Curriculum
- 14 Sections
- 14 Lessons
- Lifetime
- 1 – Introduction to Managerial Economics2
- 2 - Market Demand2
- 3 – Market Supply and Equilibrium2
- 4 – Consumer Behaviour (Utility Analysis)2
- 5 – Elasticity of Demand2
- 6 - Production Theory2
- 7 – Laws of Production2
- 8 – Cost Analysis2
- 9 – Market Structure: Perfect Competition2
- 10 – Monopoly2
- 11 – Monopolistic Competition2
- 12 – Oligopoly2
- 13 – Basic National Income Concepts2
- 14 – Calculation of National Income2
5 – Elasticity of Demand
Introduction
Elasticity is a metric for responsiveness. It is the ratio of one variable’s percent change to another variable’s percent change. The important thing to remember is that we use elasticity when we want to see how one thing changes when we change another. When we change the price of a good, how does demand change? When the price of a substitute good changes, how does the demand for that good change?
Elasticity varies by product because some products are more important to the consumer than others. A good or service is said to be elastic if a small change in price causes a significant change in the quantity demanded or supplied. Typically, these types of products are widely available on the market, and a person may not require them daily. For instance, air conditioners, televisions, movie tickets, branded clothing, etc. An inelastic good or service, on the other hand, is one in which price changes cause only minor changes in the quantity demanded or supplied if any at all. These items are more likely to be necessities for the consumer in his or her daily life. For example, rice, potatoes, onions, salt, medications, etc.
Meaning of elasticity:
Elasticity is the measure of the degree of responsiveness of change in one variable to the degree of responsiveness change in another variable.
Thus,
5.1 Price Elasticity of Demand
The concept of price elasticity of demand is a numerical measure of the extent to which the quantity demanded responds to a change in price while other demand determinants remain constant.
For example, if the price of cigarettes fell by 20% and the price of salt fell by 20%, the increase in quantity demanded as a result of equal price changes would be different for salt and cigarettes. As a result, salt and cigarettes have a different price elasticity of demand.
The formula for price elasticity of demand (Ep) is expressed as follows:
This formula quantifies the relationship between the percentage change in quantity demanded and the percentage change in price, serving as a measure of elasticity of demand in response to price fluctuations.
Price elasticity of demand, abbreviated as ep, is the degree to which the quantity demanded responds to a change in price when all other factors influencing demand, such as tastes or income, remain constant.
– Thus, price elasticity of demand allows us to compare the sensitivity of demand for different goods to price changes.
– Ep = (–) percent change in quantity demanded/ percent change in price, according to the definition.
– The demand curve for most commodities slopes downward, indicating an inverse relationship between quantity demanded and the commodity’s price.
– The price elasticity of demand, reflecting this relationship, is always negative. However, when interpreting this elasticity, the negative sign is ignored or omitted.
– The focus lies in measuring the magnitude of responsiveness of quantity demanded to changes in the commodity’s prices.
– The negative sign in the price elasticity of demand is disregarded as we seek to understand how quantity demanded reacts to price changes.
5.1.1 Factors Affecting Price Elasticity of Demand
The price elasticity of demand is influenced by several factors that determine its elasticity. These factors include:
a. Nature of Goods or Commodity: The elasticity of demand is contingent upon the nature of the commodity, whether it is a necessity, comfort, or luxury item. The demand for necessary commodities tends to be relatively inelastic, as consumers are less responsive to price changes due to the essential nature of these goods. On the other hand, luxury goods typically exhibit higher elasticity, as consumers can delay their consumption in response to price increases.
b. Availability of Substitute Goods: The existence of substitute goods in the market plays a crucial role in determining the price elasticity of demand. If there are close substitutes for a particular commodity, the demand for that commodity is likely to be more elastic. For instance, the availability of tea as a substitute for coffee makes the demand for coffee more elastic.
c. Alternative and Variety of Uses of the Product: The alternative uses of a product have an impact on the elasticity of demand. Goods with multiple uses are more likely to have elastic demand. For example, electricity, which serves various purposes, will experience a decrease in demand if its price rises.
