Session 3 : Concept of Elasticity (Prof. A.T.

F)

Outline
Definition
Different Types of Elasticity
Elasticity of Demand
Elasticity of Supply
Elasticity & Govt. Policy
 Definition of Elasticity
Elasticity measures the degree of responsiveness of one variable to
changes in a another variable. IV DV
Law of demand states:
When price falls, Qty demanded increases
& vice versa.
What elasticity does is to measure the strength of this relationship
i.e. if the price of a good changes by 1%,
by what % would Qty demanded change.
 Different Types of Elasticity

Elasticity

Demand Supply

Price Cross Income Price

Elasticity of demand: Price, Cross & Income elasticity of demand

Elasticity of supply: Price elasticity of supply
 Different Types of Elasticity

PED : Δ Px Δ Qdx (Tea & Tea)

XED : Δ PY Δ Qdx (Coffee & Tea)
Δ PY Δ Qdx (Fuel & Cars)
YED: Δ Y (income) Δ Qd (of any good)
 Definition of PED
PED measures the % change in the price of a
good & the % change in the qty demanded of
that good.

PED = % change in qty demanded of good (x)

% change in price of good (x)

ΔQ ΔP
= ÷
Q P

ΔQ P
= X
Q ΔP
 Measurement of PED

Product A Product B
Price Qty TR Price Qty TR
(Rs) (units) (Rs) (Rs) (units) (Rs)
10 10 100 10 10 100

8 20 160 8 11 88

PED = 5 PED = 0.5

PED > 1 means elastic demand. Seller gains by reducing price

PED < 1 means inelastic demand. Seller gains by raising price
Change in Price & Effect on Revenue
 Other Methods of calculating PED

ARC (Price) Elasticity of Demand:

ΔQ (P1 + P2 ) / 2
X
ΔP (Q1 + Q2 ) / 2

Arc El. of Demand- It estimates the numerical value of elasticity

at the mid point.
Point Elasticity of Demand- It is the most accurate method. Using
calculus, we calculate PED at any given point on the demand
curve.
 Varying Degrees of Elasticity
• Perfectly Inelastic: Quantity demanded does not respond to
any change in price (zero elasticity)
• Inelastic: Quantity demanded changes less than
proportionately to a change in price
• Perfectly Elastic: Quantity demanded changes infinitely with
a change in price
• Elastic: Quantity demanded changes more than
proportionately to a change in price
• Unit Elastic: Quantity demanded changes by the same
percentage as a change in price.

PED can vary from zero to infinity

 Varying Degrees of PED
(a) (b) (c) (d) (e)

P P P P P

5 D
D
4

D D

0 Q 0 Q 0 8 10 Q 0 Q 0 Q
10

Єd=0 Єd<1 Єd=1 Єd>1 Єd= ∞

Inelastic Unit elasticity Elastic

 Elasticity of a Linear Demand Curve

Price

Price (Rs) Qty Demanded (units) Total Revenue (Rs) Description of PED
10 0 0 Infinity
9 1 9 Elastic 10 Ed ∞

8 2 16 Elastic
7 3 21 Elastic Ed > 1

6 4 24 Elastic
5 5 25 Unitary Ed = 1
5
4 6 24 Inelastic
3 7 21 Inelastic Ed < 1

2 8 16 Inelastic Ed = 0
1 9 9 Inelastic 0
5 Qty
0 10 0 Zero
 Practical Importance of PED

It is important for a firm’s pricing decision

• If product has elastic Demand, then ↓ P
• If product has inelastic Demand- then ↑ P
• Supermarket dealer gains by ↓ P
• Monopolist gains by ↑ P (sole producer; no competitors &
no substitutes)
Price Elasticity of Demand - Determinants

Determinant Elastic Inelastic

Substitutes Available Not available

Nature of product Non-essential Essential goods

Nature of product -- Habit forming goods

(Addictive goods)
Nature of product Durable Perishable

Definition of product Narrow (carrot) Broad (vegetables)

Amount spent as % of High Small

total monthly expenditure
Time factor Long run Short run
Cross Price Elasticity of Demand (XED)

Definition of XED
XED for substitutes & its measurement
XED for substitutes & practical imp.
If P of coffee ↓ D for tea ↓(XED is positive for substitutes)

XED for complementary goods & measurement

XED for complementary goods & practical imp.
If P of fuel ↑ D for cars ↓ (XED is negative for complements)
 Definition of Cross Elasticity of Demand

% Change in Qty demanded of Product X

XED =
% change in price of product Y

Δ QX PY
= X
QX Δ PY
 Calculation of XED
For Substitutes
Price of Coffee (Y) Demand for Tea (X)
(Rs / kg) (kg)
100 100
150 140
XED = +0.8
 Income Elasticity of Demand (YED)

Definition of YED
Measurement
Diagram
Practical Importance
Definition of Income Elasticity of Demand

% Change in Qty demanded (of any product)

YED =
% change in consumer income

= ΔQ Y
X
Q ΔY
 Calculation of YED

Problem: Suppose consumer income rose from $ 1000

last year to $ 1100 this year. The demand for 3 products
A, B & C, changed as follows. Calculate YED

Good Qty demanded Qty demanded YED

last year (units) this year (units) coefficient
A 100 120 2.0

B 100 105 0.5

C 100 95 - 0.5
Different Degrees of Income Elasticity of Demand

Qty Demanded

YED= 0
YED+ ve
YED- ve

YED+ve

0
Y1 Y2 Y3 Y4 Income
 Practical Importance of YED

YED is important for a firm’s product decision

If peoples’ incomes are rising, then a firm must shift

resources to produce luxury items, electrical and electronic
goods.
 Price Elasticity of Supply (PES)

Definition
Measurement
Diagram
Factors determining PES
 Measurement of PES

% change in Qty Supplied

PES =
% change in Price

ΔQs P
= X
Qs ΔP

As with PED, the coefficient of PES can vary from zero to

infinity i.e. perfectly inelastic supply to perfectly elastic supply.
 Price Elasticity of Supply - Determinants
Determinant Elastic Inelastic
Cost Behaviour Unit costs fall sharply Unit costs change little
with increased output with increased output
Excess (Idle) capacity Available Not available

Production cycle Short Long

Flexibility of factors
- Labour Multi skilled labour Narrowly specialized
- machinery General purpose Specialized
Time Long run Short run

Entry of new firms to the Easy Difficult (entry barriers)

industry
 Advertising Elasticity of Sales (AES)

Definition of AES
Measurement of AES
Practical Significance

% Change in Sales
AES =
% Change in Advertising Expenditure
Elasticity & Govt. Policy

Importance of Elasticity for Govt. Policy

Elasticity & Tax Revenue
Elasticity & Inflation
Elasticity & Balance of Payments
 Practical Importance of Elasticity for
Government Policy

- On what type of goods should government impose an

indirect tax (e.g. VAT) in order to increase its revenue?
Also determine how the tax burden is shared between
producer & consumer when govt. imposes an indirect tax.
- On what type of goods should govt. impose a tax in order to
control inflation
- On what type of goods should govt. impose a tax in order to
reduce a deficit in the Balance of Trade
 Elasticity of Demand & Tax

Elastic Demand & Tax Burden ( D curve- Gentle slope) Inelastic Demand & Tax (D curve- Steep slope)

Smaller share of tax is on consumer Greater share of tax is on consumer

Greater share of tax is on seller Smaller share of tax is on seller