elasticity of demand

Elasticity

IITTM, Gwalor by Prof. A.G. Naolekar

Elasticity of demand

Shows how sensitive demand is to: 1. A change in the price of the good itself Price Elasticity of Demand (PED)2. A change in consumers’ income Income Elasticiy of Demand (YED)3. A change in the price of another good Cross Elasticity of Demand (CED)


Price Elasticiy of Demand Is the percentage/proportionate

change in the demand (quantity) for a good caused by the percentage/proportionate change in the price of that good.


PED is measured by using the following formula:

Where: P1 = the original price of the good P2 = the new price of the good Q1 = the original quantity demanded Q2 = the new quantity demanded Delta Q = the change in quantity demanded Delta P = the change in price

P1 + P2

Q1 + Q2

Q

P


Note 1A nnegative (–) number means that the good:Obeys the law of demand (eg a normal good)When P QD or when P QD

Applying this to the formula

– Q

+ P

+ Q

– Por

Each gives a negative number


Note 2A positive (+) number means that the good Does not obey the law of demand (eg. a giffen good)When P QD or when P QD

Applying this to the formula

+ Q

+ P

– Q

– Por Each gives a

positive number


Note 3

If the numerical value (ignoring the sign) is >1then the PED is elastic.This means that the percentage change in demand is greater than the percentage change in price.

If the ans is If the ans is >> ––11 then it is a then it is a LuxuryLuxury GoodGood (holiday) (holiday)ie: even if the price changes slightly there will be a large ie: even if the price changes slightly there will be a large reduction in demand.reduction in demand.


Elastic Demand Curve (flatter)

The Price Elasticity of Demand for this product is elastic.The change in price causes a more than proportionate change in demand.Degree of slope > 45º.

Luxury goods, e.g. foreign holidays.

P1P1

Q1Q1

Pric

e

Quantity

P2P2

Q2Q2

D

D


Note 4If the result is< +1< +1 or < < ––11then the PED is inelastic.This means that the percentage change in demand is less than the percentage change in price.

If the ans is < If the ans is < ––11 then it is a then it is a NecessityNecessityie. even if the price change is large the demand will ie. even if the price change is large the demand will not change much as people cannot do without it. not change much as people cannot do without it.


Inelastic Demand Curve (steeper)

The price elasticity of demand for this product is inelastic.The change in price has caused a less than proportionate change in quantity demanded.Degree of slope < 45º.

Necessities, e.g. Domesticuse of electricity.

P1P1

Q1Q1

Pric

e

Quantity

P2P2

Q2Q2

D

D


Note 5If the result is

= +1= +1 or = = ––11

then the PED is equal to unity or unit elasticity.This means that the percentage change in demand is equal to the percentage change in price.

If the ans is = If the ans is = ––11 then it is a then it is a “Luxury-necessity”“Luxury-necessity”

Eg. needs that are really wants, dvd player, I-pod… Eg. needs that are really wants, dvd player, I-pod…


Equal to Unity CurveThe price elasticity of demand for this product is equal to unity.The price change has caused demand to change in direct proportion to the change in price.Degree of slope = 45º.

“Luxury/necessities”, e.g. a freezer.

P2P2

Q2Q2

Pric

e

Quantity

P1P1

Q1Q1

D

D


Example 1 2008 Q 1. (b) (iii)

P1= Rs.40P2 = Rs.50Q1=60 unitsQ2=40 units40 + 50 X –20 = -1.8 60 + 40 10Therefore PED is elastic, obeys the law of

demand, eg. luxury good……

P1 + P2

Q1 + Q2

Q

P


Example 22007 SQ 3.

P 1 = Rs.1.50P 2 = Rs.1.00Q 1 = 50 unitsQ 2 = 90 units1.50 + 1.00 X 40 = - 1.4350 + 90 - 0.50Therefore PED is elastic, obeys the law of

demand, eg. luxury good……

P1 + P2

Q1 + Q2

Q

P


D

Price

Quantity

P

Exceptional PED (perfect comp)

In this case any change in price will cause D to fall

to zero.

Thus PED is perfectly elasticperfectly elastic (or equal to infinity).


Price

Quantity

D

D

P1P1

Q1Q1

P2P2

Exceptional PED (vital med)

In this case any change in price between P1 and P2 will have no effect on the amount demanded.Thus the PED is perfectly inelasticperfectly inelastic (or = zero).


