Elasticity of Demand

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Elasticity of Demand

(2)

Elasticity – the concept

•• The responsiveness of one variable to

The responsiveness of one variable to

changes in another

•• When price rises, what happens to

When price rises, what happens to

demand?

•• Demand falls

Demand falls

BUT!

(3)

Elasticity – the concept

•

• _{If price rises by 10% - what happens to}

_{If price rises by 10% - what happens to}

demand?

•• We know demand will fall

We know demand will fall

•• By more than 10%?

By more than 10%?

•• By less than 10%?

By less than 10%?

•

• _{Elasticity measures the extent to which}

_{Elasticity measures the extent to which}

demand will change

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DEMAND ANALYSIS AND ELASTICITY OF

DEMAND ANALYSIS AND ELASTICITY OF DEMANDDEMAND

““The elasticity of demand measures the responsiveness of the quantity demanded of aThe 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 consumer’s

good, to change in its price, price of other goods and changes in consumer’s income

income.”.”

Elasticity of Demand are of four types. Elasticity of Demand are of four types. 1.Price elasticity of demand.

1.Price elasticity of demand. a.

a. PerPerfefecctltly ely elasasttic dic dememanand. (d. (IInfnfininitite)e) b.

b. PerPerfefecctltly y iinenelalaststiic dc dememanand ( d ( ZeZeroro)) c

c.. UUnniittaarry y eellaassttiic c ddeemmaannd d ((OnOnee)) d

d.. HiigHghhlly y eellaassttiic c ddeemmaannd d e

e.. LeLesss s eellaassttiic c ddeemmaanndd..

2.Income elasticity of demand. 2.Income elasticity of demand. 3.Cross elasticity of demand. 3.Cross elasticity of demand.

4.Advertisement elasticity of sales. 4.Advertisement elasticity of sales.

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Elasticity

•

• _{Price Elasticity of Demand}

_{Price Elasticity of Demand}

–

– The responsiveness of demandThe responsiveness of demand to changes in price

to changes in price –

– Where % change in demandWhere % change in demand

is greater than % change in price –

is greater than % change in price – elasticelastic

–

– Where % change in demand is less than %Where % change in demand is less than % change in price

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Elasticity

The Formula: The Formula: Ped = Ped = ___________________________ ___________________________ % Change in Price % Change in Price

% Change in Quantity demanded % Change in Quantity demanded

If answer is between 0 and -1: the relationship is inelastic If answer is between 0 and -1: the relationship is inelastic

If the answer is between -1 and infinity: the relationship is elastic If the answer is between -1 and infinity: the relationship is elastic

Note: PED has – sign in front of it; because as price rises Note: PED has – sign in front of it; because as price rises demand falls and vice-versa (inverse relationship between demand falls and vice-versa (inverse relationship between price and demand)

(7)

Elasticity

•

• The demand curve can be a range of The demand curve can be a range of shapes each of which is associated shapes each of which is associated with a different relationship between with a different relationship between price and the quantity demanded. price and the quantity demanded.

Price (Rs) Price (Rs)

Quantity Demanded Quantity Demanded

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Price Elasticity of Demand

•• From Formula Ep = % Change in QdFrom Formula Ep = % Change in Qd % Change in Price % Change in Price

•• If Price Elasticity of Demand > 1, demand is elasticIf Price Elasticity of Demand > 1, demand is elastic

•• If Price Elasticity of Demand = 1, demand is unit elasticIf Price Elasticity of Demand = 1, demand is unit elastic •• If Price Elasticity of Demand < 1, demand isIf Price Elasticity of Demand < 1, demand is

inelastic inelastic

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Demand Elasticity

•• Elastic Demand – When % Change in QuantityElastic Demand – When % Change in Quantity Demanded > % Change in Price

Demanded > % Change in Price

•• Unit Elastic Demand – When % Change in QuantityUnit Elastic Demand – When % Change in Quantity Demanded = % Change in Price

Demanded = % Change in Price

•• Inelastic Demand – When % Change in Inelastic Demand – When % Change in QuantityQuantity Demanded < % Change in Price

Demanded < % Change in Price

•• Perfectly Elastic Demand – Perfectly Elastic Demand – When Quantity DemandedWhen Quantity Demanded Changes by a very large percentage in response to an Changes by a very large percentage in response to an almost zero Change in Price

almost zero Change in Price

•• Perfectly Inelastic Demand – When the QuantityPerfectly Inelastic Demand – When the Quantity Demanded remains constant as Price changes Demanded remains constant as Price changes

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Price Elasticity of demand and Total

Revenue

•• TR=P

TR=P X

X Q

Q

•• If EIf Edd>1, then %ΔQ>1, then %ΔQdd>%ΔP. >%ΔP. TR TR is is increasing increasing asas

the price falls. the price falls.

