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
 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

 Four major types of elasticity:

 Price elasticity,
 Income elasticity,
 Cross elasticity
 Advertising (or promotional) elasticity.
 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 ( “e p” 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.
 Degrees of Price Elasticity
Slope of demand curve is used to display Price
price elasticity of demand
Perfectly elastic demand
 e =∞ (in absolute terms). P
p D
 Horizontal demand curve
 Unlimited quantities of the commodity can
be sold at the prevailing price O
 A negligible increase in price would result Q1 Q2 Quantity
in zero quantity demanded

 Perfectly inelastic demand D

 The other extreme of the elasticity range Price
 ep=0 (in absolute terms)
 Vertical demand curve P1
 Quantity demanded of a commodity
remains the same, irrespective of any P2
change in the price
 Such goods are termed neutral. O
Q1 Quantity
 Degrees of Price Elasticity
Contd.
Highly elastic demand
 Proportionate change in quantity Price
D
demanded is more than a given change
in price P1
P2
 ep >1 (in absolute terms) D
 Demand curve is flatter
Unitary elastic demand O
Q1 Q2 Quantity
 Proportionate change in price brings Price D
about an equal proportionate change in
quantity demanded P1
 ep =1 (in absolute terms). P2
 Demand curves are shaped like a D
rectangular hyperbola, asymptotic to the
axes O
Q1 Q2 Quantity
Relatively inelastic demand Price
 Proportionate change in quantity D
demanded is less than a proportionate P1
change in price P2
 ep <1 (in absolute terms)
 Demand curve is steep D
O
Q1 Q2 Quantity
 Methods of Measuring Elasticity
 Ratio (or Percentage) Method

Proportionate change in quantity demanded of commodity X

ep =
Proportionate change in price of commodity X
Q2  Q1 / Q1
P2  P1 / P1
 Suppose quantity demanded of coconut is
initially 800 units at a price of Rs.10 and
increases to 1000 units when price falls to
Rs. 8. Calculate price elasticity of demand
of coconut.
 Methods of Measuring Elasticity
Contd…

 Point Elasticity Method

 Elasticity measured at a point of demand curve is referred
as point elasticity of demand.
 For nonlinear demand curve we need to apply calculus
to calculate point elasticity.
 As changes in price become smaller and approach zero,
Q
the ratio P becomes equivalent to the first order
dQ
derivative of the demand function with respect to price dP
 Point elasticity can be expressed as:

ep dQ / Q dQ P
= = .
dP / P dP Q
 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
Q2  Q1 P2  P1
ep = (Q1  Q2 ) / 2 / ( P1  P2 ) / 2

Q2  Q1 P1  P2
.
Q1=  Q2 P2  P1
 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:
 Income Elasticity of Demand (ey)

 ey measures the degree of responsiveness of demand

for a good to a given change in income, ceteris paribus.
Proportionate change in quantity demanded of commodity X
ey =
Proportionate 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
 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

 Advertising (or promotional) elasticity of demand (e a) measures the

effect of incurring an “expenditure” on advertising, vis-à-vis an
increase in demand, ceteris paribus.
 Some goods (like consumer goods) are more responsive to
advertising than others (like heavy capital equipments).

Proportion ate change in quantity demanded (or sales) of commodity X

ea =
Proportion ate change in advertisin g expenditure
 Degrees
 e >1
a
 Firm should go for heavy expenditure on advertisement.

 e <1
a
 Firm should not spend too much on advertisement
 Importance of 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.
 Usefulness for business to determine price: According to nature of
demand, monopolist can fix the price
 Fixation of wages: According to elastic or inelastic demand for
labour
 Determining ToT: inelastic/elastic demand for home products
 Effect on employment: Demand for product produced by machines,
if inelastic, it will stimulate more demand and hence more
production, and more employment.
 Incidence of taxation: Incidence is on buyer if demand is inelastic.If
necessities are taxed more, incidence will fall more on poor sections.
 Market forms: If cross price elasticity is infinite, its perfect
competition, if EC=0, its monopoly,if EC>1, it’s monopolistic
competition
 Price fixation of public utilities like water, transportation, cooking gas
etc.
 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.