Elasticity

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ELASTICITY OF DEMAND
THE LAW OF DEMAND ESTABLISHES AN INVERSE RELATION BETWEEN THE PRICE OF A GOOD
AND ITS DEMAND, BUT ELASTICITY OF DEMAND MEASURES THE EXTENT OF RESPONSIVENESS
OF DEMAND TO A CHANGE IN PRICE.
DEMAND CHANGES WHEN THER IS A CHANGE IN
ITS PRICE, INCOME OF THE CONSUMER, PRICE OF THE RELATED COMMODITY AS WELL AS
CHANGE IN THE EXPENDITURE ON ADVERTISEMENT. ACCORDINGLY WE HAVE,
1] PRICE ELASTICITY OF DEMAND
2] INCOME ELASTICITY OF DEMAND
3] CROSS-ELASTICITY OF DEMAND &
4] PROMOTIONAL ELASTICITY OF DEMAND
PRICE ELASTICITY OF DEMAND
(PERCENTAGE METHOD)
IN THIS METHOD, WE FIND PRICE ELASTICITY OF DEMAND AT THE GIVEN
PRICE.
Ed =
=
P
Qd
Qd
P
Qd
P
x
Qd
P
=
% CHANGE IN DEMAND
% CHANGE IN PRICE
Ex. 1 When price of chocolate rises from Rs. 10 to Rs. 15, its demand falls
from 80 to 60 pieces. Find Ed.
(Ans. Ed = - o.5)
Ex. 2 5% rise in price of a good leads to 7% fall in its demand. What is Ed ?
(Ans. Ed = - 1.4)
Price
D’ D
P
P1
D1’
D1
O
Q Q1 Q’1
Quantity Demanded
PRICE ELASTICITY DEMAND (Arc Method)
When we want to find out Ed within the given price range, we use this method.
Ed =
=
=
(Q2 – Q1)
(Q2 + Q1) /2
÷
(P2 – P1)
(P2 + P1) / 2
(Q2 – Q1)
2 (P2 + P1)
(P2 – P1)
2 (Q2 + Q1)
(Q2 – Q1)
(P2 + P1)
(P2 – P1)
(Q2 + Q1)
=
Q
P
P1+ P2
Q1+ Q2
Ex. When price a commodity was Rs. 12, its demand was 60 units and the price
was Rs. 8, it increased to 80 units. What is Ed?
Ans. Ed = - o.71
PRICE ELASTICITY DEMAND
( TOTAL OUTLAY METHOD )
THE EFFECT OF A CHANGE IN PRICE ON THE TOTAL EXPENDITURE ON
THE COMMODITY DEPENDS ON ELASTICITY OF DEMAND FOR THAT
GOOD.
P
TE
P
TE
Ed
1
For example, at the price of Rs. 4, 25 units are sold, but when the price was
increased by one rupee, its demand decreased to 16 units.
P
TE
P
TE
Ed < 1
For example, when price = Rs. 4, demand = 25 units. When price rises to Rs. 5
demand falls to 24 units.
P
OR
TE
Ed = 1
For example, when price = Rs. 4, demand = 25 units. When price rises to Rs. 5
demand falls to 20 units.
PRICE ELASTICITY DEMAND (Geometric Method)
Ed
LOWER SEGMENT
Price
UPPER SEGMENT
A
= PB / AP
P
B
o
Quantity demanded
FOR PROOF
REMEMBER ABOUT Ed
 Ed IS NEGATIVE IN CASE OF A NORMAL GOOD.
 IN CASE OF GIFFEN GOOD OR DUE TO SNOB / VEBLEN EFFECT, IT IS
POSITIVE.
 ITS NUMERICAL VALUE SHOWS SENSITIVITY OF DEMAND FOR THE GOOD
WITH RESPECT TO ITS PRICE.
FACTORS INFLUENCING Ed
1] Nature of commodity
2] Price of the product
3] Level of income of the consumer.
4] % of income spent on the commodity
5] Durability of the commodity.
6] Number of substitutes available.
7] Number of uses.
PRACTICAL SIGNIFICANCE OF ELASTICITY DEMAND
• A FIRM, ESPECIALLY, A MONOPOLIST CAN SET THE PRICE ON THE BASIS OF Ed. IF
DEMAND IS HIGHLY ELASTIC, HE REDUCES THE PRICE. BUT IF Ed IS LOW HE
WOULD SAFELY INCREASE THE PRICE. PRICE DISCRIMINATION IS ON THE BASIS OF
Ed.
• IN ORDER TO RAISE TAX-REVENUE, THE GOVT. IMPOSES TAXES ON GOODS WITH A
LOW ELASTICITY, BUT IN ORDER TO REDUCE INEQUALITY, TAXES ARE IMPOSED ON
LUXURY GOODS.
• DEMAND FOR SKILEED LABOUR IS GENERALLY LESS EALSTIC. THE WAGE RATE IS
FIXED AT A HIGHER LEVEL, UNSKILLED LABOUR WITH GREATER ELASTICITY OF
DEMAND, GET LOWER WAGE-RATE.
• IN INTERNATIONAL TRADE, A COUNTRY WITH IMPORTS CONSISTING OF GOOD
HAVING INELASTIC DEMAND AND EXPORTS OF GOODS WITH ELASTIC DEMAND
IS ALWAYS AT DISADVANTAGE.
