Textbook Chapter: Elasticity of Demand in Economics

Introduction
Elasticity of demand is a fundamental concept in economics that measures how sensitive the
quantity demanded of a good or service is to changes in factors such as price, income, or the
price of related goods. Understanding elasticity helps economists, businesses, and policymakers
predict consumer behavior, set prices, and design effective policies. This chapter explores the
types, calculations, determinants, and applications of elasticity of demand, tailored for secondary
school students.

1. What is Elasticity of Demand?

Elasticity of demand measures the responsiveness of the quantity demanded of a good or service
to a change in a specific factor, such as price, income, or the price of another good. It is
expressed as a ratio of the percentage change in quantity demanded to the percentage change in
the determining factor.
Formula for Elasticity:
% Change in Quantity Demanded
Elasticity =
% Change in Determinant
Elasticity is usually a positive or negative number, but in economics, we often focus on the
absolute value (magnitude) for simplicity.

2. Types of Elasticity of Demand

There are three main types of elasticity of demand: price elasticity, income elasticity, and cross-
price elasticity. Each measures responsiveness to a different factor.
2.1 Price Elasticity of Demand (PED)
Price elasticity of demand measures how sensitive the quantity demanded is to a change in the
price of the good or service.
Formula:
% Change in Quantity Demanded
PED=
% Change in Price
Example: Suppose the price of a soft drink increases from 1 t o 1.20 (a 20% increase), and the
quantity demanded falls from 100 cans to 90 cans (a 10% decrease).
−10 %
PED= =−0.5
20 %
The absolute value is 0.5, indicating inelastic demand (see Section 3 for classifications).
Types of Price Elasticity:

Type PED Value Description Example

Perfectly Inelastic PED = 0 Quantity Life-saving drugs
demanded does (e.g., insulin)
not change with
price changes.
Inelastic 0 < PED < 1 Quantity Salt, basic food
demanded items
changes less than
proportionally to
price changes.
Unit Elastic PED = 1 Quantity Some clothing
demanded items
changes
proportionally to
price changes.
Elastic PED > 1 Quantity Luxury goods,
demanded electronics
changes more
than
proportionally to
price changes.
Perfectly Elastic PED = ∞ Any price Identical products
increase leads to in a market
zero demand;
typical in
perfectly
competitive
markets.

Graphical Representation:
 Inelastic Demand: Steep demand curve (small change in quantity for a large price
change).
 Elastic Demand: Flatter demand curve (large change in quantity for a small price
change).
2.2 Income Elasticity of Demand (YED)
Income elasticity of demand measures how sensitive the quantity demanded is to a change in
consumers’ income.
Formula:
% Change in Quantity Demanded
YED=
% Change in Income
Example: If income rises from 1 , 000 t o 1,100 (10% increase) and demand for movie tickets
increases from 10 to 12 (20% increase):
20 %
YED= =2
10 %
This indicates a normal good with elastic demand.
Types of Income Elasticity:

Type YED Value Description Example

Normal Goods YED > 0 Demand increases Clothing,
(Positive) as income rises. electronics
- Necessities 0 < YED < 1 Demand rises less Basic food,
than utilities
proportionally
with income.
- Luxuries YED > 1 Demand rises Vacations, luxury
more than cars
proportionally
with
income. .Concurr
ent Resolution on
the Budget for
Fiscal Year 2022,
S. Con. Res. 14,
117th Cong.
(2021).
Inferior Goods YED < 0 Demand Cheap processed
decreases as foods
income rises.
2.3 Cross-Price Elasticity of Demand (XED)
Cross-price elasticity measures how the quantity demanded of one good responds to a change in
the price of another good.
Formula:
% Change in Quantity Demanded of Good A
XED=
% Change in Price of Good B
Example: If the price of tea rises from 2 t o 2.40 (20% increase) and demand for coffee increases
from 50 to 60 cups (20% increase):
20 %
XED= =1
20 %
This positive value indicates tea and coffee are substitutes.
Types of Cross-Price Elasticity:

Type XED Value Description Example

Substitutes XED > 0 Demand for one Tea and coffee
good rises when
the price of
another rises.
Complements XED < 0 Demand for one Printers and ink
good falls when cartridges
the price of
another rises.
Unrelated Goods XED = 0 Price change of Books and
one good does not toothpaste
affect demand for
another.

3. Determinants of Elasticity of Demand

The degree of elasticity depends on several factors:
3.1 Determinants of Price Elasticity
1. Availability of Substitutes:
o More substitutes → Higher PED (elastic).
o Example: If many brands of soda exist, a price increase for one brand leads to a
larger drop in demand.
2. Necessity vs. Luxury:
o Necessities → Lower PED (inelastic).
o Luxuries → Higher PED (elastic).
o Example: Insulin is inelastic; designer bags are elastic.
3. Proportion of Income Spent:
o Goods taking a large income share → Higher PED.
o Example: A car price increase affects demand more than a pencil price increase.
4. Time Period:
o Short run → Lower PED (inelastic).
o Long run → Higher PED (elastic).
o Example: Gasoline demand is inelastic in the short run but more elastic over time
as people switch to electric cars.
5. Brand Loyalty:
o Strong loyalty → Lower PED.
o Example: Apple products have less elastic demand due to brand loyalty.
3.2 Determinants of Income Elasticity
1. Type of Good:
 o Necessities have low YED; luxuries have high YED.
o Inferior goods have negative YED.
2. Income Level:
o At low incomes, YED for necessities is higher; at high incomes, YED for luxuries
is higher.
3.3 Determinants of Cross-Price Elasticity
1. Relationship Between Goods:
o Substitutes have positive XED; complements have negative XED.
2. Closeness of Substitutes/Complements:
o Closer substitutes (e.g., Coke and Pepsi) have higher positive XED.
o Strong complements (e.g., cars and fuel) have higher negative XED.

