Elasticity of Demand

What Does Demand Elasticity Mean?

In economics, the demand elasticity refers to how sensitive the demand for a good is to
changes in other economic variables. Demand elasticity is important because it helps
firms model the potential change in demand due to changes in price of the good, the
effect of changes in prices of other goods and many other important market factors. A
firm grasp of demand elasticity helps to guide firms toward more optimal competitive
behavior. Elasticities greater than one are called "elastic," elasticities less than one are
"inelastic," and elasticities equal to one are "unit elastic."
Price elasticity of demand
Price elasticity of demand measures the percentage change in quantity demanded caused by a
percent change in price. As such, it measures the extent of movement along the demand curve.
This elasticity is almost always negative and is usually expressed in terms of absolute value (i.e. as
positive numbers) since the negative can be assumed. In these terms, then, if the elasticity is
greater than 1 demand is said to be elastic; between zero and one demand is inelastic and if it
equals one, demand is unit-elastic. A perfectly elastic demand curve is horizontal (with an elasticity
of infinity) whereas a perfectly inelastic demand curve is vertical (with an elasticity of 0).
Income elasticity of demand
Income elasticity of demand measures the percentage change in demand caused by a percent
change in income. A change in income causes the demand curve to shift reflecting the change in
demand. IED is a measurement of how far the curve shifts horizontally along the X-axis. Income
elasticity can be used to classify goods as normal or inferior. With a normal good demand varies in
the same direction as income. With an inferior good demand and income move in opposite
directions.
Cross price elasticity of demand
Cross price elasticity of demand measures the percentage change in demand for a particular good
caused by a percent change in the price of another good. Goods can be complements, substitutes
or unrelated. A change in the price of a related good causes the demand curve to shift reflecting a
change in demand for the original good. Cross price elasticity is a measurement of how far, and in
which direction, the curve shifts horizontally along the x-axis. A positive cross-price elasticity means
that the goods are substitute goods.
Price elasticity of demand (PED or Ed) is a measure used in economics to show the responsiveness,
or elasticity, of the quantity demanded of a good or service to a change in its price. More precisely, it gives
the percentage change in quantity demanded in response to a one percent change in price (holding constant
all the other determinants of demand, such as income). It was devised by Alfred Marshall.
Price elasticities are almost always negative, although analysts tend to ignore the sign even though this can
lead to ambiguity. Only goods which do not conform to the law of demand, such as Veblen and Giffen goods,
have a positive PED. In general, the demand for a good is said to be inelastic (or relatively inelastic) when

Dr. Uma Sankar Mishra, Associate Professor (Marketing Management), IBCS,

SOA Deemed University, Bhubaneswar, Odisha

the PED is less than one (in absolute value): that is, changes in price have a relatively small effect on the
quantity of the good demanded. The demand for a good is said to be elastic (or relatively elastic) when its
PED is greater than one (in absolute value): that is, changes in price have a relatively large effect on the
quantity of a good demanded.

PED is derived from the percentage change in quantity (%Q d) and percentage change in price (%P).

PED is a measure of responsiveness of the quantity of a good or service demanded to changes in its
price. The formula for the coefficient of price elasticity of demand for a good is:

The above formula usually yields a negative value, due to the inverse nature of the relationship
between price and quantity demanded, as described by the "law of demand".

Point-price elasticity
The point measurement of price elasticity uses differential calculus to calculate the elasticity for an
infinitesimal change in price and quantity at any given point on the demand curve:

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)

Arc elasticity
A second solution to measure PED is Arc measurement in which two given points on a demand curve is
chosen, one as the "original" point and the other one as "new", where we have to compute the percentage
change in P and Q relative to the average of the two prices and the average of the two quantities, rather

Dr. Uma Sankar Mishra, Associate Professor (Marketing Management), IBCS,

SOA Deemed University, Bhubaneswar, Odisha

than just the change relative to one point or the other. Loosely speaking, this gives an "average" elasticity for
the section of the actual demand curvei.e., the arc of the curvebetween the two points. As a result, this
measure is known as the arc elasticity, in this case with respect to the price of the good. The arc elasticity is
defined mathematically as:

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. However, because this formula implicitly assumes the section of the demand curve
between those points is linear, the greater the curvature of the actual demand curve is over that range,
the worse this approximation of its elasticity will be.

Determinants of Price Elasticity of Demand

The overriding factor in determining PED is the willingness and ability of consumers after a price change to
postpone immediate consumption decisions concerning the good and to search for substitutes ("wait and
look"). A number of factors can thus affect the elasticity of demand for a good:
Availability of substitute goods: the more and closer the substitutes available, the higher the

elasticity is likely to be, as people can easily switch from one good to another if an even minor price
change is made; There is a strong substitution effect. If no close substitutes are available the
substitution of effect will be small and the demand inelastic.

Breadth of definition of a good: the broader the definition of a good (or service), the
lower the elasticity. For example, Company X's fish and chips would tend to have a relatively high
elasticity of demand if a significant number of substitutes are available, whereas food in general
would have an extremely low elasticity of demand because no substitutes exist.

Percentage of income: the higher the percentage of the consumer's income that the product's
price represents, the higher the elasticity tends to be, as people will pay more attention when
purchasing the good because of its cost;The income effect is substantial. When the goods represent
only a negligible portion of the budget the income effect will be insignificant and demand inelastic,

Necessity: the more necessary a good is, the lower the elasticity, as people will attempt to buy it
no matter the price, such as the case of insulin for those that need it.

