CHAPTER 2

ELASTICITY OF DEMAND

The demand function identifies the causal variables for and the direction of their effects on the
demand for their products. However, this knowledge to the managers is not enough. Managers
must know the quantitative relationship between the demand for the product and its determinants
in order to take certain managerial decisions. This leads to the concept of 'elasticity of demand'.

The concept of elasticity of demand measures the responsiveness of demand for a commodity to
changes in the variables confined to its demand function. There are, thus, as many kinds of
elasticity of demand as its determinants.

Elasticity of demand = % change in quantity demanded

% change in determinant of demand
Factors Influencing Elasticity of Demand

Whether the demand for a commodity is elastic or inelastic will depend on a variety of factors.
The major factors affecting elasticity of demand are:

1. Nature of commodity: According to the nature of satisfaction the goods give, they may
be classified into luxury, comfort or necessity goods. In general, luxury and comfort goods are
price elastic, while necessity goods are price inelastic. For example, the demand for cosmetics,
cloth, salt etc., is generally inelastic while that for radio, watches, furniture, cars etc., is elastic.

2. Availability of Substitutes: Where there exists a close substitute in the relevant price
range, the demand for that product will tend to be elastic. But in respect of commodities having
no substitutes, their demand will be somewhat inelastic. The demand for salt, potatoes, onions,
etc., is highly inelastic as there are no close or effective substitutes for these commodities. On the
other hand, commodities like tea, coffee or beverages having a wide range of substitutes, have a
more elastic demand in general.

3. Number of uses: Single use goods will have generally less elastic demand as compared
to multi-use goods, e.g., for commodities like coal or electricity having a composite demand,
their elasticity of demand is relatively high. With the fall in price, these commodities may be
demanded increasingly for various uses. It may be elastic in some of the uses, and may be
inelastic in other uses. Technically, the demand for a multi-use commodity in those uses where
marginal utility is high, will be inelastic while in those uses where the marginal utility is low, the
demand will be elastic.

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4. Consumer’s income: Generally, for larger income, the demand for overall commodities
tends to be relatively inelastic. The demand pattern of a millionaire is rarely affected even by
significant price changes. Similarly, the redistribution of income in favor of low-income people
may tend to make demand for some goods relatively elastic.

5. Height of price and range of price change: There are certain goods like costly luxury
items or bulky goods such as refrigerators, T.V. set etc., which are highly priced in general. In
their case, a small change in price will have an insignificant effect on their demand. Their
demand will, therefore, be inelastic. However, if the price change is large enough, then their
demand will be elastic.

6. Proportion of expenditure: Items that constitute a smaller amount of expenditure in a

consumer’s family budget tend to have a relatively inelastic demand, e.g., a person who sees a
film every fortnight is not likely to give it up when the ticket rates are raised. But one who sees a
film every alternate day, perhaps may cut down his number of films. So is the case with matches,
sugar, kerosene etc.

7. Durability of the commodity: In the case of durable goods, the demand generally tends to
be inelastic in the short run, e.g., furniture, bicycle, radio, etc. In the case of perishable
commodities, on the other hand, demand is relatively elastic, e.g., milk, vegetables, etc.

8. Habit: There are certain articles which have a demand on account of habit and in these
cases, elasticity is less than unity, e.g., cigarettes to a smoker have inelastic demand.

9. Complementary goods: Goods which are jointly demanded have less elasticity, e.g., ink,
petrol have inelastic demand for this reason.

10. Time: Consumers may expect a further change, so they may not react to an immediate
change in price. People are reluctant to change their habits all of a sudden. When durable goods
are worn out, these are demanded more. Demand for certain commodities may be postponed for
some time, but in the long run, it has to be satisfied.

Types of Elasticity
There are four important kinds of elasticity as discussed below:

1.Price Elasticity: This refers to the quantity demanded of a commodity in response to a given
change in the price of the commodity. It can be computed with formula.

