introduction - cairo universityelasticity becomes zero when the demand curve touches the x-axis. (3)...

Consumer Economics 351 AEC Lecture Two: Elasticity Of Demand

Dr. Mahmoud A. Arafa [email protected] http://scholar.cu.edu.eg/mahmoudarafa

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Introduction:

When the price of a goods falls, its quantity demanded rises and when the price of the goods

rises, its quantity demanded falls. This is generally known as law of demand. This law of demand

indicates only the direction of change in quantity demanded in response to change in price. This

does not tell us by how much or to what extent the quantity demanded of goods will change in

response to a change in: its price, Consumer Income, or Price of other goods. This information as

to how much or to what extent the quantity demanded of a good will change as a result of a

change in its price, Consumer Income, or Price of other goods is provided by the concept of

elasticity of demand. The concept of elasticity has a very great importance in economic theory as

well as for formulation of suitable economic policy.

Definitions:

We can define elasticity according to many factors affecting demand. In general, Elasticity of

Demand refers to the degree of responsiveness of quantity demanded to the changes in the

determinants of demand. There are mainly three quantifiable determinants of demand: rice of

the Good; Income of the Consumer; and Price of the Related Goods. Then we have three concepts

of elasticity: Price, Income, and Cross Elasticity of Demand. Price elasticity of Demand is the

degree of responsiveness of demand to a change in its price. In technical terms it is the ratio of the

percentage change in demand to the percentage change in price, keeping all other things

constant. Income elasticity of demand refers to the sensitivity of the quantity demanded for a

certain good to a change in real income of consumers who buy this good, keeping all other things

constant. Cross elasticity of demand is an economic concept that measures the responsiveness in

the quantity demand of one good when a change in price takes place in another good.

Price Elasticity of Demand:

Price elasticity of demand is a measure of the relationship between a change in the quantity

demanded of a particular good and a change in its price. Price elasticity of demand is a term in

economics often used when discussing price sensitivity. The formula for calculating price

elasticity of demand is:

Elasticity

Supply Demand

Price

Elastic

Inelastic

perfectly elastic

perfectly inelastic

unit elastic

Income

positive

negative

Cross

positive

negative



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Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price

%

%d

p

QE

P

% dd

d

QQ

Q

%P

PP

2 1

2 1

%

%

d

d dp

Q Q Q

Q Q QE

P P PP

P P

The four Important Methods of Measuring Price Elasticity of Demand:

There are four methods of measuring elasticity of demand. They are the percentage method,

point method, arc method and expenditure method.

1- The Percentage Method:

The price elasticity of demand is measured by its coefficient Ep. This coefficient Ep measures the

percentage change in the quantity of a commodity demanded resulting from a given percentage

change in its price: Thus

%*

%d d

p

d

Q Q PE

P P Q

Where q refers to quantity demanded p to price and ∆ to change. If Ep> 1, demand is elastic. If Ep <

1, demand is inelastic, it Ep = 1 demand is unitary elastic.

With this formula, we can compute price elasticities of demand on the basis of a demand

schedule.

Table: Demand Schedule:

Combination Price (Rs.) per Kg. of X

Quantity Kgs. of X

A 6

0

B 5 ————-► 10

C 4

20

D 3 ————-► 30

E 2

40

F 1 ————► 50

G 0

60



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Let us first take combinations B and D.

1--- Suppose the price of commodity X falls from Rs. 5 per kg to Rs. 3 per kg and its quantity

demanded increases from 10 kgs to 30 kgs, Then

% 30 10 5* 5 1

% 3 5 10d

p

QE

P

This shows elastic demand or elasticity of demand greater than unitary.

Note: The formula can be understood like this:

∆q =q2 –q1 where <72 is the new quantity (30 kgs.) and q1 the original quantity (10 kgs.)

∆p – p2– P1 where p2 is the new price (Rs. 3) and <$Ep sub 1> the original price (Rs. 5)

In the formula, p refers to the original price (p,) and q to original quantity (q1). The opposite is the

case in example (2) below, where Rs. 3 becomes the original price and 30 kgs. as the original

quantity.

