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Elasticity of Demand
Price 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
Price Elasticity of Demand and
Consumer Expenditure
• Defining Total consumer Expenditure
TE = P × Q
• Illustrating TE graphically
Total expenditure
4
3
P(£) 2
Consumers’ total expenditure
=
firms’ total revenue
=
£2 x 3m = £6m
1
D
0
0
1
2
3
4
Q (millions of units per period of time)
5
Price Elasticity of Demand and
Consumer Expenditure
• Effects of a price change: elastic demand
– Price rises Total Expenditure falls
Elastic demand between two points
Expenditure falls
as price rises
P(£)
5
b
a
4
0
D
10
20
Q (millions of units per period of time)
Elastic demand between two points
P(£)
5
b
a
4
0
D
10
20
Q (millions of units per period of time)
Price Elasticity of Demand and
Consumer Expenditure
• Effects of a price change: inelastic
demand
– Price rises: Total Expenditure rises
Inelastic demand
Expenditure rises
as price rises
8
c
P(£)
a
4
D
0
15
20
Q (millions of units per period of time)
Price Elasticity of Demand
• Applications to pricing decisions
• Applications to tax decisions
Income Elasticity (at end)
• Revenue predictions
• Government revenue changes from taxes on
products
Price Elasticity of Demand
• Measuring price elasticity of demand
% change in QD
% change in P
– use of percentage changes
– the sign: positive or negative?
– the value: greater or less than 1?
Price Elasticity of Demand
• Measuring price elasticity of demand
% change in QD
% change in P
– greater than -1 then price elastic
– less than -1 then price inelastic
Price Elasticity of Demand
• 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 Inelastic
Elastic or Inelastic?
Elastic or Inelastic
Elastic or Inelastic?
Measuring Elasticity
% change in QD
% change in P
Change in QD
Original QD
Change in P
÷
Original P
Measuring Elasticity
10
m
8
n
6
P (£)
4
Demand
2
0
0
10
20
30
Q (000s)
40
50
Price elasticity of demand
% change in QD
% change in P
10
10
2
÷
=4
8
Price Elasticity of Demand and
Consumer Expenditure
• Special cases
– PeD = 0
P
Totally inelastic demand (PD = 0)
D
P2
b
P1
a
O
Q1
Q
Price Elasticity of Demand and
Consumer Expenditure
• Special cases
– PeD = 0
– PeD = 
P
Infinitely elastic demand (PD = )
a
b
D
P1
O
Q1
Q2
Q
Price Elasticity of Demand and
Consumer Expenditure
• Special cases
– PeD = 0
– PeD = 
– PeD = –1
Unit elastic demand (PD = –1)
P
20
a
b
8
D
O
40
100
Q
Price Elasticity of Demand and
Consumer Expenditure
• Special cases
– PeD = 0 – perfectly inelastic
– PeD =  - perfectly elastic
– PeD = –1 – unitary elasticity
Demand 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
The London Restaurant market
• Watch the video clips and comment on
the types of goods and their elasticities:
– Restaurant Food
– Prepacked sandwiches
– Sandwich boxes
Goods can be both!
• Bread
• NORMAL if you are on a low income
• INFERIOR for higher income earners
Other 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
• 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?
• 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 highincome 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 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
Giffen 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
Income 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.
Substitution
• 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 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)
Cross 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)
Example – positive cross elasticity
Price of Fish
• A rise in the price of fish may cause
demand for chicken to increase
(substitutes)
What will have
happened to the
demand curve for
chicken?
Quantity of Chicken Demanded
Example – negative cross elasticity
Price of air travel
• A rise in the price of air travel causes a
fall in the demand for foreign holidays
(complementary goods)
What will have
happened to the
demand curve for
foreign holidays?
Quantity of foreign holidays demanded
Example – zero cross elasticity
Price of apples
• 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
The 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.