Elasticity of Demand
Dr. Utpal Chattopadhyay
Asst. Professor,
NITIE, Mumbai.
1
How price changes affect
Consumer’s Equilibrium
An increase in price of good X led to a
decrease in consumption of X (and Y).
Good Y
Y1
Y2 I1
I2
X2 X1 Good X
2
Price Change & Market
Demand
A price rise (from P1 to P2) leads to a decline in
total quantity demanded ( from Q1 to Q2).
How much of demand would decline when price
is raised by say 10%?
Price To quantify this we need to
know “Elasticity of Demand”
D
E2
P2
E1
P1
Quantity
Q2 Q1
3
Elasticities of Demand
How responsive is Demand (D) to
a change in Price (P)
E = % change in Quantity Demanded
% change in Price
E is very important for pricing
decisions
Different Types of Elasticities:
1. Price Elasticity
• Own Price Elasticity
• Cross Price Elasticity
2. Income Elasticity
4
Own Price Elasticity of
Demand
d
%QX
EQX , PX
%PX
EQx,Px is Negative according to the
“law of demand”
Elastic: (sensitive) EQX , PX 1
Inelastic: (insensitive) EQX , PX 1
Unitary: EQX , PX 1
5
Perfectly Elastic &
Inelastic Demand
Price
Price (E = 0)
D
(E = ∞)
Quantity Quantity
Perfectly Perfectly
Elastic Inelastic
6
Point & Arc Price
Elasticities of Demand
Point Elasticity is the
elasticity at a given point
on the demand curve. It is
measured by:
E= (P/Q)*(∆Q/ ∆P)
Arc Elasticity is the
elasticity between two
points on the demand
curve. It is measured by:
E=(P2+P1)/2 *(∆Q/ ∆P)
(Q2+Q1)/2
= (P2+P1) * (Q2-Q1)
(Q2+Q1) (P2-P1)
7
Price Elasticity at different
points on a Demand Curve
E= (Px/Qx)(∆Qx/ ∆Px)
Price Along the dd ∆Qx/ ∆Px= constant.
Thus E >1 if Px > Qx
A(E= ∞)
E = 1 if Px = Qx
d
E>1 E < 1 if Px < Qx
C (E=1)
Px
E<1
B (E=0)
Quantity
Qx d
8
Cross Price Elasticity of
Demand
d
%QX
EQX , PY
%PY
When EQx, Py is + ve : X & Y are Substitutes
-ve : X & Y are Complements
9
Price Elasticity, Total &
Marginal Revenue
Total Revenue (TR)= Unit price X
Quantity (no.) sold
TR = P *Q
AR = TR/Q = PQ/Q= P
MR= ∆TR/ ∆Q
Alternatively
MR = d(TR)/dQ=d/dQ(PQ)
=P+Q(dP/dQ)
i.e. MR=P(1+Q * dP)
P dQ
=P(1+1/E)
E= elasticity of demand
=(P/Q)(dQ/dP)
10
Total & Marginal Revenue
Curves
Price
Demand is price
elastic
Demand is price
inelastic
Quantity
Revenue MR
TR
Quantity
11
Impact of Price Change
on Total Revenue
MR =P(1+1/E)
If E<-1 ; MR > 0 E=-2 P=4 MR=4(1+1/-2)=2
If E>-1 ; MR < 0 E=-0.5 P=4 MR=4(1+1/-0.5)=-4
If E=-1 ; MR = 0 E=-1 P=4 MR=4(1+1/-1)=0
Elasticity Price change Total Revenue
Elastic (E >1) Rises Falls
-do- Falls Rises
Inelastic (E <1) Rises Rises
-do- Falls Falls
Unitary Elastic Rises/ Falls No change
(E=1)
12
Determinants of Price
Elasticity
Availability of Substitutes
• The more substitutes available for the
good, the more elastic the demand.
Product Definition
• How the product in question has been
defined- narrowly (jeans) or broadly
(cloth)
Time
• Demand tends to be more inelastic in
the short term than in the long term.
• Time allows consumers to seek out
available substitutes.
Expenditure Share
• Goods that comprise a small share of
consumer’s budgets tend to be more
inelastic than goods for which
consumers spend a large portion of
their incomes.
Individual Habits
13
Income Elasticity
d
%QX
EQX , M
%M
When EQx,M is + ve : X is a Normal Good
-ve : X is Inferior Good
14
Price & Income Elasticity
Estimates- A Few Examples
Product/service Price Elasticity Study
Non-cereal Food 0.804 Meenakshi & Ray (1999)
India (urban + rural)
Clothing 0.560 -do-
India (urban + rural)
Electricity, India 0.32 (winter) Filippini &
(urban) 0.39 (monsoon) Pachauri (2202)
0.16 (summer)
High-speed internet 1.08 to 1.79 Kridel, Rappoport &
Access Th. Cable modems Taylor (2000)
US (residential)
Income Elasticity
White Maize 0.15 Rosegrant,
Phillipines Agcaoili- Sombila
& Perez (1995)
Source: Das, Satya P.(2007)
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Uses of Elasticities
Pricing
Managing cash flows
Impact of changes in
competitors’ prices
Impact of economic booms and
recessions
Impact of advertising
campaigns
16
Price Elasticity &
Pricing Policy
MR =P(1+1/E)
For profit maximization by a firm
MR =MC
Thus MC =P(1+1/E)
P= MC ( 1 )
(1+1/E)
Optimal price of product depends on its
marginal cost and its price elasticity of
demand. Holding MC constant, price is
inversely related to its price elasticity of
demand.
17
Question 1: Pricing and
Cash Flows
A leading telephone co’s
price elasticity of demand
for long distance services
is -8.64.
The co. wants to boost its
revenues so as to meet
its marketing goals.
To accomplish this goal,
should it raise or lower its
price?
18
Answer
Since demand is elastic, a
reduction in price will
increase quantity demanded
by a greater percentage
than the price decline,
resulting in more revenues
for the company.
So , Reduce the price!
19
Question2 : What Impact on
Demand due to a change in
competitor’s price?
According to a Report the
cross price elasticity of
demand for a company’s
product is 9.06.
If its competitors reduce
their prices by 4 percent,
what would happen to the
company’s demand?
20
Answer
The demand would fall by 36.24%
d
% Q X
EQ X , PY 9.06
% PY
d
% Q X
9.06
4%
d
4% 9.06 % Q X
d
% Q X 36.24%
21
Advertising Elasticity
• The percentage change in quantity
demanded resulting from a (1 )
percent change in advertising
expenditure
E A = %∆Qxd
%∆A
• Is it worth to spend more on
advertising?
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