d. Role of Habits and Customs: Consumer habits and customs can affect the elasticity of demand. Goods associated with consumer habits, even if the price increases, may not experience a significant decrease in demand. For instance, commodities like alcohol and cigarettes, which are consumed due to habit, tend to have inelastic demand.
e. Income Level of the Consumer: The income level of households is a significant determinant of the elasticity of demand. Since they are less affected by price changes, higher-income groups typically exhibit lower elasticity. In contrast, lower-income groups are more responsive to price fluctuations, resulting in higher elasticity.
f. Consumption Postponement: The ability of consumers to postpone their consumption of a commodity affects the elasticity of demand. Goods with less urgent demand, where consumption can be deferred, tend to have highly elastic demand. Conversely, essential commodities with urgent demand, like medicines, have inelastic demand.
g. Time Period: The time factor also affects the price elasticity of demand. In the short run, demand is generally inelastic because consumers find it challenging to adjust their habits quickly in response to price changes. In the long run, demand becomes relatively elastic as consumers have more flexibility to explore alternative options available in the market in response to price changes.
5.2. Measurements of Price Elasticity of Demand
ΔP=1015−10×100=50%
Substitute into the Formula:
Result:
Interpretation: The negative sign indicates that it is a normal result. In absolute value,
suggests that the quantity demanded is relatively inelastic, meaning a 1% increase in price leads to a 0.4% decrease in quantity demanded.
B. Point method:
| Price of Commodity X | Quantity Demanded of X | Point |
|---|---|---|
| 20 | 60 | A |
| 15 | 90 | B |
A graphic representation of the above table:
Explanation:
Let’s explain the calculation of elasticity at points A and B:
Elasticity at Point A:
So, the elasticity at point A is -2, and at point B, it is 0.33
Arc elasticity of demand measures the responsiveness of quantity demanded to a change in price over a certain range or interval. It is calculated by taking the average of the initial and final values for price and quantity.
Given is the equation for arc elasticity of demand:
Here,
represents the change in quantity demanded,
and Q2 are the initial and final quantities demanded,
represents the change in price,
and are the initial and final prices.
The interpretation of the arc elasticity value is similar to the point elasticity. If the arc elasticity is greater than 1, the demand is elastic; if it is less than 1, the demand is inelastic; and if it is equal to 1, the demand is unitary elastic.
Explanation: The formula essentially compares the percentage change in quantity demanded to the percentage change in price, considering the average values. It provides a measure of responsiveness to price changes over a range rather than at a specific point.
For example, if the price of a good increases from $10 to $12, and the quantity demanded decreases from 100 to 80 units, the arc elasticity would be calculated using these values to assess the overall responsiveness of demand to the price change within that range.
D. Geometrical measure of elasticity of demand:
The geometrical method of measuring elasticity of demand involves using a demand curve to assess the responsiveness of quantity demanded to changes in price. It is commonly represented using a linear demand curve.
The formula for the geometrical measure of elasticity of demand is:
This formula can also be expressed as:
Symbolically:
Ep=
- Slope of Demand Curve: The slope of the demand curve represents the rate at which quantity demanded changes concerning changes in price. A steeper slope indicates inelastic demand, while a flatter slope indicates elastic demand.
- Average Price and Quantity: The formula uses the average price and average quantity to capture the overall change in price and quantity over a specific range.
Interpretation:
- If the geometric elasticity is greater than 1 (, demand is elastic.
- If the geometric elasticity is less than 1 (, demand is inelastic.
- If the geometric elasticity is equal to 1 (, demand is unitary elastic.
- Infinite elasticity (Ep = ∞) means that the quantity demanded can increase without limit for even the smallest decrease in price.
- Zero elasticity (Ep = 0) indicates that there is no change in quantity demanded in response to price variations, representing perfect inelasticity.
In a graphical representation, elasticity is often measured at a specific point by drawing a tangent to the demand curve. The steeper the tangent, the more inelastic the demand; the flatter the tangent, the more elastic the demand. This method provides a visual and geometric understanding of elasticity based on the shape and slope of the demand curve.
