Elasticity of Demand

Elasticity
elasticity of demand Introduction

Elasticitythe concept
The responsiveness of one variable to changes in another When price rises what happens to demand? Demand falls BUT! How much does demand fall?

Elasticity the concept

If price rises by 10% - what happens to demand? We know demand will fall By more than 10%? By less than 10%? Elasticity measures the extent to which demand will change

Elasticity
4 basic types used: Price elasticity of demand Advertisement elasticity of Demand Income elasticity of demand Cross elasticity

 Income Elasticity of Demand:

A positive sign denotes a normal good A negative sign denotes an inferior good

Elasticity
Income Elasticity of Demand:
The responsiveness of demand to changes in incomes

Normal Good demand rises as income rises and vice versa Y D e.g. luxury goods, necessities, cosmetics etc Inferior Good demand falls as income rises and vice versa Y D e.g. abnormal goods( dalda ghee, bajra)

 For example: Yed = - 0.6: Good is an inferior good but inelastic a rise in income of 3% would lead to demand falling by 1.8% Yed = + 0.4: Good is a normal good but inelastic a rise in incomes of 3% would lead to demand rising by 1.2% Yed = + 1.6: Good is a normal good and elastic a rise in incomes of 3% would lead to demand rising by 4.8% Yed = - 2.1: Good is an inferior good and elastic a rise in incomes of 3% would lead to a fall in demand of 6.3%

Positive income elasticity

m y = +2 n

income

Q = +10

Q (000s)

fig quantity

Zero income elasticity (Ey =0)

D

y2 income

y1

fig quantity

Q1

Negative income Elasticity Ey < 0

income

y2

Y1

D
0
100 140 Quantity Demanded (000s)

Elasticity
Price Elasticity of Demand
The responsiveness of demand to changes in price Where % change in demand is greater than % change in price elastic Where % change in demand is less than % change in price - inelastic

Elasticity
The Formula: ep = % Change in Quantity Demanded ___________________________ % Change in Price

If answer is between 0 and 1: the relationship is inelastic If the answer is between 1 and infinity: the relationship is elastic Note: EP has sign in front of it; because as price rises demand falls and vice-versa (inverse relationship between price and demand)

Price elasticity of demand

( %) QD ( %) P QD QD P

PERFECTLY INELASTIC DEMAND P D VERTICAL CURVE Ep = 0 PRICE life saving drugs meagre goods
P2

P1

QUANTITYfig DEMANDED

Q1

RELATIVELY INELASTIC DEMAND STEEP CURVE Ep < 1 necessities and habits

Price (RS) 10

Producer decides to lower price to attract sales

% Price = -50% % Quantity Demanded = +20% Total Revenue would fall

Not a good move!

D
5 6
Quantity Demanded

Unitary elastic demand (Ep = 1) coincidental no e.g.

a

PRICE

20

b
8

D
100

40

QUANTITYfig DEMANDED

Price (RS)

RELATIVELY ELASTIC DEMAND FLAT CURVE Ep>1 luxuries, durables and cosmetics
Producer decides to reduce price to increase sales % in Price = - 30% % in Demand = + 300% Total Revenue rises Good Move!
D

10 7

Quantity Demanded

20

Perfectly elastic demand (Ep ) HORIZONTAL DEMAND CURVE myth no examples

a b D

P1

Q1
fig

Q2

PRICE ELASTICITY OF DEMAND COMMON DIAGRAM

EP<1 EP=1 EP>1

EP=0

Price (Rs)

EP=

Quantity Demanded

Determinants of Elasticity
Time period the longer the time under consideration the more elastic a good is likely to be Number and closeness of substitutes the greater the number of substitutes the more elastic The proportion of income taken up by the product the smaller the proportion the more inelastic Luxury or Necessity addictive drugs

METHODS OF MEASUREMENT

PERCENTAGE METHOD POINT METHOD ARC METHOD AR-MR METHOD TOTAL EXPENDITURE METHOD

PERCENTAGE METHOD
PERCENTAGE CHANGE IN QUANTITY DEMANDED
PERCENTAGE CHANGE IN PRICE OF COMMODITY

% Qd

Ep =

Percentage method
% Qd 60% 60% D a
=1

PRICE

10

60%

b
4
60%

D
fig

40

100

QUANTITY DEMANDED

TOTAL OUTLAY / EXPENDITURE METHOD EP=1

Total expenditure and price

TE

D X QUANTITY

POINT METHOD
NUMERIC METHOD
Q x P1

Q1

y A 20

POINT METHOD geometric

15

10 price

Ep = 1

Quantity

10

15

20 B

 Cross Elasticity: The responsiveness of demand of one good to changes in the price of a related good either a substitute or a complement
% Qd of good x % Price of good y

Exy =

 Goods which are complements: E.g. car and fuel (petrol etc) Cross Elasticity will have negative sign (inverse relationship between the two) Goods which are substitutes: E.g. tea and coffee Cross Elasticity will have a positive sign (positive relationship between the two)

Elasticity

Price (Rs)

Quantity Demanded

Cross Elasticity
Y

Price of One commodity (Rs)

Quantity Demanded of other commodity

Y TOTAL REVENUE

RELATIONSHIP BETWEEN AR,MR & ELASTICITY

TR X

MARGINAL AND AVERAGE REVENUE

Y EP>1

OUTPUT

EP=1

EP<1 AR OUTPUT MR X

-Y

Importance of Elasticity
Relationship between changes in price and total revenue Importance in determining what goods to tax (tax revenue) Importance in analysing time lags in production Influences the behaviour of a firm

Advertisement Elasticity
Advertisement Elasticity of Demand:
The responsiveness of demand to changes in advertisement expenditure

demand rises as add. expenditure rises and vice versa A D e.g. cold drinks, t.v. etc demand falls as add. expenditure falls and vice versa A D e.g. shampoos, Camay soap

Advertisement Elasticity
The Formula: eA = % Change in Sales ___________________________ % Change in Add expenditure

Advertisement elasticity of demand

( %) S ( %) A S S A

y A 20

Ep

ARC METHOD geometric

Ep > 1

&

15

10 price

Ep = 1

Ep < 1 5

Ep = 0 O 5 Quantity 10 15 20 B X