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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

Objectives

of demand to changes in determinants of

demand.

To lay down the degrees of responsiveness of

demand.

To discuss various types of elasticities of

demand.

To learn how to measure elasticity by various

methods.

To understand the relevance and application of

elasticities of demand

Elasticity of Demand

responsiveness (or sensitivity) of one variable to changes

in another variable.

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.

quantity demanded of a commodity changes, in response

to a given change in any of its determinants .

Elasticity of Demand

quantity demanded of a commodity to a percentage

change in any of the (independent) variables that

determine demand for the commodity.

Price elasticity,

Income elasticity,

Cross elasticity

we assume other variables as constant (ceteris paribus)

Price is most important among all the

independent variables that affect the demand for

any commodity

considered to be the most important of all types of

elasticity of demand.

of quantity demanded of a commodity to a given

change in its own price.

Slope of demand curve is used to display

price elasticity of demand

Perfectly elastic demand

ep= (in absolute terms).

Horizontal demand curve

Unlimited quantities of the commodity can

be sold at the prevailing price

A negligible increase in price would result

in zero quantity demanded

The other extreme of the elasticity range

ep=0 (in absolute terms)

Vertical demand curve

Quantity demanded of a commodity

remains the same, irrespective of any

change in the price

Such goods are termed neutral.

Price

O

Q1

Q2

Quantity

D

Price

P1

P2

Q1

Quantity

Contd.

Proportionate

change

in

quantity

demanded is more than a given change in

price

ep >1 (in absolute terms)

Demand curve is flatter

about an equal proportionate change in

quantity demanded

ep =1 (in absolute terms).

Demand curves are shaped like a

rectangular hyperbola, asymptotic to the

axes

Proportionate

change

in

quantity

demanded is less than a proportionate

change in price

ep <1 (in absolute terms)

Demand curve is steep

Price

P1

P2

O

Price

Q1

Q2

Quantity

P1

P2

D

O

Price

Q1 Q2

Quantity

P1

P2

Q1 Q2

D

Quantity

Demand

Nature of commodity

Availability of substitutes

Number of uses

Consumers income

Proportion of expenditure (Income spent)

Durability of the commodity

Habit

Time

Possibility of postponement

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

Proportionate change in quantity demanded of commodity X

Proportionate change in price of commodity X

ep =

ep=

Q2 Q1 / Q1

P2 P1 / P1

demanded, P1= original price level, P2= new price level

Contd

as point elasticity of demand.

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

dP / P

dQ

.

dP

P

Q

Contd

Used

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

(Q1 Q2 ) / 2

Q2 Q1

Q1 Q2

P2 P1

( P1 P2 ) / 2

P1 P2

P2 P1

relationship between changes in price and

the subsequent change in quantity

demanded

The arc elasticity formula is used if the

change in price is relatively large. It is more

accurate a measure of elasticity than simple

''price elasticity''.

greater than 1, demand is said to be

elastic. The demand curve has a ''flat''

appearance.

Solution:

when calculating price elasticity.

When the price of CDs falls from $30 to

$20, and the quantity sold increases from

6 per year to 12 per year, the price

elasticity of demand is 1.67: CDs are price

elastic over this price range.

When the price of CDs is $30 per

unit, consumers buy 6 per year.

When the price falls to $20 per unit,

consumers buy 12 per year.

Contd

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

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)

Demand

Nature of commodity

Necessities

are relatively price elastic

Price

would be quite high, given availability of other

substitute brands

If

would be relatively price elastic

Contd

Demand

Time

Demand for any commodity is more price elastic in the long run

more sensitive would the commodity be to price

Reason is income effect

inelastic in comparison to durable items

Items of addiction

Demand

price would have a greater effect on revenue

than a change in quantity demanded

AR is same as the price of the product

Demand

producing one additional unit of a commodity

Demand

Contd

Till ep>1 MR is

positive and TR is

rising

At the midpoint of the

demand curve, ep=1

and MR is equal to 0

and TR is at its peak

When ep<1, MR is

negative and TR is

falling.

MR= AR[1- ep]

Price,

Revenue

ep=

ep>1

ep=1

ep<1

ep=0

O

Price,

Revenue

Quantity

MR

TR

Quantity

ey measures the degree of responsiveness of demand

for a good to a given change in income, ceteris paribus.

ey =

Proportionate change in income of consumer

Degrees:

Demand rises as income rises and vice versa

Normal good

Negative income elasticity

Demand falls as income rises and vice versa

Inferior good

one good to changes in the price of a related good

ec =

Proportionate change in price of commodity Y

Degrees

Negative Cross Elasticity

Complementary goods

Positive

Cross Elasticity

Substitute goods

Degrees

Zero Cross Elasticity

effect of incurring an expenditure on advertising, vis--vis an

increase in demand, ceteris paribus.

Some goods (like consumer goods) are more responsive to

advertising than others (like heavy capital equipments).

ea =

Proportionate change in advertising expenditure

Degrees

ea>1

Firm should go for heavy expenditure on advertisement.

ea <1

Firm should not spend too much on advertisement

Importance of Elasticity

Determination of price

while those having inelastic demand may be sold at high prices

keeping its possible effects on the demand of the product in

perspective

that have relatively elastic demand.

those having relatively inelastic demand.

Summary

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

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 consumers income. For normal goods e y is

positive; for neutral goods e y 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 (e a) 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.

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