Elasticity of Demand

Elasticity means the measurement of responsiveness

of one variable to other variable.
X =f (Y), X = dependent variable, Y = Independent
variable (If Y change how it is going to affect
for X - elasticity measure it)
An elasticity of demand = (% change in the
demand for good A)/% change in an
independent variable
Main Demand Elasticities
Price elasticity of demand
Cross price elasticity of demand
Income elasticity of demand

Other Elasticities
Supply elasticity
Advertising and cross
advertising elasticity
Conjectural price elasticity
Imports and exports elasticities

Price elasticity of demand (the percentage change in

the quantity of a good demanded divided by the
corresponding percentage change in its price. This is
related with the movement along the demand curve)

Point elasticity = AQ% = AQ/Q =

AP %
AP/P

AQ X
AP

P
Q

Elasticity measure gives two pieces of information:

It shows sign of the relationship between

changes in the relevant variables.

It measures the extent to which quantity

responds to a change in price.

Generally price elasticity can be in three ranges:

1. Price inelastic ( 0 - 1), Ed < 1
2. Unitary (1), Ed = 1
3. Price elastic (1 and infinity), Ed > 1
4

Arc elasticity allows you to calculate elasticity in two

price and two quantity combinations
Change in Q
Average Q
Change in P
Average P

Price

Q2-Q1
= (Q2+Q1)/2 =
P2-P1
(P2+P1)/2

A Q . P2+P1
AP
Q2+Q1

P2

AP

P1
AQ

Q1

Q2

Quantity
demanded

Elasticity along a linear demand curve

Ed = 00 : Perfect elastic
Ed > 1 : Elastic range
Ed = 1 : Point of unitary elasticity
Ed < 1 : Inelastic range
Ed = 0 : Perfect inelastic

Qd

Graphical Representation of Elasticity

1. Unitary Elasticity

P up 5% Qd 5%
down
P down 5% Qd 5%
up

P2
P1

5%

5%
0

Q1

Q2

Qd
7

2. Inelastic situation
(relative)
P

P up 20% Qd 5%
down

D1
P2
20%

Large range of price changes but

Small changes of quantity of demand

P1
5%

Qd

Q1 Q2
8

3. Elastic situation
(relative)
P
P up 5% Qd 20%
Down

Small range of price changes but

massive changes of quantity of demand

P2
P1

5%

20%

Q1

Qd
Q2
9

4. Perfect Inelastic situation

D

P3
P2
P1

Qd
Q1
10

5. Perfect Elastic situation

P

Qd
Q1

Q2
11

Factors affect for the price elasticity

Time period (more time lesser elasticity)
addictive nature for good/services (more
addiction lesser elasticity)
availability of substitutes and their quality
price range, and the necessity of the goods
share of income spent on good
consumers ability to change his environment
12

Importance of price elasticity

to determine pricing policies/strategy
to select inputs
to select markets
to maximize revenue
to government taxation policies

Firm and the market elasticity

(Depends on the market structure: Monopoly
same, other markets different)
13

Cross elasticity of Demand

This is related with the shift in demand curve. It can be
defined as the responsiveness of demand for one product to
changes in prices of other product.

Ex = (% change in quantity demanded of good A)/(% change

in price of B)

Epx = AQy . Px
APx

Py
14

Importance
to check the impact of prices of other goods to
the good concerned
to formulate a good pricing strategy
to analyse risks associated with the goods
check the effectiveness of advertising to create a
brand loyalty
to measure interrelationship between industries
identify the boundaries of market in differentiated
products

15

Nature of Cross Price Elasticity

1) Cross price elasticity for substitute goods
are positive

2) Cross price elasticity for complement

goods are negative

3) Cross price elasticity for independent

goods are zero

16

Complements and Substitutes

Cross-Price Ed = % change in demand for own product
% change in price of another product
Cross Ed < 0 (-)
Complements

Cross Ed > 0 (+)

Substitutes

e.g.1. DVD demand rises as

price of DVD machines declines
e.g.2. Demand for flights to
Canary Isles over Y2K fall as
price of accommodation rises

e.g.1. Rise in price of petrol

increases demand for public
transport
e.g.2. Fall in price of mobile
phones decreases demand for
land lines
17

Income Elasticity of demand

This measures the responsiveness of quantity demanded to
change in income, holding other factors are constant.
This related with the shift in demand curve due to changes in
income.
Ey = % change in quantity demanded

EY = AQ . Y

% change in disposable Y

AY Q
For normal goods this is positive and for inferior goods this is
negative
Importance (to check future demand, decisions on
investment, policy decisions in international trade, effects of
changes in real income)
Elasticity can be measure for other variables such as
advertising and interest rates, etc.

