UNIT, 3.2, Elasticity of Demand

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Elasticity of Demand



Elasticity ± the concept

� The responsiveness of one variable to

changes in another

� When price rises, what happens todemand?

� Demand falls

BUT!� How much does demand fall?



Elasticity ± the concept

� If price rises by 10% - what happens to

demand?

� We know demand will fall� By more than 10%?

� By less than 10%?

� Elasticity measures the extent to whichdemand will change



DEMAND ANALYSIS AND ELASTICITY OF DEMAND³The elasticity of demand measures the responsiveness of the quantity

demanded of a good, to change in its price, price of other goods

and changes in consumer¶s income.´

Elasticity of Demand are of four types.

1.Price elasticity of demand.

a. Perfectly elastic demand. (Infinite)

b. Perfectly inelastic demand ( Zero)c. Unitary elastic demand (One)

d. Highly elastic demand

e. Less elastic demand.

2.Income elasticity of demand.

3.Cross elasticity of demand.

4.Advertisement elasticity of sales.



Elasticity

� Price Elasticity of Demand

± The responsiveness of demand

to changes in price

± Where % change in demand

is greater than % change in price ± elastic

± Where % change in demand is less than %

change in price - inelastic



Elasticity

The Formula:

Ped = ___________________________

% Change in Price

% Change in Quantity demanded

If answer is between 0 and -1: the relationship is inelastic

If the answer is between -1 and infinity: the relationship is elastic

Note: PED has ± sign in front of it; because as price rises

demand falls and vice-versa (inverse relationship betweenprice and demand)



Elasticity

� The demand curve can be a rangeof shapes each of which isassociated with a differentrelationship between price and thequantity demanded.

Price (Rs)

Quantity Demanded



Price Elasticity of Demand

� From Formula Ep = % Change in Qd

% Change in Price

� If Price Elasticity of Demand > 1, demand is elastic

� If Price Elasticity of Demand = 1, demand is unit elastic

� If Price Elasticity of Demand < 1, demand is

inelastic



Demand Elasticity

� Elastic Demand ± When % Change in QuantityDemanded > % Change in Price

� Unit Elastic Demand ± When % Change in QuantityDemanded = % Change in Price

� Inelastic Demand ± When % Change in QuantityDemanded < % Change in Price

� Perfectly Elastic Demand ± When Quantity DemandedChanges by a very large percentage in response to an

almost zero Change in Price� Perfectly Inelastic Demand ± When the Quantity

Demanded remains constant as Price changes



Price Elasticity of demand and Total

Revenue

� TR=P X Q

� If Ed>1, then %Qd>%P. TR is increasing as

the price falls.

� If Ed<1, then %Qd<%P. TR is decreasing as

the price falls.

� If Ed=1, then %Qd=%P. TR remains

unchanged over this segment of the demandcurve.



Price Elasticity of demand

Transparency 18-7

Elasticities,

Price Changes,

and Total

RevenueExhibit 3

Elasticities,

Price Changes,

and Total

RevenueExhibit 3

Ed > 1

P o TR q

P q TR o

Ed < 1

P o TR o

P q TR q

Ed = 1

P o

P q

TR

TR




Transparency 18-3

Price Elasticity of DemandExhibit 1

Price Elasticity of DemandExhibit 1

ELASTICITY

COEFFICIENT

ES ONSIVENESS OF QUANTITY

DEMANDEDTO A CHANGE IN P ICE TERMINOLOGY

E > 1 Quantity de manded chang es proportionately Elas ticmore than price changes : %(Qd > %(P.

Ed < 1 Quantity de manded chang es proportionately Ine las tic

less than price chang es : %(Qd < %(P.

Ed = 1 Quantity de manded chang es proportionately Unit elas tic

to price change: %(Qd = %(P.

Ed = Quantity de mande d is extremely respons ive Perfec tly elas tic

to even very s mall changes in price.

Ed = 0 Quantity de manded doe s no t chang e as Perfec tly ine las tic

price chang es .




