Elasticity of Demand

Elasticity of Demand
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
DEMAND ANALYSIS AND ELASTICITY OF DEMAND

The elasticity of demand measures the responsiveness of the quantity demanded of a good, to change in its price, price of other goods and changes in consumers income. Elasticity of Demand are of four types. 1.Price elasticity of demand. a. Perfectly elastic demand. (Infinite) b. Perfectly inelastic demand ( Zero) c. Unitary elastic demand (One) d. Highly elastic demand e. Less elastic demand. 2.Income elasticity of demand. 3.Cross elasticity of demand. 4.Advertisement elasticity of sales.
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)
Elasticity
Price (Rs)
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

From Formula Ep = % Change in Qd % Change in Price If Price Elasticity of Demand > 1, demand is elastic If Price Elasticity of Demand = 1, demand is unit elastic If Price Elasticity of Demand < 1, demand is inelastic
Demand Elasticity
Elastic Demand When % Change in Quantity Demanded > % Change in Price Unit Elastic Demand When % Change in Quantity Demanded = % Change in Price Inelastic Demand When % Change in Quantity Demanded < % Change in Price Perfectly Elastic Demand When Quantity Demanded Changes by a very large percentage in response to an almost zero Change in Price Perfectly Inelastic Demand When the Quantity Demanded remains constant as Price changes
Price Elasticity of demand and Total Revenue

TR=PX Q
If Ed>1, then %Qd>%P. TR is increasing as the price falls. If Ed<1, then %Qd<%P. TR is decreasing as the price falls. If Ed=1, then %Qd=%P. TR remains unchanged over this segment of the demand curve.
Price Elasticity of demand

P Ed > 1 P TR TR
Elasticities, Price Changes, and Total Revenue

Exhibit 3
P Ed < 1 P
TR TR
P Ed = 1 P
TR TR
Transparency 18- 7

Exhibit 1
ELAS TICITY RES PONS IVENES S OF QUANTITY COEFFICIENT DEMANDEDTO A CHANGE IN PRICE Ed > 1 Quantity de mande d c hang e s pro po rtio nate ly mo re than pric e c hang e s : %Qd > %P. Quantity de mande d c hang e s pro po rtio nate ly le s s than pric e c hang e s : %Qd < %P. Quantity de mande d c hang e s pro po rtio nate ly to pric e c hang e : %Qd = %P. Quantity de mande d is e xtre me ly re s po ns ive to e ve n ve ry s mall c hang e s in pric e . Quantity de mande d do e s no t c hang e as pric e c hang e s . TERMINOLOGY Elas tic
Ed < 1
Ine las tic
Ed = 1
Unit e las tic
Ed =
Pe rfe c tly e las tic
Ed = 0
Transparency 18- 3
Pe rfe c tly ine las tic

Exhibit 2 (1 of 3)
Pric e Part (a) Ed > 1 Elas tic P2 P1 10% D 20% P2 P1 10% Pric e Part (b) Ed < 1 Ine las tic
4% D
Q2 Q1 Quantity De mande d
Q2 Q1 Quantity De mande d
Transparency 18- 4

Exhibit 2 (2 of 3)
Pric e Part (c )
Ed = 1 Unit Elas tic P2 P1 10% D
10%
Q2 Q1 Quantity Demande d
Transparency 18- 5

Exhibit 2 (3 of 3)
Pric e Part (d) Pric e Part (e ) D
P2 P1
Ed = Pe rfe c tly Elas tic 1% D
Ed = 0 Pe rfe c tly Ine las tic P2 P1 10%
Q1 Quantity Demande d
Q1 Quantity Demande d
Transparency 18-

The Determinants of price elasticity of demand:
1) The availability of substitutes 2) The time it takes for consumers to adjust their behavior in response to a change in price 3) The proportion of the expenditure in the budget of the consumer 4) Necessity vs. Luxury
Income elasticity of demand
% Qd Ey =
% Y
Y income
At a given price, how much will the quantity demanded change when the incomes of consumers change? Not a movement along the demand curve but a shift in the demand curve.
Cross elasticity of demand
% Qdx Exy =
Substitute goods
% Py
The responsiveness of consumers to changes in the price of a related good.
Exy is a positive coefficient.
Complementary goods
Exy is a negative coefficient.
Price elasticity of supply
% Qs Es =
% P
The responsiveness of suppliers (producers) to price changes. E A movement along the supply curve.
The elasticity of supply coefficient is positive (the law of supply).
Determinants of price elasticity of supply

