ELASTICITIES

PRICE ELASTIC DEMAND

Price Elastic Demand: It measures the responsiveness of the change in the quantity demanded of a product in
response to price change of a product.
%𝛥𝑄𝐷 𝛥𝑄 𝑝
PED = %𝛥𝑃
= 𝛥𝑃 (slope) x 𝑞

PED is always positive. Elasticities are measured in percentage because:

1. It is meaningless to think about price and quantity in absolute terms. If we say price increases by $50 we cannot
derive any meaningful conclusion out of this because the original price might be $100 or $500. If the original
price was $100, then there is an actual rise of 50% in the price whereas when the original price was $500 there
was an actual rise of only 10% in the price.
2. We need a measure of responsiveness that is independent of unit because we won’t be able to compare the
responsiveness of quantity demanded of different goods.
3. We won’t be able to compare responsiveness across countries that have different currencies (different
exchange rates).

Price Elastic Demand:

The percentage change in quantity demanded is greater than the
percentage change in price.
Quantity demanded is relatively unresponsive to price.
PED>1

Price Inelastic Demand:

The percentage change in quantity demanded is smaller than the
percentage change in price.
Quantity demanded is relatively responsive to price.
0<PED<1

Unitary Elastic Demand:

The percentage change in quantity demanded is equal to the
percentage change in price.
PED=1

Perfectly Inelastic Demand:

There is no change in the quantity demanded no matter what happens
to the price.
Quantity demanded is completely unresponsive to price.
PED=0
Example – Heroin
 Perfectly Elastic Demand:
When a change in price results in an infinitely large response in
quantity demanded.
Quantity demanded is infinitely responsive to price.
PED=infinite

Determinants of PED:
1. Availability of substitutes:
 More substitutes a good has the more elastic is its demand (price sensitive).
Price increases  consumers switch to substitute products large drop in quantity demanded.
 Fewer substitutes a good has the less elastic is its demand. {E.g.: Petroleum}
Price increases  small drop in quantity demanded as no close substitute.

2. Necessity Vs Luxury (Need Vs Want)

Necessary goods will have low price elasticity. (E.g.: Basic food, water)
Luxury goods will have high price elasticity. (E.g.: Dining in high-end hotels, foreign vacations.)

3. Length of time: The longer the time period in which a consumer makes a purchasing decision, the more
elastic the demand. As time goes by, consumers have the opportunity to consider whether they really
want the good, and to get information on the availability of alternatives to the good in question.
(E.g.: flight tickets)

4. Proportion of income spent on good: The larger the proportion of one’s income needed to buy a good, the
more price sensitive to the change in price, therefore more elastic the demand. (E.g.: school fees of
children)
The smaller the proportion of one’s income needed to buy a good, the less elastic the demand. (E.g.:
Stationery)

5. Addiction: The greater the degree of addiction to a substance (alcohol, cigarettes, and so on), the more
inelastic is the demand. A price increase will not bring forth a significant reduction in quantity demanded
if one is severely addicted.

6. Broad Aspect: The point here is that the narrower the definition of a good, the more the close substitutes
and the more elastic the demand (compared with the broadly defined good). {For example, beverage is
broad but soft drinks are specific.}

Variable PED along the Demand Curve:

The slope remains constant moving along a straight-line demand curve. The measure of the slope of the
demand curve is in absolute terms. For example, a price increase of $2 from $2 to $4 causes a fall in quantity
demanded from 40 to 30 units and a price increase of $2 from $6 to $8 causes a fall in quantity demanded
from 20 to 10 units. In both cases price changes by $2 causing quantity demanded to change by 10 units. PED, on
the other hand, measures the relationship between a percentage change in price and a percentage change in
quantity demanded. It is measured in relative terms. A change in price or quantity when price or quantity is
low results in a relatively large percentage change. A change in price or quantity when price or quantity
is high results in a relatively small percentage change. For example, a price increase of $2 from $2 to $4
is a 100% increase in price whereas a price increase of $2 from $6 to $8 is only a 33.33% increase in price,
even though the actual price in both cases changes by the same amount.

