ELASTICITY OF

DEMAND

Dr Monika Jain
 OPEC - Introduction
 About OPEC - Organization of the Petroleum Exporting Countries - Organization of
the Petroleum Exporting Countries, established in Bagdad, Iraq in 1960. OPEC as a
cartel, manipulate supply of oil in the market, in hopes of keeping prices, and profits,
high.

 It is comprised of 12 members – Algeria, Angola, Ecuador, Islamic Republic of Iran,

Iraq, Kuwait, Socialist People’s Liberian Arab Jamahiriya, Nigeria, Qatar, Saudi
Arabia, -United Arab Emirates and Venezuela with headquarters in Vienna, Austria.
according to the official website.

 Oil is the main marketable commodity and foreign exchange earner. Thus, for these
countries, oil is the vital key to development – economic, social and political. Their oil
revenues are used not only to expand their economic and industrial base, but also to
provide their people with jobs, education, health care and a decent standard of living

 Together, the 12 member-nations control nearly 80% of the world’s oil reserves, and
44% of the world’s daily production—a powerful force used to manipulate oil prices
around the world.
Why did OPEC fail to keep the price of oil high?

• In the 1970’s OPEC(organization of Petroleum

Exporting Countries)decided to increase their
Income by increasing the price of oil
• These countries accomplished this goal by
jointly reducing the amount of oil they
supplies
• As a resulty from 1973 to 1974 the price of oil
rose more than 50%
Why did OPEC fail to keep the price of oil high?

• A few years later OPEC dis the same thing

again
• From 1979 to 1981, the prices of oil doubled
• Measured in dollars the price of crude oil
reached 91$
• Yet OPEC found it difficult to maintain the high
price
Why did OPEC fail to keep the price of oil high?

• From 1982 to 1985 the price of oil declined about 10%

• Dissatisfaction and disarray soon prevailed among the OPEC
countries.
• Price of oil plunged 45%
• In 1990,the price of oil was back to where it started and it
stayed at that low levels throughout most of 1990s
• In 2000’s vthe price of oil rose again partly by Increased
demand from a large and growing Chinese economy.
 Why did OPEC fail to keep the price of oil high?

• This OPEC episode of the 1970s and 1980s shows how supply and
demand can behave differently in the short run and in the long run.
• In the short run, both the supply and demand for oil are relatively
inelastic.
• Supply is inelastic because the quantity of known oil reserves and
the capacity for oil extraction cannot be changed quickly.
• demand is inelastic because buying habits do not respond
immediately to changes in price.
 A Reduction in Supply in
the World Market for Oil

(a) The Oil Market in the Short Run (b) The Oil Market in the Long Run
1. In the short run, when supply 1. In the long run, when supply
and demand are inelastic, a and demand are elastic, a shift
shift in supply. . . Price in supply. . .
Price
S2 2. … leads
S1 to a small S2 S1
P2 increase in
price
2. … leads to
P2
P1 a large
P1
increase in
price
Demand Demand

0 Quantity 0 Quantity
.
 The Oil Market in the LongRun
• Over long periods of time producers of oil outside OPEC
respond to high prices by increasing oil exploration and by
building new extraction capacity.
• Consumers respond with greater conversation for instance by
replacing old inefficient cars with newer efficient ones.
• In the long run the shift in the supply curve from S1 to S2
causes a much smaller increase in the price.
• This analysis shows why OPEC succeeded in
maintaining a high price of oil only in the short run.
• When OPEC countries agreed to reduce their
production of oil, they shifted the supply curve to the
left.
• Even though each OPEC member sold les oil, the price
rose by so much in the short run that OPEC incomes
rose.
• By contrast in the long run when supply and
demand are more elastic, the same reduction
in supply, measured by the horizontal shift in
the supply curve, caused a smaller increase in
the price. Thus, OPEC’s coordinated reduction
in supply proved less profitable in the long
run.
 Oil prices Today
• Why has the price of oil been dropping so fast? Why now?
• It boils down to the simple economics of supply and demand.

United States domestic production has nearly doubled over the last six
years, pushing out oil imports.
• Saudi, Nigerian and Algerian oil that once was sold in the United States is
suddenly competing for Asian markets, and the producers are forced to drop
prices.
• Canadian and Iraqi oil production and exports are rising year after year. Even
the Russians, with all their economic problems, manage to keep pumping.
On the demand side, the economies of Europe and developing countries are
weakening and vehicles are becoming more energy-efficient. So demand for
fuel is lagging a bit.
 Elasticity . . .
• … allows us to analyze supply and demand
with greater precision.

