a) Elasticity Of Demand

Meaning Of Elasticity
 The term Elasticity expresses the degree of correlation

between demand and Price.

 The elasticity of demand is a measure of the relative

change in account purchased in response to a relative change in price on a given demand curve. - Mayer A.L.  The elasticity of demand, at any price or at any output, is the proportional change of amount purchased in response to a small change in price, divided by the proportional change of price Mrs. Joan Robinson

Classification of Elasticity of Demand
 From

the viewpoint of Elasticity Demand May be two types: a. Elastic Demand b. Inelastic Demand

Types of elasticity
elasticity •Cross elasticity •Income elasticity •Promotional elasticity

Price Elasticity
Price Elasticity = Proportion Change in amount Demanded
Proportion Change in Price

Change in Demand / Change in Price Amount Price

Five Cases Of Elasticity
 There are five cases

for measuring the price elasticity of demand. they are:
(a) Elasticity greater than one[ed>1] (b) Elasticity less than one[ed<1] (c) Elasticity equals to one[ed=1] (d) Perfect elasticity (e) Imperfect or zero elasticity[ed=0]

Elasticity greater than one [Ed > 1]:
 If

the change in demand is greater than the change in price, Then it is said to be elasticity greater than one [ed>1]. It is also called elasticity of demand

Elasticity less than one [Ed < 1]:
 If

the change in demand is less than the change in price, Then it is said to be elasticity less than one [ed<1]. It is also called inelasticity of demand.

Elasticity Equals to one [Ed = 1]:
 If

the rate of change in demand and the rate of change in price are equal, Then it is said to be elasticity equals to one [ed=1]. It is also called unit elasticity

Perfect Elasticity
 If

a little change in price of a particular product causes a severe effect on the change in demand of that particular product, then it is said to be perfect Elasticity.

Imperfect Elasticity
 If

the change in price of a product does not have any impact on the change in demand, then it is said zero (0) elasticity

Elasticities Extreme
Perfectly Inelastic Demand (Insulin)

Perfectly Elastic Demand (Clear Pepsi)


Demand Curves




Determinants of price elasticity
 Availability

of substitutes  Nature of commodity (luxuries or necessities)  Use of the commodity  Proportion of market supplied  Proportion of the income spent  Time required in adjusments

Elasticity and Revenues

The revenues generated by a firm along any point of the demand schedule are equal to the product of quantity demanded and price
R = P∙QD

Raising prices has two counter-veiling effects:
a direct positive impact on revenues because each good sold generates more revenue. a negative indirect impact because fewer goods will be sold.


Which is stronger?

Effect of price change on revenues
 Changes

in revenues are approximately %R ≈ %P+%Q  Divide through by %P to get the total impact

% R % P %Q %Q = + = 1+ %P %P %P %P





= 1 +e


Price Elasticity & Revenues

If the price elasticity of demand is
  

exactly UNITY, a price rise has no effect on total revenue ELASTIC, a price rise will decrease revenues. INELASTIC elastic, a price rise will increase revenues.

Cross Elasticity of Demand
 The relationship between changes in the

price of one commodity and the resulting changes in the quantity demand of another commodity is described as the cross elasticity of demand.
1. Positive cross Elasticity of Demand 2. Negative cross Elasticity of Demand 3. Zero cross Elasticity of Demand

 It has three types: -

Substitutes vs. Complements  A good is defined as a “Substitute”
when a rise in its price leads to a shift out/up in the demand curve for the good of interest.


good is defined as a “Complement” when a rise in its price leads to a shift in/down in the demand curve for the good of interest.

Income Elasticity

Income elasticity is a measure of responsiveness of potential buyers to change in income. It represents the ratio of change in demand of product as with the change in income of the consumer concerned. It is of four types:
1. Positive Income Elasticity of Demand 2. Negative Income Elasticity of Demand 3. zero Income Elasticity of Demand 4. Other types of Income elasticity

Nature of goods and income elasticity
 With

the concern of elasticity of demand, we can differentiate goods or products into two distinct types. They are – 1. NORMAL GOODS

Necessities luxuries

Luxuries vs. Necessities
 There

are two types of normal goods.  Luxuries take up an increasing share of income as your income grows.
are income elastic - the income elasticity of luxuries is greater than 1. Necessities take up a declining share of income as your income grows. Necessities are income inelastic – the income elasticity of luxuries is less than 1.

Inferior Goods
 Inferior

Goods are goods that are so inferior that the Law of Demand does not apply.  Example: Noodles in poorer parts of China. Noodles are a big chunk of the household budget. When prices of noodles go down, that frees up extra money for other spending. With extra money, you might buy more meat. Then, you need fewer noodles. Price of noodles drops and demand for noodles drops!

Inferior Goods

Range of Income Elasticities
Normal Goods

Income Inelastic (Necessities)

Income Elastic (Luxury Goods)

Measurement of Elasticity
 Three methods have been suggested for

the measurement of elasticity: 1. Proportional Method. 2. Geometrical Method.

Proportional Method
 In this method, we compare the

percentage change in price with the percentage change in demand. The elasticity is the ratio of the percentage change in the quantity demand to the percentage change in price change.

Geometrical Method
 Arc

Elasticity  Any two points on a demand curve make an Arc. The area between P and M on the DD curve in this figure is an arc which measures elasticity over a certain range of prices and quantities

Drawback of arc elasticity

elasticity method differs from two finite points if direction changes.

Point Elasticity: This method tells us how measure elasticity of demand at any point on a demand curve. Elasticity is represented by the fraction distance from D to a point on the curve divided by the distance from the other end to that point.

Promotional elasticity
It is defined as change in demand of the quantities in response to change in expenditure E=change in sales Change in advertisement expenditure

Determinants of promotional elasticity
 The

level of total sales of rival firms

 Advertisement  Cumulative

effect of past advertisements

Price Elasticity and Time

Elasticity of Demand Short-term vs. Long-term
 It

takes time to find substitutes for goods or to adjust consumption behavior in response to a change in prices.  The long-run demand response to a price rise is larger than the short-run. Price elasticity of demand is more negative in the long run than in the short run. .

Oil Demand much more elastic in long run than short-run

Price E
–(J.C.B. Cooper, OPEC Review, 2003)

Oil Dempand Curves




Practical Application of Elasticity of Demand
          

Taxation Monopoly Market Appraisal Economic policies International Trade Rate of Foreign Exchange Increasing Returns Output Wages Poverty in plenty Effect on the economy

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