AEA 207: Agricultural Price Analysis

Demand Elasticities
By
Sanga, G.J.
2015
 Price Elasticity

• The concept of demand curve provides;

– a description of the relationship between price and quantity
buyers are willing and able to buy, other factors remaining
constant.
• Price theory suggests an inverse relationship between
price and quantity.
• But the inverse relationship by itself says nothing about
the responsiveness of quantity demanded to a price
change of a commodity.
• This responsiveness is likely to vary from commodity to
commodity.
 Price Elasticity cont…..

• An explicitly demand curve is defined by its algebraic

equation, assuming its known.
• The quantity variable is normally expressed in
physical units, while price is expressed in monetary
terms per physical unit.
• But since different unit are often employed (shillings,
kilograms), it is difficult to make direct comparisons
from algebraic equations of;
– The impact that a given change in price will have on
different commodities.
 Price Elasticity cont…..

• To facilitate comparisons, economists frequently

make use of percentage relationships;
– Which are independent of the size of units used to
measure price and quantity.
• The most common of these relationships is the
concept of own-price elasticity of demand.
• This is simply a ratio that express the percentage
change in the quantity demanded associated with a
given percentage change in price.
 Price Elasticity cont…..

• Price elasticity is defined for a point on the demand

curve, and;
– Hence for most demand curves the magnitude of the
elasticity coefficient varies along the curve.
• Let ∆ equal a very small change, then a mathematical
definition of price elasticity is;
Q

   
Q
Q
EP  P P
P
Q
P
 Price Elasticity cont…..

• An alternative equation for defining price elasticity is

the arc formula;
Q0  Q1

EP 
Q0  Q1
P0  P1
 
Q0  Q1
Q0  Q1
 P0  P1
P0  P1

P0  P1
• Note: The subscripts presents two different points on
a demand curve.
• The arc equation is mainly used for computing
elasticity at an average between the two points and;
– Not the average of elasticities on the arc between the
points.
 Price Elasticity cont…..

• The smaller the arc or segment the more nearly the

elasticities computed from the arc and point
formulas approach each other.
• Remember elasticity is strictly defined only with
respect to a particular point.
 Interpretation

• The own price elasticity-of-demand coefficient for any

commodity can be interpreted as;
– the percentage change in quantity demanded given a very
small percentage change in the price of that commodity,
other factors held constant.
• A convenient way to think of a price elasticity is as the
percentage change in quantity corresponding to 1
percent change in price.
• Since the slopes of demand are negative, price
elasticity-of-demand coefficients have a negative sign.
 Interpretation cont…..

• The range of the price-elasticity coefficients is from

zero to minus infinity (i.e. 0→ -∞).
• This range is traditionally divided into three parts:
– If the absolute value (neglecting the sign) of the coefficient
is greater than one, the demand is said to be elastic.
– Which mean that the percentage change in quantity
demanded is greater than the corresponding percentage
change in price.
– The limiting case is the horizontal demand curve-which is
perfectly elastic (coefficient is infinity).
 Interpretation cont…..
– If the absolute value of the coefficient is less than one,
demand is inelastic.
– This imply that the percentage change in quantity is less
than the corresponding percentage change in price.
– Quantity demanded is relative unresponsive to price
changes.
– The limiting case is elasticity of zero-in this case demand is
perfectly inelastic.
– A coefficient of -1 represent the case of unitary elasticity-
which implies that the percentage change in quantity
equals the percentage change in price.
 Interpretation cont…..

• The elasticity coefficients varies along the demand

curve for most functional forms of the curve.
• If a straight line curve is extended to the two axes;
– the elasticity varies from infinity on the price axis through
various (negative) values to zero at the point on the quantity
axes.
• A few special cases exist where the elasticity is a
constant over a range the curve.
• These case includes;
– A straight horizontal line, a straight vertical line, a power
function, and a rectangular hyperbola.
 Interpretation cont…..

• Since in general the elasticity coefficient varies in

magnitude along the demand curve;
– It is not technically correct to say that the demand for
commodity is elastic or inelastic.
• Demand is elastic or inelastic only within some range of
prices.
• However, it is convenient to categorize and speak of the
demand for a commodity as being either elastic or
inelastic.
– Elasticity should be referred to within the usual range of prices.
• Note: empirical estimation of elasticity is made at the
mean of the observations.
 Price Elasticity and Total Revenue

• Total revenue is defined as price multiplied by quantity.