Transparency 18-4

Price Elasticity of DemandExhibit 2 (1 of 3)


0

Quantity Demanded

Price

D

10%

20%

Q1

Part (a)

Q2

P1

P2

Ed > 1

Elas tic

0

Quantity Demande d

Price

D

10%

4%

Q1

Part (b)

Q2

P1

P2

Ed < 1

Ine las tic




Transparency 18-5



0

Quantity Demanded

Price

D

10%

10%

Q1

Part (c)

Q2

P1

P2

Ed = 1

Unit Elas tic




Transparency 18-6

Pr i l i i y f D mi i 2 ( f )

Pr i l i i y f D mi i 2 ( f )

0

Quantity Demande d

Price

D1%

Part (d)

Q1

P1

P2

Ed = g

Pe rfec tly Elas tic

0

Quantity Demande d

PriceD

10%

Part (e)

Q1

P1

P2

Ed = 0

Perfec tly Ine las tic




� The Determinants of price elasticity of demand:

± 1) The availability of substitutes

± 2) The time it takes for consumers to adjust their behavior

in response to a change in price

± 3) The proportion of the expenditure in the budget of the

consumer

± 4) Necessity vs. Luxury



Income elasticity of demand

Y Q

E d

y(

(!

%

%Y| income

At a given price, how much will the quantity

demanded change when the incomes of

consumers change?

Not a movement along the demand curve but a

shift in the demand curve.



Cross elasticity of demand

y

dx xy

P (

(!

%

% The responsiveness of consumers

to changes in the price of a related

good.

Substitute goods Exy is a positive coefficient.

Complementary goods Exy is a negative coefficient.



Price elasticity of supply

E P E

s

s (

(!

%

%The responsiveness of

suppliers (producers) to

price changes. A movement along the

supply curve.

The elasticity of supply coefficient is positive (thelaw of supply).



Determinants of price elasticity of

supply

� 1) The availability of resource inputs (the

elasticity of supply of the factors of production).

� 2) The time period under consideration. As time

passes supply becomes more elastic.



Elasticity

Price

Quantity Demanded (000s)

Rs 5

Total Revenue

Total revenue is price x quantity sold.In this example, TR = Rs 5 x 100,000 =Rs 500,000.

This value is represented by the greyshaded rectangle.



Elasticity

� If the firm decides to decreaseprice to (say) Rs 3, the degree of price elasticity of the demandcurve would determine theextent of the increase in demandand the change therefore in total

revenue.

Price

Quantity Demanded (000s)

Total Revenue

140100

D

Rs 5

Rs3



Elasticity

Quantity Demanded

Price (Rs)Producer decides to lower price to attract sales

% Price = -50%

% Quantity Demanded = +20%Ped = -0.4 (Inelastic)

Total Revenue would fall

Not a good move!

10

5

65

D



Elasticity

Price (Rs)

10

7

5 20

Producer decides to reduce price to increase sales

% in Price = - 30%

% in Demand = + 300%

Ped = - 10 (Elastic)Total Revenue rises

Good Move!

D

Quantity Demanded



Elasticity

� If demand isprice elastic:

� Increasing pricewould reduce TR(% Qd > % P)

� Reducing pricewould increaseTR

(% Qd > % P)

� If demand is priceinelastic:

� Increasing pricewould increase TR

(% Qd < % P)

� Reducing pricewould reduce TR(% Qd < % P)



Elasticity

� Income Elasticity of Demand:

± The responsiveness of demand

to changes in incomes

� Normal Good ± demand rises

as income rises and vice versa

� Inf erior Good ± demand falls

as income rises and vice versa



Elasticity

� Income Elasticity of Demand:

� A positive sign denotes a normal good

� A negative sign denotes an inferior good



Elasticity

� For example:

� Yed = - 0.6: Good is an inf erior good but inelastic ± arise in income of 3% would lead to demand fallingby 1.8%

