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Subject Commerce

Paper No and Title 2 : Managerial Economics

Module No and Title 6: Measurement of elasticity

Module Tag Com_P2_M6

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MODULE No. 6: methods of measuring Elasticity of demand
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TABLE OF CONTENTS

1) Learning Outcomes

2) Methods of measuring elasticity of demand

3) Straight line method of elasticity

4) Outlay method of elasticity

5) Arc method of elasticity

6) Comparison between straight line and demand curves’ elasticity

7) Comparing Elasticities

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MODULE No. 6: methods of measuring Elasticity of demand
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1. Learning Outcomes

After studying this module, you shall be able to:

 Know the methods of measuring elasticity of demand

 Understand straight line method of elasticity
 Understand outlay method of elasticity
 Understand arc method of elasticity
 Compare straight line and demand curves’ elasticity

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MODULE No. 6: methods of measuring Elasticity of demand
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2 Methods of measuring price elasticity of demand

The price elasticity of demand measures the responsiveness of percentage

change in price to percentage change in quantity demanded. There are three
popular methods for measuring price elasticity of demand. These are as
follows:
(i) Straight line method

(ii) Outlay method

(iii) Arc elasticity

We will explain these methods one by one.

3. Straight line method of elasticity

It is the simplest method to calculate price elasticity. There is a simple rule

for calculating price elasticity of a demand curve, i.e., the elasticity of a
straight line at a point is given by the ratio of the length of the line segment
below the point to the length of the segment above it.

This can be shown through diagram 1. At the top of the line, a very small
percentage price change induces a very large percentage quantity change;
therefore the elasticity is extremely large.
Figure1

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MODULE No. 6: methods of measuring Elasticity of demand
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Price elasticity is relatively large when we are high up the linear demand
curve DD. The same rule is used here to calculate price elasticity, i.e., lower
segment divided by upper segment. At point B in the figure, elasticity of
demand is the ratio of segment BZ to the segment AB. Looking at axes, we
find the ratio is 3. Therefore, price elasticity at point B is 3. Similarly for
point R, demand at this point is inelastic and the elasticity is ½. Finally, at
point M, the elasticity is one because ratio of the lower segment and upper
segment is one. The calculation of price elasticity along a linear demand
curve is shown below in the table:
Table 1: Calculation of price elasticity along a linear demand curve

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MODULE No. 6: methods of measuring Elasticity of demand
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Q ∆Q P ∆P

0 6 10 ÷ 2 = 5 Elastic
10 2 5 5 5 5

10 4
10 2 15 3 10 ÷ 2 = 1 Unit Elastic
15 3
20 2
10 2 25 1 10 ÷ 2 = 0.2 Inelastic
25 1
30 0

For the mathematically inclines, we can show the algebra of elasticities for
straight line (linear) demand curves. We begin with a demand curve, which
is written as Q= a-bP.
The demand elasticity at point (Po , Qo) is defined as

This implies that the elasticity at point (Po, Qo) is

Note that the elasticity depends upon the slope of the demand curve, but it
also depends upon the specific price and quantity pair. In the diagram 1, we
have seen that linear demand curve starts out with high price elasticity,
where price is high and quantity is low, and end up with low elasticity,
where price is low and quantity is high.

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MODULE No. 6: methods of measuring Elasticity of demand
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4. Outlay or total expenditure method of elasticity of demand

Many businesses want to know whether raising prices will lower or raise the
revenue. This question is of strategic importance for businesses like airlines,
baseball teams, and magazines. They are always interested in knowing
whether it is worthwhile to raise price and whether the higher prices would
make up for demand reduction.
The sellers earn revenue in the form of expenditure incurred by the
consumers. Total revenue is by definition equal to price times quantity
(P*Q). Change in the price of a good brings a change in the revenue. The
changes in the revenue are dependent on the price elasticity of the good. The
three situations that may arise due to change in the price of the good and its
impact on the revenue are summarised below in the following table 2.

Table 2: Explaining Elasticities

Change in Change in Explanation Ed Terminology
the Price Quantity
Demanded
Falls Rises in a Expenditure e>1 Elastic
greater increases Demand
proportion
Falls Rises in the Expenditure e=1 Unitary
same remains Elastic
proportion constant Demand
Falls Rises in Expenditure e<1 Inelastic
lesser falls Demand
proportion

Now a day concept of elasticity is widely used by businesses to divide

consumers into groups with different elasticities and then accordingly
decisions are taken. This technique has been extensively used by the airlines.
Another example is software companies, which have a wide range of
products with different prices. These companies by dividing consumers into
different categories exploit elasticities. For example, if the consumer is
willing to buy a new operating system immediately, your elasticity is low
and in such a situation the seller will get benefit by charging a relatively
higher price. On the other hand, if the consumers are not in hurry to upgrade
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MODULE No. 6: methods of measuring Elasticity of demand
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their systems, it means elasticity is high and

consumer can search around for the best price. In such a situation, the seller
will try to find a way to make the sale by charging relatively low price.

5.Arc method of elasticity of demand

The measure of elasticity of Demand between two finite points is known as

Arc Elasticity. It is relevant where change in price and consequent change in
demand is substantial. Arc elasticity is a measure of average of
responsiveness of the quantity demanded to a substantial change in price.
In figure 2, the measure of elasticity between point J and point K is known
as arc elasticity. The elasticity between point J and K can be calculated by
substituting values of ΔP & ΔQ into elasticity.

