Chapter #6

Elasticity of Demand
Meaning of Price Elasticity of Demand
• The law of demand is straight forward. It tells
us when the price of a good rises, its quantity
demanded will fall, all other things held
constant. The law dose not indicate as to how
much the quantity demanded will fall with the
rise in price or how much responsive demand
is to a rise price. The economists here use and
measure the quantity demanded to a change in
price by the concept of elasticity of demand.
What is Price Elasticity of Demand?

• Price elasticity of demand measures the

degree of responsiveness of the quantity
demanded of a good to a change in its price. It
is also defined as:
• "The ratio of proportionate change in quantity
demanded caused by a given proportionate
change in price".
 Formula for Calculation
• Price elasticity of demand is computed by dividing the percentage change in quantity demanded of a good
by the percentage change in its price.
• Symbolically price elasticity of demand is expressed as under:

• Ed = Percentage Change in Quantity Demanded

Percentage Change in Price

• Simple formula for calculating the price elasticity of demand:

• Ed = %∆Q
%∆P
• Here:

• Ed stands for price elasticity of demand.

• Q stands for original quantity.

• P stands for original price.

• ∆ stands for a small change.

 Example
• The price elasticity of demand tells us the relative
amount by which the quantity demanded will change in
response to a change in the price of a particular good.
For example, if there is a 10% rise in the price of a tea
and it leads to reduction in its quantity demanded by
20%, the price elasticity of demand will be:

Ed = -20
+10

Ed = -2
 Degrees of Elasticity of Demand
• We have stated demand for a product is sensitive or responsive to price change. The
variation in demand is, however, not uniform with a change in price. In case of some
products, a small change in price leads to a relatively larger change in quantity
demanded.

• Elastic and Inelastic Demand:

• For example, a decline of 1% in price leads to 8% increase in the quantity demanded

of a commodity. In such a case, the demand is said to elastic. There are other
products where the quantity demanded is relatively unresponsive to price changes. A
decline of 8% in price, for example, gives rise to 1% increase in quantity
demanded. Demand here is said to be inelastic.

• The terms elastic and inelastic demand do not indicate the degree of responsiveness
and unresponsiveness of the quantity demanded to a change in price.
 Degrees of Elasticity of Demand
• The economists therefore, group
various degrees of elasticity of demand into
five categories.
– (1) Perfectly Elastic Demand
– (2) Perfectly Inelastic Demand
– (3) Unitary Elasticity of Demand
– (4) Elastic Demand
– (5) Inelastic Demand
 Degrees of Elasticity of Demand
• Perfectly Elastic Demand:
– A demand is perfectly elastic when a small
increase in the price of a good its quantity
demanded becomes zero. Perfect elasticity implies
that individual producers can sell all they want at a
ruling price but cannot charge a higher price. If
any producer tries to charge even one penny more,
no one would buy his product.
Perfectly Elastic Demand
Diagram/Figure 6.1
 Perfectly Elastic Demand
• People would prefer to buy from another producer
who sells the good at the prevailing market price
of $4 per unit. A perfect elastic demand curve is
illustrated in fig. 6.1.
• It shows that the demand curve DD/ is a horizontal
line which indicates that the quantity demanded is
extremely (infinitely) response to price. Even a
slight rise in price (say $4.02), drops the quantity
demanded of a good to zero. The curve DD/ is
infinitely elastic. This elasticity of demand as such
is equal to infinity.
 Degrees of Elasticity of Demand
• Perfectly Inelastic Demand:
• When the quantity demanded of a good dose not change at all to whatever change in price, the demand is
said to be perfectly inelastic or the elasticity of demand is zero.
• For example, a 30% rise or fall in price leads to no change in the quantity demanded of a good.

Ed = 0
30%
Ed = 0

• In figure 6.2 a rise in price from OA to OC or fall in price from OC to OA causes no change (zero
responsiveness) in the amount demanded.

Ed = 0
Δp

Ed = 0
 Degrees of Elasticity of Demand
• Perfectly Inelastic Demand:
 Degrees of Elasticity of Demand
• Unitary Elasticity of Demand:
– When the quantity demanded of good changes by
exactly the same percentage as price, the demand is
said to have a unitary elasticity.