The reason behind the changing PED along a straight-line demand curve has to do with how PED is calculated. At
high prices and low quantities, the percentage change in Q is relatively large (since the denominator of ΔQ/Q is
small), while the percentage change in P is relatively small (because the denominator of ΔP/P is large). Therefore,
the value of PED, given by a large percentage change in Q divided by a small percentage change in P results in a
large PED (elastic demand).
At low prices and high quantities, the opposite holds. The value of PED is given by a low percentage change in Q
divided by a high percentage change in P, resulting in a low PED (inelastic demand).
On any downward-sloping, straight-line demand curve, demand is price-elastic at high prices and low
quantities, and price-inelastic at low price and large quantities. At the midpoint of the demand curve, there
is unit elastic demand.
Revenue Maximization:
 When demand is elastic, an increase in price causes a fall in total revenue, while a decrease in price causes a
rise in total revenue.
 When demand is inelastic, an increase in price causes an increase in total revenue, while a decrease in price
causes a fall in total revenue.
 When demand is unit elastic, a change in price does not cause any change in total revenue.

PED and Firm’s Pricing Decision

A firm launching a new good want to maximize revenue over the life of the good. The firm will try to get
individual consumers to pay the most they are willing to pay. In other words, the firm tries to steal as much
consumer surplus as possible. Initially the firm charges a high price and a quantity of units are sold to less
price-sensitive consumers who are willing and able to pay the high price. When demand of these consumers
has been met and sales begin to fall the fi rm lowers price at a point on the demand curve where PED is
inelastic, more consumers enter the market to buy the good, and revenue increases. Over time the firm
continues to lower the price in order to increase quantity demanded and increase revenue. This pricing
strategy is called skimming the market and is particularly used by firms producing new technological goods.
(E.g.: Apple or Samsung)

In industries where there are firms producing branded goods a new firm might reduce the price of its new
good in order to gain market share. As brand awareness rises and the good is established in the market, PED
becomes more inelastic and the fi rm can raise the price and increase revenue. (E.g.: Jio)

Primary and Manufactured Commodities:

Many primary commodities have a relatively low PED (price inelastic demand) because they are necessities and
have no substitutes (for example, food and oil). The PED of manufactured products is relatively high (price elastic
demand) because they usually have substitutes.

PED and Indirect Tax:

The lower the elasticity of demand for the good being taxed, the larger the tax revenues for the government.
If demand is highly price elastic the rate of change in quantity demanded > the rate of change in price and a duty
that raises price will cause a large decrease in sales increasing unemployment in the industry. The government
places taxes on goods that are more price inelastic because the fall in quantity of goods bought is not as great,
therefore there are not as many job losses and the tax revenue (tax per unit × quantity sold) collected by the
government from the sale of the goods will be greater.

PED & Short-Term Price Instability of Primary Products & Manufacturing Products
Food has a highly price inelastic demand because it is a necessity & it has no substitute. The same applies to a
variety of other primary products such as oil, minerals etc which are commonly known as commodities. Low
price elastic demand in combination with fluctuation in agricultural output over short period of time due to many
factors such as drought, floods, pests etc, as well as exceptionally good weather condition, creates serious
problems for agriculture as they result in major fluctuations in agricultural product’s prices, which in turn
impacts on farmer’s income. These factors will result in the shift of the supply curve. However, the PED of
manufactured products are relatively high (price elasticity demand) because they usually have substitute.

Price fluctuations are large for primary commodities due to low PED.
The supply curve shifts give rise to major price fluctuations in the case of inelastic demand & much milder price
fluctuations in the case of elastic demand. Larger price fluctuations occurring over short periods of time are
referred to as price volatility.
Observations from the above analysis:
a. As agricultural product prices fluctuate widely, so do farmer’s income
 b. In case of inelastic demand revenue increases when crop is poor & decreases in case of a good crop,
whereas in the case of elastic demand, revenues increases when the crop is good & decreases when the
crop is poor.
This means that for consumers good harvest means lower food price but for farmers it means lower revenues.
This is one of the important factors for price support schemes.

Cross Price Elasticity Of Demand (XED)

Cross Price Elasticity of Demand (XED): XED measures the responsiveness of proportionate change in
quantity demanded of a product to proportionate change in price of another product.
𝛥𝑄𝑦
XED = 𝛥𝑃𝑥

Unlike PED, XED is either positive or negative, & the sign is crucially important for its interpretation. The
magnitude of XED i.e. how small or large is its numerical value is also important for its interpretation.

Substitute Products: There is a positive correlation between the price of one good and the demand for another
when the goods are substitutes. An increase in price of one good cause an increase in demand for the other. The
fall in price of one two goods the more responsive demand for one good is to a change in the price of the other
and the higher the service leads to a fall in demand for the other. Therefore, the value of XED for substitutes is
always positive.

The larger the value of the XED, the greater is the substitutability between two goods & larger will be the
demand curve shift. The demand for one service is very sensitive to a change in the price of the other. E.g.: Pepsi
and Coke.

