ELASTICITY OF DEMAND

Price, Income and Cross Elasticity

Dr.Sunitha.S Assistant Professor, School of Management Studies, National Institute of Technology (NIT) Calicut

Elasticity the concept

The responsiveness of one variable to changes in another When price rises, what happens to demand? Demand falls BUT! How much does demand fall?

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

The Concept of Elasticity

Elasticity is a measure of the responsiveness of one variable to another. The greater the elasticity, the greater the responsiveness.

Elasticity of Demand : Definition

The degree of responsiveness of quantity demanded as a result of change in price of the good , income or relative goods prices.

Types of elasticity of demand

Price elasticity of demand Income elasticity of demand Cross elasticity

Price Elasticity
The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price.

Percentage change in quantity demanded ED = Percentage change in price

Figure 2: Extreme Cases of Demand (a)

Price per Unit D Price per Unit

(b)

$4
3 2 Perfectly Inelastic Demand

$4
3 2 Perfectly Elastic Demand D

20 40 60 80 100 Quantity

20 40 60 80 100 Quantity

Sign of Price Elasticity

According to the law of demand, whenever the price rises, the quantity demanded falls. Thus the price elasticity of demand is always negative. Because it is always negative, economists usually state the value without the sign.

What Information Price Elasticity Provides

Price elasticity of demand and supply gives the exact quantity response to a change in price.

Classifying Demand and Supply as Elastic or Inelastic

Demand is elastic if the percentage change in quantity is greater than the percentage change in price.

E>1

Classifying Demand and Supply as Elastic or Inelastic

Demand is inelastic if the percentage change in quantity is less than the percentage change in price.

E<1

Elastic Demand
Elastic Demand means that quantity changes by a greater percentage than the percentage change in price.

Inelastic Demand
Inelastic Demand means that quantity doesn't change much with a change in price.

Defining elasticities
When price elasticity is between zero and -1 we say demand is inelastic. When price elasticity is between -1 and - infinity, we say demand is elastic. When price elasticity is -1, we say demand is unit elastic.

Elasticity Is Independent of Units

Percentages allow us to have a measure of responsiveness that is independent of units. This makes comparisons of responsiveness of different goods easier.

Calculating Elasticities
To determine elasticity divide the percentage change in quantity by the percentage change in price.

Categories of Price Elasticity of Demand

Perfect elastic demand Perfect inelastic demand Unit elasticity of demand

Relatively elastic demand

Relatively inelastic demand

Elasticity

Price Elasticity of Demand

The responsiveness of demand to changes in price Where % change in demand is greater than % change in price elastic Where % change in demand is less than % change in price - inelastic

Elasticity
The Formula: Ped = % Change in Quantity Demanded ___________________________ % Change in Price

If answer is between 0 and -1: the relationship is inelastic If the answer is between -1 and infinity: the relationship is elastic Note: PED has sign in front of it; because as price rises demand falls and vice-versa (inverse relationship between price and demand)

Price Elasticity of Demand

For example if the Price of Pepsi goes up by 5% and as a response the Quantity Demanded goes down by 10% then the Price Elasticity of Demand for Pepsi is:

Ed

-10% 2 5%

This has an interesting interpretation. Ed=2 indicates that the percentage change in the quantity demanded is twice a big as the percentage change in the price. In other words, the quantity demanded is very sensitive to changes in the price because in this case the quantity demanded changed more (in percentage terms) than the change in the price. In general the elasticity can be interpreted as follows: the percentage change in the Quantity Demanded is Ed times the percentage change in the Price. In the example above Ed=2 so we concluded that QD is sensitive to changes in P. In general, whenever the percentage change in the QD demand is greater than the percentage change in P we are going to say the demand is sensitive to changes in the price. A sensitive demand is called Elastic, and insensitive demand is called Inelastic.

Elasticity
Price ()
The demand curve can be a range of shapes each of which is associated with a different relationship between price and the quantity demanded.

Quantity Demanded

Elasticity
Price
The importance of elasticity Total revenue is price x is the information it quantity sold. In this provides on the example, TR = effect Rs5 x on total revenue of changes in 100,000 = Rs500,000. price. This value is represented by the grey shaded rectangle.

