Elasticity of Demand

by

Balaji K

2

Overview Elastic Vs Inelastic Demand Difference between elastic, inelastic, and unitary

elastic demand/supply Types of Elasticity of Demand Determinants of price elasticity of demand Income elasticity Cross price elasticity of demand

3

Elasticity of Demand

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

4

Elasticity - Concept

D

According to Marshall “The elasticity of demand in a market is great or small according as the amount demanded increases much or little for a given fall in the price and diminishes much or little for a given rise in Price”

5

Elastic Demand

D

“A small change in price may lead to a great change in quantity demanded.In this case ,demand is elastic”

Price in Rs Quantity Demanded of milk

25 1 litre

24 2 litre

27 0.5 litre

Demand is elastic if the percentage change in quantity is greater than the percentage change in price.

E > 1

6

InElastic Demand

D

“A big change in price followed by small change in quantity demanded.In this case ,demand is inelastic”

E < 1Price in Rs Quantity Demanded of

milk

25 1 litre

14 1.2 litre

20 1.5 litre

7

Types of Elasticity

D

1.Price Elasticity

a)Perfectly Elastic

b)Perfectly Inelastic

c)Relatively Elastic

d)Relatively Inelastic

e)Unit Elasticity of Demand

8

Types of Elasticity

D

2.Income Elasticity

a)Zero Income Elasticity

b)Negative Income Elasticity

c)Unit Income Elasticity

d)Income Elasticity greater than unity

e)Income Elasticity less than unity

3.Cross Elasticity of Demand

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Price Elasticity

D

The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price.

10

Part 1: Price Elasticity of Demand - Calculation

Base value for percentage changes in price or quantity is always midway between initial value and new value

Denominator

- Define the percentage change in price from any value P0 to any other value P1 as

2

)(

)( Price in Change %

PPPP

01

01

• Numerator: When quantity demanded changes from Q0 to Q1,

percentage change is calculated as

2

)_( DemandedQuantity in Change %

01

01

QQQQ

11

Figure 1: Calculating Price Elasticity of Demand-- laptop computer demand

Quantity of Laptops

C

Price per Laptop

100,000 200,000 300,000 400,000 500,000 600,000

$3,500

3,000

2,500

2,000

1,500

1,000

B

A

D

D

12

Calculating Price Elasticity of Demand -- An Example

Now let’s calculate an elasticity of demand for laptop computers using data in Figure 1 from point A to point B

% 2.18or ,182.0000,550

000,100

2)000,600000,500()000,600000,500(

Q%

• Use percentage changes for price and quantity to calculate price elasticity of demand ( )

% 40.0or ,400.0250,1$

500$

2

)000,1$500,1($)000,1$500,1($

P %

46.0400.0

182.0D

D

13

Calculating Price Elasticity of Demand -- by Total Outlay Method

Price in Rs Quantity Demanded

Total Outlay

4.50 4 18

4 4.5 18

3 6 18

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Price Elasticity of Demand -- Categorize Goods

Inelastic DemandPrice elasticity of demand between 0 and -1

1.0 P%

Q % Demand Inelastic

|% Change in Quantity Demanded| < |% Change in Price|

• Extreme Case: Perfectly Inelastic Demand– Price elasticity of demand equal to 0

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Categorizing Goods by Elasticity• Elastic Demand

– Price elasticity of demand with absolute value > 1

|% Change in Quantity Demanded| > |% Change in Price|

• Extreme Case: Perfectly (infinitely) Elastic Demand– Price elasticity of demand approaching minus infinity

• Another Special Case: Unitary Elastic Demand– Price elasticity of demand equal to -1

1 P %

Q % Demand Elastic

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Figure 2: Extreme Cases of Demand

D

Perfectly Inelastic Demand

(a)

Quantity

Price per

Unit

1

2

3

$4

20 40 60 80 100

(b)

D

Quantity20 40 60 80 100

1

2

3

$4

Price per

Unit

Perfectly Elastic Demand

Perfectly Elastic Demand CurveThe demand curve is horizontal, any change in price can and will cause consumers to change their consumption.

Perfectly Inelastic Demand CurveThe demand curve is vertical, the quantity demanded is totally unresponsive to the price. Changes in price have no effect on consumer demand.

