The elasticity of demand

Chapter 4
Learning outcomes
By the end of this chapter, you should be able to:
• explain the meaning of the price, income, and the cross-price
elasticity of demand;
• outline the determinants of the price elasticity of demand for a
product;
• explain the difference between a normal and an inferior good;
• understand the difference between a substitute and a
complementary product;
• understand the significance of the concept of elasticity for a firm’s
planning; and
• appreciate the limitations of the concept of elasticity of demand.
Introduction
In the previous chapter, we examined the factors determining the level of
demand for a product, and the differences between a shift in demand and a
movement along a demand curve.

In this chapter, we examine the extent to which changes in several variables

can affect demand, which is referred to as the determinants of elasticity of
demand.

For example, how much does demand change when the price or income
changes and what determines the scale of these changes.
The elasticity of demand
• In economics, elasticity of demand refers to how sensitive the demand for
a good is to changes in other economic variables, such as price, consumer
income, and even the prices of other goods.
• Demand elasticity is calculated as the percentage change in the quantity
demanded divided by a percentage change in another economic variable.
Two keys to understanding the elasticity of
demand:
The mathematical sign of the answer (+ or -):
• If this is a negative answer (that is -2), then it means that the change in
the quantity demanded and the change in the variable move in opposite
directions
• A positive answer (that is 2) means that the variable and the quantity
demanded move in the same direction – that is, both the variable and
the quantity demanded increase or both decrease. The implication of
this is that the answer would be positive if an increase in income results
in an increase of the quantity demanded of a product or a decrease in
income leads to a decrease in quantity demanded of a product
The numerical value of the answer:
• The numerical value of the answer for the elasticity of demand shows
how sensitive demand is to changes in the variable (price or income)
• If the value of the answer (ignoring the sign) is greater than one (>1),
then it means that the quantity demanded has changed more than
the variable, and demand is said to be elastic.
• If the answer (ignoring the sign) is less than one (<1), then this means
that the change in the quantity demanded is less than the change in
the variable. In this case, demand is said to be inelastic.
Figure 4.1 A negative price elasticity of demand: A higher price reduces the quantity demanded. (p. 61)
 Figure 4.2 Analysing elasticity. (p. 61)

Any answer (ignoring the sign) that is >1 is known as a price elastic product: the
quantity demanded will change by more than the change in price (in
percentages). If a product has a price elasticity of demand of <1 (ignoring the
sign), this means that demand is price inelastic. The change in the quantity
demanded is less than the change in price (in percentages).

Price inelasticity does not mean that consumption is not responsive to price
changes. Rather, it means that the proportional change in consumption is
smaller than the proportional change in price. Only if the price elasticity value is
0,0, will price changes have no effect on consumption.
Table 4.1 The
numeric values
of the price
elasticity of
demand (p. 62)
• In some cases, the price elasticity of demand may be positive. This occurs
when the demand curve is upward-sloping.
• When the demand curve is upward-sloping, a higher price leads to a higher
quantity demanded, meaning that both the denominator and numerator
move in the same direction, leading to a positive answer.
• An upward-sloping demand curve may occur with Giffen or Veblen goods

Figure 4.3 An upward-sloping demand curve has a positive price elasticity of demand. (p. 64)
Determinants of the price elasticity of demand
How differentiated the product is:
• If a product has a strong brand name or a unique selling proposition, then consumers cannot
easily find substitutes for these products. The impact of a price change on the quantity
demanded of this product will therefore be small relative to the price change. The demand will
be price inelastic.
The time period involved:
• If a firm increases the price of a specific product, consumers may find it difficult to find an
alternative, less expensive product in the short term.

Whether the firm has built a relationship with its consumers:

• Some businesses aim to develop loyalty from their consumers. Such loyalty programmes might
make consumers less sensitive to price changes, because they feel loyal to the business and
receive certain rewards
The breadth of product category being considered:
• The narrower the product category examined, the more price inelastic
demand will be because there are fewer alternatives
Who is paying:
• If you are paying a bill yourself, you are likely to be fairly sensitive to the
price. If, however, someone else is paying then you are likely to be less
sensitive to price.

The awareness and availability of substitutes:

• If consumers know that there are many similar substitute products
available, then they are more likely to switch between products if there
are noticeable differences in the price of the product they use on a
regular basis.
The percentage of income spent on the product:
• If you spend a considerable amount of money on an item,
then you are more likely to shop around for the best buy.

The nature of the product:

• If a product is habit-forming or addictive, such as cigarettes,
demand is likely to be price inelastic. The impact of a price
increase will be relatively small, seeing as consumers will still
buy the product despite the increase. Similarly, demand for
necessities such as bread, coffee, tea, electricity, and fuel is
price inelastic.
The value of the price elasticity of demand
along a demand curve

Figure 4.4 The price elasticity of demand changes along a demand curve. (p. 69)
When we talk of a price inelastic demand or a price elastic demand in relation to a downward-
sloping straight-line demand curve, this is because we are focusing on a particular section of a
demand curve. Demand may be insensitive to price within a given price band but if the price
continues to increase, then the demand will, at some point, become price elastic.

