VARIOUS METHODS OF PRICE

ELASTICITY OF DEMAND

Submitted to

Ms. ANJU BATRA

(FACULTY, MBA)

Submitted by

MUHAMMAD SALIM
07217003909
MBA 1ST SEMESTER
PRICE ELASTICITY OF DEMAND

The relative response of a change in quantity demanded to a change in price. More specifically the price
elasticity of demand is the percentage change in quantity demanded due to a percentage change in price.
This notion of elasticity captures the demand side of the market. A comparable elasticity on the supply
side is the price elasticity of supply. Other notable demand elasticities are income elasticity of demand
and cross elasticity of demand.
The price elasticity of demand reflects the law of demand relation between price and quantity. An elastic
demand means that the quantity demandedis relatively responsive to changes in price. An inelastic
demand means that the quantity demanded is not very responsive to changes in price.

Suppose, for example, that the price of hot fudge sundaes increases by 10 percent (say $2.00 to $2.20).
The higher price is bound to cause the quantity demanded to decline. The price elasticity of demand
answers the question: How much? If the quantity demanded decreases by more than 10 percent (say
from 100 hot fudge sundaes to 50 hot fudge sundaes), then demand is elastic. If the quantity demanded
decreases by less than 10 percent (say from 100 hot fudge sundaes to 99 hot fudge sundaes), then
demand is inelastic.

A Summary Formula

The price elasticity of demand is often summarized by this handy formula:

percentage change in quantity demanded
price elasticity of demand =
percentage change in price

According to the law of demand, higher demand prices are related to smaller quantities demanded. As
such, the numerator and denominator of this formula always have opposite signs--if one is positive, the
other is negative. If the demand price increases and the percentage change in price is positive, then the
quantity demanded decreases and the percentage change in quantity demanded is negative. When
calculated, the price elasticity of demand, therefore, is always negative.

However, it is often convenient to ignore the negative sign when evaluating the relative response of
quantity demanded to price. For example, quantity demanded is very responsive to price if a 10 percent
increase in price induces a 50 percent decrease in quantity demanded. This generates a large "negative
number," which is actually a small "value." To avoid the possible confusion over a big number being a
small value, the negative value of the price elasticity of demand is generally ignored and focus is placed
on the absolute magnitude of the number itself.

Slope and Elasticity

The price elasticity of demand is related to, but different from, the slopeof the demand curve. Consider the
formula for calculating the slope of the demand curve.
Change in price
slope =
Change in quantity demanded

Now consider the formula for calculating the price elasticity of demand.

percentage change in quantity demanded

price elasticity of demand =
percentage change in price

The key differences between these are:

• First, price is in the numerator and quantity is in the denominator for slope. In contrast, quantity is
in the numerator and price is in the denominator for elasticity. At the very least, slope is the
inverse of elasticity. When one is bigger the other is smaller.
 • Second, slope is calculated using the measurement units for price and quantity. In contrast,
elasticity is calculated using percentage changes. As such, slope includes the measurement units
(such as dollars per hot fudge sundae), whereas elasticity is just a number with no measurement
units. The value of slope changes if the measurement units change (such as cents versus
dollars). Not so for elasticity. Elasticity is in relative values not absolute measurement units.

Three Determinants

Three factors that affect the numerical value of the price elasticity of demand are the availability of
substitutes, time period of analysis, and proportion of budget. A given good can have a different price
elasticity of demand if these determinants change.

• Availability of Substitutes: The ease with which buyers can find substitutes-in-
consumption affects the price elasticity of demand. The general rule is that goods with a greater
availability of substitutes is more sensitive to price changes. With more substitutes available,
buyers can easily respond to price changes. Consider, for example, Auntie Noodles Frozen
Macaroni Dinner, an enjoyable, nutritious, and satisfying meal. Unfortunately for the Auntie
Noodles company, it is one of thousands of comparable food products on the market. The
number of available substitutes makes the price elasticity of demand extremely elastic.
• Time Period of Analysis: The longer the time period of analysis, the more responsive quantities
are to price changes. Brief periods do not allow buyers the time needed to adjust their
consumption decisions to price changes. Buyers need time to find substitutes-in-consumption.
Longer time periods allow buyers the time needed to find alternatives. For example, the demand
for 4M Cable Television is not very elastic. Given the lack of close substitutes, buyers continue to
buy even though prices rise, especially for brief periods like a few months. However, given
enough time (years? decades?) buyers are able to seek out alternatives such as satellite dishes,
and thus change their quantity demanded of cable television, resulting in a more elastic demand.
• Proportion of Budget: The price elasticity of demand depends on the proportion of the budget
that buyers devote to a good. The rule is this: The larger the portion, the more responsive
quantity demanded is to price changes. A house, for example, is a BIG budget item for most
normal human beings. A relatively small change, say 1 percent on a $100,000 house, can make a
BIG difference in the buyer's decision to buy. As such, relatively small changes in price are likely
to induce relatively large changes in quantity demanded.

