Session 5:Demand Analysis- Elasticity of Demand

Price Elasticity of Demand

1. Suppose the price of a commodity falls from Rs 6 to Rs 4 per unit and due to this quantity
demanded of the commodity increases from 80 units to 120 units. Find out the price elasticity of
demand.

Solution:

Change in quantity demanded (Q2-Q1)= 120-80=40

Percentage change in quantity demanded={Q2-Q1/(Q2+Q1)/2}*100

=40/200/2 X100

=40

Change in price= P2-P1= 4-6=-2

Percentage change in price={P2-P1/P1+P2/2}*100=-2/10/2X100=-40

Price elasticity of demand= Percentage change in quantity demanded/Percentage change in price

=40/-40=-1.

We ignore the minus sign. Therefore, price elasticity of demand is equal to one.

2. A consumer purchases 80 units of a commodity when its price is Re 1 per unit and purchases 48
units when its price rises to Rs 2 per unit. What is the price elasticity of demand for the
commodity?

Solution:

It should be noted that the change in price from Re 1 to Rs 2 in this case is very large(i.e.
100%).Therefore, to calculate the elasticity coefficient in this case midpoint elasticity formula should
be used.

Change in price= 2-1= 1

Average of the original and subsequent prices=P1+P2/2= 3/2=1.5

Change in quantity demanded= 80-48=32

Average of the original and subsequent quantities= Q1+Q2/2= 80+48/2= 64

Price elasticity of demand= (Q2-Q1/Q1+Q2/2)/(P2-P1/P1+P2/2)

=(32/64)/(1/1.5)= 0.75.
 Thus, price elasticity of demand obtained is equal to 0.75.

3. Suppose a seller of a textile cloth wants to lower the price of its cloth from Rs 150 per metre to
RS 142.5 per metre. If its present sales are 2000 metres per month and further it is estimated
that its price elasticity of demand for the product is 0.7. Show
(i) Whether or not his total revenue will increase as a result of his decision to lower the
price; and
(ii) Calculate the exact magnitude of its new revenue.

Solution:

(i)Price elasticity= dq/dp*p/q

p= Rs 150

q=2000 metres

dp= 150-142.5=7.5

Price elasticity= 0.7

dq=?

Hence, 0.7= (dq/7.5)* (150/2000)

Hence, dq= 70

Since the price has fallen the quantity demanded will increase by 70 metres. So the new quantity
demanded will be 2000+70=2070.

(ii)Total revenue before reduction in price= 2000*150=Rs 300000

Total revenue after price reduction= 2070*142.5= 2,94,975

Thus, with reduction in price his total revenue has decreased.

Income Elasticity of demand

1. If a consumer’s daily income rises from Rs 300 to Rs 350,his purchase of a good X increases from
25 units per day to 35 units, find the income elasticity of demand for X.

Solution:

Change in quantity demanded= Q2-Q1= 35-25=10

Change in income=350-300=50

Income elasticity= Percent change in quantity demanded/Percent change in price

 =(10/50)*(350+300/25+35)

=2.17.

2. Suppose demand for cars in Bombay as a function of income is given by the following equation:
Q=20000+5M
Where Q is quantity demanded, M is per capita level of income in rupees.
Find out income elasticity of demand when per capita annual income in Bombay is Rs 15000.

Solution:
Income elasticity=(dQ /dM)* M/Q
In order to obtain income elasticity ,we have to first find out quantity demanded at income level
of Rs 15000.
Q= 20000+5*15000=95000
It will be seen from the given income demand function that coefficient of income(M) is equal to
5. This implies that dQ/dM=5. With this information we can calculate income elasticity.
Income elasticity=(dQ/dM)*M/Q= 5*(15000/95000)=0.8.

3. The following demand function for readymade trousers has been estimated
Q= 2000+15Y-5.5P
Where Y is income in thousands of rupees, Q is the quantity demanded in units and P is the price
per unit.
(a) When P=Rs 150 and Y=15 thousand rupees, determine the following
1. Price elasticity of demand
2. Income elasticity of demand
(b) Determine what effect a rise in price would have on total revenue.
(c) Assess how sale of trousers would change during a period of rising incomes.

Solution:

(a) Coefficient of P,i.e. dQ/dP= 5.5

Price elasticity of demand dQ/dP*P/Q= 5.5*150/Q
Let us first find out the quantity demanded at the given income and given price. Substituting the
values of income and price in the given demand function, we have:
Q= 2000+15*15-5.5*150=1400
Price elasticity= 5.5*150/1400= 0.59
Income elasticity= dQ/dY*Y/Q= 15*(15/1400)=0.16
(b) Since price elasticity of demand for trousers is less than one, rise in price would cause increase
in total revenue.
 (c) Since income elasticity of demand for trousers is less than one, trousers are a necessity and
therefore the increase in income of the people will lead to less than a proportionate increase in
sales.

Cross Elasticity of Demand:

1. If price of coffee rises from Rs 45 per 250 grams pack to Rs 55 per 250 grams pack and as a result
the consumers demand for tea increases from 600 packs to 800 packs of 250 grams, then find
the cross elasticity of demand of tea for coffee.

Solution:

We use midpoint method to estimate cross elasticity of demand.

Change in quantity demanded demanded of tea= q2-q1= 800-600=200

Change in price of coffee= 55-45=10

Substituting the values of the various variables in the cross elasticity formula we have

Gross elasticity of demand= (800-600/(800+600)/2)/(55-45/55=45/2)=1.43

2. Suppose the following demand function for coffee in terms of price of tea is given. Find out the
cross elasticity of demand when price of tea rises from Rs 50 per 250 grams pack to Rs 55 per
250 grams pack.
Qc= 100+2.5Pt
Where Q is the quantity demand of coffee in terms of packs of 250 grams and Pt is the price of
tea per 250 grams pack.

Solution:

The positive sign of the coefficient of Pt shows that rise in price of tea cause an increase in quantity
demanded of coffee. This implies that tea and coffee are substitutes.

The demand function equation implies that coefficient dQc/dPt= 2.5

In order to determine cross elasticity of demand between tea and coffee, we first find the quantity
demanded of coffee when price of tea is Rs 50 per 250 grams pack. Thus,

Qc= 100+ 2.5*50=225.

Cross elasticity= dQc/dPt*Pt/Qc= 2.5*50/225=0.51.