– For example, a 30% change in price leads to 30%

change quantity demand = 30% / 30% = 1.

– One or a one percent change in price causes a response

of exactly a one percent change in the quantity
demand.
 Degrees of Elasticity of Demand
• Unitary Elasticity of Demand:
 Degrees of Elasticity of Demand
• Unitary Elasticity of Demand:
– In this figure (6.3) DD/ demand curve with unitary elasticity
shows that as the price falls from OA to OC, the quantity
demanded increases from OB to OD. On DD/ demand
curve, the percentage change in price brings about an
exactly equal percentage in quantity at all points a, b. The
demand curve of elasticity is, therefore, a rectangular
hyperbola.

Ed = %∆q
%∆p

Ed = 1
 Degrees of Elasticity of Demand
• Elastic Demand:
– If a one percent change in price causes greater than a one percent
change in quantity demanded of a good, the demand is said to be
elastic.

– Alternatively, we can say that the elasticity of demand is greater

than 1. For example, if price of a good change by 10% and it
brings a 20% change in demand, the price elasticity is greater than
one.

Ed = 20%
10%

Ed = 2
 Degrees of Elasticity of Demand
• Elastic Demand:
 Degrees of Elasticity of Demand
• Elastic Demand:
– In figure (6.4) DD/ curve is relatively elastic along its
entire length. As the price falls from OA to OC, the
demand of the good extends from OB to ON i.e., the
increase in quantity demanded is more than
proportionate to the fall in price.

Ed = %∆q
%∆p

Ed > 1
 Degrees of Elasticity of Demand
• Inelastic Demand:
– When a change in price causes a less than a proportionate change in
quantity demand, demand is said to be inelastic.

– The elasticity of a good is here less than 1 or less than unity. For
example, a 30% change in price leads to 10% change in quantity
demanded of a good, then:

Ed = 10%
30%

Ed = 0.3

Ed < 1
 Degrees of Elasticity of Demand
• Inelastic Demand:
 Degrees of Elasticity of Demand
• Inelastic Demand:
– In figure (6.5) DD/ demand curve is relatively
inelastic. As the price fall from OA to OC, the
quantity demanded of the good increases from OB
to ON units. The increase in the quantity
demanded is here less than proportionate to the fall
in price.
Measurement of Price
Elasticity of Demand
 Measurement of Price Elasticity of
Demand
• There are three methods of measuring price
elasticity of demand:

– (1) Total Expenditure Method.

– (2) Geometrical Method or Point Elasticity Method.

– (3) Arc Method.

• These three methods are now discussed in brief:

Total Expenditure Method/Total
Revenue Method
 (1) Total Expenditure Method/Total Revenue
Method
(Definition, Schedule and Diagram)
• The price elasticity can be measured by
noting the changes in total expenditure
brought about by changes in price and
quantity demanded.

• (i) When with a percentage fall in price, the

quantity demanded increases so much
that it results in the increase in total
expenditure, the demand is said to be
elastic (Ed > 1).
 Elastic Demand
• (i) When with a percentage fall in price, the
quantity demanded increases so much that it
results in the increase in total expenditure,
the demand is said to be elastic (Ed > 1).
 For Example:

Price Per Unit ($) Quantity Demanded Total Expenditure ($)

20 10 Pens 200.0

10 30 Pens 300.0
Figure 6.6
• The figure (6.6) shows that at price of $20 per pen,
the quantity demanded is ten pens, the total
expenditure OABC ($200). When the price falls
down to $10, the quantity demanded of pens is
thirty. The total expenditure is OEFG ($300).