Figure 4.5 The price elasticity along a demand curve. (p. 69)
 The demand curve is shown as price The demand curve is price
inelastic for the part of the curve elastic for the part of the
indicated by the solid line, but is curve indicated by the solid
price elastic at higher prices for the line, but is price inelastic at
part of the curve indicated by the lower prices for the part
dotted line. indicated by the dotted line.

Figure 4.6 Demand curves moving between price inelasticity and price elasticity. (p. 70)
 If demand is completely price If demand is completely price
inelastic this means the quantity elastic this means that a change in
demanded does not change with price leads to an infinite change in
price quantity demanded.

Figure 4.7 A completely price inelastic Figure 4.8 A perfectly elastic demand
demand curve (price elasticity of curve (price elasticity = ∞). (p. 71)
demand = 0). (p. 71)
 If demand is unit elastic this means a
percentage change in price leads to the
same percentage change in quantity
demanded. This leads to a demand curve
that is known as a rectangular hyperbola

Figure 4.9 A unit elastic demand curve (price elasticity = −1). (p. 71)
The price elasticity of demand and total revenue
• The total revenue is the earnings generated from selling a product, namely,
it is the same as the total expenditure by consumers. It represents the
value of sales and does not consider costs. The value of the total revenue
depends on the quantity sold and the price per unit

Total revenue = Price per unit x Quantity sold

Figure 4.10 The total revenue shown using a demand curve. (p. 71)
 Table 4.2 The impact of a price fall on revenue, depending on
the price elasticity of demand (p. 72)

Figure 4.11 A unitary elastic demand curve. A change in price

does not change the revenue (p. 72)
• The estimation of the price elasticity of demand is therefore very
important for firms when determining a pricing strategy.
• Managers will often want to increase the revenue (total expenditure)
that they generate from sales. To do this, managers should:
• lower price if demand is price elastic; or
• increase price if demand is price inelastic.
• An understanding of price elasticity and the impact of this on pricing
policies can be seen when firms price discriminate.
• This occurs when they charge different groups of consumers different
prices for the same product.
The income elasticity of demand
• The effect of a change in income on demand is measured by the
income elasticity of demand. The income elasticity of demand
measures the sensitivity of demand to a change in income, all other
things being equal (unchanged). It is calculated using the following
equation:
The following are the two keys to understanding
the income elasticity of demand:
• The mathematical sign of the answer:
• If the income elasticity of demand is positive→ an increase in income leads to
an increase in demand– that is, income and the quantity demanded move in
the same direction.
• If the income elasticity of demand is negative→ an increase in income leads
to a fall in demand – that is, income and the quantity demanded move in
opposite directions.
• The numeric value of the answer:
• >1 (ignoring the sign) → the product is known as a luxury product: demand is
very sensitive to income and therefore income elastic.
• <1 (ignoring the sign) → the product is known as a necessity: demand is not
particularly sensitive to income and therefore income inelastic.
Figure 4.12 An Engel curve shows what happens to the quantity demanded when income changes (p. 77).
Figure 4.13 Income elasticity and shifts in demand. The greater the income elastic demand is for a product,
the more it will shift following a change in income (p. 77)
The cross-price elasticity of demand
• Changes in the price of other products (both substitutes and
complementary products) will therefore affect demand for any given
product. This effect is measured by the cross-price elasticity of
demand.
• The cross-price elasticity of demand measures the sensitivity of
demand of one product to changes in the prices of other goods and
services, all other things unchanged. It is calculated using the
following equation:
• If the cross-price elasticity of demand is positive:
• this means that demand for one product increases when the price of another
product increases
• The size of the answer:
• this shows how close the two products are as substitutes, namely the bigger
the answer, the more closely related they are.
• If the cross-price elasticity of demand is negative:
• this means that the products are complementary products – that is, an
increase in the price of one product leads to a fall in the quantity demanded
of the other.

The cross-price elasticity of demand is important because it shows the

relationship between price changes of other products and the impact on
demand of your products.
Table 4.3 Summary table for price, income, and cross-price elasticities of demand (p. 80)
Practical limitations of the concept of elasticity
of demand
• In theory, the various measures of the elasticity of demand help
managers to understand the impact of changes in different variables
on their sales.
• In reality using them can be difficult for the following reasons:
• Each of the equations for the elasticity of demand measures the relationship
between changes in one specific factor and demand with all the other factors
held constant
• To know the elasticity of demand, managers must either look back at what
happened in the past when, for example, prices or incomes changed
(although the conditions are likely to have changed since then), or estimate
for themselves what the values are now (in which case, they may be wrong
because it is an estimate). The value of elasticity is, therefore, not actually
known at any moment but is rather an estimate based, in many cases, on past
data.
Key learning points
• The concept of elasticity measures how sensitive demand is to a change in
a variable.
• The sign of the answer highlights whether changes in quantity demanded
and the variable move in the same direction or in opposite directions.
• The size of the answer shows the strength of the relationship between the
variable and quantity demanded.
• There are many types of elasticity measuring how different variables such
as price, income, and the prices of other products affect the quantity
demanded.
• An understanding of the elasticity of demand will help a firm in its
planning, for example, of stock levels, pricing, and staffing.