Elasticity of Demand

Elasticity of Demand

 “Elasticity” is a standard measure of the degree of

responsiveness (or sensitivity) of one variable to changes
in another variable.
 Elasticity of Demand measures the degree of
responsiveness of demand for a commodity to a given
change in any of the independent variables that influence
demand for that commodity, such as price of the
commodity, price of the other commodities, income,
taste, preferences of the consumer and other factors.
 Responsiveness implies the proportion by which the
quantity demanded of a commodity changes, in response
to a given change in any of its determinants .
 Elasticity of Demand
 Mathematically, it is the percentage change in
quantity demanded of a commodity to a percentage
change in any of the (independent) variables that
determine demand for the commodity.
 Four major types of elasticity:
 Price elasticity,
 Income elasticity,
 Cross elasticity
 Advertising (or promotional) elasticity.
 In order to assess the impact of one variable on demand,
we assume other variables as constant (ceteris paribus)
 Price Elasticity of Demand

 Price is most important among all the

independent variables that affect the demand for
any commodity.
 Hence price elasticity of demand ( “e p” or “e”) is
considered to be the most important of all types of
elasticity of demand.
 Price elasticity of demand means the sensitivity
of quantity demanded of a commodity to a given
change in its own price.
 Degrees of Price Elasticity
Slope of demand curve is used to display Price
price elasticity of demand
Perfectly elastic demand
 e =∞ (in absolute terms). P
p D
 Horizontal demand curve
 Unlimited quantities of the commodity can
be sold at the prevailing price O
 A negligible increase in price would result Q1 Q2 Quantity
in zero quantity demanded

 Perfectly inelastic demand D

 The other extreme of the elasticity range Price
 ep=0 (in absolute terms)
 Vertical demand curve P1
 Quantity demanded of a commodity
remains the same, irrespective of any P2
change in the price
 Such goods are termed neutral. O
Q1 Quantity
 Degrees of Price Elasticity
Contd.
Highly elastic demand
 Proportionate change in quantity Price
D
demanded is more than a given change
in price P1
 P2
ep >1 (in absolute terms) D
 Demand curve is flatter
Unitary elastic demand O
Q1 Q2 Quantity
 Proportionate change in price brings Price D
about an equal proportionate change in
quantity demanded P1
 ep =1 (in absolute terms). P2
 Demand curves are shaped like a D
rectangular hyperbola, asymptotic to the
axes O
Q1 Q2 Quantity
Relatively inelastic demand Price
 Proportionate change in quantity D
demanded is less than a proportionate P1
change in price P2
 ep <1 (in absolute terms)
 Demand curve is steep
O D
Q1 Q2 Quantity
 Determinants of Elasticity
 Products with close substitutes tend to have
elastic demand.
 Essential goods have price inelastic demand.
 Luxurious goods have price elastic demand.
 Market defined at aggregate level and at
disaggregate level.
 Goods occupy higher proportion of income
tend to have elastic demand.
 Demand is inelastic in short-run and elastic in
the long-run.
 Methods of Measuring Elasticity
 Ratio (or Percentage) Method
 The most popular method used to measure elasticity
 Elasticity of demand is expressed as the ratio of proportionate
change in quantity demanded and proportionate change in the
price of the commodity
 It allows comparison of changes in two qualitatively different
variables
 It helps in deciding how big a change in price or quantity is

Proportionate change in quantity demanded of commodity X

ep =
Proportionate change in price of commodity X
Q2  Q1 / Q1
ep=
P2  P1 / P1
 where Q1= original quantity demanded, Q2= new quantity
demanded, P1= original price level, P2= new price level
 Methods of Measuring Elasticity
Contd…

 Point Elasticity Method

 Elasticity measured at a point of demand curve is referred
as point elasticity of demand.
 For nonlinear demand curve we need to apply calculus
to calculate point elasticity.
 As changes in price become smaller and approach zero,
Q
the ratio P becomes equivalent to the first order
dQ
derivative of the demand function with respect to price dP
 Point elasticity can be expressed as:

ep dQ / Q dQ P
= = .
dP / P dP Q
Example 1
Q: Calculate Point Elasticity:
Demand Curve: Q=100 – P2
Assuming P1=5 and Q=75
 Methods of Measuring Elasticity
Contd…

