Elasticity of Demand

Introduction
There is relationship between demand and price Law of Demand It indicates the direction of change of quantity demanded to change in price.

But it does not give the answer to how much or to what extent?
This information is given by Elasticity of Demand.

Elasticity of Demand

It is defined as degree of responsiveness of quantity demanded of a good to changes in one of the variables . Price Consumers Income Prices of related goods

Price Elasticity of Demand

It is defined as ratio of the percentage change in quantity demanded of a commodity to percentage change in price.

ep =

% change in QD % change in Price

The price elasticity are expressed with a +ve sign even if they are inversely related as we want to measure the magnitude of responsiveness.

Price Elasticity of Demand

ep = % change in QD % change in Price Change in Quantity * 100 Original Quantity Change in Price * 100 Original Price q * p q p

ep =

ep =

It has a negative sign The price elasticity are expressed with a positive sign even if they are inversely related as we want to measure the magnitude of responsiveness.

Numerical
Q 1. The price of a Chocolate Bar in the local newsagent rises from 25p to 30p. As a result, the newsagent finds that the demand for this product falls from 80 bars a day to 40 bars a day. Find the price elasticity of demand. (-2.5) Q2. The price of a litre of unleaded petrol rises from Rs 80 to Rs 84 . As a result, the quantity demanded at a local station falls from 4000 to 3880 litres a day. What is the price elasticity of demand? (-0.6) Notice: The answer is negative. This is because the price rose (+ve) causing the quantity demanded to fall (-ve). The demand curve is nearly always downward sloping showing a negative relationship between price and quantity demanded

Q A company decides to increase the price of Brand X drink from Rs2 a bottle to Rs2.10 a bottle. The price elasticity of demand for Brand X is 0.8. He currently sells 300 bottles a day. What will the new demand be (ceteris paribus)? Ans 288

Three Concept of Demand Elasticity

1. Price Elasticity: Degree of responsiveness to change in its price Income Elasticity: Sensitiveness of quantity demanded to change in income. Cross Elasticity: Degree of responsiveness to change in the price of a related good (Substitute /Complement).

2.

3.

Types of Price Elasticity

The value of ep varies from Zero (0) to Infinity ( )

Elastic Demand:
When the percentage change in quantity demanded is greater than percentage change in price.
D
P P D

Inelastic Demand:
When the percentage change in quantity demanded is less than percentage change in price.
D

P P D

Types of Price Elasticity

There are 5 types of price elasticity

The main reason for differences in elasticity is the possibility of substitution i.e presence or absence of competing products.

1)

Perfectly Elastic or ep = When demand is infinite or unlimited at given price. A reduction in price causes the quantity to increase from zero to infinite.

Types of Price Elasticity

2) Perfectly Inelastic or ep = 0 When change in prices have a zero impact on the quantity demanded

3) Unitary Elastic Demand or ep = 1 When change in quantity demanded is equal to the change in price.

Types of Price Elasticity

4) Relatively Elastic or ep > 1 When change in quantity demanded is greater than change in prices

5) Relatively Inelastic or ep < 1 When change in quantity demanded is less than the change in price.

To Summarise

Determinants of Price Elasticity

The Availability of Substitutes The number and kind of substitute makes the consumer sensitive to change in prices. If close substitute are available, its demand is elastic. If no close substitute are not available, even with rise in price the demand is inelastic.

The proportion of Consumer Income spent Greater the proportion of income spent o the commodity, greater the elasticity of demand. The number of uses of a commodity The greater the number of uses to which a commodity can be put, the greater will be its price elasticity of demand.

Determinants of Price Elasticity

Complementarity between Goods Complementarily or joint demand for goods effects the elasticity Consumers are less sensitive to change in prices of goods that are complementary with each other.

