You are on page 1of 19

Module II

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 ( “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.
Degrees of Price Elasticity
Slope of demand curve is used to display Price
price elasticity of demand
Perfectly elastic demand
 ep=∞ (in absolute terms). P D
 Horizontal demand curve
 Unlimited quantities of the commodity can
be sold at the prevailing price
O
Q1 Q2 Quantity

Perfectly inelastic demand


 The other extreme of the elasticity range D
 ep=0 (in absolute terms) Price
 Vertical demand curve
 Quantity demanded of a commodity P1
remains the same, irrespective of any
change in the price P2
 Such goods are termed neutral.
O
Q1 Quantity
Degrees of Price Elasticity Contd
Highly elastic demand .
 Proportionate change in quantity Price
D
demanded is more than a given change in
price P1
 ep >1 (in absolute terms) P2 D
 Demand curve is flatter
Unitary elastic demand O
Q1 Q2 Quantity
 Proportionate change in price brings about
Price D
an equal proportionate change in quantity
demanded P1
 ep =1 (in absolute terms). P2
Less elastic demand
D
 Proportionate change in quantity
demanded is less than a proportionate O
Q1 Q2 Quantity
change in price
Price
 ep <1 (in absolute terms) D
 Demand curve is steep P1
P2

O D
Q1 Q2 Quantity
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

Proportion ate change in quantity demanded of commodity X


ep =
Proportion ate change in price of commodity X
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.
 It measures a very minute change in price and then measure the
elasticity
 Ed = Lower segment of Demand Curve/Upper segment of Demand
Curve
 For nonlinear demand curve we need to apply calculus to calculate
point elasticity.
 As changes in price become smaller and approach zero, the ratio
becomes equivalent to the first order derivative of the demand
function with respect to price
 Point elasticity can be expressed as:
dQ / Q dQ P
ep =
dP / P
= .
dP Q
Point Elasticity of
Ed = Infinite Demand
A
Ed > 1

Price Ed = 1
E
Ed <1

Ed = 0

B
Quantity
Arc Elasticity
 It measures the responsiveness of demand between
two points on the demand curve such as X and Y. In
other words it is a measure of average elasticity i.e. the
elasticity at the midpoint of the chord that connects
the two points on the demand curve defined by the
initial and new price levels.
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.
 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)
Income Elasticity of Demand (ey)
 ey measures the degree of responsiveness of demand for a
good to a given change in income, ceteris paribus.

Proportion ate change in quantity demanded of commodity X


ey =
Proportion ate 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

Proportion ate change in quantity demanded of commodity X


ec =
Proportion ate change in price of commodity Y

 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).

Proportion ate change in quantity demanded (or sales) of commodity X


ea =
Proportion ate change in advertisin g expenditur e
 Degrees
 ea>1
 Firm should go for heavy expenditure on advertisement.
 ea <1
 Firm should not spend too much on advertisement
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
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
 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…

Price,
 Till ep>1 MR is positive Revenue
and TR is rising ep=
∞ ep>1
 At the midpoint of the
demand curve, ep=1 ep=1
ep<1
and MR is equal to 0
and TR is at its peak ep=0
O
 When ep<1, MR is Price, MR
Quantity

negative and TR is Revenue

falling.
 MR= AR[1- 1/ep]

O
TR Quantity
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.