 Arc Elasticity Method

 Used when the available figures on price and
quantity are discrete (large), and it is possible to
isolate and calculate the incremental changes.
 It is used to find the elasticity at the midpoint of an
arc between any two points on a demand curve, by
taking the average of the prices and quantities.
 This method finds wider applications, as it reflects a
movement along a portion (arc) of a demand curve
Q2  Q1 P2  P1
ep = (Q1  Q2 ) / 2 / ( P1  P2 ) / 2

Q2  Q1 P1  P2
.
Q1 = Q2 P2  P1
Numericals
 Q1. The initial price of a cup of coffee is $1, and at that
price, 400 cups are demanded. If the price falls to $0.90,
the quantity demanded will increase to 500.
 a. Calculate the (arc) price elasticity of demand for coffee.
 b. Based on your answer, is the demand for coffee elastic
or inelastic?
 c. Based on your answer to a., if the price of coffee is
increased by 10%, what will happen to the revenues from
coffee? Carefully explain how you know.
 Q2.The demand curve is: QD = 500 - 1/2 P.
 a. Calculate the (point) price elasticity of
demand when price is $100. Is demand elastic
or inelastic?
 b. Calculate the (point) price elasticity of
demand when price is $700. Is demand elastic
or
 inelastic?
 c. Find the point at which point elasticity is equal
to -1.
Numericals
Q3: The demand for automobiles must be less elastic than the
demand for videogame players because a $50 reduction in the
price of cars does not affect the number sold nearly as much as a
$50 reduction in the price of videogame players.” Is this
statement correct? Explain.
Numericals
Q4: A retails store faces a demand function Q = 180 – 1.5P
a. The store currently charges P = 80 per product. Determine
the no. of quantity.

b. If management wants to raise the price to 100, what would

be the changes in the store’s quantity and revenue?

c. Compute the point elasticity of demand at P = 80 and at P

= 100. At which price demand is more sensitive?
 Income Elasticity of Demand (ey)
 ey measures the degree of responsiveness of demand for
a good to a given change in income, ceteris paribus.

Proportionate change in quantity demanded of commodity X

ey =
Proportionate change in income of consumer

Degrees:
 Positive income elasticity
 Demand rises as income rises and vice versa

 Normal good

 Negative income elasticity

 Demand falls as income rises and vice versa

 Inferior good
 Cross Elasticity of Demand
 ec measures the responsiveness of demand of
one good to changes in the price of a related
good
Proportionate change in quantity demanded of commodity X
ec =
Proportionate change in price of commodity Y

 Degrees
 Negative Cross Elasticity
 Complementary goods
 Positive Cross Elasticity
 Substitute goods
 Problem
The general linear demand for good X is Q = 250,000 – 500 P + 1.5 M –
240 PR. The values of P, M and PR are expected to be Rs 200, Rs 90,000
and Rs1000, respectively.

a.Calculate Ep. Is the demand elastic or inelastic or unitary elastic?

b.Calculatethe Ei,j. Are the goods complements or substitute? Explain

how a 5 percent decrease in PR would impact the demand for X.
Total Expenditure, Total Revenue, and Price
Elasticity of Demand
Total Expenditure Changes When Price Changes: Inelastic Demand
Total Expenditure Changes When Price Changes: Elastic Demand
 Elasticity of a Linear Demand
Curve
Price Quantity % change % change Price Elasticity
in price in Qty Elasticity*
7 0

6 2

5 4

4 6

3 8

2 10

1 12

0 14

* Use ARC Elasticity Method

 Price Elasticity of Supply
 Similar to price elasticity of demand, price elasticity of supply measures
the responsiveness to quantity supplied to a price change.

 It takes only positive values.

 Ep > 1 Supply is elastic

 Ep < 1 Supply is inelastic
 Ep = 1 Supply is unit-elastic
 Supply Curve with different
Elasticities
Perfectly Elastic Supply Curve Highly Elastic Supply Curve

Unitary Elastic Supply Curve

 Supply Curve with different
Elasticities
Inelastic Elastic Supply Curve Perfectly Inelastic Supply Curve
The Price Elasticity of Supply and Determinants
Price elasticity of Supply depends on flexibility
of sellers to change the amount of the good
they produce in response to change in prices.

