Finance and Economics for Engineers

MME-308
Kris Harihara
Class 4 – Elasticity of Demand
 Elasticity of Demand
The definition is simple. Elasticity measures the sensitivity of demand to
changes in Price, Advertising, complement goods, substitute goods, etc.

Complement goods are those that usually go hand in hand with the product
in question. Examples include Tennis balls and racquets, movies and
popcorn, cars and petrol, etc. A price reduction in tennis racquets is likely to
increase demand not just for racquets but for the balls as well.

Substitute goods, as the name implies are competing products. Examples are
butter and ghee, cars and vans, tennis racquets and cricket bats, etc.
 Elasticity of Demand
Mathematically, in algebraic form,

Price Elasticity = % change in Demand

_______________________________________________

% change in price

Income Elasticity = % change in Demand

_______________________________________________

% change in income

Of course, we hold all other variables constant.

Or simply Price Elasticity is d(Q)/d(P).

Income Elasticity is d(Q)/d(I) and so on
 Elasticity of Demand
One last point, when calculating percentages, we average out the
denominator. You may recall Young’s Modulus of Elasticity.
So % change in Q = (Q2-Q1)/(0.5Q2+0.5Q1)
And % change in P = (P2-P1)/(0.5P2+0.5P1)

Never the end of the world if you forget to average out the denominator ☺

Inelastic means the demand is not very sensitive to the input factor at a
particular point. Think of prescription medicine costing 5% more.

Highly Elastic means the demand is VERY sensitive to the input factor at a
particular point. Think of change in demand for fancy cars if income goes up
substantially.
 Elasticity of Demand
Consider the market for a product whose demand function is P = 60 – 1.5Q

What is price elasticity of demand if price increases from P =15 to P= 30?

At P1 = 15, Q1 = 30. At P2 = 30, Q2 = 20

Elasticity of demand = (20-30)/(10+15) divided by (30-15)/(15+7.5)

= -0.6.

You will see various versions of this: with the averaging, without averaging,
absolute values and so on. We have better things to do!
 Elasticity of Demand
Another Example
Lets say per capita income in a town increased by 10% and the demand for
scooters increased by 5%, what is income elasticity of demand?

Simply apply the formula:

Income elasticity is %change in Q divided by % change in I = 0.5

 Elasticity of Demand
Why do some economists like to discuss
legalizing vices such as gambling, drugs,
prostitution, etc.?

The infamous Irish potato famine in 1845.

Income reduced, potato prices soared and yet,
consumption of potatoes increased!