Elasticity of Demand

Price Elasticity of DemandPrice Elasticity of Demand

• Defining price elasticity of demand (PeD)

– measures the strength of response of consumer demand to a change in price.

– Measures our reaction to a change in price

• Defining price elasticity of demand (PeD)

– measures the strength of response of consumer demand to a change in price.

– Measures our reaction to a change in price

Price Elasticity of Demand and Consumer Expenditure


• Defining Total consumer Expenditure

TE = P × Q

• Illustrating TE graphically

• Defining Total consumer Expenditure

TE = P × Q

• Illustrating TE graphically

0

1

2

3

4

0 1 2 3 4 5

Consumers’ total expenditure =

firms’ total revenue=

£2 x 3m = £6m

Consumers’ total expenditure =

firms’ total revenue=

£2 x 3m = £6m

P(£)

Q (millions of units per period of time)

D

Total expenditureTotal expenditure



• Effects of a price change: elastic demand– Price rises Total Expenditure falls

• Effects of a price change: elastic demand– Price rises Total Expenditure falls

4

20

P(£)


0

aD

Elastic demand between two pointsElastic demand between two points

Expenditure fallsas price rises

5

10

b

P(£)


0

aD

Elastic demand between two pointsElastic demand between two points

4

20

5

10

b



• Effects of a price change: inelastic demand– Price rises: Total Expenditure rises

• Effects of a price change: inelastic demand– Price rises: Total Expenditure rises

Expenditure risesas price rises

a4

20

P(£)


0

D

Inelastic demandInelastic demand

8

15

c


• Applications to pricing decisions

• Applications to tax decisions

Income Elasticity (at end)• Revenue predictions

• Government revenue changes from taxes on products

• Applications to pricing decisions

• Applications to tax decisions

Income Elasticity (at end)• Revenue predictions

• Government revenue changes from taxes on products


• Measuring price elasticity of demand

– use of percentage changes

– the sign: positive or negative?

– the value: greater or less than 1?


– use of percentage changes

– the sign: positive or negative?

– the value: greater or less than 1?

% change in QD

% change in P



– greater than -1 then price elastic

– less than -1 then price inelastic


– greater than -1 then price elastic

– less than -1 then price inelastic

% change in QD

% change in P


• Determinants of price elasticity of demand

– availability of substitute goods

– proportion of income spent on the good

– habit

– fashion

– frequency of purchase

• Determinants of price elasticity of demand

– availability of substitute goods

– proportion of income spent on the good

– habit

– fashion

– frequency of purchase

Elastic or Inelastic?Elastic or Inelastic?

Elastic or InelasticElastic or Inelastic

Measuring Elasticity

% change in QD

% change in P

÷Change in QD

Original QD

Change in P

Original P

0

2

4

6

8

10

0 10 20 30 40 50

P (£)

Q (000s)

Demand

m

n

Measuring ElasticityMeasuring Elasticity

Price elasticity of demand

% change in QD

% change in P

÷10

10

2

8

= 4



• Special cases– PeD = 0


P2

P

QO Q1

P1

D

b

a

Totally inelastic demand (PD = 0)Totally inelastic demand (PD = 0)




– PeD =


– PeD =

Q2

P

QO Q1

P1 Da b

Infinitely elastic demand (PD = )Infinitely elastic demand (PD = )




– PeD = – PeD = –1


– PeD = – PeD = –1

P

QO 40

20

D

100

8

a

Unit elastic demand (PD = –1)Unit elastic demand (PD = –1)

b



• Special cases– PeD = 0 – perfectly inelastic

– PeD = - perfectly elastic

– PeD = –1 – unitary elasticity

• Special cases– PeD = 0 – perfectly inelastic

– PeD = - perfectly elastic

– PeD = –1 – unitary elasticity

Demand Changes with IncomeDemand Changes with Income

• Consumers increase the demand for most good when income rises – NORMAL GOODS

• Demand for a good may fall when income rises and vice versa – INFERIOR GOODS

• Consumers increase the demand for most good when income rises – NORMAL GOODS

• Demand for a good may fall when income rises and vice versa – INFERIOR GOODS

The London Restaurant marketThe London Restaurant market

• Watch the video clips and comment on the types of goods and their elasticities:– Restaurant Food

– Prepacked sandwiches

– Sandwich boxes

• Watch the video clips and comment on the types of goods and their elasticities:– Restaurant Food

– Prepacked sandwiches

– Sandwich boxes

Goods can be both!Goods can be both!

• Bread

• NORMAL if you are on a low income

• INFERIOR for higher income earners

• Bread

• NORMAL if you are on a low income

• INFERIOR for higher income earners

Other ElasticitiesOther Elasticities

• Income elasticity of demand– measurement– determinants

• degree of necessity• rate at which people are satisfied• level of income

– Applications – we can work out the effect of a price change/tax change

• Income elasticity of demand– measurement– determinants

• degree of necessity• rate at which people are satisfied• level of income

– Applications – we can work out the effect of a price change/tax change

Income ElasticityIncome Elasticity

• If sellers know the income elasticity of their product they can predict what will happen to their revenue when incomes change

• The Government would also be able to predict changes in revenue from taxes on products

% Change in demand

% Change in Income

• If sellers know the income elasticity of their product they can predict what will happen to their revenue when incomes change

• The Government would also be able to predict changes in revenue from taxes on products

% Change in demand

% Change in Income

If income rises?If income rises?

