Elasticities of

Demand

1
An elasticity measures the sensitivity of one variable to another.
Specifically it is a number that tells us the percentage/proportionate
change that will occur in one variable in response to a 1% increase in
another variable.

The proportionate change in a variable is just the absolute change in a

variable divided by the original level of the variable.

There are as many elasticities of demand as its determinants. The

most important of these elasticities are

 the price elasticity

 the income elasticity

 the cross-elasticity
2
Price Elasticity of Demand

3
Price elasticity of demand is a measure of responsiveness of demand to changes in
the commodity’s own price. If the changes in the price are very small, we use point
price elasticity of demand.

If the changes in price are not small, we use the arc elasticity of demand as the
relevant measure.

It is defined as the proportionate change in quantity demanded resulting from a very

small proportionate change in price. So

dQ dP P dQ
ep  / 
Q P Q dP

The price elasticity of demand is usually a negative number. When price of a good
increases, the quantity demanded usually falls. Thus dQ/dP is negative as in e p. In
order to avoid dealing with negative values, a minus sign is often introduced into the
formula for ep

4
When the price elasticity is greater than one, we say that demand is price elastic
because the percentage decline in quantity demanded is greater than the percentage
increase in price. If the price elasticity of demand is less than 1 in magnitude,
demand is said to be price inelastic.

From the above equation, we can say that price elasticity of demand is the change
in quantity associated with the change in price (dQ/dP) times the ratio of price to
quantity (P/Q).

But as we move down the demand curve, dQ/dP may change, and the price and
quantity will always change. Therefore, price elasticity of demand must be
measured at a particular point on a demand curve and will generally change as we
move along the curve.

Whenever the demand function is linear, the point elasticity formula appears
almost too simple because the first derivative of the equation with respect to P is
constant. From the practical standpoint, there is really no need to use calculus for
finding the point elasticity of a linear demand function.
5
This principle is the easiest to see for a linear demand curve of the form
Q=a-bP

Let us consider a demand curve of the particular form

Q=8-2P

From this curve dQ/dP is constant and equal to -2 (a one unit change in price
results in a change in quantity by 2 units).

However, the curve does not have a constant elasticity. In cases where the demand
curve is non-linear, calculus must be employed to compute point elasticity.

Consider the following demand curves:

Q=100-P2 (Concave Shape), Q=10/P2 (Convex Shape)

Calculate Ep in both the cases where P=5, Q=75

6
For movement along a curved demand, both the slope and the ratio P/Q vary
continuously along demand curve. For this reason, elasticity generally varies
along curvilinear demand, but there is no general rule about the relation
between price and elasticity as there is for linear demand.

There is an exception to the general rule that elasticity varies along

curvilinear demands. A special kind of curvilinear demand function exists
for which the demand elasticity is constant for all points on demand. When
demand takes the form Q=aP-b, the elasticity is constant along the demand
curve

Consequently, no calculation of elasticity is required and price elasticity is

simply the value of the exponent on price, b, The absolute value of b can be
greater than, less than, or equal to 1, so that the form of the demand curve
can be elastic, inelastic, or unitary elastic.

Price elasticities of demand are pure numbers independent of the units in which
7
prices and outputs are measured.
From the figure beside, we can see that as we
move down the curve, the ratio P/Q falls,
P
elasticity therefore decreases in magnitude.
ep= ∞
Q=8-2P
Because we draw demand curves with price 4
on the vertical axis and quantity on the
horizontal axis, ep=1
Q
=(1/slope of the curve)
P 2
As a result, for any price and quantity
combination, the steeper the slope of the
ep= 0
curve, the less elastic is demand.
Thus the reciprocal of the slope of the 0 4 8 Q
demand curve has to be multiplied by the
original price-quantity ratio to find out the
numerical value of ep.
The elasticity varies along the demand curve
as price and quantity change. Slope is
constant for this linear demand curve.

8
 Point Versus Arc Elasticity

The already discussed formula for price-elasticity is applicable only for infinitesimal
changes in the price. If the price changes appreciably arc elasticity of demand.

There are times, when we want to calculate a price elasticity over some portion of
the demand curve, rather than at a single point. Suppose that we are contemplating
an increase in the price of product from Rs.8 to Rs.10 and expect the quantity
demand to fall from 6 units to 4 units.

How should we calculate the elasticity of demand?