4. Calculating Elasticity
Elasticity can be calculated using the point elasticity or arc elasticity method.
4.1 Point Elasticity
Used for small changes, calculated at a specific point on the demand curve:
ΔQ
% ΔQ Q ΔQ P
PED= = = ×
% Δ P ΔP Δ P Q
P
Example: Price falls from 10 t o 9, and quantity demanded rises from 100 to 110.
Δ Q=10 , Δ P=− 1 , P=10 ,Q=100
10 10
PED= × =− 1
−1 100
Absolute value = 1 (unit elastic).
4.2 Arc Elasticity
Used for larger changes, calculated between two points to avoid bias:
Q2 − Q1
(Q + Q )/2
PED= 1 2
P2 − P1
(P1+ P2)/2

Example: Price rises from 10 t o 15, and quantity falls from 100 to 80.
 80 −100 −20
(100+80)/2 90 − 0.222
PED= = = =−0.555
15 −10 5 0.4
(10+15)/2 12.5
Absolute value = 0.555 (inelastic).

5. Applications of Elasticity
Elasticity has practical uses in business and policy:
1. Pricing Decisions:

o Inelastic demand → Firms can raise prices to increase revenue (e.g., utilities).
o Elastic demand → Firms may lower prices to increase revenue (e.g., electronics).
o Example: A cinema with elastic demand lowers ticket prices to attract more
viewers, increasing total revenue.
2. Taxation Policies:

o Goods with inelastic demand (e.g., tobacco) are heavily taxed, as demand remains
stable, generating revenue.
o Example: Governments tax cigarettes heavily because demand is inelastic.
3. Forecasting Demand:

o Businesses use YED to predict demand changes as incomes rise.

o Example: A car manufacturer anticipates higher demand as incomes grow (YED
> 1).
4. Marketing and Product Positioning:

o Firms use XED to understand substitute and complement relationships.

o Example: A coffee shop monitors tea prices to adjust its marketing strategy.

6. Elasticity and Total Revenue

Total revenue (TR) = Price × Quantity. Elasticity affects how price changes impact TR:
 Elastic Demand (PED > 1):
o Price increase → TR decreases (quantity falls significantly).
o Price decrease → TR increases.
 Inelastic Demand (PED < 1):
o Price increase → TR increases (quantity falls slightly).
o Price decrease → TR decreases.
 Unit Elastic (PED = 1):
 o Price changes do not affect TR.
Example: A bakery raises bread prices from 2 t o 2.20 (10% increase). Demand falls from 100 to
95 loaves (5% decrease). PED = 0.5 (inelastic). TR rises from 200 t o 209, confirming inelastic
demand increases TR with price rises.

Summary
 Definition: Elasticity of demand measures how sensitive demand is to changes in price,
income, or prices of other goods.
 Types:
o Price Elasticity (PED): Responsiveness to own price changes.
o Income Elasticity (YED): Responsiveness to income changes.
o Cross-Price Elasticity (XED): Responsiveness to price changes of another good.
 Classifications:
o PED: Perfectly inelastic, inelastic, unit elastic, elastic, perfectly elastic.
o YED: Normal (necessities, luxuries), inferior.
o XED: Substitutes, complements, unrelated.
 Determinants: Substitutes, necessity, income share, time, brand loyalty, income level,
and good relationships.
 Calculations: Point and arc elasticity methods.
 Applications: Pricing, taxation, forecasting, and marketing.
 Revenue Impact: Elasticity determines how price changes affect total revenue.

Review Questions
1. Define elasticity of demand and explain why it is important in economics.
2. What is the formula for price elasticity of demand (PED)? Calculate PED if the price of a
good rises from 5 t o 6 and quantity demanded falls from 200 to 180 units.
3. Distinguish between elastic and inelastic demand with examples of each.
4. Explain the difference between normal goods and inferior goods using income elasticity
of demand.
5. How does the availability of substitutes affect price elasticity of demand? Provide an
example.
6. Calculate the arc elasticity of demand if the price of a product falls from 20 t o 15 and
quantity demanded rises from 50 to 70 units.
7. Why might demand for a good be more elastic in the long run than in the short run? Use
an example.
8. How does cross-price elasticity help businesses understand the relationship between
goods? Give an example of substitutes and complements.
9. Explain how elasticity affects a firm’s total revenue when prices change. Use a numerical
example.
 10. Why do governments tax goods with inelastic demand, such as tobacco, more heavily?
Explain with reference to elasticity.

This chapter provides a comprehensive yet accessible exploration of elasticity of demand, using
clear explanations, examples, and tables to engage secondary school students.