Figure 2: Arc elasticity

ΔQ=43-75=-32

ΔP=20-10=10

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= 1.49
This means one percent decrease in price of the commodity X means results
in 1.49 percent increase in demand for it.

The arc elasticity should be measured carefully because co-efficient may

differ between the same two finite points on a demand curve. For instance, if
direction of change in price is reversed, coefficients may be different. A
reverse movement from Point K to J gives
P=10
ΔP=10-20=-10
Q=75
ΔQ=75-43=32
By substituting these values into elasticity formula, we get-

= 0.43
Thus, while measuring price elasticity, direction of change of price
change should be carefully noted, otherwise it shall give misleading
results. It is important to note that the elasticity between the midpoints
and the upper point J or lower point K will be different. Thus, this
method does not measure one point elasticity.

6. Comparison between straight line and demand curves’ elasticity

The elasticity measured on a finite point of a demand curve is called point

elasticity. The Point Elasticity of demand is defined as proportionate change
in quantity demanded in response to a very small change in price. The

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MODULE No. 6: methods of measuring Elasticity of demand
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concept of point elasticity is useful where change

in price and consequent change in quantity demanded are very small.
The point elasticity can be expressed as-

To measure point elasticity, let us suppose a linear demand curve AB and we

measure price elasticity at point P as shown in figure3.
We know that Price= PQ
Quantity= OQ

The derivative ∂Q is the slope of demand curve AB .The slope of straight

∂P
line demand curve AB at point P is geometrically given by QB/PQ
i.e
Since at Point P, P=PQ and Q=OQ
substituting these values ignoring the (-) sign we get

Geometrically

This may be proved as follows. If we draw horizontal line from P to the

vertical axis, there will be three triangle ∆ AOB, ∆ ARP, ∆PQB (Figure3) in
which AOB, ARP and PQB are right angles. Therefore, the
corresponding angles of the three triangles will always be equal and hence ∆
AOB, ∆ ARP, ∆PQB are similar triangles.

Figure 3: Point Elasticity of linear demand curve

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According to geometrical Properties of similar triangles, the ratio of two

sides of similar triangle is always equal to the ratio of corresponding sides of
the other triangles Therefore in ∆ PQB and ∆ ARP

Since RP =OQ by substituting O for RP in above equation we get

By proportionality rule Therefore

It may thus be concluded that price elasticity at point P is given by

Measuring Point Elasticity on Non Linear demand Curve:

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Suppose we want to measure the elasticity of

demand curve DD at Point P, let us draw a tangent line AB to the Demand
curve DD at point P. Since the Demand Curve DD and the line AB pass
through the same point (P). The slope of the demand curve and that of the
line at this point is the same. Therefore, the elasticity of the demand curve
DD at the point will be equal to the elasticity of the demand line AB at the
Point P can be measured (ignoring minus sign)

Geometrically QB/OQ = PB/PA

Table 1: Calculation of price elasticity along a linear demand curve

Q ∆Q P ∆P

0 6 10 ÷ 2 = 5 Elastic
10 2 5 5 5 5

10 4
10 2 15 3 10 ÷ 2 = 1 Unit Elastic
15 3
20 2
10 2 25 1 10 ÷ 2 = 0.2 Inelastic
25 1
30 0

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Figure 4: Point elasticity of non linear demand curve

6. Comparing Elasticities

We will compare price elasticity on two demand curves.

Comparing Price Elasticity on two Intersecting Demand Curves:
In figure5 we compare elasticity at a given price where two demand curves
AB and CD intersecting at point E. We noticed that demand curve CD is
flatter than AB. For e.g. at price OP, corresponding to the point E, elasticity
at point E on demand curve CD is OP/PC. Similarly at point E on demand
curve AB elasticity is OP/PA. Hence, OP/PC > OP/PA because PC is less
than PA.

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Hence it is cleared that at every price on the

flatter demand curve CD price elasticity is greater than that on the relatively
steeper demand curve AB.
FIGURE 5:

Comparing Price Elasticity on two Parallel Demand Curves:

In figure 6 we compare elasticity at a given price where two demand curves
AB and CD are parallel to each other. Since they are parallel to each other,
so they have same slope. Here at price OP elasticities are different. Let draw
a perpendicular from point R to point P on y axis. Thus two points are Q and
R on two demand curves. Elasticity of AB curve at point Q is QB/QA and at
point R is RD/RC. Because in a right angled triangle OAB, PQ is parallel to
OB. Therefore,
QB=QA=OP/PA. So elasticity at point Q on demand curve AB= OP/PA.
Similarly on point R on demand curve CD, elasticity= OP/PC. Because PC
is greater than PA,
so, OP/PC< OP/PA.
Thus, at point R on the demand curve CD the elasticity is less than at point
Q on demand curve AB, when two demand curves are parallel to each other.
FIGURE 6

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7. Summary

The price elasticity of demand measures the responsiveness of percentage

change in price to percentage change in quantity demanded. There are three
popular methods for measuring price elasticity of demand named Straight
line method, Outlay method and Arc elasticity. Straight line at a point is
given by the ratio of the length of the line segment below the point to the
length of the segment above it. In outlay method, total revenue is by
definition equal to price times quantity (P*Q). The measure of elasticity of
Demand between two finite points is known as Arc Elasticity. The Point
Elasticity of demand is defined as proportionate change in quantity
demanded in response to a very small change in price. Finally we compare
the elasticity of the two intersecting and parallel demand curves.

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MODULE No. 6: methods of measuring Elasticity of demand