Factors affecting elasticity Necessity = inelastic v luxury =

elastic Substitute available = elastic v no substitute available = inelastic Alternative uses = elastic Durable = elastic v non durable =

inelastic


Complementary good

Eg. Set of golf clubs = dearer = elastic Golf balls = cheaper = inelastic The demand for golf balls will be

influenced more by the price of clubs rather than the balls themselves.


An increase in the price of balls is unlikely to have much effect on the demand for balls or clubs.

However an increase in the price of clubs will affect both the demand for clubs and balls.


PED of normal goods and Total Revenue

When PED > 1You need to decrease price to increase total revenue (same direction)When PED < 1You need to decrease increase price to increasetotal revenue (opp dir)When PED = 1There is no effect on TR when P changes


Giffen goods and change in TR

For Giffen goods

Price and total revenue always change in the same direction regardless of the degree of PED.

The demand for Giffen goods goes up when their price is increased.

As price increases more goods are sold at a higher price therefore TR must also increase.

The same logic applies to a decrease in price.


Income Elasticity of Demand (YED)

Measures the relationship between a change in income and the resulting change in demand.

It can be:

Positive (+) = Normal Good, as Y rises D rises

Negative (-) = Inferior Good & Giffen Good, as Y rises D falls


YED can beElasticElastic (> I1I) (> I1I):: the change in income causes a

more than proportionate change in demand. (Luxury Good)

InelasticInelastic (< I1I) (< I1I):: the change in income causes a less than proportionate change in demand. (Food)

Equal to unityEqual to unity ( = I1I) ( = I1I):: the change in income causes a proportionate change in demand.


Measurement of YEDYED is measured by using the following

formula:

Where: Y1 = the original income Y2 = the new income Q1 = the original quantity demanded Q2 = the new quantity demanded Delta Q = the change in quantity demanded (sign nb) Delta Y = the change in income (sig nb)

Y1 + Y2

Q1 + Q2

Q

Y


Example Income went from €200 to €250 Demand went from 5 units to 8 units

200+250 x +3 5 + 8 +50 +2.07 Normal, Luxury Good


2002 Q 3 (a) Normal Good Y inc, QD inc (+) Eg. holiday

Inferior Good Y inc, QD dec (-) Eg. potatoes


(b)

Let Y = Rs.100Consumer spends (40 % of Rs.100) Rs.40 on the goodY doubles to Rs.200Consumer spends (30 % of Rs.200) Rs.60 on the goodY Inc and QD Inc Normal Good


(c) YED potatoes -0.1

YED designer clothes +2.5


(d) YED = +1.8 Y D Y expected to rise by 5% Demand (Sales) will rise by 1.8 times 5% 5% X 1.8 = 9% 20,000 x 9 = 1,800 10020,000 + 1,800 = 21,800 units


YED = -0.5 Y D Y expected to rise by 2% Demand (Sales) will decrease by 2 times 0.5 % 0.5 % X 2 = 1% 10,0000 x 1 = 100 10010,000 - 100 = 9,900 units


2009 Q 1. (b) (ii)

YED low price meat -0.1

YED for iphones +4.6


2009 Q 1 (c) YED = +2.5 Y D

Y decreases by 8% Sales decrease by 2.5 times 8% 8%X2.5=20% Sales falls by 20% 100,000X20 = 20,000 units 100 100,000-20,000 = 80,000 units


Uses of YED


Cross Elasticity of Demand (CED)

Cross elasticity of demand measures the relationship between the change in price of one good (A) and the resulting change in demand for another good (B).

+ive = substitute, an inc P A = an inc D B-ive = complementary, an in P A = dec in D B> 1 elastic, < 1 inelastic, = 1 unitary


Measurement of CEDCED is measured by using the following formula:

The demand for product B reacts to a change in the price of product A.

Where: P(A)1 = the original price of A P(A)2 = the new price of A Q(B)1 = the original quantity of B Q(B)2 = the new quantity of B Delta Q(B) = the change in quantity of B (sign nb) Delta P(A) = the change in price of A (sign nb)

P(A)1 + P(A)2

Q(B)1 + Q(B)2

Q(B)

P(A)


2006 Q 1 (c)

5 + 6 X + 410 + 14 + 1

+ 1.83Substitute, elastic


2003 Q 2 (b)

27 + 23 X -400 1,200 + 800 -4

+ 2.5Substitute, elastic


1999 Q 4 (b)

B = +2.5Substitute, elasticC = -0.6Complementary, inelasticD = + 0.3Substitute, inelasticE = -1.4Complementary, elastic


Closest substitute +0.3


elasticity of demand

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