• … is a measure of how much buyers and

sellers respond to changes in market
conditions
 THE ELASTICITY OF DEMAND
• Price elasticity of demand is a measure of how
much the quantity demanded of a good
responds to a change in the price of that good.

• Price elasticity of demand is the percentage

change in quantity demanded given a percent
change in the price.
 Definition Of Price Elasticity Of Demand

• The change in the quantity demanded of a

product due to a change in its price is known
as Price elasticity of demand.
• Thus, the degree of responsiveness of
demand to change in price is as called
elasticity of demand
 Factors Affecting Price Elasticity Of
Demand
• Nature of the Commodity
• Availability of Substitutes
• The number of uses of a commodity.
• Time and elasticity.
• Influence of habits
• Proportion of Income spent on a commodity
• Range of prices
 Degrees of Price Elasticity Of Demand
1) Perfectly elastic demand
2) Perfectly inelastic demand
3) Unitary Elasticity of demand (equal to utility)
4) Relatively elastic demand
5) Relatively inelastic demand
 Perfectly Elastic Demand
- Elasticity equals infinity
Price
1. At any price
above $4, quantity
demanded is zero.

$4 Demand

2. At exactly $4,
consumers will
buy any quantity.

3. At a price below $4, Quantity

quantity demanded is infinite.
 Perfectly Inelastic Demand
- Elasticity equals 0
Price Demand

1. An $5
increase
in price... 4

100 Quantity
2. ...leaves the quantity demanded unchanged.
 Unit Elastic Demand
- Elasticity equals 1
Price

1. A 25% $5
increase
in price... 4

Demand

75 100 Quantity
2. ...leads to a 25% decrease in quantity.
 Elastic Demand
- Elasticity is greater than 1
Price

1. A 25% $5
increase
in price... 4

Demand

50 100 Quantity
2. ...leads to a 50% decrease in quantity.
 Inelastic Demand
- Elasticity is less than 1
Price

1. A 25% $5
increase
in price... 4

Demand

90 100 Quantity
2. ...leads to a 10% decrease in quantity.
Measurement Of Price Elasticity Of
Demand
There are main methods like
1. Percentage method or proportionate
method
2. Total outlay method or total revenue
method
3. Geometric method or point method
4. Arc elasticity of demand
1 Percentage method or proportionate method

• Price elasticity of demand is measured by a

ratio between the proportionate change in
the quantity of a product demanded as a
result of a proportionate change in its price
• Formula for calculate this is given further as
following
Computing the Price Elasticity of Demand

• The price elasticity of demand is computed as

the percentage change in the quantity
demanded divided by the percentage change
in price.
P e rc e n ta g e c h a n g e in q u a n tity d e m a n d e d
P ric e e la s tic ity o f d e m a n d =
P e rc e n ta g e c h a n g e in p ric e
Percentage method or proportionate method

Price
Proportionate change in demand for x
elasticity of
=
demand Proportionate change in Price for x

OR
qx px
_____ _____
/
Qx Px

Here,
qx = change in the quantity of x demanded

Qx = original quantity of x demanded

px = change in the price of x

Px = original price of x
Computing the Price Elasticity of Demand

P e rc e n ta g e c h a n g e in q u a n tity d e m a n d e d
P ric e e la s tic ity o f d e m a n d =
P e rc e n ta g e c h a n g e in p ric e

• Example: If the price of an ice cream cone

increases from $2.00 to $2.20 and the amount
you buy falls from 10 to 8 cones, then your
elasticity of demand would be calculated as:
(1 0  8 )
100 20%
10   2
( 2 .2 0  2 .0 0 )
100 10%
2 .0 0
 (1 0  8 )
100 20%
10  2
( 2 .2 0  2 .0 0 ) 1 0 %
100
2 .0 0
Total outlay method or total revenue method

• Total outlay means total expenditure and since

total expenditure of consumers on a product
implies total receipts or total revenue of
sellers, it is known as total revenue method.
Total outlay method or total revenue method

