ELASTICITY OF DEMAND &

SUPPLY
ELASTICITY: MEANING

 A general concept used to quantify the

response in one variable when another variable
changes

 A standardized measure of the sensitivity of one

(dependent) variable to changes in another
variable
ELASTICITY OF DEMAND

Degree of sensitivity or responsiveness

of demand to changes in any of the
factors affecting it
% Q
E 
% Z

+ Qd and Z are directly related

- Qd and Z are inversely related
ELASTICITY MEASURES

 Price elasticity of Demand

 Income elasticity of Demand
 Cross elasticity of Demand
 Promotional elasticity of demand
 Expectations elasticity of demand
 Elasticity of Supply
PRICE ELASTICITY OF DEMAND
A measure of the responsiveness of quantity
demanded of a good to changes in its price
d
% Q X
EQ X , PX 
% PX

Negative according to the law of demand

PRICE ELASTICITY OF DEMAND: CATEGORIES

1. Relative elasticity of demand

EP > 1
2. Relative inelasticity of demand
EP < 1
3. Unitary elasticity of demand
EP = 1
4. Perfect elasticity
EP = ∞
5. Perfect inelasticity
EP = 0
Elastic Demand
- Elasticity is greater than 1 (Percentage change in
demand exceeds percentage change in price, 1 < ED < ∞)

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(Percentage change in
demand is less than percentage change in price, 0< ED <
1)
Price

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

Demand

90 100 Quantity
2. ...leads to a 10% decrease in quantity.
Unit Elastic Demand
- Elasticity equals 1 (Percentage change in demand is
same as percentage change in price, ED = 1)
Price

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

Demand

75 100 Quantity
2. ...leads to a 25% decrease in quantity.
Perfectly Elastic Demand
- Elasticity equals infinity (ED = ∞)

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 (ED = 0)

Price Demand

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

100 Quantity
2. ...leaves the quantity demanded unchanged.
MEASURMENT OF PRICE ELASTICITY OF
DEMAND

 Percentage/ Proportionate method

 Graphical method

 Total outlay method

KINDS OF ELASTICITY

 Point elasticity: elasticity at a particular point

on demand curve

 Arc elasticity: average elasticity over a

segment of demand curve
POINT PRICE ELASTICITY OF DEMAND
Ratio of the percentage of change in quantity demanded
to the percentage change in price, at a particular point
on demand curve
% Q
Ep =
% P

Q / Q Q P
EP   
P / P P Q
ARC PRICE ELASTICITY OF DEMAND
Ratio of the percentage of change in quantity
demanded to the percentage change in price,
measured over a discrete interval of a demand
curve
Q2  Q1 P2  P1
Ep  
(Q1  Q2 ) / 2 ( P1  P2 ) / 2

Q2  Q1 P2  P1
EP  
P2  P1 Q2  Q1
EXERCISE

Suppose market demand for playing cards is

given by:

Q = 60,00,000 – 10,00,000 P
Q: no of decks of cards demanded
P: price

Find Arc Price elasticity when price increase

from Rs 2 per deck to Rs 3.
PRICE ELASTICITY OF DEMAND:
GRAPHICAL METHOD

Elasticity
differs along a
linear demand
curve
RELATIONSHIP BETWEEN PRICE, TOTAL REVENUE
& Ed: TOTAL OUTLAY METHOD

PRICE TOTAL Ed
REVENUE/
OUTLAY
↑ ↑ <1
↑ ↓ 1
↓ ↓ <1
↓ ↑ 1
↑/↓ same =1
 Price Elasticity & Total Revenue

Table 6.2
Elastic Unitary elastic Inelastic
%Q%P %Q%P %Q%P
Q-effect No dominant P-effect
dominates effect dominates
Price
TR falls No change in TR TR rises
rises
Price
TR rises No change in TR TR falls
falls

19
EXAMPLE
The manager faces foll dd curve for CDs.

 DD curve is elastic over $ 16 to $18 price range-

manager knows that by lowering price, TR will
increase.

 DD curve is inelastic over $ 9 to $ 7 price range-

manager knows that by lowering price, TR will
decrease.

 DD curve is unitary elastic over $ 11 to $13 price

range- manager knows that by lowering price, TR
will not change.
CONTD..
Price per CD ($)

24

18
16

13
11

9
7

600 800 1100 1300 1500 1700 2400

Quantity of CDs
RELATIONSHIP BETWEEN MARGINAL
REVENUE, PRICE & ELASTICITY OF DEMAND

MR = d(PQ) = dQ*P + dP*Q

dQ dQ dQ

= P + QdP = P 1 + dP.Q
dQ dQ P

 1 
MR  P  1  
 EP 
 TR 1000
900
800
700
600
500
400
300
200
100
0
100 200 300 400 500 600 700
Q
MR,P 8

Elastic
6

4
Ep = -1

2 Inelastic

0
100 200 300 400 500 600 700 Q

-2

-4

-6
RELATIONSHIP BETWEEN MARGINAL REVENUE,
PRICE & ELASTICITY OF DEMAND

MR TR Ed

MR >0 TR as Q Elastic

MR = 0 TR is max Unit elastic

MR < 0 TR ↓as Q Inelastic

DETERMINANTS OF PRICE ELASTICITY

 Availability of substitutes

 Proportion of income spent

 Nature of commodity

 Number of uses a commodity can be put to

 Length of time period

PRICE ELASTICITY AND DECISION MAKING
 Pricing decisions of business firms
Reducing P with elastic dd will lead to
increase in TR

 Uses in economic policy

 Uses in international trade

And lots more..

