Elasticity of Demand
Responsiveness of demand to
- Change in price (Ep)
- Change in income (Ey)
- Change in price of a related commodity (Ec)
- Change in advertising expenditure (Ea )
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Price Elasticity (Ep)
Price Elasticity (Ep)
% change in Qd
Ep= _______________
% change in Px
=
(Q2-Q1)/Q1
--------------(P2-P1)/P1
___________________
Where
Q1= Original quantity
P1 = Old price
Q2= New quantity
P2= New price
2
Price Elasticity (Ep)
If
P1 = 10
Q1 = 2000
Ep = (2500-2000)/2000
= -2.5
P2=9
Q2= 2500
/
(9-10)/10
Interpretation: A 1% reduction in price will
result in a 2.5% increase in quantity
demanded.
3
Types of Price Elasticity
Type
Numerical Description Shape of
expression
curve
Perfectly
elastic
∞
Infinite
Horizontal
Perfectly
inelastic
0
Zero
Vertical
Unit elastic 1
One
Rectangula
r hyperbola
Relatively
elastic
>1
More than1 Flat
Relatively
inelastic
<1
Less than 1 Steep
4
Types of Price Elasticity
Ep=0
Ep=1
price
P
r
i
c
e
P
r
i
pc
re
i
c
e
Ep= ∞
Ep> 1
price
Ep<1
Quantity demanded
5
Price Elasticity (Ep)
Identify which commodity has a more elastic
demand in the following pairs:
-Penicillin and sugar
- Car and tyre
- Ice cream and vanilla ice cream
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Measuring Price Elasticity
1. Percentage or Ratio Method
Ep = % change in Quantity demanded (Qd) /
% change in price (Px)
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Arc Method
2. Arc Method: Used when the changes in
price and quantity are substantial. The
method uses the average of the old and
new prices and the average of the old and
new quantities.
Ep= (Q2-Q1)/ (Q1+ Q2 )/2
_______________
(P2-P1)/ (P1+P2 )/2
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Total Outlay Method
3.Total Outlay Method
Elasticity is measured by comparing total
expenditure before and after a change in price
Ep=1: Unit elastic when there is no change in the
total revenue as a result of a rise or fall in priceRevenue remains constant
Ep>1: Relatively elastic when total revenue rises
with a fall in price and falls with a rise in price,
Ep<1 : Relatively inelastic when total revenue rises
with a rise in price and falls with a fall in price,
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Total Outlay Method
Elasticity
Price
Quantity
demanded
Total Outlay
Highly elastic
( Ep >1)
Increases
Decreases
Decreases
Decreases
Increases
Increases
Increases
Decreases
No Change
Decreases
Increases
No Change
Increases
Decreases
Increases
Decreases
Increases
Decreases
Unitary Elastic
( Ep=1)
Highly inelastic
(Ep < 1)
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Total Outlay Method
Unit Price (Rs)
A.
B.
C.
Quantity
TE =P*Q (Rs)
10
10
100
5
25
125
10
10
100
5
20
100
10
10
100
5
15
75
ep>1
ep=1
ep<1
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4.If demand curve is a straight line, price
elasticity at different points can be
calculated by the ratio between lower and
upper segment of the demand curve.
Ep=
Lower segment of Demand Curve/
Upper segment of Demand Curve
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Factors Determining Price Elasticity
Factors determining price elasticity
• Nature of commodities: necessitiesinelastic
• Variety of uses: If commodity has a
variety of uses, more elastic demand
• Number and closeness of substitutes:
More the substitutes, more elasticity
• Income level: Richer people are less
affected by price rise
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Uses of Elasticity
Ep, Ey and Ec are useful for
Producers - in determining price strategy
Price discrimination- higher prices for segments
with inelastic demand and lower price for
segments with inelastic demand
Government’s tax policy- Goods with inelastic
demand are taxed higher
Consumer -for designing their budget
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Factors Determining Price Elasticity
• Proportion of income spent on commodity:
Where it is small, less the elasticity
• Urgency of Demand: The more urgent the
demand, the less elastic
• Durability of a commodity: The more durable
and reparable a commodity, higher the elasticity
• Time: Demand for a product is more price
elastic in the longer run by when the consumer
gets the time to make the shift
15
Income Elasticity
Ey = % change in Quantity demanded (Q) /
% change in income of consumer (y)
Q2-Q1/Q1
Y2-Y1/Y1
16
Degrees of Income Elasticity
• Positive: Normal goods
• Zero: Neutral goods
• Negative: Inferior
17
• Filipini & Pachauri (2002) estimated price and
income elasticities of demand for electricity in
residential sector using data from 30000 urban
households- Used monthly data for summer,
monsoon and winter.
