In The Name of Allah, The Most Beneficent, The Most Merciful

Basic Economics
Elasticity of Demand

Dr. Sayyid Salman Rizavi

 Background
• Law of Demand: Quantity demanded varies inversely with
price ceteris paribus.

• Law of Demand: looks at the direction of change NOT the

magnitude of change

• The above relationship is for ‘normal commodities’ and works

for ‘inferior goods’ but does not apply to Giffen goods
 Elasticity
• Elasticity: response (%) of the independent variable due to
one percent change in the dependent variable
• Price Elasticity of Demand: Percentage change in the quantity
demanded due to one percent change in price
• Price Elasticity of Demand discusses the magnitude of change
i.e. how much quantity demanded changes due to change in
price
• Price Elasticity of Demand is a measure of response of the
consumer to price changes
• Quantity demanded can change due to changes in price,
income, prices of other goods etc
• Elasticity of Demand can be defined with reference to all
variables causing a change in quantity demanded
Price Elasticity of Demand
General Definition
 

The above (formula) method is called ‘Percentage

Method’ or ‘Flux Method’

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Example
Price Quantity Demanded
10 100
20 50

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Interpretation
-•   is called the coefficient of elasticity
- Negative sign shows the direction of change
- The value (absolute value of elasticity) 0.5
shows the magnitude of change

- One percent change in price causes 0.5

percent change in quantity demanded in the
opposite direction.
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 Arc Elasticity
• Percentage method calculates ‘point elasticity’
 
• Point elasticity measures elasticity at a single point
• Arc Elasticity measures the average elasticity between
two points (e.g. ‘a’ and ‘b’ in the figure below)
• Formula for Arc Elasticity was given by R. G. D. Allen

Arc Elasticity
•

P
.a Demand Curve

.b
Q
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 Arc Elasticity: Example
Price Quantity Demanded
10 100
20 50

 
If P1, P2, Q1, Q2 represent the two prices and
quantities, then

and
Interpretation: Between the two given points, One
percent change in price causes one percent change
in the quantity demanded in the opposite direction
on the average
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 Highly elastic and Less Elastic Demand
 

• Elasticity of demand is the response of the consumer.

• Less Elastic or Inelastic Demand: If consumer’s

response is low (or less than the percentage change
in price), the coefficient of elasticity would be
less than one.

• Highly Elastic Demand: If consumer’s response is high

(or greater than the percentage change in price), the
coefficient of elasticity would be greater than one.

• If the respons of the consumer (%) is the same as

change in price (%) then

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 Highly elastic and Less Elastic Demand
•
  Inelastic Demand: , example may be of necessities
• Highly Elastic Demand: , Luxeries
• Elasticity equal to Unity: Rare Case
• As two extremes, elasticity coefficient may be zero
(perfectly inelastic) or infinity (perfectly elastic)

Less elastic Demand Curve Highly elastic Demand Curve

P
. P .
. .
Q Q
a b c d
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Expenditure-Revenue Test
This method enables us to know the category of
elasticity (greater, less or equal to unity)
without calculating the exact value.

1. If price and total revenue move in different

directions, Ed > 1 (demand is elastic).

2. If price and total revenue move in the same

directions, Ed < 1 (demand is inelastic).

3. If total revenue does not change when price

changes, Ed = 1 (demand is unitary elastic).

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Example: Expenditure-Revenue Test
  Case 1:
Revenue or expenditure moves in opposite direction
to price change
Price Quantity Expenditure
Demanded or Revenue
Ed > 1 =P. Q
P↑, PQ↓
10 100 1000
20 30 600

 
Check by formula:
Using Mid-Point Formula
=

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Example: Expenditure-Revenue Test
  Case 2:
Revenue or expenditure moves in the same direction
to price change
Price Quantity Expenditure
Demanded or Revenue
Ed > 1 =P. Q
P↑, PQ↑
10 100 1000
20 70 1400

 
Check by formula:
Using Mid-Point Formula
=

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Example: Expenditure-Revenue Test
  Case 3:
Revenue or expenditure remains the same after
change in price
Price Quantity Expenditure
Demanded or Revenue
Ed > 1 =P. Q
P↑, PQ↓
10 100 1000
20 50 1000

 
Check by formula:
Using Mid-Point Formula
=

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 Income Elasticity of Demand
I = income of the consumer
Income elasticity of demand measure the change in quantity
demanded in response to changes in consumer’s income.

It is positive for ‘normal goods’.

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Example: Income Elasticity of Demand
Income Quantity Demanded
10,000 20
20,000 22

It is positive for ‘normal goods’.

Try to Interpret it

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Cross Elasticity of Demand
 
The percentage change in quantity demanded of one
product due to one percent change in the price of
another product”

If X and Y are two commodities,

• (The product may be a substitute or complementary

good.)

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 Example: Cross Elasticity of Demand

Cross Price Elasticity of Substitutes

• Suppose X and Y are substitutes e.g. Coca Cola
and Pepsi Cola

10 100 10 100
10 90 8 120

Note that cross elasticity is positive for

substitutes

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 Example: Cross Elasticity of Demand
Cross Price Elasticity for
complementary goods
Suppose X and Y are complementary e.g. Board Marker
and the Board.

10 100 10,000 10
10 110 8000 12

Note that cross elasticity is negative for

complementary goods

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Calculating Elasticity from Equations
 
The demand function of a firm was estimated from
market data to be:

Where
Let us calculate
i. The Quantity Demanded,
ii. Price Elasticity, Income Elasticity & Cross
Elasticity (both for substitutes and complementary
goods)

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Calculating Elasticity from Equations
i. The quantity demanded may be calculated by
 
substituting the given values in the eqation

ii. Price Elasticity of Demand

Using a datat table
Using the equation we find the partial derivative
of Q w.r.t.P . The derivative will simply be the
coefficient of the relevant variable (here it is
price) as the demand function is linear.= -3. The
formula will be

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Calculating Elasticity from Equations
 
Income Elasticity of Demand
Using a datat table
Using the equation we find the partial derivative
of Q w.r.t.I .

The derivative will simply be the coefficient of

the relevant variable (here it is price) as the
demand function is linear.= 0.3. The formula will
be

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Calculating Elasticity from Equations
 
Cross Elasticity of Demand
Using a datat table and
Remember that we have two other goods here; the
other brand (substitute) and sugar (complementary
good)

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