MANAGERIAL ECONOMICS,

3E

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Elasticity of Demand & Supply
 Elasticity of Demand

 “Elasticity” is a standard measure of the degree of responsiveness (or

sensitivity) of one variable to changes in another variable.
 Elasticity of Demand measures the degree of responsiveness of demand
for a commodity to a given change in any of the independent variables that
influence demand for that commodity, such as price of the commodity, price
of the other commodities, income, taste, preferences of the consumer and
other factors.
 Responsiveness implies the proportion by which the quantity demanded of a
commodity changes, in response to a given change in any of its
determinants .

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 Types of Elasticity of Demand

 Mathematically, it is the percentage change in quantity

demanded of a commodity to a percentage change in any
of the (independent) variables that determine demand for
the commodity.
 Four major types of elasticity:
 Price elasticity,
 Income elasticity,
 Cross elasticity
 Advertising (or promotional) elasticity.
 In order to assess the impact of one variable on demand, we
assume other variables as constant (ceteris paribus)

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 Price Elasticity of Demand

 Price is most important among all the independent variables

that affect the demand for any commodity.
 Hence price elasticity of demand ( “ep” or “e”) is considered to
be the most important of all types of elasticity of demand.
 Price elasticity of demand means the sensitivity of quantity
demanded of a commodity to a given change in its own price.

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 Degrees of Price Elasticity
Slope of demand curve is used to display degrees of Price

price elasticity of demand

Perfectly elastic demand

P D
 ep=∞ (in absolute terms).
 Horizontal demand curve
 Unlimited quantities of the commodity can be O

sold at the prevailing price Q1 Q2 Quantity

 A negligible increase in price would result in

zero quantity demanded
D

Perfectly inelastic demand Price

 The other extreme of the elasticity range

 ep=0 (in absolute terms) P1

 Vertical demand curve P2

 Quantity demanded of a commodity remains the

same, irrespective of any change in the price
O
 Such goods are termed neutral. Q1 Quantity

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 Degrees of Price Elasticity
Contd.
Highly elastic demand
 Proportionate change in quantity demanded is more Price
than a given change in price D

 ep >1 (in absolute terms) P1

P2
 Demand curve is flatter D

Unitary elastic demand

O
Q1 Q2 Quantity

 Proportionate change in price brings about an equal Price D

proportionate change in quantity demanded

P1
 ep =1 (in absolute terms). P2
 Demand curves are shaped like a rectangular
hyperbola, asymptotic to the axes D

O
Q1 Q2 Quantity

Relatively inelastic demand Price

D
 Proportionate change in quantity demanded is less
than a proportionate change in price P1

 ep <1 (in absolute terms)

P2

 Demand curve is steep

D
O
Q1 Q2
Quantity
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 Methods of Measuring Elasticity

 Ratio (or Percentage) Method

 The most popular method used to measure elasticity
 Elasticity of demand is expressed as the ratio of proportionate change in
quantity demanded and proportionate change in the price of the commodity
 It allows comparison of changes in two qualitatively different variables
 It helps in deciding how big a change in price or quantity is

Proportion ate change in quantity demanded of commodity X

ep =
ep= Proportion ate change in price of commodity X
Q2  Q1 / Q1
P2  P1 / P1

 where Q1= original quantity demanded, Q2= new quantity demanded,

P1= original price level, P2= new price level

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 Methods of Measuring Elasticity
Contd…

 Point Elasticity Method

 Elasticity measured at a point of demand curve is referred as point
elasticity of demand.
 According to this method , elasticity of demand on each point of a demand
curve shall be different, and can be measured with the help of the
following formula:-
Lower segment of the demand curve
 E = Upper segment of the demand curve

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 Methods of Measuring Elasticity
Contd…

 Arc Elasticity Method

 Used when the available figures on price and quantity are
discrete, and it is possible to isolate and calculate the
incremental changes.
 It is used to find the elasticity at the midpoint of an arc
between any two points on a demand curve, by taking the
average of the prices and quantities.
 This method finds wider applications, as it reflects a
movement along a portion (arc) of a demand curve

ep = Q2  Q1 P2  P1
/
(Q1  Q2 ) / 2 ( P1  P2 ) / 2

Q2  Q1 P1  P2
= .
Q1  Q2 P2  P1
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 

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 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)

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 Unit elasticity (e = 1): When the total money, outlay, or
expenditure (TE) remains unchanged even after a change in the
price of the commodity, elasticity is said to be unitary. Take for
instance the following example, where TE remains the same. It is
seen that when price falls to Rs 2 per unit, total expenditure does
not change.