2--- Let us measure elasticity by moving in the reverse direction. Suppose the price of X rises from

Rs. 3 per kg. to Rs. 5 per kg. and the quantity demanded decreases from 30 kgs. to 10 kgs.

Then

% 10 30 3* 1 1

% 5 3 30d

p

QE

P

This shows unitary elasticity of demand.

Notice that the value of Ep in example (2) differs from that in example (1) depending on the

direction in which we move. This difference in the elasticities is due to the use of a different base

in computing percentage changes in each case.

Now consider combinations D and F.

3--- Suppose the price of commodity X falls from Rs. 3 per kg. to Re. 1 per kg. and its quantity

demanded increases from 30 kgs. to 50 kgs. Then

% 50 30 3* 1 1

% 1 3 30d

p

QE

P

This is again unitary elasticity.

4--- Take the reverse order when the price rises from Re. 1 per kg. to Rs. 3 per kg. and the quantity

demanded decreases from 50 kgs. to 30 kgs. Then

% 30 50 1 1* 1

% 3 1 50 5d

p

QE

P

This shows inelastic demand or less than unitary.



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The value of Ep again differs in this example than that given in example (3) for the reason stated

above.

(2) The Point Method:

Prof. Marshall devised a geometrical method for measuring elasticity at a point on the demand

curve. Let RS be a straight line demand curve in Figure. If the price falls from PB (= OA) to MD (=

OC). The quantity demanded increases from OB to OD. Elasticity at point P on the RS demand

curve according to the formula is: Ep = ∆q/∆p x p/q

Where ∆ q represents changes in quantity demanded ∆p changes in price level while p and q are

initial price and quantity levels.

From Figure:

∆ q = BD = QM

∆p = PQ

p = PB

q = OB

Substituting these values in the elasticity formula:

With the help of the point method, it is easy to point out the elasticity at any point along a

demand curve. Suppose that the straight line demand curve DC in Figure below is 6 centimeters.



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Five points L, M, N, P and Q are taken oh this demand curve. The elasticity of demand at each

point can be known with the help of the above method. Let point N be in the middle of the

demand curve. So elasticity of demand at point:

We arrive at the conclusion that at the mid-point on the demand curve the elasticity of demand is

unity. Moving up the demand curve from the mid-point, elasticity becomes greater. When the

demand curve touches the Y-axis, elasticity is infinity. Ipso facto, any point below the mid-point

towards the X-axis will show elastic demand.

Elasticity becomes zero when the demand curve touches the X-axis.

(3) The Arc Method:

We have studied the measurement of elasticity at a point on a demand curve. But when elasticity

is measured between two points on the same demand curve, it is known as arc elasticity. In the

words of Prof. Baumol, “Arc elasticity is a measure of the average responsiveness to price change

exhibited by a demand curve over some finite stretch of the curve.”

Any two points on a demand curve make an arc. The area between P and M on the DD curve in

Figure below is an arc which measures elasticity over a certain range of price and quantities. On

any two points of a demand curve the elasticity coefficients are likely to be different depending

upon the method of computation. Consider the price-quantity combinations P and M as given in

Table below.



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Table: Demand Schedule:

Point Price (Rs.) Quantity (Kg)

P 8 10

M 6 12

If we move from P to M, the elasticity of demand is:

% 12 10 8 4* 1

% 6 8 10 5d

p

QE

P

If we move in the reverse direction from M to P, then

10 12 6 1* 1

8 6 12 2pE

Thus the point method of measuring elasticity at two points on a demand curve gives different

elasticity coefficients because we used a different base in computing the percentage change in

each case.

To avoid this discrepancy, elasticity for the arc (PM in Figure above) is calculated by taking the

average of the two prices [(p1, + p2 1/2] and the average of the two quantities [(p1, + q2) 1/2]. The

formula for price elasticity of demand at the mid-point (C in Figure above) of the arc on the

demand curve is

1 2 1 2 1 2

1 2 1 2

1 2

( )/2 ( )/2 ( )* *

( )/2 ( )

( )/2

d

d dp

Q

Q Qq q p p p pE

P q q P P q q

p p

On the basis of this formula, we can measure arc elasticity of demand when there is a movement

either from point P to M or from M to P.

