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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

Objectives

To understand the meaning of responsiveness


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

Elasticity is a standard measure of the degree of


responsiveness (or sensitivity) of one variable to changes
in another variable.

Elasticity of Demand measures the degree of


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.

Responsiveness implies the proportion by which the


quantity demanded of a commodity changes, in response
to a given change in any of its determinants .

Elasticity of Demand

Mathematically, it is the percentage change in


quantity demanded of a commodity to a percentage
change in any of the (independent) variables that
determine demand for the commodity.

Four major types of elasticity:

Price elasticity,

Income elasticity,

Cross elasticity

Advertising (or promotional) elasticity.

In order to assess the impact of one variable on demand,


we assume other variables as constant (ceteris paribus)

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 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

Perfectly inelastic demand


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

Degrees of Price Elasticity


Contd.

Highly elastic demand

Proportionate
change
in
quantity
demanded is more than a given change in
price
ep >1 (in absolute terms)
Demand curve is flatter

Unitary elastic demand

Proportionate change in price brings


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

Relatively inelastic demand

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

Factors Influencing Elasticity of


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

Methods of Measuring Elasticity

Ratio (or Percentage) Method

The most popular method used to measure elasticity


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

where Q1= original quantity demanded, Q2= new quantity


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

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
dP / P

dQ
.
dP

P
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
ep =
=

Q2 Q1
(Q1 Q2 ) / 2

Q2 Q1
Q1 Q2

P2 P1
( P1 P2 ) / 2

P1 P2
P2 P1

The arc elasticity of demand refers to the


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''.

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:

Remember, we ignore the minus sign


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.

Example Arc Elasticity

Consider the market for music CDs.


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.

Methods of Measuring Elasticity


Contd

Total Outlay Method (Marshall)

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.
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

When demand is elastic, a decrease in price will result in an


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)

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


Contd
Demand

Proportion of income spent on the commodity

Time

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

Durability of the commodity

The greater the proportion of income spent on a commodity, the


more sensitive would the commodity be to price
Reason is income effect

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

Revenue and Price Elasticity of


Demand

For relatively inelastic demand, a change in


price would have a greater effect on revenue
than a change in quantity demanded
AR is same as the price of the product
Demand

curve is also the AR curve of the firm.

Marginal Revenue is the revenue a firm gains in


producing one additional unit of a commodity

Revenue and Price Elasticity of


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

Income Elasticity of Demand (ey)


ey measures the degree of responsiveness of demand
for a good to a given change in income, ceteris paribus.

ey =

Proportionate change in quantity demanded of commodity X


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

ec =

Proportionate change in quantity demanded of commodity X


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--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 quantity demanded (or sales) of commodity X


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

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

Elasticity is the basis of determining the price of a product


keeping its possible effects on the demand of the product in
perspective

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.

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 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.