Elasticity of Demand

Elasticity . . .

u … is a measure of how much buyers and sellers respond to changes in market conditions

u … allows us to analyze supply and demand with greater precision.

u Question-Name 3 necessities and 3 luxuries that you would buy.

Elasticity

A measure of the responsiveness of one variable (usually quantity demanded or supplied) to a change in
another variable

Measures the rate of change in the quantity demanded due to a given change in any of the
determinants of demand such as price of the good, price of related commodities, money income of the
consumer etc.

Alfred Marshall stated “Elasticity (or responsiveness) of demand may be defined as the percentage
change in the quantity demanded divided by the percentage change in the price.”

According to Boulding, “Price elasticity of demand measures the responsiveness of the quantity
demanded to the change in price”.

Elasticity of demand will be studied in relation to three factors:

Price Elasticity of Demand

Income Elasticity of Demand

Cross Elasticity of Demand

Price Elasticity of Demand

u Price elasticity of demand is the percentage change in quantity demanded given a percent
change in the price.

u It is a measure of how much the quantity demanded of a good responds to a change in the price
of that good.

The change in quantity demanded in response to a change in price of a good

Price Elastic or Price Inelastic?

Computing the Price Elasticity of Demand

The price elasticity of demand is computed as the percentage change in the quantity demanded divided
by the percentage change in price.
Price Elasticity = Percentage Change in Qd

Of Demand Percentage Change in Price

Ranges of Elasticity

Inelastic Demand

u Percentage change in price is greater than percentage change in quantity demand.

u Price elasticity of demand is less than one.

Elastic Demand

u Percentage change in quantity demand is greater than percentage change in price.

u Price elasticity of demand is greater than one.

Perfectly Inelastic Demand

Inelastic Demand
- Elasticity is less than 1

Unit Elastic Demand

Elastic Demand
- Elasticity is greater than 1

Perfectly Elastic Demand

Factors affecting Elasticity of Demand

1. Nature of commodity : Necessities have inelastic demand while luxuries have elastic demand.

2. Availability of substitutes : Commodity which has number of substitutes to it will have elastic
demand while commodity which has no substitutes has inelastic demand.

3. Share in total expenditure : Commodities which have a higher share in total expenditure will
generally have elastic demand while those with lesser share have inelastic demand.

4. Possibility of postponing the consumption

5. Several uses of a commodity

6. Consumer habits
 7. Time factor – shorter the time lesser would be elasticity.

Determinants of
Price Elasticity of Demand

u Necessities versus Luxuries

u Availability of Close Substitutes

u Definition of the Market

u Time Horizon

Determinants of Price Elasticity of Demand

Demand tends to be more inelastic

If the good is a necessity.

If the time period is shorter.

The smaller the number of close substitutes.

The more broadly defined the market.

Determinants of
Price Elasticity of Demand

Demand tends to be more elastic :

u if the good is a luxury.

u the longer the time period.

u the larger the number of close substitutes.

u the more narrowly defined the market.

Elasticity and Total Revenue

u Total revenue is the amount paid by buyers and received by sellers of a good.

u Computed as the price of the good times the quantity sold.

TR = P x Q

Elasticity and Total Revenue

Price Elasticity of Demand and Total Revenue

If the price elasticity of demand = 1, then a reduction in price will increase demand in proportion and TR
will be unchanged

If the price elasticity of demand is < 1, then a reduction of price will increase demand less than
proportionately and TR will fall.

Price Elasticity of Demand and Total Revenue

The Total Revenue Test for Elasticity

Own price elasticity and total revenue

Computing the Price Elasticity of Demand

Computing the Price Elasticity of Demand Using the Midpoint Formula

The midpoint formula is preferable when calculating the price elasticity of demand because it gives the
same answer regardless of the direction of the change.

Computing the Price Elasticity of Demand

Price Elasticity of Demand

Elasticity of Demand with respect to the good’s own price

EDxPx= %ΔQ/%ΔP or

EDxPx= ΔQ/Q / ΔP/P or

EDxPx= ΔQ/ΔP * P/Q

For price elasticities of demand the sign is ignored as they are all negative

Elastic demand > 1

Inelastic demand < 1

Unit elastic demand = 1

Price Elasticity of Demand Over an Arc

Price Elasticity of Demand at a Point

Price Elasticity Along a Straight Line Demand Curve

Example:
P0 = 8 P1 = 7

Q0 = 40 Q1 = 48

Step 1: DQ = 48 - 40 = 8

DP = 7 - 8 = -1

Step 2: Use the formula for Ed.

