Elasticity

Price Elasticity of Demand

• A measure of the responsiveness of quantity demanded to
changes in price.
• The price elasticity of demand is the ratio of the percent change
in the quantity demanded to the percent change in the price as we
move along the demand curve
• Ed=%Change in quantity demanded/ % Change in price
• The above formula is used for price elasticity of demand over a
range of the demand curve between points A and B.
• This mid- point method gives us a sort of average elasticity of
demand at the centre point between the two points on our
demand curve. This helps to find elasticity for a specific point and
is more precise.
Exihibit 1
Elasticity Responsiveness of Terminology
Coefficient Quantity
Demanded to a
Change in Price
Price elasticity of Quantity demanded Elastic
demand (Ed)> 1 changes is
proportionately
more than price
changes
Price elasticity of Quantity demanded Inelastic
demand(Ed)< 1 changes is
proportionately less
than price changes
Price elasticity of Quantity demanded Unit Elastic
demand (Ed)=1 changes
proportionately to
price change
Price elasticity of Quantity demanded Perfectly Inelastic
demand (Ed)=0 does not change
with change in price
• Elastic Demand:-The demand that occurs when the
percentage change in quantity demanded is greater than the
percentage change in price. Quantity demanded changes
proportionately more than price changes. Example-A 10
percent increase in price causes, say, a 20 percent reduction in
quantity demanded .(Ed=2)
• Inelastic Demand-The demand that occurs when the
percentage change in quantity demanded is less than the
percentage change in price. Quantity demanded changes
proportionately less than price changes. A 10 percent increase
in price causes, say, a 4 percent reduction in the quantity
demanded.( Ed )=0.4 .
• Unit Elastic Demand-The demand that occurs
when the percentage change in quantity
demanded is equal to the percentage change
in price. Quantity demanded changes
proportionately to price changes. . For
example, a 10 percent increase in price causes
a 10 percent decrease in quantity demanded
Ed=1 .
• Perfectly Elastic Demand- The demand that occurs
when a small percentage change in price causes an
extremely large percentage change in quantity
demanded (from buying all to buying nothing). For
example, suppose buyers are willing to buy all units of
a seller’s good at $5 per unit but nothing at $5.10. . In
other words, a small percentage change in price causes
an extremely large percentage change in quantity
demanded (from buying all to buying nothing). The
percentage is so large, in fact, that economists say it is
infinitely large.
• Perfectly Inelastic Demand-The demand that
occurs when quantity demanded does not change
as price changes. If quantity demanded is
completely unresponsive to changes in price, the
result is perfectly inelastic demand. For example,
suppose the price of Dogs Love It dog food rises
10 percent (from $2 to $2.20) and Jeremy doesn’t
buy any less of it per week for his dog. Then, a
change in price causes no change in quantity
demanded.
Exihibit 2
 Price Elasticity of Demand and Total
Revenue
• The total revenue (TR ) of a seller equals the price of a good
times the quantity of the good sold. For example, if the
hamburger stand down the street sells 100 hamburgers
today at $1.50 each, its total revenue is $150.
• Suppose the price of the hamburger has increased to $2.
However, total revenue may increase, decrease, or remain
constant. Whether total revenue rises, falls, or remains
constant after a price change depends on whether the
percentage change in the quantity demanded is,
respectively, less than, greater than, or equal to the
percentage change in price. Thus, price elasticity of demand
influences total revenue.
Elastic Demand and Total Revenue
• If demand is elastic, the percentage change in quantity demanded
is greater than the percent age change in price. Given a price rise
of, say, 5 percent, the quantity demanded falls by more than 5
percent—say, 8 percent—having an effect on total revenue.
Because quantity demanded falls, or sales fall off, by a greater
percentage than the percentage rise in price, total revenue
decreases. In short, if demand is elastic, a price rise decreases
total revenue.
• If demand is elastic and price falls, the quantity demanded rises
(price and quantity demanded are inversely related) by a greater
percentage than the percentage drop in price, causing total
revenue to increase. In short, if demand is elastic, a price decline
increases total revenue.
Exihibit 4
• Exhibit 4(a) shows the relationship between a change in price and
total revenue if demand is elastic. Between points A and B on the
demand curve, demand is elastic. At point A, price is P1 and
quantity demanded is Q1. Total revenue is equal to the rectangle
OP1AQ1. After the price decline P2, total revenue is now the
rectangle OP2BQ2 which is larger than OP1AQ1. In other words,
if demand is elastic and price declines, then total revenue will
rise.
• Of course, when price moves in the opposite direction, rising from
P2 to P1 , then the total revenue rectangle becomes smaller. In
other words, if demand is elastic and price rises, then total
revenue will fall. In other words when demand is elastic, price and
total revenue are inversely related.
 Inelastic Demand and Total Revenue
• If demand is inelastic, the percentage change in quantity
demanded is less than the percentage change in price.
That is, if price rises, then quantity demanded falls, but
by a smaller percentage than the percentage rise in
price. As a result, total revenue increases. So, if demand
is inelastic, a price rise increases total revenue. However,
if price falls, then quantity demanded rises by a smaller
percentage than the percentage fall in price and total
revenue decreases. In other words, if demand is
inelastic, then a price decline , decreases total revenue.
In sum, price and total revenue are directly related.
• You can see the relationship between inelastic demand
and total revenue in Exhibit 4(b), where demand is
inelastic between points A and B on the demand curve. If
we start at P1, and lower price P2,then the total-revenue
rectangle goes from OP1AQ1 to smaller rectangle
OP2BQ2. In other words, if demand is inelastic and price
falls, then total revenue will fall.
• Moving from the lower price, P2 , to the higher price
P1,does just the opposite: If demand is inelastic and price
rises, then the total revenue rectangle becomes larger;
that is, total revenue rises.
Unit Elastic Demand and Total Revenue
• If demand is unit elastic, the percentage change in
quantity demanded equals the percentage change in
price. That is, if price rises, then quantity demanded
falls by the same percentage as the percentage rise in
price. Total revenue does not change. If price falls, then
quantity demanded rises by the same percentage as the
percentage drop in price. Again, total revenue does not
change. If demand is unit elastic, a rise or fall in price
leaves total revenue unchanged. (For a review of the
relationship between price elasticity of demand and
total revenue, see Exhibit 6.
Exihibit 6
Determinants of Price Elasticity of Demand