• It has two components which are inversely related;
– however it is not too obvious how changes in price will
influence total revenue.
• For example:
– The question whether a given percentage increase in price
will increase or decrease total revenue.
– This question is answered by the magnitude of the price
elasticity-of demand coefficient.
– If demand is elastic in the relevant range of prices, then the
total revenue vary inversely.
 Price Elasticity and Total Revenue cont…

• It follows that a price increase will decrease total

revenue, and a price decrease will increase total
revenue.
• This follows from the defin. of an elastic demand;
– which means that the percentage change in quantity
demanded is greater than the percentage change in price.
– A decrease in price for example, results in a more than
offsetting percentage increase in quantity taken. Hence total
revenue increases as price decreases.
– However, it does not follow that total revenue will increase
indefinitely as price decreases.
– At some point price will presumably move into an inelastic
range of demand relation.
 Price Elasticity and Total Revenue cont…

• If demand is inelastic in the relevant range of prices,

then price and total revenue vary directly.
– A price increase will increase total revenue and vice versa.
• It is important to note that price elasticity measures
responsiveness along the demand curve.
• This, of cause, is implicit in the discussion of
elasticities and total revenue.
• If for example, demand increases, then total revenue
and quantity may increase even though is inelastic.
– This is a function of the shift in demand and not of the
elasticity of one demand relation.
 Income Elasticity

• Income elasticity of demand is a measure of the

responsiveness of quantity to the percentage change
in disposable income.
• The income elasticity is defined at a point on the
function and typically varies along the range of the
curve.
• Let Y represent income, then the definition of
income elasticity at a point is;
Q

EY 
Q
Y
   
Q
Y
Y
Q
Y
 Income Elasticity cont…

• Income elasticity may be interpreted as;

– the percentage change in quantity corresponding to a 1 percent
change in income, other factors held constant.
• In most cases the coefficient is positive.
– This is consistent with the idea that as income increases ,
consumer buys more of most of the products and when it
decreases is the opposite.
• However, this is not the case for food products;
– Income elasticity tend to decline as income increases.
– Households with high incomes will generally have smaller
income elasticities for food than households with lower
incomes.
 Income Elasticity cont…

• Although income elasticities are used in making

demand projections, caution should be taken:
– Because the elasticity itself can change as income increases,
therefore, making projections using a single coefficient may
lead to errors.
• In empirical analysis “income elasticities” are
sometimes estimated from;
– observations on expenditures rather on physical quantities
and on incomes.
• Expenditure on a particular commodity is made a
function of total expenditures.
 Income Elasticity cont…

• Note: Observations on income obtained in surveys

often contain errors and do not correspond to the
economic concept of income.
– In such surveys income earned by a household member
other than the respondent normally is overlooked.
• Also observation on expenditure are more easily
obtained than observations on physical quantities.
– Elasticities obtained from data on expenditures represent
the percentage response of expenditure on an individual
commodity to a 1 percent change in total expenditures.
 Income Elasticity cont…

• Coefficients that measure the responsiveness of

expenditure to a change in income are sometimes called
expenditure elasticities.
• These elasticities generally are larger than those based on
physical quantities.
• Expenditures are usually more responsive than quantities
to changes in income.
– This is attributed to the fact that consumers with high incomes
buys high-quality items hence high priced items as well a s larger
quantities.
– Thus, the expenditure change in response to an income change
includes a price effect due to quality as well as the quantity
effect.
 Cross Elasticity

• Cross-price elasticities of demand are measures of

how the quantity purchased of one commodity
respond to changes in price of another commodity.
• More precisely, the cross elasticity of commodity i
j
with respect to commodity is defined as:
  
Q i
Qi Qi Pj
Eij  Pj
 Pj Qi
Pj

– This may beiinterpreted as the percentage change in the

j
quantity of given a 1 percent change in the price of .
 Cross Elasticity cont….

• In practice, three types of cross relationships can be

identified:
– The commodities may be substitutes, complements, or
independent.
– The definition of the three types of relationship is based
on the substitution effect of the price change of j .
• If the substitution effect is positive for substitute
commodities;
– The price of j and the quantity of i move in the same
direction.
 Cross Elasticity cont….

• This mean that if the price of j increases then the

consumers tend to substitute i for j.
• Generally, if the price of one of the substitute
commodity is decreases;
– then consumers will tend to substitute the relatively
cheaper commodity.
• If the substitution effect is negative for
complementary commodities;
– In this case, the price of j and the quantity i move in
opposite directions.
 Cross Elasticity cont….