Time and Elasticity Demand is more elastic if the time involved is long, as consumers can substitute goods in the long run. Demand is inelastic in the short run. Durability of the commodity

Measurement of Price Elasticity

Methods
Percentage Method Midpoint Method Total Outlay Method

1) Percentage Method:
It is defined as ratio of the percentage change in quantity demanded of a commodity to percentage change in price.

ep =

% change in QD % change in Price

Change in Quantity * 100 Original Quantity Change in Price * 100 Original Price q * p p q

ep =

ep =

Numerical
Q. If the price of the commodity falls from Rs 6 to

Rs 4 per unit and due to it QD increases from 80 units to 120 units. Find out the price elasticity of demand? Ans: 1.5 Q. If the price of the commodity rises from Rs 4 to Rs 6 per unit , the QD falls from 120 to 80 units. What is the price elasticity of demand? Ans: 0.60

2) Midpoint / ARC Method:

Which price and quantity to use while calculating the % change. When the changes in price and quantity are substantially large. In this method we take the midpoint of the initial and final values of price and quantity as a base. ( q2-q1) q1 + q2 2 ep = p2 - p1 p1 + p2 2

ep =

q * p1 + p2 p q1 + q2

 What is the point, after all, of a firm knowing the elasticity of demand for the product he sells?

If he can assess what the change in his sales will be for a given change in the price of his product, and then he can work out the change in his revenue.

P P* Q = TR D Q

3) Total Revenue Method

Total revenue is the amount received by the seller from the sale of the quantity of the good sold in the market. Total Revenue: P * Q

Numerical
Q. Suppose a seller of a textile cloth wants to lower the price of its cloth from Rs 150 per metre to Rs 142.5 per metre. If its present sales are 2000 metres per month and further estimated that its elasticity of demand for the product equals -0.7. show

a) Whether or not total revenue will increase as a result of his decision to lower the price. Ans: 2070
b) Calculate the exact magnitude of its new total revenue. Ans: Rs 2,94,975 (With reduction in price his total revenue has decreased)

1.

Demand is elastic ( ep >1) The % increase in quantity demanded of the commodity will be greater than the % fall in price. Total Revenue will increase. Conversely a rise in price reduces Total revenue.

R R

For Example:

A vegetable seller decides to cut the price of his potatoes from Rs 40/Kg to Rs 32p/Kg. The ep for this product is 2. He currently sells 80 Kg of potatoes a day. How many will he sell after the price cut?

But what will happen to his revenue?

Revenue before the price cut: Rs 40 80Kg = Rs3200 Revenue after the price cut: Rs32 112Kg = Rs3584
The price cut causes revenue to increase. The rise in demand as a result of the price cut was proportionately higher than the fall in price

'gain' box is larger than the 'loss' box, so the seller's total revenue has increased

b) What will happen if he increase the price to Rs 44 / kg

Revenue before the price increase:= 40p 80 = Rs3200 Revenue after the price increase: = 44 64 = Rs 2816

2.

Demand is Inelastic (ep<1) A fall in price reduces total revenue A rise in price raises total revenue A rise in price will lead to a percentage decline in quantity demanded that is proportionately less than the rise in price.
R
R P

For example: Petrol has a relatively inelastic demand. If value of the elasticity is 0.5, the initial price is 80p per litre and sales of 4000 litres per day.

a) What happens when the price is cut to Rs 72 per litre. The cut in the price will lead to an increase in less demand. The new demand will be 4200 litres. Revenue before the price cut:= 80 4000 litres = 3200 Revenue after the price cut: = 72 4200 litres = 3024 There is a fall in total revenue where the 'loss' box is much bigger than the 'gain' box.

 For example:
b) Increase in the price to 88p per litre. This 10% rise in the price will lead to a fall in demand, but by only 5%. The new demand will be 3800 litres.

Revenue before the price cut: = 80 4000 litres = Rs 3200 Revenue after the price rise: = 88p 3800 litres = Rs 3344 This rise in total revenue , where the 'gain' box is much bigger than the 'loss' box.

