ELASTICITY OF DEMAND

 The responsiveness or sensitivity to change is what is generally termed as elasticity.

 Elasticity of demand refers to the responsiveness or sensitivity of quantity demanded to
changes in : (a) price of the commodity
(b) house-hold disposable income and
(c) prices of other related goods.
 There are three types of elasticity of demand that is own price elasticity of demand (PED),
income elasticity of demand (YED) and cross elasticity of demand (XED).

1) PRICE ELASTICITY OF DEMAND

 Refers to a measure of responsiveness of qd of a commodity to changes in the price of the
good concerned.
 The concept of elasticity is a measure of the extent to which dd changes and therefore an
attempt to answer the following question; by how much does dd change in response to a
given price change?
FORMULA
PED = percentage change in qty demanded
percentage change in price of the good

Calculation of ( % ) percentage change

% change = change x 100

Original value
Example
Give that;
a) The price of commodity X has risen from $5 to $8 per unit.
b) The increase price is followed by a fall in dd from 1000 to 600 units per month
Elasticity of dd can be calculated as follows:-

PED = % change in qty demanded

% change in price of the good

% in qd = 400 x 100 = 40%

1000

% in price = 3 x 100 = 60%

5

Therefore PED = 40 = 0.67

60

PED Values
 PED is measured in numerical values.
 When measuring PED the sign is usually ignored or dropped and we therefore
concentrate on the absolute value of PED.

WHEN P.E.D. IS GREATER THAN ONE (Elastic demand)

 A commodity with PED greater than 1 (PED>1) is said to have elastic dd.
 It means that the dd of the product is highly sensitive to price changes.
 It means a slight change in price will lead to a greater than % change in qd.
  E.g. a 5% increase in price resulting in a 22% change in qd, PED = 22/5which is equals to 4.4

Price Ed>1
8
10%

5 D
50%

100 200 Quantity

Reasons to make a product very sensitive to price changes

 When a product is regarded as a luxury or not very essential
 If a product is not addictive or habit forming.
 Goods with many close substitutes
 A good that account for every significant % of total Y.

Advice to producers

 A producer of a good with elastic dd is advised to slightly reduce the price in order to
increase sales and revenue.

An increase in the price will reduce revenue received.

WHEN P.E.D. IS LESS THAN ONE (In elastic demand)

 The goods or services is said to be price inelastic.

 It means the dd of the goods and service is le sensitive to price changes.
 Dd does not respond too much to changes in the price.
 A greater than % change in the price will bring a less than appropriate change in qd.

10% - PEd<1 then demand is inelastic, typically for

2% - Basic commodity and habit forming goods.

dd

A good or service is inelastic under the following conditions

 When a good is essential.

 When a good is habit forming or addictive.
 When a good has no close substitute.
 A good that takes an insignificant % of the consumer income.

Advice to producers

 A producer is advised to increase the price of a good or service.

  Reducing the price will reduce total revenue.

When PED is equal to one (Unitary demand)]]]]]]]]It is called unitary elasticity.

 A given % change in price will bring the same % change in qd.

 Revenue cannot be decreased or increased through price changes.
 Changes in price offset changes in qd that is if producers changes price they will get the same revenue
after increasing or decreasing price.
 Only non price strategies can be used to increase revenue such as reducing the cost of production,
effective advertising, effective branding, packing etc.
PED = 1
-The graph falls continously without touching the axis.
-It is called asmtos.
-forms a rectangular hypergon.

When PED is equal to infinity

 It means an infinitely large quantity is demanded at a given price but non is demanded at a price
above or below.
 Dd is said to be perfectly or completely elastic.

dd
0

10 15 25

When PED is equal to zero

 It means the same quantity is demanded at a high or low price.

 Price may go up and down but the qd does not change.

6
4 PED = 0
2

10 15 25
 When PED is equal to zero Dd is said to be perfectly inelastic.
 The same quantity is going to be purchased at whatever price.
 Goods such as salt fall under this category.

FACTORS THAT AFFECT P.E.D.

