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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 ___________________

WhereQ1= Original quantity Q2= New quantityP1 = Old price P2= New price

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Price Elasticity (Ep)

If P1 = 10 P2=9

Q1 = 2000 Q2= 2500

Ep = (2500-2000)/2000 / (9-10)/10 = -2.5

Interpretation: A 1% reduction in price will result in a 2.5% increase in quantity demanded.

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Types of Price ElasticityType Numerical

expressionDescription Shape of

curve

∞ Infinite Horizontal

Perfectly inelastic

0 Zero Vertical

Unit elastic 1 One Rectangular hyperbola

Relatively elastic

>1 More than1 Flat

Relatively inelastic

<1 Less than 1 Steep

Perfectly elastic

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Types of Price Elasticity

Ep= ∞ Ep=0

Ep=1

Ep> 1Ep<1

Quantity demanded

PricePrice

price pr

ice

pric

e

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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 MethodEp = % 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 price- Revenue 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,

Total Outlay Method

Elasticity Price Quantity demanded

Total Outlay

Highly elastic ( Ep >1)

Increases Decreases Decreases

Decreases Increases Increases

Unitary Elastic ( Ep=1)

Increases Decreases No Change

Decreases Increases No Change

Highly inelastic (Ep < 1)

Increases Decreases Increases

Decreases Increases Decreases

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Total Outlay Method

Unit Price (Rs) Quantity TE =P*Q (Rs)

A. 10 10 100

5 25 125 ep>1

B. 10 10 100

5 20 100 ep=1

C. 10 10 100

5 15 75 ep<1

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: necessities-inelastic

• 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 strategyPrice 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

Income Elasticity

Ey = % change in Quantity demanded (Q) / % change in income of consumer (y)

Q2-Q1/Q1

Y2-Y1/Y1

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Degrees of Income Elasticity

• Positive: Normal goods

• Zero: Neutral goods

• Negative: Inferior

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• 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 1618

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?

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- 6000Eq: Ea= (Δ Dx / Δ A)* (A/Dx)Putting the variables in the equation we get1.4= (Dn-6000)/8,00,000 *( 12,00,000/6000)Dn-6000= (1.4* 8,00,000 * 6000)/ 12,00,000Dn = 5600+6000

=11600 units

• 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

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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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