We can solve this problem by using the arc elasticity of demand-the elasticity
calculated over a range of prices. Rather than choosing either the initial or the final
price, we use the average of the two. The formula for arc elasticity is

Q ( P1  P2 ) / 2 Q ( P1  P2 )
e p ( ) 
P Q1  Q2 / 2 P (Q1  Q2 ) 9
The previous formula can also be written as

Q2  Q1 P2  P1
Ep  
(Q1  Q2 ) / 2 ( P1  P2 ) / 2

Numerator of this coefficient indicates the percentage change in quantity

demanded. The denominator indicates the percentage change in price. It is to be
noted that the change in each variable is divided by the average of its beginning
and the ending values.
For example, if the price of a product rises from Rs.11 to Rs.12, causing a fall in
the quantity demanded from 7 to 6, the formula gives the following price elasticity
coefficient:

6 7 12  11  1 1  11.5
Ep       1.77
(7  6) / 2 (11 12) / 2 6.5 11.5 6.5

10
The reason the arc elasticity formula employs the average of the
beginning and ending values can be easily seen. If we had used
beginning values, the coefficient would be

6  7 12  11  1 1  11
Ep       1.57
7 11 7 11 7

However, suppose the price fell from Rs.12 to Rs.11, causing the
quantity demanded to rise from 6 to 7 units. Using the beginning
values would result in a coefficient of -2. (Calculate)

Thus the same unit change in price and quantity gives different values
of elasticity, depending on whether the price increases or decreases.
By using the average of the beginning and ending values, we avoid
this ambiguity.
11
An additional source of ambiguity arises in the computation of elasticity when we
consider the changes over different ranges of price and quantity.
Price in Quantity
(Rs.) The numbers in this schedule indicate a linear relationship
between quantity demanded and price, with a unit change in price
18 0 resulting in a unit change in quantity over the entire range of the
17 1 schedule.
16 2 Suppose we compute the arc elasticity for a price change from
15 3 Rs.12 to Rs.10 rather than between Rs.12 and Rs.11. The arc
14 4 elasticity formula gives:
13 5 6 8 12  10  2 2  22
12 6 Ep       1.57
(8  6) / 2 (10  12) / 2 7 11 14
11 7
10 8 Here the coefficient is different from the previously computed
value. In fact, for any given value of price, the arc elasticity
9 9 coefficient will vary depending on the new price’s distance from the
8 10 original price.
7 11
Arc elasticity decreases as the change in price increases.
6 13
5 13 The algebraic expression of this demand equation is P= 18-Q
or Q=18-P
12
The measure of the arc elasticity is an
approximation of the true elasticity of the
section AB of the demand curve when we P
know only the two points A and B from the
demand curve, but not intermediate ones.
The more convex the demand curve is, the P1 A
poorer the linear approximation attainted
by arc elasticity.
P2 B

The arc elasticity will always lie

somewhere (but not necessarily halfway) Q1 Q2 Q
between the point elasticities calculated at
the lower and higher prices.
Arc elasticity is only an estimate. This
estimate improves as the arc becomes
smaller and approaches a point in the
limit. 13
 Other method to Determine Price Elasticity

What we have explained is the percentage/proportionate method of

measurement of price elasticity of demand. There is also another
method to measure price elasticity of demand. This is known as total
expenditure method or Total revenue method. The elasticity for a
good and the total expenditure made on the good are greatly related to
each other. From the changes in the total expenditure made on a good
as a result of changes in the price, we can know the elasticity for a
good.

But it should be remembered that with the total expenditure method

we can know only whether elasticity is equal to 1, greater than 1 or
less than 1. With this method we can not find out the exact and precise
coefficient of elasticity. 14
Unit Elasticity (ep=1): When as a result of the changes in price of a good
quantity demanded of the good increases so much that the total expenditure made on
good remains the same, the ep for the good is equal to unity. This is because total
expenditure made on a good can remain same only if the % change in quantity
demanded is equal to % change in price.

ep>1: When due to fall in price the quantity demanded of a good increases so
much that the total expenditure made on the good increases, the ep will be greater
than unity. It should be carefully noted that when due to the rise in price the total
expenditure on the good declines, ep will be greater than 1. It is because increase in
Total Expenditure (TE)/ Total Revenue (TR) as a result of fall in price and decrease
in Total Expenditure (TE)/Total Revenue (TR) as a result of rise in price are the
same thing.

P (TR and TE)

OR ep  1
P (TR and TE)
15
ep <1: If as a result of fall in price of a good, The Total Expenditure (TE)/ Total
Revenue (TR) on it decreases , the ep is less than 1. Due to rise in price if Total
Expenditure (TE) / Total Revenue (TR) made on the good increases, e p is less than
one.