• Total outlay means total expenditure and since total expenditure

of consumers on a product implies total receipts or total revenue
of sellers, it is known as total revenue method.
• It will be clear with following table

price quantity Total outlay Price elasticity

1 5 100 500 Elasticity of demand
4 130 520 is greater than
1(e>1)
2 5 100 500 Elasticity of demand
4 120 480 is less than 1(e<1)

3 5 100 500 Elasticity of demand

4 125 500 is equal than 1(e=1)
 Geometric method or point
method
• This method attempts to measure numerical
elasticity of demand at a particular point on
the demand curve
• Price elasticity can be measure by following
method

Price Lower segment of the demand curve

elasticity of =
upper segment of the demand curve
demand
Geometric method or point method
• It can be shown in graph as following

y d

e=
8

b
e>1

c e=1

e<1 d

e=0
0 a x
 Arc elasticity of demand
• It is the use of middle points between old and
new figures in the case of both price and
quantity. This method is known as arc
elasticity method
• We can measure it with formula as given
 Arc elasticity of demand

Price elasticity of ∆Q ∆P
demand = /
Q1+Q2 P1+P2

WHERE,
Q1 = original quantity demanded
Q2 = new quantity demanded
p1 = original price
p1 = new price
The Midpoint Method: A Better Way to
Calculate Percentage Changes and Elasticities
• Example: If the price of an ice cream cone
increases from $2.00 to $2.20 and the amount
you buy falls from 10 to 8 cones, then your
elasticity of demand, using the midpoint
formula, would be calculated as:
(1 0  8 )
(1 0  8 ) / 2 22%
  2 .3 2
( 2 .2 0  2 .0 0 ) 9 .5 %
( 2 .0 0  2 .2 0 ) / 2
 Practical Importance of the
Concept of Price Elasticity Of
Demand
Practical Importance of the Concept of
Price Elasticity Of Demand
• The concept is helpful in taking Pricing
Decisions by Business Firms
• Importance of the concept in formatting Tax
Policy of the government
• Uses in Economic Policy regarding Price
regulation,esp of farm products.
• Explanation of Paradox of plenty
• Use in international Trade
(7) Income Elasticity Of Demand
Income Elasticity of Demand

• Income elasticity of demand measures how

much the quantity demanded of a good
responds to a change in consumers’ income.
• It is computed as the percentage change in
the quantity demanded divided by the
percentage change in income.
Computing Income Elasticity

P e rc e n ta g e c h a n g e
in q u a n tity d e m a n d e d
In c o m e e la s tic ity o f d e m a n d =
P e rc e n ta g e c h a n g e
in in c o m e
Types Of Income Elasticity Of Demand

• Positive Income elasticity of demand

• Negative Income elasticity of demand
• Zero Income elasticity of demand
 Positive Income elasticity of demand
Y
D

P
A

D
Income

B S
O Quantity Demanded X
Negative Income elasticity of demand
Income

Total Revenue

B S

Quantity Demanded (000s)

Zero Income elasticity of demand
Y
D
Income

O X
D

Quantity Demanded
Income Elasticity

• Types of Goods
– Normal Goods
– Inferior Goods
• Higher income raises the quantity demanded
for normal goods but lowers the quantity
demanded for inferior goods.
 Measurement Of Income Elasticity Of
Demand

Proportionate change in Demand

Income Elasticity Of Demand =
Proportionate change in Income
i.e. ∆q y
Income Elasticity Of Demand = X
∆y q
 Measurement Of Income Elasticity Of
Demand
• Here , ∆q = Change in the quantity demanded.
Q = Original quantity demanded.
∆y = Change in income.
Y = Original income.
• For e.g. ,when Income of the consumer =
2,500/- , he purchases 20 units of X, when
income = 3,000/- he purchases 25 units of X
 Cross Elasticity of Demand

• Cross elasticity of demand express a

relationship between the change in the
demand for a given product in response to a
change in the price of some other product
• E.g. if the X tea demand reduces
tremendously than it effect could be seen in
demand of sugar and milk.
 Types of Cross Elasticity of Demand

• Cross Elasticity of Demand Equal to Unity or

One
• Cross Elasticity of Demand Greater than Unity
or one
• Cross Elasticity of demand less than unity or
one
 Measurement Cross Elasticity of
Demand
Proportionate change in Demand
for product X
Cross Elasticity of Demand =
Proportionate change in Price of
i.e. product Y

∆qx ∆p y
Cross Elasticity of Demand = x
Qx Py