• Since OEFG is greater than OABC, it implies that

change in quantity demanded is proportionately
more than the change in price. Hence the demand
is elastic (more than one) Ed > 1.
 Unitary Elastic Demand
• (ii) When a percentage fall in price raises the
quantity demanded so much as to leave the
total expenditure unchanged, the elasticity
of demand is said to be unitary (Ed = 1).
 Unitary Elastic Demand
• Example:

Price Per Pen ($) Quantity Demanded Total Expenditure ($)

10 30 300

5 60 300
Unitary Elastic Demand
(Figure)
 Unitary Elastic Demand
(Figure)
• The figure (6.7) shows that at price of $10 per
pen, the total expenditure is OABC ($300). At
a lower price of $5, the total expenditure is
OEFG ($300).
• Since OABC = OEFG, it implies that the
change in quantity demanded is
proportionately equal to change in price. So
the price elasticity of demand is equal to one,
i.e., Ed = 1.
 Inelastic Demand
• (iii) When a percentage fall in price raises the
quantity demanded of a good so as to cause the total
expenditure to decrease, the demand is said to be
inelastic or less than one, i.e., Ed < 1
 Example Inelastic Demand
Price Per Pen ($) Quantity Demanded Total Expenditure ($)

5 60 300

2 100 200
Figure Inelastic Demand
 Inelastic Demand
• In the fig (6.8) at a price of $5 per pen the quantity
demanded is 50 pens. The total expenditure is
OABC ($300). At a lower price of $2, the quantity
demanded is 100 pens.

• The total expenditure is OEFG ($200). Since

OEFG is smaller than OABC, this implies that the
change in quantity demanded is proportionately
less than the change in price. Hence price elasticity
of demand is less than one or inelastic.
 Note

• As the demand curve slopes downward,

therefore, the coefficient of price elasticity of
demand is always negative. The economists
for convenience sake omit the negative sign
and express the price elasticity of demand by
positive number.
 (2) Geometric
Method/Point Elasticity
Method:
 (2) Geometric Method/Point Elasticity Method:

• "The measurement of elasticity at a point of the

demand curve is called point elasticity".

• The point elasticity of demand method is used as a

measure of the change in the quantity demanded in
response to a very small change in price. The point
elasticity of demand is defined as:

• "The proportionate change in the quantity

demanded resulting from a very small
proportionate change in price".
Measurement of Geometric/Point Elasticity Method:

• (i) Measurement of Elasticity on a Linear

Demand Curve:
– The price elasticity of demand can also be measured at
any point on the demand curve. If the demand curve is
linear (straight line), it has a unitary elasticity at the
mid point. The total revenue is maximum at this point.
– Any point above the midpoint has an elasticity greater
than 1, (Ed > 1). Here, price reduction leads to an
increase in the total revenue (expenditure). Below the
midpoint elasticity is less than 1. (Ed < 1). Price
reduction leads to reduction in the total revenue of the
firm.
Graph/Diagram
 Explanation of Graph/Diagram
• The formula applied for measuring the elasticity at any point on the straight line
demand curve is:

Ed = %∆q X p
%∆p q

• The elasticity at each point on the demand curve can be traced with the help of point
method as:

Ed = Lower Segment
Upper Segment

• In the figure (6.9) AG is the linear demand curve (1). Elasticity of demand at its mid
point D is equal to unity. At any point to the right of D, the elasticity is less than unity
(Ed < 1) and to the left of D, the elasticity is greater than unity (Ed > 1).
 Explanation of Graph/Diagram
• (1) Elasticity of demand at point D = DG = 400 = 1 (Unity).
DA 400

• (2) Elasticity of demand at point E = GE = 200 = 0.33 (<1).

EA 600

• (3) Elasticity of Demand at point C = GC = 600 = 3 (>1).

CA 200

• (4) Elasticity of Demand at point A is infinity.

• (5) At point G, the elasticity of demand is zero.

• Summing up, the elasticity of demand is different at each point along a linear demand
curve. At high prices, demand is elastic. At low prices, it is inelastic. At the midpoint,
it is unit elastic.
(3) Arc Elasticity
 (3) Arc Elasticity:

• Normally the elasticity varies along the length

of the demand curve. If we are to measure
elasticity between any two points on the
demand curve, then the Arc Elasticity
Method, is used. Arc elasticity is a measure of
average elasticity between any two points on
the demand curve. It is defined as:
• "The average elasticity of a range of points on
a demand curve".
 (3) Arc Elasticity:

• Formula:

• Arc elasticity is calculated by using the following formula:

Ed = ∆q X P1 + P2
∆p q1 + q2
• Here:
• ∆q denotes change in quantity.

• ∆p denotes change in price.

• q1 signifies initial quantity.

• q2 denotes new quantity.

