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Chapter 5

Elasticity of Demand
Lecture plan
 Objectives
 Elasticity of demand
 Price elasticity of demand
 Degrees of price elasticity of demand
 Methods of measuring elasticity
 Revenue and price elasticity of demand
 Income elasticity of demand
 Cross elasticity of demand
 Promotional elasticity of demand
 Importance of elasticity
Objectives
 To understand the meaning of responsiveness
of demand to changes in determinants of
demand.
 To lay down the degrees of responsiveness of
demand.
 To discuss various types of elasticities of
demand.
 To learn how to measure elasticity by various
methods.
 To understand the relevance and application of
elasticities 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 ( “ep” 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
Price
Perfectly elastic demand
 ep=∞ (in absolute terms).
 Unlimited quantities of the commodity P D
can be sold at the prevailing price
 A negligible increase in price would
result in zero quantity demanded O Q1 Q1
Quantity
 Horizontal demand curve

Perfectly inelastic demand D


 The other extreme of the elasticity Price
range
 ep=0 (in absolute terms) P1

 Quantity demanded of a commodity P2


remains the same, irrespective of any
change in the price
 Such goods are termed neutral O
 Vertical demand curve Q1 Quantity
Degrees of Price Elasticity
Highly elastic demand Price
 Proportionate change in quantity D
demanded is more than a given change in P1
price P2 D
 ep >1 (in absolute terms)
 Such goods are called luxuries O
Q1 Q2
Unitary elastic demand Quantity
Price D
 Proportionate change in price brings
about an equal proportionate change in P1
quantity demanded
P2
 ep =1 (in absolute terms).
 Demand curves are shaped like a D
rectangular hyperbola, asymptotic to the O
axes Q1 Q2 Quantity
Price
Relatively inelastic demand D
 Proportionate change in quantity
P1
demanded is less than a proportionate
P2
change in price
 ep <1 (in absolute terms)
D
 Such goods are called necessities O
Q1 Q2 Quantity
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

ep= Q2 − Q1 / Q1
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
Methods of Measuring Elasticity
Contd…

 Arc Elasticity Method


 Used when the available figures on price and quantity
are discrete, 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
=
Methods of Measuring Elasticity Contd…
 Total Outlay Method (Marshall)
 Elasticity is measured by comparing expenditure levels before
and after any change in price, i.e. whether the new expenditure
is more than, or less than, or equal to the initial expenditure
level.
 Helps a seller in taking a decision to raise price only if:
 Reduction in quantity demanded does not reduce total
revenue or
 Reduction in price increases the quantity demanded to the
extent that total revenue also increases.
 Degrees
 When demand is elastic, a decrease in price will result in an
increase in the revenue (sales).
 When demand is inelastic, a decrease in price will result in
a decrease in the revenue (sales).
 When demand is unit-elastic, an increase (or a decrease)
in price will not change the revenue (sales)
Determinants of Price Elasticity of
Demand
 Nature of commodity
 Necessities are relatively price inelastic, while luxuries
are relatively price elastic
 Availability and proximity of substitutes
 Price elasticity of demand of a brand of a product
would be quite high, given availability of other
substitute brands
 Alternative uses of the commodity
 If
a commodity can be put to more than one use, it
would be relatively price elastic
Determinants of Price Elasticity of
Demand
 Proportion of income spent on the commodity
 The greater the proportion of income spent on a commodity, the
more sensitive would the commodity be to price
 Reason is income effect
 Time
 Demand for any commodity is more price elastic in the long run
 Durability of the commodity
 Perishable commodities like eatables are relatively price
inelastic in comparison to durable items
 Items of addiction
 Items of intoxication and addiction are relatively price inelastic
Revenue and Price Elasticity of
Demand
 For relatively inelastic demand, a change in
price would have a greater effect on revenue
than a change in quantity demanded
 AR is same as the price of the product
 Demand curve is also the AR curve of the firm.
 Marginal Revenue is the revenue a firm gains in
producing one additional unit of a commodity
Revenue and Price Elasticity of
Demand
 Till ep>1 MR is Price,
Revenue ep=∞
positive and TR is ep>1
rising ep=1

 At the midpoint of ep<1

the demand curve, ep=0


ep=1 and MR is O
MR
Quantity

equal to 0 and TR Price,


Revenue
is at its peak
 When ep<1, MR is
negative
 MR= AR[1- ep] O
TR Quantity
Income Elasticity of Demand (ey)

 ey measures the degree of responsiveness of demand


for a good to a given change in income, ceteris paribus.

Proportion ate change in quantity demanded of commodity X


ey =
Proportion ate 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
Proportion ate change in quantity demanded of commodity X
ec =
Proportion ate change in price of commodity Y

 Degrees
 Negative Cross Elasticity
 Complementary goods
 Positive Cross Elasticity
 Substitute goods
Promotional Elasticity of Demand

 Advertising (or promotional) elasticity of demand (ea) measures the


effect of incurring an “expenditure” on advertising, vis-à-vis an
increase in demand, ceteris paribus.
 Some goods (like consumer goods) are more responsive to
advertising than others (like heavy capital equipments).

Proportion ate change in quantity demanded (or sales) of commodity X


ea =
Proportion ate change in advertising expenditure
 Degrees
 ea>1
 Firm should go for heavy expenditure on advertisement.

 ea <1
 Firm should not spend too much on advertisement
Importance of Elasticity

 Determination of price
 Elasticity is the basis of determining the price of a product keeping
its possible effects on the demand of the product in perspective
 Basis of price discrimination
 Products having elastic demand may be sold at lower price, while
those having inelastic demand may be sold at high prices
 Determination of rewards of factors of production
 Factors having inelastic demand are rewarded more than factors
that have relatively elastic demand.
 Government policies of taxation
 Goods having relatively elastic demand are taxed less than those
having relatively inelastic demand.
Summary
 Elasticity of demand measures the degree of responsiveness of the
quantity demanded of a commodity to a given change in any of the
independent variables that influence demand for that commodity.
Price elasticity of demand (ep) measures the degree of responsiveness
of the quantity demanded of a commodity to a given change in its price,
other things remaining the same.
By the percentage method ep is expressed as the ratio of proportionate
change in quantity demanded and proportionate change in price of the
commodity.
As per the total outlay method elasticity is measured by comparing
expenditure levels before and after any change in price, i.e. whether the
new expenditure is more than, or less than, or equal to the initial
expenditure level.
Arc elasticity is used to calculate price elasticity of demand at the
midpoint of an arc between any two points on the demand curve, by
taking the average of the prices and quantities; point elasticity can be
approximated by calculating the arc elasticity for a very small arc on the
demand curve.
Summary
 If the demand curve is a straight line, price elasticity of demand at
different points of the demand curve can be calculated by the ratio
of the lower segment and upper segment of the demand curve.
 MR= AR[1- ep]
 Income elasticity of demand (ey) measures the degree of
responsiveness of the quantity demanded of a commodity to a
given change in consumer’s income. For normal goods ey is
positive; for neutral goods ey is zero; for inferior goods ey is
negative.
 Cross elasticity of demand (ec) shows how changes in prices of
other goods would affect the demand for a particular good. For
substitutes ec is positive; and for complements ec is negative.
 Advertising (or promotional) elasticity of demand (ea) measures the
effect of incurring an “expenditure” on advertising of a firm on the
demand for its product at constant price.
 Elasticity is used for determination of right price by seller and for
taxation by government.