INCOME ELASTICITY OF DEMAND

A measure of the degree of

responsiveness of demand (for a good) to
a change in income, ceteris paribus
d
% Q X
EQ X ,M 
% M
+ Normal Good
- Inferior Good
INCOME ELASTICITY OF DEMAND

Point Elasticity
dQ Y
εY = x
dY Q

Arc Elasticity
Q2  Q1 Y2  Y1
EY  
(Q1  Q2 ) / 2 (Y1  Y2 ) / 2
 EXCERCISE

If a consumer’s demand for a commodity

increases from 100 units per week to 200 units
per week when his income rises from Rs 2000 to
Rs 3000, find his income elasticity of demand.
 Suppose a company sells its products globally and is
looking at two emerging markets where the aggregate
income is expected to grow at a decent rate. In one
market, income elasticity is less than one and in the
other market, income elasticity is greater than one.

 In which market the company should promote its product

more aggressively?
INCOME ELASTICITY OF DIFFERENT CONSUMER GOODS

COMMODITIES COEFFICIENT OF IMPACT ON

INCOME EXPENDITURE
ELASTICITY OF
DEMAND
Necessities 0<E≤1 Less than proportionate
(Inelastic demand) change in income
Inferior E<0 Increase in income
associated with decline
in quantity demanded
Superior/ E>1 More than proportionate
Luxuries (Elastic demand) change in income
INCOME ELASTICITY AND DECISION
MAKING
 Planning for firm’s growth (If income elasticity > 1
then sales of product will increase more rapidly
than general economic growth)

 Forecasting demand

 Formulating marketing strategy

 CROSS-ELASTICITY OF DEMAND

A measure of the degree of

responsiveness of the demand for one
good (X) to a change in the price of
another good (Y)
d
% Q X
EQ X , PY 
% PY
+
-Substitutes
Complements
CROSS-ELASTICITY OF DEMAND

Point Elasticity
dQA PB
εx = x
dPB QA

Arc Elasticity
Q2 A  Q1 A P2 B  P1B
Ex  
(Q1 A  Q2 A ) / 2 ( P1B  P2 B ) / 2
 EXCERCISE

The price of coffee increases from Rs 50 per kg

to Rs 70 per kg. Because of this, the demand for
tea increases from 5 kg to 10 kg. what is the
cross elasticity of demand of tea for coffee?

Answer: 2.5
 KNOWING FROM THE DEMAND FUNCTION

Example:

d
QX  10  2 PX  3PY  2 M

 X and Y are substitutes (coefficient of PY is positive)

 X is an inferior good (coefficient of M is negative)

 KNOWING FROM THE DEMAND FUNCTION
Linear Demand

QX   0   X PX   Y PY   M M   H H
d

PX PY M
EQX , PX X EQX , PY  Y EQX , M  M
QX QX QX
Own Price Cross Price Income
Elasticity Elasticity Elasticity
 EXAMPLE
Given:

Qd = 200 - 2 P + .05 I + .5 W + .5 Pc
P = 95, I = 1000, W = 80, Pc = 200

Find Ep, EI, Epc

SOLUTION

Qd = 200

Ep = - 2 (95/200) = -.95

EI = .05 (1000/200) = .25

Epc = .5(200/200)= .5
PROMOTIONAL (ADVERTISING)
ELASTICITY OF DEMAND

Measures the responsiveness of quantity

demanded to a change in expenditure on
advertising & other sales promotion
activities
 When should a company go for heavy expenditures on
advertising- when advertising elasticity of demand is
greater or less than one?
ELASTICITY OF PRICE EXPECTATIONS

Measures the responsiveness of

expected future price to a change in
current price
REAL LIFE APPLICATIONS OF
THE CONCEPT OF ELASTICITY
CASE1: PRICING AND CASH FLOWS

 According to an FTC Report by Michael Ward,

AT&T’s own price elasticity of demand for long
distance services is -8.64.

 AT&T needs to boost revenues in order to meet it’s

marketing goals.

 To accomplish this goal, should AT&T raise or

lower it’s price?
ANSWER: LOWER PRICE!

