Elasticity

Elasticity
By the end of this chapter you will be able to:

● Understand the concept of elasticity of demand and supply.

● Identify the factors affecting price, income and cross elasticity of demand and

price elasticity of supply.

● Explain the relationship between price elasticity of demand and total revenue.

● Understand the importance of elasticity.

● Apply the concept of elasticity to various situations.

What is Elasticity?

Elasticity is an economic concept used to measure the change in the

aggregate quantity demanded for a good or service in relation to price
movements of that good or service.

A product is considered to be elastic if the quantity demand of the

product changes drastically when its price increases or decreases.
Types of Elasticity
• In this section we are going to discuss how the demand and supply
respond to the above changes are important and can be measured by
the use of a concept known as elasticity.

a) Price Elasticity of Demand

b) Income Elasticity of Demand

c) Cross Elasticity of Demand

d) Price Elasticity of Supply.

 PRICE ELASTICITY OF DEMAND (PED)
What is price elasticity of demand?

To measure how the demand for a good responds to a change in its own
price by using the concept of price elasticity of demand (PED).
When you raise the price of most items, people will
buy less of them.
For example, when one airline raises its price, air
passengers may switch to a rival airline.

When you reduce the price of most items, people will

buy more of them.
For example, when supermarkets make special offers
with reduced prices, they expect a sharp increase in
corresponding sales.
The relationship between price and quantity
demanded is measured by 'price elasticity of
demand' (PED). This is calculated as:change
in sales/% change in price
 
where:
Q = the original quantity
P = the original price
ΔQ = the change in quantity
ΔP = the change in price

Demand is said to be elastic if e >1, inelastic if e <1, and unitary elastic if e =1.
 
Numerical value Terminology Description
Whatever the % change in price
0
Perfectly Inelastic Demand no change in quantity
 
demanded
A given % change in price leads
0 < PED < 1 Relatively Inelastic Demand
to a smaller % change in
   
quantity demanded
A given % change in price leads
1 Unit elastic demand
to exactly the same % change in
   
quantity demanded
A given % change in price leads
1 < PED < ∞ Relatively Elastic Demand
to a larger % change in quantity
   
demanded

An infinitely small % change in

∞ (infinity) Perfectly Elastic Demand price leads to an infinitely large
    % change in quantity demanded
 
Perfectly Inelastic Perfectly Elastic Unit Elastic
Demand is infinite at a price P0
Why does a firm want to know PED?
Sales forecasting
The firm can forecast the impact of a change in price on its sales volume, and
sales revenue (total revenue, TR).

For example, if PED for a product is (-) 2, a 10% reduction in price (say, from
Rs. 10 to Rs. 9) will lead to a 20% increase in sales (say from 1000 to 1200). In
this case, revenue will rise from Rs. 10,000 to Rs. 10,800.
Pricing Policy

Knowing PED helps the firm decide whether to raise or

lower price, or whether to price discriminate.
Price discrimination is a policy of charging consumers
different prices for the same product.
If demand is elastic, revenue is gained by reducing price,
but if demand is inelastic, revenue is gained by raising
price.
Determinants of PED
There are several reasons why consumers may respond elastically or in
elastically to a price change, including
1. The number and ‘closeness’ of substitutes
2. The degree of necessity of the good
3. Whether the good is habit forming
4. The proportion of consumer income which is spent on the good
5. Whether consumers are loyal to the brand
6. Life cycle of product
 For Example

Price of Quantity
Point
X of X
A 8 0
B 7 1000
C 6 2000
D 5 3000
F 4 4000
G 3 5000
H 2 6000
L 1 7000
M 0 8000
EXAMPLE 1
Given the market demand schedule in above table and market demand
curve in above Fig. 3-1, we can find e for a movement from point B to
point D and from D to B, as follows
Example

For the market demand schedule in Table find the price elasticity of demand for a movement from point B to
point D, from point’ D to point B, and (b) Do the same for points D and G.

Quantity of
Point Price of X
X

A 6 0
B 5 20000
C 4 40000
D 3 60000
F 2 80000
G 1 100000
H 0 120000
 INCOME ELASTICITY OF DEMAND
(YED)

income elasticity of demand (YED) measures how

the demand for a product responds to a change in
income.
 𝛥 𝑄 ∕ 𝑄 𝛥𝑄 𝑌
ⅇ=− =− ⋅
𝛥𝑌 ∕ 𝑌 𝛥𝑌 𝑄
where:
Q = the original quantity
Y = the original income
ΔQ = the change in quantity
ΔY = the change in income
The coefficient of income elasticity of demand (eM)
measures the percentage change in the amount of a
commodity purchased per unit time (DQ/Q) resulting from
a given percentage change in a consumer’s income (DY/Y).
 Types of income elasticity of demand

Income elasticity of demand

Can you explain why the inferior product might experience an increase
in demand for a fall in income (+/− = −) over certain ranges of income?
CROSS ELASTICITY OF DEMAND (CED)

