elasticity of demand
DESCRIPTION
TRANSCRIPT
Chapter 5Elasticity of Demand
Lecture plan
Objectives Elasticity of demand Price elasticity of demand Degrees of price elasticity of demand Methods of measuring elasticity Revenue and price elasticity of demand Income elasticity of demand Cross elasticity of demand Promotional elasticity of demand Importance of elasticity
Objectives To understand the meaning of responsiveness
of demand to changes in determinants of demand.
To lay down the degrees of responsiveness of demand.
To discuss various types of elasticities of demand.
To learn how to measure elasticity by various methods.
To understand the relevance and application of elasticities of demand
Elasticity of Demand
“Elasticity” is a standard measure of the degree of responsiveness (or sensitivity) of one variable to changes in another variable.
Elasticity of Demand measures the degree of responsiveness of demand for a commodity to a given change in any of the independent variables that influence demand for that commodity, such as price of the commodity, price of the other commodities, income, taste, preferences of the consumer and other factors.
Responsiveness implies the proportion by which the quantity demanded of a commodity changes, in response to a given change in any of its determinants .
Elasticity of Demand
Mathematically, it is the percentage change in quantity demanded of a commodity to a percentage change in any of the (independent) variables that determine demand for the commodity.
Four major types of elasticity: Price elasticity, Income elasticity, Cross elasticity Advertising (or promotional) elasticity.
In order to assess the impact of one variable on demand, we assume other variables as constant (ceteris paribus)
Price Elasticity of Demand
Price is most important among all the independent variables that affect the demand for any commodity. Hence Price elasticity of demand ( “ep” or “e”) is considered to be the most important of all types of elasticity of demand. Price elasticity of demand means the sensitivity of quantity demanded of a commodity to a given change in its own price.
Perfectly elastic demand ep=∞ (in absolute terms). Unlimited quantities of the commodity
can be sold at the prevailing price A negligible increase in price would
result in zero quantity demanded Horizontal demand curve
Perfectly inelastic demand The other extreme of the elasticity
range ep=0 (in absolute terms) Quantity demanded of a commodity
remains the same, irrespective of any change in the price
Such goods are termed neutral Vertical demand curve
Degrees of Price Elasticity Price
Quantity O
P D
Q1 Q1
Price
Quantity
O
D
Q1
P2
P1
Degrees of Price Elasticity
Highly elastic demand Proportionate change in quantity
demanded is more than a given change in price
ep >1 (in absolute terms) Such goods are called luxuries Unitary elastic demand Proportionate change in price brings
about an equal proportionate change in quantity demanded
ep =1 (in absolute terms). Demand curves are shaped like a
rectangular hyperbola, asymptotic to the axes
Relatively inelastic demand Proportionate change in quantity
demanded is less than a proportionate change in price
ep <1 (in absolute terms) Such goods are called necessities
Price
Quantity O
D
D
Q1 Q2
P2
P1
Price
Quantity O
D
D
Q1 Q2
P2
P1
Price
Quantity O
D
DQ1 Q2
P2
P1
Ratio (or Percentage) Method The most popular method used to measure elasticity Elasticity of demand is expressed as the ratio of proportionate
change in quantity demanded and proportionate change in the price of the commodity
It allows comparison of changes in two qualitatively different variables
It helps in deciding how big a change in price or quantity is
ep=
where Q1= original quantity demanded, Q2= new quantity demanded, P1= original price level, P2= new price level
Methods of Measuring Elasticity
Xcommodity of pricein change ateProportion
Xcommodity of demandedquantity in change ateProportion=ep
112
112
/
/
PPP
QQQ
Methods of Measuring Elasticity
Point Elasticity Method Elasticity measured at a point of demand curve is referred
as point elasticity of demand.
For nonlinear demand curve we need to apply calculus to calculate point elasticity.
As changes in price become smaller and approach zero, the ratio becomes equivalent to the first order derivative of the demand function with respect to price
Point elasticity can be expressed as:
ep = =PdP
QdQ
/
/dP
dQQ
P
Contd…
.
dP
dQP
Q
Methods of Measuring Elasticity
Arc Elasticity Method Used when the available figures on price and quantity
are discrete, and it is possible to isolate and calculate the incremental changes.
It is used to find the elasticity at the midpoint of an arc between any two points on a demand curve, by taking the average of the prices and quantities.
This method finds wider applications, as it reflects a movement along a portion (arc) of a demand curve
ep = /
=
2/)( 21
12
2/)( 21
12
PP
PP
Contd…
21
12
.
12
21
PP
PP
Methods of Measuring Elasticity Total Outlay Method (Marshall)
Elasticity is measured by comparing expenditure levels before and after any change in price, i.e. whether the new expenditure is more than, or less than, or equal to the initial expenditure level.
Helps a seller in taking a decision to raise price only if: Reduction in quantity demanded does not reduce total
revenue or Reduction in price increases the quantity demanded to the
extent that total revenue also increases. Degrees
When demand is elastic, a decrease in price will result in an increase in the revenue (sales).