P (TR and TE)

OR ep  1
P (TR and TE)

16
ILLUSTRATION

Price of a Quantity TR or TE ep Problem 1: Suppose ep is 1 and at

Pen Demanded (P*Q) Rs.15/litre an individual consumes 80
(P) (Q) liters of petrol in a week. How much
5.00 30 150 ----- price of petrol should be fixed so that he
demands 60 liters of petrol? Use the
4.75 40 190 >1 expenditure method.
4.50 50 225 >1
4.25 60 255 >1
Problem 2: Suppose price of a
4.00 75 300 >1 commodity rises from Rs.15 to Rs.16 per
3.75 80 300 1 unit. As a result its quantity demanded
falls from 100 units to 80 units. Find out
3.50 84 294 <1 price elasticity coefficient by
3.25 87 282.75 <1 expenditure method.

17
 Relationship between Price Elasticity and Marginal Revenue (MR)

The marginal revenue is related to the price elasticity of demand with the formula
MR=P(1-1/e)

This is crucial relationship for the theory of pricing.

18
 P,MR
Q = C - b P
|E|=1
C 1
P = ----- - ----- Q
b b

D C 2
MR MR = ------ - ------ Q
0 Q
b b
TR C

Note:
In the demand equation
dQ/dP = -b

That means

Q P
0 E p = -b ----- 19
Q
 The Relationship between Price Elasticity and Total
Revenue (TR)

A decrease in price would decrease revenue if nothing else were to happen. But
because demand curves tend to be downward sloping, a decrease in price will
increase the quantity purchased, and this will increase receipts.

Which of the two tendencies is stronger?

Elasticity is defined as the percentage change in quantity divided by percentage

change in price. If the former is larger (and, therefore, the coefficient will be
greater than 1 in absolute terms), then the quantity effect is stronger and will more
than offset the opposite price effect.

What does that entail for revenue?

If price decreases and, in percentage terms, quantity rises more than price has
dropped, then total Revenue (TR) will increase. 20
As price decreases, revenue rises when demand is elastic and reaches its peak
when elasticity of demand equals 1.

From the relationship between MR and price elasticity of demand the

decision makers can easily know whether or not it is advantageous to change
the price. From the relationship:

MR=P(1-1/e), if e=1, MR=0

If e<1, MR<0, and therefore, TR decreases when price decreases and TR

increases when price increases.

If e>1, MR>0, then TR increases if price decreases, and TR decreases when

price increases.

If the demand curve is falling the TR curve initially increases, reaches a

maximum, and then starts declining. We can use the derived relationship
between MR, P, and e to establish the shape of the TR curve. 21
Elasticity Nature of Change in Price Change in TR
Coefficient Demand
ep=0 Perfectly Increases Increases
Inelastic Decreases Deceases

ep<1 Inelastic Increases Increases

Decreases Decreases

ep=1 Unitary Elastic Increases No change in TR

Decreases

ep>1 Elastic Increases Decreases

Decreases Increases

ep=∞ Perfectly Increases Decreases to 0

Elastic
Decreases Increases up to
market size

Relationship between Price Elasticity and Total Revenue (TR)

22
In case of an inelastic demand (e<1) quantity demanded increases
less than the proportionate decreases in price and hence TR falls
when price falls. TR increases when price increases because quantity
demanded decreases less than proportionately.

In case of elastic demand (e>1) change in quantity demanded if

greater than the proportionate change in price. Therefore TR
increases when price falls.

23
 The Basic determinants of Price Elasticity of
Demand are

The availability of Substitutes. If the price of a commodity for which close

substitutes are available goes up, the people will shift to its close substitutes
and as a result, the demand for that commodity will greatly decline. The
greater the possibility of substitution, the greater the price elasticity demand
for it.

The nature of the need that the commodity satisfies. (Luxury is price
elastic; necessity is price inelastic). There are inconsistencies because one
person’s luxury is another person’s necessity. Ex: Demand for Mercedez
Autos.c

Time period. The demand is more elastic in the long-run. This is because
consumers can substitute goods in the long-run. In the short-run, substitution
of one commodity by another is not so easy.

If the price of fuel oil rises, it may be difficult to substitute fuel oil by other
types of fuels such as coal or cooking gas. But given sufficient time, people
will make adjustments and use coal or cooking gas instead of fuel oil whose
price has risen.
24
The number of uses to which a commodity can be put. The more the possible
uses, the greater is price elasticity.

