Elasticity of Demand

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.
Price Elasticity

 Elasticity of demand is expressed as the ratio of proportionate

change in quantity demanded and proportionate change in the
price of the commodity

Proportionate change in quantity demanded of commodity X

ep =
Proportionate change in price of commodity X

ep= Q2  Q1 / Q1 dQ P
= x
P2  P1 / P1 dP Q

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

demanded, P1= original price level, P2= new price level
Price Elasticity
Contd…

 Arc Elasticity Method

 Itis 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.

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

Q2  Q1 P1  P2
= .
Q1  Q2 P2  P1
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
 Proportion of income spent on the commodity
 The greater the proportion of income spent on a commodity, the
more sensitive would the commodity be to price
 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 addiction
 Items of intoxication and addiction are relatively price inelastic
Degrees of Price Elasticity
Perfectly elastic demand
 ep=∞ (in absolute terms).
 Unlimited quantities of the
commodity can be sold at the
prevailing price
 A negligible increase in price
would result in zero quantity
demanded
 Horizontal demand curve
Price

P D

O Q1 Q1
Quantity
Degrees of Price Elasticity

Perfectly inelastic demand

 The other extreme of the
elasticity range
 ep=0 (in absolute terms)
 Quantity demanded of a
commodity remains the D
same, irrespective of any Price

change in the price P1

 Vertical demand curve P2

O
Q1 Quantity
Degrees of Price Elasticity
Highly elastic demand Price
D
 Proportionate change in P1

quantity demanded is P2 D

more than a given change

in price O
Q1 Q2 Quantity
Price D
 ep >1 (in absolute terms)
P1
 Such goods are called P2
luxuries D
O
Q1 Q2 Quantity
Price
D
P1
P2

O D
Q1 Q2 Quantity
Degrees of Price Elasticity
Unitary elastic demand Price
D
 Proportionate change in P1

price brings about an P2 D

equal proportionate
change in quantity O
Q1 Q2 Quantity

demanded Price D

 ep =1 (in absolute terms). P1

P2
 Demand curves are D
shaped like a rectangular O
Q1 Q2 Quantity
hyperbola Price
D
P1
P2

O D
Q1 Q2 Quantity
Degrees of Price Elasticity
Relatively inelastic Price
D
demand P1

 Proportionate change in P2 D

quantity demanded is less

than a proportionate O
Q1 Q2 Quantity

change in price Price D

 ep <1 (in absolute terms) P1

P2
 Such goods are called D
necessities O
Q1 Q2 Quantity
Price
D
P1
P2

O D
Q1 Q2 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.

Proportionate change in quantity demanded of commodity X

ey =
Proportionate change in income of consumer
 Income Elasticity of Demand (ey)
 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 commodityY
Cross Elasticity of Demand

 Degrees
 Negative Cross Elasticity
 Complementary goods
 Positive Cross Elasticity
 Substitute goods
Promotional Elasticity of Demand
 Advertising (or promotional) elasticity of demand (ea)
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).

Proportionate change in quantity demanded (or sales) of commodity X

ea =
Proportionate change in advertising expenditure
Promotional Elasticity of Demand

 Ife>1
 Firm should go for heavy expenditure on
advertisement.
 If e <1
 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.
Consumer Surplus

 The difference between the price consumers are

willing to pay and what they actually pay is called
consumer surplus.
 Individual consumer surplus measures the gain
that a consumer makes by purchasing a product
at a price lower than what he/she had expected
to pay.
 In a market the total consumer surplus measures
the gain to the society due to the existence of a
market transaction.
Consumer Surplus

 Equilibrium market price and Price

quantity are at (P*, Q*) D
 If there is a customer who is willing
A Consumer
to pay as high as P1 but actually P1 Surplus
pays only P*, the difference
between the two prices (P1 – P*) P2 B
S
represents the surplus of the first
consumer. P*
E

 If a second consumer is willing to S

D’
pay P2 and actually pays P* gains
a surplus of (P2 – P*).
 Total consumer surplus in the O
Q1 Q2 Q* Quantity
economy is given by the triangular
area P*DE