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Elasticity of Demand

Meaning of Elasticity
Elasticity of demand measures the responsiveness of demand due to the change in the factor affecting demand Price Elasticity of Demand It is the absolute value of the ratio of percentage change in the quantity demanded to the percentage change in price ep = |(dQ/Q) / (dP/P)| = |(dQ/dP) / (P/Q)|

e<1 = inelastic demand, e=0 = no change in demand e>1 = elastic demand , e=infinity = infinite demand

e=1 = unitary demand

Unitary Elastic demand

Measurement of Elasticity
There are two approaches to computing price elasticities.The choice between the two depends on available data & the intended use. Point Elasticity : This is used when there is an extremely small change in price or we need to find the price elasticity of demand at any particular price. ep = -{(dq/dp) X (P/Q)} Arc Elasticity : This is used for analyzing the effect of discrete changes in price i.e. an increase in price from Re. 1 to Rs. 3 can be evaluated by computing the arc elasticity. ep = [(Q2-Q1)/{(Q2 +Q1)/2)}] X [(P2-P1)/{(P2 +P1)/2)}]

Point Elasticity

Arc Elasticity

Cross Elasticity of Demand


The responsiveness of quantity demanded to changes in price of other goods is measured by cross elasticity, which is defined as the percentage change in quantity demanded of one good caused by a 1% change in the price of some other good. ec = %dQx / %dPy = (dQx /dPy) / (Py/Qx) Substitute goods : ec >0 Compliment goods : ec<0

Income Elasticity
It is used to measure the responsiveness of demand to changes in income. When other factors are held constant, the income elasticity of a good or service is the percentage change in demand associated with a 1 percent change in income. ei = %dQ / %dI = (dQ/Q) / (dI/I) ei>0 Normal good ei<1 Necessary good
ei<0 - Inferior good ei>1 - Luxury good ei=0 - Neutral good

Engel Curve-When quantity demanded of good x is plotted against income then the derived curve is termed s engel curve

Effect of elasticity on Revenue


Revenue for Q unit sold at P/per unit price is PXQ E>1 As P rises by I unit q falls greater than 1 unit, so PXQ also falls E<1 As P rises by 1 unit Q falls but less than 1 unit, so PXQ rises E=1 As prices by 1 unit, Q falls by 1 unit, so PXQ remains unchanged

Elasticity of Supply
It refers to the percentage change in quantity supplied of a product to one percent change in its price. es = |(dQ/Q) / (dP/P)| = |(dQ/dP) / (P/Q)|

Types of Supply Elasticity


When elasticity of supply Known as is Equal to infinity More than 1 but less than infinity Equal to 1 Less than 1 but more than 0 Equal to 0 Perfectly elastic supply Relatively elastic supply Unitary elastic supply Relatively inelastic supply Perfectly inelastic supply

Market Equilibrium

Shifting of Equilibrium due to shift in dd curve

Shifting of equm due to shift in supply curve

Shift in both supply & demand

Demand and supply shifts If demand rises The demand curve shifts to the right The demand curve shifts to the left The supply curve shifts to the left The supply curve shifts to the left

Effect on price and quantity Both price and quantity increses Both prices and quantity falls Price falls but quantity increase Price increases and quantity decreases

If demand falls

If supply rises

If supply falls

Factors determining Price Elasticity of demand Availability & closeness of substitute: fewer the close substitute, less elastic the demand for the product. eg. Movie tickets & VCD players Proportion of income spent on the product : Demand tends to be inelastic for those products and services that account for a small proportion of consumers total expenditure eg. Price of sugar Time Period: Demand is more elastic in the long run than in the short run. Eg. Petrol car & diesel car Habit formation : Some products are consumed more due to habits of consumers like cigarettes. The demand is relatively inelastic

Application of Price elasticity of demand Pricing decision of business organization Pricing regulations by government Paradox of plenty Use in international trade Fiscal policy Application of cross price elasticity of demand Application of income elasticity of demand

Determinants of Price Elasticity of Demand


Necessities versus Luxuries Availability of Close Substitutes Definition of the Market Time Horizon

Determinants of Price Elasticity of Demand


Demand tends to be more inelastic If the good is a necessity. If the time period is shorter. The smaller the number of close substitutes. The more broadly defined the market.

Determinants of Price Elasticity of Demand


Demand tends to be more elastic : if the good is a luxury. the longer the time period. the larger the number of close substitutes. the more narrowly defined the market.