amity school of business elasticity of demand– the concept elasticity of demand refers to the...
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Amity School of Business
Elasticity of demand– the concept
• Elasticity of demand refers to the responsiveness of change in quantity demanded because of change in any of the factors affecting quantity demanded.
• The more popular types of elasticity of demand are w.r.t. price, income, and cross (related goods) elasticity of demand.
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Amity School of BusinessPrice Elasticity
Methods of calculating Price elasticity of demand
1. Percentage Method:
(% change in Qty demanded)
Ep = _________________________
(% change in price)
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Amity School of Business
Types of Price Elasticity of Demand
• Elastic Demand (Ep > 1): When % Change in Quantity Demanded > % Change in Price
• Unit Elastic Demand (Ep = 1): When % Change in Quantity Demanded = % Change in Price
• Inelastic Demand (Ep < 1): When % Change in Quantity Demanded < % Change in Price
• Perfectly Elastic Demand (Ep = ∞): When Quantity Demanded Changes by a very large percentage in response to an almost zero Change in Price
• Perfectly Inelastic Demand (Ep = 0): When the Quantity Demanded remains constant as Price changes
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Amity School of Business
2. Point Method: Used when the price change is very small; Here, price elasticity of demand at any given point on the demand curve is equal to the ‘lower segment’ divided by the ‘upper segment’.
E p = Lower segment of demand curve Upper segment of demand curve
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Amity School of Business
Elasticity Along a Demand Curve
Pri
ce
0 Quantity
Elasticity declines along demand curve as we move
toward the quantity axis
Ed = 1
Ed = 0
Ed < 1
Ed > 1
Ed = ∞
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Amity School of Business
X X
P P
Methods of Measuring Price elasticity
3. Arc Method: Used when the price change is relatively large; i.e where we want to calculate elasticity over an arc (a segment) of the demand curve.
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Amity School of Business
4) Total expenditure (outlay) method
It is often useful to know what happens to total expenditure made by the consumer on a good when its price changes. Total expenditure = (Price) x (Qty. purchased)
Price change
E(p) > 1 E(p) < 1 E(p) = 1
Price falls T.E increases T.E decreases
T.E remains constant
Price rises T.E decreases
T.E increases T.E remains constant
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Amity School of Business
Determinants of the Price Elasticity of Demand
• Availability and proximity of substitutes• Nature of commodity• Alternative uses of the commodity• Proportion of consumer’s income spent on the
commodity• Time available
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Amity School of Business
Exy > 0 Substitutes Py Qx
Cross Elasticity of Demand
Exy < 0 Complements Py Qx
Classification of Goods According to Cross Elasticity
Cross Elasticity Responsiveness
Type of Good
E = p ercentage change in q uantity o f X d emand ed
p ercentage change in p r ice o f Yxy
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Amity School of BusinessIncome Elasticity of Demand
A measure of the extent to which the demand for a good changes when income changes, ceteris paribus.
Ey = % Change in Quantity Demanded% Change in Income
Positive (Ey < 1 or Zero): for necessitiesPositive (Ey > 1): Normal goods & luxuriesEy is Negative for inferior goods
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Amity School of Business
Significance of Price Elasticity of Demand
• Profit maximization requires that business sets a price that will maximize the firm’s profit.
• Elasticity tells the firm how much control it has over using price to raise profits.
• If Ep > 1, then the % Change in Qd is greater than % change is price, in such a case the firm (seller) would have lesser control over selling price (even if cost of production rises). Because any increase in price will reduce total revenue. And vice-versa also, i.e. a decrease in price will increase total revenues.