Managerial Economics

M.Com. IV Sem.
Mr. Abhi Dutt Sharma
Dated: 14/04/2020
Elasticity Of Demand

Contt..

5.2 Price Elasticity of Demand

The concept of price elasticity of demand is a numerical measure of the extent to which quantity demanded
responds to a change in price, other determinants of demand being kept constant.

Example: If the price of cigarettes fell by 20% and the price of salt fell by 20%, the increase in quantity
demanded due to equal changes in prices would be different for salt and cigarettes. Thus salt and cigarettes are
said to have a different price elasticity of demand.

Price elasticity of demand, ep, measures the degree to which the quantity demanded responds to a change in price
when all other factors that influence demand such as tastes or income are kept constant. In the example, it is
extremely likely that the percentage increase in quantity demanded would be much more for cigarettes than for
salt, even though the percentage decreases in price are the same. Thus price elasticity of demand allows us to
compare the sensitivity of the demand for various goods for the same changes in price. From the definition:

ep = (–)% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑

% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒

Let us consider a commodity X. If its price rose, then the percentage change in price would be positive (since the
new price is greater than the old price) and the denominator in the expression for e p would be positive. However,
the quantity demanded would fall and the percentage change in quantity demanded would be negative. Hence
the numerator in the expression would be negative.

Thus, for most goods as quantity demanded and price have an inverse relationship, cetris paribus, e p is always
likely to be negative.

!
Caution However by placing a minus sign in the formula we make e p positive. The reason is that we want to
equate "more elastic" with "more responsive". For example, let two commodities X and Y have elasticities of
+ 10 and +0.5 (calculated after multiplying by (–1) in accordance with the formula). The demand for
commodity X is more responsive to price changes than is the demand for commodity Y, and X has a larger
elasticity since +10 is greater than +0.5. Hence "more elastic" is equated with "more responsive". However, if
we did not multiply by (–1), the two elasticities would be –10 and –0.5. Since –0.5 is greater than –10 we
would be likely to say that Y has a greater elasticity than X (when in fact it is the other way round). Hence
without multiplying by (–1) we would not be able to substitute "more elastic" for "more responsive".

A review of the basic formula of elasticity will show that it follows from the definition of price elasticity.

% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑

ep = (-)
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
where,

𝑛𝑒𝑤 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦−𝑜𝑙𝑑 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦

% change in quantity demanded= × 100
𝑜𝑙𝑑 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦

𝑁𝑒𝑤 𝑝𝑟𝑖𝑐𝑒−𝑂𝑙𝑑 𝑝𝑟𝑖𝑐𝑒

% change in price= × 100
𝑂𝑙𝑑 𝑝𝑟𝑖𝑐𝑒

Let P = Old price

Q = Old quantity
Q = New quantity – Old quantity

P = New price – Old price

𝛥𝑄 𝛥𝑃 𝛥𝑄 𝑃
ep = ( -) × 100 / × 100 = (-) .
𝑄 𝑃 𝛥𝑃 𝑄

Task Given the following data, calculate the price elasticity of demand when (a) price
increases from 5.00 per unit to 8.00 per unit and (b) the price falls from 8.00 per unit
to 5.00 per unit.

Px (per unit) 6 5 4 3 2 1

Qx 200 350 600 850 900 1200

The price elasticity of a straight line demand curve varies from infinity at the price axis to zero at the quantity axis.

Consider a straight line demand curve cutting both the axes as shown in Figure 5.5. Elasticity of deman d, e p, is
defined as the numerical measure of the degree to which quantity demanded responds to a change in price ceteris
paribus.

𝛥𝑄 𝑃
Ep= (-) .
𝛥𝑃 𝑄

Figure 5.5

Now the slope of the demand curve is dP/dQ (since the demand curve is a straight line and the slope of a straight
line is given by change in Y divided by change in X).

Hence the term dQ/dP in the expression for ep is the reciprocal of the slope of the demand curve.

Since the slope of a straight line is the same throughout, the reciprocal of the slope will also be the same throughout.
Thus, for any straight line demand curve, the elasticity at any point is a function of (depends upon) the P/Q ratio.