In between the two extreme shapes of demand curves are the demand curves for most products

17

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Figure 3: Relationship between demand slope and elasticity

Elasticity Elasticity = |(1/slope)*(P/Q)|= |(1/slope)*(P/Q)|

Quantity

PRICE

Perfectly elastic

Perfectly inelastic

Relatively Inelastic Demand

Relatively Elastic Demand

Elasticity Along a Demand CurveP

rice

$10987654321

0 1 2 3 4 5 6 7 8 9 10 Quantity

Elasticity declines along demand curve as we move toward

the quantity axis

Ed = 1

Ed = 0

Ed < 1

Ed > 1

Ed = ∞

Relatively Inelastic

Perfectly Inelastic

Unit Elastic

Relatively Elastic

Perfectly Elastic

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Elasticity and Total Revenue

Total revenue (TR) of all firms is defined as TR = P x Q

Rule: when two numbers are both changing, percentage change in their product is (approximately) the sum of their individual percentage changes Applying this to total revenue

Example: assume demand is unitary elastic and Q rises by 10% % Change in TR = 10% + (-10%) = 0

PQTR %%%

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Figure 4(a): When does it pay to raise the price?

Price increases from P0 to P1 and quantity demanded decreases from Q0 to Q1

Quantity

PRICE

Demand

P1

P0

Q1 Q0

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Figure 4(b): When does it pay to raise the price? How about revenue change?

Quantity

PRICE

Demand

P1

P0

Q1 Q0

Change in total revenue =

P1Q1-P0Q0

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Figure 4(c): When does it pay to raise the price? How much is the change in total revenue?

Quantity

PRICE

Demand

P1

P0

Q1 Q0

Change in total revenue =

P1Q1-P0Q0

Loss = P0*(Q0 - Q1)

= P0 ΔQ

Gain = Q1(P1 – P0)

= Q1ΔP

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Figure 5 Effects of Price Changes on Expenditure

W here demand is: A price increase will: A price decrease will:

Ine lastic ( | | < 1) increase expenditure decrease expenditure unitary e lastic ( | | = 1) cause no change in

expenditure cause

no change in

expenditure

e lastic ( | | > 1) decrease expenditure increase expenditure

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Elasticity & Straight-Line Demand Curves

Look at percentage change in P Look at percentage change in Q As we move upward and leftward by equal distances,

percentage change in quantity rises Percentage change in price falls

Elasticity of demand varies along a straight-line demand curve Demand becomes more elastic as we move upward

and leftward

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0

2

4

6

8

10

0 10 20 30 40 50

PRICE

QUANTITY

1

(1/ ) 5

DPE slope Q

slope fixed

As P increases, Q falls, elasticity gets bigger

| ED | > 1

elastic

| ED | = 1

Unit elastic

| ED | < 1

inelastic

2525

55

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Small SummaryInelastic

Demand

Unitary Elastic Demand

Elastic Demand

Definition |ED| <1 |ED| =1 |ED| >1

Total Revenue Same direction as price change

Does not change with price

change

Opposite direction

from price

Straight Line Demand Curve

Lower segment

Middle point Upper segment

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What Affects Elasticity? -- 1. Availability of Substitutes

Demand is more elastic If close substitutes are easy to find and buyers

can cut back on purchases of the good in question

Demand is less elastic If close substitutes are difficult to find and

buyers can not cut back on purchases of the good in question

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What Affects Elasticity? -- 2. Narrowness of Market

More narrowly we define a good, easier it is to find substitutesMore elastic is demand for the good

More broadly we define a goodHarder it is to find substitutes and the less

elastic is demand for the good Different things are assumed constant

when we use a narrow definition compared with a broader definition

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What Affects Elasticity? -- 3.Necessities vs. Luxuries

The more “necessary” we regard an item, the harder it is to find a substituteExpect it to be less price elastic

The less “necessary” (luxurious) we regard an item, the easier it can be substitutedExpect it to be more price elastic

Example?

