Elasticity of Demand

Elasticity of Demand

 “Elasticity” is a standard measure of the degree of

responsiveness (or sensitivity) of one variable to changes
in another variable.
 Elasticity of Demand measures the degree of
responsiveness of demand for a commodity to a given
change in any of the independent variables that influence
demand for that commodity, such as price of the
commodity, price of the other commodities, income,
taste, preferences of the consumer and other factors.
 Responsiveness implies the proportion by which the
quantity demanded of a commodity changes, in response
to a given change in any of its determinants .
 Elasticity of Demand
 Mathematically, it is the percentage change in
quantity demanded of a commodity to a percentage
change in any of the (independent) variables that
determine demand for the commodity.
 Four major types of elasticity:
 Price elasticity,
 Income elasticity,
 Cross elasticity
 Advertising (or promotional) elasticity.
 In order to assess the impact of one variable on demand,
we assume other variables as constant (ceteris paribus)
 Price Elasticity of Demand

 Price is most important among all the

independent variables that affect the demand for
any commodity.
 Hence price elasticity of demand ( “e p” or “e”) is
considered to be the most important of all types of
elasticity of demand.
 Price elasticity of demand means the sensitivity
of quantity demanded of a commodity to a given
change in its own price.
 Degrees of Price Elasticity
Slope of demand curve is used to display Price
price elasticity of demand
Perfectly elastic demand
 e =∞ (in absolute terms). P
p D
 Horizontal demand curve
 Unlimited quantities of the commodity can
be sold at the prevailing price O
 A negligible increase in price would result Q1 Q2 Quantity
in zero quantity demanded

 Perfectly inelastic demand D

 The other extreme of the elasticity range Price
 ep=0 (in absolute terms)
 Vertical demand curve P1
 Quantity demanded of a commodity
remains the same, irrespective of any P2
change in the price
 Such goods are termed neutral. O
Q1 Quantity
 Degrees of Price Elasticity
Contd.
Highly elastic demand
 Proportionate change in quantity Price
D
demanded is more than a given change
in price P1
 P2
ep >1 (in absolute terms) D
 Demand curve is flatter
Unitary elastic demand O
Q1 Q2 Quantity
 Proportionate change in price brings Price D
about an equal proportionate change in
quantity demanded P1
 ep =1 (in absolute terms). P2
 Demand curves are shaped like a D
rectangular hyperbola, asymptotic to the
axes O
Q1 Q2 Quantity
Relatively inelastic demand Price
 Proportionate change in quantity D
demanded is less than a proportionate P1
change in price P2
 ep <1 (in absolute terms)
 Demand curve is steep
O D
Q1 Q2 Quantity
 Determinants of Elasticity
 Products with close substitutes tend to have
elastic demand.
 Essential goods have price inelastic demand.
 Luxurious goods have price elastic demand.
 Market defined at aggregate level and at
disaggregate level.
 Goods occupy higher proportion of income
tend to have elastic demand.
 Demand is inelastic in short-run and elastic in
the long-run.
 Methods of Measuring Elasticity
 Ratio (or Percentage) Method
 The most popular method used to measure elasticity
 Elasticity of demand is expressed as the ratio of proportionate
change in quantity demanded and proportionate change in the
price of the commodity
 It allows comparison of changes in two qualitatively different
variables
 It helps in deciding how big a change in price or quantity is

Proportionate change in quantity demanded of commodity X

ep =
Proportionate change in price of commodity X
Q2  Q1 / Q1
ep=
P2  P1 / P1
 where Q1= original quantity demanded, Q2= new quantity
demanded, P1= original price level, P2= new price level
 Methods of Measuring Elasticity
Contd…

 Point Elasticity Method

 Elasticity measured at a point of demand curve is referred
as point elasticity of demand.
 For nonlinear demand curve we need to apply calculus
to calculate point elasticity.
 As changes in price become smaller and approach zero,
Q
the ratio P becomes equivalent to the first order
dQ
derivative of the demand function with respect to price dP
 Point elasticity can be expressed as:

ep dQ / Q dQ P
= = .
dP / P dP Q
Example 1
Q: Calculate Point Elasticity:
Demand Curve: Q=100 – P2
Assuming P1=5 and Q=75
 Methods of Measuring Elasticity
Contd…

