VARIOUS METHODS OF PRICE

ELASTICITY OF DEMAND
Submitted to
Ms. ANJU BATRA
(FACULTY, MBA)
Submitted by
MUHAMMAD SALIM
07217003909
MBA 1
ST
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 eample, that the price of hot fudge sundaes increases by !" percent #say $%."" to $%.%"&.
The higher price is bound to cause the quantity demanded to decline. The price elasticity of demand
answers the question' (ow much) *f the quantity demanded decreases by more than !" percent #say
from !"" hot fudge sundaes to +" hot fudge sundaes&, then demand is elastic. *f the quantity demanded
decreases by less than !" percent #say from !"" hot fudge sundaes to ,, hot fudge sundaes&, then
demand is inelastic.
A Summary Formula
The price elasticity of demand is often summari-ed by this handy formula'
price elasticity of demand .
percentage change in quantity demanded
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. *f 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. 0hen
calculated, the price elasticity of demand, therefore, is always negative.
(owever, it is often convenient to ignore the negative sign when evaluating the relative response of
quantity demanded to price. 1or eample, quantity demanded is very responsive to price if a !" percent
increase in price induces a +" percent decrease in quantity demanded. This generates a large 2negative
number,2 which is actually a small 2value.2 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. 3onsider the
formula for calculating the slope of the demand curve.
slope .
3hange in price
3hange in quantity demanded
4ow consider the formula for calculating the price elasticity of demand.
price elasticity of demand .
percentage change in quantity demanded
percentage change in price
The key differences between these are'
1irst, price is in the numerator and quantity is in the denominator for slope. *n contrast, quantity is
in the numerator and price is in the denominator for elasticity. At the very least, slope is the
inverse of elasticity. 0hen one is bigger the other is smaller.
Second, slope is calculated using the measurement units for price and quantity. *n contrast,
elasticity is calculated using percentage changes. As such, slope includes the measurement units
#such as dollars per hot fudge sundae&, whereas elasticity is 5ust a number with no measurement
units. The value of slope changes if the measurement units change #such as cents versus
dollars&. 4ot so for elasticity. 6lasticity is in relative values not absolute measurement units.
Tree 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.
A!aila"ility o# Su"stitutes' 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. 0ith more substitutes available,
buyers can easily respond to price changes. 3onsider, for eample, Auntie 4oodles 1ro-en
Macaroni 7inner, an en5oyable, nutritious, and satisfying meal. 8nfortunately for the Auntie
4oodles company, it is one of thousands of comparable food products on the market. The number
of available substitutes makes the price elasticity of demand etremely elastic.
Time Period o# Analysis' The longer the time period of analysis, the more responsive quantities
are to price changes. 9rief periods do not allow buyers the time needed to ad5ust their
consumption decisions to price changes. 9uyers need time to find substitutes/in/consumption.
:onger time periods allow buyers the time needed to find alternatives. 1or eample, the demand
for ;M 3able Television is not very elastic. <iven the lack of close substitutes, buyers continue to
buy even though prices rise, especially for brief periods like a few months. (owever, 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 o# $ud%et' 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 eample, is a 9*< budget item for most normal
human beings. A relatively small change, say ! percent on a $!"",""" house, can make a 9*<
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.
MEAS&REMENT OF ELASTICITY OF DEMAND
'( PERCENTA)E MET*OD
The credit for measuring the elasticity of demand by this method goes to 1lu. That is why, it is sometimes
called 1lu>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.
price elasticity of demand .
percentage change in quantity demanded
percentage change in price
?roportional change in quantity can be epressed as where q! is the initial and q% is the new
quantity demanded.
?roportional change in price is similarly @ where ?! is initial and ?% is the new price.
6lasticity ratio e is therefore,
*f symbols q and ? are used for small variations in quantity and price respectively then,
4ote that 7q A 7p is in the limit derivative or marginal change and pAq is the reciprocal of average change,
therefore
:et>s illustrate this. *n our demand schedule eample above, when price changes from % to B units, the
quantity demanded changes from ; to ! units. Substituting these values we have'
A Ran%e o# 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.
Alternati!e Coe##icient +E(
?erfectly 6lastic 6 . C
Delatively 6lastic ! E 6 E C
8nit 6lastic 6 . !
Delatively *nelastic " E 6 E !
?erfectly *nelastic 6 . "
The chart to the right displays the five alternatives based on the coefficient #6&. The negative value
obtained when calculating the price elasticity of demand is ignored.
Per#ectly Elastic' The top of the chart begins with perfectly elastic, given by 6 . C. ?erfectly
elastic means an infinitesimally small change in price results in an infinitely large change in
quantity demanded.
Relati!ely Elastic' The second category is relatively elastic, in which the coefficient of elasticity
falls in the range ! E 6 E C. 0ith relatively elastic demand, relatively small changes in price
cause relatively large changes in quantity. Fuantity is very responsive to price. The percentage
change in quantity is greater than the percentage change in price. (ere a !" percent change in
price leads to more than a !" percent change in quantity demanded #maybe something %"
percent&.