At the price axis, Q = 0 and P/Q is undefined, but as we let q approach zero, without ever reaching it, the ratio
p/q increase without limit. In other words, ep approaches infinity as q approaches 0. Thus, e p is infinity at the price
axis.
At the quantity axis, P = 0 and P/Q is zero. Thus ep = 0 at the quantity axis.

By a similar reasoning we conclude that as we move down a demand curve, the p/q ratio falls steadily as p keeps
decreasing and q keeps increasing. Hence the coefficient of elasticity is greater at a higher point (point B) than at
a lower point (point C) since the higher point will have a greater p/q ratio and dQ/dP is inconsequential.

Two parallel straight line demand curves have a different elasticity at each price.
Explain why the (proposition above) is true?

Let D 1 and D 2 be two parallel straight line demand curves, and let the (same) price at which their elasticities are
being compared be OM (Figure 5.6).
Figure 5.6

Elasticity of demand, ep, is defined as the numerical measure of the degree to which quantity demanded responds
to a change in price, ceteris paribus. From the definition,
𝑑𝑄 𝑃
ep = (-). .
𝑑𝑃 𝑄

Since the slope of a demand curve is dP/dQ, the term dQ/dP in the expression for e p is the reciprocal of the slope
of a demand curve. Also, as the two demand curves are parallel, it follows that their slopes and hence the
reciprocals of their slopes are the same.

Thus at any given price level the elasticities of the straight line demand curves can be compared by comparing
their corresponding quantities.

At point A (demand curve D 1) the quantity demanded is OR and at point B (demand curve D 2, but at the same
price as A) the quantity demanded is OS. Since OS > OR the P/Q ratio is greater in the case of D 1. Hence point A
has a higher elasticity than point B or the demand curve further away from the origin is less elastic at each price
than the one closer to the origin.

The elasticities of two intersecting straight line demand curves can be compared at the point of intersection merely
by comparing slopes, the steeper curve being less elastic.

Let two straight line demand curves, D 1 and D 2, having different slopes, intersect each other at A, as in Figure 5.7.

At the point of intersection, price (P) and quantity (Q) are the same for both demand curves. Hence the P/Q ratio
is the same for both demand curves at the point of intersection (point).
 Figure 5.7

Since the slope of a demand curve is dP/dQ, the term dP/dQ in the expression for e p is the reciprocal of the slope.
For both demand curves, since P/Q is the same, the elasticities can be compared by comparing dQ/dP.

As D 1 is steeper than D 2, dQ/dP for D 1 is less than that for D 2. (Remember that dQ/dP measures the reciprocal of
the slope). Hence D 2 (the steeper curve) is less elastic than D 1.

Arc Elasticity

The geometrical method of measurement of price elasticity of demand is applicable only for infinitesimal changes
in price. If price changes appreciably then we use the arc elasticity of demand. Arc elasticity is calculated with the
help of the following formula:

𝛥𝑄 (𝑃1+𝑃2)/2 𝛥𝑄 (𝑃1 +𝑃2 )/2

ep = . = .
𝛥𝑝 (𝑄1+𝑄2)/2 𝛥𝑃 (𝑄1+𝑄2)/2

Where P1 and Q1 are initial price and quantity, P2 and Q2 are new price and quantity and P and Q are the changes
in price and quantity respectively.

The arc elasticity is a measure of average elasticity, that is, the elasticity at the midpoint of the chord that connects
the two points (A and B) on the demand curve defined by the initial and new price levels. The measure of arc
elasticity is an approximation of the true elasticity of the section AB of the demand curve. The more convex to the
origin the demand curve is, the poorer the linear approximation attained by the arc elasticity formula.

!
Caution It would be observed that the only difference between this formula and the point elasticity formula
is in the use of the average quantities and average prices. A basic limitation of the point elasticity formula
relates to the use of the base. If in Figure 5.8 we have to measure elasticity of demand between the points A
and B by the percentage method, it is difficult to say which one of those will make a better base. The choice
will be entirely arbitrary. The problem can be solved by using average prices and average quantities.
 Figure 5.8

5.3 Income Elasticity

The income elasticity of demand (ei) is similar to the concept of price elasticity of demand. Just as price determines
price elasticity, so does income, another determinant of demand, determine income elasticity.

