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Elasticity of Demand

Lecture plan

Objectives

Elasticity of demand

Price elasticity of demand

Degrees of price elasticity of demand

Methods of measuring elasticity

Revenue and price elasticity of demand

Income elasticity of demand

Cross elasticity of demand

Promotional elasticity of demand

Importance of elasticity

Objectives

To understand the meaning of responsiveness

of demand to changes in determinants of

demand.

To lay down the degrees of responsiveness of

demand.

To discuss various types of elasticities of

demand.

To learn how to measure elasticity by various

methods.

To understand the relevance and application of

elasticities of demand

Elasticity of Demand

“Elasticity” is a standard measure of the degree of

responsiveness (or sensitivity) of one variable to changes

in another variable.

Elasticity of Demand measures the degree of

responsiveness of demand for a commodity to a given

change in any of the independent variables that influence

demand for that commodity, such as price of the

commodity, price of the other commodities, income,

taste, preferences of the consumer and other factors.

Responsiveness implies the proportion by which the

quantity demanded of a commodity changes, in response

to a given change in any of its determinants .

Elasticity of Demand

Mathematically, it is the percentage change in

quantity demanded of a commodity to a percentage

change in any of the (independent) variables that

determine demand for the commodity.

Four major types of elasticity:

Price elasticity,

Income elasticity,

Cross elasticity

Advertising (or promotional) elasticity.

In order to assess the impact of one variable on demand,

we assume other variables as constant (ceteris paribus)

Price Elasticity of Demand

independent variables that affect the demand for

any commodity.

Hence Price elasticity of demand ( “ep” or “e”) is

considered to be the most important of all types of

elasticity of demand.

Price elasticity of demand means the sensitivity

of quantity demanded of a commodity to a given

change in its own price.

Degrees of Price Elasticity

Price

Perfectly elastic demand

ep=∞ (in absolute terms).

Unlimited quantities of the commodity P D

can be sold at the prevailing price

A negligible increase in price would

result in zero quantity demanded O Q1 Q1

Quantity

Horizontal demand curve

The other extreme of the elasticity Price

range

ep=0 (in absolute terms) P1

remains the same, irrespective of any

change in the price

Such goods are termed neutral O

Vertical demand curve Q1 Quantity

Degrees of Price Elasticity

Highly elastic demand Price

Proportionate change in quantity D

demanded is more than a given change in P1

price P2 D

ep >1 (in absolute terms)

Such goods are called luxuries O

Q1 Q2

Unitary elastic demand Quantity

Price D

Proportionate change in price brings

about an equal proportionate change in P1

quantity demanded

P2

ep =1 (in absolute terms).

Demand curves are shaped like a D

rectangular hyperbola, asymptotic to the O

axes Q1 Q2 Quantity

Price

Relatively inelastic demand D

Proportionate change in quantity

P1

demanded is less than a proportionate

P2

change in price

ep <1 (in absolute terms)

D

Such goods are called necessities O

Q1 Q2 Quantity

Methods of Measuring Elasticity

Ratio (or Percentage) Method

The most popular method used to measure elasticity

Elasticity of demand is expressed as the ratio of proportionate

change in quantity demanded and proportionate change in the

price of the commodity

It allows comparison of changes in two qualitatively different

variables

It helps in deciding how big a change in price or quantity is

Proportionate change in quantity demanded of commodity X

ep =

Proportionate change in price of commodity X

ep= Q2 − Q1 / Q1

P2 − P1 / P1

where Q1= original quantity demanded, Q2= new quantity

demanded, P1= original price level, P2= new price level

Methods of Measuring Elasticity

Contd…

Elasticity measured at a point of demand curve is referred

as point elasticity of demand.

For nonlinear demand curve we need to apply calculus

to calculate point elasticity.

As changes in price become smaller and approach zero,

∆Q

the ratio ∆P becomes equivalent to the first order

dQ

derivative of the demand function with respect to price dP

Point elasticity can be expressed as:

ep = dQ / Q dQ P

= .

dP / P dP Q

Methods of Measuring Elasticity

Contd…

Used when the available figures on price and quantity

are discrete, and it is possible to isolate and calculate

the incremental changes.

It is used to find the elasticity at the midpoint of an

arc between any two points on a demand curve, by

taking the average of the prices and quantities.

This method finds wider applications, as it reflects a

movement along a portion (arc) of a demand curve

Q2 − Q1 P2 − P1

ep = (Q1 + Q2 ) / 2 ( P1 + P2 ) / 2

/

Q2 − Q1 P1 + P2

.

Q1 + Q2 P2 − P1

=

Methods of Measuring Elasticity Contd…

Total Outlay Method (Marshall)

Elasticity is measured by comparing expenditure levels before

and after any change in price, i.e. whether the new expenditure

is more than, or less than, or equal to the initial expenditure

level.