Ec = eDc = Proportionate Change in quantity demanded of Product

Proportionate change in price of product

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 Ec = eDc = (Q2 – Q1)/Q1
(P2 – P1)/P1
Where
Ql = quantity demanded before change.
Q2 = Quantity demanded after change.
P1 = price before change.
P2 = price after change.

OR

Percentage change ∈quantity demanded

Price elasticity =
Percentage change∈ price

Change∈quantity demanded /Quantity demanded

=
Change∈ price /Price

Or, in symbolic terms

Δ q/q Δ q Δ p
e p= = ÷
Δ p/ p q p

Δq p
= ×
q Δp

Δq p
= ×
Δp q

Where e p stands for price elasticity

q stands for quantity demanded

p stands for price

∆ stands for infinitesimal small change.

If something only stretches a small amount under pressure, then we say it is inelastic. In
economics, we say that a good is inelastic if its quantity demanded does not change very much
with a change in price. On a supply and demand diagram, an inelastic good is one that has a very
steep slope. This is shown in the following diagram:

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Figure 2.7 Elasticities of various demand curves

Typically, goods that are thought of as necessities will be very inelastic. That is, no matter how
expensive they get, we will still buy them. Health care, staple foods and gasoline are goods with
low elasticities. If a demand curve is perfectly vertical (up and down) then we say it is perfectly
inelastic. If the curve is not steep, but instead is shallow, then the good is said to be “elastic”
or “highly elastic.” This means that a small change in the price of the good will have a large
change in the quantity demanded. If the curve is perfectly flat (horizontal), then we say that it is
perfectly elastic. Luxury goods are often very elastic – if the price increases a little, then people
will move over to something else.

Remember that the elasticity is a ratio of percent changes in quantity and price.

Also, remember that all elasticities of demand will be negative, since the demand curve slopes
downwards.

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NOTE: Price elasticity of demand is always negative since the change in quantity demanded is
in opposite direction to change in price. But for the sake of understanding the magnitude of
response of quantity demanded to change in price we ignore the negative sign.

The demand is said to be elastic with respect to price if the change in quantity demanded is more
than the change in price. This implies that price elasticity of demand is more than one (e > I).

The demand is said to be inelastic with respect to price when the change in quantity demanded is
less than the proportionate change in price. This implies that the elasticity is less than one (e <
1).

The demand is said to be unity with respect to price when the change in quantity demanded is
equal to the change in price (e = I).

The demand elasticity is zero when a change in price causes no change in quantity
demanded .

The demand elasticity is said to be infinity when no reduction in price is needed to cause an
increase in demand.

Importance of Price Elasticity

(i) A knowledge of price elasticity helps to guide a firm on whether its sales proceeds,
decrease or remain invariable under conditions of price variations.

(ii) It also helps the firm to estimate the likely demand for its product at different prices.

Illustration 1: For the following demand functions, determine whether demand is elastic,
inelastic or unitary elastic at the given price:

(i) Q = 100 – 4P and the given P = Shs 20

(ii) Q = 1500 – 20P and the given P = Shs 5
(iii) P = 50 – 0.1Q and the given P = Shs 20
Solution.

(i) Q = 100 – 4P where P = Shs 20

dQ
In this demand function the derivative =4.
dP

Substituting the value of P in this demand function (i)

Q = 100 – (4 ×20) = 20

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 dQ P 20
ep = × =4 × =4.
dP Q 20

Since e p >1, demand is elastic.

(ii) Q = 1500 – 20P where P = Shs 5

dP
In this demand function equation, the derivative =20
dQ

Substituting the value of P in this demand function

Q = 1500 – (20 ×5 ) = 1400

dQ P 5 5
e p= × =20 × = = 0.07
dP Q 1400 70

Since e p <1 , demand is inelastic.

(iii) P = 50-0.1Q where P = Shs. 20

Let us first express this demand function in terms of quantity demanded as a function of

P = 50 - 0.1Q

0.1Q = 50 – P

Q = 50 × 10 – 10P

With given price equal to Shs. 20,

Q = 500 – (10 × 20) = 300

dQ
The derivative =10
dP

dQ P 20 2
ep = × = 60 × = =0.66
dP Q 300 3

Since e p <1, demand is inelastic.

