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Elasticity and Its

Application

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Elasticity – The concept
 The responsiveness of one variable to
changes in another
 When price rises what happens to
demand?
 Demand falls
 BUT!
 How much does demand fall?

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Elasticity – The concept
 If price rises by 10% - what happens to
demand?
 We know demand will fall
 By more than 10%?
 By less than 10%?
 Elasticity measures the extent to which
demand will change

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Elasticity . . .

 … is a measure of how much buyers and


sellers respond to changes in market
conditions

 … allows us to analyze supply and


demand with greater precision.

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Price Elasticity of Demand

 Price elasticity of demand is the


percentage change in quantity demanded
given a percent change in the price.

 It is a measure of how much the quantity


demanded of a good responds to a change
in the price of that good.

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Determinants of Elasticity
 Time period – the longer the time under
consideration the more elastic a good is likely
to be.
 Number and closeness of substitutes –
the greater the number of substitutes,
the more elastic the demand.
 The proportion of income taken up by the product
– the smaller the proportion the more inelastic
 Luxury or Necessity – necessary goods have
inelastic demand vs. luxury goods have elastic
demand. E.g. Salt vs. luxury cars.

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Determinants of
Price Elasticity of Demand
Demand tends to be more elastic :
 if the good is a luxury.
 the longer the time period.
 the larger the number of close
substitutes.
 If the consumer is spending large portion
of his income on the product.

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Computing the Price Elasticity
of Demand
The price elasticity of demand is computed
as the percentage change in the quantity
demanded divided by the percentage
change in price. Percentage Change
in Quantity Demanded
Price Elasticity of Demand =
Percentage Change
in Price

The Percentage Method


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Computing the Price Elasticity
of Demand
Percentage change in quatity demanded
Price elasticity of demand 
Percentage change in price
Example: If the price of an ice cream increases from
2.00 to 2.20 and the amount you buy falls from 10 to 8
then your elasticity of demand would be calculated as:

(10  8 )
 100
10 20 percent
 2
( 2.20  2.00 )
 100 10 percent
2.00
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Ranges of Elasticity
 Perfectly Inelastic
Quantity demanded does not respond at
all to price changes.
Inelastic Demand
Quantity demanded does not respond
strongly to price changes.
Price elasticity of demand is less than one.

.
Ranges of Elasticity
 Unit Elastic
Quantity demanded changes by the same
percentage as the price.
Elastic Demand
Quantity demanded responds strongly to
changes in price.
Price elasticity of demand is greater than one.
 Perfectly Elastic
Quantity demanded changes infinitely with any
change in price.

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A Variety of Demand Curves

 Because the price elasticity of


demand measures how much
quantity demanded responds to the
price, it is closely related to the
slope of the demand curve.

.
Perfectly Inelastic Demand
- Elasticity equals 0
Price Demand

1. An 5
increase
in price... 4

100 Quantity
2. ...leaves the quantity demanded unchanged.
.
Inelastic Demand
- Elasticity is less than 1
Price

5
1. A 25%
increase
in price... 4

90100 Quantity
2. ...leads to a 10% decrease in quantity.
.
Unit Elastic Demand
- Elasticity equals 1
Price

1. A 25% 5
increase
in price... 4

75 100 Quantity
2. ...leads to a 25% decrease in quantity.
.
Elastic Demand
- Elasticity is greater than 1
Price

1. A 25%
increase 5
in price...
4

50 100 Quantity
2. ...leads to a 50% decrease in quantity.
.
Perfectly Elastic Demand
- Elasticity equals infinity
Price
1. At any price
above 4, quantity
demanded is zero.

4 Demand

2. At exactly 4,
consumers will
buy any quantity.

3. At a price below 4, Quantity


quantity demanded is infinite.
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Computing the Price Elasticity
of Demand ( Other methods)
 Price elasticity of demand can also be
calculated by a few other methods. These
methods are :
 Total Outlay Method
 Midpoint Formula
 Geometric Method

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Total Outlay Method
 This method, measures the change on
expenditure on commodities due to a change in
price.
 If a given change does not cause any change in
the total amount spent on the commodity, the
demand is said to be unitary elastic.
 If the total expenditure increases due to fall in
price, the demand is said to be elastic and vice
versa.

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Demand is Unitary elastic
Price ( in Rs.) Quantity demanded Total expenditure
4.50 4 18
4.00 4.5 18
3.00 6 18

As price falls, the quantity demanded increases,


But the total outlay remains constant.
Hence, elasticity of demand is equal to unity.

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Demand is Elastic
Price ( in Rs.) Quantity demanded Total expenditure
4.50 6 27
4 7 28
3 10 30

As price falls, the quantity demanded increases,


And the total outlay also increases.
Hence, demand is elastic. ( Greater than unity)

.
Demand is inelastic
Price ( in Rs.) Quantity demanded Total expenditure
4.50 4 18
4 4.25 17
3 5 15

As price falls, the quantity demanded increases,


but the total outlay decreases.
Hence, demand is inelastic. ( Lesser than unity)

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Midpoint Formula

The midpoint formula is preferable when


calculating the price elasticity of demand
because it gives the same answer regardless
of the direction of the change.

