Professional Documents
Culture Documents
Elasticity of Demand
Elasticity of Demand
Determinants
- The availability of substitutes; the demand for a commodity is more elastic if
there are close substitutes for it.
- The nature of the need that the commodity satisfies. In general, luxury goods are
price elastic, whilst necessities are price inelastic.
- The time period. Demand is more elastic in the long run.
- The number of uses of the commodity. The more the possible uses of a
commodity, the more inelastic the commodity will be.
- The proportion of income spent on the commodity. The more the income spent on
a commodity, the more elastic the commodity will be.
- Point elasticity
- Arc elasticity
i. Point elasticity
This measures elasticity at a particular point on the demand curve. That is:
It must be noted that price elasticity is always negative because of the inverse relationship
between the quantity (Q) and the price (P) by the ‘law of demand’. However, traditionally
1
the negative sign is always omitted when writing the formula of the elasticity (ie only the
absolute values are considered).
0 ≤ ep ≤ ∞
[Diagram 1]
Elastic Demand
Demand is elastic when a small proportionate/percentage change in price leads to more
than proportionate/percentage change in quantity demanded. For instance a 10% change
in price leading to 70% change in quantity demanded means the elasticity coefficient
(ep), either point or arc, will be greater than one. A small fall in price leads to a more
than proportionate increase in quantity demanded. Goods that have elastic demand may
include milo, soft drink, milk and soap (these are goods that have close substitutes).
Inelastic Demand
Demand is inelastic when a greater proportionate/percentage change in price leads to less
proportionate/percentage change in quantity demanded. For instance a 60% change in
price leads to a 10% change in quantity demanded means the elasticity coefficient (ep )
either point or arc, will be less than one. A great increased in price leads to a lesser than
2
proportionate fall in quantity demanded. Goods that have inelastic demand include
cigarettes, beer, guinness, water, food (these goods are goods of necessity or habit
forming goods).
3
Perfectly elastic /infinitely elastic demand
Perfectly elastic demand occurs when price does not change yet there is proportionate/a
percentage change in quantity demanded. For instance a 0% change in price resulting in
50% change in quantity demanded. The elasticity coefficient, either point or arc is
infinite. The demand curve of perfectly elastic demand is horizontal as shown below.
Goods that have perfectly elastic demand may include agricultural produce (these are
goods which are produced by uncountable producers).
Illustration 1:
Using the demand curve and the demand schedule below, the point elasticity
coefficients as price changes are calculated below:
Price
($per unit)
A
80
B
60
40 C
D
20
D
10 20 30 40
Quantity
0 0 0 0
(per time
period)
4
Point Price Quantity Point Elasticity Arc (mid point)
$ Demanded coefficient elasticity
coefficient
A 80 100 - -
B 60 200 4 2.3
C 40 300 1.5 1.0
D 20 400 0.67 0.42
Note: The negatives attached to the elasticity coefficients are due to the negative slope of
the normal demand curve or the inverse relationship between price and quantity
demanded and therefore are always omitted.
5
It is change in quantity demanded divided by mid-point of arc quantity demanded divided
by change in price divided by mid point of arc price.
ep = ∆Q × (P1+P2)/2
∆P (Q1+Q2)/2
= ∆Q × P1+P2
∆P Q1+Q2
Illustration 2
Using the demand curve and the demand schedule above ,the Arc (mid point)
elasticity coefficients as price changes are calculated below;
• Arc (mid point) elasticity between Point A and B i.e. a change in price from $80 to
$60
• ∆Q =200-100=100
• Mid point between Q1 and Q2 =(200+100)/2=150
• ∆P =60-80=-20
• Mid point between P1 and P2 =(60+80)/2=70
• Therefore Arc (mid point) elasticity between Point A and B is
100 × 70 = -2.3 (ie 2.3 demand for the price range is elastic)
-20 150
• Arc (mid point) elasticity between Point B and C i.e. a change in price from $60 to
$40
• ∆Q =300-200=100
• Mid point between Q1 and Q2 = (300+200)/2=250
• ∆P = 40-60 = -20
• Mid point between P1 and P2 = (40+60)/2=50
• Therefore Arc (mid point) elasticity between Point B and C is
100 × 50 = -1.0 (ie 1.0 demand for the price range is unitary)
-20 250
• Arc (mid point) elasticity between Point C and D i.e. a change in price from $40 to
$20
• ∆Q =400-300=100
• Mid point between Q1 and Q2 = (400+300)/2=350
• ∆P =20-40=-20
• Mid point between P1 and P2 = (20+40)/2 = 30
• Therefore Arc (mid point) elasticity coefficient between Point C and D is
100 × 30 = -0.42 (ie 0.42 demand for the price range is inelastic)
-20 350
6
Note: The negatives attached to the elasticity coefficients are due to the negative slope of
the normal demand curve or the inverse relationship between price and quantity
demanded and are always omitted.
b. A guide to pricing
Goods that have inelastic demand can be priced high to increase sales revenue as a
higher percentage increased in price leads to less percentage fall in quantity demanded.
Goods that have elastic demand should be priced low to increase sales revenue as a
small percentage fall in price leads to more percentage increased quantity demanded.
c. A guide to taxation
Government can levy high taxes on goods that have inelastic demand to raise more
revenue. This is because a higher percentage increased in price of such commodities
leads to less percentage fall in quantity demanded. Good that have elastic demand
should attract low taxes. This is because a small fall in price can lead to more than
proportionate increased in quantity demanded which can result in increased government
revenue.
d. A guide to devaluation
Currency devaluation is a reduction in the rate of a currency in relation to other
currencies to help solve balance of payment problems. Devaluation makes exports
cheaper and imports more expensive and this can help correct adverse balance of
payment. For devaluation to be successful both imports and exports must be elastic. If
exports are elastic a small fall in prices of the exports can lead to more than
proportionate increased in quantity demanded of exports which can result in increased
foreign exchange to help correct the balance of payment difficulties. If imports are
inelastic balance of payment problem worsens as a greater increased price lead to less
than proportionate fall in demand.
7
Income Elasticity of Demand
The Income elasticity is defined as the proportionate change in quantity demanded
resulting from a proportionate change in income of the consumer. Symbolically we may
write
Where:
Proportional Change in quantity demanded = ∆Q/Q
Proportional Change in income = ∆M/M
Therefore em = ∆Q/Q÷∆M/M
=∆Q × M
∆M Q
∆Q = 220-200 = 20
Q = 200
∆Y = 12000-10000 = 2000
Y = 10000
8
Therefore em = 20 × 10000 = 0.5 (Income is inelastic)
2000 200
Where:
Proportional Change in quantity demanded of good X= ∆Qx/Qx
Proportional Change in price of a related good = ∆Py/Y
exy = ∆Qx/Qx÷∆Py/Py
or
= ∆Qx × Py
∆Py Qx
9
Price of Quantity Demanded Cross Elasticity
good Y ($) of good X coefficient
80 100 -
100 200 0.40
Using the table above ,the cross elasticity coefficients as price of good Y
Changes are calculated below;
• exy as price of good y increases from $80 to $100 is
∆Qx = 200-100 = 100
Qx = 100
∆Py = 100-80 = 20
Py=80
10
Try Questions:
11