Elasticities of

Demand

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An elasticity measures the sensitivity of one variable to another.
Specifically it is a number that tells us the percentage/proportionate
change that will occur in one variable in response to a 1% increase in
another variable.

The proportionate change in a variable is just the absolute change in a

variable divided by the original level of the variable.

There are as many elasticities of demand as its determinants. The most

important of these elasticities are

 the price elasticity

 the income elasticity

 the cross-elasticity
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Price Elasticity of Demand

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Price elasticity of demand is a measure of responsiveness of demand to changes in
the commodity’s own price. If the changes in the price are very small, we use point
price elasticity of demand.

If the changes in price are not small, we use the arc elasticity of demand as the
relevant measure.

It is defined as the proportionate change in quantity demanded resulting from a very

small proportionate change in price. So

dQ dP P dQ
ep  / 
Q P Q dP

The price elasticity of demand is usually a negative number. When price of a good
increases, the quantity demanded usually falls. Thus dQ/dP is negative as in ep. In
order to avoid dealing with negative values, a minus sign is often introduced into the
formula for ep

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When the price elasticity is greater than one, we say that demand is price elastic
because the percentage decline in quantity demanded is greater than the percentage
increase in price. If the price elasticity of demand is less than 1 in magnitude,
demand is said to be price inelastic.

From the above equation, we can say that price elasticity of demand is the change
in quantity associated with the change in price (dQ/dP) times the ratio of price to
quantity (P/Q).

But as we move down the demand curve, dQ/dP may change, and the price and
quantity will always change. Therefore, price elasticity of demand must be
measured at a particular point on a demand curve and will generally change as we
move along the curve.

Whenever the demand function is linear, the point elasticity formula appears almost
too simple because the first derivative of the equation with respect to P is constant.
From the practical standpoint, there is really no need to use calculus for finding the
point elasticity of a linear demand function.
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 Other method to Determine Price Elasticity

What we have explained is the percentage/proportionate method of

measurement of price elasticity of demand. There is also another
method to measure price elasticity of demand. This is known as total
expenditure method or Total revenue method. The elasticity for a good
and the total expenditure made on the good are greatly related to each
other. From the changes in the total expenditure made on a good as a
result of changes in the price, we can know the elasticity for a good.

But it should be remembered that with the total expenditure method

we can know only whether elasticity is equal to 1, greater than 1 or
less than 1. With this method we can not find out the exact and precise
coefficient of elasticity.
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Unit Elasticity (ep=1): When as a result of the changes in price of a good
quantity demanded of the good increases so much that the total expenditure made on
good remains the same, the ep for the good is equal to unity. This is because total
expenditure made on a good can remain same only if the % change in quantity
demanded is equal to % change in price.

ep>1: When due to fall in price the quantity demanded of a good increases so
much that the total expenditure made on the good increases, the ep will be greater
than unity. It should be carefully noted that when due to the rise in price the total
expenditure on the good declines, ep will be greater than 1. It is because increase in
Total Expenditure (TE)/ Total Revenue (TR) as a result of fall in price and decrease
in Total Expenditure (TE)/Total Revenue (TR) as a result of rise in price are the
same thing.

P (TR and TE)

OR ep  1
P (TR and TE)
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ep <1: If as a result of fall in price of a good, The Total Expenditure (TE)/ Total
Revenue (TR) on it decreases , the ep is less than 1. Due to rise in price if Total
Expenditure (TE) / Total Revenue (TR) made on the good increases, ep is less than
one.

P (TR and TE)

OR ep  1
P (TR and TE)

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ILLUSTRATION

Price of a Quantity TR or TE ep Problem 1: Suppose ep is 1 and at

Pen Demanded (P*Q) Rs.15/litre an individual consumes 80
(P) (Q) liters of petrol in a week. How much
5.00 30 150 ----- price of petrol should be fixed so that he
demands 60 liters of petrol? Use the
4.75 40 190 >1 expenditure method.
4.50 50 225 >1
4.25 60 255 >1 Problem 2: Suppose price of a
4.00 75 300 >1 commodity rises from Rs.15 to Rs.16 per
unit. As a result its quantity demanded
3.75 80 300 1
falls from 100 units to 80 units. Find out
3.50 84 294 <1 price elasticity coefficient by
3.25 87 282.75 <1 expenditure method.