 Since demand is elastic, a reduction in price

will increase quantity demanded by a greater
percentage than the price decline, resulting
in more revenues for AT&T.
CASE 2: QUANTIFYING THE CHANGE

If AT&T lowered price by 3 percent, what would

happen to the volume of long distance telephone
calls routed through AT&T?
 ANSWER
• Calls would increase by 25.92 percent!
d
% Q X
EQ X , PX  8.64 
% PX
d
% Q X
 8.64 
 3%
 3%    8.64   % Q X
d

d
% Q X  25.92%
 CASE 3: IMPACT OF A CHANGE IN A
COMPETITOR’S PRICE

 According to an FTC Report by Michael Ward,

AT&T’s cross price elasticity of demand for long
distance services is 9.06.

 If competitors reduced their prices by 4 percent,

what would happen to the demand for AT&T
services?
 ANSWER
• AT&T’s demand would fall by 36.24 percent!
d
% Q X
EQ X , PY  9.06 
% PY
d
% Q X
9.06 
 4%
d
 4%  9.06  % Q X
d
% Q X  36.24%
 EXERCISE (1)

 A consultant estimates the dd function for

Pizzas as
P = 50 – 5 Q

 At what O/P rate is dd unitary elastic?

 Over what range of O/P is dd elastic?
 At the current Price, 8 units are demanded. If
the objective is to increase TR, should the price
be increased or decreased? Why?
EXERCISE (2)

 The generalised linear dd function for good X is

estimated to be:
Q = 2,50,000 – 500P – 1.50 M -240 Pr
Where P: Price of good X
M: income
Pr: Price of related goods

 The values of P, M, Pr are expected to be Rs. 200,

Rs. 60,000 & Rs. 100 respectively.

CONTD…
EXERCISE (2) QUESTIONS
 Compute Quantity of X demanded for given values of P,
M, Pr.
 Calculate Ed. At this point on dd for X, is dd elastic,
unitary elastic or inelastic? How would increasing the
price of X effect TR? Explain.
 Calculate income Ed. Is the good normal or inferior?
Explain how a 4% increase in income would affect dd for
X, cetirus peribus.
 Calculate cross Pd. Are the goods X & Y substitutes or
compliments? Explain how a 5% decrease in price of
related good would effect dd for X, cetirus peribus.
ELASTICITY OF SUPPLY
 ELASTICITY OF SUPPLY

Percentage change in quantity supplied as a result of the

percentage change in price

% ∆ Quantity supplied
ES =
% ∆ Price
ELASTICITY OF SUPPLY
Point elasticity
dQ P1
S  
dP Q1

Arc elasticity

Q2  Q1 P2  P1
Es  
(Q1  Q2 ) / 2 ( P1  P2 ) / 2
ELASTICITY OF SUPPLY: TYPES

Es = ∞ Perfectly elastic
1 < Es < ∞ Relatively elastic
Es = 1 Unitary elastic
0 < Es < 1 Relatively
inelastic
Es = 0 Perfectly
inelastic
(I) PERFECTLY ELASTIC SUPPLY
Y
When the supply
for a product
PRICE changes –
S increases or
decreases even
when there is no
change in price,
it is known as
O X
PERFECTLY
ELASTIC SUPPLY
QUANTITY SUPLIED
(II) RELATIVELY ELASTIC SUPPLY
Y
When the
S proportionate
PRICE change in
supply is more
than the
proportionate
changes in
price, it is known
O X as relatively
elastic supply.
QUANTITY SUPLIED
(III) UNITARY ELASTIC SUPPLY
Y When the
proportionate
S
change in
PRICE supply is equal
to proportionate
changes in
price, it is
known as
unitary elastic
O X supply

QUANTITY SUPLIED
(IV) RELATIVELY INELASTIC SUPPLY
Y
When the
S proportionate
PRICE change in
supply is less
than the
proportionate
changes in
price, it is
O X
known as
relatively
QUANTITY SUPLIED inelastic supply
(V) PERFECTLY INELASTIC SUPPLY
Y S
When there is
PRICE no change in
the quantity
supplied with
the change in
its price, it is
perfectly
O X inelastic
supply
QUANTITY SUPLIED
ELASTICITY OF SUPPLY: DETERMINANTS
 Time

 Relationship b/w minimum supply prices of

different firms

 Cost of attracting factors of production

 Flexibility of inputs

 Mobility of inputs

 Ability to produce substitute inputs

Time Factor
Short period - relatively less elastic
Long period – more elastic
Nature of the commodity
Perishable goods – relatively less elastic
Durable goods – elastic supply
Technique of production
Complex technique – inelastic
Simple technique – elastic
Nature Of Inputs Used
 Commonly used factors – elastic
 Specialised factors –inelastic
Future price expectation
 price increase- inelastic
 price decrease – elastic
Natural constraint
 elastic
Risk Taking
 Willing to take risk- more elastic
 Unwilling to take risk- less elastic
 EXCERCISE

Firm XYZ supplies 2000 pens at a price of Rs 8

per pen. When price increases to Rs 10, the
supply increases to 3000 pens. Find the elasticity
of supply of pens.

Answer: 2