The Elasticity of Demand

Chapter 2

The Concept of Elasticity

Elasticity is a measure of the responsiveness of one variable to another. The greater the elasticity, the greater the responsiveness.

The Concept of Elasticity

Elasticity is a measure of the

responsiveness of one variable to another. The greater the elasticity, the greater the responsiveness.

Price Elasticity
The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price. Percentage change in quantity demanded ED = Percentage change in price

Price Elasticity
ep = Percentage Change in Quantity Demanded Percentage Change in Price = Change in Quantity Demanded Quantity Demanded Initially = Where

Change in Price Initial Price

Qd P
*

P
Qd

Qd = Change in Quantity Demanded

P = Change in Price

Sign of Price Elasticity

According to the law whenever the price rises, demanded falls. Thus elasticity of demand negative.

of demand, the quantity the price is always

Because it is always negative, economists usually state the value without the sign.

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 Quantity Demanded > % Change in Price Unit Elastic Demand When % Change in Quantity Demanded = % Change in Price Inelastic Demand When % Change in Quantity Demanded < % Change in Price Perfectly Elastic Demand When Quantity Demanded Changes 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

Elasticity and Demand Curves

Two important points to consider:

Elasticity is related (but is not the same as) slope. Elasticity changes along straight-line demand and supply curves.

Elasticity Is Not the Same as Slope

The steeper the curve at a given point, the less elastic is supply or demand. There are two limiting examples of this.

Elasticity Is Not the Same as Slope

When the curves are flat, we call the curves perfectly elastic. The quantity changes enormously in response to a proportional change in price (E = ).

Elasticity Is Not the Same as Slope

When the curves are vertical, we call the curves perfectly inelastic. The quantity does not change at all in response to an enormous proportional change in price (E = 0).

Perfectly Inelastic Demand Curve

Perfectly inelastic demand curve

0 Quantity

Perfectly Elastic Demand Curve

Perfectly elastic demand curve

0 Quantity

Demand Curve Shapes and Elasticity

Perfectly Elastic Demand Curve

The demand curve is horizontal, any change in price can and will cause consumers to change their consumption.

Perfectly Inelastic Demand Curve

The demand curve is vertical, the quantity demanded is totally unresponsive to the price. Changes in price have no effect on consumer demand.

In between the two extreme shapes of demand curves are the demand curves for most products.

Demand Curve Shapes and Elasticity

Elasticity Changes Along Straight-Line Curves

Elasticity is not the same as slope. Elasticity changes along straight line supply and demand curvesslope does not.

Elasticity Along a Demand Curve

Ed = $10 9 8 7 6 5 4 3 2 1 0 1 2 Ed > 1 Elasticity declines along demand curve as we move toward the quantity axis

Price

Ed = 1
Ed < 1 Ed = 0 3 4 5 6 7 8 9 10 Quantity

The Price Elasticity of Demand Along a Straight-line Demand Curve

Significance of Price Elasticity of Demand

Profit maximization requires that business set a price that will maximize the firms profit Elasticity tells the firm how much control it has over using price to raise profit If Ep > 1, then the % Change in Qd > % Change is Price and demand is said to be elastic

An increase in price will reduce total revenue A decrease in price will increase total revenue

Significance of Price Elasticity of Demand

If Ep < 1, then the % change in Qd < % change in price, and demand is said to be inelastic

An increase in price will increase total revenue A decrease in price will decrease total revenue

If Ep = 1, then the % change in Qd = % change in

Price, and demand is said to be unit elastic

An increase in price will have no impact on total revenue A decrease in price will have no impact on total revenue

Predicting Changes in Total Revenue and Total Expenditure in Response to Price Increase
Summary of Elasticity Measures (increase in Price) Unitary Elastic % Q = %P e =1 e>1 e = No Change Decrease -

Relatively Elastic % Q > %P Perfectly Elastic % Q = 0

Relatively Inelastic
Perfect inelastic

% Q < %P
% Q = 0

e<1
e =0

Increase
Increase

Calculating Elasticities

To determine elasticity divide the percentage change in quantity by the percentage change in price.

The Arc price elasticity of demand

It is the percentage change differs depending on whether you view the change as a rise or a decline in price.

The Arc price elasticity of demand

Economists use the average of the end points to calculate the percentage change.

(Q2 - Q1)

Elasticity =

Q2 Q1 P1 + P2

(P2 - P1)

Graphs of Elasticities
B $26 24 22 20 18 16 14 0 C (midpoint) A D Elasticity of demand between A and B = 1.27

10 12 14 Quantity of software (in hundred thousands)

Calculating Elasticity
Q 2 Q1 1 % Q 2 (Q 1 Q 2 ) E P2 P1 % P 1 1 P2 ) 2 (P

Calculating Elasticity of Demand Between Two Points

$26
24 22 20 18 16 14 0

Elasticity of demand between A and B:

B midpoint C A

%Q E %P 10 14 4 1 .33 2 (14 10 ) ED 12 1.27 26 20 6 .26 1 23 2 (26 20 )

Demand

10 12 14 Quantity of software (in hundred thousands)

Calculating Elasticity at a Point

Let us now turn to a method of calculating the elasticity at a specific point, rather than over a range or an arc.

Calculating Elasticity at a Point

To calculate elasticity at a point, determine a range around that point and calculate the arc elasticity.

