Elasticity of Demand

Law of Demand
• Rise and Fall
QUALITATIVE
• Increase and Decrease
• Consumers usually buy more goods when the price is lower and vice –
versa.

By how much? – Quantitative

We need to discuss not just the direction of change in demand because

of an event or policy but also the magnitude of change
Concept of Price Elasticity of Demand
• The degree of responsiveness of quantity demanded of a commodity
to a change in its price other things remaining constant.
• Extent of % change in demand due to given % change in price.
Price elasticity of demand
Using the Price Elasticity of Demand
• Calculate the Price elasticity of Demand , if Price falls from Rs.50 to
Rs.48 and consequently demand rises from 100 to 110 units.
1. Change in price
2. Change in Qty demanded

1. ∆P = New Price – Old Price

2. ∆Q = New Qty – Old Qty
3. P1 = Old Price
4. Q1 = Old qty. demanded
Calculate the Price elasticity of Demand , if Price falls from Rs.50 to
Rs.48 and consequently demand rises from 100 to 110 units.

• ∆Q = New Qty – Old Qty = 110 -100 = 10

• ∆P = New Price – Old Price = 48 – 50 = - 2

Ep = - 2.5
Arc Method
 Total outlay/ expenditure method

(i) When price (P) and Total Expenditure

(TE), changes in same direction (i.e. with rise
in price, TE also rises and vice-versa),
elasticity is less than unity or inelastic.
(ii)When price (P) and Total Expenditure (TE),
changes in the opposite direction (i.e. with
rise in price TE falls and vice-versa), elasticity
is greater than unity or elastic.
(iii)When price changes (i.e. rises or falls) TE
remains constant, elasticity is equal to unit or
unit elastic
Degrees of price elasticity of demand

Eg.: Salt

Eg.: TV, AC, etc.

Eg.: Foodgrains
Factors affecting price elasticity
1. Availability of substitutes
2. Necessities vs. Luxuries
3. Durable goods vs. Perishable goods
4. Time Horizon
5. Degree of competition in the market
6. Category of Good/service: Broad or specific (Food or Pizza)
7. Consumer habits
8. Postponement of demand
9. Diversity of uses
10. Income level of the buyers
11. Proportion of income spent on a commodity
Income Elasticity of Demand
• Income is another important variable affecting demand
• The degree of responsiveness of quantity demanded of a
commodity to a change in the income of the consumer.
Types/Degrees of income elasticity
1. Highly elastic: e > 1 (Luxuries)
2. Unitary: e = 1
3. Inelastic: e < 1 (Necessities)
4. Zero: e = 0 (Neutral)
5. Negative: e < 0 (Inferior)
Cross elasticity of demand
• Price of related goods affects demand
• Degree of responsiveness in demand for one commodity to change in
the price of another commodity.
• Check whether the goods – Substitutes or Complimentary
Promotional Elasticity of demand
• Advertisements affects demand
• The degree of responsiveness of quantity demanded of a commodity
to a change in advertisement expenditure of firm
Problems and Applications: No. 1
For each of the following pairs of goods, which good would you expect
to have more elastic demand and why?
a. required textbooks or mystery novels
b. Pandit Ravi Shankar’s recordings or classical music recordings in
general
c. Metro train rides during the next six months or metro train rides
during the next five years
d. fruit juice or water
No. 2
Maria has decided always to spend one-third of her income on
clothing.
a. What is her income elasticity of clothing demand?
b. What is her price elasticity of clothing demand?
c. If Maria’s tastes change and she decides to spend only one-fourth
of her income on clothing, how does her demand curve change?
What is her income elasticity and price elasticity now?
No. 3
• Two drivers—Tom and Jerry—each drive up to a petrol station.
• Before looking at the price, each places an order.
• Tom says, “I’d like 40 litres of petrol.”
• Jerry says, “I’d like Rs. 3000 worth of petrol.”
• What is each driver’s price elasticity of demand?
No. 4
Consider public policy aimed at smoking.
Studies indicate that the price elasticity of demand for cigarettes is
about 0.4.
a. If a pack of cigarettes currently costs $2 and the government wants
to reduce smoking by 20 percent, by how much should it increase
the price?
b. If the government permanently increases the price of cigarettes,
will the policy have a larger effect on smoking one year from now or
five years from now?
c. Studies also find that teenagers have a higher price elasticity than
do adults. Why might this be true?
5. Suppose that business travelers and vacationers have the following
demand for airline tickets from New York to Boston:
Price Quantity Quantity
Demanded Demanded
(business travelers) (vacationers)
$150 2,100 tickets 1,000 tickets
200 2,000 800
250 1,900 600
300 1,800 400
a. As the price of tickets rises from $200 to $250, what is the price
elasticity of demand for
(i) business travelers and (ii) vacationers? (Use the midpoint method
in your calculations.)
b. Why might vacationers have a different elasticity from business
travelers?
No. 6
Commodity ORIGINAL NEW
PRICE (Rs.) QTY PRICE (Rs.) QTY
DD(Units) DD(Units)
1. Milk 30 50 30 60
2. Milk Powder 40 30 50 20
3. Bread 20 80 20 90
4. Butter 75 30 60 40

