ELASTICITIES OF DEMAND

- Elasticity refers to the responsiveness of something (an economic variable) when

something else (another economic variable) changes.
- Elasticities of demand include the following:
o Price Elasticity of Demand
o Cross Elasticity of Demand
o Income Elasticity of Demand

Price Elasticity of Demand

- This refers to the responsiveness of quantity demanded to a change in price.

- It is the relationship between the proportionate change in price and the proportionate
change in quantity demanded.
- The symbol PED or Ep can be used to represent price elasticity of demand.
- PED is therefore a ratio of the changes of two variables, Price (P) and quantity
demanded (Qd).
- Basing on the basic law of demand, when P rises; Qd decreases and when P
decreases; Qd rises.
- As a result of this PED is always negative though the negative sign is usually ignored.

Mathematical formula for PED

% Change∈Qd
PED=
% Change∈P

Degrees of elasticity
- There are different degrees of elasticity and these depend on the outcome of
calculations using the above formula.

1. Elastic Demand
- This basically means that demand is relatively responsive to price changes.
- When demand is elastic, PED is greater than 1.
- This means that the proportionate change in Qd is greater than the proportionate
change in P. E.g. if a 10% increase in price results in a 20% decrease in quantity
demanded.
- This means that an increase in price will reduce total revenue for a firm while a
decrease in price will increase total revenue for a firm.
- This also means that an increase in price will reduce total consumer expenditure and a
decrease in price will increase total consumer expenditure.
- The following diagram illustrates elastic demand:

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Price
$ D

P1 gentle slope

P0

0
Q1 Q0 Quantity of laptops demanded

- In the diagram above, a relatively small increase in price of laptops from P0 to P1 will
bring about a relatively large proportionate decrease in quantity demanded from Q0 to
Q1 the slope of the demand curve is gentle.
- This applies to goods like cars, refrigerators, sofas, washing machines, computers etc.

2. Inelastic Demand
- This means that demand is relatively unresponsive to changes in price.
- When demand is inelastic, PED is less than 1.
- Percentage change in Qd will be less than percentage change in price. E.g. a 10%
increase in price leads to a 4% decrease in quantity demanded.
- This means that an increase in price will increase total revenue of a firm and a fall in
price will reduce total revenue of a firm.
- This also means that a price increase increases total consumer expenditure and a price
reduction reduces total consumer expenditure.
- The following diagram shows inelastic demand.
D
Price
$

P1 steep slope

0
Q1 Q0 Quantity of laptops demanded

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 - In the diagram above, a relatively small increase in price of laptops from P0 to P1 will
bring about a smaller proportionate decrease in quantity demanded from Q0 to Q1 the
slope of the demand curve is steep.
- This applies to goods like basic necessities, goods that take a small proportion of a
consumer’s income, habit forming goods (addictive goods), goods that have no close
substitutes and goods that have a number of uses. E.g. alcohol, cigarettes etc.

Unitary elasticity
- This occurs when a percentage change in price results in an equal percentage change
in quantity demanded.
- In this case PED is equal to 1.
- This is reflected on a graph by a rectangular hyperbola as shown below:
Price

0 Quantity demanded

- The curve does not touch both axes.

Perfectly elastic demand

- A change in price will cause an infinite change in quantity demanded.
- If the price rises even by a very small percentage, nothing will be bought.
- In this case PED= ∞ (infinity) and the graph is a horizontal straight line.

Price

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 0 Quantity demanded

- The graph shows that the amount demanded at the ruling price is infinite.

Perfectly inelastic demand

- This occurs when a change in price causes no change in quantity demanded.
- In this case PED= 0 and it is represented by a vertical straight line on the graph.

Price D

0 Quantity demanded

- The graph shows that quantity demanded does not change as price changes.

