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ELASTICITY OF DEMAND

ELASTICITY OF DEMAND 

 Elasticity is the proportional (or percent) change in one


variable due to the proportional change in another
variable. The formula for elasticity is:
   E = percentage change in X / percentage change in Y
 Elasticity can either be a positive or a negative value.
 When the proportional change in one variable is equal to
the proportional change in the other variable, then it is
called Unit Elasticity. It can be represented as E = 1.
 Elasticity can be relatively elastic (E >1), when the
proportional change in x is greater than the proportional
change in y.
 Elasticity can be perfectly inelastic (E = 0), when any
change in y will have no effect on x.
 Elasticity can be infinity (E = infinity) or perfectly elastic
when a change in y will have infinite effect on x.
 Elasticity can be less than one (E < 1) i.e., relatively
inelastic when the proportional change in x is less than
the proportional change in y.

price elasticity of
demand
 The price elasticity of demand
measures the responsiveness of
the quantity demanded of a good
or services to a change in the price
of the good or service. The price
elasticity of demand is defined as
the magnitude (absolute value) of
the percentage change in the
quantity demanded divided by the
percentage change in the price.
Elasticity and Revenue

 Whether a change in the price of the good


raises, does not change, or lowers the sellers'
total revenue depends on the elasticity of
demand.
 If the demand for the good is elastic, a rise in
its price lowers total revenue.
 If the demand for the good is unit elastic, a rise
in its price does not change total revenue.
 If the demand for the good is inelastic, a rise in
its price raises total revenue.
 The total revenue test uses the relationships
between the price elasticity of demand and
the change in total revenue to determine
whether demand is elastic, inelastic, or unit
elastic by examining how total revenue
changes in response to a change in the price
What determines the size
of Elasticity of Demand?
 The magnitude of the elasticity of demand for a good
depends on four factors:
 Closeness of substitutes. The more readily other goods
can be substituted for the product under study, the
larger is the product’s elasticity of demand. Necessities
generally have fewer substitutes and have an inelastic
demand; luxuries often have many substitutes, so their
demand frequently is elastic.
 The proportion of income spent on the good. The
greater the proportion of income spent on a good, the
larger is its elasticity of demand.
 The significance of price in total cost to the consumer.
 The time elapsed since a price change. In general, the
more time that has elapsed since a price change, the
larger is the elasticity of demand. Distinguishing
between two time frames, the short-run demand and the
long-run demand, is useful.
 The short-run demand shows the initial response of buyers
to a change in price and is often inelastic.
 The long-run demand describes the response of buyers to
a price change after all adjustments have been made
Application of price
elasticity of demand
 Pricing decisions of business organizations: 
 Before taking any decision regarding pricing of a
product, a business organization has to consider the
price elasticity of demand for that product. The reason
to consider price elasticity is because the change in
the price of product would change the quantity
demanded of that product depending on its coefficient
of price elasticity.
 Pricing regulation by governments: In many
countries, the government fixes the price of some
products. Prominent among such products are
agricultural products, demand for which is highly
inelastic in nature. By restricting the supply of
agricultural products, governments can raise these
product prices. Demand for these products being
inelastic, even after a rise in the price consumers will
not reduce consumption. Hence, the expenditure of
consumers on agricultural products will increase, and
this in turn will increase the income of agriculturists. 
 ‘Paradox’ of plenty: In agricultural sector, the theory
of price elasticity explains the ‘paradox’ of plenty.
An increase in the supply of crops as a result of
good harvest season leads to a fall in their prices.
As a result, the income of farmers falls and
sometimes they are unable to meet their
expenditures on crop production. Hence, to ensure
that farmers do not lose during the time of
overproduction of crops, the government declares
the minimum price for crops. Minimum price is the
price at which the government is prepared to buy
the crops from the farmers. 
 Use in international trade: Price elasticity of demand
plays an important role in international trade. In
case a country faces a poor balance of payments
position due to rising imports and stagnant exports,
the government of that country has to decide
whether to devalue its currency or not. Here, the
price elasticity of demand should be taken into
 Fiscal policy: If the government wants to raise its
income through fiscal policies, price elasticity plays
a major role. The government mainly raises its
income through imposing taxes. Taxes are of two
types – direct and indirect. Usually the government
tries to raise income through indirect taxes such as
excise duty or sales tax, which raises the price of
the product being sold in the market. Here, the
analysis of price elasticity plays a crucial role. For
example, if the government is increasing the tax on
an elastic good, its price will increase. The rise in
price reduces the demand for that commodity,
which in turn will not help the government to
increase its revenue. The government can increase
its revenue through increasing indirect taxes only
when they impose taxes on those products whose
demand is inelastic. 
income elasticity of
demand
 The income elasticity of demand measures how the
demand for a good responds to a change in income. The
income elasticity of demand is defined as the
percentage change in the quantity demanded divided by
the percentage change in income,.