18

Income and Elasticity - Relationship

Income
Y

Income
Elasticity < 0

Income Elasticity = 0

Income Elasticity>0
0

Demand

Qd
O A = Normal good, A - Y = Inferior good

19

Relationship between TR, AR and MR

Total Revenue = TR = P . Q
Average Revenue: TR/Q = P . Q/Q = AR = P
Marginal Revenue: d(TR)/d(Q) = MR
Angels Law
The proportions of expenditure on all necessities (foods) declines
as incomes rise and in contrast the proportionate expenditure on l
uxuries (durable) would increase. (this is related with the consum
ers bahaviour with income increases)
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price ()

The effect on revenue of a price

change

x
Elastic Range

between x and y, TR
increases (i.e. MR is +ve)
at y TR is at its maximum
(i.e. MR = 0)
between y and z, TR
decreases (i.e. MR is -ve)

p*

total revenue ()

at point y, Ed = 1
between x and y, Ed > 1
between y and z, Ed < 1

Unitary
Inelastic Range

AR
z

quantity

MR

q*

quantity21

Income Elasticity Examples (Looking at this coefficient name which

good is Normal and inferior)
Good Category

Consumers
expenditure
(M, 1985)

change in
expenditure
(%)

Income
elasticity of
demand

1981

1991

Cars & other vehicles

7,754

10,657

37.44

1.25

Furniture & Floor coverings

4,031

4,893

21.38

0.72

Food

30,217

33,409

10.56

0.35

Beer

8,561

8,211

-4.09

-0.14

Other alcoholic drink

6,363

7,616

19.69

0.66

Tobacco

8,167

6,569

-19.57

-0.66

Clothing

9,563

14,410

50.21

1.68

Footwear

2,195

2,895

31.89

1.07

Energy products

17,319

21,331

23.16

0.78

note : In the same period, real national disposable income rose by 29.86%
22
source : Pass & Lowes (1994)

Supply Elasticity
This always should go with lag: If price changes it takes sometime to
respond supply to price changes in some sectors.
Es = % change in quantity supplied/% change in price

S
S

Es > 1,
Elastic

Es =1, Unitary

Es < 1, Inelastic
S
S
Es = 0
Es = 00
perfect elastic Perfect inelastic

23

Advertising Elasticity
A measure of the effect of a change in advertising upon the
sales of a given good.
Ea = (% change in quantity demanded of good A)/(% change
in expenditure on advertising good A)
If Ea >1: Inelastic (large amount of expenditure needed to
increase demand).
If Ea<1: Elastic (small amount of expenditure needed to
increase demand).

Cross Advertising Elasticity

A measure of the responsiveness of the quantity of demand
of one good to a change in the expenditure upon advertising
on another good. Positive for complements and negative for
substitutes.
24

Conjectural Price Elasticity

This measures interdependence between firms and
a good measure to forecast price changes in
retaliation specially in oligopolistic markets. This wil
l help to firms pricing decision making strategy.
Ec = (Expected % change in the price charged by
firm B)/(Actual % change in price charged by firm A
)

25

Exports and Imports Elasticity

Price elasticity of demand for exports = (% change in the
demand for exports in country x/% change in price of expo
rts in country A)
Income elasticity of demand for exports = (% change in
the demand for exports in country x/% change in disposabl
e income abroad)
Price elasticity of demand for imports = (% change in the
demand for imports in country x/% change in price of impo
rts in country A)
Income elasticity of demand for imports = (% change in
the demand for imports in country x/% change in disposab
le income aboard)
These elasticities are important to policy decisions in
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external trade and devaluation.

Demand Estimation
Identification of firms real demand curve helps to
determine

the correct price,

inputs requirements
profit maximising output

Identification of demand

Consumer interviews
Consumer surveys
Consumer clinics and focus groups
Market studies
Market experiments in test stores

27

Statistical Estimation of Demand

Regression technique (Identification of
variables, obtain data on variables, equation
specification, estimation of regression
parameters, interpretation of regression
results: coefficient of determination, F and t
statistics, SE, problems of regression:
Auto correlation, multi-collinearity,
heteroscedasticity).