Price (Rs. Per unit) Quantity (Q) Total Expenditure (TE)

5 10 50
2 25 50

 More than unit elastic (e > 1): When the total money
expenditure rises with a fall in price and falls with a rise in price,
it is the case of elasticity greater than one or elastic demand. This
will be clear from the table. When price falls from Rs. 5 to Rs. 2
per unit, total expenditure rises from Rs. 50 to Rs. 60. Thus there
is inverse relationship between price and total expenditure.

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 Price (Rs. Per Quantity (Q) Total
unit) Expenditure
(TE)
5 10 50
2 30 60

 Inelastic demand (e < 1): When the total money

expenditure rises with an increase in price and falls with a
fall in price, it is the case of inelasticity of demand or
elasticity less than one. The adjacent table shows this case.
In this case, when price decreases, total expenditure also
declines. Thus price and total expenditure have direct
relationship.

Price (Rs. Per Quantity Total Expenditure

unit) (Q) (TE)
5 10 50
2 15 30

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 Price change and its effect on Total Expenditure:

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 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

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 Determinants of Price Elasticity of
Demand Contd…

 Income of the consumer

 Proportion of income spent on the commodity
 Time
 Demand for any commodity is more price elastic in the long run
 Durability of the commodity
 Perishable commodities like eatables are relatively price inelastic in
comparison to durable items.
 Items of habit and customs
 Reoccurence of Demand
 Possibility of postponement
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 Income Elasticity of Demand (ey)

 ey measures the degree of responsiveness of demand for a good to a

given change in income, ceteris paribus.

Proportion ate change in quantity demanded of commodity X

ey =
Proportion ate change in income of consumer

 Degrees:
 Positive income elasticity
 Demand rises as income rises and vice versa
 Normal good
 Negative income elasticity
 Demand falls as income rises and vice versa
 Inferior good
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Use of Income elasticity in business
decisions:
 The knowledge of income elasticity can be useful in forecasting
demand, when a change in personal incomes is expected, other things
remaining the same. It also helps in avoiding over-production or
under-production.
 In forecasting demand, however, only the relevant concept of income
and data should be used. It is generally believed that the demand for
goods and services increases with increase in GNP, depending on the
marginal propensity to consume. This may be true in the context of
aggregate national demand, but not necessarily for each product. It is
quite likely that increase in GNP flows to a section of consumers who
do not consume the product in which a businessman is interested.
 The concept of income-elasticity may also be used to define the
‘normal’ and ‘inferior’ goods.

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 Cross Elasticity of Demand

e measures the responsiveness of demand of one

c
good to changes in the price of a related good
Proportion ate change in quantity demanded of commodity X
ec =
Proportion ate change in price of commodity Y

 Degrees
 Negative Cross Elasticity
 Complementary goods
 Positive Cross Elasticity
 Substitute goods

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 Use of Cross Elasticity in business
decisions:
 The concept of cross-elasticity is of vital importance in pricing
decisions, i.e., in changing prices of products having substitutes and
complementary goods.
 If cross-elasticity in response to the price of substitutes is greater
than one, it would be inadvisable to increase the price; rather,
reducing the price may prove beneficial.
 In case of complementary goods also, reducing the price may be
helpful in maintaining the demand in case the price of the
complementary good is rising.
 Besides, if accurate measures of cross-elasticities are available, the
firm can forecast the demand for its product and can adopt necessary
safeguards against fluctuating prices of substitutes and complements.

