Elasticity of Demand

Dr. Nandita Sethi

Elasticity of Demand
 Measures the responsiveness of the
quantity demanded to a change in
one of its determinants, ceteris
paribus
 Uses percentage changes - unit free
 Four demand elasticities
 price, income, cross, promotional
 Price Elasticity of Demand
 measures the percentage change in quantity
demanded for a percentage change in price,
ceteris paribus

% ∆Q Or (-)
ε = ( −)
∆Q/Q x 100
∆P/P
% ∆P
Q = Original price P = Original Price
∆Q= Change in Quantity ∆P = Change in Price
 Price Elasticity
Price Figure 3.1

Measured as a
movement along a
P1 A demand curve
P
P2 B
Q Demand
0 Q1 Q2 Quantity
Price Elasticity and
Decision Making
 Tells managers what will happen if
product prices change
 Helps firms to develop pricing
strategies
 Helps to develop pricing strategies
in the public sector
 Example: Price Elasticity
Price of a good falls from £40
∆Q Q
to £38 ε = ( −)
Quantity demanded rises from ∆P P
80 to 90
10 80
= ( −)
∆Q = 90 − 80 = 10 − 2 40
Q = 80 0.125
= ( −)
∆P = 38 − 40 = −2 − 0.05
P = 40 = 2.5
 Degrees of Elasticity
 Relatively Elastic demand : change in quantity
demanded is greater than the change in price
 ( E>1)
 Inelastic demand : change in quantity demanded is less
than the change in price (E<1)
 Unitary elasticity: change in quantity demand is equal
to change in price (E=1)
 Perfectly Elastic: change in quantity demand is infinite
even without a change in price (E=∞)
 Perfectly Inelastic: no change in quantity demand to
change in price (E=0)
 Range and Meaning
Type Value of ε Meaning

Perfectly 0 No change in quantity when

Inelastic price changes
Inelastic <1 Quantity changes by less
than price
Unit Elasticity 1 Quantity & price change by
same %
Elastic >1 Quantity changes by more
than price
Perfectly ∞ Demand only exists at one
Elastic price
 Degrees of Price Elasticity
Figure 3.2
 Relatively Inelastic Relatively
elastic

P
P

Q Q
 Degrees of Price Elasticity
 Perfectly Inelastic Perfectly elastic

P
P

Q Q
 Degrees of Price Elasticity
 Unitary Elastic
P

Q
 Elasticity and Total
Revenue
 If demand is elastic, higher prices result in
lower total revenue. Lower prices result in
higher total revenue
 Changes in price and the resulting total
revenue are inversely proportionate
 P TR
 P TR
 Elastic Demand and Total
Revenue Figure 3.3

If prices decrease,
12 revenue increases.
A If prices increase,
(P1) 10 revenue decreases.
Y
(P2) 9 B
C Area X = Q1CBQ2
Area Y = P1ACP2
X
Price

Demand
0 2 3 12 Quantity
(Q1) (Q2)
 Inelastic Demand
 If demand is inelastic –
- by lowering prices the quantity demanded
will not increase proportionately
- by increasing prices demand will not fall
proportionately
 Changes in price and the resulting total revenue

move in the same direction

 P TR
 P TR
 Inelastic Demand and
Price
Total Revenue
Figure 3.4

If prices decrease,
12 revenue decrease. If
prices increase,
revenue increases.

A Area X = Q1CBQ2
Area Y = P1ACP2
(P1) 4 Y B
(P2) 3 C
X Demand
0 8 9 12 Quantity
(Q1) (Q2)
 Price Elasticity &
Expenditure/Revenue
 Total expenditure/revenue = price per unit
x no. of units purchased/sold

If demand
Demand, Total Revenue, Marginal
Revenue, and Elasticity
Price and marginal

Figure 3.5
D E>1
E=1
revenue ($)

p0 E<1
D
0 q0 Quantity
MR
Total Revenue
($)

0 q0 Quantity
Managerial Rule of Thumb:
Estimating Price Elasticity
Managers can estimate price elasticity by
asking customers:
1. What do you currently pay for my product?
2. At what price would you stop buying my
product altogether?
Managers should ask themselves:
1. How much will revenue increase as a result of
higher sales?
2. How much will revenue decrease as a result of
lower prices for each unit?
Measurement of Elasticity-
Methods
 Mathematical method
 Expenditure method
 Point elasticity
 Arc elasticity
 Geometric
Mathematical method -
contd
ε = ∆Q/Q x 100
∆P/P x 100