Helps a seller in taking a decision to raise price only if:

Reduction in quantity demanded does not reduce total

revenue or

Reduction in price increases the quantity demanded to the

extent that total revenue also increases.

Degrees

When demand is elastic, a decrease in price will result in an

increase in the revenue (sales).

When demand is inelastic, a decrease in price will result in

a decrease in the revenue (sales).

When demand is unit-elastic, an increase (or a decrease)

in price will not change the revenue (sales)

Determinants of Price Elasticity of

Demand

Nature of commodity

Necessities are relatively price inelastic, while luxuries

are relatively price elastic

Availability and proximity of substitutes

Price elasticity of demand of a brand of a product

would be quite high, given availability of other

substitute brands

Alternative uses of the commodity

If

a commodity can be put to more than one use, it

would be relatively price elastic

Determinants of Price Elasticity of

Demand

Proportion of income spent on the commodity

The greater the proportion of income spent on a commodity, the

more sensitive would the commodity be to price

Reason is income effect

Time

Demand for any commodity is more price elastic in the long run

Durability of the commodity

Perishable commodities like eatables are relatively price

inelastic in comparison to durable items

Items of addiction

Items of intoxication and addiction are relatively price inelastic

Revenue and Price Elasticity of

Demand

For relatively inelastic demand, a change in

price would have a greater effect on revenue

than a change in quantity demanded

AR is same as the price of the product

Demand curve is also the AR curve of the firm.

Marginal Revenue is the revenue a firm gains in

producing one additional unit of a commodity

Revenue and Price Elasticity of

Demand

Till ep>1 MR is Price,

Revenue ep=∞

positive and TR is ep>1

rising ep=1

ep=1 and MR is O

MR

Quantity

Revenue

is at its peak

When ep<1, MR is

negative

MR= AR[1- ep] O

TR Quantity

Income Elasticity of Demand (ey)

for a good to a given change in income, ceteris paribus.

ey =

Proportion ate change in income of consumer

Degrees:

Positive income elasticity

Demand rises as income rises and vice versa

Normal good

Demand falls as income rises and vice versa

Inferior good

Cross Elasticity of Demand

one good to changes in the price of a related

good

Proportion ate change in quantity demanded of commodity X

ec =

Proportion ate change in price of commodity Y

Degrees

Negative Cross Elasticity

Complementary goods

Positive Cross Elasticity

Substitute goods

Promotional Elasticity of Demand

effect of incurring an “expenditure” on advertising, vis-à-vis an

increase in demand, ceteris paribus.

Some goods (like consumer goods) are more responsive to

advertising than others (like heavy capital equipments).

ea =

Proportion ate change in advertising expenditure

Degrees

ea>1

Firm should go for heavy expenditure on advertisement.

ea <1

Firm should not spend too much on advertisement

Importance of Elasticity

Determination of price

Elasticity is the basis of determining the price of a product keeping

its possible effects on the demand of the product in perspective

Basis of price discrimination

Products having elastic demand may be sold at lower price, while

those having inelastic demand may be sold at high prices

Determination of rewards of factors of production

Factors having inelastic demand are rewarded more than factors

that have relatively elastic demand.

Government policies of taxation

Goods having relatively elastic demand are taxed less than those

having relatively inelastic demand.

Summary

Elasticity of demand measures the degree of responsiveness of the

quantity demanded of a commodity to a given change in any of the

independent variables that influence demand for that commodity.

Price elasticity of demand (ep) measures the degree of responsiveness

of the quantity demanded of a commodity to a given change in its price,

other things remaining the same.

By the percentage method ep is expressed as the ratio of proportionate

change in quantity demanded and proportionate change in price of the

commodity.

As per the total outlay method elasticity is measured by comparing

expenditure levels before and after any change in price, i.e. whether the

new expenditure is more than, or less than, or equal to the initial

expenditure level.

Arc elasticity is used to calculate price elasticity of demand at the

midpoint of an arc between any two points on the demand curve, by

taking the average of the prices and quantities; point elasticity can be

approximated by calculating the arc elasticity for a very small arc on the

demand curve.

Summary

If the demand curve is a straight line, price elasticity of demand at

different points of the demand curve can be calculated by the ratio

of the lower segment and upper segment of the demand curve.

MR= AR[1- ep]

Income elasticity of demand (ey) measures the degree of

responsiveness of the quantity demanded of a commodity to a

given change in consumer’s income. For normal goods ey is

positive; for neutral goods ey is zero; for inferior goods ey is

negative.

Cross elasticity of demand (ec) shows how changes in prices of

other goods would affect the demand for a particular good. For

substitutes ec is positive; and for complements ec is negative.

Advertising (or promotional) elasticity of demand (ea) measures the

effect of incurring an “expenditure” on advertising of a firm on the

demand for its product at constant price.

Elasticity is used for determination of right price by seller and for

taxation by government.

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