Illustration 2. Demand for “Advanced Economic Theory book is given by

Q = 20,000 – 60P
(a) Compute the point price elasticity of demand at price = Shs. 200.

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 (b) If the objective is to increase total revenue from the sales of the book, should
the price be increased or reduced?
Solution. The given demand function is given by:

Q = 20,0000 – 60P

Substituting the value of P = 200 in the demand function equation

Q = 20,000 – (60 ×200) = 8,000

ΔQ
The derivative =60
ΔP

dQ P 200 3
e pat Shs. 200 = × =60 × = =1.5
dP Q 8,000 2

Since price elasticity of demand is greater than one, reduction in price will increase revenue.
Therefore, price of the book should be reduced to increase revenue from the sales of the book.

2. Income elasticity
Income elasticity refers to the quantity demanded of the commodity in response to a given
change in income of the consumer. It can be computed from the following formula:

Ei= Proportionate Change in quantity demanded of Product

Proportionate change in income

= (Q2 – Q1)/Q1
(M – M1)/M
OR
∆Q
Q ∆Q M
ei = = ×
∆M Q ∆M
M
∆Q M
= .
∆M Q

Where:
- M stands for initial income
−∆ M stands for a small chaange∈income
- Q stands for initial quantity purchased demand.
−∆ Q stands for a change∈quantity purchased as a result of a change ∈income .

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Illustration 3: Suppose demand for cars in Nairobi as a function of income is given by:the
following equation:

Q = 20,000 + 5M

Where Q is quantity demanded, M is per capita level of income in shillings.

Find out income elasticity of demand when per capita annual income in Nairobi is Shs 15,000.

Solution.

ΔQ M
Income elasticity (e i ¿= .
ΔM Q

In order to obtain income elasticity, we have to first find out quantity demanded (Q) at income
level of Shs 15,000. Thus,

Q=20,000 + 5 ×15,000=95,000

It will be seen from the given income demand function that coefficient of income (M) is equal to
ΔQ
5. This implies that =5.With this information we can calculate income elasticity.
ΔM

ΔQ M 15,000
e i= × =5 × =0.8
ΔM Q 95,000

Illustration 4: The market demand for good X is given by the function:

QX= 500 – PX + 0.5PY – 0.4 I

QX = quantity demand of good X

PX = price of good X

PY = price of good Y

I = consumer income (thousands of dollars)

Calculate the income elasticity of demand assuming PX = $100, PY = $100, and I = $50

Step 1: Solve for QX

QX =500 – (100) + 0.5(100) – 0.4(50)

QX = 430
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 ∂ Qx
Step 2: Take the partial derivative:
∂I

∂ Qx
= -0.4
∂I

Step 3: Income elasticity formula

∂ Qx 1 50
EX,Y = = -0.4 = 0.047
∂ I Qx 430

Negative coefficient so good X is an inferior good.

A 1% increase in income decreases the quantity demanded of good X by 0.047%

Illustration 5: The market demand for good X is given by:the function:

QX = 900 – 2PX + 0.05I

QX = quantity demand of good X

PX = price of good X

I = consumer income

Calculate the income elasticity of demand assuming PX =$50 and I = $100,000

Step 1: Solve for QX

QX =900 – 2(50) + 0.05(100,000)

QX = 900- 100 + 5,000 = 5,800

∂ Qx
Step 2: Take the partial derivative:
∂I

∂ Qx
= 0.05
∂I

Step 3: Income elasticity formula

∂ Qx Iy 100,000
EI = = -0.05 = -0.86
∂ I Qx 5,800

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Positive coefficient so good X is a normal good.

Good X and Y are complements.