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 The Basic determinants of Price Elasticity of
Demand are

The availability of Substitutes. If the price of a commodity for which close

substitutes are available goes up, the people will shift to its close substitutes
and as a result, the demand for that commodity will greatly decline. The
greater the possibility of substitution, the greater the price elasticity demand
for it.

The nature of the need that the commodity satisfies. (Luxury is price elastic;
necessity is price inelastic). There are inconsistencies because one person’s
luxury is another person’s necessity. Ex: Demand for Mercedez Autos.c

Time period. The demand is more elastic in the long-run. This is because
consumers can substitute goods in the long-run. In the short-run, substitution
of one commodity by another is not so easy.

If the price of fuel oil rises, it may be difficult to substitute fuel oil by other
types of fuels such as coal or cooking gas. But given sufficient time, people
will make adjustments and use coal or cooking gas instead of fuel oil whose
price has risen.
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The number of uses to which a commodity can be put. The more the possible
uses, the greater is price elasticity.

Milk has several uses. If its price rises to high level, it will be used only for
essential purposes such as feeding the children and for seek persons. If the price
of milk falls, it will be devoted to other uses as preparation of curd, cream, ghee
and sweets. Therefore, demand for milk tends to be elastic.

The proportion of income spent on a particular commodity. The greater the

proportion of income spent on a commodity, the greater will be its elasticity of
demand and vice-versa.

Addiction (Inelastic Demand)

Price Expectations

Durability of the Product: Possibility of postponing purchase, Possibility of

repair, used Product market cause the elasticity to increase.
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 Empirical Studies on Price Elasticity

 A study of the demand for coffee estimated the price-elasticity to be -0.2 in the
short-run and -0.33 in the long-run.

 Meals (excluding alcoholic beverages) purchased at restaurants have a high

demand elasticity of -2.27

 A study of the demand for kitchen and other household appliances stated that
the elasticity was -0.63.

 The price elasticity of beer has been estimated at -0.84 and of wine at -0.55.

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Problem

Point Px Qx
Calculate Point elasticity when moving from
A 8 0
(i) B to D
B 7 1000
(ii) D to B
C 6 2000
Calculate arc elasticity also.
D 5 3000
F 4 4000
G 3 5000
H 2 6000
L 1 7000
M 0 8000

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Problem
Calculate point and arc price elasticity when moving from (C to F) and (F to C).

Point Px Qx
A 7 500
B 6 750
C 5 1250
D 4 2000
F 3 3250
G 2 4750
H 1 8000

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Problems

** The demand law is given by

x=10-P, near the point x=4 and P=6.

If the price increases by 5%, determine the % decrease in demand and hence an
approximation to the elasticity of demand .

Compare the result with the current value of elasticity of demand corresponding to x=4.

** Consider the competitive market for which the quantities demanded and supplied
(per year) at various prices are given as follows
(a) Calculate price elasticity of demand when price
Price Demand Supply is 80 and price is 100.
60 22 14 (b) What is the equilibrium quantity?
80 20 16 (c) Suppose Govt. sets a price ceiling of Rs.80.
Will there be a shortage and if so how large will
100 18 18 it be?
120 16 20 (d) Calculate price elasticity of supply when the
price is 80 and the price is 100. 15
Income Elasticity of Demand

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The income elasticity is defined as the proportionate change in the quantity
demanded resulting from a proportionate change in income. Symbolically

dQ / Q Y dQ
ey   
dY / Y Q dY

It is a measure of the percentage change in quantity demanded resulting from a 1

percent change in income.

As before, we turn to arc elasticity for the actual calculation of income elasticity

(Q2  Q1 ) (Y2  Y1 )
EY  
(Q2  Q1 ) / 2 (Y2  Y1 ) / 2

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Income elasticity of demand being 0 is of great significance. It implies
that a given increase in income does not at all lead to any increase in
quantity demanded of a good or expenditure on it. It is significant
because it represents dividing line between positive income elasticity
and negative income elasticity.

