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

 Price is most important among all the

independent variables that affect the demand for
any commodity.
 Hence price elasticity of demand ( “ep” or “e”) is
considered to be the most important of all types of
elasticity of demand.
 Price elasticity of demand means the sensitivity
of quantity demanded of a commodity to a given
change in its own price.
 Degrees of Price Elasticity
Slope of demand curve is used to display Price
price elasticity of demand
Perfectly elastic demand
 ep=∞ (in absolute terms). P D
 Horizontal demand curve
 Unlimited quantities of the commodity can
be sold at the prevailing price
O
 A negligible increase in price would result Q1 Q2 Quantity
in zero quantity demanded

 Perfectly inelastic demand D

 The other extreme of the elasticity range Price
 ep=0 (in absolute terms)
 Vertical demand curve P1
 Quantity demanded of a commodity
remains the same, irrespective of any P2
change in the price
 Such goods are termed neutral.
O
Q1 Quantity
 Degrees of Price Elasticity
Contd.
Highly elastic demand
 Proportionate change in quantity Price
D
demanded is more than a given change
in price P1
 ep >1 (in absolute terms) P2 D
 Demand curve is flatter
Unitary elastic demand O
Q1 Q2 Quantity
 Proportionate change in price brings
about an equal proportionate change in Price D
quantity demanded P1
 ep =1 (in absolute terms). P2
 Demand curves are shaped like a
rectangular hyperbola, asymptotic to the D
axes O
Q1 Q2 Quantity
Relatively inelastic demand
Price
 Proportionate change in quantity D
demanded is less than a proportionate
change in price P1
P2
 ep <1 (in absolute terms)
 Demand curve is steep
O D
Q1 Q2 Quantity
 Methods of Measuring Elasticity
 Ratio (or Percentage) Method
 The most popular method used to measure elasticity
 Elasticity of demand is expressed as the ratio of proportionate
change in quantity demanded and proportionate change in the
price of the commodity
 It allows comparison of changes in two qualitatively different
variables
 It helps in deciding how big a change in price or quantity is

Proportion ate change in quantity demanded of commodity X

ep =
Proportion ate change in price of commodity X
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…

 Point Elasticity Method

 Elasticity measured at a point of demand curve is referred
as point elasticity of demand.
 For nonlinear demand curve we need to apply calculus
to calculate point elasticity.
 As changes in price become smaller and approach zero,
Q
the ratio P becomes equivalent to the first order
dQ
derivative of the demand function with respect to price dP
 Point elasticity can be expressed as:

ep dQ / Q dQ P
= = .
dP / P dP Q
 To find the derivative of Q w.r.t P (ie. dQ/dP) we need
algebraic expressionof the demand equation: Q= 18-P
 Data from the table:price (rs 18 to 5 ) and quantity (0 to 13
units)
 The derivative of Q w.r.t P is -1. thus point ed coefficient at
Rs 12 and 6 units is = -1 x 12/6= -2
 Whenever demand function is linear,the first derivative of the
equation with respect to P is a constant. The 1st derivative
dQ/dP is same as = ∆Q / ∆ P
 In cases where demand curve is non-linear, calculus must be
applied
Example
 Q=100 – P2
 Assuming P1=5 and Q=75,point ed is,
 =-2Px5/75
 =-2(5) x 5/75
 =-50/75
 =-0.67
 Q= 100 - P2,
 Assuming P1=5 Q =75,
 Point es = -2Px5/75
 = -2 (5)x5/75
 =-50/75
 -0.67
 ELASTICITIES OF SUPPLY AND DEMAND

Linear Demand Curve

● linear demand curve Demand curve that is a straight line.