The smaller the value of the XED, the smaller is the substitutability between two goods. E.g.: Pepsi and Tea.

Complementary Goods: The value of XED is always negative in the case of complements because of the
inverse relationship between the price of one good and the demand of the other. The XED is negative
(XED<0), when change in quantity demanded of one good & the change in the price of another good are in
the opposite direction. This occurs when the two goods say, ‘A’ & ‘B’ are complements.
The larger the negative value of XED the greater is the complementarities between the two goods. E.g.: Mobile
chargers and mobile.

The smaller the negative value of XED the smaller is the complementarities between the two goods. E.g.: Mobile
chargers and earphones.

Unrelated Goods:

XED is 0 of independent goods because the change in the price of one good has no effect on the
change in the quantity demanded of the other good.
Application of XED
There are number of situations where business as well as government would be interested in
knowing XED for various products.
1. Substitute goods
a. Substitute produced by single business
When business produces a line of products that are similar to each other, such as Coke & Sprite
which are both produced by coca cola, XED plays a very important role in pricing decision, because
fall in the price of coke would be followed by fall in the demand for sprite.
Therefore, before cutting price of coke, Coca cola must determine PED of coke whether price cut will
lower or raise the total revenue from coca cola.
Apart from knowing XED for coke & sprite is >0, we need also to know the degree of substitutability
between them.
If the value of XED is positive but low, a percentage decrease in the price of coke will produce only a
small percentage drop in the demand for sprite.
But If the value of XED is positive but high, a percentage decrease in the price of coke will produce a
large drop in the demand for sprite, which coca cola would probably want to avoid.
XED of Coke and Sprite < PED of Coke = High revenue for Coca-Cola.
b. Substitute produced by rival business
Coca cola would be interested in knowing the XED between Cocoa cola & Pepsi Co. A large XED
means that if coca cola drops its prices, Pepsi would suffer a serious drop in sales. Therefore, larger
the XED for coca cola and Pepsi better it is for coca cola.
c. Substitute & mergers between firms
A merger takes place when two or more firms unite to form a single firm. Business that produce close
substitutes means goods with high XED, might be interested in merger because they would eliminate
the competition between them, whereas government generally try to prevent firms’ mergers that are
likely to result in a major reduction in competition, because government is interested in promoting
competition between firms. Therefore, XED plays a very important role in determining whether to
permit the merger or not.
2. Complementary goods
High negative XED means that lowering price of one good result in a significant increase in demand
or sale for the other good. This promotes collaboration between businesses that produce
complementary goods. For example: sports clothing & sports equipment, charter flights & holiday
hotels etc.
Effect of indirect taxes of one product on the other, can be determined by the XED. E.g.: High tax on petrol and
large vehicle.

INCOME ELASTIC DEMAND (YED)

Income Elastic Demand (YED): YED measures responsiveness of proportionate change in quantity demanded
of a product to proportionate change in income of its consumers. YED for normal goods is positive and YED for
inferior goods is negative.
As quantity demanded becomes more responsive to changes in income, demand becomes more income
elastic and the positive value of YED increases.

YED>0 – The income elasticity of demand is positive, when demand & income change in the same
direction. It indicates that good is normal.
YED<0 – A negative income elasticity of demand indicates that the good is inferior, here demand for goods &
income moves in opposite direction. For example, demand for inferior goods like bus rides, used clothes etc. is
replaced by the demand for normal goods such new clothes, new car etc as the income increase.

Income Elastic Demand: When proportionate change in quantity demanded of a product is greater than the
proportionate change in income of the consumer then the product is income elastic. Here, YED>1.
Income Elastic Demand: When proportionate change in quantity demanded of a product is smaller than the
proportionate change in income of consumer then the product is income inelastic. Here, YED<1.
Shift of the demand curve that occurs in response to increases in income, depending on the sign & value
of the YED. If the YED is negative, indicating inferior good, an increase in income causes leftward shift in
the demand curve, greater the value larger the leftward shift. Positive YED results in rightward shift in
the demand curve. Demand curve shift in response to change in income for different YEDs:

Determinants of income elasticity of demand

1. Necessities or luxuries – Necessities such as food, clothing & housing, tend to have an YED
that is positive but less than one. By contrast, luxuries, such as travel to other countries, private
education & eating in restaurants have income elasticity greater than one, they are income
elastic

2. Income level of consumers – What is necessity & what is luxury depends on the income
levels. For people with extremely lower incomes even food & clothing can be luxury. As income
increases certain items that used to be luxuries become necessities. The income elasticity of
demand for particular items therefore varies widely depending on income levels.