• P1 stands for initial price.

• P2 denotes new price.

Graphic Presentation of Measuring Elasticity Using the Arc
Method:
Graphic Presentation of Measuring Elasticity Using the Arc
Method:

• In this fig. (6.11), it is shown that at a price of $10, the quantity of

demanded of apples is 5 kg. per day. When its price falls from $10
to $5, the quantity demanded increases to 12 Kgs of apples per day.
The arc elasticity of AB part of demand curve DD/ can be
calculated as under:

Ed = ∆q X P1 + P2
∆p q1 + q2

Ed = 7 X 10 + 5 = 7 X 15 = 7 X 15 = 21 = 1.23
5 5 + 12 5 17 5 17 17

• The arc elasticity is more than unity.

 Types of Elasticity of Demand:

• The quantity of a commodity demanded per unit of time depends upon

various factors such as the price of a commodity, the money income of the
prices of related goods, the tastes of the people, etc., etc.

• Whenever there is a change in any of the variables stated above, it brings

about a change in the quantity of the commodity purchased over a specified
period of time. The elasticity of demand measures the responsiveness of
quantity demanded to a change in any one of the above factors by keeping
other factors constant. When the relative responsiveness or sensitiveness of
the quantity demanded is measured to changes, in its price, the elasticity is
said be price elasticity of demand.

• When the change in demand is the result of the given change in income, it
is named as income elasticity of demand. Sometimes, a change in the price
of one good causes a change in the demand for the other. The elasticity
here is called cross electricity of demand. The three main types of elasticity
of demand are now discussed in brief.
 1) Price Elasticity of Demand:
• Definition and Explanation:

• The concept of price elasticity of demand is commonly used in economic literature. Price elasticity
of demand is the degree of responsiveness of quantity demanded of a good to a change in its price.
Precisely, it is defined as:

• "The ratio of proportionate change in the quantity demanded of a good caused by a given
proportionate change in price".

• Formula:

The formula for measuring price elasticity of demand is:

Price Elasticity of Demand = Percentage in Quantity Demand

Percentage Change in Price

Ed = Δq X P
Δp Q
 1) Price Elasticity of Demand:
• Example:

• Let us suppose that price of a good falls from $10 per unit to $9 per unit in a day. The decline in price
causes the quantity of the good demanded to increase from 125 units to 150 units per day. The price
elasticity using the simplified formula will be:

Ed = Δq X P
Δp Q

• Δq = 150 - 125 = 25

• Δp = 10 - 9 = 1

• Original Quantity = 125

• Original Price = 10

• Ed = 25 / 1 x 10 / 125 = 2

• The elasticity coefficient is greater than one. Therefore the demand for the good is elastic.
 Types:

• The concept of price elasticity of demand can

be used to divide the goods in to three groups.
 Elastic
• (i) Elastic. When the percent change in
quantity of a good is greater than the percent
change in its price, the demand is said to be
elastic. When elasticity of demand is greater
than one, a fall in price increases the total
revenue (expenditure) and a rise in price
lowers the total revenue (expenditure).
 Unitary Elasticity
• (ii) Unitary Elasticity. When the percentage
change in the quantity of a good demanded
equals percentage in its price, the price
elasticity of demand is said to have unitary
elasticity. When elasticity of demand is equal
to one or unitary, a rise or fall in price leaves
total revenue unchanged.
•
 Inelastic
• (iii) Inelastic. When the percent change in
quantity of a good demanded is less than the
percentage change in its price, the demand is
called inelastic. When elasticity of demand is
inelastic or less than one, a fall in price
decreases total revenue and a rise in its price
increases total revenue.
(2) Income Elasticity of Demand:

• Definition and Explanation:

• Income is an important variable affecting the demand for a good.

When there is a change in the level of income of a consumer, there
is a change in the quantity demanded of a good, other factors
remaining the same. The degree of change or responsiveness of
quantity demanded of a good to a change in the income of a
consumer is called income elasticity of demand. Income elasticity
of demand can be defined as:

• "The ratio of percentage change in the quantity of a good

purchased, per unit of time to a percentage change in the income of
a consumer".
(2) Income Elasticity of Demand:

• Formula:

• The formula for measuring the income elasticity of demand is the

percentage change in demand for a good divided by the percentage change
in income. Putting this in symbol gives.