A 1% increase in income results in the quantity demanded of good X increasing by 0.862%

Income elasticity of demand is positive for superior goods and negative for inferior goods.
Positive income elasticity of demand can be of three kinds – more than unity elasticity, unity
elasticity, less than unity elasticity and negative.

(i)Income elasticity of demand is positive and more than unity when change in income leads to a
direct and more than proportionate change in quantity demanded. eg : Luxury articles.

(ii)Income elasticity of demand is positive and unity when a change in income results into a
direct and proportionate change in quantity demanded eg: semi-luxury.

(iii) Income elasticity of demand is positive and less than unity when an increase in consumer's
income causes a less than proportionate increase in quantity demanded and vice-versa.
eg: food, clothing etc.

(iv) Income elasticity of demand is negative, when an increase in income leads to

decrease in quantity demanded.

Applications of Income Elasticity

i) Long-term business planning: In the long run, demand for comforts and luxury goods
may tend to be highly income elastic. Hence, prospects for long run growth in sales for these
goods are very bright. The firm can plan out its business accordingly.
ii) Market strategy: Income elasticity of demand is helpful in developing market strategies.

iii) Housing development strategies: On the basis of income elasticity, housing development
requirement can be predicted and construction work can be effectively launched upon.

3. Cross Elasticity:

In arriving at the price elasticity of demand, one takes into account the change in demand due to
a change in the price of the same commodity. In cross elasticity of demand, we take into account
the change in the price of commodity Y and its effects on the demand for commodity X. The
concept of cross elasticity is important in the case of commodities which are substitutes and
complementary. Tea and coffee are substitutes for each other, pen and ink, car and petrol are
complementary goods.

The cross elasticity demand refers to the degree of responsiveness of demand for a commodity to
a given change in the price of some related commodity.

Proportionate change in quantity demanded product A

Ec = eDc =
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 Proportionate change in price of product B

(Q2 -Q,)/Q,
Ec = e Dc = (PB - PA)/PA

Where: Q1 = Quantity demanded before change.

Q2 = Quantity demanded after change.
P A = Price of product A.
P B = Price of related product B.

Coefficient of cross elasticity of demand of X for Y =

Proportionate change ∈the quantity X
Proportionate change∈the price of good Y

qx
∆ qx ∆ py
or, e c = ∆ py = ÷
qx py
Py

∆ qx py
= ×
qx ∆ py

∆ qx py
= ×
∆ py qx

Where e c stands for cross elasticity of demand of X for Y.

q x stands for the original quantity demanded of good X

Cross elasticity is always positive for substitute and negative for complements. It should be
noted that greater the cross elasticity, the more related the two goods are. The cross elasticity will
be zero, if the two goods have no relationship.

Two goods that

complement each Two goods that are Two goods that are
other show a substitutes have a independent have a
negative cross positive cross zero cross elasticity of
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 elasticity of demand: elasticity of demand:
as the price of good demand: as the price
as the price of good of good Y rises, the
Y rises, the demand
for good X falls Y rises, the demand demand for good X
for good X rises stays constant

Illustration 6: Suppose the following demand function for coffee in terms of price of tea is
given. Find out the cross elasticity of demand when price of tea rises from Shs 50 per 250 grams
pack to Shs 55 per 250 grams pack.

Qc=100 + 2.5Pt

Where Qc is the quantity demand of coffee in terms of packs of 250 grams and Pt is the price of
tea per 250 grams pack.

Solution: The positive sign of the coefficient of Pt shows that rise in price of tea will cause an
increase in quantity demanded of coffee. This implies that tea and coffee are substitutes.

dQc
The demand function equation implies that coefficient =2.5 .
dPt

In order to determine cross elasticity of demand between tea and coffee, we first find out
quantity demanded of coffee when price of tea is Shs 50 per 250 grams pack. Thus,

Qc=100+2.5×50=225

dQc Pt
Cross elasticity, ec= ×
dPt Qc

50 125
=2.5× = =0.51 .
225 225

Illustration 7: Suppose the following demand function for coffee in terms of price of tea is
given. Find out the cross elasticity of demand when price of tea rises from Shs 50 per 250 grams
pack to Shs 55 per 250 grams pack.

