7.1 Elasticity
Main Topics: Price Elasticity of Demand, Determinants of Elasticity, Total Revenue and
Elasticity, Income Elasticity, Cross-Price Elasticity of Demand, Price Elasticity of Supply
Studying the economic concept of elasticity is much like a corporate executive work-
shop, the topic of which is “Sensitivity Training.” When we observe a consumer’s purchase
decision, say for good X, change in response to a change in some external variable (the price
of good X or her income), elasticityhelps us measure the sensitivity of her consumption to
that external change. We also examine the sensitivity of suppliers of good X to a change in
the price of good X. We use basic mathematical relationships to measure elasticity, but it is
useful to remember that all elasticity formulas measure sensitivity to a change.
Price Elasticity of Demand
The law of demand tells us that: “All else equal, when the price of a particular good falls, the quan-
tity demanded for that good rises.” But what it fails to answer for us is “by how much”? Will it be
a relatively large increase in quantity demanded or will it be almost negligible? In other words,
we would like to measure how sensitive consumers are to a change in the price of this good.
Price Elasticity of Demand Formula
Ed =(%Din quantity demanded of good X)/(%Din the price of good X)
Note:The law of demand ensures that Edis negative, but for ease of interpretation, econo-
mists usually ignore the fact that price elasticity of demand is negative and simply use the
absolute value. The greater this ratio, the more sensitive, or responsive, consumers are to a
change in the price of good X.
Range of Price Elasticity
Economists like to classify things. It’s a sickness, but it is usually done for a reason. (You do
need to know these for the exam.) For example, we classify price elasticities based upon how
sizable the reaction of consumers is to a change in the price. Rather than describing consumers
as “really responsive” or “really, really responsive” or “super-duper responsive,” we classify con-
sumer responses as elastic or inelastic. The examples that follow should clarify things.
Example:
The price of a laptop computer increases by 10 percent, and we observe a 20 percent
decrease in quantity demanded. Using the above formula:
Ed=(–20%)/(+10%) =–2, or simply Ed= 2
- If Ed>1, demand is said to be “price elastic” for good X. The responsiveness of the
consumer exceeded, in percentage terms, the initial change in the price.
Example:
The price of a package of chewing gum increases by 10 percent, and we observe a
5 percent decrease in quantity demanded. Using the above formula:
Ed=(5%)/(10%) =^1 / 2
- If Ed <1, demand is said to be “price inelastic” for good X. The initial change in
the price exceeded, in percentage terms, the responsiveness of the consumer.
Example:
The price of oranges increases by 5 percent, and the quantity demanded decreases
by 5 percent. Using our elasticity formula:
Ed=(5%)/(5%) = 1
Elasticity, Microeconomic Policy, and Consumer Theory ‹ 75
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