Ey = Percentage Change in Demand

Percentage Change in Income

• Simplified formula:

Ey = Δq X Y
ΔY Q
 Example:

• A simple example will show how income elasticity of demand can be calculated. Let
us assume that the income of a person is $4000 per month and he purchases six CD's
per month. Let us assume that the monthly income of the consumer increase to $6000
and the quantity demanded of CD's per month rises to eight. The elasticity of demand
for CD's will be calculated as under:

• Δq = 8 - 6 = 2

• Δy = $6000 - $4000 = $2000

• Original quantity demanded = 6

• Original income = $4000

• Ey = Δq / Δy x Y / Q = 2 / 2000 x 4000 / 6 = 0.66

• The income elasticity is 0.66 which is less than one.

 Types
• When the income of a person increases, his
demand for goods also changes depending
upon whether the good is a normal good or an
inferior good. For normal goods, the value of
elasticity is greater than zero but less than one.
Goods with an income elasticity of less than 1
are called inferior goods. For example, people
buy more food as their income rises but the %
increase in its demand is less than the %
increase in income.
 (3) Cross Elasticity of Demand:

• Definition and Explanation:

• The concept of cross elasticity of demand is used
for measuring the responsiveness of quantity
demanded of a good to changes in the price of
related goods. Cross elasticity of demand is
defined as:
• "The percentage change in the demand of one
good as a result of the percentage change in the
price of another good".
 (3) Cross Elasticity of Demand:

• Formula:

• The formula for measuring, cross, elasticity of demand is:

• Exy = % Change in Quantity Demanded of Good X

% Change in Price of Good Y

• The numerical value of cross elasticity depends on whether

the two goods in question are substitutes, complements or
unrelated.
 (3) Cross Elasticity of Demand:
Types and Examples
• Types and Example:

• (i) Substitute Goods. When two goods are substitute of each other, such as coke and Pepsi, an increase in the price of
one good will lead to an increase in demand for the other good. The numerical value of goods is positive.

• For example there are two goods. Coke and Pepsi which are close substitutes. If there is increase in the price of Pepsi
called good y by 10% and it increases the demand for Coke called good X by 5%, the cross elasticity of demand
would be:

• Exy = %Δqx / %Δpy = 0.2

• Since Exy is positive (E > 0), therefore, Coke and Pepsi are close substitutes.

• (ii) Complementary Goods. However, in case of complementary goods such as car and petrol, cricket bat and ball, a
rise in the price of one good say cricket bat by 7% will bring a fall in the demand for the balls (say by 6%). The cross
elasticity of demand which are complementary to each other is, therefore, 6% / 7% = 0.85 (negative).

• (iii) Unrelated Goods. The two goods which a re unrelated to each other, say apples and pens, if the price of apple
rises in the market, it is unlikely to result in a change in quantity demanded of pens. The elasticity is zero of unrelated
goods.
 Factors Determining Price Elasticity
of Demand:
• The price elasticity of demand is not the same for all commodities. It may be or low depending upon number of factor.
These factors which influence price elasticity of demand, in brief, are as under:

• (i) Nature of Commodities. In developing countries of the world, the per capital income of the people is generally
low. They spend a greater amount of their income on the purchase of necessaries of life such as wheat, milk, course
cloth etc. They have to purchase these commodities whatever be their price. The demand for goods of necessities is,
therefore, less elastic or inelastic. The demand for luxury goods, on the other hand is greatly elastic.

• For example, if the price of burger falls, its demand in the cities will go up.

• (ii) Availability of Substitutes. If a good has greater number of close substitutes available in the market, the demand
for the good will be greatly elastic.

• For examples, if the price of Coca Cola rises in the market, people will switch over to the consumption of Pepsi Cola,
which is its close substitute. So the demand for Coca Cola is elastic.

• (iii) Proportion of the Income Spent on the Good. If the proportion of income spent on the purchase of a good is
very small, the demand for such a good will be inelastic.