1) The availability of resource inputs (the elasticity of supply of the factors of production). 2) The time period under consideration. As time passes supply becomes more elastic.
Elasticity
Price
Total revenue is price x quantity sold. In this example, TR = Rs 5 x 100,000 = Rs 500,000. This value is represented by the grey shaded rectangle.
Rs 5
Total Revenue
Quantity Demanded (000s)
Elasticity
Price
If the firm decides to decrease price to (say) Rs 3, 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
Rs3
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
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
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%
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
% Price of good X __________________ % Price of good Y
Xed =
Elasticity
Goods which are complements:
Cross Elasticity will have negative sign (inverse relationship between the two)
Goods which are substitutes:

Cross Elasticity will have a positive sign (positive relationship between the two)
Elasticity
Advertising elasticity of demand
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
DETERMINANTS OF PRICE ELASTICITY OF DEMAND

1. 2. 3. 4. Availability of Substitutes-the higher the degree of closeness of the substitutes, the greater the elasticity of demand for the commodity. Nature of Commodity-luxuries, comforts and necessities. Weightage in the total consumption-if proportion of income spent on a commodity is large, its demand will be more elastic and vice versa. Time factor in adjustment of consumption pattern-the time consumers need to adjust their consumption pattern to a new price: the longer the time allowed, the greater the elasticity. Range of commodity use-the wider the range of the uses of a product, the higher the elasticity of demand for the decrease in price. Proportion of market supplied-if less than half of the market is supplied at the ruling price, price elasticity of demand will be higher than 1 and if more than half of the market is supplied then elasticity will be less than 1.
5. 6.
MANAGERIAL USES OF ELASTICITY OF DEMAND

1. Determination of Price Under Monopoly-a) If the demand for his product is elastic he will earn more profit by fixing a low price. Low price means large sales and hence, large total revenue. b) If the demand is inelastic, he will be in a position to fix up high price. Basis of Price Discrimination- When a monopolist sells his product at different prices, it is called price discrimination. On the basis of elasticity he can charge various prices from the customers. Determination of Wages-If the demand for labour in an industry is elastic, strikes and other trade union tactics will not be of any avail in raising wages. Advantage to Finance Minister-a) Taxes on goods having elastic demand will yield less revenue. It is because of the fact that taxes will raise their prices and thus bring down their demand and finally it means less revenue, b) Goods having inelastic demand are taxed at a higher rate. No doubt the price of the goods will rise on account of these taxes but there will be little fall in their demand.
2.
3.
4.
5.
6. 7.
8.
Determination of Prices of Public Utilities-Where the demand for services is inelastic, a high price is charged, while in the case of elastic demand a lower price is charged. That is why, household consumers are charged a high rate of electricity than industrial or agricultural customers. International Trade-Those exports with inelastic demand will fetch high price. The knowledge of income elasticity can be useful in forecasting demand, when a change in personal incomes is expected. It thus helps in avoiding over production or under production. The concept of cross elasticity is of vital importance in changing price of products having substitutes and complementary goods. If cross elasticity in response to the price of substitutes is greater than 1, it would be inadvisable to increase the price; rather, reducing the price may prove more benecial.
Relationship between AR, MR, TR and Elasticity of Demand
Relationship between TR, AR and MR(As discussed in the class) Utility analysis and Indifference Curve analysis discussed in the class

Elasticity of Demand

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Elasticity of Demand

Elasticity the concept

Elasticity the concept

DEMAND ANALYSIS AND ELASTICITY OF DEMAND

Price Elasticity of Demand

Price Elasticity of demand and Total Revenue

Price Elasticity of demand

Elasticities, Price Changes, and Total Revenue

Price Elasticity of demand

Ine las tic

Unit e las tic

Pe rfe c tly e las tic

Pe rfe c tly ine las tic

Price Elasticity of demand

Price Elasticity of demand

Ed = 1 Unit Elas tic P2 P1 10% D

Price Elasticity of demand

Ed = Pe rfe c tly Elas tic 1% D

Ed = 0 Pe rfe c tly Ine las tic P2 P1 10%

Price Elasticity of demand

Income elasticity of demand

Cross elasticity of demand

The responsiveness of consumers to changes in the price of a related good.

Exy is a positive coefficient.

Exy is a negative coefficient.

Price elasticity of supply

The elasticity of supply coefficient is positive (the law of supply).

Determinants of price elasticity of supply

Quantity Demanded (000s)

Producer decides to lower price to attract sales

A negative sign denotes an inferior good

Goods which are substitutes:

DETERMINANTS OF PRICE ELASTICITY OF DEMAND

MANAGERIAL USES OF ELASTICITY OF DEMAND

Relationship between AR, MR, TR and Elasticity of Demand

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