Milk has several uses. If its price rises to high level, it will be used only for
essential purposes such as feeding the children and for seek persons. If the
price of milk falls, it will be devoted to other uses as preparation of curd,
cream, ghee and sweets. Therefore, demand for milk tends to be elastic.

The proportion of income spent on a particular commodity. The greater the

proportion of income spent on a commodity, the greater will be its elasticity of
demand and vice-versa.

Addiction (Inelastic Demand)

Price Expectations

Durability of the Product: Possibility of postponing purchase, Possibility of

repair, used Product market cause the elasticity to increase.
25
 Empirical Studies on Price Elasticity

 A study of the demand for coffee estimated the price-elasticity to be -0.2 in the
short-run and -0.33 in the long-run.

 Meals (excluding alcoholic beverages) purchased at restaurants have a high

demand elasticity of -2.27

 A study of the demand for kitchen and other household appliances stated that
the elasticity was -0.63.

 The price elasticity of beer has been estimated at -0.84 and of wine at -0.55.

26
Problem

Point Px Qx Calculate Point elasticity when moving from

A 8 0 (i) B to D
B 7 1000 (ii) D to B
C 6 2000
Calculate arc elasticity also.
D 5 3000
F 4 4000
G 3 5000
H 2 6000
L 1 7000
M 0 8000

27
Problem
Calculate point and arc price elasticity when moving from (C to F) and (F to C).

Point Px Qx
A 7 500
B 6 750
C 5 1250
D 4 2000
F 3 3250
G 2 4750
H 1 8000

28
Problems

** The demand law is given by

x=10-P, near the point x=4 and P=6.

If the price increases by 5%, determine the % decrease in demand and hence an
approximation to the elasticity of demand .

Compare the result with the current value of elasticity of demand corresponding to x=4.

** Consider the competitive market for which the quantities demanded and supplied
(per year) at various prices are given as follows
(a) Calculate price elasticity of demand when price
Price Demand Supply is 80 and price is 100.
60 22 14 (b) What is the equilibrium quantity?
80 20 16 (c) Suppose Govt. sets a price ceiling of Rs.80.
Will there be a shortage and if so how large will
100 18 18 it be?
120 16 20 (d) Calculate price elasticity of supply when the
price is 80 and the price is 100. 29
Problems

 If the demand law is given by

 x/2
P 10e

find the elasticity of demand.

 kx
Also show that if the demand law is of the form P ae
 1
Then, ed 
kx

(P is the price and x is quantity demanded).

30
Problems
20
 If the Demand law is x 
P 1

Find the coefficient of price elasticity of demand where P=3

 .If the demand function is P (4  5 x ) 2

For what value of x the price elasticity of demand will be unity.

31
Problems

Much of the demand of US agricultural output has come from other countries. In
1998, the total demand for wheat was Q=3244-283P. Of this, total domestic
demand was QD=1700-107P and Domestic supply was QS=1944+207P.

Suppose export demand for wheat falls by 40%.

(i)Us farmers are concerned about this drop in export demand. What happens to the
free market price of wheat in the US? Do farmers have much reason to worry?

(i)Now suppose US government wants to buy enough wheat to raise the price to
3.50 dollar per bushel. With the drop in export demand, how much wheat would the
government have to buy? How much would this cost to government?

32
 Problems

Find out the Demand curve when price

elasticity of demand is a constant.

Derive Demand function when the price

elasticity is a linear function of price.

33
Solution 1:
p dq
Price elasticity of demand is given by 
q dp

Now in this problem Price elasticity of demand is constant.

So, p dq
 c
q dp

Integrating both sides we get,

dq dp
 q k  p  log q k log p  c
 log q log p k  c
 log q  log p k c
 log( q / p k ) c
k c a log ea
 q / p e (let , log  z  e e e z  a e z )
 q  p k e c
 q c / p k ( where, e c c / ) This is the demand Curve34
Solution 2:
According to the question
p dq
e p   a  bp
q dp
p dq
  a  bp
q dp
dq p dp dp
 (a  bp) / (a  bp)  a   b dp
q dp p p

Taking integral on both sides we get,

dq dp
 q a  p  b dp
 log q [ a log p  bp ]  k
 log q log p a  bp  k
 log( q / p a ) bp  k
 q / p a e bp  k
 q  p a [e bp  k ] This is the demand function 35
Income Elasticity of Demand

36
The income elasticity is defined as the proportionate change in the quantity
demanded resulting from a proportionate change in income. Symbolically

dQ / Q Y dQ
ey   
dY / Y Q dY

It is a measure of the percentage change in quantity demanded resulting from a 1

percent change in income.

