Elasticity of Demand

Dr Kishor Bhanushali
kishorkisu@gmail.com

Elasticity of Demand
The extent to which the quantity demanded will rise (fall) due to fall (rise) in the price of the same good or a related good or due to the rise in the income of the consumer Analysis of demand sensitivity with respect to prices of goods and income helps the business to forecast market trends in future

Price Elasticity of Demand

Responsiveness of quantity demanded to changes in the price Price elasticity of demand is defined as the percentage change in quantity demanded resulting from one percent change in the price of the good, other things remaining constant ep = Percentage Change in quantity demanded Elasticity is unit free as it is measured in proportion of two percentages We can predict the expected changes in quantity demanded Forecast required changes in price, when we want to realize a targeted change in quantity demanded
Percentage change in price

Price Elasticity
Ed = 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

Elasticity over a Segment of Demand Curve

Price D

P0

P1

S D

Q0

Q1

Quantity Demanded

Price Elasticity over a Segment of Demand Curve

Q1 Q0 P1 P0 Q1 Q0 P1 P0 = Q P X (P0 + P1)/2 (Q0 + Q1)/2 P0 + P1 X Q0 + Q1

ep

P0 + P1
Q0 + Q1

Elasticity at a Point on the Demand Curve

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

Elasticity at a Point on the Demand Curve

Draw a tangent AB on the demand curve at point R ep = Lower Segment Upper Segment S M R D Slope of AB = OB/OA Ep = (OB/OA)* (RN/RM) As triangle AOB, AMR and NRB are similar (OB/OA)= (NB/RN) Ep = (NB/RN)*(RN/RM) = NB/RM

Price

Again NB/RM = RB/AR Ep = RB/AR

O B N Quantity Demanded Ep = Lower Segment Upper Segment

Elasticity at a Point on the Demand Curve

Price A ep = ep > 1

ep = 1

ep < 1

ep = 0 0 Quantity Demanded

Categories of Price Elasticity of Demand

Perfect elastic demand

Perfect inelastic demand

Unit elasticity of demand Relatively elastic demand Relatively inelastic demand

Difference between Slope and Elasticity

Slope of the Demand Curve P = Q Elasticity on the demand curve
P P Q

Tow demand curves may have the same slope but different elasticities as well as different slope and the same elasticities

Price C A The absolute elasticity of demand curve AB is more than that of demand curve CD, in spite of their slopes being the same

Quantity Demanded

Price

Elasticities of both the curves are equal , where as their slopes are different

C Quantity Demanded

Price Elasticity, Total Revenue and Total Expenditure

Total expenditure by the consumer over any given period of time is the number of units of a product purchased over a period Q, multiplied by the price of the product , P Total Expenditure = P.Q = Total Revenue
Price

Supply
Total Revenue = OAEQ A E Total Expenditure = OAEQ

Demand 0 Q Quantity

Predicting Changes in Total Revenue and Total Expenditure in Response to Price Increase
Price New Supply Curve Old Supply Curve Gain in revenue P2 F

P1

Loss in revenue Demand Curve

Q2

Q1

Quantity

Predicting Changes in Total Revenue and Total Expenditure in Response to Price Increase
Summary of Elasticity Measures (increase in Price) Unitary Elastic % Q = %P Relatively Elastic Perfectly Elastic % Q > %P % Q = 0 e =1 e>1 e = No Change Decrease -

Relatively Inelastic
Perfect inelastic

% Q < %P
% Q = 0

e<1
e =0

Increase
Increase

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 demand of ith good Percentage change in the price of jth good

Cross Elasticity of Demand

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.

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 =

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.

M. Zahoor Shah BS Commerce 1st Semester QACC