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Elasticity of Demand

# Elasticity of Demand

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01/08/2013

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1ASSINGMENT:
A.
Define the concepts of ‘Own Price Elasticity of Demand ‘, ‘Cross PriceElasticity of Demand’ and ‘Income Elasticity of Demand’.SOLUTION:
Elasticity of demand measures the extent to which the quantity demanded of acommodity increases or decreases in response to increase or decrease in any of its quantitative determinates. As we know that, demand for the commoditymainly depends upon its price, income of the consumer or price of related goods. Thus, by elasticity of demand, we mean the extent to which the quantitydemanded of a commodity changes with change in its price or income of theconsumer or price of related goods.In the words o
Dooley
,
“the elasticity of demand measures theresponsiveness of the quantity demanded of a good, to change in its price, price of other goods and changes in consumer’s income.”
Accordingly, elasticity of demand can be of three types:
1.Price elasticity of Demand (Own Elasticity of Demand)2.Income Elasticity of Demand3.Cross elasticity of DemandPrice (Own) Elasticity of Demand:
Price elasticity of demand is defined as
the percentage change in quantitydemanded of a product due to the percentage change in its price, otherthings remaining constant
. It can also be denoted as:
E
p
= Percentage change in quantity demanded / Percentage change inprice
Assume that the demand for petrol reduces by 2% as a result of an increase inpetrol prices by 10%. The price elasticity of demand for petrol is:Sujeet Kumar | MBA 1
st
SemesterRoll No 25

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2-2% / 10% = - 0.20
Let us assume that a wholesaler of biscuits knows that the price elasticity of demand for biscuits remains unchanged at -1.5. The price of the biscuit increasesby 20%. We can determine the decrease in quantity demanded due to theincrease in price.
Percentage change in quantity demanded = -1.5 * 20% = -30%Income Elasticity of Demand:
An increase in real income increases the demand for products, other factorsremaining the same.
Income elasticity of demand for a product is thepercentage change in demand for that product divided by thepercentage change in the consumer’s income (d Y)
. The income elasticityof demand of a product X can be mathematically denoted as:
E
Y
= (% change in the quantity demanded of product X) / (% change inthe income of the consumer)= (dQ
X
/Q
X
) / (dY/Y)= (dQ
X
* Y) / (dY/Q
X
)
Products and services with
income elasticity above one
are called
IncomeElastic
. For example, air travel, restaurant meals, movies, and otherentertainment are services on which people spend a lot with an increase inincome. Products and services with
income Elasticity between zero and one
are called
inelastic goods
. For example, in developed countries like the US,clothing, alcoholic beverages, and newspapers are examples of products forwhich a rise in income generates little additional consumption. The demand forcertain products and services reduces when there is an increase in income. These are known as
inferior products
having
negative income elasticity
.Examples of inferior products are low-end brands of household products andcoarse cereals.Sujeet Kumar | MBA 1
st
SemesterRoll No 25

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3Cross Elasticity of Demand:
Cross Elasticity of Demand is
the ratio of percentage change in thequantity demanded for one product to a percentage change in the priceof another related product, other factors remaining constant.

Cross-price elasticity
can be
positive or negative
, based on the change in the priceof a substitute or complementary products. If the two products are
goodsubstitutes
, the value of cross-elasticity will be
positive
. If they are
complementary products
, the value of cross-elasticity of demand will be
negative
, because change in price of one product causes opposite change in thequantity demanded of the other product. For example, let us consider two closesubstitute products: Pepsi and Coke. If the price of Pepsi increases significantly,its consumers may switch to Coke. The change in the price of Pepsi and demandfor Coke are moving in the same direction and hence the cross elasticity ispositive. On the other hand, complementary products like tea and sugar havenegative cross elasticity. If the price of sugar increases, the demand of sugar aswell as tea comes down. Since the price of sugar increases while demand of teadecreases i.e. they move in opposite direction, their cross elasticity would benegative.Let us assume that the quantity demanded for two products X and Y are Q
1
andQ
2
and they are priced at P
1
and p
2
respectively. The cross elasticity of demandof product X is the percentage change in the quantity demanded due to thepercentage change in price. This can be mathematically denoted as:
E
cp
= (%change in the quantity demanded of product X) / (%change inthe price of product Y)= (dQ
1
/Q
1
) / (dP
2
/P
2
)= (dQ
1
* P
2
) / (dP
2
/Q
1
)
A.
Explain the importance of ‘Elasticity of Demand’.SOLUTION:
Sujeet Kumar | MBA 1
st
SemesterRoll No 25