Rs 5

Total Revenue

D 100 Quantity Demanded (000s)

Elasticity
Price
If the firm decides to decrease price to (say) Rs3, the degree of price elasticity of the demand curve would determine the extent of the increase in demand and the change therefore in total revenue.

Rs 5 Rs 3

Total Revenue

D
100 140 Quantity Demanded (000s)

Elasticity
Price (Rs) 10

Producer decides to lower price to attract sales

% Price = -50% % Quantity Demanded = +20% Ped = -0.4 (Inelastic) Total Revenue would fall

Not a good move!

D
5 6
Quantity Demanded

Elasticity
Price (Rs)

Producer decides to reduce price to increase sales % in Price = - 30% % in Demand = + 300% Ped = - 10 (Elastic) Total Revenue rises Good Move!
D

10 7

Quantity Demanded

20

Elasticity

If demand is price elastic: Increasing price would reduce TR (% Qd > % P) Reducing price would increase TR (% Qd > % P)

If demand is price inelastic: Increasing price would increase TR (% Qd < % P) Reducing price would reduce TR (% Qd < % P)

Examples of Own Price Demand Elasticities

When the price of gasoline rises by 1% the quantity demanded falls by 0.2%, so gasoline demand is not very price sensitive. Price elasticity of demand is -0.2 . When the price of gold jewelry rises by 1% the quantity demanded falls by 2.6%, so jewelry demand is very price sensitive. Price elasticity of demand is -2.6 .

Examples of Unit-free Comparisons Gasoline and jewelry

It doesnt matter that gas is sold by the gallon for about $1.09 and gold is sold by the ounce for about $290. We compare the demand elasticities of -0.2 (gas) and -2.6 (gold jewelry). Gold jewelry demand is more price sensitive.

Inelastic Economic Relations

When an elasticity is small (between 0 and 1 in absolute value), we call the relation that it describes inelastic.
Inelastic demand means that the quantity demanded is not very sensitive to the price. Inelastic supply means that the quantity supplied is not very sensitive to the price.

Elastic Economic Relations

When an elasticity is large (greater than 1 in absolute value), we call the relation that it describes elastic.
Elastic demand means that the quantity demanded is sensitive to the price. Elastic supply means that the quantity supplied is sensitive to the price.

Size of Price Elasticities

Unit elastic Inelastic
0 1 2 3 4 5

Elastic
6

Unit elastic: own price elasticity equal to 1

Inelastic: own price elasticity less than 1

Elastic: own price elasticity greater than 1

General Formula for own price elasticity of demand P = Current price of good X
XD = Quantity demanded at that price DP = Small change in the current price DXD= Resulting change in quantity demanded

Percentage Change in Quantity Demanded Elasticity Percentage Change in Price

Note:
The own price elasticity of demand is always negative. Economists usually refer to the own price elasticity of demand by its absolute value (ignore the negative sign). So, even though the formula says that the own price elasticity of demand is negative, we would say the elasticity of demand is 1.5 in the first example and 0.67 in the second.

Perfectly Elastic Demand We say that

demand is perfectly elastic when a 1% change in the price would result in an infinite change in quantity demanded.
Price Perfectly Elastic Demand (elasticity = )

Quantity

Perfectly Inelastic Demand We say that demand

is perfectly inelastic when a 1% change in the price would result in no change in quantity demanded.
Price

Perfectly Inelastic Demand (elasticity = 0)

Quantity

Elasticity

Income Elasticity of Demand:

The responsiveness of demand to changes in incomes

Normal Good demand rises as income rises and vice versa Inferior Good demand falls as income rises and vice versa

Elasticity

Income Elasticity of Demand:

A positive sign denotes a normal good A negative sign denotes an inferior good

The Price Elasticity of Demand will vary across goods. The following are the main determinants of Ed: Goods with many close substitutes will have higher elasticities: if a good can be easily substituted for another then consumer will be very sensitive to prices. For example if two gas stations are located in the same corner (and the gasoline is roughly the same between the two) then consumers will pay close attention to the price between the two gas stations.

