CCT Unit 3 Elasticity of demand

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Elasticity of demand
The law of demand explains about the inverse relationship
between price and quantity demanded. The elasticity of
demand explains about how much the quantity demanded
changes to the price. In short the elasticity of demand is
the measure of relative change in amount purchase in
response to relative change in price. The term elasticity
expresses the degree of correlation between demand and
price. Elasticity of demand are price elasticity of demand,
cross elasticity of demand and income elasticity of
demand.

Price elasticity of demand

Price elasticity of demand measures the change in
quantity demanded to the change in price. According to A C
Ferguson " price elasticity is the proportionate change in
quantity demanded divided by proportionate change in
price." In other words price elasticity of demand is the
ratio of % change in quantity demanded to the % change
in price. Symbolically,
Q
Q Q P
Elasticity (e p )   
P P Q
P

Kinds of price elasticity of demand

A change in demand is not always same to the change in
price. For example a small change in price may lead great
change in demand and great change in price may lead the
small change in demand.

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1 Perfectly elastic demand (ep = ∞)

The small change in price leads to unlimited change
demand is known as perfectly elastic demand. In other
words the demand increases in unlimited quantity with an
infinitesimally small reduction in price or quantity
demanded decreases to zero with a small increase in price.
Such case is not found in reality and it is expressed as ep =
∞.

2 Perfectly inelastic demand (ep = 0)

If the demand remains unchanged whatever the price may
rise or fall is called perfectly in elastic demand. In other
words when price changes demand remains same. Such
case is also not found in reality and symbolically expressed
as ep = 0.

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3 Relatively elastic demand (ep>1)

If the % change in quantity demanded is greater than %
change in price is known as relatively elastic demand. For
example, if price falls by 5% demand increases by 10%
then demand is relatively elastic. Generally demand for
luxurious good has been found relatively elastic demand
and symbolically it is written as ep>1.

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4 Unitary elastic demand (ep=1)

If the % change in quantity demanded is exactly equal to %
change in price is known as unitary elastic demand. For
example, if price falls by 5% demand increases by 5% then
demand is unitary elastic. Such case is also not found in
reality and it is denoted as ep=1.

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5 Relatively inelastic demand (ep<1)

If the % change in quantity demanded is less than the %
change in price is known as relatively inelastic. For
example, if price falls by 10% demand increases by 5%
then demand is relatively inelastic. Such type of elasticity
is found in case of necessary goods and symbolically
written as ep<1.

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Measurement of elasticity
Three methods have been suggested to measure the
elasticity of demand are total outlay, proportional and
geometrical (point and arc).

Total outlay method

In this method we compare the total expenditure of
consumer on particular good after and before the change
in price.

1 Elasticity of demand greater than unity(ed>1)

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If the total expenditure of consumer on particular good

increases with the fall in price is known as elasticity of
demand greater than unity.

Price quantity total expenditure

demanded

5 100 500

4 150 600

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At price OP1 total expenditure = OP1×OQ1 = OP1AQ1

rectangular
At price OP2 total expenditure = OP2×OQ2 = OP2BQ2
rectangular
-area is less than + area so total expenditure increases
(OP1AQ1<OP2BQ2)

2 Elasticity of demand equal to unity(ed = 1)

If the total expenditure of consumer on particular good
remains same with the change in price of commodity is
known as unitary elastic.

Price Quantity Total expenditure

demanded

5 100 500

4 125 500

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At price OP1 total expenditure = OP1×OQ1 = OP1AQ1

rectangular
At price OP2 total expenditure = OP2×OQ2 = OP2BQ2
rectangular
-area is equal to + area so total expenditure remains same
(OP1AQ1=OP2BQ2)

3 Elasticity of demand less than unity(ed<1)

If the total expenditure of consumer on particular good
decreases with the fall in the price is known as elasticity of
demand less than unity.