5.3. Degrees of Elasticity of Demand
The degree of elasticity of demand refers to the responsiveness or sensitivity of the quantity demanded to changes in price. There are different levels of elasticity, including elastic, inelastic, and unitary elastic, each with its own mathematical expression.
1. Perfectly Elastic Demand:
Explanation: Demand is perfectly elastic when consumers are willing to buy any quantity at a specific price, and the quantity demanded drops to zero at any other price.
Mathematical Expression: Ep = ∞
Example: The demand for a specific brand of water in a market where consumers are only willing to pay a fixed price, and any increase in price results in zero sales.
Graphical Representation:
2. Perfectly Inelastic Demand:
Explanation: Demand is perfectly inelastic when the quantity demanded remains constant, regardless of changes in price.
Mathematical Expression: Ep = 0
Example: Life-saving medications or critical medical treatments where consumers have no choice but to purchase at any price.
Graphical Representation:
3. Relatively Elastic demand:
Explanation: Demand is elastic when the percentage change in quantity demanded is greater than the percentage change in price.
Mathematical Expression: Ep > 1
Example: Luxury goods such as high-end electronics or designer clothing, where consumers are sensitive to price changes.
Graphical Representation:
4. Relatively Inelastic demand:
Explanation: Demand is inelastic when the percentage change in quantity demanded is less than the percentage change in price.
Mathematical Expression: 0 < Ep < 1
Example: Necessities like basic groceries or utilities, where consumers are less responsive to price changes.
Graphical Representation:
5. Unitary Elastic Demand:
Explanation: Demand is unitary elastic when the percentage change in quantity demanded is equal to the percentage change in price.
Mathematical Expression: Ep = 1
Example: Generic products or goods for which consumers adjust their quantity demanded proportionally to changes in price.
Graphical Representation:
5.4: Income Elasticity of Demand
Income Elasticity of Demand (YED) is a measure that helps us understand how the quantity demanded of a good or service changes in response to changes in consumer income. It is expressed as the percentage change in the quantity demanded divided by the percentage change in income. The sign and magnitude of YED provide insights into the nature of the good and how consumers perceive it in relation to their income.
Mathematical Expression:
1. Luxury Goods (YED > 1):
Explanation: For luxury goods, as income increases, the demand for these goods increases even more. Consumers view them as discretionary items that they can afford when their income rises.
Mathematical Expression:
Example: Expensive cars, high-end fashion, luxury vacations.
2. Necessities (0 < YED < 1):
Explanation: Necessities are goods that consumers consider essential, and as income increases, the demand for these goods also increases, but at a slower rate than the increase in income.
Mathematical Expression: 0 <
Example: Basic food items, utilities, healthcare services.
3. Inferior Goods (YED < 0):
Explanation: Inferior goods experience a decrease in demand when consumer income rises. As consumers’ purchasing power increases, they tend to shift away from these goods to higher-quality alternatives.
Mathematical Expression:
Example: Generic products, low-quality goods.
Practical Example: Suppose a country experiences economic growth, leading to an increase in overall income. Luxury car manufacturers may see a substantial increase in demand (YED > 1) as consumers, with higher incomes, decide to splurge on premium vehicles. On the other hand, demand for basic household items like rice and flour (necessities) may also increase but at a slower rate (0 < YED < 1) as people allocate a larger portion of their income to these essential goods.
Graphical representation of Income Elasticity of Demand:
The degree to which a specific product responds to changes in consumer income is reflected in its income elasticity of demand. By classifying products into inferior luxury goods and necessities, we can measure their income elasticity. This elasticity may be negative, positive, or even unresponsive, providing insights into consumer behavior and preferences.
5.5. Cross Elasticity of Demand
Cross elasticity of demand measures how the quantity demanded of one good responds to changes in the price of another good. It helps in understanding the relationship between different goods and whether they are substitutes or complements.
Mathematical Expression: The cross elasticity of demand (Exy) is calculated using the formula:
Interpretation:
- If: Goods X and Y are substitutes (an increase in the price of Y leads to an increase in the quantity demanded of X, and vice versa).
