Concept of Elasticity

Learning Objectives:

• define concept of elasticity

• describe different measurements of elasticity

• explain price, income, cross and promotional elasticity

• identify determinants of price elasticity

• illustrate the importance of concept of elasticity in firm’s

decision making
 Concept of Elasticity

• In Economics elasticity is the measurement of how

responsive an economic variable is to a change in
another.

• "If I lower the price of my product, how much more

will I sell?“

• "If I raise the price of one good, how will that affect
sales of this other good?"
• Elasticity can be quantified as the ratio of the
percentage change in one variable to the
percentage change in another variable.

Percentage Change in Y
Elasticity of Y =
Percentage Change in X

Measurements of Elasticity

• Point Elasticity
• Arc Elasticity
 Point Elasticity
It is used when the change in the independent variable
is very small.

Point elasticity computes elasticity at a given point on a

function.

Y / Y
Point Elasticity e =
X / X

Y X
= x
X Y
 Point Elasticity of Demand

Price • e = (%∆ quantity

demanded)/(%∆ price)
100
– Suppose we wish to measure
80
A (q1,p1)
the price elasticity of demand at
60
point A….
40

20
D

2,000 4,000 6,000 8,000 10,000

Quantity (pairs of shoes)
6
 Point Elasticity of Demand

Price consider a small movement

along the demand curve to point
100 B
80
A (q1,p1)
60
B (q2,p2)
40

20
D

2,000 4,000 6,000 8,000 10,000

Quantity (pairs of shoes)
7
 Point Elasticity of Demand

Price – What is the percentage

change in quantity
100 demanded?
80 • %∆ quantity demanded = (q2-
60
A (q1,p1) q1)/q1
B (q2,p2)
40

20
D

2,000 4,000 6,000 8,000 10,000

Quantity (pairs of shoes)
8
 Point Elasticity of Demand

Price – What is the percentage

change in price?
100 • %∆ price = (p2-p1)/p1
80 • e = [(q2-q1)/q1]÷[(p2-p1)/p1]
A (q1,p1)
60
B (q2,p2)
40

20
D

2,000 4,000 6,000 8,000 10,000

Quantity (pairs of shoes)
9
 Point Elasticity of Demand

Price – Let us calculate elasticity at

point A
100 • h = [(q2-q1)/q1]÷[(p2-p1)/p1]
80 • %∆ quantity demanded = (q2-
p1 A (q ,p )
1 1 q1)/q1=(8000-6000)/6000=.33
60
p2 B (q ,p )
2 2 • %∆ price = (p2-p1)/p1=(40-
40
60)/60=-.33
D • …hence e = -1
20

q1 q2
2,000 4,000 6,000 8,000 10,000
Quantity (pairs of shoes)
10
 Point Elasticity of Demand

Price – Now what is the elasticity at

point B
100 • e = [(q2-q1)/q1]÷[(p2-p1)/p1]
80 • %∆ quantity demanded = (q2-
p1 A (q1,p1) q1)/q1=(6000-8000)/8000=-.25
60
p2 B(q2,p2) • %∆ price = (p2-p1)/p1=(60-
40
40)/40=.5
D • hence e = -.5
20

q1 q2
2,000 4,000 6,000 8,000 10,000
Quantity (pairs of shoes)
11
• The price elasticity of demand will always be
negative

• By convention economists usually drop this

negative term

12
 Arc Elasticity
• Arc Elasticity is used when the change in the
independent variable is large.

• Arc elasticity computes elasticity over a given range

of function.
 Arc Elasticity of Demand or
Midpoint Method
Price The formula for arc elasticity is a
little bit different
100

q2  q1 
80

 q1  q2  2
60

h
40
 p2  p1 
20
D  p1  p2  2
2,000 4,000 6,000 8,000 10,000
Quantity (pairs of shoes)
14
 Arc Elasticity of Demand