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Price Quantity Total expenditure

demanded

5 100 500

4 120 480

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Geometrical method

Point Method
Point elasticity of demand is defined as the proportionate
change in quantity demanded resulting from very small
change in price. If the change in price is very small we use
point elasticity to measure elasticity.
We know,
Q
Q Q P
Elasticity (e p )    …………1
P P Q
P

If the demand curve is linear,

Q  b0  b1 P

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dQ
Its slope  b1 substituting in 1 we get,
dP

P
e p  b1 
Q

Implies that elasticity changes at various points of demand

curve. Formula to measure point elasticity can be derived
with help of following diagram.

If we move from C to D,
dQ = Q1Q2 = ED
Q = OQ1
dP = P1P2 = CE
P = OP1
Substituting in 1 we get
dQ P
ep  
dP Q
ED OP1
ep   .........2
CE OQ1

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∆CED and ∆CQ1B are similar,

ED BQ1 BQ1
  (CQ1  OP1)
EC CQ1 OP1

Again ∆AP1C and CQ1B are similar,

BQ1 CP1 OQ1
  (CP1  OQ1)
BC AC AC

BQ1 OQ1

BC AC
BQ1 BC

OQ1 AC

Substituting in 2 we get,
ED OP1
ep  
CE OQ1
BQ1 OP1
ep  
OP1 OQ1
BQ1
ep 
OQ1
BC
ep 
AC

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Graphical measurement of elasticity can be explained as

follows.

Arc elasticity
According to Baumol “arc elasticity is a measure of the
average responsiveness to price changes exhibited by a
demand curve over some finite stretch of the curve. Any
two points of demand curve makes an arc. If the change in
price is very small we use point elasticity if the change in
price is appreciable we use arc elasticity to measure
elasticity of demand. This can be explained with the help
of following diagram.

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If we move from C to D,
dQ P
ep  
dP Q
86 3
ep  
23 6
e p  1

If we move from D to C,
dQ P
ep  
dP Q
68 2
ep  
32 8
1
ep  
2

On any two points of demand curve price elasticity of

demand depends upon our calculation. To avoid above
problem we calculate average of two variables.

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dQ P
ep  
dP Q
P1  P 2
dQ 2
ep  
dP Q1  Q 2
2
Q1  Q 2 P1  P 2
ep  
P1  P 2 Q1  Q 2
Q1  Q 2 P1  P 2
ep  
Q1  Q 2 P1  P 2

Total revenue and elasticity

Total revenue is the amount received by sellers and paid
by buyers. Total revenue in any market will be P×Q. we
know that more will be demanded at lower price means to
sell more price must decrease. So demand curve of
consumer is the marginal revenue curve of supplier. This
can be explained with help of following table.

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Price Quantit Total % % Price

y revenue change change elasticity(ep
in in )
price quantit
y

1 12 12

2 10 20 100 16.66 Ep<1

3 8 24 50 20 Ep<1

4 6 24 33.33 25 Ep=1

5 4 20 25 33.33 Ep>1

6 2 12 Ep>1

7 0 0

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This can be explained with the help of following diagram.

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Conclusions
At very low level of price demand is relatively inelastic so
any increase in price increases the total revenue. Above
diagram shows when price increases from 1 to 2 total
revenue increases from 5 square unit to 8 square unit
(total revenue = price ×quantity).
At very high level of price demand is relatively elastic so
any increase in price decreases the total revenue. So to
increase total revenue price must cut down.
When elasticity equals 1 total revenue becomes maximum
and change in price do not changes total revenue.

Income elasticity of demand

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It explains how much the quantity demanded changes

when the income of consumer changes. In other words it
measures the responsiveness demand to the change in
income while price remains same. Hence income elasticity
of demand is the ratio of proportionate change in quantity
demanded by proportionate change in income. In other
words income elasticity of demand is % change in quantity
demanded divided by % change in price. Symbolically,
dQ
Q
ey 
dY
Y
dQ Y
ey  
dY Q

Types of income elasticity of demand

A change in demand is not always same to change in
income. So according to change in demand income
elasticity are three kinds.
1 Positive income elasticity (ey>0).
If the demand for good increases with the increases in
income then the elasticity is said to be positive. Such type
of elasticity is found in case of normal goods.
2 Zero income elasticity (ey=0)
If the demand for good remains same when income of
consumer changes is known as zero income elasticity. Such
type of elasticity is found in case of salt, matches etc.
3 Negative income elasticity (ey<0)
If the demand for good decreases with the increase in
income the income elasticity of demand is called negative.
Such type of elasticity is found in case of inferior goods.