Qc=100 + 2.5Pt

Where Qc is the quantity demand of coffee in terms of packs of 250 grams and Pt is the price of
tea per 250 grams pack.

Solution: The positive sign of the coefficient of Pt shows that rise in price of tea will cause an
increase in quantity demanded of coffee. This implies that tea and coffee are substitutes.

dQc
The demand function equation implies that coefficient =2.5 .
dPt
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In order to determine cross elasticity of demand between tea and coffee, we first find out
quantity demanded of coffee when price of tea is Shs 50 per 250 grams pack. Thus,

Qc=100+2.5×50=225

dQc Pt
Cross elasticity, ec= ×
dPt Qc

50 125
=2.5× = =0.51 .
225 225

Illustration 8: The market demand for good X is given by:the function

QX = 2,500 – 4PX + 0.75PY

QX = quantity demand of good X

PX = price of good X

PY = price of good Y

Calculate the cross-price and elasticity of demand assuming PX =$300 and PY = $200

Step 1: Solve for QX

QX =2,500 – 4(300) - 0.75(200)

QX = 1450

∂ Qx
Step 2: Take the partial derivative:
∂I

∂ Qx
= 0.75
∂I

Step 3: Cross-price elasticity formula

∂ Qx Py 200
EX,Y = = -0.75 = -0.103
∂ I Qx 1450

Positive coefficient so substitutes.

Good X and Y are substitutes.

A 1% increase in the price of good Y increases the quantity demanded of good X by 0.103%
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Illustration 9:

The market demand for good X is given by:

QX = 500 – PX + 0.5PY

QX = quantity demand of good X

PX = price of good X

PY = price of good Y

Calculate the cross-price and elasticity of demand assuming PX =$100 and PY = $200

Step 1: Solve for QX

QX =500 – (100) - 0.5(200)

QX = 300

∂ Qx
Step 2: Take the partial derivative:
∂I

∂ Qx
= -0.5
∂I

Step 3: Cross-price elasticity formula

∂ Qx Py 200
EX,Y = = -0.5 = -0.333
∂ I Qx 300

Negative coefficient so complements.

Good X and Y are complements.

A 1% increase in the price of good Y decreases the quantity demanded of good X by 0.333%

Application of cross elasticity

(i) It is useful in measuring the inter dependence of demand for a commodity and the prices of its
related commodities.
(ii) It helps to estimate the likely effect on its sales of pricing decisions, its competitors and
helpers.

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4. Advertising elasticity :
It refers to the measurement of proportionate change in demand in response to the proportionate
change in promotional efforts. Advertising elasticity is always positive.

Proportionate change in quantity demanded

E =edA= Proportionate change in advertisement costs

= (Q2 -QI)/QI
(A2 -AI)/ AI

where QI = quantity demanded before change.

Q2 = quantity demanded after change.
Al = amount spent on advertisement before change.
A2 = amount spent on advertisement after change.

Advertising elasticity of demand is high when even a small percentage change in advertising
expenditure results in a large percentage of change in the level of quantity demanded.

Importance:
It helps a decision maker to determine his advertisement outlay and necessary amount to be
invested for the advertisement.

Importance of elasticity of demand:

The concept of elasticity of demand has a wide range of practical application in economics and
business.

1. Application for Businessmen

The concept of elasticity of demand is of utmost practical use, for while taking decision for
pricing policy, the businessman has to know the likely effect of price changes on the demand for
his product in the market. He has to consider, for instance, whether lowering of price will cause
an expansion in the demand for his product, and if so to what extent and thus to what extent his
total revenue would rise fetching what amount of profit.

Most businessmen consciously or unconsciously know by intuition something about the

elasticity of demand for their product while making a price decision. Several, however, do not
pay any attention to the price elasticity of demand and make the wrong decisions, so suffer heavy
losses. In scientific management decision making, thus, one has to try to form as precise an idea
as possible of the degree of elasticity of demand, for it is a convenient short-hand way of
expressing the effects of price change on the demand for a product.