= ∆Q x P
∆P Q
Calculating Price
Elasticities
 Arc price elasticity: base quantity
(or price) is the average value of
the starting and ending points
 Point price elasticity: measurement
of the price elasticity of demand
calculated at a point on the curve
using infinitesimal changes in
prices and quantities
 Arc Elasticity
 Used when the price change is relatively
large

∆Q Q Q = Q1 + Q 2 / 2
ε = ( −)
∆P P
P = P1 + P 2 / 2
 Arc Elasticity - contd Figure 3.6
Price

Measured at the mid

point of the range
P1 A along a demand curve
M
P
P2 B
Q Demand
0 Q1 Q2 Quantity
 Example: Arc Elasticity
Price of a good rises from £10
∆X X
to £20
ε = ( −)
Quantity demanded falls from ∆P P
200 to 120
− 80 160
= ( −)
∆X = 120 − 200 = −80 10 15
X = ( 120 + 200 ) / 2 = 160 − 0.5
∆P = 20 − 10 = 10 = ( −)
0.67
P = ( 20 + 10 ) / 2 = 15 = 0.75
Point Elasticity
 Used when the price change is
relatively small. Elasticity is
determined on a point on the
demand curve
∂Q Q
ε = (−)
∂P P
 Point Elasticity - contd
Price Figure 3.6

Measured at a mid
point on a demand
curve
P1
A
P2
Demand
0 Q1 Q2 Quantity
 Example: Point Elasticity
Demand equation of a Firm is
Q= 30,000-1000P. What is the
point elasticity of demand at ∂Q Q
Price = 20 ε = ( −)
∂P P
20
= ( −) −1000 X
∂Q / ∂P = (−) − iooo 10000
AtP = 20 , Q = 10 ,000 =2
 Elasticity along a Demand
Curve-geometric method
Figure 3.7
Price
per unit ε = inf  ε = Lower segment of the
curve
ε >1
Upper segment of
ε =1 the curve

ε <1
ε =0
Quantity per period
Elasticity along a Demand
Curve-geometric method
Figure 3.8

 ε = Lower segment of the

curve
Upper segment of
the curve
Elasticity along a Demand
Curve-geometric method
Figure 3.7

 ε = Lower segment of the

curve
Upper segment of
the curve
Determinants of Price
Elasticity
 Availability and closeness of Substitutes
 the more substitutes the more elastic the demand
 The closer the substitutes the more the elasticity
 Commodity share (i.e. the % share of total expenditure
on the good)
 the smaller the % the more inelastic the demand

 The larger the share the higher the elasticity

 Time
 demand is more elastic in the long run than in the short
run – The demand for gasoline
 Determinants of Price
Elasticity-contd
 Nature of the commodity
Necessities – inelastic demand
Luxuries – elastic demand
Habitual Necessities – highly inelastic demand
 Price range of the commodity
Very high and very low- inelastic
In between- elastic
 Number of uses of a commodity
 More the no. of uses - more elastic
 Less the no. of uses- more inelastic
Empirical Estimates
Category of Good Price elasticity

Fuel & Light 0.47

Food 0.52

Entertainment 1.40
 Income Elasticity of
Demand
 measures the percentage change
in quantity demanded for a one
percent change in income, ceteris
paribus
%∆Q
Positive (< 1): Normal

ε=
“necessity”
Positive (> 1): Normal “luxury”
%∆I Negative: Inferior Good
Categories of Income Elasticity
Figure 3.8
Y Normal

Superio
r

Inferior

Q
 Income elasticity > 1: superior goods
 Income elasticity > 0, and <1: normal
goods
 Income elasticity < 0: inferior goods
Empirical Estimates

Category of Good Income

elasticity
Fuel & Light 0.30

Alcohol 1.14

Bread & Cereals -0.50

 Elasticities of
Demand
Product Short Run Long Run
Electricity (residential) 0.1 1.9
Air travel 0.1 2.4
Medical care and 0.3 0.9
hospitalization
Gasoline 0.4 1.5
Movies 0.9 3.7
Natural gas (residential) 1.4 2.1
Application :Income
Elasticity
 The demand for Housing (Author:
Pindyck & Rubinfeld) pp 123

 (2)Income elasticity of demand for

cars
(Author: Perloff) pp 116
Cross Elasticity of Demand
 measures the % change in
quantity demanded of good X for a
1% change in the price of good Y,
ceteris paribus

%∆Q Positive: Substitutes

ε= Negative:
%∆PY Complements
 Cross Elasticity of Demand
Substitutes
Complimentary Goods distant sub
0<e<1
e<0 Close
1<e< ∞ sub
PY PY

Q Q
Promotional Elasticity of
Demand
 It measures the responsiveness of
demand to the advertisement
expenditure of the firm

 E = % change in the demand for X

% change in the ad. exp. on X