Elasticity of

Demand
 Elasticity–the concept
• The responsiveness of one variable to changes in
another
• When price rises what happens to demand?
• Demand falls
• BUT!
• How much does demand fall?
 Elasticity – the concept
• If price rises by 10% - what happens to demand?
• We know demand will fall
• By more than 10%?
• By less than 10%?
• Elasticity measures the extent to which demand will
change
 Elasticity
• 4 basic types used:
• Price elasticity of demand
• Advertisement elasticity of Demand
• Income elasticity of demand
• Cross Price elasticity of related goods
 Elasticity
• Other possible types used:
• elasticity of Substitution
• Fashion elasticity of
• elasticity of Taste
• elasticity of consumer preferences
• elasticity of change in weather
 Elasticity
• Price Elasticity of Demand
– The responsiveness of demand to changes in
price
– Where % change in demand is greater than %
change in price – elastic
– Where % change in demand is less than %
change in price - inelastic
 Elasticity

The Formula:
% Change in Quantity Demanded
___________________________
ep =
% Change in Price

If answer is between 0 and 1: the relationship is inelastic

If the answer is between 1 and infinity: the relationship is elastic

Note: EP has – sign in front of it; because as price rises

demand falls and vice-versa (inverse relationship between
price and demand)
 Elasticity

Decreasing…. Increasing….

0 <1 =1 >1 ∞
ZERO LESS EQUAL MORE INFINITE
 PERFECTLY
P
INELASTIC DEMAND
PRICE
VERTICAL CURVE
D Ep = 0
life saving drugs
meagre goods
P2 b

P1 a

O Q1 Q
QUANTITYfig
DEMANDED
RELATIVELY INELASTIC DEMAND
STEEP CURVE Ep < 1
necessities and habits
Price (RS)
Producer decides to lower price to attract sales

10 % Δ Price = -50%
% Δ Quantity Demanded = +20%

5 Total Revenue would fall

Not a good move!

D
5 6
Quantity Demanded
 P Unitary elastic demand (Ep = 1)
coincidental no e.g.
PRICE

a
20

b
8
D

O 40 100 Q
QUANTITYfig
DEMANDED
 RELATIVELY ELASTIC DEMAND
FLAT CURVE Ep>1
luxuries, durables and cosmetics
Price (RS)
Producer decides to reduce price to increase sales
% Δ in Price = - 30%
% Δ in Demand = + 300%

Total Revenue rises

10
Good Move!
7
D

5 Quantity Demanded 20
 Perfectly elastic demand (Ep ά )
P
HORIZONTAL DEMAND CURVE
myth no examples
a b
P1 D

O Q1 Q2
fig Q
 PRICE ELASTICITY OF DEMAND COMMON DIAGRAM

EP=0
EP<1
EP=1

EP>1

Price (Rs) EP=∞

Quantity Demanded
• Income Elasticity of
Demand:

• A positive sign denotes a

normal good
• A negative sign denotes an
inferior good
 Positive income elasticity
m

y = +2
n

income
Q = +10

fig
quantity
Q (000s)
 P Zero income elasticity (Ey =0)
D

y2 b
income

y1 a

O Q1 Q
fig
quantity
Negative income Elasticity Ey < 0
income

y2

Y1

D
0 100 140 Quantity Demanded (000s)
• Cross Elasticity:
• The responsiveness of demand of
one good to changes in the price
of a related good
either a substitute or a complement

Exy = % Δ Qd of good x
% Δ Price of good y
 Cross Elasticity
Y

Price
of
One
commodity
(Rs)

X
Quantity Demanded of other commodity
 Advertisement Elasticity
• Advertisement Elasticity of Demand:
– The responsiveness of demand to changes in
advertisement expenditure
• demand rises as add. expenditure rises and
vice versa
A D
e.g. cold drinks, t.v. etc
• demand falls as add. expenditure falls and vice
versa
A D
e.g. shampoos, Camay soap
 Advertisement Elasticity

The Formula:
% Change in Sales
___________________________
eA =
% Change in Add expenditure
 METHODS OF MEASUREMENT

• PERCENTAGE METHOD
• POINT METHOD
• ARC METHOD
• AR-MR METHOD
• TOTAL EXPENDITURE METHOD
 PERCENTAGE
METHOD
PERCENTAGE CHANGE IN QUANTITY
DEMANDED
PERCENTAGE CHANGE IN PRICE OF
COMMODITY
% Qd
Ep =
% P
 P
Percentage
method
% Qd 60% =1
PRICE D
% P 60%
a
10

60%

b
4

D
60%

O 40 100 Q
fig
QUANTITY DEMANDED
Price elasticity of demand

( %) QD
( %) P

QD P
QD
÷
P
NUMERIC METHOD
Q P1
x
P Q1
 y
A
POINT METHOD
20
geometric
15

Ep = 1
10
price

X
O 5 Quantity 10 15 20 B
 y
A
ARC METHOD
Ep
20
&
geometric
Ep > 1
15

Ep = 1
10
price

Ep < 1
5

Ep = 0
X
O 5 Quantity 10 15 20 B
 TOTAL OUTLAY / EXPENDITURE METHOD
Price Quantity Total trend ELASTICITY
expenditure
Rs Units Rs

3 1 3 INCREASE Ep>1

2 2 4

1.75 3 5.25

1.5 4 6 CONSTANT Ep=1

1.25 5 6

1.00 6 6

0.75 7 5.25 DECREASE Ep<1

0.60 8 4.80

0.50 9 4.50
 Y TOTAL OUTLAY / EXPENDITURE METHOD

EP=1
Total expenditure and price

TE

D
X
QUANTITY
 Determinants of Elasticity
• Time period
• the longer the time under consideration the more
elastic a good is likely to be
• Number and closeness of substitutes
• the greater the number of substitutes the more
elastic
• The proportion of income taken up by the
product
• the smaller the proportion the more inelastic
• Luxury or Necessity addictive drugs
 Importance of Elasticity
• Relationship between changes in price and total
revenue
• Importance in determining what goods to tax
(tax revenue)
• Importance in analysing time lags in production
• Influences the behaviour of a firm