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ELASTICITY OF

DEMAND

Prof. Shampa Nandi


Law of Demand

Law of Demand states that if price of commodity


increases quantity demanded will falls and if price of
commodity falls quantity will increases.

Law of demand indicates only direction of change in


quantity demanded in response to change in price
but ELASTICITY OF DEMAND states with how much
or to what extent the quantity demanded will change
in response to change in any determinants.
ELASTICITY - The Concept

• If price rises by 10% - what happens to demand?

• We know demand will fall.

• By more than 10% ?

• By less than 10% ?

• Elasticity measures the extent to which demand will


change.
Meaning & Definition of Elasticity of
Demand
Elasticity of Demand measures the extent to which quantity demanded of
a commodity increases or decreases in response to increase or decrease in
any of its quantitative determinants.

So, we have several types of elasticity of demand according to the source


of the change in the demand. For example, if the price is the source of the
change, we have the “price elasticity of demand”.

“The elasticity (or responsiveness) of demand in a market is great or small


according as the amount demanded increases much or little for a given fall
in price, and diminishes much or little for a given rise in price”. – Dr.
Marshall.
Elasticity of Demand
According to the source of the change, the following types of elasticity of
demand can be mentioned:
• Price Elasticity of Demand
• Cross Elasticity of Demand (the elasticity in relation to the change of the
price of other good and services)
• Income Elasticity of Demand
• Advertisement Elasticity of Demand (the elasticity in relation to the
advertisement expenditure)

According to the degree of the change in the demand, the elasticity can
be classified in:
• Perfectly Elastic
• Relatively Elastic
• Unitary Elasticity
• Relatively Inelastic
• Perfect Inelastic
Price Elasticity of Demand

Price Elasticity of demand is a measurement of


percentage change in demand due to percentage
change in own price of the commodity.

The price elasticity of Demand may be defined as the


ratio of the relative change in demand and price
variables.

e= Percentage/Proportional Change in Quantity Demanded


Percentage/Proportional Change in Price
Price Elasticity of Demand
Degree of Price Elasticity of Demand

Five cases of elasticity of demand are studied depending


upon their degree:

• Perfectly Elastic
• Perfectly Inelastic
• Unitary Elastic
• Relatively Elastic
• Relatively Inelastic
Perfectly Elastic Demand
When a small change in price of a product causes a major change in its demand, it
is said to be perfectly elastic demand. In perfectly elastic demand, a small rise in
price results in fall in demand to zero, while a small fall in price causes increase in
demand to infinity.

A perfectly elastic demand refers to the situation when demand is infinite at the
prevailing price.

In perfectly elastic demand, a small rise in price results in fall in demand to zero,
while a small fall in price causes increase in demand to infinity.

The degree of elasticity of demand helps in defining


the shape and slope of a demand curve. Therefore,
the elasticity of demand can be determined by the
slope of the demand curve. Flatter the slope of the
demand curve, higher the elasticity of demand.
Perfectly Inelastic Demand
A Perfectly inelastic demand is one in which a change in price causes no change in
quantity demanded.
It is a situation where even substantial changes in price leave the demand
unaffected.

It can be interpreted from Figure that the


movement in price from OP1 to OP2 and OP2 to
OP3 does not show any change in the demand
of a product (OQ).

The demand remains constant for any value of


price.

Perfectly inelastic demand is a theoretical


concept and cannot be applied in a practical
situation. However, in case of essential goods,
such as salt, the demand does not change with
change in price. Therefore, the demand for
essential goods is perfectly inelastic.
Unitary Elastic Demand

• When the proportionate change in demand


produces the same change in the price of the
product, the demand is referred as unitary elastic
demand. The numerical value for unitary elastic
demand is equal to one (ep=1).

• The demand curve for unitary elastic demand is


represented as a rectangular hyperbola.
Relatively Elastic Demand
Relatively elastic demand refers to the demand when the proportionate change
produced in demand is greater than the proportionate change in price of a
product.

Mathematically, relatively elastic demand is


known as more than unit elastic demand (ep>1).
For example, if the price of a product increases by
20% and the demand of the product decreases by
25%, then the demand would be relatively elastic.