When income elasticity is more than 0 (positive), then an increase in

income leads to the increase in quantity demanded of the good. This
happens in case of Normal Goods.

When income elasticity is less than 0, increase in income will lead to

the fall in quantity demanded. Goods having negative elasticity are
called Inferior Goods. These goods will be demanded by the
consumers whose incomes are low: but as income rises, and
consumers feel “better off”, they will shift consumption to goods more
commensurate with their new economic status.
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A commodity is considered to be a Luxury, if its income elasticity is
greater than unity. These commodities take larger proportion of
consumer’s income as income increases.

A commodity is a Necessity, if its income elasticity is small (less than

unity usually)

The three categories are

Income Elasticity>1: Superior goods/ Luxury goods

Income elasticity≥ 0 and ≤ 1: Normal goods
Income Elasticity<0: Inferior Goods

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 Determinants of Income Elasticity

 The nature of the need that the commodity covers: the percentage
of income spent on food declines as income increases. (Engel’s
Law)

The initial level of income of a country: Forexample, a TV set is

luxury in an underdeveloped, poor country while it is a “necessity”
in a country with higher per capita income.

The time period, because consumption patterns adjust with a time-

lag to changes in income.

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 Empirical Studies on Income Elasticities

Short-run income elasticity for food expenditure has been estimated to be about
0.5 and the elasticity of restaurant meals 1.6. The results show that as incomes rise,
spending for food eaten at home increases at a slower rate than income, and, thus,
takes up a smaller portion income. In contrast, the expenditure on restaurant meals
rises substantially more rapidly as income rises, thus becoming a higher portion of
income.

The short-run income elasticity for jewelry and watches appeared to be 1.;
however, the elasticity in the long-run was estimated at 1.6. Apparently, consumers
take some time to adjust their demand.

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Cross-Price Elasticity of Demand

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The cross-elasticity of demand is defined as the proportionate change
in the quantity demanded of x resulting from a proportionate change
in the price of y. It is actually the impact on the quantity demanded of
a particular product created by a price change in a related product.
Symbolically,

dQx dPy dQx Py

exy ( )/  
Qx Py dPy Qx
Again, we run into a little problem regarding the P and Q in the above
expression and arc elasticity comes to the rescue.

(Q2 A  Q1 A ) ( P2 B  P1B )
Exy  
(Q2 A  Q1 A ) / 2 ( P2 B  P1B ) / 2
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What is the meaning of related products? In economics, we talk of two
types of relationships: substitute goods and complementary goods.

Much of the time when we consider cross-elasticity we are dealing

with similar products (not just different brands of the same product) in
a more general sense. Thus chicken and beef can be considered to be
substitutes. Sign of cross-elasticity is positive in this case.

Other instances of substitutes come to mind easily: coffee and tea,

aluminum and steel, glass and plastic.

Complements are products that are consumed or used together. Sign of

cross-elasticity is negative in this case.

Examples of complementary products are: tennis racket and tennis

balls, stereo sets and CDs, personal computer and floppy disks. 24
Problem

Calculate Cross elasticities (exy in the first case and exz in the second case)

Before After
Commodity Price Quantity Price Quantity

Coffee (Y) 40 50 60 30

Tea (X) 20 40 20 50

Before After
Commodity Price Quantity Price Quantity

Lemon (z) 10 20 20 15

Tea (x) 20 40 20 35
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 Empirical Studies on Cross-elasticity

A study of the residential demand for electric energy found the

cross-elasticity with respect to prices of the gas energy to be low,
about +0.13.

Aluminum’s cross-elasticity of demand with respect to prices of

steel was estimated at about +2.0, and even somewhat higher with
respect to copper.

The cross-elasticity of demand for beef with respect to pork prices

was calculated to be +0.25. With respect to prices of chicken, it was
about +0.12. Both numbers indicate that products are substitutes,
but in this study, the elasticity coefficients were relatively low.

The cross-elasticity for domestic and imported cigarettes in Taiwan

is a +2.78, indicating that they are substitutes.
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