 ηy= % of ∆ demand / % of ∆ income


 If the income elasticity exceeds 1, an increase in income


increases demand more than proportionally. Luxuries
often have income elasticities of demand that exceed 1.

 If the income elasticity is positive but less than 1, an
increase in income increases demand but by a smaller
proportion. Necessities frequently have positive income
elasticities of demand that is less than 1.

 If the income elasticity is negative, an increase in income
decreases the demand for the good.
  
income elasticity of
demand
 The income elasticity of demand is positive
for normal goods. For a normal good, as
income increases, the quantity demanded
increases. The income elasticity of
demand is negative for inferior goods. For
an inferior good, as income increases, the
quantity demanded decreases.
 The level of income influences the
magnitude of the income elasticity of
demand because what is a necessity and
what is a luxury depend on the level of
income. When people have very low
incomes, food can be a luxury, but for
people with high incomes, food is a
necessity. As income increases, the
Application of income
elasticity of demand 
 In developing countries like India, having scarce resources,
income elasticity of demand helps firms to decide what to
produce. Normally, developing economies face frequent
fluctuations in business cycle. The demand for luxury products
fluctuates very much during different phases of business
cycles. During boom period, demand for luxury products
increases significantly and declines sharply during
recessionary period. Taking into account the income elasticity
of a product, managers of a firm can decide what to produce.
The firms producing products, which have a high income
elasticity, have great potential for growth in a growing
economy. For example, if a firm’s product income elasticity of
demand is greater than one, it means that it will gain more
than proportionately to the increase in national income. Hence,
firms producing products having high-income elasticity are
more interested in forecasting the level of national income.
The concept of income elasticity of demand also helps a firm to
decide its location and to develop its marketing strategies. For
example, the firms producing products having high-income
cross elasticity of
demand
 The cross elasticity of demand
shows how the demand for a good
responds to a change in the price of
another product. The cross elasticity
of demand equals the percentage
change in the quantity demanded of
the good divided by the percentage
change in the price of the other
good.
 ηx= % of ∆ demand of A / % of ∆
 When the cross elasticity of demand
is positive, the goods are
substitutes. The increase in the
price of a good increases the
demand for its substitutes. When
the cross elasticity of demand is
negative, the goods are
complements. The increase in the
price of a good decreases the
demand for its complements.
Application of cross
elasticity of demand
 The knowledge of cross elasticity of demand is very important in
managerial decision making for developing an appropriate
price strategy. Firms selling multiple products use cross
elasticity of demand to analyze the effect of change in the
price of one product to the demand of others. For example,
Hindustan Lever Limited (HLL), the leading fast-moving
consumer goods manufacturer offers several soaps for the
middle income segment – Hamam, Lux, Breeze, Liril, Lifebuoy
Gold, etc. These soaps are good substitutes for each other and
therefore cross elasticity of demand between them is high. If
HLL increases the price of Lux significantly, the demand for Lux
goes down while the demand for other soaps like Breeze or Liril
will increase. So considering the cross elasticity of demand,
HLL will be fixing appropriate prices for all its soaps. Thus,
cross elasticity of demand helps an organization to price its
products in such a way that any increase or decrease in the
price of a product should have positive influence on the
organization's profits.

 Firms producing similar kinds of product and services i.e.,
operating in same industry having a positive cross elasticity of
demand. For example, P&G and HLL are having a positive cross
elasticity of demand between each other in fabric and home
care products. Hence, if HLL plans to increase the price of Surf,
Advertising or Promotional
Elasticity of Demand

 Advertising includes visual and oral
promotional activities with an objective to
create new and increase existing demand
for a product or service. Advertising plays
an important role in the competitive
market economy. Advertising elasticity of
demand measures the extent of change
in the quantity demanded of a product to
change in expenditure on advertisements
and other promotional activities. The
demand for certain products is more
responsive to advertising e.g. cosmetics.
The advertising elasticity can be
measured by two methods – Point method
and Arc method. The point formula for