• IF THE PRODUCT SOLD HAS INELASTIC DEMAND, THE GOVT. HAS TO REGULATE THE
TRADE.
• DEVALUATION OF CURRENCY DOES NOT PRODUCE THE DESIRED RESULT FOR A
NATION WHOSE DEMAND FOR IMPORTS IS LESS ELASTIC AND THAT OF EXPORTS IS
ALSO LESS ELASTIC.
• IN CASE OF A PRODUCT WITH LESS ELASTICITY DEMAND, INCREASE IN SUPPLY
CAUSES A LARGE REDUCTION IN EQUILIBRIUM PRICE, BUT VERY SMALL INCREASE IN
SALES VOLUME. BUT AN INCREASE IN SUPPLY OF A PRODUCT WITH HIGHLY ELASTIC
DEMAND, PRICE WILL FALL BY A SMALL AMOUNT, BUT SALES VOLUME WILL RISE
SUBSTANTIALLY.
INCOME ELASTICITY OF DEMAND
Ey
MEASURES THE SENSITIVITY OF DEMAND TO A CHANGE IN INCOME.
Ey =
=
=
Proportionate change in demand
Proportionate change in income
Q
Y
Q
Q
Y
Y
Y
Q
% CHANGE IN DEMAND
=
% CHANGE IN INCOME
Ex. When income of consumer increases by 15%, demand for dry-fruits
increases by 18%. What is Ey?
Ans. Ey = + 1.2
REMEMBER ABOUT Ey

Ey is positive in case of a normal good.
 It is negative in case of an inferior good
 0 < Ey < 1
FOR A NECESSARY GOOD
 Ey = 1
FOR A COMFORT GOOD
 Ey > 1
FOR A LUXURY GOOD
CROSS ELASTICITY OF DEMAND
IT MEASURES ELASTICITY OF DEMAND FOR A COMMODITY WITH RESPECT
TO THE PRICE OF THE RELATED GOOD
Exy=
=
PROPORTIONATE CHANGE IN DEMAND FOR GOOD X
PROPORTIONATE CHANGE IN PRICE OF GOOD Y
Qx
Py
X
Py
Qx
Ex. When price of Cadberry chocolate increased from Rs. 10 to
Rs. 15, demand from Amul chocolate went from 80 to 125.
Find cross elasticity demand for Amul with respect to Cadberry.
Ans. +1.125
Ex. Increase in the price of petrol from Rs. 50 to R. 55 in May
2011 demand for Maruti car reduced by 3%. Find cross Ed.
Ans. - 0.3
REMEMBER ABOUT CROSS-ELASTICITY OF DEMAND
 Exy IS POSITIVE IF THE TWO COMMODITIES ARE SUBSTITUTES
 IT IS NEGATIVE IF THE TWO GOODS ARE COMPLEMENTARY GOODS
 IT IS EQUAL TO ZERO IF THOSE GOODS ARE INDEPENDENT
 NUMERICAL VALUE INDICATES THE CLOSENESS OF THE RELATION.
 ITS VALUE ALSO INDICATES THE TYPE OF MARKET.
 IT INDICATES EXTENT OF COMPETITION IN THE MARKET.
PROMOTIONAL ELASTICITY OF DEMAND
IT MEASURES RESPONSIVENESS OF SALES TO ANY EXPENDITURE ON PROMOTION
OF A PRODUCT SUCH AS EXPENDITURE ON ADVERTISEMENT.
% CHANGE IN SALES VOLUME
EA =
% CHANGE IN EXPENDITURE ON ADVERTISEMENT
Ex. PROMOTIONAL ELASTICITY OF DEMAND FOR THE PRODUCT OF A
COMPANY IS KNOWN TO BE EQUAL TO +0.8. IF THE COMPANY WANTS TO
DOUBLE ITS SALES, WHAT WOULD BE THE RISE IN ADVERTISEMENT BUDGET?
Ans. = 125% INCREASE
PRICE
WHEN PRICE IS OP, DEMAND IS OQ & WHEN PRICE RISES TO
A
P
OP1, DEMAND FALLS TO OQ1
T
P1
S
R
EP = [D Q /DP] * [P/Q]
= [QQ1/PP1] * [OP/OQ]
O
Q1
Q
B
DEMAND
= [SR/ST] * [OP/OQ]
= [PR/AP] * [OP/OQ]
= [OQ/AP] * [OP/OQ]
PR = OQ
= [OP/AP]
= [QR/AP]
OP = QR
= [RB/AR]
= LOWER SEGMENT ÷ UPPER SEGMENT
PRICE ELASTICITY OF DEMAND IN THE REAL WORLD
ELASTICITY
COMMODITIES
BUTTER
TEA
PETROL
SHORT RUN
LONG RUN
1.47
2.78
0.712
1.14
0.3
0.9
INCOME ELASTICITY OF DEMAND IN THE REAL WORLD
COMMODITIES
INCOME ELASTICITY
MILK (INDIA)
1.07
MUTTON (INDIA)
3.19
CHEESE (UK)
0.37
POTATOES (UK)
- 0.32
CROSS-ELASTICITY OF DEMAND IN THE REAL WORLD
COMMODITY X
COMMODITY Y
TEA (INDIA)
COFFEE (INDIA)
0.345
BUTTER (UK)
1.53
ASIAN CARS
0.76
FOOD (US)
- 0.72
MARGARINE (UK)
EUROPEAN CARS
ENTERTAINMENT (US)
CROSS-ELASTICITY
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