&nit Elastic' The third category is unit elastic, in which the coefficient of elasticity is 6 . !. *n 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. 1or eample, a !" percent change
in price induces a equal !" percent change in quantity demanded. 8nit elastic is essentially a
dividing line or boundary between the elastic and inelastic ranges.
Relati!ely Inelastic' The fourth category is relatively inelastic, in which the coefficient of elasticity
falls in the range " E 6 E !. 0ith relatively inelastic demand, relatively large changes in price
cause relatively small changes in quantity. Fuantity is not very responsive to price. The
percentage change in quantity is less than the percentage change in price. *n this case, a !"
percent change in price induces less than a !" percent change in quantity demanded #perhaps
only + percent&.
Per#ectly Inelastic' The final category presented in this chart is perfectly inelastic, given by 6 .
". ?erfectly inelastic means that quantity demanded is unaffected by any change in price. The
quantity is essentially fied. *t does not matter how much price changes, quantity does not budge.
,( TOTAL O&TLAY MET*OD
Total outlay method refers to the total ependiture on the good after its price 3hanges.
Total outlay is obtained by multiplying the number of units sold by the price of a product
i.e. #Total revenue . Total unit sold G price&
Sr.
No.
Price (Rs.) Quantity of
mangoes
demanded in
units
Total outlay Price elasticity of
demand
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
6p H! if total outlay of a commodity increases after a fall in price of a commodity then price
elasticity of demand is elastic. ?rice elasticity is grater than one over ?F range of the curve.
6p.! 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 FD range of the curve is equal to one.
6p E ! if the total outlay decreases, after a fall in price then the elasticity of demand is less than
one. ?rice elasticity is less than one over DS range of demand curve.
-( POINT MET*OD
0hen we measure elasticity of demand at a point on linear demand curve which intersects both
aes, 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.
6p . :ower segment of demand curve
8pper segment of demand curve
7! 7% is straight line demand curve. 0hen price decreases from O?! to O?% demand etends from O
F! to O F%. :et us consider two points on demand curve i.e M! and M% to measure elasticity of demand
through point method.
6p . proportionate change in demand . I F G ?
?roportionate change in price I ? F
*n This fig
6p . F! F% G O?! #!&
?! ?% OF!
As per the fig. q!q% . 4M%, ?!?% . M! 4, O? !. M!F!, OF! . ?!M!
6?. 4M% G M!F!
M!4 OF! #%&
(ence, 4M% . F!7%
M!4 M!F!
Substitute, F!7% in place of 4M% in equation #%&
F!M! M!4
0e get 6p. F!7% G M!F!
M!F! OF!
6? . F!7%
OF!
4ow OF! is equal to ?!M! then 6p. F!7%
?!M!
Taking F!7% and ?!M! as the base we have tow triangles I ?!M!7! and I F!7%M! by geometrical
rules these tow triangles are equal. Therefore their sides are proportionate
0e can state 6p. F!7% . M!F! . M!7%
?!M! ?!7! M!7!
6p. M! 7% . :ower segment of he demand of point M!
M!7! 8pper segment of the demand of point M!
6lasticity of point M! . M!7%
M!7!
Thus elasticity of demand varies from point to point on a straight line demand curve. 6lasticity will
gradually decrease as we move towards 7% as the lower segment will become smaller.
.( ARC MET*OD
Are elasticity of demand measures the price elasticity of demand over a range on the demand curve
rather than a point on demand curve. *n reality we often come across a situation where price changes are
substantial.
*f price of commodity G is Ds. + then +"" units of G goods are sold. 0hen price falls to Ds. ; the J""
units are sold. Arc elasticity of demand is worked as under
IMPORTANCE OF ELASTICITY OF DEMAND FOR T*E MANA)ERS
There is need to understand price elasticity of demand for the goods they sell in order to decide on
optimal pricing policy. *f demand were relatively elastic, the firm would know that lowering the price would
epand 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 etent, business often engage in
statistical market research in order to determine consumer preferences, and in particular, the price
elasticity of demand for the product.
?rice elasticity of demand describes the way in which the demand for a product response to a change in
its price. *f 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, 7K7 players and washing machine are price elastic. *f
the demand for a product shows little response to change in price, the product is said to be price inelastic.
6ssential goods such as basic foods #e.g. bread, medicine& and fuel tend to be price inelastic.
Degarding 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. 6lasticity measures help the sales
manager in fiing the price of his product. The concept is also important to the economic planners of the
country. *n trying to fi 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 fiing the output mi in a production period. The concept is also useful to the policy
makers of the government, in particular in determining taation policy, minimum wages policy, stabili-ation
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
eplanatory variables. 1rom the standpoint of control and management of eternal factors, such empirical
estimates and their interpretations are therefore, very relevant.
*n market economics consumer can eercise 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 ad5ust 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. 1inally, this information is important to business, which need to find their optimal pricing policy in
order to achieve their goal of business of maimi-e the profits.