MEASUREMENT OF ELASTICITY OF DEMAND

1) PERCENTAGE METHOD

The credit for measuring the elasticity of demand by this method goes to Flux. That is why, it is
sometimes called Flux’s percentage method. According to this method, elasticity of demand is the ratio of
the percentage (or proportionate) change in quantity demanded to a percentage (or proportionate)
change in its price.

percentage change in quantity demanded

price elasticity of demand =
percentage change in price

Proportional change in quantity can be expressed as where q1 is the initial and q2 is the new
quantity demanded.
Proportional change in price is similarly & where P1 is initial and P2 is the new price.

Elasticity ratio e is therefore,

If symbols q and P are used for small variations in quantity and price respectively then,

Note that Dq / Dp is in the limit derivative or marginal change and p/q is the reciprocal of average change,
therefore

Let’s illustrate this. In our demand schedule example above, when price changes from 2 to 3 units, the
quantity demanded changes from 4 to 1 units. Substituting these values we have:

Alternative Coefficient (E)

Perfectly Elastic E=∞

Relatively Elastic 1<E<∞

Unit Elastic E=1

Relatively Inelastic 0<E<1

Perfectly Inelastic E=0

A Range of Elasticity

The price elasticity of demand is commonly divided into one of five elasticity alternatives--perfectly
elastic, relatively elastic, unit elastic, relatively inelastic, and perfectly--depending on the relative response
of quantity to price. These five alternatives form a continuum of possibilities.

The chart to the right displays the five alternatives based on the coefficient (E). The negative value
obtained when calculating the price elasticity of demand is ignored.
 • Perfectly Elastic: The top of the chart begins with perfectly elastic, given by E = ∞. Perfectly
elastic means an infinitesimally small change in price results in an infinitely large change in
quantity demanded.
• Relatively Elastic: The second category is relatively elastic, in which the coefficient of elasticity
falls in the range 1 < E < ∞. With relatively elastic demand, relatively small changes in price
cause relatively large changes in quantity. Quantity is very responsive to price. The percentage
change in quantity is greater than the percentage change in price. Here a 10 percent change in
price leads to more than a 10 percent change in quantity demanded (maybe something 20
percent).
• Unit Elastic: The third category is unit elastic, in which the coefficient of elasticity is E = 1. In this
case, any change in price is matched by an equal relative change in quantity. The percentage
change in quantity is equal to the percentage change in price. For example, a 10 percent change
in price induces a equal 10 percent change in quantity demanded. Unit elastic is essentially a
dividing line or boundary between the elastic and inelastic ranges.
• Relatively Inelastic: The fourth category is relatively inelastic, in which the coefficient of elasticity
falls in the range 0 < E < 1. With relatively inelastic demand, relatively large changes in price
cause relatively small changes in quantity. Quantity is not very responsive to price. The
percentage change in quantity is less than the percentage change in price. In this case, a 10
percent change in price induces less than a 10 percent change in quantity demanded (perhaps
only 5 percent).
• Perfectly Inelastic: The final category presented in this chart is perfectly inelastic, given by E =
0. Perfectly inelastic means that quantity demanded is unaffected by any change in price. The
quantity is essentially fixed. It does not matter how much price changes, quantity does not budge.

2) TOTAL OUTLAY METHOD

Total outlay method refers to the total expenditure on the good after its price Changes.
Total outlay is obtained by multiplying the number of units sold by the price of a product
i.e. (Total revenue = Total unit sold X price)

Sr. Price (Rs.) Quantity of Total outlay Price elasticity

mangoes of demand
demanded in
 No. units

I 15 200 3000 Ep > 1

12 300 3600

II 15 200 3000 Ep= 1

12 250 3000

III 15 200 3000 Ep < 1

12 210 2520

Ep >1 if total outlay of a commodity increases after a fall in price of a commodity then price
elasticity of demand is elastic. Price elasticity is grater than one over PQ range of the curve.

Ep=1 if total outlays remains constant, even after a fall in price of commodity, then, it is the case
of unit elastic demand, price elasticity or demand over QR range of the curve is equal to one.

Ep < 1 if the total outlay decreases, after a fall in price then the elasticity of demand is less than
one. Price elasticity is less than one over RS range of demand curve.

