CHAPTER 6: ELASTICITY
Learning Outcomes
Elasticity is an important concept as economists do not only want to know the direction of changes in
response to changes in demand (or supply), they also want to know what the magnitude of the changes
will be. The purpose of this chapter is thus to explain the meaning and significance of various elasticity
concepts. Students who have mastered the prescribed sections should be able to:
Define and calculate elasticity;
Explain the meaning and significance of price elasticity of demand;
Distinguish between five categories of price elasticity of demand;
Explain the relationship between price elasticity of demand and total revenue in the case where
demand is elastic and where demand is inelastic;
Explain the determinants of price elasticity of demand; and
Define income elasticity and cross elasticity of demand.
Written assignment questions / Tutorial questions / Self-study questions:
Note:
Elasticity is a measure of responsiveness or sensitivity of a dependent variable to a change in an
independent variable (Mohr et al. 2015:104). In this chapter we examine the responsiveness of a change
in the quantity consumed to changes in market conditions. The change in quantity is always the dependent
variable, and the change in market conditions the independent variable.
1 Define the concept “price elasticity of demand” and give its formula (p. 104). (2)
2 Illustrate (Fig. 6-2, pp. 109 – 110) price elasticity of demand at different points along a linear demand
curve. Ensure that you have provided the value of the price elasticity of demand at each point as
well as the corresponding price elasticity of demand category. (6)
For your information:
A technical problem is encountered when an attempt is made to calculate the percentage change between
two different points on a demand curve, as the answer will depend on which point is used as the basis for
the calculation. The solution is to use the average of the two points as the basis. In this way, the same
answer will always be obtained, irrespective of the basis or direction of change. The elasticity coefficient
calculated by comparing two points on a demand curve is called arc elasticity.
Example:
Suppose the price of flour increases from R0.80 to R1.00 a kilogram and the quantity demanded decreases
from 100 kilograms to 95 kilograms. Using the arc elasticity method, what is the price elasticity of demand
for flour? Is the demand for flour elastic or inelastic?
Q 2 Q1 / Q1 Q 2
ep
P2 P1 / P1 P2
ep
95 100 100 95
1 0.8 0.8 1 The price elasticity of demand is usually negative
because the quantity demanded usually
5 195
ep decreases as the price increases and vice versa.
0.2 1.8 The textbook follows the convention of ignoring
the negative sign of the price elasticity of
0.02564
ep demand and as such we do the same in this
0.11111 course.
ep 0.23
Because the elasticity is less than 1, the demand is inelastic.
Note:
You can also use the following formula:
ΔQ Pave
ep X
ΔP Qave
ep
Q2 Q1 X P1 P2/2
P2 P1 (Q1 Q2)/2
(95 100) (0.8 1)/2 The price elasticity of demand is usually negative
ep X because the quantity demanded usually
(1 0.8) (100 95)/2 decreases as the price increases and vice versa.
5 0.9 The textbook follows the convention of ignoring
ep X the negative sign of the price elasticity of
0.2 97.5 demand and as such we do the same in this
4.5 course.
ep
19.5
e p 0.23
3 Suppose the quantity of blankets demanded increases from 4 600 to 5 700 in response to a decrease
in their price from R220 to R190. Using the arc elasticity formula calculate the price elasticity of
demand for blankets. [Round off to two decimal places in your last step.] (3)
4 Explain the relationship between price elasticity of demand and total revenue for each of the FIVE
different categories of price elasticity of demand as given in Table 6-2 (p. 112). Remember to explain
the meaning in each case. (5)
Note:
The five categories discussed in Question 4 are illustrated in Figure 6-3 (p. 111). The two most important
diagrams to take note of are the diagrams illustrating perfectly inelastic demand (represented by a
vertical demand curve) and perfectly elastic demand (represented by a horizontal demand curve).
5 Explain the relationship between price elasticity of demand and total revenue in the case where:
a) demand is elastic (for a price increase and decrease) (p. 110 and Box 6-2, p. 113); and
b) demand is inelastic (for a price increase and decrease) (p. 110 and Box 6-2, p. 113). (2 X 2 = 4)
6 The price elasticity of demand for personal computers is 4.0. What would happen to the total revenue
earned by firms making computers if they decreased their prices? (2)
7 The price elasticity of demand for eggs is 0.3. What would happen to the total revenue earned by
egg producers if they raised their prices? (2)
8 You run the only cooldrink stand in Happy Valley. If people don't buy lemonade from you, their only
other option is to buy orange juice from a nearby vendor on the Humewood beachfront. One day,
you decide to raise the price of your lemonade from R1 per glass to R1.25 per glass. As a result,
half of your usual customers decide to get orange juice instead of lemonade that day. What does
this experience tell you about the demand for lemonade in Happy Valley? (1)
The demand for lemonade in Happy Valley is price elastic
Change in price = (1.25 -1)/(1) = 0.25. So change in price was only 25%, but 50% of your
customers decided to buy orange juice.
%change in Qd / % change in P = -50/+25 = -2 (absolute value of 2)
9 Name and explain any THREE of the FIVE MAIN determinants of the price elasticity of demand (pp.
112 – 113). (3 X 2 = 6)
Substitution possibilities – The greater the number of substitutes and the closer (or better)
the substitutes are, the greater is the e p , ceteris paribus. E.g., hamburgers and hot dogs are
good substitutes and will tend to have an elastic demand.
The degree of complementarity of the product – In the case of highly complementary goods
(i.e. goods which tend to be used jointly with other goods) the e p tends to be low.