From P to M at P, p1 = 8, q1, =10, and at M, P2 = 6, q2 = 12

Applying these values, we get



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Thus whether we move from M to P or P to M on the arc PM of the DD curve, the formula for arc

elasticity of demand gives the same numerical value. The closer the two points P and M are, the

more accurate is the measure of elasticity on the basis of this formula. If the two points which

form the arc on the demand curve are so close that they almost merge into each other, the

numerical value of arc elasticity equals the numerical value of point elasticity.

(4) The Total Outlay Method:

Marshall evolved the total outlay, total revenue or total expenditure method as a measure of

elasticity. By comparing the total expenditure of a purchaser both before and after the change in

price, it can be known whether his demand for a good is elastic, unity or less elastic. Total outlay

is price multiplied by the quantity of a good purchased: Total Outlay = Price x Quantity

Demanded. This is explained with the help of the demand schedule in Table below.

(i) Elastic Demand:

Demand is elastic, when with the fall in price the total expenditure increases and with the rise in

price the total expenditure decreases. Table 11.3 shows that when the price falls from Rs. 9 to Rs.

8, the total expenditure increases from Rs. 180 to Rs. 240 and when price rises from Rs. 7 to Rs. 8,

the total expenditure falls from Rs. 280 to Rs. 240. Demand is elastic (Ep > 1) in this case.

(ii) Unitary Elastic Demand:

When with the fall or rise in price, the total expenditure remains unchanged; the elasticity of

demand is unity. This is shown in the Table when with the fall in price from Rs. 6 to Rs. 5 or with

the rise in price from Rs. 4 to Rs. 5, the total expenditure remains unchanged at Rs. 300, i.e., Ep =

1.

(iii) Less Elastic Demand:



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Demand is less elastic if with the fall in price the total expenditure falls and with the rise in price

the total expenditure rises. In the Table when the price falls from Rs. 3 to Rs. 2 total expenditure

falls from Rs. 240 to Rs. 180, and when the price rises from Re. 1 to Rs. 2 the total expenditure

also rises from Rs. 100 to Rs. 180. This is the case of inelastic or less elastic demand, Ep < 1.

Table below summarises these relationships:

Table: Total Outlay Method:

Price ТЕ Ep

Falls Rises >> 1

Rises Falls

Falls Unchanged = 1

Rises Unchanged

Falls Falls

Rises Rises << 1

Figure below illustrates the relation between elasticity of demand and total expenditure. The

rectangles show total expenditure: Price x quantity demanded. The figure shows that at the

midpoint of the demand curve, total expenditure is maximum in the range of unitary elasticity,

i.e. Rs. 6, Rs. 5 and Rs. 4 with quantities 50 kgs., 60 kgs. and 75 kgs..

Total expenditure rises as price falls, in the elastic range of demand, i.e. Rs. 9, Rs. 8 and Rs. 7 with

quantities 20 kgs., 30 kgs. and 40 kgs. Total expenditure falls as price falls in the elasticity range,

i.e. Rs.3, Rs. 2 and Re. 1 with quantities 80 kgs., 90 kgs. and 100 kgs. Thus elasticity of demand is

unitary in the AB range of DD, curve, elastic in the range AD above point A and less elastic in the

BD1 range below point B. The conclusion is that price elasticity of demand refers to a movement

along a specific demand curve.

Types of Price Elasticity of Demand:

The extent of responsiveness of demand with change in the price is not always the same.

The demand for a product can be elastic or inelastic, depending on the rate of change in the

demand with respect to change in price of a product.