By knowing the type of elasticity of demand it is easy to know whether a price cut is better or a
price rise for increasing the sales, total revenue and the profit. When the demand for the product
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is found unitary elastic, price change is ineffective in bringing more total revenue, so unless the
cost is changed it is not worthwhile to change the price.

2. Application for the Government and Finance Minister

In determining fiscal policy, the concept of elasticity of demand is very important to the
Government. The finance minister has to consider the elasticity of demand while selecting
commodities for taxation. Tax imposition on commodities for getting substantial revenue
becomes worthwhile only if the taxed goods have an inelastic demand. Otherwise, if the demand
is more elastic, it will contract very much with a rise in price as a result of added taxation (like
sales tax or excise duty), hence the total revenue yield would not be much. That is why, generally
taxes are levied on commodities like kerosene, matches, cigarettes, sugar, etc., which have an
inelastic demand.

3. Application for International Trade

The concept is also useful in formulating export and import policies of a country. Further, in
determining terms in the sphere of international trade, the relative elasticity’s of demand for
commodities in the two countries are very important.

4. Application for Trade Union

The concept of price elasticity is useful to trade unions in wage bargaining. The union leaders,
when they find that demands for their industry’s product is fairly elastic, will ask for a higher
wage to workers that will make the producer to cut the price and increase sales which will
compensate for his loss in total profit.

Point elasticity:
Elasticity is defined with reference to two observations on two variables and thus there is a
problem as to which observation's values, if any to use in the formula. If we use two points A
and B on a demand curve, the problem is whether to use A or point B or some other values in
elasticity calculation. When the elasticities are calculated the two elasticities are different. Both
these are called point elasticities.

The point elasticity is defined as the proportionate change in quantity demanded resulting
from a very small change in price of that commodity. It is expressed as:

In other words, it is equal to the absolute value of the first derivative of quantity with respect to price
(dQd/dP) multiplied by the point’s price (P) divided by its quantity (Qd). Point elasticity is used to
find out a change in one variable corresponding to a small change in the other variable.
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Arc Elasticity
The elasticity between two separate points of demand curve is called 'arc elasticity'. It measures
the average responsiveness to price change over a finite stretch on the demand curve. Its
calculation uses the mid-point values of the two variables under question. Thus, the arc
elasticity value lies between the two-point elasticity's.
The arc elasticity is defined mathematically as:
Midpoint formula for measuring income elasticity of demand when changes in income are quite
large can be written as

Q2−Q1 M 2−M 1
÷
e i = Q2 +Q1 M 2+¿ M
¿ 1

2 2

∆Q M 2+ M
= × 1

Q2+Q
1
∆M

∆ Q M 2+ M
= × 1

∆ M Q2+Q 1

This method for computing the price elasticity is also known as the “midpoints formula”, because the
average price and average quantity are the coordinates of the midpoint of the straight line between
the two given points.

Illustration 10: If price of coffee rises from Shs 45 per 250 grams pack to Shs. 55 per 250 grams
pack and as a result the consumers demand for the tea increases from 600 packs to 800 packs of
250 grams, then find the cross elasticity of demand of tea for coffee.

Solution:

We use midpoint method to estimate cross elasticity of demand.

Change in quantity demanded of tea =qt2 –qt1=800-600

Change in price of coffee =PC2-PC1=55-45

Substituting the values of the various variables in the cross-elasticity formula we have

Q2−Q1 M 2−M 1
÷
e i = Q2 +Q1 M 2+¿ M
¿ 1

2 2

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 ∆Q M 2+ M
= × 1

Q2+Q
1
∆M

∆ Q M 2+ M
= × 1

∆ M Q2+Q 1

800−600 55−45
200 50 10
cross elasticity of demand = 800+600 55+ 45 ¿ × = =1.43
÷ 700 10 7
2 2

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