In this the demand is more responsive to the


change in price
Relatively Inelastic Demand

Relatively inelastic demand is one when the


percentage change produced in demand is less
than the percentage change in the price of a
product.

For example, if the price of a product increases by


30% and the demand for the product decreases
only by 10%, then the demand would be called
relatively inelastic.

The numerical value of relatively elastic demand


ranges between zero to one (ep<1).

Marshall has termed relatively inelastic demand


as elasticity being less than unity.
The different types of price elasticity of
demand are summarized in Table
Flatter the slope of the demand curve, higher the
elasticity of demand.
Measurement of Price Elasticity of
Demand

Measurement of Price Elasticity of Demand

Total Expenditure Method Proportionate Method

Point Elasticity of Demand Arc Elasticity of Demand


Total Expenditure Method
Dr. Marshall has evolved the total expenditure method to measure the price
elasticity of demand. According to this method, elasticity of demand can be
measured by considering the change in price and the subsequent change in the
total quantity of goods purchased and the total amount of money spent on it.

Total Outlay/ Total Expenditure = Price X Quantity Demanded

There are three possibilities:


If with a fall in price (demand increases) the total expenditure increases or
with a rise in price (demand falls), the total expenditure falls, in that case the
elasticity of demand is greater than one i.e. ED > 1.

If with a rise or fall in the price (demand falls or rises respectively), the
total expenditure remains the same, the demand will be unitary elastic or ED = 1.

If with a fall in price (Demand rises), the total expenditure also falls, and
with a rise in price (Demand falls) the total expenditure also rises, the demand is
said to be less classic or elasticity of demand is less than one (ED < 1).
Total Expenditure Method
Table shows that when the price falls from Rs. 9 Price Quantity TE in Rs Ep
to Rs. 8, the total expenditure increases from Rs. Rs Per in Kgs
180 to Rs. 240 and when price rises from Rs. 7 to Kg
Rs. 8, the total expenditure falls from Rs. 280 to
1 2 (1x2=3)
Rs. 240. Demand is elastic (Ep > 1) in this case.
9 20 180 >>1
When with the fall in price from Rs. 6 to Rs. 5 or
8 30 240
with the rise in price from Rs. 4 to Rs. 5, the total
expenditure remains unchanged at Rs. 300, i.e., 7 40 280
Ep = 1.
6 50 300 =1
When the price falls from Rs. 3 to Rs. 2 total 5 60 300
expenditure falls from Rs. 240 to Rs. 180, and
4 70 300
when the price rises from Re. 1 to Rs. 2 the total
expenditure also rises from Rs. 100 to Rs. 180. 3 80 240 <<1
This is the case of inelastic or less elastic
2 90 180
demand, Ep < 1.
1 100 100
Summarized Relationship In Total Expenditure
Method

Price TE Ep
Falls Rises >>1

Rises Falls

Falls Unchanged =1

Rises Unchanged

Falls Falls <<1

Rises Rises
Example

Price Quantit Exp. Price Quantit Exp. Price Quantit Exp.


(P) y (Q) (PxQ) (P) y (Q) (PxQ) (P) y (Q) (PxQ)

2 300 600 2 300 600 2 300 600

4 150 600 4 100 400 4 200 800

6 100 600 6 50 300 6 150 900

P E (No Effect) P E P E
E=1 E>1 E<1
Question
Ques 1: Price(1) = 2, Quantity (1) = 10
Price (2) = 4, Quantity (2) = 5
E=?
Solution
Price Quantity Expenditure
2 10 20
4 5 20

P E (No Effect)
E=1
Percentage or Proportionate Method
This method is also associated with the name of Dr. Marshall.

According to this method “Price elasticity of demand is the ratio of the


proportionate change in quantity demanded to proportionate change in price.

It is also known as the Percentage Method, Flux Method, Ratio Method, and
Arithmetic Method. Its formula is as under:
Formula
Ep = Percentage Change in Quantity Demanded
Percentage Change in the Price of the good
Percentage or Proportionate Method (Ex 1)
Calculate the Price Elasticity of demand if the price fell by 10% causing the
demand to rise from 800 to 850 units.

