Level 1 CFA® Exam:
Demand Elasticities

Last updated: January 10, 2023

Types of Elasticity for Level 1 CFA Candidates

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Elasticity is a ratio of a percentage change of one variable to a percentage change of another variable. There are 3 types of elasticity that are connected with the demand function:

  • own-price elasticity of demand,
  • income elasticity of demand, and
  • cross-price elasticity of demand.

Own-Price Elasticity of Demand

The own-price elasticity of demand is calculated with the following formula that you can use in your level 1 CFA exam:

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Own-Price Elasticity of Demand
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\(E_p=\frac{\text{% change in quantity demanded}}{\text{% change in price}}=\\=\frac{\frac{\Delta{Q}}{Q}}{\frac{\Delta{P}}{P}}=\frac{\Delta{Q}}{\Delta{P}}\times\frac{P}{Q}\)

  • \(E_p\) – own-price elasticity of demand
  • \(Q\) – quantity demanded
  • \(P\) – price
  • \(\Delta{P}\) – small change in price
  • \(\Delta{Q}\) – small change in quantity demanded
     
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Interpretation of elasticity:

  • If the absolute value of price elasticity of demand is greater than 1, then the demand for a certain good is elastic – in other words, it is highly sensitive to changes in price.
  • If the absolute value of price elasticity of demand is less than 1, then the demand for a certain good is inelastic, which means that it is not highly sensitive to changes in price.
  • If the price elasticity of demand is equal to -1 then demand is unitary elastic. If demand is unitary elastic then a one percent change in price results in a one percent change in quantity demanded.
  • Demand is perfectly inelastic if the change in price doesn’t affect the quantity demanded. We deal with perfectly inelastic demand if the demand curve is a vertical line. For perfectly inelastic demand, the own-price elasticity of demand equals 0.
  • We deal with perfectly elastic demand if the demand curve is a horizontal line. For perfectly elastic demand, the own-price elasticity of demand equals infinity.

Remember: Own-price elasticity is measured at a given price and will change if the price of the good changes.

The factors that affect the price elasticity of demand include the following:

  • the number of substitutes for a good – when it is small or there are none, the demand is inelastic,
  • the share of the consumer's budget spent on the product – the higher the value of bought items in relation to the budget, the higher the elasticity of demand,
  • time – in the long run, the price elasticity of demand is higher than in the short run.
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Example 1 (own-price elasticity of demand)

The demand curve is given by the formula:

\(Q=100-5\times{P}\)

If P is equal to 10, what is the own-price elasticity of demand? Also, decide whether demand is elastic or not and interpret the answer.

(...)

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CFA Exam: Cross-Price Elasticity of Demand

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The cross-price elasticity of demand is calculated with the following formula:

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Cross-Price Elasticity of Demand
Click to show formula

\(E_c=\frac{\text{% change in quantity demanded}}{\text{% change in price of another good}}=\\=\frac{\frac{\Delta{Q}}{Q}}{\frac{\Delta{P}}{P}}=\frac{\Delta{Q}}{\Delta{P}}\times\frac{P}{Q}\)

  • \(E_i\) – cross-price elasticity of demand
  • \(Q\) – quantity demanded
  • \(P\) – price of another good
  • \(\Delta{P}\) – small change in price of another good
  • \(\Delta{Q}\) – small change in quantity demanded
     
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Based on the cross-price elasticity of demand, we can distinguish between 2 types of goods:

  • substitutes, and
  • complements.

If the cross-price elasticity of demand is positive, then a given good is a substitutive product. A rise in the price of another good leads to a rise in demand for the given good.

If the cross-price elasticity of demand is negative, then a given good is a complement. A rise in the price of another good leads to a drop in the demand for the given good.

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Lesson Video

Level 1 CFA Exam Takeaways: Demand Elasticities

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  1. Elasticity is a ratio of a percentage change of one variable to a percentage change of another variable.
  2. There are 3 types of elasticity that are connected with the demand function: own-price elasticity of demand, income elasticity of demand, and cross-price elasticity of demand.
  3. If the absolute value of price elasticity of demand is greater than 1, then the demand for a certain good is elastic – in other words, it is highly sensitive to changes in price.
  4. If the absolute value of price elasticity of demand is less than 1, then the demand for a certain good is inelastic, which means that it is not highly sensitive to changes in price.
  5. The income elasticity of demand helps us answer the question: By how many percentage points will the demand change if there is one percentage change in income?
  6. If the income elasticity of demand is positive, then a given good is a normal good.
  7. If the income elasticity of demand is negative, then a given item is an inferior good.
  8. If the cross-price elasticity of demand is positive, then a given good is a substitutive product.
  9. If the cross-price elasticity of demand is negative, then a given good is a complement.
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