries versus Necessities
 Time

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Determinants of Price
Elasticity of Demand
 Price elasticity of demand is greater:
the larger the number of substitute goods
that are available
the higher the price of a product relative to
one’s income
the more that a good is considered to be a
“luxury” rather than a “necessity”
the longer the time period under
consideration

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Price Elasticity of Supply
 Price elasticity of supply
measures the responsiveness
of sellers to changes in the
price of a product.

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Price Elasticity of
Supply
 The price elasticity of supply coefficient Es
is defined as:

percentage change in quantity supplied of X

Es =
percentage change in price of X
or
%∆Qs
Es =
%∆P

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Price Elasticity of Supply
 If Es < 1, supply is inelastic.
 If Es > 1, supply is elastic.
 If Es = 1, supply is unit-elastic.

 Since price and quantity supplied are

directly related, Es is never negative.

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Price Elasticity of Supply
 The amount of time it takes
producers to shift resources between
alternative uses to alter production of
a good can determine the degree of
price elasticity of supply.

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Price Elasticity of Supply and
Time Periods
 The market period is a
period in which producers of
a product are unable to
change the quantity
produced in response to a
change in price.
.

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Price Elasticity of Supply and
Time Periods
 In the short run, producers are able
to change the quantities of some but
not all the resources they employ.

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Price Elasticity of Supply and
Time Periods
 In the long run, producers are able to
change all the resources they
employ.

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Price Elasticity of Supply and
Time Periods

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Income Elasticity of Demand
 Income elasticity of demand measures the
responsiveness of consumer purchases to
changes in consumer income.
 The coefficient of income elasticity of
demand Ei is determined with the formula

EI = percentage change in quantity demanded

percentage change in income
McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Income Elasticity of Demand
 Normal Goods will have an income
elasticity of demand that is positive. More
of them are demanded as income
increases. Ei > 0

 Inferior goods have a negative income

elasticity of demand. As income rises, the
demand for them falls. Ei < 0

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Cross-Price Elasticity of
Demand
Responsiveness of D for one good
to changes in P of another good
%∆ in demand for one good
divided by %∆ in price of another
good
–If positive: substitutes
–If negative: complements
–If zero: unrelated

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Two goods are considered
substitute s if there is a
positive relationship
between the quantity
demanded of one good and
the price of the other good.

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 The cross elasticity of
demand for a substitute is
positive. A fall in the price
of a substitute good brings
forth a DECREASE in the
quantity demanded of the
good.

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 • Two goods are
considered
complements if there is a
negative relationship
between the quantity
demand of one good and
the price of the other
good.

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 • NORMAL NECCESITIES
are the products that
have a low but positive
elasticity. Its income
inelastic.
• NORMAL LUXURIES are
products that have high
and positive income
elasticity. Its income
elastic.

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 • Estimates of cross
elasticity of demand are
useful to retailers in their
pricing decisions.

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 MEMBERS:

• Emmielou A. Semilla
• Lady Jane Capuchino
• John Arvin Mendoza
• Eunice Angela Fabellon
AC1 - A

McGraw-Hill/Irwin Copyright 2007 by The McGraw-Hill Companies, Inc. All rights reserved.