Solution:
Percentage or Proportionate Method (Ex 2)

When Price of Commodity is Rs. 1, then Consumer spends Rs. 80 & If the
price of commodity is Rs. 20 then consumer spends Rs. 96.

Calculate the Elasticity of demand with Percentage Method.


Percentage or Proportionate Method (Ex 2)

Solution:

Price Expenditure Quantity


1 80 80
2 96 48
Point Method or Geometrical Method

Measures the price Elasticity of demand of different points on the demand


curve .

This method was also suggested by Dr. Marshall

Used only with the reference to a linear demand curve.

Elasticity of demand at a point =


Point Method or Geometrical Method
Arc Method

We have studied the measurement of elasticity at a point on a demand curve.

But when elasticity is measured between two points on the same demand
curve, it is known as arc elasticity.

In the words of Prof. Baumol, “Arc elasticity is a measure of the average


responsiveness to price change exhibited by a demand curve over some
finite stretch of the curve.”

Any two points on a demand curve make an arc.


Arc Method

The area between P and M on the DD curve in Figure 11.4 is an arc which
measures elasticity over a certain range of price and quantities.

On any two points of a demand curve the elasticity coefficients are likely to be
different depending upon the method of computation.
Why there is need of Arc Method?
Arc Method

Consider the price-quantity combinations P and M as given in Table.

Demand Schedule
Point Price Quantity
P 8 10
M 6 12
Arc Method

As per Percentage Method:


If we move from P to M, the elasticity of demand is:

If we move in the reverse direction from M to P, then

Thus this method of measuring elasticity at two points on a demand curve


gives different elasticity coefficients because we used a different base in
computing the percentage change in each case.

To avoid this discrepancy, elasticity for the arc method has been developed
Arc Method

Formula For Arc Method:

Where,

P1 = Original Price

P2 = New Price

Q1 = Original Quantity Demanded

Q2 = New Quantity Demanded


Arc Method
On the basis of formula, we can measure arc elasticity of demand when there
is a movement either from point P to M or from M to P.

From P to M at P, p1 = 8, q1, =10, and at M, P2 = 6, q2 = 12

Applying these values, we get

Thus whether we move from M to P or P to M on the arc PM of the DD curve,


the formula for arc elasticity of demand gives the same numerical value.
INCOME ELASTICITY OF DEMAND
Income Elasticity of Demand

Income elasticity of demand is the degree of responsiveness of quantity


demanded of a commodity due to change in consumer’s income, other things
remaining constant.

In other words, it measures by how much the quantity demanded changes


with respect to the change in income.

The income elasticity of demand is defined as the percentage change in


quantity demanded due to certain percent change in consumer’s income.
Expression of Income Elasticity of Demand

Where,
•EY = Elasticity of demand
•q = Original quantity demanded
•∆q = Change in quantity demanded

y = Original consumer’s income


•∆y= Change in consumer’s income
Example to Explain Income Elasticity of
Demand
Suppose that the initial income of a person is Rs.2000 and quantity
demanded for the commodity by him is 20 units. When his income increases
to Rs.3000, quantity demanded by him also increases to 40 units. Find out
the income elasticity of demand.

Solution:
Here, q = 100 units
∆q = (40-20) units = 20 units
y = Rs.2000
∆y =Rs. (3000-2000) =Rs.1000

Hence, an increase of Rs.1000 in income i.e. 1% in income leads to a rise of 2%


in quantity demanded.
Types of Income Elasticity of demand

Types of Income
Elasticity of
Demand

Positive Income Negative Income Zero Income


Elasticity Of Elasticity Of Elasticity E=0
Demand E>0 Demand E<0

Income Elasticity Income Elasticity Income Elasticity


Greater than Equal to Unity Less than Unity
Unity E>1 E=1 E<1
1. Positive income elasticity of demand
(EY>0)
If there is direct relationship between income of the consumer and demand
for the commodity, then income elasticity will be positive.