Linear Demand Curve

The price elasticity of demand

depends not only on the slope
of the demand curve but also
on the price and quantity.
The elasticity, therefore, varies
along the curve as price and
quantity change. Slope is
constant for this linear demand
curve.
Near the top, because price is
high and quantity is small, the
elasticity is large in magnitude.
The elasticity becomes smaller
as we move down the curve.
Measurement of price elasticity at a point on the
demand curve
Measuring price elasticity at a point on the
demand curve by measuring the ratio of the
distances of lower segment and upper segment
is a popular method of measuring point price
elasticity on a demand curve.
Formula: lower segment/upper segment
(derivation in the class)
Elasticity at a Point on the Demand Curve
Price

ep = ∞
A

ep > 1

ep = 1

ep < 1

ep = 0

0
B
Quantity Demanded
 Methods of Measuring Elasticity
Contd…

 Arc Elasticity Method

 Used when the available figures on price and
quantity are discrete (large), and it is possible to
isolate and calculate the incremental changes.
 It is used to find the elasticity at the midpoint of an
arc between any two points on a demand curve, by
taking the average of the prices and quantities.
 This method finds wider applications, as it reflects a
movement along a portion (arc) of a demand curve
Q2  Q1 P2  P1
ep = (Q1  Q2 ) / 2 / ( P1  P2 ) / 2

Q2  Q1 P1  P2
= .
Q1  Q2 P2  P1
 Methods of Measuring Elasticity
Contd…
 Total Outlay Method (Marshall)
 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.
 Helps a seller in taking a decision to raise price only if:
 Reduction in quantity demanded does not reduce total
revenue or
 Reduction in price increases the quantity demanded to the
extent that total revenue also increases.
 Degrees
 When demand is elastic, a decrease in price will result in an
increase in the revenue (sales).
 When demand is inelastic, a decrease in price will result in
a decrease in the revenue (sales).
 When demand is unit-elastic, an increase (or a decrease) in
price will not change the revenue (sales)
Measuring elasticity by outlay method
Degree of Price QD (units) Total Outlay (rs)
elasticity

Highly elastic increased decreased decreased

(ep >1)
decreased increased increased

Unitary elastic increased decreased NO change

(ep =1)
decreased increased No change

Highly inelastic increased decreased increased

(ep <1)
decreased increased decreased
Price QD Total outlay Elasticity

6 200 1200

8 60 480 Ep >1

4 350 1400

6 200 1200

8 150 1200 Ep =1

4 300 1200

6 200 1200

8 180 1440 Ep<1

4 250 1000
Numericals
 Q1. The initial price of a cup of coffee is $1, and at that
price, 400 cups are demanded. If the price falls to $0.90,
the quantity demanded will increase to 500.
 a. Calculate the (arc) price elasticity of demand for
coffee.
 b. Based on your answer, is the demand for coffee
elastic or inelastic?
 c. Based on your answer to a., if the price of coffee is
increased by 10%, what will happen to the revenues
from coffee? Carefully explain how you know.
 Answer:
 a. Arc elasticity = -2.11
 b. Elastic
 c. Revenues will fall. Demand is elastic, and thus
a 1% increase in price will lead to a greater
percentage decrease in quantity demanded.
Revenues fall because the price increase does
not make up for the reduction in sales.
 Q2.The demand curve is: QD = 500 - 1/2 P.
 a. Calculate the (point) price elasticity of demand
when price is $100. Is demand elastic or
inelastic?
 b. Calculate the (point) price elasticity of demand
when price is $700. Is demand elastic or
 inelastic?
 c. Find the point at which point elasticity is equal
to -1.
 Answer:
 a. Elasticity = -1/2 (100/450) = -0.11, and
is inelastic.
 b. Elasticity = -1/2(700/150) = -2.5, and is
elastic.
 c. Elasticity is -1 at the midpoint of the
demand curve, which is at a price of $500
and a quantity of 250.
 Determinants of Price Elasticity of
Demand
 Nature of commodity
 Necessities are relatively price inelastic, while
luxuries are relatively price elastic
 Availability and proximity of substitutes
 Price elasticity of demand of a brand of a product
would be quite high, given availability of other
substitute brands
 Alternative uses of the commodity
 If
a commodity can be put to more than one use, it
would be relatively price elastic
 Determinants of Price Elasticity of
Demand Contd…

 Proportion of income spent on the commodity

 The greater the proportion of income spent on a commodity, the
more sensitive would the commodity be to price
 Reason is income effect
 Time
 Demand for any commodity is more price elastic in the long run
 Durability of the commodity
 Perishable commodities like eatables are relatively price inelastic
in comparison to durable items
 Items of addiction
 Items of intoxication and addiction are relatively price inelastic
 Income Elasticity of Demand (ey)
 ey measures the degree of responsiveness of demand
for a good to a given change in income, ceteris paribus.

