ELASTICITY – MEASURE OF RESPONSIVENESS

Generally speaking, whenever the price of a certain commodity goes up, the quantity demanded
of the commodity goes down, keeping all other determinants of demand intact. This is what we
call the law of demand. But, the law of demand does not tell the extent or degree to which the
increase in the price of a commodity would cause the quantity demanded of the commodity to
decline.
The owner of a business may not be able to find the influence of the variables that affect the
demand for his/her product by using only the demand function. Moreover, it is insufficient for
businesses to know only the negative relationship that exists between the price of a commodity
and the quantity demanded of the commodity. Businesses also need to predict the effect of
price changes on their revenues and the sensitiveness of buyers to price changes.
The degree of responsiveness or sensitiveness of quantities exchanged (quantities bought and
sold) to the change in various variables is called elasticity. In general, elasticity measures the
responsiveness or sensitiveness of consumers and sellers to changes in various variables such
as price and income and time. The greater the degree of responsiveness, the larger the size of
elasticity; and the smaller the degree of sensitiveness; the smaller the size of elasticity.
There are different dd elasticities:
[[

1) Price elasticity of demand (Ed)

The price elasticity of demand (Ed) measures the responsiveness of quantity demanded of a
commodity to changes in its price, other things being equal. The price elasticity of demand (Ed)
at any point on the demand curve is defined as the percentage change in quantity demanded as
a result of the percentage change in own price.
Mathematically,
Price elasticity of = Percentage change in quantity demanded of X
Demand (Ed) Percentage change in price of X
Ed = % change in Qx
% change in Px
= Q2 – Q1 X 100
Q1
P2 – P1 X 100
P1
= Q ÷ P Where:
Q1 P1 Q = Change in quantity demanded
P = Change in Price
= Q X P1 Ed = -Q x P1
Q1 = Original quantity demanded
Q1 P P Q1
P1 = Original price

The above formula is known as the point elasticity of demand. This is because it measures
the price elasticity of demand at a given point on the demand curve.
 Elasticity can also be measured between two points on the demand curve. The measure of
elasticity of demand between any two finite points on the demand curve is known as arc
elasticity of demand (average elasticity of demand).

Arc elasticity of demand can be mathematically expressed as:

Arc = -Q x (P1 + P2)

Ed P 2

(Q1 + Q2)
2

Arc Ed = Q x P1+ P2
P Q1 +Q2

Where:
P1 and Q1 represent the original price and quantity respectively and P2 and Q2 represent the
new price and quantity respectively.

The coefficients of elasticity (numerical value) of demand which refer to the proportionate
change in the dependent variable divided by the proportionate change in the independent
variable can range from zero to infinity which can be categorized and illustrated as follows:

(i) When the price elasticity of demand is greater than unity, demand is elastic (Ed >
1). To state it differently, demand is said to be elastic if a given percentage change
in price results in a larger percentage change in quantity demanded.
Example:- a) If a two percent change in price causes a three percent change in quantity
3%
demanded of a commodity, demand is elastic (Ed = = 1.5)
2%
b) If a 5% decline in price results in (is accompanied by) a 6% increase in quantity
demanded, demand is elastic (Ed = 6% = 1.2)
5%
The demand curve for elastic demand is flatter.
 P

d
0 Q

Note that most luxury goods are demand elastic because a change in the price of luxury goods
would cause the demand to respond more highly to the change in the price of these goods.

ii) When the price elasticity of demand is less than one, demand is inelastic (Ed< 1). This
means a given percent change in price is accompanied by a relatively smaller percentage
change in quantity demanded.

Example a) If a 3% change in price brings about a 2% change in quantity demanded, demand

2%
is inelastic (Ed = = 0.67)
3%
b) If a 4 increase in price causes a 2% decrease in quantity demanded, demand is
inelastic (Ed = 2% = 0.50).
[
4%
Most essential commodities or necessities are demand inelastic and their demand curve is
usually steeper because the quantity demanded of necessities doesn’t respond significantly to
the change in the prices of same. Hence, the coefficient of elasticity for necessities can be expressed
as o< Ed <1.