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What Affects Elasticity? -- 4. Time Horizon

Short-run elasticity Measured a short time after a price change

Long-run elasticity Measured a year or more after a price change

Usually easier to find substitutes for an item in the long run than in the short run Therefore, demand tends to be more elastic in the

long run than in the short run

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What Affects Elasticity? -- 5. Importance in the Buyer’s Budget

The more of their total budgets that households spend on an itemThe more elastic is demand for that item

The less of their total budgets that households spend on an itemThe less elastic is demand for that item

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Importance of Elasticity of Demand

Price Fixation Production Distribution International Trade Public Finance

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Figure 6 Some Short-Run Price Elasticities of Demand

Specific Brands Narrow Categories Broad Categories

T ide Detergent – 2.7 9 Transatlantic A ir Travel – 1.3 0 Recreation – 1.09 Tourism in Thailand – 1.2 0

Pepsi – 2.08 G round Beef – 1.02 C loth ing – 0.89 Coke – 1.7 1 Pork – 0.7 8 Food – 0.6 7

M ilk – 0.5 4 Im ports – 0.5 8 C igarettes – 0.45 Transportation – 0.5 6 E lectric ity – 0.40 to – 0.5 0 Beer – 0.2 6 Eggs – 0.2 6 G asoline – 0.2 0 O il – 0.1 5

inelastic

elastic

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Part 2: Income Elasticity of Demand Percentage change in quantity demanded

divided by the percentage change in income With all other influences on demand with the price of

the good kept constant

Y %

Q %

Incomein Change %

DemandedQuantity in change %Y

• Interpretation: percentage increase in quantity demanded for each 1% rise in income

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Income Elasticity of Demand vs. Price Elasticity of Demand

Price elasticity measures sensitivity of demand to price as we move along a demand curve from one point to another

Income elasticity tells us relative shift in demand curve—increase in quantity demanded at a given price

While a price elasticity is virtually always negative, income elasticity can be positive or negative Normal goods Inferior goods

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Income Elasticity of Demand Economic necessity

Good with an income elasticity of demand between 0 and 1 Economic luxury

Good with an income elasticity of demand greater than 1 An implication

As income rises, proportion of income spent on economic necessities will fall

While proportion of income spent on economic luxuries will rise

But, it is important to remember that economic necessities and luxuries are categorized by actual consumer behavior Not by our judgment of a good’s importance to human survival

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Income Elasticity of DemandZero Income Elasticity Quantity demanded remains the same, even though money income increases. E=0

Negative Income ElasticityWhen income increases,quantity demanded falls(E<0)

Unit ElasticityWhen an increase in income brings about a proportionate increase in quantity demanded

,then income elasticity of demand is equal to 1(E=1)

Income Elasticity Greater Than UnityIn this case,an increase in income brings about a more than Proportionate increase in

quantity demanded.(E>1)

Income Elasticity Less Than UnityWhen income increases quantity demanded also increases but less than

Proportionately(E <1)

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Figure 9 Some Income Elasticities

Income Elasticity

Income Elasticity Good or Service Good or Service

F resh F ru it 1 .99 Im ports 2.7 3 C om puters 1.7 1 Transatlantic A ir Travel 1 .40 Transportation 1.7 9 C ollege Education 0.5 5 C igarettes 0.5 0 R ecreation 1.0 7 C hicken 0.42 C loth ing 1.02 Pork 0.3 4 F ood 0.60 to 0 .85 Fresh Vegetables 0.2 6 Tooth Extraction – 0.1 3 to 0 .4 7 G round Beef – 0.2 0 B read – 0.42 Potatoes – 0.8 1 Luxury (>1), Necessity (0<EY <1),

Normal (>0) and Inferior (<0) Goods defined by Income elasticties

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Part 3: Cross-Price Elasticity of Demand Cross-price elasticity of demand

Percentage change in quantity demanded of one good (x) caused by a 1% change in price of another good (z)

While all other influences on demand remain unchanged

z

x

P

Q

%

%XZ

• % Change in Quantity of Prod X / %Change in Price of

Prod Y• Substitutes (+)• Complements (-)

• Its size tells us how closely the two goods are related– A large absolute value for suggests that the two goods

are close substitutes or complements

xz

41

Thank You

Complements (-) vs Substitutes (+)

defined by sign of cross price elasticity