Application of YED

1. YED and rate of expansion of industries

Increase in income means a growing demand for goods & services, & growing output to meet this
demand. Information on the YED of different products can be interesting for firms because if the
income of people is increasing then market of good or service with higher YED will enjoy greater
scope for expansion, whereas the market for goods and services with lower YED will expand at a
smaller rate.

2. YED & sectoral change in an economy

A sector is defined to be a part of an economy. All economic activity in every economy can be
classified under the following three sectors:

Primary Sector: Everything extracted from land is called a primary sector good or a primary commodity.
Examples include, agriculture, forestry, fishing, mining, oil, coal. Firms operating in the primary sector are
involved with extraction, harvesting and collection of natural resources.
Manufacturing Sector: It is also known as the secondary sector. Manufactured goods are man-made goods.
They are produced by transforming primary goods into finished goods. They include automobiles,
stationery, processed foods, clothing, buildings etc. Firms operating in manufacturing sector are involved in
the production or construction of products.
Tertiary Sector: It is also known as the service sector. It includes non-tangible economic goods such as
banking, insurance, transportation, healthcare, entertainment etc whose consumption indicates
improvements in standard of living of the consumer. Firms operating in tertiary sector specialize in
providing these services to their consumers.
The contribution of each of these sectors to total economic activity can be measured in several ways,
such as in terms of the value of output they produce (GDP), or the number of people they employ etc.
Regardless of how it is measured, the relative size of their contribution tends to change over time as
country grows & become economically more developed. LDCs tend to have very large primary
sectors due to predominance of agriculture in the economy as well as extractive activities (oil,
mineral, natural gas & so on) & small manufacturing & services sectors. The developed countries of
today were in similar position several decades ago. Their historical experience shows that as they
grew & developed, their agricultural sector become less & less important & were partly replaced by
manufacturing & services & later on dominated by services.
Changes in the relative importance of the three sectors as economic growth & development occur
can be explained in terms of income elasticity of demand (YED). As we know as society’s income
grows over time, the demand for agricultural output & other primary sectors product grows more
slowly due to low YED, where as in case of manufacturing products due to their high YED their
demand grows faster than increase in income. This results in the relative importance & share of
agriculture output to shrink & the share of manufacturing output to grow in an economy.
At the same time that the share of manufacturing output is increasing at the expense of agriculture,
the share of services sector tends to expand at the expense of both the agricultural & manufacturing
sectors. Many services have very high YED, so that the percentage increase in the demand of services
is significantly larger than the percentage increase in the income.

3. YED & long-term impacts on agricultural & other primary product prices
A low YED for food (agricultural products), compared with a high YED for manufactured products and
services, has important implications for the level of prices of agricultural products relative to prices of
manufactured products and services over long periods of time. We have seen that a low YED for food
means that as income rises, a relatively smaller proportion of income is spent on food and a relatively
larger proportion on manufactured products and services, indicating that as incomes rise, demand for
manufactured products and services rise more rapidly than the demand for food. The result is that the
prices of these goods and services rise more rapidly than the prices of agricultural products, this
implications on LDCs and MDCs.

a. The case of more developed countries

Over the period of time the supply curve of the agricultural products has shifted to right due to
technological advances. Demand curve also shifted to right due to economic growth & increasing
incomes but because of low YED the size of demand shift is relatively small which has resulted in
putting downward pressure on the prices.
b. The case of less developed countries

LDC’s tend to have very large agricultural sector & their economy heavily depends on the export of
agriculture products, over the period of time their experiences are also very similar to more
developed countries as far as the scenario in agriculture & other primary product market is
concerned, which is making LDS’s to suffer from declining export revenues. Consequences of this are
anti-growth & development.
YED and Tax:
Direct tax is a tax on income. It is called a direct tax because it goes directly from the payer of the tax to the
government. Increasing tax reduces consumers’ disposable income and causes a fall in demand for necessities
and luxury goods and an increase in demand for inferior goods. This will have an impact on employment in those
industries producing goods that have high positive and high negative YEDs

PRICE ELASTICITY SUPPLY

Price Elasticity Supply: It is the measure of responsiveness of the quantity supplied to changes in its price.
%𝛥𝑄𝑆 𝛥𝑄 𝑝
PES = %𝛥𝑃
= 𝛥𝑃 (slope) x 𝑞
 Price Inelastic Supply
 The percentage change in quantity supplied is smaller than the percentage
change in price.
 The quantity supplied is less responsive to price
 PES<1
 The Q intercept is positive

Price Elastic Supply

 The percentage change in quantity supplied is greater than the percentage
change in price.
 The quantity supplied is very responsive to price
 PES<1
 The Q intercept is negative.

