Elasticity of Demand

DR. PRERNA JAIN

Introduction
Law of demand gives only the direction of change of

quantity demanded in response to a given change in the price of a commodity, but not the magnitude of such a change.
A firm needs to know about the responsiveness or

sensitivity of demand for the commodity it produces to changes in all the independent variables.

 Responsiveness of a commodity is the amount by

which its quantity demanded changes in response to a given change in any of the determinants of demand. A firm would be particularly interested to know the impact on the quantity demanded of a commodity either when the price of the commodity is changed, or when it increases its advertising expenditure etc. Answers to all these questions can be found with the help of the concept of elasticity.

 Elasticity

of demand measures the degree of responsiveness of the quantity demanded of a commodity to a given change in any of the independent variables that influence demand for that commodity

Methods of Measuring Elasticity

Ratio or Percentage Method Arc Elasticity Method Total Outlay Method

Price Elasticity of Demand

Point Definition

Q / Q Q P EP P / P P Q
P EP a1 Q

Linear Function

Price Elasticity of Demand

Arc Definition

Q2 Q1 P2 P 1 EP P2 P Q2 Q1 1

Total Outlay Method

Measuring Elasticity by Outlay Method

Degree of Elasticity
Highly Elastic (ep > 1)

Price (Rs.)
Increased Decreased

Quantity Demanded (Units)

Decreased Increased

Total Outlay (Rs.)

Decreased Increased

Unit Elastic (ep =1)

Highly Inelastic (ep < 1)

Increased
Decreased Increased Decreased

Decreased
Increased Decreased Increased

No change
No change Increased Decreased

Determinants of Price Elasticity of Demand

Nature of Commodity: This implies whether the

commodity is a necessity or luxury. Necessities are relatively price inelastic, while luxuries are relatively price elastic.
Availability and Proximity of Substitutes In case a

commodity has close substitutes price elasticity would be quite high. Ex: Apparels

 Alternative uses of the commodity: If a commodity

can be put to more than one use, it would be relatively price elastic. Ex: Electricity Proportion of income spent on the commodity: The greater the proportion of income a consumer spends on purchasing a commodity, the more sensitive would the commodity be to price, due to the income effect. The reverse also holds good.

 Time: Demand for any commodity is usually more

price elastic in the long run. The reason is simple, consumers take time to adjust their consumption pattern to accommodate substitutes in their consumption bundles. A shift from petrol driven automobiles to CNG driven is a typical example. It may not be feasible for consumers to switch from petrol driven cars in the short run, but they would gradually shift to CNG in the long run.

 Durability

of the commodity: Perishable commodities like eatables are relatively price inelastic in comparison to durable items like consumer electronic appliances, cars etc. Items of addiction: These are relatively price inelastic.

Income Elasticity of Demand

Point Definition

Q / Q Q I EI I / I I Q
I EI a3 Q

Linear Function

Income Elasticity of Demand

Arc Definition Normal Good

EI 0

Q2 Q1 I 2 I1 EI I 2 I1 Q2 Q1

Inferior Good
EI 0

Cross-Price Elasticity of Demand

Point Definition

E XY

QX / QX QX PY PY / PY PY QX
PY a4 QX

Linear Function

E XY

Arc Definition Substitutes

E XY 0

E XY

QX 2 QX 1 PY 2 PY 1 PY 2 PY 1 QX 2 QX 1

Complements
E XY 0

Promotional Elasticity of Demand

It measures the degree of responsiveness of demand

to a given change in advertising expenditure. Ea > 1, a firm should go for heavy expenditures on advertisement. Ea < 1, a firm should not spend too much on advertisement.

Importance of Elasticity of Demand

Determination of Price: Products having elastic

demand should be sold at lower price, while those having inelastic demand should be sold at higher price. Basis of Price Discrimination Determination of Rewards of Factors of Production Govt. policies of taxation