Elasticity and Its

Applications
Why to Study Elasticity?

The demand for a good depends not only on its price, but also
it depends on consumer income and price of other goods
etc. Likewise, supply of a good depends not only on its
price but also it depends on cost of production, govt policy
etc. If price of coffee increases, its quantity demand will
fall and quantity supplied will rise. How sensitive is the
demand for coffee to its price. If price will increase by
10%, how much quantity demand changes and how much
quantity supply will change?. How much quantity demand
for coffee will change if income rises by 5%. Here, we use
elasticity to answer these questions.
 What is Elasticity
Measure of Responsiveness
Measure: The results are reported as numbers or Elasticity
Coefficients
Responsiveness: Stimulus-Reaction Involved
Elasticity = % Change in Response
% Change in Stimulus
What is Elasticity of demand
Elasticity of demand refers to the degree of responsiveness of quantity
demanded of a commodity due to change in any of its determinants, Viz.,
price of the commodity, price of the other commodities(related goods)
and income of the consumer. It is a measure of how sensitive the quantity
demanded due to change in any of its determinants. In other words,
elasticity measures the responsiveness of one variable with respect to
change in other variable. Elasticity of demand means expansion or
contraction in demand. For eg. if mobile phone discount increases,
quantity demand for mobile phone increases.
Why 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

A tool which helps the manager of a company in taking

good decision about fixing the price of his Product.
Sensitive and hence
elastic in Behavior

Not Sensitive and hence Cool. It does not

inelastic in Behavior Bother Me
TYPES OF ELASTICITY of DEMAND:

In the theory of demand for goods, generally 3 types of

elasticity are used.

Price Elasticity

Income Elasticity

Cross Elasticity
THE PRICE 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.
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 ercen tag e ch an g e in q u an tity d em an d ed
P rice elasticity o f d em an d =
P ercen tag e ch an g e in p rice

Price Elasticity of Demand = Q Q2  Q1 P

Q = Q * P  *
P Q
P P2  P1 Q
P
 Q and P refers to change in quantity and price. Since
price and quantity are inversely related as per law of
demand, the price elasticity of demand is usually a negative
number. Hence, Q/P is negative but we refer the
magnitude of the price elasticity i.e absolute size. The
negative sign is ignored while calculating price elasticity of
demand.

Interpretation of Price elasticity of demand

If the price elasticity of demand coefficient is 0.59%, it
means that 1% increase in price reduces the quantity demand
by 0.59%.
 Types of Price Elasticity of demand
On the basis of coefficient of demand we have 5 types of demand
elasticity.

Elastic Demand: %Q  %P

Inelastic Demand: % Q  % P
Unit Elastic Demand: % Q  % P
Perfectly Elastic Demand: %Q  

Perfectly Inelastic Demand: %Q  0

 Elastic Demand: Elasticity Is Greater Than 1  
A product is called as elastic in demand if the % change in quantity
demand exceeds the % change in price. For example, if price will fall by
: the quantity demand will increase more than 50%. In this case, the
50%
price elasticity of demand is greater than 1.

Price D
Elastic in demand
1000
Example:
Luxurious or Non
500 Essential Goods
such as restaurant
D meals or Airline
0 travel etc.
1 3
Another Ex: Quantity
Price 50 25
Qd 20 60
Here, the price elastic of demand is 4 which is greater than 1. It means if price
will increase by 1% the quantity demand will fall by 4%.
 Inelastic Demand: Elasticity Is less Than 1  
A product is called as inelastic in demand if the % change in quantity
demand: is less than the % change in price. For example, if price will
fall by 50% the quantity demand will increase by less than 50%. In this
case, the price elasticity of demand is less than 1.

Price D
Inelastic in demand
1000 Example: Necessary or Essential
Goods Such as Gasoline, Matches
500 etc.

D
0 1 1.3 Quantity
Another example Price 50 20
Qd 15 20
Here, the price elasticity of demand is less than 1. It is inelastic.
Unitary Elastic Demand: Elasticity Is equal to 1
When percentage change in quantity demanded is exactly
equal to percentage change in price, then demand is said to be
unitary elastic. Here, price elasticity of demand is equal to
one. It is a special case.