Cross elasticity of demand (CED) refers to the

response of demand for one product to the
change in the price of another product.
 𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏𝒕𝒉𝒆 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒐𝒇 𝒅𝒆𝒎𝒂𝒏𝒅𝒆𝒅 𝒐𝒇 𝒑𝒓𝒐𝒅𝒖𝒄𝒕 𝑨
𝑷𝑬𝑫=
𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒉𝒆𝒑𝒓𝒊𝒄𝒆 𝒐𝒇 𝒑𝒓𝒐𝒅𝒖𝒄𝒕 𝑩

This can be rewritten as:

𝐂 𝐄𝐃=− ¿ ¿
where:
QA = the original quantity of product A
PB = the original price of product B
ΔQA = the change in the quantity of Product of A
ΔPB = the change in the price of product B

In situation (1) relates to
substitutes product, as the
price of B increases the
quantity demanded of A
increases. The cross
elasticity of demand is
therefore positive (+/+).
Situation (3) relates to
two products which are
totally unrelated. If, for
example, the price of
soap increased it is
unlikely to result in a
change in the quantity of
ballpoint pens
demanded.
Situation (2) relates to
complementary products, in that as
the price of product B rises (for
example petrol), the quantity
demanded of product A demanded
decreases (for example cars) (-/+ = -)
1. Find the cross elasticity of demand between tea (X) and coffee (Y)
and between tea (X) and lemons (Z)?
Answer
 Price Elasticity of Supply
Price Elasticity of Supply (PES) refers to the responsiveness of supply of
a product to a change in its own price. PES refers to movement along
the supply curve, i.e. expansion/contraction of supply
 Price Elasticity of Supply

where:
Qs= the original supply
P = the original price
ΔQs= the change in supply
ΔP = the change in price
 Perfectly Inelastic
In the case of Fig a the supply
curve S1 is perfectly inelastic, as
the price rice there is no
change in the quantity
supplied
Unit Elasticity
In the case of Fig b the supply curve s2 is
unit elastic (=1). Any given percentage
Change in the price leads to exactly the
same percentage change in the quantity
supplied
In case of Fig c the supply
curve S3 Is perfectly elastic with
a numerical value equal to
infinity
Factors Determining Price Elasticity of
Supply
(a) The existence of spare capacity
Non-availability of spare capacity (perfectly inelastic)
Availability of spare capacity( elastic)

(b) The availability of stocks

Accumulated a large quantity of unsold stocks or inventories (Supply will tend to be more elastic)

(c) Mobility of the factors of production

Reallocate of its resources from one type of production to another, then the supply for that
product will tend to be more elastic.

(d) The time period

Supply is likely to be more elastic in the long run time period
Key Points
Price elasticity of demand (PED

measures the responsiveness of the demand for a good or service to a change in its own price. It tells us
about movements along a demand curve (expansion/contraction).

What relatively inelastic ?

If the percentage change in demand is less than the percentage change in price, then demand is said to be
relatively inelastic

What relatively elastic ?

If the percentage change in demand is greater than the percentage change in price, then demand is said to be
relatively elastic.
The concept used to reveal the responsiveness of demand for a product to a change in the price of that product is
termed:
a) price elasticity of supply
b) price elasticity of demand
c) cross elasticity of demand
d) income elasticity of demand
e) none of the above.

If a small percentage drop in the price of a good leads to a large percentage increase in the quantity of that good demanded
then:
a) demand is inelastic
b) demand is elastic
c) demand is unit elasticity
d) demand is perfectly inelastic
e) demand is perfectly elastic.
If a 10% increase in price leads to a 4% reduction in the quantity of a good demanded
then the price elasticity of demand is:
a) - 0.4
b) - 0.6
c) - 2.5
d) - 4.0
e) -10.0

If a demand curve is horizontal it indicates that:

a) income elasticity of demand is zero
b) price elasticity of demand is infinity
c) price elasticity of demand is zero
d) price elasticity of demand is between zero and one
e) none of the above.
The revenue obtained from the sale of a good will fall if:
a) income increases and the good is a normal good
b) price increases and demand is inelastic
c) price increases and demand is elastic
d) price falls and demand is elastic
e) income falls and the good is an inferior good.

A rise in the price of product Y from Rs 50 to Rs 54 has resulted in the demand for product X increasing from 100 to 104
units per month. The cross elasticity of demand is:
a) 0.2
b) 0.5
c) 1.0
d) 2.0
e) 2.4
If the cross elasticity of demand between two goods X and Y is positive then:
a) the two goods are substitutes
b) the two goods are complements
c) the demand for the two goods is price inelastic
d) the demand for the two goods is price inelastic
e) none of the above.

A 5% increase in income leads to an increase in the quantity demanded from 24 units per week to 27 units per week. The
income elasticity of demand is:
a) 1.0
b) 1.5
c) 2.0
d) 2.5
e) 3.0