• For example, if the price of a box of matches or salt rises by 50%, it will not affect the consumers demand for these
goods. The demand for salt, match box therefore will be inelastic. On the other hand, if the price of a car rises from $6
lakh to $9 lakh and it takes a greater portion of the income of the consumers, its demand would fall. The demand for
car is, therefore, elastic.
 Factors Determining Price Elasticity
of Demand:
• (iv) Time. The period of time plays an important role in shaping the demand curve. In the short run, when the
consumption of a good cannot be postponed, its demand will be less elastic. In the long run if the rise price persists,
people will find out methods to reduce the consumption of goods. So the demand for a good in the, long run is elastic,
other things remaining constant.

– For example if the price of electricity goes up, it is very difficult to cut back its consumption in the short run. However, if the
rise in price persists, people will plan substitution gas heater, fluorescent bulbs etc. so that they use less electricity. So the
electricity of demand will be greater (Ed = > 1) in the long run than in the short run.

• (5) Number of Uses of a Good. If a good can be put to a number of uses, its demand is greater elastic (Ed > 1).

– For example, if the price of coal falls, its quantity demanded will rise considerably because demand will be coming from
households, industries railways etc.

• (6) Addiction. If a product is habit forming say for example, cigarette, the rise in its price would not induce much
change in demand. The demand for habit forming good is, therefore, less elastic.

• (7) Joint Demand. If two goods are Jointly demanded, then the elasticity of demand depends upon the elasticity of
demand of the other Jointly demanded good.

– For example, with the rise in price of cars, its demand is slightly affected, then the demand for petrol will also be less elastic.
Importance of Elasticity of Demand:

• (1) Theoretical Importance:

• The concept of elasticity of demand is very useful as it

has got both theoretical and practical advantages. As
regards its importance in the academic interest, the
concept, is very helpful in the theory of value. In the
words of Keynes:
• "The concept of elasticity is so important that in the
provision of terminology and apparatus to aid thought,
I do not think, Marshall did any greater service than by
the explicit introduction of the idea of the elasticity".
 Importance of Elasticity of Demand:

• (2) Practical Importance:

• (i) Importance in taxation policy. As regards its practical advantages, the concept has immense
importance in the sphere of government finance. When a finance minister levies a tax on a certain
commodity, he has to see whether the demand for that commodity is elastic or inelastic.

• If the demand is inelastic, he can increase the tax and thus can collect larger revenue. But if the
demand of a commodity is elastic, he is not in a position to increase the rate of a tax. If he does so,
the demand for that commodity will decrease considerably and the total revenue will be reduced.

• (ii) Price discrimination by monopolist. If the monopolist finds that the demand for his
commodities is inelastic, he will at once fix the price at a higher level in order to maximize his net
profit. In case of elastic demand, he will lower the price in order to increase his sale and derive the
maximum net profit. Thus we find that the monopolists also get practical advantages from the
concept of elasticity.

• (iii) Price discrimination in cases of joint supply. The concept of elasticity is of great practical
advantage where the separate, costs of Joint products cannot be measured. Here again the prices are
fixed on the principle. "What the traffic will bear" as is being done in the railway rates and fares.
 Importance of Elasticity of Demand:

• (2) Practical Importance:

• (iv) Importance to businessmen. The concept of elasticity is of great importance to businessmen. When the demand
of a good is elastic, they increases sale by lowering its price. In case the demand' is inelastic, they are then in a
position to charge higher price for a commodity.

• (v) Help to trade unions. The trade unions can raise the wages of the labor in an industry where the demand of the
product is relatively inelastic. On the other hand, if the demand, for product is relatively elastic, the trade unions
cannot press for higher wages.

• (vi) Use in international trade. The term of trade between two countries are based on the elasticity of demand of the
traded goods.

• (vii) Determination of rate of foreign exchange. The rate of foreign exchange is also considered on the elasticity of
imports and exports of a country.
.
• (viii) Guideline to the producers. The concept of elasticity provides a guideline to the producers for the amount to be
spent on advertisement. If the demand for a commodity is elastic, the producers shall have to spend large sums of
money on advertisements for increasing the sales.

• (ix) Use in factor pricing. The factors of production which have inelastic demand can obtain a higher price in the
market then those which have elastic demand. This concept explains the reason of variation in factor pricing.
Questions