•• If EIf Edd<1, then %ΔQ<1, then %ΔQdd<%ΔP. <%ΔP. TR TR is is decreasing decreasing asas

the price falls. the price falls.

•• If EIf Edd=1, then %ΔQ=1, then %ΔQdd=%ΔP. =%ΔP. TR TR remainsremains

unchanged over this segment of the demand unchanged over this segment of the demand curve.

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Price Elasticity of demand

Tra

Transnspaparerencncy 1y 18-8- 77

Elasticities, Elasticities, Price Changes, Price Changes, and Total and Total Revenue Revenue Exh Exhibit ibit 33 Elasticities, Elasticities, Price Changes, Price Changes, and Total and Total Revenue Revenue Exh Exhibit ibit 33

E E_d_d > > 11 P P ↑↑ TTR R ↓↓ P P ↓↓ TTR R ↑↑ E E_d_d < < 11 P P ↑↑ TTR R ↑↑ P P ↓↓ TTR R ↓↓ E E_d_d = = 11 P P ↑↑ P P ↓↓ T TR R T TR R

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Price Elasticity of demand

T

Traransnsparpareencncy 1y 18-8- 33

Price Elasticity of Demand Price Elasticity of Demand

Exhibit 1 Exhibit 1

Price Elasticity of Demand

Exhibit 1

ELAS

ELAS TITICITCITYY COEFFICIENT COEFFICIENT

RES

RES PPONSONS IIVVENESENES S S OF QUANTOF QUANTIITTYY DEMANDEDTO A CHANGE IN PRICE

DEMANDEDTO A CHANGE IN PRICE TERMINOLOGYTERMINOLOGY

E

Edd > > 11 QQuuaannttiitty y ddee mmaannddee d d cc hhaanngg ee s ps p rroo ppoo rrttiioo nnaattee llyy EEllaas ts tiicc mor

more e tthan prhan priice ce changchang eses : %: %∆∆Q_Qd_{d >}> %%∆∆PP.. E

Edd < < 11 QQuuaannttiitty y ddee mmaanndde d e d c hc haanng eg es ps prroo ppo ro rttiio no naattee llyy IInne le laas ts tiicc lleses s s tthan phan prriice ce changeschanges : : %%∆∆Q_Qd_{d <}< %%∆∆PP..

E

Edd = = 11 QQuuaannttiitty y ddee mmaanndde d e d c hc haanng eg es ps p rroo ppo ro rttiio no naattee llyy UUnniit t e le laas ts tiicc to price change: %

to price change: %∆∆Q_Qd_{d =}= %%∆∆PP.. E

Edd ==   QQu au an tn tiitty d e my d e ma na nd e d id e d is s e x te x trre m e le m e ly ry re se s p o n s ip o n s iv ev e P e rP e rffe c te c tlly e ly e la s ta s tiicc tto eo e ven veven ve rry sy s malmall changel change s s iin prn priicece ..

E

Edd = = 00 QQuuaannttiitty y ddee mmaannddee d d ddoo ee s s nnoo t t cc hhaanngg e e aass PePe rrffee cc ttlly y iinnee llaas ts tiicc pr

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Price Elasticity of demand

T

Traransnspareparency 1ncy 18-8- 44

Exh

Exhibit 2 (1 ibit 2 (1 of 3)of 3)

Exh

0 0 Quantity Demanded Quantity Demanded Price Price D D 10 10 %% 20 20 %% Q Q11 Part (a) Part (a) Q Q22 P P11 P P22 E Edd > > 11 El Elasas titicc 0 0 Quantity Demanded Quantity Demanded Price Price D D 10 10 %% 4% 4% Q Q11 Part (b) Part (b) Q Q22 P P11 P P22 E Edd < < 11 I

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Price Elasticity of

Price Elasticity of deman

demand

d

Tra

Transnsparpareency 1ncy 18-8- 55

Exh

Price Elasticity of Demand Exh

0 0

Quan

Quantitity Demandty Demand ee dd Price Price D D 10 10%% 10 10%% Q Q11 Part ( Part (cc )) Q Q22 P P11 P P22 E Edd = = 11 Unit E