The type of want satisfied by the product – The e p for necessities, e.g. basic foodstuffs and
electricity, tends to be lower than the e p of luxury goods and services such as recreation and
luxury motor vehicles.
The time period under consideration – Demand tends to be more price elastic in the long run
than in the short-run (e.g. airline tickets). An example is the e p for fuel. In the 1970s the price
of crude oil increased more than 20-fold. In the short-run consumers could do little about it and sales
didn’t decrease significantly. But in the long run, consumers switched to smaller, more fuel-efficient
cars.
The proportion of income spent on the product – The greater the proportion of income spent
on a product, the greater the e p will be (or that the smaller the proportion, the lower the e p
will be).
10 Consider the following representative households in our market for electricity:
Household A: Uses electricity for lighting, appliances and heating.
Household B: Uses electricity for lighting, appliances and heating. Furthermore, Household B has a
heating system that can, with one day’s labour, be switched to run off solar energy.
Write the correct answer in the answer blanks or underline the correct words in parentheses.
a) Household ___ will have the more elastic demand because of the presence of a ___ good. (2)
b) Because Household A has no available substitutes, should we assume that the quantity demanded
of electricity will remain unchanged given the increase in price? (Yes / No). (1)
c) Household A’s response will be more (elastic / inelastic) than Household B’s. (1)
d) To summarise: Demand is (more / less) elastic for goods with many available substitutes. (1)
11 Define the following “other” elasticity concepts and give the formula for calculating each:
a) income elasticity of demand (pp. 115 – 116); and
b) cross elasticity of demand (pp. 116 – 117). (2 X 2 = 4)
Note:
Goods with a positive e y are called normal goods.
Normal goods are further classified as luxury goods ( e y > 1) or essential goods ( e y < 1).
Goods with a negative e y are called inferior goods.
In the case of substitutes (e.g. butter and margarine) the ec is positive. In the case of complements
(e.g. motor cars and motor car tyres) the ec is negative.
12 The income elasticities of demand for movies, dental services, and clothing have been estimated to
be +3.4, +1.0, and +0.5 respectively. Interpret these coefficients. What does it mean if the income
elasticity coefficient is negative? (2)
All are normal goods--income & QD move in the same direction. These coefficients reveal that
a 1% in income will the quantity of movies demanded by 3.4%, of dental services by 1.0%,
& of clothing by 0.5%. A negative coefficient indicates an inferior good.
13. A 10% increase in income brings about a 15% decrease in the demand for candles. Given this
information, calculate the income elasticity of demand. Are candles a normal good or an inferior
good?
percentage change in the quantity demanded of the product
ey
percentage change in consumers' income
15
ey
10
e y 1.5
The income elasticity of demand is 1.5. The good is an inferior good.
14. What will be the cross price elasticity of demand for computer software if the demand for computer
software increases by 45% because of a decrease of 15% in the price of personal computers?
Application Question (to be discussed during the tutorial):
AQ1 A local pizza outlet charges R40 for a medium pizza. The owner of the pizza outlet wants to increase
her total revenue. Recent market research shows that the price elasticity of demand for her pizza is
about 1.5. Should the owner of the pizza outlet lower or raise the price? Explain your answer.
AQ2 The following products / items were advertised at discount prices:
Note: Pick ‘n Pay prices were valid from 28 October to 1 November 2009.
Shoprite prices were valid from 26 October to 8 November 2009.
AQ2.1Take a look at the products being advertised at discount prices above. Most special offers at
supermarkets such as Pick ‘n Pay and Shoprite include meat, usually chicken. Why do you think this
is so?
AQ2.2Why, do you (almost) never see discount prices being offered on products such as salt or matches?
Revision:
Indicate whether each of the following statements is True (T) or False (F).
True False
(T) (F)
1 Price elasticity of demand varies from point to point along a linear demand curve.
2 Producers are interested in the price elasticity of demand for their product because
it indicates what will happen to their total revenue (= P x Q) when the price of the
product changes.
Figure 1
3 In the above figure (i.e. Figure 1), the price elasticity of demand is equal to 1 at point
c.
4 In the above figure (i.e. Figure 1), at point b on the demand curve, a price cut of R1
will decrease total revenue.
5 Consider the straight-line demand curve illustrated in the figure above (i.e. Figure
1). At a price of R6, demand is elastic.
6 If the price elasticity of demand for popcorn is greater than one, then the
manufacturers of popcorn can increase their total revenue by raising the price of
popcorn.
7 If price elasticity is less than one, a fall in price lowers the total revenue of the
suppliers in question.
8 The more (or better) substitutes a good has, the greater the price elasticity of
demand for the good will be.
9 One reason why petrol has a low price elasticity of demand is that it has no close
substitutes.
10 Income elasticity of demand is a measure of the responsiveness of quantity
demanded to changes in consumers’ income.
11 If cheese has a positive income elasticity of demand, then cheese is classified as
an inferior good.
12 In South Africa the income elasticity of demand for biltong for high-income
households has been estimated at 1,36. This implies that biltong is a normal good
and also a luxury good.
13 If the cross elasticity of demand (ec) is positive, the products are complements.
14 A horizontal demand curve has a price elasticity of demand equal to 0.
15 A perfectly inelastic demand curve is vertical.
16 The price elasticity of demand for a good is greater the shorter the time period under
consideration.
17 During recessions, when some workers lose their jobs and have lower incomes,
sales of durable goods (goods with a life expectancy of 3 years or more) decline.
Apparently, durables are normal goods.
18 Suppose that the quantity demanded of good X falls by 6% when the price of good
Y falls by 4%. The cross elasticity of demand between goods X and Y is -1.5.