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Elastic demand is the one when the response of demand is greater with a small proportionate

change in the price. On the other hand, inelastic demand is the one when there is relatively a less

change in the demand with a greater change in the price. For better understanding the

concepts of elastic and inelastic demand, the price elasticity of demand has been divided

into five types, which are shown in Figure below:

1. Perfectly Elastic Demand:

When a small change in price of a product causes a major change in its demand, it is said to be

perfectly elastic demand. In perfectly elastic demand, a small rise in price results in fall in demand

to zero, while a small fall in price causes increase in demand to infinity. In such a case, the

demand is perfectly elastic or ep = 00.

The degree of elasticity of demand helps in defining the shape and slope of a demand curve.

Therefore, the elasticity of demand can be determined by the slope of the demand curve. Flatter

the slope of the demand curve, higher the elasticity of demand. In perfectly elastic demand, the

demand curve is represented as a horizontal straight line, which is shown in Figure below:

From Figure it can be interpreted that at price OP, demand is infinite; however, a slight rise in

price would result in fall in demand to zero. It can also be interpreted from Figure that at price P

consumers are ready to buy as much quantity of the product as they want. However, a small rise

in price would resist consumers to buy the product.

Types of Price Elasticity of Demand

Perfectly Elastic

Perfectly Inelastic

Relatively Elastic

Relatively Inelastic

Unitary Elastic



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Though, perfectly elastic demand is a theoretical concept and cannot be applied in the real

situation. However, it can be applied in cases, such as perfectly competitive market and

homogeneity products. In such cases, the demand for a product of an organization is assumed to

be perfectly elastic.

From an organization„s point of view, in a perfectly elastic demand situation, the organization can

sell as much as much as it wants as consumers are ready to purchase a large quantity of product.

However, a slight increase in price would stop the demand.

2. Perfectly Inelastic Demand:

A perfectly inelastic demand is one when there is no change produced in the demand of a

product with change in its price. The numerical value for perfectly inelastic demand is zero

(ep=0). In case of perfectly inelastic demand, demand curve is represented as a straight

vertical line, which is shown in Figure below:

It can be interpreted from Figure-3 that the movement in price from OP1 to OP2 and OP2 to OP3

does not show any change in the demand of a product (OQ). The demand remains constant for

any value of price. Perfectly inelastic demand is a theoretical concept and cannot be applied in a

practical situation. However, in case of essential goods, such as salt, the demand does not change

with change in price. Therefore, the demand for essential goods is perfectly inelastic.

3. Relatively Elastic Demand:

Relatively elastic demand refers to the demand when the proportionate change produced in

demand is greater than the proportionate change in price of a product. The numerical value of

relatively elastic demand ranges between one to infinity.

Mathematically, relatively elastic demand is known as more than unit elastic demand (ep>1). For

example, if the price of a product increases by 20% and the demand of the product decreases by

25%, then the demand would be relatively elastic. The demand curve of relatively elastic

demand is gradually sloping, as shown in Figure below:



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It can be interpreted from Figure-4 that the proportionate change in demand from OQ1 to OQ2

is relatively larger than the proportionate change in price from OP1 to OP2. Relatively elastic

demand has a practical application as demand for many of products respond in the same manner

with respect to change in their prices.

For example, the price of a particular brand of cold drink increases from Rs. 15 to Rs. 20. In such a

case, consumers may switch to another brand of cold drink. However, some of the consumers

still consume the same brand. Therefore, a small change in price produces a larger change in

demand of the product.

4. Relatively Inelastic Demand:

Relatively inelastic demand is one when the percentage change produced in demand is less than

the percentage change in the price of a product. For example, if the price of a product increases

by 30% and the demand for the product decreases only by 10%, then the demand would be

called relatively inelastic. The numerical value of relatively elastic demand ranges between zero

to one (ep<1). Marshall has termed relatively inelastic demand as elasticity being less than unity.

The demand curve of relatively inelastic demand is rapidly sloping, as shown in Figure

below:

It can be interpreted from Figure-5 that the proportionate change in demand from OQ1 to OQ2

is relatively smaller than the proportionate change in price from OP1 to OP2. Relatively inelastic

demand has a practical application as demand for many of products respond in the same manner

with respect to change in their prices. Let us understand the implication of relatively inelastic

demand with the help of an example.