Proportion ate change in quantity demanded of commodity X

ey =
Proportion ate change in income of consumer

Degrees:
 Positive income elasticity
 Demand rises as income rises and vice versa

 Normal good

 Negative income elasticity

 Demand falls as income rises and vice versa

 Inferior good
 Cross Elasticity of Demand

 ec measures the responsiveness of demand of

one good to changes in the price of a related
good
Proportion ate change in quantity demanded of commodity X
ec =
Proportion ate change in price of commodity Y

 Degrees
 Negative Cross Elasticity
 Complementary goods
 Positive Cross Elasticity
 Substitute goods
 Promotional Elasticity of Demand

 Advertising (or promotional) elasticity of demand (ea) measures the

effect of incurring an “expenditure” on advertising, vis-à-vis an
increase in demand, ceteris paribus.
 Some goods (like consumer goods) are more responsive to
advertising than others (like heavy capital equipments).

Proportion ate change in quantity demanded (or sales) of commodity X

ea =
Proportion ate change in advertisin g expenditur e
 Degrees
 ea>1
 Firm should go for heavy expenditure on advertisement.
 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.
 ELASTICITIES OF SUPPLY AND DEMAND

During recent decades, changes in the wheat market had major implications for both
American farmers and U.S. agricultural policy.

To understand what happened, let’s examine the behavior of supply and demand beginning in 1981.

By setting the quantity supplied equal to the quantity demanded, we can determine the market-clearing
price of wheat for 1981:
 ELASTICITIES OF SUPPLY AND DEMAND

Substituting into the supply curve equation, we get

We use the demand curve to find the price elasticity of demand:

Thus demand is inelastic.

We can likewise calculate the price elasticity of supply:

P QS 3.46
EPS   (240)  0.32
Q P 2630
Because these supply and demand curves are linear, the price elasticities will vary as we move along
the curves.
 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Demand

Figure

(a) Gasoline: Short-Run and Long-Run Demand Curves

(a) In the short run, an increase in price has only

a small effect on the quantity of gasoline
demanded. Motorists may drive less, but they
will not change the kinds of cars they are driving
overnight.

In the longer run, however, because they will

shift to smaller and more fuel-efficient cars, the
effect of the price increase will be larger.
Demand, therefore, is more elastic in the long
run than in the short run.
 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Demand
Demand and Durability

(b) Automobiles: Short-Run and Long-Run Demand Curves

(b) The opposite is true for automobile demand. If price

increases, consumers initially defer buying new cars;
thus annual quantity demanded falls sharply.
In the longer run, however, old cars wear out and must
be replaced; thus annual quantity demanded picks up.
Demand, therefore, is less elastic in the long run than
in the short run.
2.5 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Figure 2.17

Price of Brazilian Coffee

When droughts or freezes

damage Brazil’s coffee trees, the
price of coffee can soar.
The price usually falls again
after a few years, as demand
and supply adjust.
2.5 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Figure 2.18

Supply and Demand for Coffee

(a) A freeze or drought in Brazil causes

the supply curve to shift to the left.
In the short run, supply is completely
inelastic; only a fixed number of coffee
beans can be harvested.
Demand is also relatively inelastic;
consumers change their habits only
slowly.
As a result, the initial effect of the freeze
is a sharp increase in price, from P0 to
P1.
2.5 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Figure 2.18

Supply and Demand for Coffee

(b) In the intermediate run, supply and

demand are both more elastic; thus price
falls part of the way back, to P2.
2.5 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Figure 2.18

Supply and Demand for Coffee

(c) In the long run, supply is extremely

elastic; because new coffee trees will
have had time to mature, the effect of
the freeze will have disappeared. Price
returns to P0.
Self study
 Significance of Elasticity of demand:
 Level of output and price
 Fixation of rewards for the factors of
production
 Government policies
 Demand forecasting
Note:Application for demand and supply
elasticity given in soft copy format