As before, we turn to arc elasticity for the actual calculation of income elasticity

(Q2  Q1 ) (Y2  Y1 )
EY  
(Q2  Q1 ) / 2 (Y2  Y1 ) / 2

37
Income elasticity of demand being 0 is of great significance. It implies
that a given increase in income does not at all lead to any increase in
quantity demanded of a good or expenditure on it. It is significant
because it represents dividing line between positive income elasticity
and negative income elasticity.

When income elasticity is more than 0 (positive), then an increase in

income leads to the increase in quantity demanded of the good. This
happens in case of Normal Goods.

When income elasticity is less than 0, increase in income will lead to

the fall in quantity demanded. Goods having negative elasticity are
called Inferior Goods. These goods will be demanded by the
consumers whose incomes are low: but as income rises, and
consumers feel “better off”, they will shift consumption to goods more
commensurate with their new economic status.
38
A commodity is considered to be a Luxury, if its income elasticity is
greater than unity. These commodities take larger proportion of
consumer’s income as income increases.

A commodity is a Necessity, if its income elasticity is small (less than

unity usually)

The three categories are

Income Elasticity>1: Superior goods/ Luxury goods

Income elasticity≥ 0 and ≤ 1: Normal goods
Income Elasticity<0: Inferior Goods

39
 Determinants of Income Elasticity

 The nature of the need that the commodity covers: the percentage
of income spent on food declines as income increases. (Engel’s
Law)

The initial level of income of a country: For example, a TV set is

luxury in an underdeveloped, poor country while it is a “necessity”
in a country with higher per capita income.

The time period, because consumption patterns adjust with a time-

lag to changes in income.

40
 Empirical Studies on Income Elasticities

Short-run income elasticity for food expenditure has been estimated to be about
0.5 and the elasticity of restaurant meals 1.6. The results show that as incomes rise,
spending for food eaten at home increases at a slower rate than income, and, thus,
takes up a smaller portion income. In contrast, the expenditure on restaurant meals
rises substantially more rapidly as income rises, thus becoming a higher portion of
income.

The short-run income elasticity for jewelry and watches appeared to be 1.;
however, the elasticity in the long-run was estimated at 1.6. Apparently, consumers
take some time to adjust their demand.

41
Cross-Price Elasticity of Demand

42
The cross-elasticity of demand is defined as the proportionate change
in the quantity demanded of x resulting from a proportionate change
in the price of y. It is actually the impact on the quantity demanded
of a particular product created by a price change in a related product.
Symbolically,

dQx dPy dQx Py

exy ( )/  
Qx Py dPy Qx
Again, we run into a little problem regarding the P and Q in the above
expression and arc elasticity comes to the rescue.

(Q2 A  Q1 A ) ( P2 B  P1B )
Exy  
(Q2 A  Q1 A ) / 2 ( P2 B  P1B ) / 2
43
What is the meaning of related products? In economics, we talk of two
types of relationships: substitute goods and complementary goods.

Much of the time when we consider cross-elasticity we are dealing

with similar products (not just different brands of the same product) in
a more general sense. Thus chicken and beef can be considered to be
substitutes. Sign of cross-elasticity is positive in this case.

Other instances of substitutes come to mind easily: coffee and tea,

aluminum and steel, glass and plastic.

Complements are products that are consumed or used together. Sign

of cross-elasticity is negative in this case.

Examples of complementary products are: tennis racket and tennis

balls, stereo sets and CDs, personal computer and floppy disks. 44
Problem

Calculate Cross elasticities (exy in the first case and exz in the second case)

Before After
Commodit Price Quantity Price Quantity
y

Coffee (Y) 40 50 60 30
Tea (X) 20 40 20 50

Before After
Commodity Price Quantity Price Quantity

Lemon (z) 10 20 20 15
Tea (x) 20 40 20 35
45
 Empirical Studies on Cross-elasticity

 A study of the residential demand for electric energy found the

cross-elasticity with respect to prices of the gas energy to be low,
about +0.13.

Aluminum’s cross-elasticity of demand with respect to prices of

steel was estimated at about +2.0, and even somewhat higher with
respect to copper.

The cross-elasticity of demand for beef with respect to pork prices

was calculated to be +0.25. With respect to prices of chicken, it was
about +0.12. Both numbers indicate that products are substitutes,
but in this study, the elasticity coefficients were relatively low.

The cross-elasticity for domestic and imported cigarettes in Taiwan

is a +2.78, indicating that they are substitutes. 46