Example: The demand schedule for milk is given in Table below:

Calculate the price elasticity of demand and determine the type of price elasticity.



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Solution:

P= 15, Q = 100, P1 = 20, Q1 = 90

Therefore, change in the price of milk is:

∆P = P1 – P

∆P = 20 – 15

∆P = 5

Similarly, change in quantity demanded of milk is:

∆Q = Q1 – Q

∆Q = 90 – 100

∆Q = -10

The change in demand shows a negative sign, which can be ignored. This is because of the reason

that the relationship between price and demand is inverse that can yield a negative value of price

or demand.

Price elasticity of demand for milk is:

ep = ∆Q/∆P * P/Q

ep = 10/5 * 15/100

ep = 0.3

The price elasticity of demand for milk is 0.3, which is less than one. Therefore, in such a case, the

demand for milk is relatively inelastic.

5. Unitary Elastic Demand:

When the proportionate change in demand produces the same change in the price of the

product, the demand is referred as unitary elastic demand. The numerical value for unitary elastic

demand is equal to one (ep=1). The demand curve for unitary elastic demand is represented

as a rectangular hyperbola, as shown in Figure below:

From Figure-6, it can be interpreted that change in price OP1 to OP2 produces the same change

in demand from OQ1 to OQ2. Therefore, the demand is unitary elastic.

The different types of price elasticity of demand are summarized in Table below:



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Income Elasticity of Demand:

Income elasticity of demand is the degree of responsiveness of quantity demanded of a

commodity due to change in consumer„s income, other things remaining constant. In other

words, it measures by how much the quantity demanded changes with respect ot the change in

income.

The income elasticity of demand is defined as the percentage change in quantity demanded due

to certain percent change in consumer„s income.

Where, EY = Elasticity of demand

q = Original quantity demanded

∆q = Change in quantity demanded

y = Original consumer„s income

∆y= Change in consumer„s income

Example to Explain Income Elasticity of Demand: Suppose that the initial income of a person is

Rs.2000 and quantity demanded for the commodity by him is 20 units. When his income

increases to Rs.3000, quantity demanded by him also increases to 40 units. Find out the income

elasticity of demand.

Solution:

Here, q = 100 units

∆q = (40-20) units = 20 units



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y = Rs.2000

∆y =Rs. (3000-2000) =Rs.1000

Now,

Hence, an increase of Rs.1000 in income i.e. 1% in income leads to a rise of 2% in quantity

demanded.

Types of Income Elasticity of demand:

1. Positive income elasticity of demand (EY>0)

If there is direct relationship between income of the consumer and demand for the commodity,

then income elasticity will be positive. That is, if the quantity demanded for a commodity

increases with the rise in income of the consumer and vice versa, it is said to be positive income

elasticity of demand. For example: as the income of consumer increases, they consume more of

superior (luxurious) goods. On the contrary, as the income of consumer decreases, they consume

less of luxurious goods.

Positive income elasticity can be further classified into three types:

Income elasticity greater then unity (EY > 1)

If the percentage change in quantity demanded for a commodity is greater than percentage

change in income of the consumer, it is said to be income greater than unity. For example: When

the consumer„s income rises by 3% and the demand rises by 7%, it is the case of income elasticity

greater than unity.

In the given figure, quantity demanded and consumer„s income is measured along X-axis and Y-

axis respectively. The small rise in income from OY to OY1 has caused greater rise in the quantity

demanded from OQ to OQ1 and vice versa. Thus, the demand curve DD shows income elasticity

greater than unity.

Income elasticity equal to unity (EY = 1)



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If the percentage change in quantity demanded for a commodity is equal to percentage change in

income of the consumer, it is said to be income elasticity equal to unity. For example: When the

consumer„s income rises by 5% and the demand rises by 5%, it is the case of income elasticity

equal to unity.


axis respectively. The small rise in income from OY to OY1 has caused equal rise in the quantity


equal to unity.