1) WHETHER GOODS ARE LUXURY OR NECESSITIES

luxury have elastic demand whilst neccessities have inelastic.
2) PROPORTION OF INCOME TO SPEND
If we spend a large proportion of income demand will be elastic and when we spend
negligible proportion 0f income demand will be in elastic.
3) HABIT FORMING GOODS OR ADDICTIVE GOODS
These goods have got inelastic demand or perfectly inelastic eg drugs, alchohol, cigarettes.
4) TIME PERIOD
Demand for goods and services is inelastic in the short run and elastic in the long run.
 5) AVAILABILITY OF SUBSTITUTES
If a good has close substitutes the demand is elastic and if the product have no substitutes
the demand is inelastic.

Income elasticity of demand

Refers to the degree to which qd of a good responses to change in consumer disposable Y.
Formula
YED = %change in qd
% change in disposable income
 YED is very important to economics
It is a tool to tell whether a good is a normal good or inferior.

The case of a normal good

 All normal goods’ demand is positively related to Y. Thus with normal goods qd increases as income
increase.
 Income and qd move in the same direction.
 YED is therefore positive.
Example
 Suppose a consumer income of 200 quantity demanded for beef is 20kg, when income increases to
300 demand increases to 50kgs of beef. Required : Calculate YED?
 Solution
YED = %change in qty dded
% change in income
50-20 X 100
2 1 = 150% =3
300 -200 X 100 = 50%
200 1
 Normal goods have got positive income elasticity because a proportionate increase in income
increase the quantity demanded e.g meat, air travel.

The case of a giffen good

 A good is described as a giffen good when qd falls as consumer disposable Y rises.
 There is an inverse relationship between Y and qd an consumer income increases, consumers reduce
their dd for a good and switch to superior ones.
 E.g. basic or necessities, staple, goods consumed by majority (poor).
 All inferior goods have negative income elasticity.
Example
 Suppose a consumer income of 200 quantity demanded for KAPENTA is 20kg, when income increases
to 300 demand decreases to 5kgs of kapenta. Required : Calculate YED?
 Solution
YED = %change in qty dded
% change in income
5-20 X 100
20 1 = -75% = -1
300 -200 X 100 = 50%
200 1
 Inferior goods have a negative income elasticity of demand because a proportionate increase in
income will result in a proportionate fall in quantity demanded eg kapenta, soya mince.

Cross elasticity of demand

 Refers to the degree to which qd responds to change in price of related goods.

Formula
XED = %change in qd of one good
% change in price of the other good
 XED is an economic tool to explain the relationship between two goods.
 It helps in identifying whether goods are substitutes or compliments.
 Substitutes Goods
 When goods are substitutes, price of one good and qd of the other good move in the same direction.
 Therefore they are positively related.
 XED is therefore positive in the case of a substitute.
Example
 Suppose the price of butter is $2 quantity demanded for is 5kg, if the price if butter increases to $3
demand increases to 15kgs. Required : Calculate XED?
 Solution
XED = %change in qty dded of good X
% change in price of good Y
15 - 5 X 100
5 1 = 200% XED=4
3 - 2 X 100 = 50%
2 1

Complimentary goods
 When goods are complimentary, price of one good and qd of the other good move in the opposite
direction.
 Therefore they are negatively related.
 XED is therefore negatively in the case of a complimentary goods.
Example
 Suppose the price of motor van is $5000 quantity demanded for petrol is 500litres. If the price of
motor van increases to $7500 quantity demanded for petrol will decrease to 300litres. Required :
Calculate XED?
 Solution
XED = %change in qty dded of good X
% change in price of good Y
300 - 500 X 100
500 1 = 40% XED=-0.8
7500 - 5000 X 100 = 50%
5000 1
 Motor van and petrol are complimentary goods because they have a negative XED (-0.8)

Elasticity and revenue maximisation

 PED is different along the demand curve which touches both the axis the price and quantity.
 Total revenue is maximised when elasticity is unitary.

Question???
1. To what extent is the knowledge of PED useful in management decision making. (15)
2. Describe the factors that influence the market demand for a product such as personal
computers. (10)
3. Discuss how the understanding of price elasticity of demand, cross elasticity and income
elasticity of demand might be of use to a computer manufacturer. (15)
4. Explain price elasticity, income elasticity and cross elasticity of demand.
5. If you have the task of promoting a holiday resort with its various attractions how far could these
concepts help you? (13)