• Number of substitutes-If a product can be easily

substituted, its demand is elastic, like tooth paste. If
the product cannot be substituted easily, its
demand is inelastic, like gasoline.
• Luxury vs Necessity-Necessity’s demand is usually
inelastic because usually there are few substitutes
for necessities. Luxury products such as leisure sail
boats, they are not needed in the daily basis. There
are usually many substitutes for these products. So
there demand is more elastic.
• Amount of money spent-The elasticity of demand for a product is determined
by the proportion of income spent by the individual on that product. In case
of certain goods, such as match box, salt a consumer spent a very small
amount of income, say $2 then even if the price increases the demand for
the product will not be affected to a greater extent. Then the demand for
such product is said to be in elastic. Whereas food and clothing are the items
where an individual spends a major proportion of income and therefore if
there is any change in price of these items the demand will be affected.
• The larger the percentage of income spend on a good, the more elastic is its
demand. Consumer will respond by cutting back more of these product when
price increases. On the other hand , the smaller the percentage of income
spent on a good, the less elastic is its demand.
• Time lag-The longer the time after the price change, the more elastic will be
the demand. It is because consumers are given more time to carry out their
actions.
 Other elasticity concepts
• Cross elasticity of demand -A measure of the
responsiveness in quantity demanded of one
good to changes in the price of another good. It
is calculated by dividing the percentage change
in the quantity demanded of one good by the
percentage change in the price of another.
• Ec = Percentage change in quantity demanded
of one good /Percentage change in priceof
another good
• A positive cross elasticity of demand is a
characteristic of goods that are substitutes. As
the price of Jif rises, the demand curve for
Skippy shifts rightward, causing the quantity
demanded of Skippy to increase at every
price. So, if Ec . → . 0 Goods are substitutes.
Whereas if the elasticity coefficient is
negative , then Ec <0 , then the two goods are
complements: → Goods are complements.
• Income Elasticity of Demand- A measure of the
responsive ness of quantity demanded to
changes in income.
• Ey = Percentage change in quantity
demanded /Percentage change in income
• If EY is greater than 0 then it is normal good.
• If EY is less than 0 then it is inferior good.
Because demand for inferior goods decreases
when the income increases.