3. Demand is Unit elastic ( ep = 1) The percentage increase in quantity demanded of the commodity will be equal to the percentage fall in price. Total Revenue will be same.

P P

R R

Elasticity and Revenue

P 5.00 4.75 4.50 4.25 4.00 3.75 3.50 3.25 Qd 30 40 50 60 75 80 84 87 TR P *Q 150 190 225 255 300 300 294 282.75 (ep) e >1 e >1 e >1 e >1 e =1 e <1 e <1

To Summarise..

Numerical
Q1. Price of the good falls from Rs 10 to Rs 8 per unit. As a result, its quantity demanded increases from Rs 80 units to 100 units. Find out the elasticity of the goods. Ans: ep=1 Q2. If the price of commodity rises from Rs 15 to Rs 16 per unit. As a result the QD falls from Rs 100 to 80 units. Find out ep is more than one or less than one? Ans: ep> 1 Q3. The ep for petrol is equal to unity and at Rs 15/litre an individual demand 80 litre of petrol in a week. How much price of petrol should be fixed so that he demands 60 litres of petrol? Ans: 60 Litre

Importance for Business Decision Making

Pricing of Public Utilities: Charging higher prices for high end consumers/ lower prices to the low end consumers. International Trade: Charge a higher export prices if the demand for exports is inelastic, charge lower prices and earn higher revenue. Product differentiation and Differential pricing: Company to produce different products and charge different prices depending on the elastic or inelastic demand. Shifting the Taxation: Shifting the taxation depends upon the elasticity of demand.

Cross Elasticity of Demand

The degree of responsiveness of demand for one good in response to the change in prices of another good. Good X and Good Y are substitute of each other

P1 P2

M2 M Good 1 X

Q1 Q2 Good Y

What would have happen if Good X & Y were complement Goods?

Cross Elasticity of Demand

ec =

Percentage change in Qd of X Percentage change in the price of good Y

ec = Qx2 Qx1 Py2 Py1 Qx2 + Qx1 Py2 + Py1 2 2

Substitute and Complementary Goods

Positive Cross Elasticity: Rise in price of good X leads to rise in demand of good Y They are substitute goods Negative Cross Elasticity: Rise in price of good X leads to fall in demand of good Y They are Complementary goods Zero Cross Elasticity: Rise in price of good X will have no effect on good Y They are unrelated goods

Importance for Business Decision Making

It helps in formulating pricing strategy for multi-product firms. It defines the boundaries of an Industry ( Anyone company cannot raise the price of the product without losing sales to the other firm)

Numerical
Q.

Colgate sells its standard size toothpaste for Rs 25. Its sales have been on an average 8000 units per month over the past year. Recently, its close competitor Binaca reduced the price of its same standard size toothpaste from Rs 35 to Rs30. As a result colgate sales declined by 1500 per units per month. 1) Calculate the cross elasticity between the two products.

2) What does it indicate about the relationship between the two.

Income Elasticity
It shows the degree of responsiveness of quantity demanded of a good to a small change in the income of consumers.
Income Elasticity = % change in purchase of a good % change Income

ei = q2 q1 q2 + q1 2

y2 y1 y2 + y1 2

Income Elasticity and Goods

Zero Income Elasticity : Rise in Income does not lead to increase in quantity demanded (Unresponsive to change) Positive Income Elasticity: Rise in Income leads to rise in quantity demanded ( Luxury / Normal goods) Negative Income Elasticity: Rise in income leads to fall in quantity demanded ( Necessity /Inferior Goods) Income Elasticity is Unity: Proportion of income spent on the good remain the same a consumers income increases.

Importance for Business Firms

The firms which are producing goods which have high income elasticity have a great potential for growth. The firms will be located in those areas which are growing The marketing strategies will be targeted to those segment whose income is increasing. Demand for products which have low income elasticity will be not be greatly effected by economic fluctuations. ( Recession proof)