Hand-out - 3

PROGRAMME
:
FIRST YEAR FIRST SEMESTER
BACHELOR OF COMMERCE (SPECIAL) DEGREE
COURSE TITLE : ECONOMICS FOR ENTERPRISES
COURSE CODE : COM 11032
COURSE STATUS : COMPULSORY
HAND-OUT TITLE : CONCEPTOF ELASTICITY
LECTURER B.PRAHALATHAN, DEPARTMENT OF COMMERCE

Learning Objectives:
define concept of elasticity
describe different measurements of elasticity
explain price, income, cross and promotional elasticity
identify determinants of price elasticity
illustrate the importance of concept of elasticity in firms decision making

Introduction
In economics, elasticity is the measurement of how responsive an economic variable is to a change in
another. Elasticity is one of the most important concepts in neoclassical economic theory. In the case
of firms, it is very important for a firm to know the quantitative change in demand due to a given
change in the variables influencing demand.

Concept of Elasticity
The term elasticity is used by economists to measure the responsiveness of one variable to changes in
another variable. That is, Elasticity can be quantified as the ratio of the percentage change in one
variable to the percentage change in another variable.

Elasticity of Y =
X
Y
in Change Percentage
in Change Percentage



Measurements of Elasticity
Elasticity can be measured in two ways
1. Point Elasticity
2. Arc Elasticity

Demand Function
A function is the mathematical relationship of a variable with its determinants.

Y = f(x)
Here Y is a function of X. That is X determines Y. Thus demand function is the relationship of
demand with the determinants.
D
x
= f (I, P
x
, P
s
, P
c
, A )

D
x
: Demand for the good X
P
x
: Price of good X
I: Consumers income
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P
s
: Price of substitute goods
P
c
: Price of complementary goods
A: Advertisement expenditure

Elasticity of Demand
Elasticity of Demand is defined as the ratio of percentage change in demand to the change in one of
the determinants of demand.

e
D
=
Demand of ts Determinan in Change Percentage
Demand in Change Percentage


Demand elasticity shows how sensitive demand is to the changes in the underlying factors in the
demand function.

Elasticity and Firms
Change by a particular amount and particular direction is very useful in managerial decision making.
With this knowledge of elasticity of demand, a manager can use the changes to his advantage.
Therefore it will be able to respond effectively to the changes in the economic environment.

Different Types of Elasticity of Demand

a. Price elasticity of demand
b. Income elasticity of demand
c. Cross elasticity of demand
d. Promotional elasticity of demand

Price Elasticity of Demand
Price elasticity of demand measures the change in demand for a good to the changes in the price of that
good, certeris paribus

E
p
=
commodity the of price in change Percentage
commodity a for demand in change Percentage


E
p
=
Px
Dx

x
Dx
Px


D
x
: Changes in demand
P
x
: Changes in price
D
x
: Demand for good
P
x
: Price of good

Different Types of Price Elasticity
1. Perfectly inelastic demand Ep = 0
2. Perfectly elastic demand Ep =
3. Elastic demand Ep > 1
4. Inelastic demand Ep < 1
5. Unitary elastic Ep = 1
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Determinants of the Price Elasticity of Demand
1. Nature of the commodity
2. Availability of Substitutes
3. Variety of Uses
4. Postponement of the Use
5. Proportion of the income spent on a commodity
6. Habits
7. Time period
8. Joint demand

Income Elasticity of Demand
The income elasticity of demand measures the responsiveness of a change in the quantity demanded to
a change in the level of consumer income. It is calculated using the following formula,
Income in Change
Quantity in Change
x
Quantity Original
Income Original


E
i
=
I
x

D
x
Dx
I



Income Elasticity and Firms
The income elasticity of demand shows the responsiveness of demand for a particular commodity to
the variation in the consumers income. It enables the firm to foresee the magnitude and direction of
the change in the demand for its product with the changes in the level of consumers income in the
industry.