Q1. Find the cross elasticity for milk and milk powder.
Q2. Find the cross elasticity for Bread and Butter.
Theoretical and practical applications of
elasticity of demand
Explain several economic events
Formulation of economic policies
• Poverty amidst plenty
• Crop restriction programme to raise farmers’ income
• Fight against drugs
• Incidence of indirect taxes
Poverty amidst plenty
• ‘Good news for agriculture is bad news for farmers’
• Good weather/monsoon- bumper harvest
• Improvement in agricultural technology- increased production
• But, substantial fall in prices, income of the farmer
• WHY??
• Demand for agricultural products- inelastic
– DD
• S1- initial supply curve
• Then equilibrium price – P1 (500) &
quantity – Q1 (100 quintals)
• If due to good monsoon Supply increases
to S2
• Then new equilibrium price falls – P2 (400)
• And quantity rises to Q2 (110 quintals)
• In effect, price falls by a larger extent than
rise in quantity
• 100 (500 – 400) > 10 (110 -100)
• Farmers’ income/ revenue = P X Q
• Initial income = P1 X Q1
= 500 X 100 = 50,000
• After bumper crop, income = P2 X Q2
= 400 X 110 = 44,000
• Hence, ‘Good news for agriculture is bad
news for farmers’
Crop Restriction Programme & Farmers’
Income
• Govt. often helps farmers – subsidies/ MSP for every unit of crop
produced
• US- many decades- govt. helps farmers by asking them to restrict
production
• Provides subsidy for not cultivating on entire land
• Aim – to reduce supply such that market price rises
• DD – inelastic demand curve
• S1Q1 – original supply curve
• Initial equilibrium E1 – P1 & Q1
• Revenue= P1 X Q1 = OP1E1Q1
• Due to Crop Restriction Programme
– Supply reduces to S2Q2
• New equilibrium E2 – P2 & Q2
• Revenue= P2 X Q2 = OP2E2Q2
• OP2E2Q2 > OP1E1Q1
• Farmers income higher than before
• But consumers – hurt by higher
prices just like during shortage due
to floods or droughts
• Thus interests of farmers &
consumers clash with one another
Fight against drugs
• Modern society- extensive use of illegal drugs
• Many harmful effects on not just users but also their families
• Crime rate also increases to fund their addictions
• Therefore, Government – measures to discourage drug use
• 2 Strategies:
1. Reduce the supply of drugs - Prohibition of flow of drugs - Arrest &
heavy fines for smugglers/ peddlers – increased cost of supply
2. Reduce the demand for drugs – education, awareness to the young
regarding harmful effects
Strategy 1: Reduce the supply of drugs
• D1- Demand curve – inelastic due to addiction
• S1 – initial supply curve
• E1 – initial equilibrium
• P1 – initial price
• Q1- initial quantity
• If Supply reduces to S2 due to prohibitory
measures resulting in higher costs
• Then price rises to P2 and Quantity reduces to
Q2
• This policy often criticized, since this may not
prevent, in fact increase drug related crimes
• Drug addicts are unlikely to forego their habit
but spend more money on drugs
• Total expenditure – OP2E2 Q2 > OP1E1Q1
• Greater crime rate
• Also higher price means more people would
want to sell drugs
 Strategy 2: Reduce the demand for drugs
• S1 – given supply curve
• D1 – initial demand
• E1 – initial equilibrium
• P1 – initial price
• Q1 – initial quantity
• D2 – decreased demand due to effective
education/ awareness campaigns
• E2 – new equilibrium
• P2 – REDUCED price
• Q2 – reduced quantity
• Total expenditure on drugs also reduces
• OP1E1Q1 > OP2E2Q2
• Less profitable to produce/ supply/ sell drugs
• Hence reduction in drug use and drug related
crimes
Both supply reducing and demand reducing measures are required if fight against drugs is to be won
Incidence of indirect taxes
• GST, excise duty, sales tax, customs duty, etc.
• Who bears the burden of paying indirect taxes?
• Impact of a tax- initial burden of paying a tax
• Incidence of a tax – ultimate burden of paying a tax
• Incidence depends on elasticity of demand as well as supply
In case of
perfectly
inelastic
demand
In case of
perfectly elastic
demand
In case of
Unitary
elastic
demand
In case of
relatively
inelastic
demand
In case of
relatively
elastic
demand
General rule
• The lower the elasticity of demand, the greater will be the incidence/
burden of tax borne by the buyers/consumers