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Elasticity of Demand
Lecture plan
Objectives
Elasticity of demand
Price elasticity of demand
Degrees of price elasticity of demand
Methods of measuring elasticity
Revenue and price elasticity of demand
Income elasticity of demand
Cross elasticity of demand
Promotional elasticity of demand
Importance of elasticity
Objectives
To understand the meaning of responsiveness
of demand to changes in determinants of
demand.
To lay down the degrees of responsiveness of
demand.
To discuss various types of elasticities of
demand.
To learn how to measure elasticity by various
methods.
To understand the relevance and application of
elasticities of demand
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
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…
ep = dQ / Q dQ P
= .
dP / P dP Q
Methods of Measuring Elasticity
Contd…
Degrees:
Positive income elasticity
Demand rises as income rises and vice versa
Normal good
Inferior good
Cross Elasticity of Demand
Degrees
Negative Cross Elasticity
Complementary goods
Positive Cross Elasticity
Substitute goods
Promotional Elasticity of Demand
ea <1
Firm should not spend too much on advertisement
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.
Summary
Elasticity of demand measures the degree of responsiveness of the
quantity demanded of a commodity to a given change in any of the
independent variables that influence demand for that commodity.
Price elasticity of demand (ep) measures the degree of responsiveness
of the quantity demanded of a commodity to a given change in its price,
other things remaining the same.
By the percentage method ep is expressed as the ratio of proportionate
change in quantity demanded and proportionate change in price of the
commodity.
As per the total outlay method 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.
Arc elasticity is used to calculate price elasticity of demand at the
midpoint of an arc between any two points on the demand curve, by
taking the average of the prices and quantities; point elasticity can be
approximated by calculating the arc elasticity for a very small arc on the
demand curve.
Summary
If the demand curve is a straight line, price elasticity of demand at
different points of the demand curve can be calculated by the ratio
of the lower segment and upper segment of the demand curve.
MR= AR[1- ep]
Income elasticity of demand (ey) measures the degree of
responsiveness of the quantity demanded of a commodity to a
given change in consumer’s income. For normal goods ey is
positive; for neutral goods ey is zero; for inferior goods ey is
negative.
Cross elasticity of demand (ec) shows how changes in prices of
other goods would affect the demand for a particular good. For
substitutes ec is positive; and for complements ec is negative.
Advertising (or promotional) elasticity of demand (ea) measures the
effect of incurring an “expenditure” on advertising of a firm on the
demand for its product at constant price.
Elasticity is used for determination of right price by seller and for
taxation by government.