By Muhammad Shahid Iqbal

1. Engineering Economics By Muhammad Shahid Iqbal • Module No. 04 Elasticity and Its Applications (Quantitative Demand Analysis)

2. Elasticity of Demand • We know, from the Law of Demand, that price and quantity demanded are inversely related. • Now, we are going to get more specific in defining that relationship, … allows us to analyze demand and supply with greater precision. • We want to know just how much will quantity demanded change when price changes? That is what elasticity of demand measures. • It is a measure of how much buyers and sellers respond to changes in market conditions • Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good. • Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price.

3. Elasticity of Demand • The above formula usually yields a negative value, due to the inverse nature of the relationship between price and quantity demanded. • How Do We Interpret the Price Elasticity of Demand? • A good economist is not just interested in calculating numbers. The number is a means to an end; • in the case of price elasticity of demand it is used to see how sensitive the demand for a good is to a price change. • The higher the price elasticity, the more sensitive consumers are to price changes. • A very low price elasticity implies just the opposite, that changes in price have little influence on demand.

4. Elasticity of Demand • We can read it as the percentage change in quantity for a 1% change in price • Thus, if Ed = 2, that means in that part of the demand curve, a 1% change in price will cause a 2% change in quantity demanded. Or if we extrapolate, a 2% change in price will cause a 4% change in quantity demanded, and so on.

5. Degrees of Ed • Perfectly Inelastic • Ed = % Δ in Qd % Δ in P • Ed = 0___ % Δ in P • Ed = 0 it is also called zero elasticity

6. Degrees of Ed • Perfectly elastic demand • Ed = % Δ in Qd % Δ in P • Ed = % Δ in Qd 0 • Ed = ∞

7. Degrees of Ed • Relatively Inelastic or Inelastic Ed = % Δ in Qd % Δ in P Ed < 1 (in absolute value) % Δ in Qd < % Δ in P • For every 1% change in P, Qd changes by less than 1% • Quantity demanded does not respond strongly to price changes.

8. Degrees of Ed • Relatively elastic or elastic Demand Ed = % Δ in Qd % Δ in P Ed > 1 (in absolute value) % Δ in Qd> % Δ in P • For every 1% change in P, Qd changes by more than 1% (in opposite direction)

9. Degrees of Ed • Unitary Elastic Demand Ed = % Δ in Qd % Δ in P Ed = 1 (in absolute value) % Δ in Qd = % Δ in P • For every 1% change in P, Qd changes by 1% (in opposite direction) • Quantity demanded responds strongly to changes in price.

10. Elasticity of Demand and Its Determinants • Availability of Close Substitutes • Necessities versus Luxuries • Definition of the Market • Time Horizon

11. Elasticity of Demand and Its Determinants • Availability of Substitutes • The more choices that are available, the more elastic is the demand for a good. (and vice versa) • If the price of Pepsi goes up by 20%, one can always purchase Coke, 7-Up and so forth. • One's willingness and ability to postpone the consumption of Pepsi and get by with a "lesser brand" makes the PED of Pepsi relatively elastic.

12. Elasticity of Demand and Its Determinants • Amount of Consumers Budget • The less expensive a good is as a fraction of our total budget, the more inelastic the demand for the good is (and vice versa). • Most consumers have both the willingness and ability to postpone the purchase of big ticket items. • If an item constitutes a significant portion of one's income, it is worth one's time to search for substitutes. • A consumer will give more time and thought to the purchase of a $3000 television than a $1 candy bar, so demand for the former will be more elastic than demand for the latter.

13. Elasticity of Demand and Its Determinants • Time • The longer the time frame is, the more elastic the demand for a good is (and vice versa). • The more time a consumer has to search for substitute goods, the more elastic the demand.

14. Elasticity of Demand and Its Determinants • Necessities vs. Luxuries • The more necessary a good is, the more inelastic the demand for the good (and vice versa). • With a true necessity a consumer has neither the willingness nor the ability to postpone consumption. • There are few or no satisfactory substitutes. • Insulin is the ultimate necessity, so the demand for it is inelastic.

15. Elasticity of Demand and Its Determinants • Availability of information concerning substitute goods • The easier it is for a consumer to locate the substitute goods, the more willing he will be to undertake the search, and the more elastic demand will be. • an attachment to a certain brand—either out of tradition or because of proprietary barriers—can override sensitivity to price changes, resulting in more inelastic demand

16. Total Revenue and Elasticity of Demand

17. Total Revenue and Elasticity of Demand • When the price elasticity of demand for a good is perfectly inelastic (Ed = 0), changes in the price do not affect the quantity demanded for the good; raising prices will cause total revenue to increase. • When the price elasticity of demand for a good is relatively inelastic (0 < Ed < 1), the percentage change in quantity demanded is smaller than that in price. Hence, when the price is raised, the total revenue rises, and vice versa. • When the price elasticity of demand for a good is unitary elastic (Ed = 1), the percentage change in quantity is equal to that in price, so a change in price will not affect total revenue. • When the price elasticity of demand for a good is relatively elastic (Ed > 1), the percentage change in quantity demanded is greater than that in price. Hence, when the price is raised, the total revenue falls, and vice versa.

18. Income Elasticity of Demand • Income elasticity of demand (EdY) measures how much the quantity demanded of a good responds to a change in consumers’ income. • It is computed as the percentage change in the quantity demanded divided by the percentage change in income. • EdY = %D in Qd %D in Y

19. Income Elasticity of Demand • Typically, if our income rises, we buy more and visa versa. These types of goods are called normal goods. • EdY > 0 - normal good • A necessity good is a good whose quantity demanded is not very sensitive to income changes • In other words, we buy it no matter what happens to our income. • If a good’s elasticity is 0 < EdY < 1 then it is a necessity good. • A luxury good is one that we buy a lot of when our income goes up and we cut back on significantly when our income goes down. • If a good’s elasticity is EdY > 1, then it is a luxury good. • If a goods elasticity is EdY < 0 it is an inferior good

20. Cross Price Elasticity of Demand • Another type of elasticity is the Cross Price Elasticity. This gets at how changes in price of one good can effect the demand of another • Cross Price Elasticity of Demand (E1,2) • Cross price elasticity of demand measures the percentage change in demand for a particular good caused by a percent change in the price of another good. • It measures the responsiveness of quantity demanded of good one when the price of good 2 changes. E1,2 = % ∆ in Qd of Good 1 % ∆ in P of Good 2

21. Cross Price Elasticity of Demand • This relationship is called substitutes and can be seen when E1,2 > 0. • This relationship is called complements and can be seen when E1,2 < 0