(15)

Price Elasticity of demand

T

Traransnspaparerencncy y 1818-- 66

Exhibit 2 (3 of 3) Exhibit 2 (3 of 3)

Price Elasticity of Demand Exhibit 2 (3 of 3) Exhibit 2 (3 of 3) 0 0 Quantity Demanded Quantity Demanded Price Price D D 1% 1% Pa Parrt (d)t (d) Q Q11 P P 11 P P22 E Edd == ∞∞ Pe

Pe rrfecfec tltly y ElElasas titicc

0 0

Quant

Quantitity Demandy Demand ee dd Price Price D D 10 10 %% Par Part (et (e )) Q Q11 P P11 P P22 E Edd = 0= 0 Pe

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Price Elasticity of demand

•• The Determinants of price elasticity of The Determinants of price elasticity of demand:demand:

–

– 1) The 1) The availabiavailability of lity of substitutessubstitutes –

– 2) The time it takes for 2) The time it takes for consumers to adjust their behavior consumers to adjust their behavior in response to a change in price

in response to a change in price –

– 3) The proportion of the expenditure in the budget of the3) The proportion of the expenditure in the budget of the consumer

consumer –

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Income elasticity of demand

Y

Q

E

y

d

∆∆

==

%

_%

YY≡≡ incomeincome

At a given price, how much will the quantity At a given price, how much will the quantity demanded change when the incomes of demanded change when the incomes of consumers change?

consumers change?

Not a movement along the demand curve but a Not a movement along the demand curve but a shift in the demand curve.

(18)

Cross elasticity of demand

y y ddxx x xyy

P

Q

E

∆

==

%

_%

The responsiveness of consumersThe responsiveness of consumersto changes in the price of to changes in the price of a relateda related good.

good.

Substitute goods

Substitute goods EE_x_xy_y is a positive coefficient.is a positive coefficient.

Complementary goods

Complementary goods _E_E

x

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Price elasticity of supply

E E

P

Q

E

s s ss

∆∆

==

%

_%

The responsiveness of The responsiveness of suppliers (producers) to suppliers (producers) to price changes.

price changes.

A movement along the A movement along the supply curve.

supply curve.

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

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Determinants of price elasticity of

supply

•• 1) The availability of resource inputs (the1) The availability of resource inputs (the

elasticity of supply of the factors of production). elasticity of supply of the factors of production). •• 2) T2) The he time time period period under under consideration. consideration. As As timetime

passes supply becomes more elastic. passes supply becomes more elastic.

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Elasticity

Price Price Quantity Demanded (000s) Quantity Demanded (000s) Rs 5 Rs 5 Total Revenue Total Revenue

Total revenue is price

Total revenue is price x quantity sold.x quantity sold. In this example, TR = Rs 5 x 100,000 = In this example, TR = Rs 5 x 100,000 = Rs 500,000.

Rs 500,000.

This value is represented by the grey This value is represented by the grey shaded rectangle.

(22)

Elasticity

•

• If the firm decides to decreaseIf the firm decides to decrease price to (say) Rs 3, the degree price to (say) Rs 3, the degree of of price elasticity of the demand price elasticity of the demand curve would determine the extent curve would determine the extent of the increase in demand and of the increase in demand and the change therefore in total the change therefore in total revenue. revenue. Price Price Quantity Demanded (000s) Quantity Demanded (000s) Total

Total RevenueRevenue

140 140 100 100 D D Rs 5 Rs 5 Rs3 Rs3

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Elasticity

Quantity Demanded Quantity Demanded Price (Rs) Price (Rs)

Producer decides to lower price to attract sales Producer decides to lower price to attract sales

% Δ Price = -50% % Δ Price = -50% % Δ Quantity Demanded = +20% % Δ Quantity Demanded = +20% Ped = -0.4 (Inelastic) Ped = -0.4 (Inelastic) Total Revenue would fall Total Revenue would fall

Not a good move! Not a good move!