That is, if the quantity demanded for a commodity increases with the rise in
income of the consumer and vice versa, it is said to be positive income
elasticity of demand.

For example: as the income of consumer increases, they consume more of


superior (luxurious) goods. On the contrary, as the income of consumer
decreases, they consume less of luxurious goods.

Positive income elasticity can be further classified into three types:

•Income Elasticity Greater than Unity E>1


•Income Elasticity Equal to Unity E=1
•Income Elasticity Less than Unity E<1
(A) Income elasticity greater than unity
(EY > 1)
If the percentage change in quantity
demanded for a commodity is greater than
percentage change in income of the
consumer, it is said to be income greater than
unity.

For example: When the consumer’s income


rises by 3% and the demand rises by 7%, it is
the case of income elasticity greater than
unity.

In the given figure, quantity demanded and consumer’s income is


measured along X-axis and Y-axis respectively. The small rise in income
from OY to OY1has caused greater rise in the quantity demanded
from OQ to OQ1 and vice versa. Thus, the demand curve DD shows
income elasticity greater than unity.
(B) Income elasticity equal to unity (EY = 1)

If the percentage change in quantity


demanded for a commodity is equal to
percentage change in income of the
consumer, it is said to be income elasticity
equal to unity.

For example: When the consumer’s income


rises by 5% and the demand rises by 5%, it is
the case of income elasticity equal to unity.

In the given figure, quantity demanded and consumer’s income is


measured along X-axis and Y-axis respectively. The small rise in income
from OY to OY1 has caused equal rise in the quantity demanded
from OQ to OQ1 and vice versa. Thus, the demand curve DD shows
income elasticity equal to unity.
(C) Income elasticity less than unity
(EY < 1)
If the percentage change in quantity
demanded for a commodity is less than
percentage change in income of the
consumer, it is said to be income greater than
unity.

For example: When the consumer’s income


rises by 5% and the demand rises by 3%, it is
the case of income elasticity less than unity.

In the given figure, quantity demanded and consumer’s income is


measured along X-axis and Y-axis respectively. The greater rise in
income from OY to OY1has caused small rise in the quantity demanded
from OQ to OQ1 and vice versa. Thus, the demand curve DD shows
income elasticity less than unity.
2. Negative income elasticity of demand
( EY<0)
If there is inverse relationship between income
of the consumer and demand for the
commodity, then income elasticity will be
negative. That is, if the quantity demanded
for a commodity decreases with the rise in
income of the consumer and vice versa, it is
said to be negative income elasticity of
demand.

For example: As the income of consumer


increases, they either stop or consume less of
inferior goods.
In the given figure, quantity demanded and consumer’s income is measured
along X-axis and Y-axis respectively. When the consumer’s income rises
from OY to OY1 the quantity demanded of inferior goods falls
from OQ to OQ1 and vice versa. Thus, the demand curve DD shows negative
income elasticity of demand.
3. Zero income elasticity of demand ( EY=0)

If the quantity demanded for a commodity


remains constant with any rise or fall in
income of the consumer and, it is said to be
zero income elasticity of demand.

For example: In case of basic necessary goods


such as salt, kerosene, electricity, etc. there is
zero income elasticity of demand.

In the given figure, quantity demanded and consumer’s income is measured


along X-axis and Y-axis respectively. The consumer’s income may fall to OY1 or
rise to OY2 from OY, the quantity demanded remains the same at OQ. Thus, the
demand curve DD, which is vertical straight line parallel to Y-axis shows zero
income elasticity of demand.
CROSS ELASTICITY OF DEMAND
Cross Elasticity of Demand

The measure of responsiveness of the demand for a good towards the


change in the price of a related good is called cross price elasticity of
demand. It is always measured in percentage terms.

With the consumption behavior being related, the change in the price of a
related good leads to a change in the demand of another good.

Related goods are of two kinds, i.e. substitutes and complementary


goods.
Cross Elasticity of Demand

In case the two goods are substitutes for each other like tea and coffee,
the cross price elasticity will be positive, i.e. if the price of coffee
increases, the demand for tea increases.

