Elasticity of Demand

INTRODUCTION
 What is Elasticity?
 If my firm wants to raise revenue,
should we decrease or increase the
price?
 The answer relies on elasticity
 “Elasticity” is similar to
“responsiveness”
 Price Elasticity of Demand – a
measure of how responsive quantity
demanded is to a price change
 Price Elasticity of Demand
Mathematically…

Percentage change in quantity demanded

Price elasticity of demand =
Percentage change in price

q '−q p '− p
Price elasticity of demand = ÷
( q '+ q ) / 2 ( p '+ p ) / 2
 Example
 What is the price elasticity
of demand for CDs?
 At a price of Rs14 per CD,
there are 10,000 CDs sold
 When the price is Rs 14

Price per CD
decreased to Rs12 per CD, Rs 12
11,000 CDs are sold

(11− 10) (12 − 14)

ED = ÷
(11+ 10) / 2 (14 + 12) / 2 D
E D = (0.095) ÷ (− 0.154) = − 0.616 10 11
Thousands of CDs
 Important Points…
 Because price and quantity are inversely
related, the price elasticity of demand will
be negative
 This is because a price decrease will cause
an increase in quantity demanded (and vice
versa)
 Most of the time, then, I will refer to the
absolute value of the elasticity
 The magnitude is most important
 Categories of Price
Elasticity of Demand
 Inelastic Demand – a change in price
has very little effect on the quantity
demanded (-1 < ED < 0)
• These goods are often necessities
 Elastic Demand – a change in the price
has a relatively large effect on the
quantity demanded (ED < -1)
• These are often more “unnecessary”
 Unit-Elastic Demand – the percentage
change in quantity demanded equals the
percentage change in price (ED = -1)
 Unit-Elastic
Elastic Inelastic

Elasticity of Demand -1 0
 Elasticity…
 Varies along the demand curve for
the same product
• You respond differently if the price
changes from 1 cent to 2 cents, than you
do if the price changes from Rs5 to Rs10
(both are 100% increases)
 Varies across products
• Regardless of where we are on the
demand curve, you might expect the
demand for milk to be less elastic than the
demand for BMWs
P More Inelastic

More Elastic

Demand Curve

Q
Elasticity and Total Revenue

 Total Revenue – the amount of money a firm

collects through sales
 TR = Price * Quantity
 How is Total Revenue related to Elasticity?
 Recall that a lower price leads to an increase
in quantity demanded…
 Whether Total Revenue increases or decreases
change (due to a price decrease) will depend
on whether the percentage increase in the
quantity demanded is less than or greater than
the price decrease
P Elastic
Unit Elastic

Inelastic

Q
TR

Q
 What Does this Graph
Show?
 Should you increase or decrease price to
increase Total Revenue???
 In the elastic portion of the demand curve, the
% change in quantity demanded is greater than
the % change in price, so you should decrease
price in order to increase total revenue
 In the inelastic portion of the demand curve,
the % change in quantity demanded is less than
the % change in price, so you should increase
price in order to increase total revenue
 Total revenue is maximized at the unit elastic
point
Constant-Elasticity Demand
Curves
 For a downward sloping linear demand
curve, the price elasticity changes as you
move along the demand curve
 Some demand curves have an elasticity that
does NOT vary along the demand curve
1. Perfectly Elastic Demand Curve – an increase
in price reduces the quantity demanded to
zero (horizontal demand curve)
2. Perfectly Inelastic Demand Curve – price
changes have no effect on the quantity
demanded (vertical demand curve)
 P P D

Q Q

Perfectly Elastic Demand Perfectly Inelastic Demand

 Determinants of the Price
Elasticity of Demand
 Availability of Substitutes – the more
substitutes are available for a good, the more
elastic the demand (if the price increases, you
might be likely to switch to another good)
 Proportion of a Consumer’s Budget Spent on
the Good – the larger the percentage of a
consumer’s budget, the greater the price
sensitivity (ex. comparison shopping for cars)
 Time – the longer you have to make your choice,
the more elastic your demand will be (ex. what if
your refrigerator breaks down?)
 Other Elasticity Measures
 Income Elasticity of Demand – a
measure of the responsiveness of demand
to changes in income

