chap 3-elasticity of demand

8/3/2019 Chap 3-Elasticity of Demand

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Elasticity of Demand

Rabin Mazumder; Faculty of Economics


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Elasticity measures

What are they? Responsiveness measures

Why introduce them? Demand and supply responsiveness clearly

matters for lots of market analyses. Why not just look at slope? Want to compare across markets: inter

market Want to compare within markets: intra market slope can be misleading want a unit free measure



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Why Economists UseElasticity

An elasticity is a unit-free measure.

By comparing markets usingelasticities it does not matter howwe measure the price or the quantityin the two markets.

Elasticities allow economists toquantify the differences amongmarkets without standardizing theunits of measurement.



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What is an Elasticity?

Measurement of the percentage change in onevariable that results from a 1% change inanother variable.

- These variables are price of the commodity,

prices of the related commodities, income of the consumer & other various factors on whichdemand depends. Thus, we have

i. Price Elasticity,ii. Income Elasticity,

iii. Cross Elasticity,iv. Arc Elasticity.

It is always price elasticity of demand which isreferred to as elasticity of demand



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Price elasticity of demand : Keeping other

things constant it is the percentagechange in quantity demanded due to apercentage change in the price.

price elasticity of demand % change in quantity demandedchange in price%

P = Current price of good XQ = Quantity demanded at that priceP = Small change in the current price Q= Resulting change in quantity demanded ep= Price elasticity of demandep =

Mathematically:

Q/Q

P/P (-) -ve sign indicates that there is an inverse

relationship between price & quantity demanded


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Factors affecting Elasticityof Demand

1. Availability of substitutes2. Postponement of consumption3. Proportion of expenditure (needles: inelastic; TV:

elastic)4. Nature of the commodity (necessity vs. luxury;

durability/reparability eg., shoes)5. Different uses of the commodity (paper vs. ink)6. Time period (elastic in the long term)7. Change in income (necessaries: inelastic; milk and fruit

for a rich man)8. Habits9. Joint demand10. Distribution of income11. Price level (very costly & very cheap goods: inelastic)



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Types of PriceElasticity of Demand



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Elastic Demand

When quantity demanded responds more thanthe price changes then it is called elasticdemand

Here, e p>1

P0P1

Q0 Q1

AB

0 Q

PLuxurious commodity


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Inelastic Demand

When quantity demanded responds lessthan the price changes then it is calledinelastic demand.

Here, e p < 1

P0P1

Q0 Q1

A

B

0 Q

PNecessary commodities


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Perfectly Elastic Demand Demand is perfectly elastic when 1%

change in the price would result in aninfinite change in quantity demanded .

Price

Quantity

Perfectly Elastic Demand (elasticity = )

0

Po

Qo Q1

Super

Luxurious

Commodities


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Perfectly Inelastic Demand

Demand is perfectly inelastic when 1%change in the price would result in nochange in quantity demanded.

0

Price

Quantity

Perfectly InelasticDemand (elasticity= 0)

P1

Po

Qo

SupernecessaryCommodities


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Income Elasticity of Demand

Other things remaining constant, thepercentage change in quantitydemanded of a good to a smallchange in the income of theconsumer.

E I= Q X/Q X / I/I



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When the income elasticity of demandis positive (normal good), consumersincrease their purchases of the goodas their incomes rise (e.g.automobiles, clothing).

When the income elasticity of demandis greater than 1 (luxury good),consumers increase their purchases of the good more than proportionate tothe income increase (e.g. Diamond).

When the income elasticity of demandis negative (inferior good), consumersreduce their purchases of the good astheir incomes rise (e.g. potatoes).


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Income elasticityTypes: Zero Negative Positive (i) low (ii) unitary (iii) high

Income elasticity and business decisions1.If e i is >0 but 1, sales will increase more rapidly than

general economic growth3. Corollary: in a growing economy while farmerssuffer as their products have low incomeelasticity, industrialists gain as their productshave high income elasticity.



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Cross Price Elasticitycross-price elasticity for complementary good isnegative because as the price of a complementarygood rises, the quantity demanded of the good itself falls. Example : software is complementary with

computers. When the price of software rises thequantity demanded of computers falls.

cross-price elasticity for substitute good ispositive because as the price of a substitute goodrises, the quantity demanded of the good itself rises.

Example : hockey is substitute for basketball.When the price of hockey tickets rises thequantity demanded of basketball tickets rises.



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Complements andSubstitutes

The demand curve for good X shifts withchanges in the price of good Y

Q

PPrice of a complement falls

Price of a substitute rises

Price of a complement risesPrice of a substitute falls

0 Rabin Mazumder; Faculty of Economics

h d f


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Methods of measurementof Elasticity

1. Percentage or Proportionate Method

= Percentage change in demandPercentage change in price

or;

= Proportionate change in demandProportionate change in price

2. Total Outlay (Expenditure) MethodsTO=TQ* P ; where,TO=total outlay; TQ=total quantity; P=price of thecommodity

3. Geometric (Point) method at any given point on thecurve

= lower segment of demand curveupper segment of demand curve Rabin Mazumder; Faculty of Economics

l f d


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Price Elasticity of Demandand Total Revenue

If the price elasticity of demand is > 1,then a reduction in price will increasedemand more than proportionately and TR(P x Q) will increase.

If the price elasticity of demand = 1, thena reduction in price will increase demandin proportion and TR will be unchanged

If the price elasticity of demand is < 1,then a reduction of price will increasedemand less than proportionately and TRwill fall.


P i El i i f D d


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Price Elasticity of Demandand Total Revenue

E = 1

D

P

Q

Q

TR

E > 1

E < 1

TRfalling

Max TR

TRrising

0

0


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The effect of a price change on revenuedepends on the elasticity of demand

Type of

demand Value of E d Price quantity Effect on total revenueElastic More than -

1.0P decreasesP increases

Q increasesQ decreases

Total revenue increasesTotal revenue decreases

Inelastic Between 0and -1.0

P decreases

P increases

Q increases

Q decreases

Total revenue decreases

Total revenue increases

Unitaryelastic

Equal to -1.0 P decreasesP increases

Q increasesQ decreases

Total revenue unchangedTotal revenue unchanged

Rabin Mazumder; Faculty of

chap 3-elasticity of demand

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