Elasticity of Demand
Dr. Mohamed Riyazh Khan
DoMS
Elasticity . . .
• … allows us to analyze supply and demand
with greater precision.
• … is a measure of how much buyers and
sellers respond to changes in market
conditions
Meaning
• The relationship between small changes in
price and the consequent changes in the
amount demanded is known as elasticity of
demand
Three types of elasticity
»Price elasticity
»Income elasticity
»Cross elasticity
THE ELASTICITY OF DEMAND
• Price elasticity of demand is a measure of how
much the quantity demanded of a good
responds to a change in the price of that
good.
• Price elasticity of demand is the percentage
change in quantity demanded given a percent
change in the price. (Ep)
The Price Elasticity of Demand and Its
Determinants
•
•
•
•
Availability of Close Substitutes
Necessities versus Luxuries
Definition of the Market
Time Horizon
The Price Elasticity of Demand and Its
Determinants
• Demand tends to be more elastic :
– the larger the number of close substitutes.
– if the good is a luxury.
– the more narrowly defined the market.
– the longer the time period.
Computing the Price Elasticity of Demand
• The price elasticity of demand is computed as
the percentage change in the quantity
demanded divided by the percentage change
in price.
Price elasticity of demand =
Percentage change in quantity demanded
Percentage change in price
Computing the Price Elasticity of Demand
Price elasticity of demand =
Percentage change in quantity demanded
Percentage change in price
• Example: If the price of an ice cream cone
increases from $2.00 to $2.20 and the amount
you buy falls from 10 to 8 cones, then your
elasticity of demand would be calculated as:
(10  8)
 100
20%
10

2
(2.20  2.00)
 100 10%
2.00
The Midpoint Method: A Better Way to
Calculate Percentage Changes and Elasticities
• The midpoint formula is preferable when
calculating the price elasticity of demand
because it gives the same answer regardless
of the direction of the change.
(Q 2  Q1 ) / [(Q 2  Q1 ) / 2]
Price elasticity of demand =
(P2  P1 ) / [(P2  P1 ) / 2]
The Midpoint Method: A Better Way to
Calculate Percentage Changes and Elasticities
• Example: If the price of an ice cream cone
increases from $2.00 to $2.20 and the amount
you buy falls from 10 to 8 cones, then your
elasticity of demand, using the midpoint
formula, would be calculated as:
(10  8)
22%
(10  8) / 2

 2.32
(2.20  2.00)
9.5%
(2.00  2.20) / 2
Computing the Price Elasticity of Demand
(100 - 50)
ED 
Price
$5
4
0
(4.00  5.00)/2
67 percent

