ECON 101 – Chapter #4 Notes
Elasticity in economics is the measurement of how changing one economic
variable (such as: supply, demand, income) affects other. In my words, it is the
responsiveness of a good or service to a change in price.
Price Elasticity of Demand
We know that when supply increases the equilibrium price falls and the
equilibrium quantity increases. BUT does the price fall by a lot and the QD
increase only a little? OR does the price barely fall and the QD increase a lot?
The answer to this is: It depends on the responsiveness of the quantity
demanded to a change in price. For example, if the quantity demanded is greatly
affected by a small change in price, this means that the QD is elastic. In the
textbook we get two different scenarios that give rise to 2 different outcomes
The different outcomes arise from the differing degrees of responsiveness of
QD to a change in price, otherwise known as the price elasticity of demand.
In this case, ONLY because we are using the same units we can compare the
responsiveness of the QD to a change in price of both scenarios. So we can
compare the price elasticity of demand of each product in the 2 scenarios, and
we can do this by using SLOPE. The slope of demand curve D A is steeper than the
slope of demand curve D B.
Remember: We can ONLY compare in this case because they are using
the SAME UNITS! (pizzas).
Usually, we cannot make this kind of comparisons using slopes since we generally
don’t compare products measured is the same units. So since they aren’t
measure in the same units they CANNOT BE COMPARED USING SLOPES.
As a matter of fact, elasticity is measured using NO units of measurement, it is
simply a number: 0, greater than 0 but less than 1, simply 1, or greater than 1.
The price elasticity of demand is a units-free measure of the responsiveness of
the quantity demanded of a good to a change in its price; when all other
influences on buying plans remain the same. Calculating price Elasticity of Demand
We calculate the price elasticity of demand by using:
Δ % in Quantity Demanded
Price elasticity of demand = Δ % in Price
SO, in order to calculate price elasticity of demand, we express the changes in
price and QD as percentages of the average price and the average quantity.
The only way to explain this is using an example: Let’s say that initially the price
of a HUGE pizza you want to buy because you’re smashed is $20.50 per pizza and
the pizza joint sells about 9 pizzas an hour. Suddenly a giant Lion appears out of
nowhere and just eats half the pizza. Now, having been licked by a lion the owner
decides to lower the price of the pizza to $19.50 (Your drunk beyond recognition
so, you’ll take it either way) and therefore the QD of pizzas increases to 11 an
SO, the original price was $20.50, the new price is $19.50, and the AVERAGE
price is $20. So we calculate:
ΔP / ΔPAvg= (1/20) = 5%
SIMILARLY, the original quantity demanded was 9 pizzas and the new quantity
demanded is 11 pizzas, so the AVERAGE quantity is 10 pizzas. So we calculate:
ΔQ / ΔQ Avg= (2/10) = 20%
SO, Price elasticity of demand = 20%/5% = 4
Sometimes, the price of a good rises, in these cases we know that this causes a
negative change on QD. This would make the price elasticity of demand a
negative number. But it’s the absolute value or the magnitude of the price
elasticity of demand that tells us how responsive the QD is; therefore we use
the absolute value of elasticity.
Inelastic and Elastic Demand
There are 5 types of elasticity:
1. Perfectly Inelastic demand – if the QD remains constant when the price
changes, then the price elasticity = 0, and it is said to be perfectly inelastic.
Example – Insulin has perhaps an elasticity of 0. This is because its of such
importance to diabetics that if price rises or falls they do not change the quantity
they buy. 2. Unit Elastic demand – If the percentage change in the quantity demanded
equals the percentage change in the price, then elasticity = 1, and the good is
said to have unit elastic demand.
3. Perfectly Elastic demand – if the QD changes by an infinitely large
percentage in response to a tiny price change, then the price elasticity of
demand = ∞, and the good is said to have perfectly elastic demand.
4. Inelastic demand – When the percentage change in the QD is greater than
the percentage change in price. In this case, the price elasticity of demand is
between 1 and infinity, the good is said to have inelastic demand.
5. Elastic demand – When the percentage change in QD is less than the
percentage change in price. In this case, the price elasticity of demand is
between 0 and 1. The good is said to have elastic demand.
Total Revenue and Elasticity
When a price changes, total revenue also changes. But a rise in price does not
always increase total revenue. The change in total revenue depends on the
elasticity of demand:
• If demand is elastic, a 1% price cut increases the quantity sold by more
than 1% and total revenue increases. elastic remember means
responsive to a change in price.
• If demand is inelastic, a 1% price cut increases the quantity sold by less
than 1% and total revenue decreases. • If demand is unit elastic, a 1% price cut increases the quantity sold by
1% and total revenue does NOT change.
These very same rules apply to expenditures;
• If your demand is elastic then a 1% price cut increases the quantity you
buy by more than 1% and your expenditure on the item increases.
• If your demand is inelastic, then a 1% price cut increases the quantity
you buy by less than 1% and your expenditure on the item decreases.
• If your demand is unit elastic, then a 1% price cut increase the quantity
you buy by 1% and expenditure on the item does not change.
The Factors that influence the Elasticity of demand
The elasticity of demand depends on:
1. The closeness of substitutes – The closer the substitute for a good or
service, the more elastic is the demand for it. For example – oil from
which gasoline is made has substitutes but NONE that are close. SO the
demand for oil is inelastic. Plastics are close substitutes for metals, so the
demand for metals is elastic.
2. The proportion of income spent on the good – The greater the
proportion of income spent on the good, the more elastic is the demand
for it. For example – Think of chocolate and Hummers. If the price of
chocolate doubles, you’ll consume almost as much chocolate as before. So
your demand for chocolate is inelastic. If hummer prices double, you
FREAK OUT and sell that shit away (or just don’t buy it). SO basically your
demand for hummers is not as inelastic as your demand