3) POINT METHOD

When we measure elasticity of demand at a point on linear demand curve which intersects both
axes, it is linear demand curve which measuring elasticity of demand. The demand curve has a
negative slops but price elasticity varies from point to point.

Ep = Lower segment of demand curve

Upper segment of demand curve

D1 D2 is straight line demand curve. When price decreases from OP1 to OP2 demand extends from O
Q1 to O Q2. Let us consider two points on demand curve i.e M1 and M2 to measure elasticity of demand
through point method.

Ep = proportionate change in demand = ∆Q X P

Proportionate change in price ∆P Q

In This fig

Ep = Q1 Q2 X OP1 (1)

P1 P2 OQ1

As per the fig. q1q2 = NM2, P1P2 = M1 N, OP 1= M1Q1, OQ1 = P1M1

EP= NM2 X M1Q1

M1N OQ1 (2)

Hence, NM2 = Q1D2

M1N M1Q1

Substitute, Q1D2 in place of NM2 in equation (2)

Q1M1 M1N

We get Ep= Q1D2 X M1Q1

M1Q1 OQ1

EP = Q1D2

OQ1

Now OQ1 is equal to P1M1 then Ep= Q1D2

P1M1
Taking Q1D2 and P1M1 as the base we have tow triangles ∆ P1M1D1 and ∆ Q1D2M1 by geometrical
rules these tow triangles are equal. Therefore their sides are proportionate

We can state Ep= Q1D2 = M1Q1 = M1D2

P1M1 P1D1 M1D1

Ep= M1 D2 = Lower segment of he demand of point M1

M1D1 Upper segment of the demand of point M1

Elasticity of point M1 = M1D2

M1D1

Thus elasticity of demand varies from point to point on a straight line demand curve. Elasticity will
gradually decrease as we move towards D2 as the lower segment will become smaller.

4) ARC METHOD

Are elasticity of demand measures the price elasticity of demand over a range on the demand curve
rather than a point on demand curve. In reality we often come across a situation where price changes are
substantial.

If price of commodity X is Rs. 5 then 500 units of X goods are sold. When price falls to Rs. 4 the 700
units are sold. Arc elasticity of demand is worked as under
IMPORTANCE OF ELASTICITY OF DEMAND FOR THE MANAGERS

There is need to understand price elasticity of demand for the goods they sell in order to decide on
optimal pricing policy. If demand were relatively elastic, the firm would know that lowering the price would
expand the volume of sales thus increasing total revenue. On the other hand, if demand were relatively
inelastic the firm could increase the price, which would also lead to an increase in total revenue.
Awareness of the elasticity of demand in different price ranges is important for determining the best
pricing policy and in deciding whether to change prices. To that extent, business often engage in
statistical market research in order to determine consumer preferences, and in particular, the price
elasticity of demand for the product.

Price elasticity of demand describes the way in which the demand for a product response to a change in
its price. If small change in price leads to a large change to a demand, a product is said to be highly price
elastic. Many consumer goods such as calculators, DVD players and washing machine are price elastic. If
the demand for a product shows little response to change in price, the product is said to be price inelastic.
Essential goods such as basic foods (e.g. bread, medicine) and fuel tend to be price inelastic.

Regarding the importance of the concept of elasticity of demand, it must be pointed out that the concept is
useful to the business managers as well as government managers. Elasticity measures help the sales
manager in fixing the price of his product. The concept is also important to the economic planners of the
country. In trying to fix the production target for various goods in a plan, a planner must estimate the likely
demand for goods at the end of the plan. This requires the use of income elasticity concept.

The price elasticity of demand as well as cross elasticity would determine the substitution between goods
and hence useful in fixing the output mix in a production period. The concept is also useful to the policy
makers of the government, in particular in determining taxation policy, minimum wages policy,
stabilization programmer for agriculture, and price policies for various other goods (where administered
prices are used).
The managers are concerned with empirical demand estimates because they provide summary
information about the direction and proportion of change in demand, as a result of a given change in its
explanatory variables. From the standpoint of control and management of external factors, such empirical
estimates and their interpretations are therefore, very relevant.

In market economics consumer can exercise their rights to buy whatever they want however consumer
will only purchase certain goods in certain quantities at certain prices, if there is price change, quantity
demanded will adjust correspondingly. This is where price elasticity of demand comes in, measuring the
responsiveness of the quantity demanded to changes in price using methods such as the total outlay
method. Finally, this information is important to business, which need to find their optimal pricing policy in
order to achieve their goal of business of maximize the profits.