10 10 5 5 6 6 5 5 D D

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Elasticity

Price (Rs) Price (Rs) 10 10 7 7 5 5 2020

Producer decides to reduce price to increase sales

% % Δ Δ in in Price Price = = - - 30%30% % Δ in Demand = + 300% % Δ in Demand = + 300% Ped = - 10 (Elastic) Ped = - 10 (Elastic)

Total Revenue rises Total Revenue rises

Good Move! Good Move! D D Quantity Demanded Quantity Demanded

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Elasticity

•

• If demand is

If demand is

price elastic:

•• Increasing price

Increasing price

would

would reduce

reduce

TR

(%Δ Qd > % Δ P)

•• Reducing price

Reducing price

would

would increase

increase

TR

(%Δ Qd > % Δ P)

•

• _{If demand is}

_{If demand is}

price

inelastic:

••

_{Increasing price}

would

would increase

increase

TR

(%Δ Qd < % Δ

P)

••

_{Reducing price}

would

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Elasticity

•

• _{Income Elasticity of Demand:}

_{Income Elasticity of Demand:}

–

– The responsiveness of demandThe responsiveness of demand to changes in incomes

to changes in incomes

•

• Normal Good

Normal Good

– demand rises

as income rises and vice versa

•

• _{Inferior Good}

_{Inferior Good}

_{– demand falls}

as income rises and vice versa

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Elasticity

•

• _{Income Elasticity of Demand:}

_{Income Elasticity of Demand:}

•• A positive sign denotes aA positive sign denotes a normal goodnormal good

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Elasticity

•• For example:For example:

•• Yed = - 0.6: Good is anYed = - 0.6: Good is an inferior goodinferior good butbut inelasticinelastic – a rise in– a rise in income of 3% would lead to demand falling

income of 3% would lead to demand falling by 1.8%

by 1.8%

•• Yed = + 0.4: Good is aYed = + 0.4: Good is a normal goodnormal good butbut inelasticinelastic –– a rise in incomes of 3%

a rise in incomes of 3% would lead to demand risingwould lead to demand rising by 1.2%

by 1.2%

•• Yed = + 1.6: Good is aYed = + 1.6: Good is a normal goodnormal good andand elasticelastic –– a rise in incomes of 3%

a rise in incomes of 3% would lead to demand risingwould lead to demand rising by 4.8%

by 4.8%

•• Yed = - 2.1: Good is anYed = - 2.1: Good is an inferior goodinferior good andand elasticelastic –– a rise in incomes of 3%

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Elasticity

•

• _{Cross Elasticity:}

_{Cross Elasticity:}

•• The responsiveness of demand

The responsiveness of demand

of one good to changes in the price of a

related good – either

a substitute or a c

a substitute or a complement

omplement

Xed = Xed = __________________ __________________ % Δ Price of good Y % Δ Price of good Y % Δ Price of good X % Δ Price of good X

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Elasticity

•

• _{Goods which are complements}

_{Goods which are complements}

_:

–

– Cross Elasticity will have negative signCross Elasticity will have negative sign (inverse relationship between the two) (inverse relationship between the two)

•

• _{Goods which are substitutes}

_{Goods which are substitutes}

_:

–

– Cross Elasticity will have a positive signCross Elasticity will have a positive sign (positive relationship between the two) (positive relationship between the two)

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Advertising elasticity of demand

Elasticity

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Determinants of Elasticity

•

• Time periodTime period – the longer the time – the longer the time under under

consideration the more elastic a good is likely to consideration the more elastic a good is likely to be

be •

• Number and closeness of substitutesNumber and closeness of substitutes –– the greater the number of substitutes,

the greater the number of substitutes, the more elastic

the more elastic •

• The proportion of income taken up by theThe proportion of income taken up by the

product

product – the smaller the proportion the more– the smaller the proportion the more inelastic

inelastic •

• Luxury or NecessityLuxury or Necessity - for example, addictive- for example, addictive drugs

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Importance of Elasticity

•• Relationship between changes in price andRelationship between changes in price and total revenue

total revenue

•• Importance in determining what goods to taxImportance in determining what goods to tax (tax revenue)

(tax revenue)

•• Importance in analysing time lags in productionImportance in analysing time lags in production •• Influences the behaviour of a firmInfluences the behaviour of a firm

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DETERMINANTS OF PRICE ELASTICITY

OF DEMAND

1

1.. AAvvaaiillaabbiilliitty y oof f SSuubbssttiittuutteess--the higher the degree of closeness of thethe higher the degree of closeness of the substitutes, the greater the elasticity of demand

substitutes, the greater the elasticity of demand for the commodity for the commodity .. 2

2.. NNaattuurre e oof f CCoommmmooddiittyy--luxuries, comforts and necessitiesluxuries, comforts and necessities.. 3

3.. WWeeiigghhttaagge ie in tn thhe te toottaal cl coonnssuummppttiioonn--if proportion of income spent on aif proportion of income spent on a commodity is large, its demand will

commodity is large, its demand will be more elastic and vice versabe more elastic and vice versa.. 4.