Elasticity

For example: Yed = - 0.6: Good is an inferior good but inelastic a rise in income of 3% would lead to demand falling by 1.8% Yed = + 0.4: Good is a normal good but inelastic a rise in incomes of 3% would lead to demand rising by 1.2% Yed = + 1.6: Good is a normal good and elastic a rise in incomes of 3% would lead to demand rising by 4.8% Yed = - 2.1: Good is an inferior good and elastic a rise in incomes of 3% would lead to a fall in demand of 6.3%

Luxuries and Necessities: Luxuries will tend to have higher elasticities. Necessities will tend to have lower elasticities. In the latter, since the good is a necessity consumer will not be very responsive to price changes, they still have to purchase the good. In the case of luxuries since consumers do not really need to buy the good then they will pay attention to the price and therefore will be sensitive to price changes. For example, vacations are luxury goods, if the price of a vacations increases most consumer will reduce the number of vacations more than proportionally to the change in price. However, if the price of food goes up people will only reduce the amount of food purchased a little bit because without food they will die or get sick.

Elasticity

Cross Elasticity: The responsiveness of demand of one good to changes in the price of a related good either a substitute or a complement
% Qd of good t __________________ Xed = % Price of good y

Elasticity

Goods which are complements:

Cross Elasticity will have negative sign (inverse relationship between the two) Cross Elasticity will have a positive sign (positive relationship between the two)

Goods which are substitutes:

Elasticity

Price Elasticity of Supply:

The responsiveness of supply to changes in price If Pes is inelastic - it will be difficult for suppliers to react swiftly to changes in price If Pes is elastic supply can react quickly to changes in price

Pes =

% Quantity Supplied ____________________ % Price

Determinants of Elasticity

Time period the longer the time under consideration the more elastic a good is likely to be Number and closeness of substitutes the greater the number of substitutes, the more elastic The proportion of income taken up by the product the smaller the proportion the more inelastic Luxury or Necessity - for example, addictive drugs

Importance of Elasticity

Relationship between changes in price and total revenue Importance in determining what goods to tax (tax revenue) Importance in analysing time lags in production Influences the behaviour of a firm

What does the elasticity measure really measure? The elasticity measure is a ratio between two
percentage measures: the percentage change in one variable over the percentage change in another variable A price elasticity of -6.25 means that for each one percent change in price the quantity demanded will change by 6.25 percent.

Income Elasticity of Demand

EI = % D Qd / % D Id
Measures the sensitivity of DEMAND to changes in disposable income.

Luxury Goods
Luxury Goods are Normal Goods but they have an

Quantity demanded is very sensitive to changes in disposable income

EI >= 1

Necessities
Necessities are Normal Goods but

0 < EI < 1
Quantity demand is not very sensitive to changes in disposable income

 Normal Goods (EI >0)

Luxury Goods (EI >= 1) Necessitates (0 < EI < 1)

Inferior Goods (EI < 0)

Cross-Price Elasticity
Measures how sensitive DEMAND for a commodity is to changes in the price of a substitute or compliment commodity

Cross-Price Elasticity

Ecp of x,y =

% D Qx / % D Py

Cross-Price Elasticity

Ecp > 0 Substitute

Ecp < 0 Compliment Ecp = 0 Independent

Example
The Cross-Price Elasticity of tea and coffee would be calculated as:

Ecp, tea, coffee=

% D Q tea/ % D P coffee

Interpretation?

If the Ecp, tea, coffee = + .65

Then for every 1% increase in the price of coffee, the Qd of tea would increase .65%. We also would know that tea and coffee are substitutes

Slope Compared to Elasticity

The slope measures the rate of change of one variable (P, say) in terms of another (X, say). The elasticity measures the percentage change of one variable (X, say) in terms of another (P, say).

Summing up : Priceelasticity elasticity of demand measures how much Price of demand

the quantity demanded responds to changes in the price.

Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. If a demand curve is elastic, total revenue falls when the price rises. If it is inelastic, total revenue rises as the price rises.

Summing up : Income elasticity of demand

The income elasticity of demand measures how much the quantity demanded responds to changes in consumers income. The cross-price elasticity of demand measures how much the quantity demanded of one good responds to the price of another good. The price elasticity of supply measures how much the quantity supplied responds to changes in the price. .
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