On the other hand, in case the goods are complementary in nature like
pen and ink, then the cross elasticity will be negative, i.e. demand for ink
will decrease if prices of pen increase or vice-versa.

It can be expressed as:


Cross Elasticity of Demand
Definition:
“The cross elasticity of demand is the proportional change in the quantity of
X good demanded resulting from a given relative change in the price of a
related good Y” Ferguson

“The cross elasticity of demand is a measure of the responsiveness of


purchases of Y to change in the price of X” Leibafsky

In case the two goods are substitutes for each other like tea and coffee, the
cross price elasticity will be positive, i.e. if the price of coffee increases, the
demand for tea increases.

On the other hand, in case the goods are complementary in nature like pen
and ink, then the cross elasticity will be negative, i.e. demand for ink will
decrease if prices of pen increase or vice-versa.
Cross Elasticity of Demand
Substitute Goods:
In case the two goods are substitutes for each other like tea and coffee, the
cross price elasticity will be positive, i.e. if the price of coffee increases, the
demand for tea increases.

Complementary Goods:
On the other hand, in case the goods are complementary in nature like pen
and ink, then the cross elasticity will be negative, i.e. demand for ink will
decrease if prices of pen increase or vice-versa.
Types of Cross Elasticity of Demand

Types of Cross
Elasticity of
Demand

Positive Negative Zero


Positive Cross Elasticity of Demand

When goods are substitute of each other then


cross elasticity of demand is positive.

In other words, when an increase in the price


of Y leads to an increase in the demand of X.

For instance, with the increase in price of tea,


demand of coffee will increase.

In figure quantity has been measured on OX-axis and price on OY-axis. At


price OP of Y-commodity, demand of X-commodity is OM. Now as price of Y
commodity increases to OP1 demand of X-commodity increases to OM1 Thus,
cross elasticity of demand is positive.
Negative Cross Elasticity of Demand

In case of complementary goods, cross


elasticity of demand is negative.

A proportionate increase in price of one


commodity leads to a proportionate fall in the
demand of another commodity because both
are demanded jointly.

In figure quantity has been measured on OX-axis while price has been
measured on OY-axis. When the price of commodity increases from OP to
OP1 quantity demanded falls from OM to OM1. Thus, cross elasticity of
demand is negative.
Zero Cross Elasticity of Demand

Cross elasticity of demand is zero when two


goods are not related to each other.

For instance, increase in price of car does not


effect the demand of cloth. Thus, cross
elasticity of demand is zero.
Advertising and Promotional Elasticity
of Demand
Advertising Elasticity of Demand

Advertising elasticity of demand refers to the proportionate


change in demand of a commodity due to proportionate change
in advertising expenses.

Advertising elasticity is a measure of an advertising campaigns


effectiveness in generating sales.

Formula:
Types Of Advertising Elasticity of Demand

•Perfectly Elastic Advertising elasticity

•Perfectly Inelastic Advertising Elasticity

•Highly Elastic Advertising Elasticity

•Unitary Elastic Advertising Elasticity

•Highly Inelastic Advertising Elasticity


Perfectly Elastic AED

Perfectly

Expense
elastic
When the demand for a product curve
changes – increases or decreases

D
even when there is no change in
x advertising expense.

demand
Perfectly Inelastic AED

When a change in advertising Perfectly


expense , doesn’t lead to any inelastic
curve

Advertising Expense
change in quantity demanded ,
it is known as perfectly
inelastic demand.

D
demand
Relatively Elastic AED

Relatively elastic
When the proportionate
curve
change in demand is more than

Advertising Expense
the proportionate changes in
advertising expense , it is
known as relatively elastic

demand
Unitary Elastic AED

When the proportionate


change in demand is equal to
proportionate changes in

Advertising
Expense
advertising expense price, it is Unitary
AED
known as unitary elastic
demand.

demand
Relatively Inelastic AED

When the proportionate Relatively


change in demand is less inelastic

Advertising Expense
demand
than the proportionate curve
changes in advertising
expense , it is known as
relatively inelastic demand

demand
Uses of Elasticity of Demand for
Managerial Decision Making
1. Determination of Price

The primary objective of any firm is to earn profit or increase


revenue. Therefore, increasing price of its products to maximize
profit is one of the primary concerns of producers.