 -3
- 22 percent
Demand
50
(4.00 - 5.00)
(100  50)/2
100 Quantity
Demand is price elastic
The Variety of Demand Curves
• Because the price elasticity of demand
measures how much quantity demanded
responds to the price, it is closely related to
the slope of the demand curve.
Perfectly elastic demand
• Perfectly Elastic (Ep=∞)
– Quantity demanded changes infinitely with any change in price.
• Very small change in price will result in infinitely large
response in demand
• A small rise in price may result in contraction of demand
even to zero and a small fall in rise may result in
extension of demand to infinity
• Demand curve D1D1 is a horizontal straight line showing
that at price OP the amount demanded is infinity
Perfectly elastic demand
Perfectly Inelastic demand
• Perfectly Inelastic (Ep=0)
– Quantity demanded does not respond to price
changes.
• A large fall in price or rise in price will not
induce the consumer to change in the
quantity demanded
• Demand curve D2D2 shows a fixed quantity
will be purchased whatever changes takes
place in price
Perfectly inelastic demand
Relatively elastic demand
• Elastic Demand (Ep>1)
– Quantity demanded responds strongly to changes in price.
Where a small change in price will lead to a very big change in
the quantity demanded
– Price elasticity of demand is greater than one.
– The curve D3D3 is flatter showing that quantities demanded are
larger than change in price
– When the price falls from P to P1 the dmand increased form Q
to Q1 which is comparitively larger than fall in price. So the
demand is relatively elastic
Relatively elastic demand
Relatively inelastic demand
• Inelastic Demand (Ep<1)
– Quantity demanded does not respond strongly to
price changes.
– Price elasticity of demand is less than one.
– It refers to a condition where a large change in price
will result in smaller change in quantity demanded
– D4D4 is a steeper curve showing a steep fall in price
leads to a little change in qty demanded
– When price falls from P to P1 the qty demanded is
increased from Q to Q1 which is comparatively lower
than fall in price
Relatively inelastic demand
Unitary elastic demand
• Unit Elastic (Ep=1)
– Quantity demanded changes by the same
percentage as the price.
• The demand curve D5D5 slopes uniformly
shows that PP1+QQ1. i.e. change in price has
created an equal change in quantity
demanded
Unitary elastic demand
Total Revenue and the Price Elasticity of
Demand
• Total revenue is the amount paid by buyers
and received by sellers of a good.
• Computed as the price of the good times the
quantity sold.
TR = P x Q
Figure 2 Total Revenue
Price
$4
P × Q = $400
(revenue)
P
0
Demand
100
Q
Quantity
Elasticity and Total Revenue along a Linear
Demand Curve
• With an inelastic demand curve, an increase in
price leads to a decrease in quantity that is
proportionately smaller. Thus, total revenue
increases.
Figure 3 How Total Revenue Changes When Price Changes:
Inelastic Demand
Price
Price
… leads to an Increase in
total revenue from $100 to
$240
An Increase in price from $1
to $3 …
$3
Revenue = $240
$1
Demand
Revenue = $100
0
100
Quantity
Demand
0
80
Quantity
Elasticity and Total Revenue along a Linear
Demand Curve
• With an elastic demand curve, an increase in
the price leads to a decrease in quantity
demanded that is proportionately larger. Thus,
total revenue decreases.
Figure 4 How Total Revenue Changes When Price Changes:
Elastic Demand
Price
Price
… leads to an decrease in
total revenue from $200 to
$100
An Increase in price from $4
to $5 …
$5
$4
Demand
Demand
Revenue = $200
0
50
Revenue = $100
Quantity
0
20
Quantity
Elasticity of a Linear Demand Curve
Income Elasticity of Demand
• Income elasticity of demand measures how much
the quantity demanded of a good responds to a
change in consumers’ income.
• It is computed as the percentage change in the
quantity demanded divided by the percentage
change in income.
• The relationship between changes in income of
the consumer and the consequent changes in the
quantity demanded is expressed through the
concept of income elasticity of demand
Computing Income Elasticity
Percentage change
in quantity demanded
Income elasticity of demand =
Percentage change
in income
Income Elasticity
• Types of Goods
– Normal Goods
– Inferior Goods
• Higher income raises the quantity demanded
for normal goods but lowers the quantity
demanded for inferior goods.
Factors influencing elasticity of
demand
•
•
•
•
•
•
•
Nature of the commodity
Uses of the commodity
Existence of substitutes
Postponement of demand
Amount of money spent
Habits
Time factor
Income elasticity of demand
• The relationship between changes in income
of the consumer and the consequent changes
in quantity demanded expressed through the
concept of income elasticity of demand
• Ei= Proportionate change in qty demanded
Proportionate change in income
Income Elasticity
• Goods consumers regard as necessities tend
to be income inelastic
– Examples include food, fuel, clothing, utilities, and
medical services.
• Goods consumers regard as luxuries tend to
be income elastic.
– Examples include sports cars, furs, and expensive
foods.
Types of income elasticity of demand
•
•
•
•
•
Zero income elasticity (Ei=0)
Negative income elasticity (Ei<0)
Unitary income elasticity of demand (E=1)
Income elasticity is greater than one (Ei>1)
Income elasticity is less than one (Ei<1)
Zero income elasticity (Ei=0)
• It refers to a situation in which the given
increase in consumers income will not have
any increase in the quantity demanded of a
commodity
Negative income elasticity (Ei<0)
• It refers to a situation in which the increase in
money income of the consumer will lead to
decrease in the quantity purchased of a
commodity
Unitary income elasticity of demand
(E=1)
• It refers to a situation in which the proportion
of income spent on the commodity remain
exactly the same even after the increase in
income
• Suppose the income increases from 1000 to
2000 , the consumer increase his purchase
from 10 units to 20 units. This is unitary
income elasticity.
Income elasticity is greater than one
(Ei>1)
• When the consumers spends larger portion of
his increased income on the commodity it is
said to be income elastic
• Suppose the consumer income increases from
1000 to 2000 he increased his purchase from
10 units to 25 units.
Income elasticity is less than one (Ei<1)
• When the consumer spends lesser proportion
of his increased income on the purchase of a
commodity
• When the consumer income increases from
1000 to 2000, the consumer increases his
purchases from 10 units to 15 units.
Graph showing income elasticity
• aa=
Ei<0
•ab=Ei=0
•ac=Ei<1
•ad=Ei=1
•ae=Ei>1
Cross elasticity of demand
• It tells us the extent of change in the quantity
demanded of a commodity A due to change in
the price of another commodity B which may
either be substitute of A or complimentary of
A
• Ec= % change in demand for commodity A
% change in price of commodity B
Cross elasticity of demand
• Suppose commodity A & B are substitutes, if the
price of B increases consumer will substitute A for
B and the demand for commodity will get
extended
• If the price of B falls and the price of A remains
constant and B becomes cheaper than A, the
demand will be contracted
• Elasticity of demand will vary between infinity
and zero depending upon the degree of
substitution between the two commodities
Cross elasticity of demand
• If both A & B are perfect substitutes for each
other cross elasticity will be infinite
• If two goods are un related then Ec will be
zero as the change in price of one will not
affect the demand for offer
• The cross elasticity is positive in case of good
substitutes
Cross elasticity of demand
• Suppose the two commodities are
complimentary goods the rise in the price of
one will lead to fall in qty demanded of that
commodity & also of the complimentary
commodity. In such case the cross elasticity is
negative
Summary
• Price elasticity of demand measures how much
the quantity demanded responds to changes in
the price.
• Price elasticity of demand is calculated as the
percentage change in quantity demanded divided
by the percentage change in price.
• If a demand curve is elastic, total revenue falls
when the price rises.
• If it is inelastic, total revenue rises as the price
rises.
Summary
• The income elasticity of demand measures
how much the quantity demanded responds
to changes in consumers’ income.
• The cross-price elasticity of demand measures
how much the quantity demanded of one
good responds to the price of another good.
• The price elasticity of supply measures how
much the quantity supplied responds to
changes in the price. .
Summary
• In most markets, supply is more elastic in the
long run than in the short run.
• The price elasticity of supply is calculated as
the percentage change in quantity supplied
divided by the percentage change in price.
• The tools of supply and demand can be
applied in many different types of markets.