Elasticity of Demand

1. Elasticity of Demand Kishor Bhanushali

2. Elasticity of Demand • The extent to which the quantity demanded will rise (fall) due to fall (rise) in the price of the same good or a related good or due to the rise in the income of the consumer • Analysis of demand sensitivity with respect to prices of goods and income helps the business to forecast market trends in future

3. Price Elasticity of Demand • Responsiveness of quantity demanded to changes in the price • Price elasticity of demand is defined as the percentage change in quantity demanded resulting from one percent change in the price of the good, other things remaining constant • ep = Percentage Change in quantity demanded Percentage change in price • Elasticity is unit free as it is measured in proportion of two percentages • We can predict the expected changes in quantity demanded • Forecast required changes in price, when we want to realize a targeted change in quantity demanded

4. Price Elasticity Ed Percentage Change in Quantity Demanded = Percentage Change in Price Change in Quantity Demanded Change in Price = ÷ Quantity Demanded Initially Initial Price P ∆Qd = * ∆P Qd Where ∆Qd = Change in Quantity Demanded ∆P = Change in Price

5. Elasticity over a Segment of Demand Curve Price D R P0 S P1 D 0 Quantity Demanded Q0 Q1

6. Price Elasticity over a Segment of Demand Curve Q1 – Q0 (P0 + P1)/2 X ep = P1 – P0 (Q0 + Q1)/2 P0 + P1 Q1 – Q0 = X Q0 + Q1 P1 – P0 P0 + P1 Q = X P Q0 + Q1

7. Elasticity at a Point on the Demand Curve • Measurement of point elasticity is same as the price elasticity of demand in a limiting sense • Here changes in quantity demanded and price are infinitesimally small • Point elasticity of demand is different at different point on the demand curve

8. Elasticity at a Point on the Demand Curve Draw a tangent AB on the demand curve at point R Slope of AB = OB/OA Ep = (OB/OA)* (RN/RM) As triangle AOB, AMR and NRB are similar (OB/OA)= (NB/RN) Ep = (NB/RN)*(RN/RM) = NB/RM Again NB/RM = RB/AR Ep = RB/AR Ep = Lower Segment Upper Segment Price D Lower Segment ep = Upper Segment A S R M D B O N Quantity Demanded

9. Elasticity at a Point on the Demand Curve Price ep = ∞ A ep > 1 ep = 1 ep < 1 ep = 0 0 B Quantity Demanded

10. Categories of Price Elasticity of Demand • Perfect elastic demand • Perfect inelastic demand • Unit elasticity of demand • Relatively elastic demand • Relatively inelastic demand

11. Difference between Slope and Elasticity • Slope of the Demand Curve ðP ðQ • Elasticity on the demand curve • Tow demand curves may have the same slope but different elasticities as well as different slope and the same elasticities = P ðP = Q ðQ

12. Price C The absolute elasticity of demand curve AB is more than that of demand curve CD, in spite of their slopes being the same A R S P Quantity Demanded 0 B D

13. Price Elasticities of both the curves are equal , where as their slopes are different A R S P 0 B C Quantity Demanded

14. Price Elasticity, Total Revenue and Total Expenditure • Total expenditure by the consumer over any given period of time is the number of units of a product purchased over a period Q, multiplied by the price of the product , P • Total Expenditure = P.Q = Total Revenue Price Supply Total Revenue = OAEQ Total Expenditure = OAEQ E A Demand Quantity 0 Q

15. Predicting Changes in Total Revenue and Total Expenditure in Response to Price Increase New Supply Curve Price Old Supply Curve Gain in revenue F P2 P1 E H Loss in revenue Demand Curve 0 Q2 Quantity Q1

16. Predicting Changes in Total Revenue and Total Expenditure in Response to Price Increase

17. Cross Elasticity of Demand • Cross elasticity of demand is defined as the percentage change in the quantity demanded of a good due to the changes in the prices of other good, other things remaining the same. Percentage change in the demand of ith good Percentage change in the price of jth good ecji =

18. Cross Elasticity of Demand • When two goods are substitutes, than increase in the price of one good decreases its own demand and increases the demand of another good. In this case cross elasticity of demand is positive In the case of complementary goods the increase in the price of one good decreases the demand for both the goods. In this case cross elasticity of demand is negative.

19. Income elasticity of Demand • The income elasticity of demand is defined as the rate of change in the quantity demanded of a good due to changes in the income of the consumer. • If the amount of good demanded rises as the income of the consumer increases, than value of income elasticity of demand is positive (Normal good) • If the amount of good demanded decreases as the income of the consumer increases, than value of income elasticity of demand is negative (Inferior good) • Income elasticity of demand is also used to classify goods into luxuries and necessities. If the income elasticity of good is greater than one, it is called luxury. If the income elasticity is less than one, it is called a necessity. If it is equal to one, it can be called as a semi-luxury good.

20. Income Elastic E1 Q2 Income elasticity of demand is greater than one. In this case as income increases, the quantity demanded also increases. But the percentage increase in demand is more than percentage increase in income Quantity Demanded E Q1 0 Y1 Y2 Income

21. Income Inelastic Quantity Demanded E2 Q1 Income elasticity is between zero and one. In this case, as income increases quantity demanded increases but the percentage increase in quantity demanded is less than percentage increase in income Q2 E1 0 Y1 Y2 Income

22. Varying Income Elasticities Income elasticity is positive at low incomes but becomes negative as income increases above level M. Maximum consumption of good occurs at income M. Quantity Demanded Positive income elasticity Negative income elasticity Income 0 M Elasticity less than 1 and becomes negative

23. Promotional (or Advertising) Elasticity of Demand • The advertising elasticity of demand measures an extent to which the demand of a product will be influenced by advertisement and other promotional activities. • Advertising elasticity of demand measures the responsiveness of quantity demanded to changes in the expenditure on advertising and other sales promotional activities. ðQ A . eA = Q ðA

24. Determinants of Price Elasticity of Demand • Closeness of substitutes • The proportion of income spent on the good • The time elapsed since the price change • Nature of good

25. Determinants of Income Elasticity of Demand • Nature of the need the good covers • The initial level of income of a country • Time period

26. Determinants of Cross Elasticity of Demand The main determinant of cross elasticity of demand is the nature of the goods relatives to their usages. If two goods can satisfy equally well the same need, the cross elasticity is high and vice versa.