Price Elasticity

Price Elasticity of demand measures the responsiveness of demand to a change in the price. 

  • Price elasticity of demand = % Change in quantity demanded / % Change in price

  • Midpoint Method: Calculate changes in a variable compared with the midpoint of the starting and final values. 

    • Qb-Qa/(Qb+Qa/2) = Q 

    • Pb-Pa/(Pb+Pa/2) = P

    • Q/P = Midpoint

Elasticity of demand is determined by:

  • Do Substitutes exist?                                                                                                                                                                                                             

  • Is it a Necessity or Luxury

  • Share of Income Spent

    • As the share in income increases, the price elasticity of demand increases. 

  • Time

  • Inelastic Demand - Elasticity < 1

  • Percentage change in quantity demanded is lower than the percentage change in price

  • Typically includes things like Eggs and Beef

  • Goods with inelastic demand tend to be necessities

  • Elastic Demand - Elasticity > 1

  • Percentage change in quantity is higher than the percentage change in price

  • Typically includes housing, restaurant meals, airline travel

  • Goods with elastic demand tend to be substitutable or luxuries. 

  • Unitary Elastic - Elasticity = 1

  • Percentage change in quantity demanded is equal to the percentage change in price.

  • Extreme case of Elasticity. 


Extreme Cases of Price Elasticity


  • Perfectly inelastic: the quantity demanded doesn’t respond at all to changes in price. Graphically represented as a vertical line. 

    • Good or service that are necessary in life or death scenarios, like Insulin or Water

  • Perfectly elastic: any price increase will drop the quantity demanded to zero. Graphically represented as a horizontal line. 

    • If the price goes above the demand curve then nobody will buy the good/ service

  • Unit elastic: the price elasticity of demand is equal to one. 


Elasticity and Revenue


Classification of Elasticity predicts how changes in the price of a good will affect the total revenue earned by producers from the sale of that particular good. 

  • Total revenue is defined as the total value of sales

  • Total revenue = Price x quantity


With an increase in price, two factors are considered to determine whether revenue will increase

  • Price Effect - more revenue

  • Quantity Effect - after a price increase fewer units are sold, which tends to lower revenue. 


Price Elasticity determines which will be dominant:

  • Price Elasticity > 1, an increase in price reduces the total revenue. In this case the quantity effect is stronger than the price effect. 

  • Price Elasticity < 1, an increase in price will increase the total revenue. In this case the price effect is stronger than the quantity effect. 


Price Elasticity of Demand is determined by:

  • Whether close substitutes are available - more substitutes result in higher elasticity, as switching costs are lower for the consumer. 

  • Whether the product is a necessity or luxury - how easily can consumption be reduced. Luxury products are more elastic than necessities. 

  • Share of Income spent on that good

  • Time


Cross-Price Elasticity of Demand


Elasticity measured between two goods, the effect of the change in one good measures the effect of the change in one goods price based on the quantity demanded of the other good. 


Cross-Price = %Change in Quantity Demanded of Good1 / %Change in Price of Good2

  • Substitutes

  • Complements

Income Elasticity of Demand


It is the percentage change in the quantity demanded when a consumer's income changes. 

  • Income Elasticity = % Change in Quantity Demanded / % Change in Income


Normal - Higher income increases the Quantity Demanded

Inferior - Higher income decreases the Quantity Demanded


Price Elasticity of Supply


Measure of responsiveness of the quantity of a good supplied to the price of that good. 

  • Price Elasticity of Supply = % Change in Quantity Supplied / % Change in Price

  • Perfectly Inelastic Supply when the supply is zero so that changes in the price of that good will have no effect on the quantity supplied. Graphed as a vertical line. 

  • Perfectly elastic supply when even a tiny increase or reduction in price will lead to very large changes in the quantity supplied, so that the price elasticity of supply is infinite. Graphed as a horizontal line. 

  • Availability of Inputs:

    • Price Elasticity of Supply tends to be large when inputs are readily available and can be shifted into and out of production at a relatively low cost. 

    • Price Elasticity of Supply tends to be small when inputs are difficult to obtain.