Price

d
0 Q Quantity
iii) When the price elasticity of demand is equal to unity, demand is unitary elastic (E d = 1).
This means quantity demanded changes by exactly the same percent as price does.
Example: a) If a 4% change in price leads to a 4% change in quantity demanded, demand is
unitary elastic ( i.e. Ed = 4% = 1).
4%
b) When a 10% drop in price leads to a 10% increase in quantity demanded, demand
10%
is said to be unitary elastic (Ed = = 1).
10%
The rectangular hyperbola reflects the shape of the unitary elastic demand curve and its price
elasticity of demand is equal to one. That is,

d
Px

d
0 Q Qx

i) When the price elasticity of demand is equal to zero, demand is perfectly

inelastic ( Ed = 0).
This is a situation in which the quantity demanded of a certain product is invariable relative to
a change in price. The demand curve for perfectly inelastic demand is a vertical line drawn
parallel to the price axis. This shows that quantity demanded does not respond to price change.

Px

d(Ed = 0)

0 Q = 0 Qx

Typical examples of a perfectly inelastic demand are an acute diabetic patient’s demand for
insulin or an addicted person’s demand for heroin.
V) When the price elasticity of demand is equal to infinity, demand is perfectly elastic (Ed
=  ).
This indicates that a one-percentage change in price results in infinite change in quantity
demanded. A demand curve of infinite elasticity means that a small price reduction would
embolden consumers to buy any desired quantities of the commodity at this price, while at an
even slightly higher prices they would buy none. The demand curve for a perfectly elastic
demand is a horizontal line drawn parallel to the quantity axis.

Px

d(Ed=  )

0
Qx

Practical Applications of Price Elasticity of Demand

The main objective of business firms in producing goods and services is to maximize profits
from the revenues they earn. A businessman aspiring to enhance his total sales revenue would
like to know whether raising or reducing the price of a product will increase the revenue. How
a change in price affects total revenue (Price X quantity) depends upon elasticity of demand.
In light of this, therefore, the price elasticity of demand has many practical applications. If the
seller of a certain product reduces the price of his product and the demand for the commodity
turns out to be price elastic, total revenue increases. This is so because even though the price
cut reduces total revenue the rise in quantity demanded, caused by the price reduction, increases
total revenue. In other words, demand is price elastic means that when price is reduced by a
given percent, quantity demanded increases by more than the decrease in price and as a
consequence, total revenue increases.
On the other hand, if the price of a commodity falls when the demand of the commodity is
price inelastic, then total revenue declines. This is because since the increase in quantity
demanded is less than the fall in price (when demand is inelastic), total revenue falls. Hence,
when demand is inelastic it is advisable for the profit-maximizing firm to increase price rather
that reducing it.

Alternatively, if demand for a commodity is unitary elastic, then a fall in the price of the
commodity does not change total revenue. This is because if price falls by a given percent,
quantity demanded increases by the same percent and as a result, total revenue remains
unaltered.
An increase in the price of a commodity would have the opposite effect on total revenue when
price elasticity of demand coefficient changes. That is, when Ed > 1, total revenue decreases
when price increases; when Ed <1, total revenue increases when price increases and if Ed = 1,
total revenue doesn’t change when price increases.
Apart from total revenue, the price elasticity of demand is also related to marginal revenue
(MR = TR). When total revenue is increasing, marginal revenue is positive and elasticity of demand is greater than
one.
Q
When total revenue is decreasing, marginal revenue is negative (Ed<1) and when total revenue
is maximum and constant, marginal revenue is zero and demand is unitary elastic (Ed = 1).

In summary, we can establish the following relationship between various elasticity coefficients
and total revenue when price changes:

i) When demand is price elastic, a reduction in price increases total revenue and an
increase in price reduces total revenue.
ii) When demand is price inelastic, a cut in price lowers total revenue and an increase in
price raises total revenue.
iii) When demand is unitary elastic, a reduction in price does not change total revenue and
a rise in price does not affect total revenue, either.
ILLUSTRATION
Price of a commodity (Birr/ unit) Quantity demanded of a Total sales revenue of a firm
commodity (unit/week) (Birr/ week)
7 1 7
6 2 12
5 3 15
4 4 16
3 5 15
2 6 12
1 7 7

A) Compute the price elasticity of demand when the price of the commodity equals 4.
B) Compute the price elasticity of demand in the price range from 5 to 6.
C) Sketch the elasticity of demand on a liner demand curve.
Solution
a) Ed = Q x P1
P Q1