Duration: for most goods, the longer a price change holds, the higher the elasticity is likely to be,
as more and more consumers find they have the time and inclination to search for substitutes. When
fuel prices increase suddenly, for instance, consumers may still fill up their empty tanks in the short run,
but when prices remain high over several years, more consumers will reduce their demand for fuel by

Dr. Uma Sankar Mishra, Associate Professor (Marketing Management), IBCS,

SOA Deemed University, Bhubaneswar, Odisha

switching to carpooling or public transportation, investing in vehicles with greater fuel economy or taking
other measures. This does not hold for consumer durables such as the cars themselves, however;
eventually, it may become necessary for consumers to replace their present cars, so one would expect
demand to be less elastic.
Brand loyalty: an attachment to a certain brandeither out of tradition or because of proprietary

barrierscan override sensitivity to price changes, resulting in more inelastic demand.

Who pays: where the purchaser does not directly pay for the good they consume, such as with

corporate expense accounts, demand is likely to be more inelastic.

Interpreting values of price elasticity coefficients

Perfectly inelastic demand

Perfectly elastic demand[10]

Elasticities of demand are interpreted as follows

Value

Ed = 0

Descriptive Terms

Perfectly inelastic demand

Dr. Uma Sankar Mishra, Associate Professor (Marketing Management), IBCS,

SOA Deemed University, Bhubaneswar, Odisha

- 1 < Ed < 0

Inelastic or relatively inelastic demand

Ed = - 1

Unit elastic, unit elasticity, unitary elasticity, or unitarily elastic demand

- < Ed < - 1 Elastic or relatively elastic demand

Ed = -

Perfectly elastic demand

A decrease in the price of a good normally results in an increase in the quantity demanded by consumers
because of the law of demand, and conversely, quantity demanded decreases when price rises. As
summarized in the table above, the PED for a good or service is referred to by different descriptive terms
depending on whether the elasticity coefficient is greater than, equal to, or less than 1. That is, the demand
for a good is called:

relatively inelastic when the percentage change in quantity demanded is less than the percentage
change in price (so that Ed > - 1);

unit elastic, unit elasticity, unitary elasticity, or unitarily elastic demand when the percentage change
in quantity demanded is equal to the percentage change in price (so that Ed = - 1); and

relatively elastic when the percentage change in quantity demanded is greater than the percentage
change in price (so that Ed < - 1).

As the two accompanying diagrams show, perfectly elastic demand is represented graphically as a
horizontal line, and perfectly inelastic demand as a vertical line. These are the only cases in which the PED
and the slope of the demand curve (P/Q) are bothconstant, as well as the only cases in which the PED is
determined solely by the slope of the demand curve (or more precisely, by the inverse of that slope).

INCOME ELASTICITY OF DEMAND

In economics, income elasticity of demand measures the responsiveness of the demand for a good to a
change in the income of the people demanding the good, ceteris paribus. It is calculated as the ratio of the
percentage change in demand to the percentage change in income. For example, if, in response to a 10%
increase in income, the demand for a good increased by 20%, the income elasticity of demand would be
20%/10% = 2.

A negative income elasticity of demand is associated with inferior goods; an increase in income will
lead to a fall in the demand and may lead to changes to more luxurious substitutes.

Dr. Uma Sankar Mishra, Associate Professor (Marketing Management), IBCS,

SOA Deemed University, Bhubaneswar, Odisha

A positive income elasticity of demand is associated with normal goods; an increase in income will

lead to a rise in demand. If income elasticity of demand of a commodity is less than 1, it is a necessity
good. If the elasticity of demand is greater than 1, it is aluxury good or a superior good.
A zero income elasticity (or inelastic) demand occurs when an increase in income is not associated

with a change in the demand of a good. These would be sticky goods.

Income elasticity of demand can be used as an indicator of industry health, future consumption patterns and
as a guide to firms investment decisions. For example, the "selected income elasticities" below suggest that
an increasing portion of consumer's budgets will be devoted to purchasing automobiles and restaurant
meals and a smaller share to tobacco and margarine.

Cross elasticity of demand

In economics, the cross elasticity of demand or cross-price elasticity of demand measures the
responsiveness of the demand for a good to a change in the price of another good. It is measured as
the percentage change in demand for the first good that occurs in response to a percentage change in price
of the second good. For example, if, in response to a 10% increase in the price of fuel, the demand of new
cars that are fuel inefficient decreased by 20%, the cross elasticity of demand would be:

.
A negative cross elasticity denotes two products that are complements, while a
positive cross elasticity denotes two substitute products. These two key relationships go against one's
intuition, but the reason behind them is fairly simple: assume products A and B are complements, meaning
that an increase in the demand for A is caused by an increase in the quantity demanded for B. Therefore, if
the price of product B decreases, then the demand curve for product A shifts to the right, increasing A's
demand, resulting in a negative value for the cross elasticity of demand. The exact opposite reasoning holds
for substitutes.

The formula used to calculate the coefficient cross elasticity of demand is

or:

Dr. Uma Sankar Mishra, Associate Professor (Marketing Management), IBCS,

SOA Deemed University, Bhubaneswar, Odisha