 Time Period- Long-run and Short-run.

 Production Capacity
 Size of the Firm/Industry
 Mobility of Factors of Production.
 Ease of Storing Stock/Inventory.
 The Midpoint (Arc) Method of Calculating the
Elasticity of Supply

 Arc Elasticity Method

 Used when the available figures on price and quantity
are discrete (large), and it is possible to isolate and
calculate the incremental changes.
 It is used to find the elasticity at the midpoint of an arc
between any two points on a supply curve, by taking the
average of the prices and quantities.
 Methods of Measuring Elasticity
 Point Elasticity Method
 Elasticity Varies over a Supply Curve

Calculate the elasticity of supply using ARC Elasticity Method.

 Changes in Total Revenue when price
changes

 Impact on Total  Impact on Total

Revenue when Revenue when
supply is price supply is price
inelastic. elastic.
 ELASTICITIES OF SUPPLY AND DEMAND

During recent decades, changes in the wheat market had major implications for both American

farmers and U.S. agricultural policy.

To understand what happened, let’s examine the behavior of supply and demand beginning in 1981.

By setting the quantity supplied equal to the quantity demanded, we can determine the market-clearing

price of wheat for 1981:

 ELASTICITIES OF SUPPLY AND DEMAND

Substituting into the supply curve equation, we get

We use the demand curve to find the price elasticity of demand:

Thus demand is inelastic.

We can likewise calculate the price elasticity of supply:

P QS 3.46
EPS   (240) 0.32
Q P 2630

Because these supply and demand curves are linear, the price elasticities will vary as we move along the curves.
 Numerical: Elasticity and Prediction

Ques: Suppose that the Tasty Company markets coffee brand X and estimated the following

regression of the demand for its brand of coffee:

Qx = 1.5 – 3.0Px + 0.81I + 2.0 Py – 0.6 Ps + 1.2 A

Qx = Sales of coffee brand X in India, in millions of pounds per year

Px= Price of coffee brand X, in dollars per pound

I= personal disposable income, in trillions of dollars per year

Py = price of the competitive brand of coffee, in dollars per pound

Ps= price of sugar, in dollar per pound

A= Advertising expenditures for coffee brand X, in hundreds of thousands of dollars per

 Numerical: Elasticity and Prediction

Suppose that next year the firm intends to increase the price of its brand of coffee by

5% and advertising expenditures by 12%. Firm also expects personal disposable

income to rise by 4%, Py to rise by 7%, Ps to fall by 8%.

Using the level of sales as computed earlier, elasticities, and changes in variables,

determine the sales of company next year.

 Long-run and Short-run Elasticities
There is a time lag to analyze the impact of prices and income on

quantity demanded.

There is a time lag to analyze the impact of prices on quantity supplied.

Long-Run and Short –Run Demand Elasticities

•Food, Beverages, Petrol

•Durable Goods, like Refrigerator, Automobile

 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Demand

Figure

(a) Gasoline: Short-Run and Long-Run Demand

Curves

(a) In the short run, an increase in price has

only a small effect on the quantity of gasoline
demanded. Motorists may drive less, but they
will not change the kinds of cars they are
driving overnight.

In the longer run, however, because they will

shift to smaller and more fuel-efficient cars,
the effect of the price increase will be larger.
Demand, therefore, is more elastic in the long
run than in the short run.
 SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Demand
Demand and Durability

(b) Automobiles: Short-Run and Long-Run

Demand Curves

(b) The opposite is true for automobile

demand. If price increases, consumers initially
defer buying new cars; thus annual quantity
demanded falls sharply.

In the longer run, however, old cars wear out

and must be replaced; thus annual quantity
demanded picks up. Demand, therefore, is less
elastic in the long run than in the short run.
SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Income Elasticities Income Elasticities

Durables:
Petrol:
Demand is inelastic in the Demand is elastic in the
Short-Run. short-run.

Demand is elastic in the Demand is inelastic in the

Long-run. long-run.
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