The slope of a linear equation = (P) = 1 - 7 = -6 = -1

Q 7-1 6
Thus, Ed, = -Q x P1
P Q1

The reciprocal of the slope

(P) = Q = 1 = -1
Q P -1
 4
= - (-1) x
4
Ed = 1
Therefore, demand is unitary elastic.
b) Ed = - Q x P1 + P2
P Q1 + Q2
= -(-1) x 5 + 6
3+2
= 1 x 11
5
Ed = 2.2 Therefore, demand is price elastic.

c) P
d
6

5 Ed > 1

4 Ed = 1

3 Ed < 1

2 d
Q
0 1 2 3 4 5 6

Fig. 2.19 Elasticity of demand on a linear demand curve

From Fig. 2.19 it is easy to expound that if price decreases up to 4, total sales revenue increases
because demand is price elastic. At the price of 4, total revenue is at its maximum (demand is
unitary elastic). Finally, if price decreases below 4 (where demand is inelastic) total revenue
declines.

2) Cross (price) elasticity of demand (Exy)

The cross elasticity of demand (Exy) measures the responsiveness of quantity demanded of
commodity X as a result of change in the price of commodity Y. Mathematically,

Cross elasticity of = Percentage change in quantity demanded of X

Demand (Exy) Percentage change in price of Y
= % change in Qx
% change in Py
 Q x2  Q x1
Q x1

PY2  PY1
PY1
Q x PY1
E xY  
PY Q x1
The numerical value of the cross elasticity of demand (Exy) can be negative, positive or zero
depending on the degree of substitutability or complementarity between two goods which can
be categorized and interpreted as follows:
a) Substitute Commodities: If the cross elasticity of demand (Exy) is positive –that is, if the
quantity demanded of commodity X varies directly with the change in the price of commodity
Y, then X and Y are substitute commodities. The larger the positive coefficient, the greater the
degree of substitutability between X and Y.

For instance, an increase in the price of butter (Y) would encourage consumers to purchase
more of oil (X). Likewise, a rise in the price of white teff (Y) would embolden consumers to
raise their purchases of red teff (X). Thus, Exy = +ve.
b) Complementary Commodities: Because complementary goods go together – that is, the
consumption of one good necessitates the consumption of the other good, the cross elasticity
of demand for these goods turns out to be negative. The larger the negative coefficient, the
greater the degree of complementarity between X and Y.

For example, an increase in the price of camera (Y) would reduce the quantity of film purchased
(X). Thus, Exy = -ve.
c) Independent (unrelated) Commodities:
If the cross elasticity of demand for two commodities X and Y (Exy) is zero, the commodities
are independent or unrelated.
For example, a change in the price of sugar (Y) would have no impact on the quantity
demanded of coca-cola (X). Thus, Exy = 0
In summary, substitute commodities have positive cross elasticities (Exy>0) and
complementary commodities have negative cross elacticities (Exy<0). But, independent
(unrelated) commodities have zero cross elasticity (Exy = 0 ).

3) Income Elasticity of Demand (E1)

Income elasticity of demand measures the responsiveness of quantity demanded of a
commodity for an individual consumer to the change in the income of the consumer. The
income elasticity of demand (E1) is expressed as a percentage change in quantity demanded of
a commodity divided by a percentage change in income, ceteris paribus.
 Mathematically,
Income elasticity = Percentage change in quantity demanded
Of demand (EI) Percentage change in income
EI = % change in Q
% change in I

For most goods a rise in income leads to increase in demand and the income elasticity
of demand for these goods will be positive. These types of goods are said to be normal goods.
For inferior goods, demand (consumption) decreases in response to an increase in income.
Thus, the income elasticity of demand for inferior goods is negative. This is so because when
the income of the consumer increases, he/she substitutes the superior goods for the inferior
ones.
On the whole, the income elasticity of demand for most commodities varies as income changes
depending on the nature of the commodity. If the income elasticity of demand (EI) is negative,
the commodity is inferior. If the income elasticity of demand (EI) is positive, the commodity is
normal (either luxury or necessity). A normal good is usually a luxury if EI > 1, and a necessity
if 0<EI<1.
Depending on the level of income, the income elasticity of demand (EI) for a commodity is
likely to vary considerably. Thus, a commodity may be a luxury at low level of income; a
necessity at intermediate level of income; and inferior at high level of income.