- If: Goods X and Y are complements (an increase in the price of Y leads to a decrease in the quantity demanded of X, and vice versa).
- If: Goods X and Y are unrelated, or there is no cross elasticity.
Classification of goods based on the value of cross elasticity of
demand:
1. Substitutes (Positive Cross Elasticity):
Goods: Tea and Coffee
Scenario: If the price of coffee increases, the demand for tea may increase as consumers switch to a more affordable substitute.
2. Complements (Negative Cross Elasticity):
Goods: Printers and Printer Ink
Scenario: If the price of printers increases, the demand for printer ink may decrease as fewer printers are sold.
3. Unrelated Goods (Zero Cross Elasticity):
Goods: Laptops and Refrigerators
Scenario: Changes in the price of laptops have no significant impact on the demand for refrigerators, indicating zero cross elasticity.
5.6. Promotional Elasticity of Demand (Advertisement Elasticity)
Promotional elasticity of demand measures how the quantity demanded of a product responds to changes in promotional activities, such as advertising, discounts, or other marketing strategies. It helps businesses understand the effectiveness of promotional efforts in influencing consumer demand.
Mathematical Expression: The promotional elasticity of demand (Eprom) is calculated using the formula:
Interpretation:
- If: The promotional activity is effective in increasing demand. A positive value indicates a favourable response to the promotion.
- If: The promotional activity is not effective or may be counterproductive, leading to a decrease in demand.
- If: No significant impact of promotional activities on demand.
Examples:
1. Positive Promotional Elasticity:
Scenario: A company runs a promotional campaign offering a 20% discount on a product, leading to a 15% increase in the quantity demanded.
Calculation:
Interpretation: The promotional activity is effective, with a positive elasticity of 0.75.
2. Negative Promotional Elasticity:
Scenario: A company invests heavily in advertising, but the quantity demanded decreases by 10% during the promotional period.
Calculation:
Interpretation: The promotional activity may not be effective, as indicated by the negative elasticity.
5.7. Concept of Revenue
Revenue is the total amount of money received by a firm from selling its goods or services. It is calculated by multiplying the quantity sold by the price per unit.
There are three key components of revenue:
- Total Revenue (TR): The overall income a firm generates from selling a particular quantity of goods or services. where
P is price, Q is the quantity sold.
- Average Revenue (AR): The revenue earned per unit of output.
- Marginal Revenue (MR): The additional revenue gained by selling one more unit of a product. is the change in quantity sold.
2. Income Elasticity of Demand (Ey): Income elasticity of demand measures the responsiveness of the quantity demanded to a change in consumer income. The formula is:
Relationship between Price Elasticity and Total Revenue: The relationship between price elasticity of demand (Ep) and total revenue (TR) can be explained using a table:
| Ep | Price | Quantity | TR | Explanation |
| >1 | Decreases | Increases | Increases | Demand is elastic |
| =1 | Unchanged | Unchanged | Unchanged | Unitary Elastic Demand |
| <1 | Increases | Decreases | Decreases | Demand is inelastic |
1. Elastic Demand (Ep > 1):
If Ep is greater than 1, a decrease in price increases quantity demanded, leading to an increase in total revenue.
Example: If Ep = 2, a 10% price reduction results in a 20% increase in quantity demanded, leading to a 10% increase in total revenue.
2. Inelastic Demand (Ep < 1):
If Ep is less than 1, a decrease in price results in a proportionally smaller increase in quantity demanded, leading to a decrease in total revenue.
Example: If Ep = 0.5, a 10% price reduction results in only a 5% increase in quantity demanded, leading to a 5% decrease in total revenue.
This relationship can be understood by the following
diagram:
The connection between Average Revenue (AR), Marginal Revenue (MR), and elasticity of demand is crucial for comprehending the dynamics at various production levels. This relationship also plays a significant role in grasping price determination across diverse market scenarios. It has been explained that a firm’s average revenue curve coincides with the demand curve for the firm’s product in the market.