Income elasticity less then unity (EY < 1)

If the percentage change in quantity demanded for a commodity is less than percentage change

in income of the consumer, it is said to be income greater than unity. For example: When the

consumer„s income rises by 5% and the demand rises by 3%, it is the case of income elasticity less

than unity.


axis respectively. The greater rise in income from OY to OY1 has caused small rise in the quantity


less than unity.

2. Negative income elasticity of demand (EY<0):

If there is inverse relationship between income of the consumer and demand for the commodity,

then income elasticity will be negative. That is, if the quantity demanded for a commodity

decreases with the rise in income of the consumer and vice versa, it is said to be negative income



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elasticity of demand. For example: As the income of consumer increases, they either stop or

consume less of inferior goods.


axis respectively. When the consumer„s income rises from OY toOY1 the quantity demanded of

inferior goods falls from OQ to OQ1 and vice versa. Thus, the demand curve DD shows negative

income elasticity of demand.

3. Zero income elasticity of demand (EY=0):

If the quantity demanded for a commodity remains constant with any rise or fall in income of the

consumer and, it is said to be zero income elasticity of demand. For example: In case of basic

necessary goods such as salt, kerosene, electricity, etc. there is zero income elasticity of demand.


axis respectively. The consumer„s income may fall to OY1 or rise to OY2 from OY, the quantity

demanded remains the same at OQ. Thus, the demand curve DD, which is vertical straight line

parallel to Y-axis shows zero income elasticity of demand.

Uses of Income Elasticity of Demand in Business Decision Making:

Any products that are manufactured by the producers can be classified into two types – normal

goods and inferior goods. Normal goods – Goods whose demand is directly proportional to the

income of the consumers are known as normal goods. Simply, goods whose demand rises with

rise in income and whose demand falls with fall in income is known as normal goods e.g jewelry.

The coefficient of income elasticity of these goods is always positive. Inferior goods – Goods

whose demand is inversely proportional to the income of the consumers are known as inferior

goods.



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In other words, inferior goods are such goods whose demand falls with rise in income and vice

versa e.g. budget smartphones. The coefficient of income elasticity of these goods is always

negative. Knowledge about the nature of products is important to any producers in order to make

further decisions related to the goods in right manner.

To know about stage of trade cycle, we have already known that demand of normal goods is

directly proportional to the income of consumers while demand of inferior goods is inversely

proportional to the income of consumers.

We see, people prefer riding public bus when their income is low but with comparatively high

income, same people start using cab for transportation. In this situation, public bus is an inferior

good while cab is a normal good.

Demand for normal goods increases during prosperity and decreases during regression.

Conversely, demand for inferior goods increases during regression and decreases during

prosperity. However, demands for goods that are necessary in our day to day lives are not much

affected during prosperity as well as during regression.

For forecasting demand:

Income elasticity of demand can be used for predicting future demand of any goods and services

in case when manufacturers have knowledge of probable future income of the consumers.

For example: Let us suppose, ‘Wheels„ is a car manufacturing company which manufactures

luxury cars as well as small cars. The company has calculated that income elasticity of luxury car

(normal good) is +4 while income elasticity of small car (inferior good) is -5.

Let us also suppose that the company has undertaken a research and has found that consumer

income will rise by 3% in upcoming year.

Through the above information, Wheels can forecast by how much the demand of luxury car and

small car will undergo change in the upcoming year. This information can save the company a lot

of money by preventing overproduction or underproduction.



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To determine price, Having knowledge of income elasticity of any product is essential in

order to correctly price them.

Demand of income elastic goods or goods with positive income elasticity tends to fall with fall in

income of the demanding consumers. Thus, a reduction in price of the commodity may help in

increasing the demand and compensate for the reduction in price by generating more sales and

revenue.

Cross Elasticity of Demand:

It is the ratio of proportionate change in the quantity demanded of Y to a given proportionate

change in the price of the related commodity X.

