Elasticity and Its Application

Elasticity . . .
x is a measure of how much buyers and sellers respond to changes in market conditions. x allows us to analyze supply and demand with greater precision.

ELASTICITY OF DEMAND

DEFINITION
The demand elasticity is simply a measure of relative responsiveness of quantity demanded to changes in one of the determinants, other determinants assumed as unchanged. In other words, elasticity of demand (ed) is defined as the ratio of the percentage change in quantity demanded to the percentage change in the demand determinant under consideration.

DEFINITION

Where the parameter Z may be one of the following: 1 Current price of the commodity (Px)

2 Current price of the related good (Pn) 3 Current income (Y) 4 The expected price of the commodity (EPx) 5 Advertising expenditure (A)

TYPES OF ELASTICITY OF DEMAND

Price elasticity of demand Income elasticity of demand Cross elasticity of demand Promotional elasticity of demand Expectations elasticity of demand

Price Elasticity of Demand

xPrice elasticity of demand in is the percentage in the price. xIt is a measure of how much the quantity that good. demanded of a good responds to a change in the price of change quantity

demanded given a percent change

Computing Price Elasticity of Demand

Where : P = Initial Price Q = Initial Quantity

P1 = New Price Q1 = New Quantity

Computing Price Elasticity of Demand

Example: If the price of an ice cream cone increases fromRs.2.00 toRs.2.20 and the amount you buy falls from 10 to 8 cones then your elasticity of demand would be calculated as:

(10 8 ) 100 20 percent 10 = =2 ( 2.20 2.00 ) 100 10 percent 2.00

Types of Price Elasticity

1. Perfectly elastic (ep = infinity) 2. Relatively elastic demand (ep > 1) 3. Unitary elastic demand (ep = 1) 4. Relatively inelastic demand (ep < 1) 5. Perfectly inelastic (ep = 0 )

Perfectly Elastic Demand

- Elasticity equals infinity
Price 1 . At any price aboveRs . 4 , quantity demanded is zero . $4 2 . At exactlyRs . 4 , consumers will buy any quantity . Quantity Demand

3 . At a price belowRs . 4 , quantity demanded is infinite .

Relative Elastic Demand

- Elasticity is greater than 1
Price

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

Quantity 50 100 2 . ... leads to a 50 % decrease in quantity .

Unitary Elastic Demand

- Elasticity equals 1
Price

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

Quantity 75 100 2 . ... leads to a 25 % decrease in quantity .

Relative Inelastic Demand

- Elasticity is less than 1
Price

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

Quantity 90 100 2 . ... leads to a 10 % decrease in quantity .

Perfectly Inelastic Demand

- Elasticity equals 0
Price Demand

$5 1 . An increase in price ...4

Quantity 100 2 . ... leaves the quantity demanded unchanged .

Measurement of Price Elasticity

Ratio or Percentage Method Point method/ Geometric method Total Revenue method Arc method

Ratio or Percentage Method

Where : P = Initial Price Q = Initial Quantity

P1 = New Price Q1 = New Quantity

Point Method/Geometric method

Y
A Ep=

Ep=
Ep>1

Lower Segment Upper Segment

8
C

Price

Ep=1
F

Ep<1
G

Ep=0

Quantity Demanded

ARC Method
Y

P1

Arc

Price

Q=Q2-Q1, P=P2-P1

P2

b DD

Q1

Q2

Quantity Demanded

Total Revenue Method

When Elastic When with Price ,TR or with Price ,TR then Ep is greater than Unity. When with Price ,TR or with Price ,TR then Ep is less than Unity. Price Changes TR remains

unchanged then demand is Unitary

Total Revenue method

Price Original 2 Change 4 1 Change 4 1 Change 4 1 Quantity 10 5 20 4 24 6 16 TR 20 20 20 16 24 24 16 Ep Ep=1 Ep>1 Ep<1

Case:1
When the price of Tea is Rs 20, Janak purchases 10 Kgs. When the price of Tea increases to Rs 22 now he purchases 9 Kgs. Find elasticity.

Answer : Ep = 1

Case:2
Example: If the price of an ice cream cone increases fromRs.2.00 toRs.2.20 and the amount you buy falls from 10 to 8 cones the your elasticity of demand, using Ratio and Arc Method would be calculated as:

Ratio method

Answer

(10 8 ) 100 20 percent 10 = =2 ( 2.20 2.00 ) 10 percent 100 2.00

Arc method

Factors influencing elasticity of demand

1.Nature of the commodity :
Necessaries Inelastic Comforts and Luxuries Elastic

2.Availability of substitutes :
No substitutes Inelastic Close substitutes Elastic

3.Number of Uses :
Single Use Inelastic Multi Use Elastic

Factors influencing elasticity of demand

4.Range of Price Change:
Highly Priced Elastic Low Priced Inelastic

6.Proportion of Expenditure :
Less expenditure Inelastic More expenditure Elastic

8.Time Period :
Short Period Inelastic Long Period elastic

Factors influencing elasticity of demand

7.Possibility of Postponement :
Can be Postpone -- Elastic Cannot be Postpone Inelastic

8.Influence by Habits & Customs

Inelastic

Practical Applications of Price elasticity

1.To a Businessman
To know whether a price cut or a price rise is better for increasing the sales, total revenue and the profits. If the demand is more elastic, a price cut would lead to an increase in total revenue. It the demand is inelastic, by raising a price, no significant decrease in sales will be effected so the total revenue and the profit would rise.

Practical Applications of Price elasticity

2.To the Finance Minister
Finance minister has to consider the elasticity of demand while selecting commodities for tax. Tax imposition on commodities for getting substantial revenue becomes worthwhile only if the taxed goods have an inelastic demand. Taxes are levied on commodities which has inelastic demand like cigarettes, wine, sugar etc.

Practical Applications of Price elasticity

3.In International Trade

Elasticity is important in formulating export and import policies of a country. The relative elasticity's of demand for commodities in the two countries are very important. Export those commodities which are inelastic in the international market.

Practical Applications of Price elasticity

4.To Trade Unionists Useful to trade unions in wage bargaining.
The union leaders, when they find that demands for their industrys product is fairly elastic, will ask for a higher wage to workers and use the producer to cut the price and increase sales which will compensate for his loss in total profit.

Thank You