However, during the course of increasing price, the producers


must not forget that demand and price share inverse
relationship. They must be aware that demand falls with rise in
price. And thus, they must increase price of their commodity to
that level where their desired or optimal profit is still achievable.
1. Determination of Price

For example: In the table given below are shown three cases
(I, II & III) of a restaurant that sells burger.
1. Determination of Price
In the above table, we can see that when price of the burger was $10 per
unit, its demand in the market were 100 units per day, causing the firm profit
of $300.

When the firm increased the price to $10.2, its demand fell by 10 units per
day.

As a result, the firm gained profit of $288, causing reduction of $12 in initial
profit. In the same way, when the price is increased to $11 per unit, there is
once again decrease in demand. The new demand in market is 85 units per
day and the new profit is $340.

From the example, it is clear that producers must always analyze elasticity of
their product and must evaluate the impact of changes in price on the total
revenue and profit of their firm.
2. Wage Determination

If a commodity is of inelastic nature, the labor can force the


employer to increase their wage through extreme ways like
strike. As a result, the company will have to consider the
demands of labor in order to meet the demand of consumers for
the inelastic goods.

However, if the commodity is of elastic nature, labor unions and


other associations cannot force the employers to raise wage as
the producers can alter the demand of their products.
3. Importance in International Trade
We have already known that change in price cannot bring drastic change in
demand of the product in case of inelastic commodity. But even a slight
change in price can cause huge effect on demand of elastic commodity.

We have also known that higher price can be charged for inelastic goods and
lowest possible price must be set for elastic goods.

Taking into account the above information, a country may fix higher prices for
goods of inelastic nature. However, if the country wants to export its
products, the nature (elasticity/inelasticity) of the commodity in the
importing country should also be considered.

For example: Rice maybe an inelastic product for China and thus exports
around the world at the price “x”. But, if rice is price elastic in the US, China
will be forced to decrease the price from the initial value of “x” to be able to
sell the product in American market.
4. Importance to Finance Minister
Price elasticity of demand can also be used in the taxation policy
in order to gain high tax revenue from the citizens. One of the
ways would be for the government to raise tax revenue in
commodities which are price inelastic.

For example: Government could increase the tax amount in


goods like cigarettes and alcohol. Given how these are the
commodities people choose to purchase regardless of the price
tag, the tax revenue would significantly rise.

On the other hand, in case of a commodity with elastic demand


high tax rates may fail to bring in the required revenue for the
government.
5.Price Discrimination
The situation where a single group or company controls all or almost all of
market for a particular good or service is called monopoly. The monopolistic
market lacks competition. Thus, the goods or services are often charged high
prices in such market.

If the product is inelastic (less or no effect on demand with change in price),


the producer can earn profit by setting high price. However, if the product is
elastic (highly affected by even slightest change in price), the producer must
set low or at least reasonable price so that the consumers are attracted to
buy the goods.

For example: Fuel is necessity of consumers. Therefore, monopolist who runs


the market of fuel can generate profit even by setting high price of fuel.
6. Price Determination of Joint Products
Joint products are various products generated by a single production
procedure at a single time. Sheep and wool, cotton and cotton seeds, wheat
and hay, etc. are some examples of joint products.

However, since they are two different products, we cannot sell them at the
same price in the market. Price elasticity of demand plays important role in
determining the prices of these joint products.

Let us suppose, there has been bumper production of cotton this season. As a
result, huge amount of cotton as well as cotton seeds have been produced.
Cotton has wide scope in the market as it can be used for different purposes.
The producers of cotton can gain maximum profit by setting high price of
cotton, as demand of cotton in market is not easily altered. But cotton seeds
have limited scope, so it is an elastic product. If the business does not
decrease the price, then demand will be less.
By setting a high price for cotton (inelastic product) and low price for cotton
seeds (elastic product), the business can maximize its revenue.