When demand is inelastic, a decrease in price will result in a decrease in the revenue (sales).
When demand is unit-elastic, an increase (or a decrease) in price will not change the revenue (sales)
Contd…
Nature of commodity Necessities are relatively price inelastic, while luxuries
are relatively price elastic
Availability and proximity of substitutes Price elasticity of demand of a brand of a product
would be quite high, given availability of other substitute brands
Alternative uses of the commodity If a commodity can be put to more than one use, it
would be relatively price elastic
Determinants of Price Elasticity of Demand
Determinants of Price Elasticity of Demand Proportion of income spent on the commodity
The greater the proportion of income spent on a commodity, the more sensitive would the commodity be to price
Reason is income effect
Time Demand for any commodity is more price elastic in the long run
Durability of the commodity Perishable commodities like eatables are relatively price
inelastic in comparison to durable items
Items of addiction Items of intoxication and addiction are relatively price inelastic
Revenue and Price Elasticity of Demand
For relatively inelastic demand, a change in price would have a greater effect on revenue than a change in quantity demanded
AR is same as the price of the product Demand curve is also the AR curve of the firm.
Marginal Revenue is the revenue a firm gains in producing one additional unit of a commodity
Revenue and Price Elasticity of Demand
Till ep>1 MR is positive and TR is rising
At the midpoint of the demand curve, ep=1 and MR is equal to 0 and TR is at its peak
When ep<1, MR is negative
MR= AR[1- ep]
Price, Revenue
ep>1
TRO
Quantity
Price, Revenue
MR
O
Quantity
ep<1
ep=∞
ep=1
ep=0
Income Elasticity of Demand (ey)
ey measures the degree of responsiveness of demand for a good to a given change in income, ceteris paribus.
Degrees: Positive income elasticity
Demand rises as income rises and vice versa Normal good
Negative income elasticity Demand falls as income rises and vice versa Inferior good
consumer of incomein change ateProportion
Xcommodity of demandedquantity in change ateProportion=e y
Cross Elasticity of Demand
ec measures the responsiveness of demand of one good to changes in the price of a related good
DegreesNegative Cross Elasticity
Complementary goodsPositive Cross Elasticity
Substitute goods
Ycommodity of pricein change ateProportion
Xcommodity of demandedquantity in change ateProportion=ec
Promotional Elasticity of Demand
Advertising (or promotional) elasticity of demand (ea) measures the effect of incurring an “expenditure” on advertising, vis-à-vis an increase in demand, ceteris paribus.
Some goods (like consumer goods) are more responsive to advertising than others (like heavy capital equipments).
Degrees ea>1
Firm should go for heavy expenditure on advertisement. ea <1
Firm should not spend too much on advertisement
eexpenditur gadvertisinin change ateProportion
Xcommodity of sales)(or demandedquantity in change ateProportion=ea
Importance of Elasticity
Determination of price Elasticity is the basis of determining the price of a product
keeping its possible effects on the demand of the product in perspective
Basis of price discrimination Products having elastic demand may be sold at lower price,
while those having inelastic demand may be sold at high prices Determination of rewards of factors of production
Factors having inelastic demand are rewarded more than factors that have relatively elastic demand.
Government policies of taxation Goods having relatively elastic demand are taxed less than
those having relatively inelastic demand.
Summary
Elasticity of demand measures the degree of responsiveness of the quantity demanded of a commodity to a given change in any of the independent variables that influence demand for that commodity.
Price elasticity of demand (ep) measures the degree of responsiveness of the quantity demanded of a commodity to a given change in its price, other things remaining the same.
By the percentage method ep is expressed as the ratio of proportionate change in quantity demanded and proportionate change in price of the commodity.
As per the total outlay method elasticity is measured by comparing expenditure levels before and after any change in price, i.e. whether the new expenditure is more than, or less than, or equal to the initial expenditure level.
Arc elasticity is used to calculate price elasticity of demand at the midpoint of an arc between any two points on the demand curve, by taking the average of the prices and quantities; point elasticity can be approximated by calculating the arc elasticity for a very small arc on the demand curve.
Summary
If the demand curve is a straight line, price elasticity of demand at different points of the demand curve can be calculated by the ratio of the lower segment and upper segment of the demand curve.
MR= AR[1- ep] Income elasticity of demand (ey) measures the degree of
responsiveness of the quantity demanded of a commodity to a given change in consumer’s income. For normal goods ey is positive; for neutral goods ey is zero; for inferior goods ey is negative.
Cross elasticity of demand (ec) shows how changes in prices of other goods would affect the demand for a particular good. For substitutes ec is positive; and for complements ec is negative.
Advertising (or promotional) elasticity of demand (ea) measures the effect of incurring an “expenditure” on advertising of a firm on the demand for its product at constant price.
Elasticity is used for determination of right price by seller and for taxation by government.