Unit Elastic Supply

 The percentage change in quantity supplied is equal to the percentage
change in price.
 All the supply curves passing through the origin have unit elastic supply
because between two points along the slope the %change in the vertical
axis is equal to %change in horizontal axis.
 PES = 1

Perfectly Inelastic Supply

 The percentage change in quantity supplied is zero.
 QS is completely unresponsive to price
 PES =0
 Example: Limited products like Picasso paintings, movie tickets

Perfectly Elastic Supply

 The percentage change in quantity supplied is infinite.
 QS is very responsive to price
 PES = infinity

Determinants of PES:
1. Length of time: This is the main factor determining the PES. We can distinguish between three time
periods:

i. Immediate time period: In this case firm is unable to change any of its inputs in order to change the
quantity it produces, therefore the supply in this case is highly inelastic, may be even perfectly inelastic.

ii. Short run – It is a period of time during which firm can vary some but not all of its inputs. At least one of its
inputs is fixed in quantity. The quantity of labour is variable (changeable) but the quantities of capital and
land are fixed (unchangeable). The firm can only increase output by adding more labour to existing capital,
so supply is price inelastic. The result is that quantity supplied will increase only a little in response to the
price increase, supply is inelastic.
 iii. Long run - It is a time period long enough, so that firm can vary all its inputs, therefore the fi rm can employ
more labour and buy more capital in order increase output. The response of quantity supplied to the price
will be much greater, supply is elastic.

2. Mobility of Factors of Production: The ease & the speed with which firms can shift its resources &
production between different products depends upon the time firms have to adjust resource use.
Constant Opportunity Cost  More price elastic supply
Increasing Opportunity Cost  Less price elastic supply
2. Spare Capacity: A firm is able to increase output if it has spare capacity.
 When a firm is operating at full capacity it is difficult to increase output. Supply is more price inelastic.
 The greater spare capacity of the fi rm the more responsive quantity supplied is to an increase in price,
so supply is more price elastic.
3. Ability to Store Stocks: (for short period)
More Store stocks  sell more quickly as the price rises  supply is more price elastic
Less Store stocks cannot sell more quickly as the price rises  supply is less price elastic
4. Availability of Factors of Production:
 High Economic Activity: Low unemployment  Short supply of workforce + Less availability of
Resources  Irresponsive to price  Price Inelastic
 Low Economic Activity: High unemployment  High supply of workforce + more availability of
Resources  Irresponsive to price  Price Inelastic
It is easier for firms that use unskilled labour to increase the size of the workforce in order to increase output, so
supply is more price elastic.
When specialized capital and skilled labour are needed, factors are less mobile. A firm will not be able to employ
factors quickly in order to increase output, so supply is more price inelastic

For primary goods quantity supplied is less responsive to changes in price.

 Agricultural products are well known as other primary products such as oil, minerals, natural gas, etc.
end to have lower PES than industrial/manufacturing products, particularly over short period of time. As
we know agriculture is controlled by growing seasons which are beyond farmers control and other
primary products needs investments before they begin production.

 Fluctuating supply over short period of time in combination with price inelastic demand for food is a
major factor contributing to short term price and income instability for farmers.

 The demand for agricultural products fluctuates because of certain reasons although within the particular
country the demand for food is relatively stable. Fluctuating demand over a short period of time, in
combination with price inelastic supply of agricultural and other primary products, also contributes to
price and income instability in farm sector. The reasons for such short-term fluctuation in demand can be
instability of foreign demand for agricultural products. It may be due to crop failure in other country
which may boost the demand or maybe a good harvest elsewhere which may drop the demand. Increased
protection of farmers in other countries by means of taxation (also other protectionist measures) will
 result in lower imports from foreign and vice-versa. Change in customer taste can also cause demand to
fluctuate.

 There can be a price fluctuation in case of both high PES and low PES but are substantially larger in case
of low PES. Large price fluctuation means, large revenue fluctuations for the farmer.

 It is important to distinguish between short run and long run price elasticity of supply. Agricultural
product tends to have a lower price elasticity of supply compared to manufacturing products over the
short period of time, because they need more or longer period to respond to the price changes. From
this we can conclude that over long period of time PES of agriculture product is larger.

Manufactured goods are likely to be more price elastic than agricultural goods because it is easier for firms
producing manufactured goods to reallocate their factors to different production processes and thereby increase
output.