It is a measure of relative change in the quantity demanded of a commodity due to a change in

the price of its substitute/complement. It can be expressed as:

percentage change in the quantity demanded of Y

percentage change in the price of the related commodity XcrossE

Y

X

% Q

% PcrossE

Cross elasticity may be infinite or zero if the slightest change in the price of X causes a substantial

change in the quantity demanded of Y. It is always the case with goods which have perfect

substitutes for one another. Cross elasticity is zero, if a change in the price of one commodity will

not affect the quantity demanded of the other. In the case of goods which are not related to each

other, cross elasticity of demand is zero.

Definition:

“The cross elasticity of demand is the proportional change in the quantity of X good demanded

resulting from a given relative change in the price of a related good Y” Ferguson. “The cross

elasticity of demand is a measure of the responsiveness of purchases of Y to change in the price

of X” Leibafsky.

Types of Cross Elasticity of Demand:

1. Positive:

When goods are substitute of each other than cross elasticity of demand is positive. In other

words, an increase in the price of Y leads to an increase in the demand of X. For instance, with the

increase in price of tea, demand of coffee will increase. In figure below quantity has been

measured on OX-axis and price on OY-axis. At price OP of Y-commodity, demand of X-

commodity is OM. Now as price of Y commodity increases to OP1 demand of X-commodity

increases to OM1 Thus, cross elasticity of demand is positive.



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2. Negative:

In case of complementary goods, cross elasticity of demand is negative. A proportionate increase

in price of one commodity leads to a proportionate fall in the demand of another commodity

because both are demanded jointly. In figure below quantity has been measured on OX-axis

while price has been measured on OY-axis. When the price of commodity increases from OP to

OP1 quantity demanded falls from OM to OM1. Thus, cross elasticity of demand is negative.

3. Zero:

Cross elasticity of demand is zero when two goods are not related to each other. For instance,

increase in price of car does not affect the demand of cloth. Thus, cross elasticity of demand is

zero. It has been shown in figure below:

Therefore, it depends upon substitutability of goods. If substitutability is perfect, cross elasticity is

infinite; if on the other hand, substitutability does not exist, cross elasticity is zero. In the case of

complementary goods like jointly demanded goods cross elasticity is negative. A rise in the price

of one commodity X will mean not only decrease in the quantity of X but also decrease in the

quantity demanded of Y because both are demanded together.

Measurement of Cross Elasticity of Demand:



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Cross elasticity of demand can be measured by the following formula:

The Importance of Elasticity of Demand:

Some important points from which you can realize the important of price elasticity of

demand! Price elasticity of demand is a very important concept. Its importance can be realized

from the following points:

1. International trade:

In order to fix prices of the goods to be exported, it is important to have knowledge about the

elasticity„s of demand for such goods.

A country may fix higher prices for the products with inelastic demand. However, if demand for

such goods in the importing country is elastic, then the exporting country will have to fix lower

prices.



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2. Formulation of Government Policies:

The concept of price elasticity of demand is important for formulating government policies,

especially the taxation policy. Government can impose higher taxes on goods with inelastic

demand, whereas, low rates of taxes are imposed on commodities with elastic demand.

3. Factor Pricing:

Price elasticity of demand helps in determining price to be paid to the factors of production.

Share of each factor in the national product is determined in proportion to its demand in the

productive activity. If demand for a particular factor is inelastic as compared to the other factors,

then it will attract more rewards.

4. Decisions of Monopolist:

A monopolist considers the nature of demand while fixing price of his product. If demand for the

product is elastic, then he will fix low price. However, if demand is inelastic, then he is in a

position to fix a high price.

5. Paradox of poverty amidst plenty:

A bumper crop, instead of bringing prosperity to farmers, brings poverty. This is called the

paradox of poverty amidst plenty. It happens due to inelastic demand for most of the agricultural

products. When supply of crops increases as a result of rich harvest, their prices drastically fall

due to inelastic demand. As a result, their total income goes down.

introduction - cairo universityelasticity becomes zero when the demand curve touches the x-axis. (3)...

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