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Types of income elasticity of demand can be explained

with the help of following diagram.

Cross elasticity of demand

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Some goods are related to each other as substitute (tea

and coffee) and complementary (pen and ink). Cross
elasticity of demand measures the responsiveness of
demand of one commodity to the change in the price of
other commodity. For example if price coffee decreases the
demand for tea decreases because the consumers who
drink tea now drink coffee because coffee is cheaper now.
In short a change in the price of one good cause the change
in the demand for other is measured in cross elasticity of
demand. If X and Y are two goods cross elasticity can be
defined as proportionate change in quantity demanded of
X good divided by proportionate change in the price of Y
good. In other words % change in quantity demanded of X
good divided by the % change in price of Y good.
Symbolically,
Q x
Qx
ec 
Py
Py
Q x Py
ec  
Py Q x

1 Positive cross elasticity of demand (ec>0)

If two goods are substitute to each other the elasticity of
demand will be positive. In other words demand for one
good varies directly with the price of other good. For
example if price of tea increases demand for coffee
increases.

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2 Negative cross elasticity of demand (ec<0)

If two goods are complementary the elasticity of demand
will be negative. In other words the demand for one good
varies inversely to the price of other good. For example
demand for cricket ball increases with the fall in the price
of cricket bats.

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Factors determining elasticity of demand

1 Necessaries of life
2 Luxurious goods
3 Existence of substitute
4 Goods having several uses
5 Level of prices

The elasticity of supply

The law of supply only explains about the positive relation
between price and supply. The price elasticity of supply
measures how much the quantity supplied changes to the
change in price. Price elasticity of supply can be defined as
the proportionate change in quantity supplied divided by
proportionate change in price. In other words price
elasticity of demand is the ratio of % change in quantity
supplied to the % change in price. Symbolically,
Q
Q
es 
P
P
Q P
es  
P Q

Types of price elasticity of supply

1 Perfectly elastic supply (es=∞)

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The small change in price leads to unlimited change supply

is known as perfectly elastic supply. In other words the
supply decreases in unlimited quantity with an
infinitesimally small reduction in price or quantity supply
increases to infinity to the small increase in price. Such
case is not found in reality and it is expressed as es = ∞.

At any price less than OP supply becomes zero and at any

price above OP supply will be infinity.

2 Elastic supply (es>1)

If the % change in quantity supplied is greater than %
change in price is known as relatively elastic supply. For
example, if price increases by 5% supply increases by 10%
then supply is relatively elastic symbolically it is written as
es>1.

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3 Unitary elastic supply (es=1)

If the % change in quantity supplied is exactly equal to %
change in price is known as unitary elastic supply. For
example, if price increases by 5% supply increases by 5%
then supply is unitary elastic. Such case is also not found in
reality and it is denoted as es=1.

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4 Inelastic supply (es<1)

If the % change in quantity supplied is less than the %
change in price is known as relatively inelastic. For
example, if price increases by 10% supply increases by 5%
then supply is relatively inelastic.

5 Perfectly inelastic supply (es=0)

If the supply remains unchanged whatever the price may
rise or fall is called perfectly in elastic supply. In other
words when price changes supply remains same.

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The price elasticity of supply varies over the supply curve

The price elasticity of supply will be higher at very low
level of price or low level of supply because at low level of
supply firm have capacity for production that not being
used. In other words at initial stage production law of
increasing return to scale of production operates so the
marginal and average cost decreases when firm increases
the production.
The price elasticity of supply will be lower at very higher
level of price or higher level of supply because at high level
of supply the maximum capacity of firm have been already
utilized so to increases supply firm have to construct new
plant and building and managerial diseconomy operates.
So the suppliers do not increases their supply more at very
high level of price or high level of supply because marginal
and average cost tends to increase.

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