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 Importance of Price Elasticity:

 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.
 Helpful in determining the Rate of Exchange

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 Comparing Price Elasticity of
Demand at different points:
 Two parallel straight line  Elasticity at two
demand curves have a intersecting straight line
different elasticity at each demand curves
price

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 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.
 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.

 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.

 Elasticity is used for determination of right price by seller and for taxation by government.
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 Law of Supply:
 Supply refers to the amount
of good offered for sale in the
market at a given price.
 The law of supply can be
stated as the supply of a
product increases with the
increase in its price and
decreases with decrease in its
price, other things remaining
constant.
 It implies that the supply of a
commodity and its price are
positively related..

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 Determinants of Supply:

 Supply function describes the functional relationship

between supply of a commodity (say X) and other
determinants of supply, i.e., price of the commodity (PX),
prices of related commodities (PY), price of the factors of
production (F), technology (T) and goals (G) or general
objectives of the producer.
 Price of the Product
 Price of the factors of production
 Technology
 Price of other goods
 Future Price Expectation

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Movement & Shift on the Supply
Curve:
 A movement along the same curve simply indicates changes
in quantities offered as a result of a change in the price.
When there is a change in price (rise/fall), supply also
changes (increases/decreases) and the phenomena is called
extension and contraction in supply.
 When supply changes not due to changes in the price of the
product but due to other factors, such as change in
technology, changes in the prices of related commodities,
changes in price of inputs etc, it is said to be shifts in supply
curve.

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 S''S" shows an increase in supply because at the same price OH, more is
supplied (OM" > OM).
What will happen in the supply curve for the following:
 Decrease in Input prices
 Change in Technology leading to less cost of production
 Increase in the size of the industry
 Increase in the price of the product itself
 Fall in the price of product substitutes
 Imposition of taxes by government
 War in the economy
 Monopolized industry is made competitive now
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 Elasticity of Supply:
The price elasticity of supply is the measure of responsiveness of the quantity
supplied of a good to the changes in its market price.

Using above formula we can measure elasticity of supply. In the given formula–
Ep= elasticity of supply
ΔQ = change in quantity supplied
ΔP = change in price
P = price of commodity
Q = quantity supplied of the commodity
Note that the formula for measuring the price elasticity of supply is the same as
for the price elasticity of demand, without a minus sign.

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Demand Supply Equilibrium:
 In a general sense, the term equilibrium means the “state of
rest”. It indicates the condition where forces working in
opposite direction are in balance.
 In the context of the market analysis, equilibrium refers to a
state of market in which the quantity demanded of a
commodity equals the quantity supplied of the commodity.
 The equality of demand and supply produces an equilibrium
price. The equilibrium price is also called market-clearing
price (the quantity that suppliers want to supply equals the
quantity that buyers are willing to buy). Market is cleared in
the sense that there is no unsold stock and no unsupplied
demand.

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Price is determined in a free market by the interaction of supply and
demand. We can underline three dynamic laws of supply and
demand.
 When quantity demanded is greater than quantity supplied,
prices tend to rise; when quantity supplied is greater than
quantity demanded, prices tend to fall.
 In a market, larger the difference between quantity supplied and
quantity demanded, the greater the pressure on prices to rise (if
there is excess demand) or fall (if there is excess supply).
 When quantity supplied equals quantity demanded, prices have
no tendency to change.

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 Price Ceiling & Price Floor:

 A price ceiling occurs when the price is

artificially held below the equilibrium price and
is not allowed to rise.
 If the price ceiling is above the market price,
then there is no direct effect. If the price ceiling
is set below the market price, then a “shortage”
is created leading to queuing, black marketing,
etc.
 A price floor exists when the price is artificially
held above the equilibrium price and is not
allowed to fall.
 When a “price floor” is set, a certain minimum
amount must be paid for a good or service.
 If the price floor is below a market price, no
direct effect occurs. If the market price is lower
than the price floor, then a surplus will be
generated. Minimum wage laws are good
examples of price floors.
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