D
1000

500
D
0 1 1.5 Quantity

Another example Price 10 5

Quantity 100 150
Here, the price elasticity of demand is equal to 1
Unitary Elastic Demand (e=1):
For instance, a 10% fall in price of a commodity leads to 10%
rise in demand of that commodity.

Exampls of unit elastic: Movies, Private Education,

Radio and Television Receivers (Approximately) etc
Perfectly Elastic Demand: Elasticity Equals Infinity
A horizontal line reflecting a situation in which any price increase would reduce the
quantity demand to zero.
Eg. Two stores are selling computers with same quality and same price and same
location. Information's are available to the public. Now, one has increased the price
and other kept the price same. Hence, demand will decease drastically who
increases the price.
Price 1. At any price
above $4, quantity
demanded is zero.
$4 Demand

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

0 Quantity
3. At a price below $4,
quantity demanded is infinite.
A small change in price leads to an enormous change in demand, the elasticity of
demand is infinite.
Perfectly Inelastic Demand: Elasticity Equals 0

A vertical line reflecting a situation in which any price changes has no effects
on quantity demand, the elasticity value is zero. In perfectly inelastic demand
consumer buys a fixed quantity no matter what the price is. For vertical demand
curve Delta Q/Delta P is zero.
Price
Demand

$5
Example: Medicine,
4
Salt(basic necessities)
1. An
increase
in price . . .

0 100 Quantity

2. . . . leaves the quantity demanded unchanged.

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Elasticity Changes along a Straight-Line Demand Curve
• Price elasticity of
demand decreases as
we move downward
along a straight line
demand curve.
• Demand is elastic in
the upper range and
inelastic in the lower
range of the line.
Methods of Measuring Elasticity
 A
Price
B

50 C

0 E
5
Quantity
Calculate elasticity at point D
At point D=lower segment/upper segment=ED/AD
ED is <AD Elasticity is less than 1 (inelastic)
Calculate elasticity at point B
EB/AB. EB>AB. Hence elasticity is> 1, it is elastic.
ARC Elasticity
The Determinants of Price Elasticity of Demand
Availability of Close Substitutes- When there are close
substitutes, a price increase will cause the consumer to buy
less of that good and will buy more substitute goods.
Demand will be highly price elastic, when there are close
substitutes. When there are no close substitutes, demand
will be price inelastic
Nature of the commodities(Necessities versus
Luxuries):
Example: The demand for vacation air travel is more elastic
than the demand for business air travel. Luxury goods are
elastic in demand whereas necessary goods are inelastic in
demand(less price, less elastic).
Proportion of Income Spent on commodity:
Time Horizon
In short run, goods demand are highly inelastic whereas in long
run goods demand are highly elastic. In long run, information
based on price change is available to the public but it short run
very few people have information.
Brand image: If you like a particular brand, then your
demand is inelastic in nature irrespective of price increase.
Habit Forming Goods: Goods such as cigarettes and
drugs tend to be inelastic in 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

The income elasticity of demand varies from commodity to

commodity whether it is normal goods, inferior goods or
luxury goods
Remember income can be written as Y or I
Income Elasticity-The income elasticity of demand can be
used to classify the type of goods.
Types of Goods
Normal Goods
Inferior Goods
Luxury goods
Normal goods: Higher income raises the quantity demanded for
Normal goods. It has +ve income elasticity of demand(0 to 1).
For ex. If income increases by 10%, the demand increases by
4%. Demand is increasing less than proportionately to income.
Ex. of normal goods are branded dress, LED TV, CAR, etc
Inferior goods: The demand for those goods decreases with
increase in consumer income. Inferior goods have negative
income elasticity of demand. Eg. Low quality bread. As
income of the people increases, they will go for organic bread
rather than low quality bread.
Income Elasticity
Necessity goods: Goods consumers regard as necessities tend to
be income inelastic.
Examples include food, fuel, clothing, utilities, and medical
services.
As income increases, demand for necessities also increases, but
it is marginal in nature.
Luxury goods: Luxury goods have income elasticity of demand
which is greater than 1. The demand rises more than proportionally
due to change in income. For example, if income increases by 10%,
the demand for luxury goods rises 16%. Quantity demand is very
sensitive to increase or decrease in income. Goods consumers
regard as luxuries tend to be income elastic.
Examples include sports cars, furs, and expensive
foods.
 Need to remember
If income elasticity of demand is >1 , then the good is luxury goods
If income elasticity of demand is<0 , then the good is inferior goods and has
negative income elastic.
If income elasticity of demand is>0 , then the good is a normal goods
If income elasticity of demand is less than one (>0 but <1) , then the good is a
necessity goods
Interpretation of Income Elasticity
If income elasticity of demand for wine in India is 2.59 which means 1% increase
in consumers income lead to 2.59% increase in consumption expenditure.
If income elasticity of demand for flour in India is -0.59 which means 1%
increase in consumers income lead to 0.59% reduction in consumption
expenditure on flour.
ARC Elasticity of Demand
 Cross price Elasticity of Demand