 Cross-Price Elasticity of Demand- a

measure of how responsive one good’s
quantity demanded is to a change in the
price of another good (i.e. how do brand
X’s sales respond to changes in the price of
brand Y)
 Income Elasticity of Demand
 Normal Good – a good with an income
elasticity greater than zero
 Why is the elasticity greater than zero?
Because the demand curve shifts out with
income increases
 Most goods are normal goods
 Inferior Good – a good with an income
elasticity less than zero
 Why is the Income Elasticity of Demand
negative? Because the demand curve shifts in
with income increases
 Cross-Price Elasticity of
Demand
 Substitutes – if an increase in the price of
one good leads to an increase in the demand
for another good, they are substitutes
 The Cross-Price Elasticity is POSITIVE
 Example: Coke and Pepsi have a positive cross-
price elasticity

 Complements – if an increase in the price of

one good leads to a decrease in the demand
for another good, they are complements
 The Cross-Price Elasticity is NEGATIVE
 Example: Peanut butter and jelly or hot dogs and
buns
 Elasticity Examples
 To help us think about elasticity concepts,
we are going to look at four different
industries/products:
 Cars, soft drinks, cereal, and beer
 Your book has a ton of other examples
 When you look at the elasticities, try to
explain the differences among brands
and products
 Substitutability, proportion of income spent
on the item, and time to make your
decision
 Elasticity of Automobiles
 Price elasticity of demand:
 BMW 735i = -9.376
 Honda Accord = -51.637
 Ford Escort = -106.497

 Cross-price elasticity of demand:

 BMW 735i & Lexus LS400 = 0.336
 BMW 735i & Honda Accord = 0.203
 BMW 735i & Ford Escort = 0.009

 Which cars are close substitutes? What

role does income play? Which consumers
are most price sensitive?
 Elasticity of Breakfast
Cereal
 Price elasticity of demand:
 Kellogg’s Corn Flakes = -3.379
 Lucky Charms = -2.536
 Rice Krispies = -2.340

 Cross-price elasticity of demand:

 Corn Flakes & Wheaties = 0.242
 Corn Flakes & Lucky Charms = 0.019
 Corn Flakes & Cinnamon Toast Crunch = 0.026
 Lucky Charms & Cin. Toast Crunch = 0.102
 Elasticity of Soft Drinks
 Price elasticity of demand:
 Coke (2-liter bottle) = -3.89
 7-Up (2-liter bottle) = -4.25
 Mountain Dew (2-liter bottle) = -3.75

 Cross-price elasticity of demand:

 Coke & Pepsi = 0.63
 Coke & Mountain Dew = 0.12
 Coke & Diet Coke = 0.81
 Elasticity of Beer
 Price elasticity of demand:
 Miller Lite = -2.10
 Budweiser = -3.80
 Heineken = -0.42

 Cross-price elasticity of demand:

 Miller Lite & Bud Light = 1.26
 Miller Lite & Heineken = 0.12
 MGD & Bud = 1.68
 Questions to think about?
 Why is the price elasticity of the Ford Escort
lower than the BMW?
 Why is the price elasticity of cereal less than
the price elasticity of cars?
 Why is the cross-price elasticity greater for
Corn Flakes & Wheaties than it was for Corn
Flakes & Lucky Charms?
 Are Miller Lite and Bud Light closer
substitutes than Miller Lite and Heineken?
 Selected Income Elasticities of Demand

Income Income
Product Elasticity Product Elasticity
Private education 2.46 Physicians’ services 0.75
Automobiles 2.45 Coca-Cola 0.68
Wine 2.45 Beef 0.62
Owner-occupied housing 1.49 Food 0.51
Furniture 1.48 Coffee 0.51
Dental service 1.42 Cigarettes 0.50
Restaurant meals 1.40 Gasoline and oil 0.48
Shoes 1.10 Rental housing 0.43
Chicken 1.06 Beer 0.27
Spirits (“hard” liquor) 1.02 Pork 0.18
Clothing 0.92 Flour –0.36
Conclusion