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Demand Forecasting Methods

Deterministic Time Series Analysis (secular trend,

cyclical fluctuation, seasonal variation and random
influences).
Trend projection, extrapolation or curve fitting
Barometric or lag or lead indicator methods.
Econometric models (Single, multiple, lag, structural
modeletc).
Input-output analysis (interrelationships).
Opinion polling and survey techniques (future plans).
Techniques selection depends on the forecasting
distance, complexity of the forecasting problem, lead
time, accuracy, relationship, resources and time
availability, etc.
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Product Life Cycle

Sales (units sold)

This shows four stages of demand for a product.

Introduction phase - demand increases slowly.
Growth phase - demand increases rapidly.
Maturity phase - demand increases less slowly.
Decline phase - demand decreases.

Launch

Growth

Maturity
(saturation)

Decline

30

Time

Characteristics Approach to Demand

This says that consumers are demanded goods
because of their characteristics rather than consumers
own sake.
Therefore, managers should learn how to incorporate
the consumer desired characteristics to products and
services.
This can show by using indifference curve analysis.

31

Market Segmentation
Segmentation is the process of slicing a market for a particular product or service into a
number of different segments. The segments are usually based on factors such as
demographics, beliefs or the occasion of use of the product.

Market segments or niches are groups of consumers with similar tastes and preference
patterns.
Maximum
number according
of market segments
willcharacteristics,
not exceed the consumer
number of potential
Market can
be segmented
to product
income
customers.
level, age and geographic area. Elasticities can help to identify market segments.

Segmentation can aid in: identifying competitors, new product development,

targeting advertising expenditure, branding and exploiting market niches.
The internet promises to provide new opportunities for segmentation. It offers
continuous opportunities to capture information about customer behaviour.
Consumers identify themselves and their characteristics by their electronic
participation in particular interest groups, and by their general online behaviour.
32

Market Segmentation : Mobile Internet Access

Access to www
WAP
Phones

Laptop
computers

Desktop
PCs

Not portable

Highly portable
Mobile
phones

No access to www
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Segmentation Example 1 : Beer

Beer Category
51%
49%
Ales

Which are the growing product

segments through the 1990s?
In which product segments are
branding and advertising most
important?

Lagers

34

Segmentation Example 2 : Paint

Paint

Overall market
Decorative paint

Broad sectors
Major users

DIY

Professional
Decorators

Product group

Primer

Matt

Product line

Basic

De Luxe

Colour range

White

Blue

Packaging

Can/brush

Geographical cover

Gloss

Local

General
Industrial
Special
Purpose

Specialised

etc.

Super de luxe
Red

Aerosol

Wholesaler

Distribution outlets

Industrial paint

Regional

etc.
Tray/roller
Retailer
National

International

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Criticism about demand theory

1) Consumers rationality is unpractical.
2) Demand not always behave as it is stated in
the law.
3) Price is not the main concern of consumer.
They concern about quality, reliability, design, afte
r sales services, brand names, recommendations
from friends, previous experience, consumer guid
es, advertisements, etc.
36

1)

Self -Study
Demand Estimation

1) Specify the demand function for the following

products.
2) How do you estimate market demand for the
following products?
1) a new version of Microsoft Office?
2) a new brand of toothpaste?
3) internet bank accounts?
4) car exhaust systems?
5) theatre performances?
6) a new toll road?
7) electricity supply?
8) Sri Lankan tourist sector/Sri Lankan airline
9) Sri Lankan seaports
10) Sri Lankan professionals

37

Questions to discuss
Explain market mechanism (demand, supply functions
and equilibrium price) with an example.
Distinguish between movement along the supply curve
and shift in demand curve.
Explain demand estimation techniques.
Explain demand forecasting techniques.
Distinguish between consumer and producer surplus.
Explain main demand elasticity concepts with
examples.
Distinguish point elasticity and arc elasticity.
Distinguish between cross price and income elasticity.
Explain why elasticity is so important to managers to
take business decisions.
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References
Chapter 3 and 4 in McGuigan R.J, Moyer, R.C
and Harris F.H (2005), Managerial Economics,
Applications, strategy and Tactics, ISBN: 0-32405881-0.
Chapter 3 in Worthington.I, Britton.C and Reese.
A (2001), Economics for Business: Blending
Theory and Practice, ISBN: 0273632450,
Publisher: Financial Times/Prentice Hall.
39