Step 3:

Ed = (DQd / DP) * P0 / Q0

= (8 /-1) * (8/40) = - 1.6

Step 4:

This means that for every 1 % change in price that there is a 1.6 % change in quantity demanded in
the opposite direction.

Since we know that an Ed = - 1.6 means that a 1 % change in price results in a 1.6% change in quantity
demanded in the opposite direction,

What would a 20% increase in price result in?

Step 1: Ed = %DQ/%DP

Step 2: %D Q = Ed * %D P

Step 3: %D Q = - 1.6 * +20% = - 32%

What would a 20% increase in the quantity demanded result in ?

Step 1: Ed = % D Q / % D P

Step 2: %D P = 1 / Ed * %D Q

Step 3:

%D P = (1 / - 1.6) * +20% = - 12.5%

Income Elasticity of Demand

u Income elasticity of demand measures how much the quantity demanded of a good responds to
a change in consumers’ income.
 u It is computed as the percentage change in the quantity demanded divided by the percentage
change in income.

Computing Income Elasticity

Income Elasticity
- Types of Goods -

u Normal Goods

u Income Elasticity is positive.

u Inferior Goods

u Income Elasticity is negative.

u Higher income raises the quantity demanded for normal goods but lowers the quantity
demanded for inferior goods.

Income Elasticity of Demand

The elasticity of demand for good X with respect to income (I)

EDxI= %ΔQX/%ΔI or

EDxI= ΔQX/QX / ΔI/I or

EDxI= ΔQX/ΔI * I/QX

EDxI > 1 normal and income elastic

EDxI < 1 > 0 normal and income inelastic

EDxI <0 inferior good

Necessaries, luxuries and income levels

Cross Price Elasticity of Demand

Elasticity measure that looks at the impact a change in the price of one good has on the demand of
another good.

Cross-price elasticity measures the relative responsiveness of the quantity purchased of some good
when the price of another good changes, holding the price of the good and money income constant.

% change in demand Q1/% change in price of Q2.

Positive-Substitutes
Negative-Complements.

Cross Price Elasticity of Demand

The elasticity of the demand for good X with respect to the price of another good Y

EDxPy= %ΔQX/%ΔPY or

EDxPy= ΔQX/QX / ΔPY/PY or

EDxPy= ΔQX/ΔPY * PY/QX

The sign matters, positive cross price elasticities indicate substitutes, negative cross price elasticities
indicate complements

Complements and Substitutes

Cross-Elasticity of Demand

Cross-elasticity of demand: The percentage change in quantity consumed of one product as a

The Cross-Elasticity of Demand

Arc Elasticity

Elasticity of Supply

The elasticity of the supply of good X with respect to its own price

ESxPx= %ΔQS/%ΔP or

ESxPx= ΔQS/QS / ΔP/P or

ESxPx= ΔQS/ΔP * P/QS

Elasticities of supply can range from zero to infinity. Depends on technology, resource substitution, and
time frame

All straight line supply curves through the origin will have elasticities of supply = 1

Elasticity of Supply

Elasticities of Demand for Coke and Pepsi

Price discrimination
different customers are charged different prices for the same product, due to differences in price
elasticity of demand

higher prices for those customers who have the most inelastic demand

lower prices for those customers who have a more elastic demand.

customers who are willing to pay the highest prices are charged a high price, and

customers who are more sensitive to price differentials are charged a low price.

Tax incidence

Distribution of the burden of a tax depends on the elasticities of demand and supply.

When supply is more elastic than demand, consumers bear a larger share of the tax burden.

Producers bear a larger share of the burden of a tax when demand is more elastic than supply.

Managerial Uses of Concept of Elasticity

Determination of price under monopoly

Determination of wages

Advantages to Finance Minister

International Trade

Paradox of Poverty for farmers – as demand of agricultural produce is inelastic.

Price discrimination

Distribution of burden of taxes.

Than “Q”