Calculating Elasticity at a Point

Measurement of point elasticity is same as the price elasticity of demand in a limiting sense Here changes in quantity demanded and price are infinitesimally small Point elasticity of demand is different at different point on the demand curve

Calculating Elasticity at a Point

Slope of the Demand Curve dP dQ Point Elasticity on the demand curve ep = dP P dQ Q

Determinants of the Price Elasticity of Demand

The degree to which the price elasticity of demand is inelastic or elastic depends on:

How many substitutes there are How well a substitute can replace the good or service under consideration The importance of the product in the consumers total budget The time period under consideration

Income elasticity of Demand

The income elasticity of demand is defined as the rate of change in the quantity demanded of a good due to changes in the income of the consumer. If the amount of good demanded rises as the income of the consumer increases, than value of income elasticity of demand is positive (Normal good) If the amount of good demanded decreases as the income of the consumer increases, than value of income elasticity of demand is negative (Inferior good) Income elasticity of demand is also used to classify goods into luxuries and necessities. If the income elasticity of good is greater than one, it is called luxury. If the income elasticity is less than one, it is called a necessity. If it is equal to one, it can be called as a semi-luxury good.

Income Elastic
Q2 E1 Income elasticity of demand is greater than one. In this case as income increases, the quantity demanded also increases. But the percentage increase in demand is more than percentage increase in income Y2

Quantity Demanded

Q1

Y1

Income

Income Inelastic
Quantity Demanded E2

Q1 Q2 E1

Income elasticity is between zero and one. In this case, as income increases quantity demanded increases but the percentage increase in quantity demanded is less than percentage increase in income

Y1

Y2

Income

Varying Income Elasticities

Quantity Demanded Income elasticity is positive at low incomes but becomes negative as income increases above level M. Maximum consumption of good occurs at income M.

Positive income elasticity

Negative income elasticity

0 M Elasticity less than 1 and becomes negative

Income

Promotional (or Advertising)

Elasticity of Demand The advertising elasticity of demand measures an extent to which the demand of a product will be influenced by advertisement and other promotional activities. Advertising elasticity of demand measures the responsiveness of quantity demanded to changes in the expenditure on advertising and other sales promotional activities.
eA
Q =

Cross Elasticity of Demand

Cross elasticity of demand is defined as the percentage change in the quantity demanded of a good due to the changes in the prices of other good, other things remaining the same.
ecji =
Percentage change in the price of jth good
Percentage change in the demand of ith good

When two goods are substitutes, than increase in the price of one good decreases its own demand and increases the demand of another good. In this case cross elasticity of demand is positive In the case of complementary goods the increase in the price of one good decreases the demand for both the goods. In this case cross elasticity of demand is negative.

Cross Elasticity of Demand

Determinants of Price Elasticity of Demand

Closeness of substitutes The proportion of income spent on the good The time elapsed since the price change Nature of good

Determinants of Income Elasticity of Demand

Nature of the need the good covers The initial level of income of a country Time period

Determinants of Cross Elasticity of Demand

The main determinant of cross elasticity of demand is the nature of the goods relatives to their usages. If two goods can satisfy equally well the same need, the cross elasticity is high and vice versa.

Substitution and Elasticity

As a general rule, the more substitutes a good has, the more elastic is its supply and demand.

Substitution and Demand

The less a good is a necessity, the more elastic its demand curve. Necessities tend to have fewer substitutes than do luxuries.

Substitution and Demand

Demand for goods that represent a large proportion of one's budget are more elastic than demand for goods that represent a small proportion of one's budget.

Substitution and Demand

Goods that cost very little relative to your total expenditures are not worth spending a lot of time figuring out if there is a good substitute. It is worth spending a lot of time looking for substitutes for goods that take a large portion of ones income.

Substitution and Demand

The larger the time interval considered, or the longer the run, the more elastic is the goods demand curve.

There are more substitutes in the long run than in the short run. The long run provides more options for change.

Relationship between ep , AR,MR

ep = dP P dQ Q AR = P (Price)

MR = d TR dQ
MR = d P.Q dQ MR = P { 1 + Q dP } P dQ

TR = P . Q
MR = P + Q . dP dQ MR = P { 1 1} IepI

MR = AR { 1 -

1} IepI

The difference between AR and MR depends inversely on the absolute value of the elasticity of demand.

Managerial Implication
Q. Consider the demand equation Q= 25-3P , where Q represents quantity demanded and P the selling price. What price should manufacturer charge in order to maximize its total revenue. What is the point price elasticity of demand and total revenue at this price.

Consumer surplus

Consumer surplus is a measure of the welfare that people gain from the consumption of goods and services, or a measure of the benefits they derive from the exchange of goods. Consumer surplus is the difference between the total amount that consumers are willing and able to pay for a good or service (indicated by the demand curve) and the total amount that they actually do pay (i.e. the market price for the product).

Consumer Surplus
:

Consumer surplus and price elasticity of demand

When the demand for a good or service is perfectly elastic, consumer surplus is zero because the price that people pay matches precisely the price they are willing to pay. This is most likely to happen in highly competitive markets where each individual firm is assumed to be a price taker in their chosen market and must sell as much as it can at the ruling market price. In contrast, when demand is perfectly inelastic, consumer surplus is infinite. Demand is totally invariant to a price change. Whatever the price, the quantity demanded remains the same. The majority of demand curves are downward sloping. When demand is inelastic, there is a greater potential consumer surplus because there are some buyers willing to pay a high price to continue consuming the product.