Elasticity of Demand

Rabin Mazumder; Faculty of Economics

Elasticity measures
What are they? Why introduce them?
Responsiveness measures
Demand and supply responsiveness clearly matters for lots of market analyses. Want to compare across markets: inter market Want to compare within markets: intra market slope can be misleading want a unit free measure

Why not just look at slope?

Rabin Mazumder; Faculty of Economics

Why Economists Use Elasticity

An elasticity is a unit-free measure. By comparing markets using elasticities it does not matter how we measure the price or the quantity in the two markets. Elasticities allow economists to quantify the differences among markets without standardizing the units of measurement.
Rabin Mazumder; Faculty of Economics

What is an Elasticity?
Measurement of the percentage change in one variable that results from a 1% change in another variable.

- These variables are price of the commodity, prices of the related commodities, income of the consumer & other various factors on which demand depends. Thus, we have i. Price Elasticity, ii. Income Elasticity, iii. Cross Elasticity, iv. Arc Elasticity. It is always price elasticity of demand which is referred to as elasticity of demand
Rabin Mazumder; Faculty of Economics

 Price elasticity of demand: Keeping other things constant it is the percentage change in quantity demanded due to a percentage change in the price.
% change in quantity demanded price elasticity of demand % change in price Mathematically: P = Current price of good X Q = Quantity demanded at that price P = Small change in the current price Q= Resulting change in quantity demanded ep= Price elasticity of demand Q/Q -ve sign indicates that there is an inverse ep = (-) P/P relationship between price & quantity demanded

Factors affecting Elasticity of Demand

1. 2. 3. Availability of substitutes Postponement of consumption Proportion of expenditure (needles: inelastic; TV: elastic) 4. Nature of the commodity (necessity vs. luxury; durability/reparability eg., shoes) 5. Different uses of the commodity (paper vs. ink) 6. Time period (elastic in the long term) 7. Change in income (necessaries: inelastic; milk and fruit for a rich man) 8. Habits 9. Joint demand 10. Distribution of income 11. Price level (very costly & very cheap goods: inelastic)
Rabin Mazumder; Faculty of Economics

Types of Price Elasticity of Demand

Rabin Mazumder; Faculty of Economics

Elastic Demand
When quantity demanded responds more than the price changes then it is called elastic demand Here, ep>1 P Luxurious commodity
P0 P1

A B

Q0

Q1

Inelastic Demand
When quantity demanded responds less than the price changes then it is called inelastic demand.
Here, ep P Necessary commodities
P0 P1

<1

Q0 Q1

Unitary Elastic demand

When quantity demanded responds equally to the price changes then it is called unitary elastic demand.
Here, ep P

=1

Elasticity = 1
Necessary commodities

0
Rabin Mazumder; Faculty of Economics

Perfectly Elastic Demand

Demand is perfectly elastic when 1% change in the price would result in an infinite change in quantity demanded.
Price

Super Luxurious
Perfectly Elastic Demand (elasticity = )

Po

Commodities

Qo

Q1

Quantity

Perfectly Inelastic Demand

Demand is perfectly inelastic when 1% change in the price would result in no change in quantity demanded.
Price

P1
Perfectly Inelastic Demand (elasticity = 0)

Super necessary Commodities

Po

Qo

Quantity

Income Elasticity of Demand

Other things remaining constant, the percentage change in quantity demanded of a good to a small change in the income of the consumer. EI= QX/QX / I/I

Rabin Mazumder; Faculty of Economics

 When the income elasticity of demand is positive (normal good), consumers increase their purchases of the good as their incomes rise (e.g. automobiles, clothing). When the income elasticity of demand is greater than 1 (luxury good), consumers increase their purchases of the good more than proportionate to the income increase (e.g. Diamond). When the income elasticity of demand is negative (inferior good), consumers reduce their purchases of the good as their incomes rise (e.g. potatoes).

Income elasticity
Types: Zero Negative Positive (i) low (ii) unitary (iii) high Income elasticity and business decisions 1. If ei is >0 but <1, sales will increase but slower than the general economic growth; 2. If ei is >1, sales will increase more rapidly than general economic growth 3. Corollary: in a growing economy while farmers suffer as their products have low income elasticity, industrialists gain as their products have high income elasticity.
Rabin Mazumder; Faculty of Economics

Cross Price Elasticity

A change in the demand for one good in response to a change in the price of another good represents cross elasticity of demand of the former good for the later good. EDxPy= QX/QX / PY/PY or EDxPy= QX/PY PY/QX Example: responsiveness of demand for Dell computers to prices of Lenovo computers

Rabin Mazumder; Faculty of Economics

Cross Price Elasticity

cross-price elasticity for complementary good is negative because as the price of a complementary good rises, the quantity demanded of the good itself falls. Example : software is complementary with computers. When the price of software rises the quantity demanded of computers falls. cross-price elasticity for substitute good is positive because as the price of a substitute good rises, the quantity demanded of the good itself rises. Example : hockey is substitute for basketball. When the price of hockey tickets rises the quantity demanded of basketball tickets rises.
Rabin Mazumder; Faculty of Economics

The demand curve for good X shifts with changes in the price of good Y
P

Complements and Substitutes

Price of a complement falls Price of a substitute rises

Price of a complement rises Price of a substitute falls 0

Rabin Mazumder; Faculty of Economics

1.

Percentage or Proportionate Method = Percentage change in demand Percentage change in price or; = Proportionate change in demand Proportionate change in price

Methods of measurement of Elasticity

2. Total Outlay (Expenditure) Methods TO=TQ* P ; where, TO=total outlay; TQ=total quantity; P=price of the commodity 3. Geometric (Point) method at any given point on the curve = lower segment of demand curve Rabin Mazumder; Faculty of upper segment of demand curve Economics

Price Elasticity of Demand and Total Revenue

If the price elasticity of demand is > 1, then a reduction in price will increase demand more than proportionately and TR (P x Q) will increase.

If the price elasticity of demand = 1, then a reduction in price will increase demand in proportion and TR will be unchanged If the price elasticity of demand is < 1, then a reduction of price will increase demand less than proportionately and TR will fall.
Rabin Mazumder; Faculty of Economics

Price Elasticity of Demand and Total Revenue

P E>1 E=1 E<1 D

0 TR

Q Max TR

TR rising
0

TR falling
Q

The effect of a price change on revenue depends on the elasticity of demand

Type of demand Elastic

Value of Ed More than 1.0 Between 0 and -1.0 Equal to -1.0

Price P decreases P increases P decreases P increases P decreases P increases

quantity

Effect on total revenue

Q increases Total revenue increases Q decreases Total revenue decreases Q increases Total revenue decreases Q decreases Total revenue increases Q increases Total revenue unchanged Q decreases Total revenue unchanged

Inelastic

Unitary elastic

Rabin Mazumder; Faculty of Economics