� Yed = + 0.4: Good is a normal good but inelastic ±a rise in incomes of 3% would lead to demand risingby 1.2%

� Yed = + 1.6: Good is a normal good and elastic ±a rise in incomes of 3% would lead to demand risingby 4.8%

� Yed = - 2.1: Good is an inf erior good and elastic ±a rise in incomes of 3% would lead to a fall in demand of 6.3%



Elasticity

� Cross Elasticity:

� The responsiveness of demand

of one good to changes in the price of arelated good ± either

a substitute or a complement

Xed = __________________

% Price of good Y

% Price of good X



Elasticity

� Goods which are complements:

± Cross Elasticity will have negative sign

(inverse relationship between the two)

� Goods which are substitutes:

± Cross Elasticity will have a positive sign

(positive relationship between the two)



Advertising elasticity of demand

Elasticity



Determinants of Elasticity

� Time period ± the longer the time under consideration the more elastic a good is likely tobe

� Number and closeness of substitutes ±the greater the number of substitutes,the more elastic

� The proportion of income taken up by the

product ± the smaller the proportion the moreinelastic

� Luxury or Necessity - for example, addictivedrugs



Importance of Elasticity

� Relationship between changes in price

and total revenue

� Importance in determining what goods totax (tax revenue)

� Importance in analysing time lags in

production

� Influences the behaviour of a firm



DETERMINANTS OF PRICE ELASTICITY

OF DEMAND

1. Availability of Substitutes-the higher the degree of closeness of thesubstitutes, the greater the elasticity of demand for the commodity .

2. Nature of Commodity-luxuries, comforts and necessities.

3. Weightage in the total consumption-if proportion of income spent on a

commodity is large, its demand will be more elastic and vice versa.

4. Time factor in adjustment of consumption pattern-the time consumersneed to adjust their consumption pattern to a new price: the longer the

time allowed, the greater the elasticity.

5. Range of commodity use-the wider the range of the uses of a product,

the higher the elasticity of demand for the decrease in price.

6. Proportion of market supplied-if less than half of the market issupplied at the ruling price, price elasticity of demand will be higher

than 1 and if more than half of the market is supplied then elasticity

will be less than 1.



MANAGERIAL USES OF ELASTICITY OF DEMAND

1. Determination of Price Under Monopoly-a) If the demand for hisproduct is elastic he will earn more profit by fixing a low price. Low

price means large sales and hence, large total revenue. b) If the

demand is inelastic, he will be in a position to fix up high price.

2. Basis of Price Discrimination- When a monopolist sells his product at

different prices, it is called price discrimination. On the basis of

elasticity he can charge various prices from the customers.

3. Determination of Wages-If the demand for labour in an industry is

elastic, strikes and other trade union tactics will not be of any avail in

raising wages.

4. Advantage to Finance Minister-a) Taxes on goods having elastic

demand will yield less revenue. It is because of the fact that taxes will

raise their prices and thus bring down their demand and finally it

means less revenue, b) Goods having inelastic demand are taxed at a

higher rate. No doubt the price of the goods will rise on account of

these taxes but there will be little fall in their demand.



5. Determination of Prices of Public Utilities-Where the demand for

services is inelastic, a high price is charged, while in the case of

elastic demand a lower price is charged. That is why, household

consumers are charged a high rate of electricity than industrial or

agricultural customers.

6. International Trade-Those exports with inelastic demand will

fetch high price.

7. The knowledge of income elasticity can be useful in forecasting

demand, when a change in personal incomes is expected. It thus

helps in avoiding over production or under production.

8. The concept of cross elasticity is of vital importance in changing

price of products having substitutes and complementary goods. If

cross elasticity in response to the price of substitutes is greater than 1, it would be inadvisable to increase the price; rather,

reducing the price may prove more benecial.



Relationship between AR, MR, TR and

Elasticity of Demand



Relationship between TR, AR and MR(As

discussed in the class)Utility analysis and Indifference Curve

analysis discussed in the class

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UNIT, 3.2, Elasticity of Demand