(Q 2  Q 1 )/[(Q 2  Q 1 )/2 ]
P rice E la sticity o f D e m a n d =
(P 2  P1 )/[(P 2  P1 )/2 ]

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Geometric method
 Elasticity at a point on a straight line demand curve
can be calculated as follows :

 e= Length of the lower segment


--------------------------------------------------
Length of the upper segment

 At the midpoint of the demand curve e = 1


 At all points above the midpoint e >1
 At all points below the midpoint e < 1

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Geometric Method
 At the point M,
Price Elasticity > 1
the demand curve
Elasticity = 1
is unit elastic. M is
the midpoint of
this linear demand
curve
Elasticity < 1
 Above M, demand M
is elastic,
 Below M, demand
is inelastic
Quantity

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Income elasticity of Demand

 Income elasticity of Percentage change in quatity demanded


=
demand Percentage change in income

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Income elasticity of Demand
 Income Elasticity of Demand:
The responsiveness of demand to changes in
incomes.
 Normal Good – demand rises as income
rises and vice versa
 Inferior Good – demand falls as income
rises and vice versa

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Cross Elasticity of Demand
 Cross Elasticity:
 The responsiveness of demand of one
good to changes in the price of a related
good – either a substitute or a
complement
Percentage Change
in Quantit y Demanded
in Quantity of good X
Demanded
PriceElas
Cross Elasticity
ticity of of Demand
Demand = =
Percentage Change
in Price of good Y

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Price elasticity of Supply
 Responsiveness of supply to a given
change in the price.

Percentage Change
in Quantity Demanded
Supplied
Price Elasticity of Demand
Supply =
Percentage Change
in Price

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Ranges of Price Elasticity of
Supply
 Perfectly inelastic Supply – Quantity supplied
does not change at all with a given change in
price.
 Relatively Inelastic Supply – Quantity supplied
does not respond strongly to a given change in
price.
 Unitary elastic supply – The change is quantity
supplied is as much as the change in price.

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Ranges of Price Elasticity of
Supply
 Relatively Elastic Supply – Quantity
supplied respond strongly to a given
change in price.
 Perfectly elastic supply - Quantity
supplied changes infinitely with a
given change in price.

.
Perfectly Inelastic Supply
Elasticity equals 0
Price Supply

1. An 5
increase
in price... 4

100 Quantity
2. ...leaves the quantity supplied unchanged.
.
Inelastic Supply
Elasticity is less than 1
Price

1. A 25% 5
increase
in price... 4

100 110 Quantity


leads to a 10% increase in Supply
.
Unit Elastic Supply
Elasticity equals 1
Price

1. A 25% 5
increase
in price... 4

100 125 Quantity


leads to a 25% increase in Supply
.
Elastic Supply
Elasticity is greater than 1
Price

1. A 25% 5
increase
in price... 4

100 150 Quantity


Leads to a 50% increase in quantity supplied
.
Perfectly Elastic Supply
Elasticity equals infinity
Price
1. At any price
above 4, quantity
supplied is infinite.

4 Supply

2. At exactly 4,
Producers will sell any quantity.

3. At a price below 4, Quantity


quantity supplied is zero.
.
Total revenue is The importance of
price x quantity elasticity is the
Elasticity sold. In this
example, TR = 5 x
information it
provides on the
Price 100 = 500. effect on total
This value is revenue of
represented by the changes in price.
shaded rectangle.

Total Revenue

100 Quantity Demanded

.
If the firm decides
to decrease price
Elasticity to (say) 3, the
Price degree of price
elasticity of the
demand curve
would determine
the extent of the
5 increase in
demand and the
change therefore
in total revenue.
3

Total Revenue
D
100 140 Quantity Demanded

.
Elasticity
Price
Producer decides to lower price to attract sales

10 % Δ Price = -50%
% Δ Quantity Demanded = +20%
Ped = -0.4 (Inelastic)
5 Total Revenue would fall
Not a good move!

D
5 6
Quantity Demanded

.
Elasticity
Price (£)
Producer decides to reduce price to increase sales
% Δ in Price = - 30%
% Δ in Demand = + 300%
Ped = - 10 (Elastic)
Total Revenue rises
10
Good Move!
7
D

5 Quantity Demanded 20

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Elasticity
 If demand is price  If demand is price
elastic: inelastic:
 Increasing price  Increasing price
would reduce TR would increase TR
(%Δ Qd > % Δ P) (%Δ Qd < % Δ P)
 Reducing price  Reducing price
would increase TR would reduce TR
(%Δ Qd > % Δ P) (%Δ Qd < % Δ P)

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Importance of Elasticity
 Relationship between changes in price
and total revenue
 Importance in determining what goods to
tax (tax revenue)
 Importance in analysing time lags in
production
 Influences the behaviour of a firm

.
Importance of Elasticity
Concepts
 For a Businessman : If a businessman
finds that the demand is inelastic, he is
free to increase prices.
 In case if the demand is elastic, by
slightly reducing the price, the demand
will increase sharply and hence the total
revenue will also increase.