The income elasticity of demand is a numerical measure of the degree to which quantity demanded responds to a
change in income, other determinants of demand being kept constant.

For example, let there be two goods, clothing and salt. Let the consumers income increase by 5%. Then the
percentage change (increase) in quantity demanded would be different for clothing and different for salt (the
percentage increase in quantity demanded for clothing is likely to be much higher than that for salt). Thus, clothing
and salt are said to have a different income elasticity of demand. Thus, for the same percentage increase in income
(i.e., 5%) the percentage increase in the quantity demanded for different goods is different. Income elasticity of
demand provides us with a numerical measure of this difference.

Thus, income elasticity of demand allows us to compare the sensitivity of the demand for various goods for the
same change in income. From the definition,

ei = % change in quantity demanded/ %change in income

The income elasticity of a commodity may be positive (the usual or likely case) or negative, depending on whether
the good is normal or inferior.

A normal good is one where a percentage increase in income ceteris paribus causes a percentage increase in
quantity demanded and vice-versa. Thus for normal goods (e.g., clothing, cigarettes) income and quantity
demanded vary in direct proportion ceteris paribus due to which the income elasticity of demand is positive.

An inferior good is one where a percentage increase in income ceteris paribus, causes a percentage decrease in
quantity demanded and vice-versa. Thus for inferior goods (e.g., cheap whisky, artificial jewellery, imitation shoes,
etc.) income and quantity demanded vary in an inverse proportion ceteris paribus due to which the income
elasticity of demand is negative.

When ei = 1, the good is said to have unitary income elasticity; when e i > 1, the good is said to be income elastic,
and so on. Remember when ei is negative, the good is an inferior good.

5.4 Cross Elasticity of Demand

!
 Caution The cross elasticity of demand (ec) is a numerical measure of the degree to which quantity demanded
of a good responds to changes in the prices of other commodities, the other determinants of demand bein g
kept constant.

Let there be two goods X and Y. If the price of Y changes (increases or decreases), this may have an effect on the
quantity demanded of good X. The concept of cross elasticity provides a numerical measure of the percentage
change in quantity demanded due to a change in price of other commodities. It measure the degree to which
quantity demanded is a function of the price of all other commodities. From the definition,

% change in quantity demanded of good X

ec = % change in price of good Y

Example: If X and Y (say butter and bread) are complements, e c will be negative. If the price of bread rose
ceteris paribus, there would be a decrease in the quantity demanded of bread and a decrease in the quantity
demanded of butter. Thus, for complements, a change in price of one good ceteris parbius causes the quantity
demanded of the complements to move in the opposite direction. If there is a percentage increase in the price of
bread, the denominator in the formula would be positive. Similarly, if there is a percentage decrease in the quantity
of butter, the numerator in the formula would be negative. Hence, e c is negative for complements.

If X and Y (say tea and coffee) are substitutes, e c will be positive. If the price of coffee rose ceteris paribus, there
would be a decrease in the quantity demanded of coffee and an increase in the quantity demanded of tea as
consumers would readily "substitute" tea for coffee. Thus, for substitutes the price change of one good ceteris
paribus causes the quantity demanded of the substitute to move in the same direction. If there is a percentage
increase in the price of coffee, the denominator in the formula would be positive. Similarly, if there is a percen tage
increase in the quantity demanded of tea, the numerator in the formula would be positive. Hence, e c is positive for
substitutes.

The higher the numerical magnitude of cross elasticity, the greater is the degree of complementarity/substitution
between the two goods. Thus, theoretically the value of cross elasticity ranges from minus infinity (- ) for perfect
complements to plus infinity (+ ) for perfect substitutes.