In cross price elasticity of demand, we measure the

responsiveness of demand for commodity X to a change in price
of commodity Y .
Cross price elasticity of demand can be positive or negative, based
on the change in price of substitute and complementary products.
If Cross-price Elasticity is Positive (> 0) if and only if the goods are
Substitutes
If Cross-price Elasticity is Negative (< 0) if and only if the goods are
complements
If Cross-price Elasticity is = 0 if and only if the goods are Unrelated. Ex.
of not related goods are water and computer
How cross price elasticity of demand is +ve for substitute goods
Lets assume that Pepsi and Coke are close substitutes for many customers.
If the price of Pepsi increases, some of the customer may switch to coke.
The change in price of Pepsi and the demand for Coke are now moving in
the same direction. Hence, cross price elasticity of demand is +ve.
How cross price elasticity of demand is -ve for complementary
goods
Complementary products like petrol run car and petrol have a negative cross
elasticity. If the price of petrol increases significantly, then the demand for
petrol runs cars fall, while the demand for diesel runs cars may increase.
Since the price of petrol and the demand for petrol runs cars move in
opposite direction, then the cross price elasticity of demand is negative.
Interpretation of Cross price elasticity of demand:
If the cross price elasticity of demand of tea with respect to the price of
coffee is 0.345%. This means that 1% increase in the price of tea leads to
0.35% increase in demand for coffee(substitute goods)
If the cross price elasticity of demand of table with respect to chair is -
0.45%. This means 1 % increase in price of table leads to 0.45% reduction
in the demand for chair.
Elasticity of Supply
A measure of responsiveness of quantity supplied to a price
change. The percentage change in quantity supplied divided
by percentage change in price. The elasticity of supply is
usually positive, because higher the price gives producers an
incentive to increase output. There are certain variables
which influences the elasticity of supply namely interest rate,
wage rate, input prices.
 Elastic supply: Elasticity Is Greater Than 1  
A product is called as elastic in supply if the % change in quantity
: supplied exceeds the % change in price. For example, if price will
increase by 50% the quantity supplied will increase by more than 50%.
In this case, the price elasticity of supply is greater than 1.
Price Elastic in Supply
s
1000
Examples: Luxury
products, oilseed
500 products

S
0
1 3
Another Ex: Quantity
Price 50 25
QS 20 60
Here, the price elastic of supply is 4 which is greater than 1. It means if price will
increase by 1% the quantity supply will increase by 4%.
 Inelastic Supply: Elasticity Is less Than 1  
A product is called as inelastic in supply if the % change in quantity
supplied: is less than the % change in price. For example, if price will
increase by 50% the quantity supplied will increase by less than 50%.
In this case, the price elasticity of supply is less than 1.

Price S
Inelastic in Supply
1000
Examples: Necessary goods

500
S
0 1 1.3 Quantity
Another example Price 50 20
QS 15 20
Here, the price elasticity of demand is less than 1. It is inelastic.
Unitary Elastic Demand: Elasticity Is equal to 1
When percentage change in quantity supplied is exactly equal
to percentage change in price, then supply is said to be
unitary elastic. Here, price elasticity of supply is equal to one.
It is a special case.
Price S

1000 Examples: Normal goods

500
S
0 1 1.5 Quantity

Another example Price 10 5

Quantity 100 150
Here, the price elasticity of supply is equal to 1
 Perfectly Elastic supply: Elasticity Equals Infinity
A horizontal line reflecting a situation in which any price decrease would reduce the
quantity suppied to zero.

