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Economics
Economics
Elasticity of Demand
Lecture Plan
Objectives
Elasticity of demand
Price elasticity of demand
Degrees of price elasticity of demand
Methods of measuring elasticity
Revenue and price elasticity of demand
Income elasticity of demand
Cross elasticity of demand
Promotional elasticity of demand
Importance of elasticity
Objectives
To understand the meaning of responsiveness
of demand to changes in determinants of
demand.
To lay down the degrees of responsiveness of
demand.
To discuss various types of elasticities of
demand.
To learn how to measure elasticity by various
methods.
To understand the relevance and application of
elasticities of demand
Elasticity of Demand
ep= Q2 Q1 / Q1
P2 P1 / P1
where Q1= original quantity demanded, Q2= new quantity
demanded, P1= original price level, P2= new price level
Methods of Measuring Elasticity
Contd…
ep dQ / Q dQ P
= = .
dP / P dP Q
Methods of Measuring Elasticity
Contd…
Q2 Q1 P1 P2
= .
Q1 Q2 P2 P1
The arc elasticity of demand refers to the
relationship between changes in price and
the subsequent change in quantity
demanded
The arc elasticity formula is used if the
change in price is relatively large. It is more
accurate a measure of elasticity than simple
''price elasticity''.
If the arc or price elasticity of demand is
greater than 1, demand is said to be
elastic. The demand curve has a ''flat''
appearance.
Solution:
Remember, we ignore the minus sign
when calculating price elasticity.
When the price of CDs falls from $30 to
$20, and the quantity sold increases from 6
per year to 12 per year, the price elasticity
of demand is 1.67: CDs are price elastic
over this price range.
Example Arc Elasticity
Consider the market for music CDs.
When the price of CDs is $30 per
unit, consumers buy 6 per year.
When the price falls to $20 per unit,
consumers buy 12 per year.
Methods of Measuring Elasticity
Contd…
Total Outlay Method (Marshall)
Elasticity is measured by comparing expenditure levels before
and after any change in price, i.e. whether the new expenditure
is more than, or less than, or equal to the initial expenditure
level.
Helps a seller in taking a decision to raise price only if:
Reduction in quantity demanded does not reduce total
revenue or
Reduction in price increases the quantity demanded to the
extent that total revenue also increases.
Degrees
When demand is elastic, a decrease in price will result in an
increase in the revenue (sales).
When demand is inelastic, a decrease in price will result in
a decrease in the revenue (sales).
When demand is unit-elastic, an increase (or a decrease)
in price will not change the revenue (sales)
Determinants of Price Elasticity of
Demand
Nature of commodity
Necessities are relatively price inelastic, while luxuries
are relatively price elastic
Availability and proximity of substitutes
Price elasticity of demand of a brand of a product
would be quite high, given availability of other
substitute brands
Alternative uses of the commodity
If
a commodity can be put to more than one use, it
would be relatively price elastic
Determinants of Price Elasticity of
Demand Contd…
Price,
Till ep>1 MR is Revenue
positive and TR is ep=∞
rising ep>1
and MR is equal to 0 O
ep=0
and TR is at its peak Price, Quantity
MR
When ep<1, MR is Revenue
negative and TR is
falling.
MR= AR[1- ep]
O
TR Quantity
Income Elasticity of Demand (ey)
ey measures the degree of responsiveness of demand
for a good to a given change in income, ceteris paribus.
Degrees:
Positive income elasticity
Demand rises as income rises and vice versa
Normal good
Inferior good
Cross Elasticity of Demand
ec measures the responsiveness of demand of
one good to changes in the price of a related
good
Proportionate change in quantity demanded of commodity X
ec =
Proportionate change in price of commodity Y
Degrees
Negative Cross Elasticity
Complementary goods
Positive Cross Elasticity
Substitute goods
Degrees
Zero Cross Elasticity
Promotional Elasticity of Demand
Determination of price
Elasticity is the basis of determining the price of a product
keeping its possible effects on the demand of the product in
perspective
Basis of price discrimination
Products having elastic demand may be sold at lower price,
while those having inelastic demand may be sold at high prices
Determination of rewards of factors of production
Factors having inelastic demand are rewarded more than factors
that have relatively elastic demand.
Government policies of taxation
Goods having relatively elastic demand are taxed less than
those having relatively inelastic demand.
Summary
Elasticity of demand measures the degree of responsiveness of the
quantity demanded of a commodity to a given change in any of the
independent variables that influence demand for that commodity.
Price elasticity of demand (ep) measures the degree of
responsiveness of the quantity demanded of a commodity to a given
change in its price, other things remaining the same.
By the percentage method ep is expressed as the ratio of
proportionate change in quantity demanded and proportionate
change in price of the commodity.
As per the total outlay method elasticity is measured by comparing
expenditure levels before and after any change in price, i.e. whether
the new expenditure is more than, or less than, or equal to the initial
expenditure level.
Arc elasticity is used to calculate price elasticity of demand at the
midpoint of an arc between any two points on the demand curve, by
taking the average of the prices and quantities; point elasticity can
be approximated by calculating the arc elasticity for a very small arc
on the demand curve.
Summary
If the demand curve is a straight line, price elasticity of demand at
different points of the demand curve can be calculated by the ratio
of the lower segment and upper segment of the demand curve.
MR= AR[1- ep]
Income elasticity of demand (ey) measures the degree of
responsiveness of the quantity demanded of a commodity to a
given change in consumer’s income. For normal goods ey is
positive; for neutral goods ey is zero; for inferior goods ey is
negative.
Cross elasticity of demand (ec) shows how changes in prices of
other goods would affect the demand for a particular good. For
substitutes ec is positive; and for complements ec is negative.
Advertising (or promotional) elasticity of demand (ea) measures the
effect of incurring an “expenditure” on advertising of a firm on the
demand for its product at constant price.
Elasticity is used for determination of right price by seller and for
taxation by government.