Elasticity of Demand

SARBJEETLecturer in Economics

Contents

Meaning of Elasticity Meaning of Price Elasticity Types of Price elasticity• Perfectly Elastic• Perfectly Inelastic• Unitary Elastic• Elastic• Inelastic Methods of measuring Price elasticity

ElasticityA general definition:

“Elasticity” is a (standard) measure of the degree of sensitivity ( or responsiveness) of one

variable to changes in another variable. The price elasticity of Demand

The (self) price elasticity of demand is a measure of the degree of sensitivity of demand

to changes in the (self) price, ceteris paribus

Determining Price Elasticity

Percentage Change in Quantity Ep =

Percentage Change in Price

Change in Quantity Quantity Ep =

Change in Price Price

• The elasticity measure is a ratio between two percentage measures: the percentage change in one variable over the percentage change in another variable

• The terms elastic and inelastic demand do not indicate the degree responsiveness and unresponsiveness of the quantity demanded to a change in price. The economists therefore, group various degrees of elasticity of demand into five categories. (1) Infinitely elastic, (2) Perfectly inelastic, (3) Unitary elasticity, (4) Relatively elastic, and (5) Relatively inelastic demand.

• Perfectly elastic demand: A demand is perfectly elastic when a small increase in the price of a good its quantity to zero. Perfect elasticity implies that individual producers can sell all they want at a ruling price but cannot charge a higher price. If any producer tries to charge even one penny more, no one would buy his product. People would prefer to buy from another producer who sells the good at the prevailing market price of $4 per unit. A perfect elastic demand curve is illustrated in fig. 6.1. It shows that the demand curve DD/ is a horizontal line which indicates that the quantity demanded is extremely (infinitely) response to price. Even a slight rise in price (say $4.02), drops the quantity demanded of a good to zero. The curve DD/ is infinitely elastic. This elasticity of demand as such is equal to infinity.

• Perfectly inelastic demand: When the quantity demanded of a good dose not change at all to whatever change in price, the demand is said to be perfectly inelastic or the elasticity of demand is zero. For example, a 30% rise or fall in price leads to no change in the quantity demanded of a good.

• Unitary elasticity of demand: When the quantity demanded of a good changes by exactly the same percentage as price, the demand is said to has a unitary elasticity. For example, a 30% change in price leads to 30% change quantity demand = 30% /30% = 1 One or a one percent change in price causes a response of exactly a one percent change in the quantity demand. In this figure (6.3) DD/ demand curve with unitary elasticity shows that as the price falls from OA to OC, the quantity demanded increases from OB to OD. On DD/ demand curve, the percentage change in price brings about an exactly equal percentage in quantity at all points a, b. The demand curve of elasticity is, therefore, a rectangular hyperbola.

• Elastic demand: If a one percent change in price causes greater than a one percent change in quantity demanded of a good, the demand is said to be elastic. Alternatively, we can’ say that the elasticity of demand is greater than I. For example, if price of a good change by 10% and it brings a 20% change in demand, the price elasticity is greater than one.

•

• Inelastic demand: When a change in price causes a less than a proportionate change in quantity demand, demand is said to be inelastic. The elasticity of a good is here less than I or less than unity. For example, a 30% change in price leads to 10% change in quantity demanded of a good, then:

• Measurement of Price Elasticity of Demand• There are three methods of measuring price

elasticity of demand.• (1) Total revenue method• (2) Geometrical method• (3) Arc method

• Total Revenue Method (also called Total Expenditure Method):• • The total revenue method finds total revenue (total expenditure) by

multiplying the quantity sold by the selling price of the good. When a firm increase the price of a good, will its total sales revenue increase or decrease? Well, this depends upon the elasticity of demand for the good- For example, if the demand for a good is elastic or (> 1), a rise in the price of a good decreases its total revenue and a decrease in price increases the total revenue of the firm. If the demand for the good is inelastic (< 1), a rise in the price of a good increase total revenue and a fail in price decreases total revenue of the firm. In case the elasticity of demand, for

• the good is equal to unity, a rise or fall in price of good leaves total revenue unchanged. The total revenue methods is now explained with the help of curves below:

• Geometric Method:• • (a) Measurement of elasticity at any point on a linear demand curve.• • The price elasticity of demand varies along a linear demand curve. In the middle of demand

curve, the price elasticity is unitary. The total revenue is maximum at this point. Any point above the middle point has elasticity greater than one (Ed > 1). Here price reduction leads to an increase in total revenue (or expenditure). At any point below the mid point, the elasticity is less than 1

• (Ed< 1). Price reduction leads to decrease in the total revenue and increase in price increases total revenue. The measurement, of elasticity at any point on a linear demand curve is now explained with the help of figure 6.9.

• • • In this figure, the demand curve is linear. It has a unitary elasticity at the mid point d. Elasticity is

greater than one (> 1) above the mid point. Below the midpoint the elasticity is less than one. By applying the percentage method of measurement of elasticity ΔQ / ΔP x p / q, we measure the elasticity at any point, on the linear demand curve.

• Arc Elasticity:• • The point method is applicable only for measuring infinitesimal changes in the price. If the price change is

quite large, than the Arc Method is used to measure the price elasticity of demand. The arc elasticity is a measure of average elasticity. It is the elasticity at the midpoint of the chord that connects two points A and B on the demand curve. Arc elasticity is calculated by using the following formula.

• Ep = Δq / Δp . p1 + p2 / q1+ q2

• • Δq = denotes change in quantity• Δp = denotes change in price.• q1 = signifies initial quantity, q2 denotes new quantity. .• p1 = stands for initial price, p2 denotes new price.• • Graphic presentation of measuring elasticity using the arc method.• • In this fig. (6.11) It is shown that at a price of Rs.10, (P1) the quantity of demanded of apples is 5 kg. per day

(Q1), When its price falls from $10 to $5, (P2) the quantity demanded Increases to 12 Kg (Q2) of apples per day. The arc elasticity of AB part of demand curve DD' can be calculated as under.

• The arc elasticity is more than unity.