Price 1. At any price

above $4, quantity
Supplied is infinity
$4 Supply

2. At exactly $4,
Producer will
Produce any quantity.

0 Quantity
3. At a price below $4,
quantity supplied is zero
 Perfectly Inelastic Demand: Elasticity Equals 0

A vertical line reflecting a situation in which any price changes has no effects
on quantity supplied, the elasticity value is zero. In perfectly inelastic demand
consumer buys a fixed quantity no matter what the price is.

Price
Supply

$5

4
1. An
increase
in price . . .

0 100 Quantity

2. . . . leaves the quantity supplied unchanged.

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Total Revenue and the Price Elasticity
of Demand
Total Revenue is the amount paid by buyers
and received by sellers of a good.
Computed as the price of the good times the
quantity sold.

TR = P x Q
 Figure 2 Total Revenue
Price
revenue: the income generated from sales of goods and services

$4

P × Q = $400
P
(revenue) Demand

0 100 Quantity

Q
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Elasticity and Total Revenue along a
Linear Demand Curve
With an inelastic demand curve, an
increase in price leads to a decrease in
quantity that is proportionately smaller.
Thus, total revenue increases.
 Figure 3 How Total Revenue Changes When Price
Changes: Inelastic Demand

Price Price
An Increase in price from $1 … leads to an Increase in
to $3 … total revenue from $100 to
$240

$3

Revenue = $240
$1
Revenue = $100 Demand Demand

0 100 Quantity 0 80 Quantity

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Elasticity and Total Revenue along a
Linear Demand Curve
With an elastic demand curve, an increase
in the price leads to a decrease in quantity
demanded that is proportionately larger.
Thus, total revenue decreases.
 Figure 4 How Total Revenue Changes When Price
Changes: Elastic Demand

… leads to an decrease in total

Price An Increase in price from $4 Price
revenue from $200 to $100
to $5 …

$5

$4

Demand
Demand

Revenue = $200 Revenue = $100

0 50 Quantity 0 20 Quantity

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Ep >1 Ep = 1

Ep<1
 Ep >1 Ep = 1
5
4
3
1 Ep<1

20 50 80 100

B
200
100

A C
The upper part of the demand curve corresponds to AB portion of total revenue curve
which is elastic in nature. The lower part of the demand curve corresponds to BC
portion of the total revenue curve which is inelastic in nature.

In case of elastic product: If the demand of a product is elastic in nature (means it is

very sensitive to price change) demand will fall if there is increase in price and vice
versa. As a manager how you will make profit if the product is elastic in nature?. If the
manager will reduce the price, quantity demand will increase, sales volume will
increase and profit will increase there after. Lets assume initial price is 5 and quantity
demand is 20. TR=5*20=100. If the manager will reduce the price from 5 to 4 then
quantity demand will increase from 20 to 50 and total revenue is (4*50=200).

On the other hand, coming to inelastic portion of the demand curve it is less sensitive
to price change. For example cigarate. The people who are consuming cigarate
/alcohol will not stop consuming cigarate if there is increase in cigarate price. So, in
order to make profit, a manager should increase price . For ex. If government will
increase cigarate price still people will buy because there are no way to substitute it.

In inelastic portion of the demand curve when price is 1 quantity demand is 100. Total
revenue is 100*1=100. If the price will increase to 3, the quantity demand is 80 and
total revenue is (3*80=240). Hence, if the product is inelastic in nature the manager
can make profit by increasing the price.
 Table
Elasticity For Price Decision Manager’s
Manager’s of Manager Total Revenue
Product
Ep >1 Price Increase TR Decreases
Ep >1 Price Decreases TR Increases
Ep < 1 Price Increase TR Increases
Ep < 1 Price Decreases TR Decreases

Ep = 1 Price Increases TR Remains

Price Decreases Same
Thank you