• Found that electricity demand is income and
price INELASTIC in all three seasons.
• Household, demographic and geographical
variables are significant determinants of
demand.
• www. cepe.ethz.ch cepe working paper No 16 18
Cross Elasticity
Ec = % change in Quantity demanded of X
(Qdx) / % change in price of a related
commodity, Y (Py)
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Positive Cross Elasticity: Quantity demanded of X
moves in the same direction as the price of Y
Case of Substitutes – E.g.,Coke and Pepsi
Negative Cross Elasticity: Quantity demanded of X
moves in the opposite direction as the price of Y
Case of Complements – Tea and sugar, car and
petrol
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Cross Elasticity
Given cross elasticity, identify nature of
relationship and give logical reasoning:
Commodity Ec wrt P of: Ec
Margarine
Butter
1.55
Natural gas
Electricity
0.80
Clothing
Food
-0 .18
Entertainment Food
-0.72
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Cross Elasticity
1.Margarine & Butter
1.55
Means 1% increase in price of butter leads to a
1.55% increase in demand for margarine. Thus,
the two goods are substitutes.
4. Entertainment & Food
-0.72
Means 1% increase in price of food leads to a
decrease in demand for entertainment by
0.72%. Why?
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Promotional Elasticity
• Degree of responsiveness of demand to a
change in advertising expenditure
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Sums in Elasticity
Compute the relevant elasticities of demand when
the demand for a product increases from 100
to 150 units (when all other things remain
constant) when
i) Price of product decreases from Rs. 8 per unit
to Rs. 6 per unit
ii) Income of consumer increases from Rs. 1000
to Rs. 4500
iii) Price of a related good increases from Rs. 8 to
Rs. 10 per unit. Also, state the relationship
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Promotional Elasticity (Ea)
A company presently sells 6000 units of
shoe polish at a price of Rs. 30 per unit.
Suppose it decides to increase its
advertising expenditure from Rs. 12 lakh
to Rs. 20 lakh. If the promotional elasticity
for shoe polish is 1.4, find out the new
demand for shoe polish.
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Promotional Elasticity (Ea)
Old A=12 L;
New A=20L;
Δ A =8L;
Ea= 1.4;
Dx (Old demand)= 6000
New D =Dn
Δ Dx = D- 6000
Eq: Ea= (Δ Dx / Δ A)* (A/Dx)
Putting the variables in the equation we get
1.4= (Dn-6000)/8,00,000 *( 12,00,000/6000)
Dn-6000= (1.4* 8,00,000 * 6000)/ 12,00,000
Dn
= 5600+6000
=11600 units
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• Globalisation and elasticity:
• High cross elasticity
• High Substitutability between domestic
and foreign goods and services expected to increase even further..
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Items of joint consumption will have -------Cross elasticity
When Ea is -------- than 1, the firm can incur heavy
promotional expenditure.
When EA is high, it means the firm should incur
________ expenditure on advertising its
product.
If labour has less elastic demand than capital,
wages would be _________ than interest
28
A Study by Venkatram and Deodhar in 1999
showed that DD for coffee in India is inelastic in
the long run and highly inelastic in the short run
Means , for coffee, DD is not very responsive to
price
So authors proposed that the Coffee Board should
focus attention on non-price factors rather than
price incentives in its coffee promotion campaign
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Managerial Applications
• Should the manager lower the price of his
good if its demand is inelastic?
• If advertising elasticity is positive, should
the manager spend money on sales
promotion or improving product quality?
• If cross elasticity with a competitor’s
product is high, how should a manager
respond to a price reduction by the
competitor?
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