4. TiTime me fafactctor or in in adadjujuststmement nt of of coconsnsumumptptioion n papatttterernn-the time consumers-the time consumers need to adjust their consumption pattern to a

need to adjust their consumption pattern to a new price: the longer thenew price: the longer the time allowed, the greater the elasticity.

time allowed, the greater the elasticity. 5

5.. RRaanngge e oof f ccoommmmooddiitty y uussee--the wider the range of the uses of a product,the wider the range of the uses of a product, the higher the elasticity of demand for the

the higher the elasticity of demand for the decrease in price.decrease in price. 6

6.. PPrrooppoorrttiioon on of mf maarrkkeet st suupppplliieedd--if less than half of the market is supplied at if less than half of the market is supplied at the ruling price, price elasticity of demand

the ruling price, price elasticity of demand will be higher than 1 and if will be higher than 1 and if more than half of the market is

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MANAGERIAL USES OF ELASTICITY OF

MANAGERIAL USES OF ELASTICITY OF DEMANDDEMAND

1.

1. DeDetetermrmininatatioion of n of PrPricice Une Undeder Mor Mononopopolyly-a-a) If ) If ththe dee demamand fnd for hor hisis product is elastic he will earn more profit by fixing a low price. Low 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 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. demand is inelastic, he will be in a position to fix up high price. 2.

2. BaBasisis os of Pf Pricrice De Disiscrcrimimininatatioion- n- WhWhen en a ma mononopopololist ist seselllls hs his is prprododucuct at att different prices, it is called price

different prices, it is called price discrimination. On the basis of discrimination. On the basis of elasticity he can charge various prices from the customers.

elasticity he can charge various prices from the customers. 3.

3. DeDetetermrmininatatioion on of Wf Wagageses-I-If tf the he dedemamand nd fofor lr lababouour ir in an an in indndusustrtry iy iss elastic, strikes and other trade union tactics will not be of any avail in elastic, strikes and other trade union tactics will not be of any avail in raising wages.

raising wages. 4.

4. AdAdvavantntagage to Fe to Fininanance Mce Mininisisteter-r-a) Ta) Taxaxes oes on gon goodods has haviving eng elalaststicic

demand will yield less revenue. It is because of the fact that taxes will 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

raise their prices and thus bring down their demand and finally it

means less revenue, b) Goods having inelastic demand are taxed at a 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

higher rate. No doubt the price of the goods will rise on account of these taxes but there will be

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5.

5. Determination Determination of of Prices Prices of of Public Public Utilities-Where Utilities-Where the the demand demand for for services services isis inelastic, a high price is charged, while in

inelastic, a high price is charged, while in the case of elastic demand athe case of elastic demand a lower price is charged. That is why, household consumers are charged a lower price is charged. That is why, household consumers are charged a high rate of electricity than industrial or ag

high rate of electricity than industrial or agricultural customers.ricultural customers. 6.

6. InInteternrnatatioional Tnal Traradede-T-Thohose ese expxpororts wits with inth inelelasastitic demc demanand wid will fell fetch htch higighh price.

price. 7.

7. ThThe kne knowowleledgdge of ine of incocome eme elalastisticicity cty can ban be use usefeful iul in fon forerecacaststining deg demamandnd,, when a change in personal incomes is expected. It thus

when a change in personal incomes is expected. It thus helps in avoidinghelps in avoiding over production or under production.

over production or under production. 8.

8. ThThe coe concncepept of ct of croross ess elalastisticicity ity is of vis of vitatal iml impoportrtanance in cce in chahangngining prg pricice of e of products having substitutes and complementary goods. If cross elasticity in products having substitutes and complementary goods. If cross elasticity in response to the price of substitutes is greater

response to the price of substitutes is greater than 1, it would bethan 1, it would be inadvisable to increase the price; rather, reducing the price

inadvisable to increase the price; rather, reducing the price may prove moremay prove more benecial.