𝑑𝑄𝑥 𝑑𝑃𝑥
ec = ÷
𝑄𝑥 𝑃𝑥

𝑑𝑄𝑥 𝑃𝑥
= .
𝑑𝑃𝑥 𝑄𝑥

Notes Applications of Elasticity

The concept of elasticity has a wide range of applications in economics. In particular, an
understanding of elasticity is fundamental in understanding the response of supply and demand in
a market.

Some common applications of elasticity include:

1. Effect of changing price on firm's revenues: If the demand for the product is
price inelastic, the firm would not want to lower its price since that would reduce its
total revenue, increase its total costs and this will give it lower profits.
2. Analysis of incidence of the tax burden and other government policies: In
economics, tax incidence is the analysis of the effect of a particular tax on the
distribution of economic welfare. Tax incidence is said to "fall" upon the group that,
at the end of the day, bears the burden of the tax. The key concept is that the tax
incidence or tax burden does not depend on where the revenue is collected, but on
the price elasticity of demand (and price elasticity of supply). For example, a tax on
orange farmers might actually be paid by owners of agricultural land or consumers
of oranges.

3. Effect of international trade and terms of trade effects: Marshall-Lerner

Condition gives a technical reason why a reduction in value of a nation's currency
need not immediately improve its balance of payments. The condition states that, for
 a currency devaluation to have a positive impact on trade balance, the sum of price
elasticity of exports and imports (in absolute value) must be greater than 1.
4. Analysis of consumption and saving behavior: the way consumers respond
to the change in prices or other determinants of demand, determines their
consumption pattern and savings pattern. For example, a consumer purchases 2
bottles of cold drinks instead to 4, when price rose from 10 to 15. Other things
remaining constant, he is saving more money than before.
5. If the elasticity of the firm's sales with reference to advertisement
expenditure is positive and higher than for its expenditure on product quality and
customer service, then the firms would find it more beneficial to concentrate its sales
efforts on advertising rather than on product quality and customer service.

5.5 Summary
Elasticity of demand tells the degree of responsiveness of consumer to a price change. It is measured as:

Percentage change in quantity demanded

ed
Percentage change in price

The arc elasticity is a measure of average elasticity, that is, the elasticity at the midpoint of the chord that
connects the two points (A and B) on the demand curve defined by the initial and new price levels.

The income elasticity of demand is a numerical measure of the degree to which quantity demanded responds
to a change in income, other determinants of demand being kept constant.

The cross elasticity of demand is a numerical measure of the degree to which quantity demanded of a good
responds to changes in the prices of other commodities, the other determinants of demand being kept
constant.

An understanding of elasticity is fundamental in understanding the response of supply and demand in a market.

5.6 Keywords
Arc elasticity: It computed if the data is discrete and therefore incremental change is measurable.
Cross elasticity: Degree to which demand for one product is affected by the price of another product.
Demand elasticity: Elasticity used to show the responsiveness of the quantity demanded of a good or service to a
change in its price.

Elasticity: It measures the degree of responsiveness of demand/supply to change in price.

Point elasticity: It computed if demand function is continuous and therefore only marginal changes are calculable.

5.7 Self Assessment

1. Fill in the blanks:

(a) Elasticity of demand measures responsiveness of demand of a commodity to ………..,

…………… and ...................... .

(b) Such horizontal demand curves, where quantity demanded is infinitely responsive to price
changes, are called ........................ .

(c) Demand curves which have an elasticity coefficient as 1 are called ........................ .

(d) All such demand curves where quantity demanded is totally unresponsive to changes in price
are called .............. .

(e) The demand is ................ in the long run.

2. State true or false for the following statements:

 (a) If we go by the Law of Demand, the price elasticity for most goods would be negative.

(b) The price elasticity of a straight line demand curve varies from zero to infinity.

(c) When the income elasticity is equal to 1, the good is said to be income inelastic.

(d) When the income elasticity is negative, the good is an inferior good.

(e) For complementary goods, the cross elasticity will always be positive.

Answers: Self Assessment

1. (a) Price, income of consumers and price of other goods

(b) Perfectly elastic (c) Unit elastic

(d) Perfectly elastic (e) More elastic

2. (a) True (b) True (c) False

(d) True (e) False