• Some products are still out of our reach. How much is an Aston Martin? £183,000

• Some products we will buy no more of. Eg a newspaper

• Some we will buy a little more of eg food. (Food is income inelastic in a high-income economy such as ours).

• Some we will buy more of eg entertainment, meals out. Income elasticity tends to be greater than 1

• Some we will buy less of eg no more Tesco Value for me or white bread!

• Some products are still out of our reach. How much is an Aston Martin? £183,000

• Some products we will buy no more of. Eg a newspaper

• Some we will buy a little more of eg food. (Food is income inelastic in a high-income economy such as ours).

• Some we will buy more of eg entertainment, meals out. Income elasticity tends to be greater than 1

• Some we will buy less of eg no more Tesco Value for me or white bread!

Income ElasticityIncome Elasticity

• A normal good will always have a positive income elasticity because quantity demanded and income either both increase (+/+) or both decrease (-/-)

• An inferior good will always have a negative elasticity - opposite signs each way

• A normal good will always have a positive income elasticity because quantity demanded and income either both increase (+/+) or both decrease (-/-)

• An inferior good will always have a negative elasticity - opposite signs each way

Giffen GoodsGiffen Goods

• Theory by Sir Robert Giffen!

• A giffen good is a special sort of inferior good

• Giffen observed that the consumption of bread increased as the price rose

• Bread was the staple food of those on low incomes – bread would ‘fill’ empty stomachs! And as its price had risen they could afford less luxuries like meat and so bought more bread

• Theory by Sir Robert Giffen!

• A giffen good is a special sort of inferior good

• Giffen observed that the consumption of bread increased as the price rose

• Bread was the staple food of those on low incomes – bread would ‘fill’ empty stomachs! And as its price had risen they could afford less luxuries like meat and so bought more bread

Income EffectIncome Effect

• If the price of a good rises, the real income of a consumer falls

• Cannot buy the same basket of goods and services as before.

• If the price of a good rises, the real income of a consumer falls

• Cannot buy the same basket of goods and services as before.

SubstitutionSubstitution

• If the price of a good rises, consumers will buy less of that good and more of others because it is relatively more expensive.

• If the price of a good rises, consumers will buy less of that good and more of others because it is relatively more expensive.

Cross ElasticityCross Elasticity

• The quantity demanded of a good varies according to the price of other goods

• Eg a rise in the price of beef would increase demand for pork (substitute)

• A rise in the price of cheese would lead to a fall in demand for macaroni (complement)

• The quantity demanded of a good varies according to the price of other goods

• Eg a rise in the price of beef would increase demand for pork (substitute)

• A rise in the price of cheese would lead to a fall in demand for macaroni (complement)

Cross ElasticityCross Elasticity

% ∆ Q demanded good X

% ∆ Price of another good Y

• Two goods which are substitutes will have a positive cross elasticity

• Two goods which are complements will have a negative cross elasticity

• The cross elasticity of goods which have little relationship to each other would be zero (independents)

% ∆ Q demanded good X

% ∆ Price of another good Y

• Two goods which are substitutes will have a positive cross elasticity

• Two goods which are complements will have a negative cross elasticity

• The cross elasticity of goods which have little relationship to each other would be zero (independents)

Example – positive cross elasticityExample – positive cross elasticity

• A rise in the price of fish may cause demand for chicken to increase (substitutes)

• A rise in the price of fish may cause demand for chicken to increase (substitutes)

Pri

ce o

f F

ish

Quantity of Chicken Demanded

What will have happened to the demand curve for chicken?

Example – negative cross elasticityExample – negative cross elasticity

• A rise in the price of air travel causes a fall in the demand for foreign holidays (complementary goods)

• A rise in the price of air travel causes a fall in the demand for foreign holidays (complementary goods)

Quantity of foreign holidays demanded

Pri

ce o

f ai

r tr

avel

What will have happened to the demand curve for foreign holidays?

Example – zero cross elasticityExample – zero cross elasticity

• A rise in the price of apples leaves the demand for gloves unaffected!

• However we must remember that a change in the price of a product affects our purchasing power and may affect the demand for an unrelated product.

• A rise in the price of apples leaves the demand for gloves unaffected!

• However we must remember that a change in the price of a product affects our purchasing power and may affect the demand for an unrelated product.

Quantity of gloves demanded

Pri

ce o

f ap

ple

s

The significance of cross elasticityThe significance of cross elasticity

• Firms may realise that if a product has a high positive cross-elasticity, then a decrease in price will attract more customers.

• A low positive cross –elasticity gives a firm more power to raise the price.

• A high negative cross elasticity means lowering the price of the cheaper complement can increase sales of the other product.

• Firms may realise that if a product has a high positive cross-elasticity, then a decrease in price will attract more customers.

• A low positive cross –elasticity gives a firm more power to raise the price.

• A high negative cross elasticity means lowering the price of the cheaper complement can increase sales of the other product.

Elasticity of Demand

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