Principles of Economics

EGMC001
Elasticity of Demand and Supply: Unit 3

Learning Objectives:
Define and measure price elasticity of demand.
Understand the relationship between price elasticity and revenue.
Infer the association between demand and income elasticity
Correlate the relationship between demand and cross price elasticity..
Price Elasticity of Demand
% q q / q
ED  
% p p / p
 If %∆q < %∆p
– ED between 0 and 1
– Inelastic D
 If %∆q > %∆p
– ED greater than 1
– Elastic D
 If %∆q = %∆p
– ED = 1
– Unit elastic D
Constant-Elasticity Demand
Curves
(a) Perfectly elastic (b) Perfectly inelastic (c) Unit elastic

Price per unit

Price per unit
Price per unit

D’

ED ’’ = 1
ED’’ = 0
ED = ∞ $10 a
p D
b
6
D’’

0 Quantity per period0 Q 0

Quantity 60 100 Quantity
per period per period
Consumers demand all quantity
offered for sale at p, but demand Consumers demand Q Total revenue is the same
nothing at a price above p regardless of price for each p-q combination
Determinants of Price Elasticity
of Demand
1. Closeness of Substitutes

2. Nature of Good

3. Proportion of Income Spent

4. Time Period
Demand Becomes More Elastic
over Time
Price per unit

$1.25

1.00 e

Dy
Dw Dm

0 50 75 95 100 Quantity per day

Dy is more elastic than Dm , which is more elastic than Dw
Revenue Concepts

• Total Revenue
TR = Q . P

Marginal Revenue
MR = TR
Q

Average Revenue
AR = TR = Q.P = P
Q Q
Demand, Price Elasticity,
and Total Revenue
S
Rs.100
90
a
Panel A
80 Elastic, ED >1
Price per unit
70 b
60 Unit elastic, ED =1
50 Where D is elastic, a
40 c Inelastic, ED <1 lower P increases TR
30
20 AR Where D is inelastic, a
d lower P decreases TR
10 e T

0 100 200 500 800 900 1,000 Quantity per period

MR
Panel B
Rs. 25,000
TR reaches a
Total maximum at the rate
of output where D is
Total revenue

revenue
unit elastic

0 500 1,000 Quantity per period

Price Elasticity & Total Revenue
P P P

Rs 8

Rs 4
D1 D2 D3
0 20 50 Q0 20 28 Q0 20 40 Q

Elastic Inelastic Unit Elastic

Demand Demand Demand
ep >1 ep <1 ep =1
P TR P TR P TR
P P TR P TR
TR
Price Elasticity of Demand
and Total Revenue
Price Elasticity Total Revenue (TR)

Price increase Price decrease

Perfectly elastic Question does not arise Infinite, Size of market
determines TR
Elastic demand TR decreases TR increases
Unitary elastic demand TR is constant TR is constant

Inelastic demand TR increases TR decreases

Perfectly inelastic TR increases TR decreases

demand
Income Elasticity of Demand
Ei = % Q  Inferior goods – Negative
Income Elasticity

% Y  Normal/Superior goods – Positive

Income Elasticity between 0 to1

– Necessities are Income inelastic

• Ei < 1
– Luxuries are Income elastic
• Ei > 1
Cross-Price Elasticity of
Demand
Exy = % QX

 %∆ in demand for one good divided by

%∆ in price of another good, other
% PY
factors taken as constant

– If positive (Exy > 0): substitutes

– If negative (Exy < 0): complements
– If zero: unrelated
THANKS!
THANKS!