 Arc Elasticity Method

 Used when the available figures on price and
quantity are discrete (large), and it is possible to
isolate and calculate the incremental changes.
 It is used to find the elasticity at the midpoint of an
arc between any two points on a demand curve, by
taking the average of the prices and quantities.
 This method finds wider applications, as it reflects a
movement along a portion (arc) of a demand curve
Q2  Q1 P2  P1
ep = (Q1  Q2 ) / 2 / ( P1  P2 ) / 2

Q2  Q1 P1  P2
.
Q1 = Q2 P2  P1
Numericals
 Q1. The initial price of a cup of coffee is $1, and at that
price, 400 cups are demanded. If the price falls to $0.90,
the quantity demanded will increase to 500.
 a. Calculate the (arc) price elasticity of demand for coffee.
 b. Based on your answer, is the demand for coffee elastic
or inelastic?
 c. Based on your answer to a., if the price of coffee is
increased by 10%, what will happen to the revenues from
coffee? Carefully explain how you know.
 Q2.The demand curve is: QD = 500 - 1/2 P.
 a. Calculate the (point) price elasticity of
demand when price is $100. Is demand elastic
or inelastic?
 b. Calculate the (point) price elasticity of
demand when price is $700. Is demand elastic
or
 inelastic?
 c. Find the point at which point elasticity is equal
to -1.
Numericals
Q3: The demand for automobiles must be less elastic than the
demand for videogame players because a $50 reduction in the
price of cars does not affect the number sold nearly as much as a
$50 reduction in the price of videogame players.” Is this
statement correct? Explain.
Numericals
Q4: A retails store faces a demand function Q = 180 – 1.5P
a. The store currently charges P = 80 per product. Determine
the no. of quantity.

b. If management wants to raise the price to 100, what would

be the changes in the store’s quantity and revenue?

c. Compute the point elasticity of demand at P = 80 and at P

= 100. At which price demand is more sensitive?
 Income Elasticity of Demand (ey)
 ey measures the degree of responsiveness of demand for
a good to a given change in income, ceteris paribus.

Proportionate change in quantity demanded of commodity X

ey =
Proportionate change in income of consumer

Degrees:
 Positive income elasticity
 Demand rises as income rises and vice versa

 Normal good

 Negative income elasticity

 Demand falls as income rises and vice versa

 Inferior good
 Cross Elasticity of Demand
 ec measures the responsiveness of demand of
one good to changes in the price of a related
good
Proportionate change in quantity demanded of commodity X
ec =
Proportionate change in price of commodity Y

 Degrees
 Negative Cross Elasticity
 Complementary goods
 Positive Cross Elasticity
 Substitute goods
 Problem
The general linear demand for good X is Q = 250,000 – 500 P + 1.5 M –
240 PR. The values of P, M and PR are expected to be Rs 200, Rs 90,000
and Rs1000, respectively.

a.Calculate Ep. Is the demand elastic or inelastic or unitary elastic?

b.Calculatethe Ei,j. Are the goods complements or substitute? Explain

how a 5 percent decrease in PR would impact the demand for X.
 ELASTICITIES OF SUPPLY AND DEMAND

During recent decades, changes in the wheat market had major implications for both American

farmers and U.S. agricultural policy.

To understand what happened, let’s examine the behavior of supply and demand beginning in 1981.

By setting the quantity supplied equal to the quantity demanded, we can determine the market-clearing

price of wheat for 1981:

 ELASTICITIES OF SUPPLY AND DEMAND

Substituting into the supply curve equation, we get

We use the demand curve to find the price elasticity of demand:

Thus demand is inelastic.

We can likewise calculate the price elasticity of supply:

P QS 3.46
EPS   (240) 0.32
Q P 2630

Because these supply and demand curves are linear, the price elasticities will vary as we move along the curves.