Determinants of Price elasticity of demand

- These are the factors that influence the degree of elasticity of a product

1. Availability of substitutes at the ruling price

- The greater the number of substitutes available for a product, the greater will be its
elasticity of demand.
- Also the closer the substitutes are, the greater the elasticity of demand. For example,
demand for products like salt and insulin (which have no close substitutes) is
relatively inelastic while demand for margarine (which has butter or jam as
substitutes) tends to be elastic.
2. The proportion of income spent on the product
- Demand for goods on which a small proportion of income is spent e.g. match boxes
tends to be inelastic while demand for those goods where a larger proportion of
income (e.g. motor vehicles) is spent tends to be elastic.
- Thus the greater the proportion of income which the price of the product represents,
the more elastic the demand will tend to be.
3. Addiction or habit forming
- When a product is habit forming or addictive e.g. alcohol or cigarettes, it tends to
have inelastic demand.
- In extreme cases of addiction demand may become perfectly inelastic.

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 4. Necessities and luxuries
- Necessities are those goods which people cannot do without and at the same time
cannot increase consumption even if price falls. For example, a family which eats
three loaves of bread every morning will have to get the same amount in both the
event of a price rise and a price fall.
- Luxuries are goods that people can do without and hence a rise in price may mean that
people cut consumption. E.g. furniture, cars etc.
- Demand for luxuries tends to be elastic while that for necessities tend to be inelastic.
- However whether a product is considered a luxury or a necessity depends on the
standards of living of a particular geographical area.
5. The time period involved
- When price rises, people may take time to adjust their consumption patterns and find
alternatives.
- The longer the time period after a price change, the greater the price elasticity of
demand.

6. Brand loyalty
- Some consumers are attached to certain brands and are loyal to them e.g. Nike,
Adidas, Puma etc.
- In such markets, demand tends to be inelastic.
- Some are attached to certain products due to their culture, e.g. Muslims have an
attachment to Halal meat (meat from an animal that has been slaughtered in a way
that is approved by Islamic law) and this makes demand inelastic in that particular
market.

7. Whether a product is jointly consumed

- Joint products are products used with other products. E.g. electricity is jointly used
with goods like ovens, fridges etc.
- Such goods tend to have inelastic demand.

Importance of price elasticity of demand

1. Pricing decisions
- If a firm faces an inelastic demand curve, then pushing up price will always increase
total revenue.
- Total revenue (TR) or total sales is the amount of money received from the sale of an
output.
- It is given by price multiplied by quantity (TR = P x Q).
- If demand is elastic, total revenue increases as price falls.
- if demand is elastic, it is wise to reduce the price in order to maximise total revenue.

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 2. Price discrimination
- A discriminating monopolist will maximise total revenue by charging high price in
the market where demand is inelastic and a low price in the market where demand is
elastic.
- For instance, ZESA tariffs in high and low density residential areas or cell phone peak
and off peak call charges.
3. Taxation policy by the government
- Government levies indirect taxes such as value added tax (VAT) and excise duty on
expenditure in order to raise revenue.
- To maximize on revenue collected the government should levy a low tax on goods
with elastic demand while laying a high tax on goods with inelastic demand such as
alcohol and cigarettes.
4. Shifting of tax burden
- The extent a producer can pass on the burden of indirect tax to the consumer by
increasing prices depends on the degree of elasticity of the goods being sold.
- If demand is inelastic, the greater part of the tax burden is passed on to the consumer.
- If demand is elastic, the producer bears the greater part of the tax burden.

5. Determination of factor prices (rent, wages and interest)

- A factor of production with inelastic demand usually commands a higher price
compared to a factor with elastic demand.
- E.g. because of scarcity demand for pilot tends to be inelastic and hence they earn
highly.

6. International trade and Exchange rate policy

- Currency devaluation will be beneficial if demand for imports and exports is price
elastic.
- When currency is devalued exports become cheaper and if they have elastic demand,
a country will earn more foreign currency from exporting more.
- A government can also benefit by imposing high tariffs on goods with inelastic
demand.

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