Types of Income Elasticity
a. Positive income elasticity
b. Negative income elasticity
c. Zero Income elasticity

Positive Income Elasticity
Demand increases with a arise in consumers income
(Ex) superior OR Normal goods

Negative Income Elasticity
Demand decreases with a arise in consumers income
(Ex) inferior goods

Zero Income Elasticity
When the demand for commodity does not respond to changes in income of the consumer, the income
elasticity of demand is zero.
(Ex) Very cheap commodity: salt, post card, newspaper, candles, and buttons


Positive income elasticity may be:
a. Unity
b. More than unity
c. Less than unity

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The Concept of Income Elasticity and National Income
Changes in national income affect the demand for the firms product. If product has high income
elasticity will grow faster when the economy will expand. Firms having low income elasticity will be
less affected by economic changes.

Cross Elasticity of Demand
Price of some related product causes a variation in the demand for commodity. Therefore cross
elasticity of demand measures the responsiveness of demand for one product to the changes in price of
another

E
c
=
Y of Price in Change Percentage
X of Demand in Change Percentage


E
c
=
Py
Dx

x
Dx
P
Y


D
x
: demand for commodity X
P
y
: price of commodity Y


Kinds of Cross Elasticity of Demand
1. Positive cross elasticity
2. Negative cross elasticity
3. Zero cross elasticity

Cross elasticity of demand is positive for substitutes and negative for complements. Zero cross
elasticity indicates that goods are totally unrelated.

Cross Elasticity and Firms
Cross Elasticity of demand become important for a manager to develop some sort of relationship
between the demand for a commodity and the price of related goods. Thus cross elasticity enables the
firm to formulate pricing strategy in relation to the pricing strategy of its competitors. Therefore cross
elasticity helps in measuring the inter relationship among different industries.

Advertising Elasticity of Demand [AED]
The advertising elasticity of demand measures the responsiveness of changes in the quantity demanded
to changes in the level of advertising. It is calculated using the following formula;

E
a
=
nts advetiseme on e expenditur in Change Percentage
Demand in Change Percentage


- If E
a
> 1, it implies a relatively elastic demand. In other words, an increase in the level of
advertising will cause a proportionately greater increase in the demand for the good.
- If E
a
< 1, it implies a relatively inelastic demand. In other words, an increase in the level of
advertising will cause a proportionately smaller increase in the demand for the good.


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Advertising Elasticity of Demand and the Firms
The promotional elasticity of demand plays an important role in the marketing decisions of any firm.
A low promotional elasticity would indicate that demand changes less as compared to a change in the
advertisement expenditure of a firm. In such a case the firm will have to incur relatively much higher
expenditure on advertisements to increase the demand for its product. Thus the manager can plan
alternative marketing approach in order to produce sales effectively.

Elasticity and Total Expenditure
On a straight line demand curve, elasticity at different points is different. A straight line demand curve
is elastic above its mid point, has unitary elasticity at the mid point, and is inelastic blow its mid point.

Price Elasticity of Demand
Direction of Price
Change
Direction of Total Expenditure
Change

Elastic Demand E > 1 Rise in price Total expenditure falls
Fall in price Total expenditure increases

Inelastic Demand E <1 Rise in price Total expenditure increases
Fall in price Total expenditure decreases

Unitary Elastic Demand E =1 Rise in price Total expenditure same
Fall in price Total expenditure same



Relationship among Price Elasticity, Marginal Revenue and Total Revenue

Price elasticity of Demand Marginal Revenue
Total Revenue when Price
is Reduced
Elastic Positive Increases
Unitary Zero Remains constant
Inelastic Negative Decreases


References:

1. H. L. Ahuja ; Principles of Microeconomics, 18th Edition; S.Chand Publishing
2. Raj Kumar and Kuldip Gupta, Managerial Economics; Revised Edition, 2006; UDH
Publishers & Distributors (Pvt) Ltd, New Delhi.









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Additional Notes