Elasticity of Demand

Elasticity of Demand
Dr. U. Devasenadhipathi
Introduction
• Elasticity of demand are measures of responsiveness
of quantity demanded of a product to different
determinants of demand i.e. price, income, prices of
substitute and complements, etc.
• The most popular elasticity of demand is the price
elasticity of demand.
• There are three main types of elasticities of demand:
– Price elasticity of demand
– Income elasticity of demand and
– Cross elasticity of demand.
Price elasticity of demand
• Price elasticity of demand (PED) shows the
relationship between price and quantity demanded
and provides a precise calculation of the effect of a
change in price on quantity demanded.
• We can use the below equation to calculate the
effect of change in price on quantity demanded, and
on the revenue received by firms before and after
any price change.
Example:
• If the price of a daily newspaper increases
from Rs. 1.00 to Rs. 1.20, and the daily sales
fall from 500,000 to 250,000, the PED will be:
– 50 / 20=(-) 2.5.
• The negative sign indicates that P and Q
are inversely related.
• In this case, revenue at Rs. 1.00 is Rs. 500,000
(Rs. 1 x 500,000) but falls to Rs. 300,000 after
the price rise (Rs. 1.20 x 250,000).
The range of responses
• The degree of response of quantity demanded to a change in
price can vary considerably. The key benchmark for
measuring elasticity is whether the co-efficient is
greater or less than proportionate.
• PED can also be:
– Zero (0), which is perfectly inelastic.
– Less than one, which means PED is inelastic.
– Equals to one, is called unit elasticity.
– Greater than one, which is elastic.
– Infinite (∞), which is perfectly elastic.
Zero (0), which is perfectly inelastic
Less than one, which means PED is inelastic.
Equals to one, is called unit elasticity.
Greater than one, which is elastic.
Infinite (∞), which is perfectly elastic.
Income Elasticity of Demand
• Income elasticity of demand (YED) shows the effect
of a change in income on quantity demanded.
• YED shows precisely the extent to which changes in
income lead to changes in demand.
• YED can be calculated using the following equation:
Normal goods
• A normal good is one where demand is directly
proportional to income.
– For example, if an increase in income from Rs. 40,000 to
Rs. 50,000, an individual consumer buys 40 DVD films per
year, instead of 20, then the coefficient is:+ 100+ 25=(+)
4.0.
• The positive sign means that the good is a normal good.
• If the coefficient is greater than one, demand for the good
responds more than proportionately to a change in income.
• This indicates the good is not a necessity like food, and
would be considered a relative luxury for this individual.
Inferior goods
• When YED is negative, the good is classified
as inferior.
– For example, if an increase in income from Rs. 40,000 to
Rs. 50,000, a consumer buys 180 loaves of bread per
year instead of 200, then the YED is: 10+ 25=(-) 0.4
• If the coefficient is less than one, demand for the
good does not respond significantly to a change in
income.
• This indicates that the good is not particularly
inferior compared with a good which has a YED of
> (-)1.
Cross elasticity of demand
• Cross elasticity of demand (XED) is the
responsiveness of demand for one product to a
change in the price of another product. Many
products are related, and XED indicates just how
they are related.
• The XED can be calculated with the following
equation
Substitute Goods
• When XED is positive, the related goods are
substitutes. For example, if the price of Coca Cola
increases from 50p to 60p per can, and the demand
for Pepsi Cola increases from 1m to 2m per year, the
XED between the two products is:
• If the coefficient is greater than one, they are

regarded as close substitutes.
Complementary Goods
• When XED is negative, the goods are complementary
products.
– For example, if the price of Cinema Tickets increases from
Rs. 50.00 to Rs. 70.00 , and the demand for Popcorn
decreases from 1000 tubs to 700, the XED between the
two products will be:
• If the coefficient is less than one, it indicates that

they are not particularly complementary.
Exercise-1: Income Elasticity of Demand
Exercise-2: Cross Price Elasticity of Demand
1. Compute cross price elasticity of salsa with respect to the price of

bags of chips
2. Compute cross price elasticity of pretzels with respect to the price of
bags of chips
3. Compute cross price elasticity of soda with respect to the price of
bags of chips.
4. Are chips and salsa substitutes or complements? How do you know?
5. Are chips and pretzels substitutes or complements? How do you
know?
6. Are chips and soda substitutes or complements? How do you know?

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Elasticity of Demand

• If the coefficient is greater than one, they are

• If the coefficient is less than one, it indicates that

1. Compute cross price elasticity of salsa with respect to the price of

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