• This implies that an increase in price of j means that

the quantity demanded of j decreases and hence the
quantity of the complementary commodity i also
decreases.
• When the substitution effect is zero, the
commodities are independent, and
– Independent means that no substitution or
complementary relationship exists between the two
commodities.
 Cross Elasticity cont….
• On the basis of the reasoning outlined above;
– Economists generally say that substitute commodities have
positive cross elasticities; complementary commodities
have negative cross elasticities and independent
commodities have zero cross elasticities.
• However, from mathematical point of view these
generalizations need not to be true. j
– Because there is also income effect of the price change for
i
– The income effect on the demand for is generally, but not
always negative for cross elasticities.
• A decrease in price increases real income and hence
tends to increase quantities purchased and vice versa.
 Cross Elasticity cont….

• If the income effect outweighs the substitution effect,

there will be a net reduction in the demand for
commodity when i the price for commodity increases.
j
– Consumer will normally substitute for if the price of
i of jis equivalent to aj
increases; but an increase in the price
real income. j
– Thus, the real income effect on consumption of will be
i
negative, while the substitution effect will be positive.
– If the former exceeds the latter, the net effect may be
negative even though the two commodities are substitutes.
 Cross Elasticity cont….

• The interpretation of cross elasticities become

complicated by the fact that the income effect is
always inversely related to price.
– There are inferior commodities, which means some
commodities have negative income elasticities.
– This implies a positive income effect that would reinforce
or add to the substitution effect for some commodities.
• Note: the important of income effect depends on the
size of expenditure on the commodity relative to
total expenditure.
 Cross Elasticity cont….

• Typically, the expenditure on one commodity is a small

fraction of total expenditures and;
– Hence the income effect usually does not outweigh the
substitution effect.
• Thus generalizations economist make about the signs
of cross elasticities usually hold.
– That is, a positive cross elasticity implies that commodities
are substitute.
– While a negative cross elasticity implies the commodities are
complement and,
– A coefficient near or equal to zero implies commodities are
independent.
 Measuring cross elasticities and its
challenges
• In practice, economists have found the measurement
of cross elasticities very difficult.
• Substitution relationships have been some what
easier to identify than complementary relationships.
• Reversing the commodities in the cross-elasticity
equation does not necessarily give the same
coefficient.
– For example, the cross elasticity for sugar with respect to
coffee is not the same as the cross elasticity of coffee with
respect to sugar.
 Measuring cross elasticities and its
challenges cont….
• A change in price of coffee is likely to have a modest
influence on the use of sugar,
– but a change in price of sugar probably will have very little
influence on the use of coffee.
• The explicit relationship between cross elasticities
can be spelled mathematically.
• The substitution effect (whether for complements or
substitutes) is symmetric, but income effect is not.
 Relationship among elasticities

• A great deal of effort has been devoted to the

implications of demand theory for the relationships
among elasticities for food products.
• The theory from which these interrelationships are
derived makes certain assumptions regarding
individual consumer behavior.
– Thus, elasticity conditions hold for an individual consumer
with a given utility function, which satisfies certain
assumption that the individual’s tastes and preference are
in some sense reasonable.
 Relationship among elasticities cont…..
• Homogeneity condition:
– States that the sum of the own and cross-price elasticities
and the income elasticity for a particular commodity is
equal to zero.
Eii  Ei1  Ei 2  .......  Eiy  0
Type of elasticity Elasticity
Own-price elasticity -0.62
Cross-price elasticity with pork 0.11
Cross-price elasticity with lamb 0.01

Cross-price elasticity with chicken 0.06

All other cross elasticities -0.01

Income elasticity 0.45
Sum 0
 Relationship among elasticities cont…..

• Symmetry condition:
Rj
Eij  Ri E ji  R j ( E jy  Eiy )

– Assumes that consumer’s expenditure on commodity j is a

small fraction of total income or that the income
elasticities for the two commodities are approximately
equal.
Rj
Eij  Ri E ji
– This relation has been called the Hotelling-Jureen relation;
it is an approximation the symmetry relation.
 Relationship among elasticities
Symmetry condition cont…..
• The symmetry (or Hotelling-Jureen) relation indicates
how cross elasticities are related.
– If Eij is known, then E ji can be estimated and vice versa.
– This relation has also been used in applied research
combination with another restriction to place a limit on
the maximum admissible values for cross elasticities.
– This is of interest because cross elasticities are difficult to
estimate directly from available data.
 Relationship among elasticities cont…..

• Engel aggregation condition:

– States that the weighted sum of the income elasticities for
all items in a consumer’s budget is one.
– The weight are the expenditures on the respective
commodities as a proportion of total expenditures(the Ri ' s)
R1 E1 y  R2 E2 y  .......  Rn Eny  1

– This equation does not mean that all income elasticities

need to be small.
– The weights are fractions (less than one).
• Example: (.1)(5)+(.4)(1)+(.5)(.2)=1.0