Price • Let us calculate the elasticity at

point A using the arc-elasticity
100 formula
80
A (q1,p1)
60

40

20
D

2,000 4,000 6,000 8,000 10,000

Quantity (pairs of shoes)
15
 Arc Elasticity of Demand

Price Consider a small movement along the

demand curve to point B
100

80
A (q1,p1)
60
B (q2,p2)
40

20
D

2,000 4,000 6,000 8,000 10,000

Quantity (pairs of shoes)
16
 Arc Elasticity of Demand

Price First we need to calculate the

change in quantity demanded
100
divided by the average quantity
80
A (q1,p1) • (q2-q1)/(q1+q2)/2=…
60
B (q2,p2) • (8000-6000)/7000=.29
40

20
D
q1 q2
2,000 4,000 6,000 8,000 10,000
Quantity (pairs of shoes)
17
 Arc Elasticity of Demand

Price Next we need to calculate the

change in price divided by the
100 average price
80
p1 A (q1,p1)
• (p2-p1)/(p1+p2)/2=
60
• (40-60)/50=-.4
p2 B (q2,p2)
40

20
D
q1 q2
2,000 4,000 6,000 8,000 10,000
Quantity (pairs of shoes)
18
 Arc Elasticity of Demand

Price Hence the arc elasticity of

demand at point A is
100

80 • e =.71 (negative dropped)

p1 A (q1,p1)
60
p2 B (q2,p2)
• Note the value is somewhere in
40
between the point elasticity at A
20
D and the point elasticity at B
q1 q2
2,000 4,000 6,000 8,000 10,000
Quantity (pairs of shoes)
19
 Arc Elasticity of Demand

Price The arc elasticity at point B is also e

=.71
100 • Note harc=.71 is somewhere in
80 between hA=1 and hB=.5
p1 A (q1,p1)
60
p2 C (q*,p*) B (q2,p2) • In fact the arc elasticity between
40
A and B is the point elasticity at
20 point C
D
q1 q2
2,000 4,000 6,000 8,000 10,000
Quantity (pairs of shoes)
20
 Demand Function
A function is the mathematical relationship of a
variable with its determinants.

Y = f(x)

Here Y is a function of X. That is X determines Y.

 Demand Function
Thus demand function is the relationship of demand with
the determinants.

Dx = f (I, Px, Ps, Pc, A …)

Px: Price of good X

I: Consumer’s income
Ps: Price of substitute goods
Pc: Price of complementary goods
A: Advertisement expenditure
 Elasticity of Demand

Elasticity of Demand is defined as the ratio of percentage

change in demand to the change in one of the
determinants of demand.

Percentage Change in Demand

eD =
Percentage Change in Determinan ts of Demand
 Different Types of Elasticity of Demand
•

• Price elasticity of demand

• Income elasticity of demand
• Cross elasticity of demand
• Promotional elasticity of demand
 Price Elasticity of Demand
Price elasticity of demand measures the change in
demand for a good to the changes in the price of
that good, certeris paribus
•
Percentage change in demand for a commodity
Ep =
Percentage change in price of the commodity
 Different Types of Price Elasticity

 Perfectly inelastic demand – Ep = 0

 Perfectly elastic demand – Ep = ∞
 Elastic demand – Ep > 1
 Inelastic demand Ep < 1
 Unitary elastic Ep = 1
 Perfectly Inelastic Demand

• Perfectly inelastic demand means that a consumer

will buy a good or service regardless of the
movement of price.

• A Perfectly Inelastic Demand is a demand where the

quantity demanded does not respond to price.

• In order for perfectly inelastic demand to exist, there

can be no substitutes available.

• Another example would be insulin to a diabetic.

 Perfectly Inelastic Demand

Price • When the demand curve is

vertical, demand is perfectly
inelastic

• Even a large change in price

will have no effect on
demand
D

Quantity
30
The implication of a perfectly inelastic demand is that
price does not matter; the consumer would purchase
the same amount of a good or service no matter its
price. A diabetic’s demand for insulin has a demand
curve that is almost vertical. A diabetic must have
insulin to survive. The diabetic would also be hurt if an
overdose of insulin were taken, so more insulin would
not be purchased at lower prices. These demands are
perfectly inelastic
 Perfectly Elastic Demand
A Perfectly Elastic Demand is a demand where any
price increase would cause the quantity demanded to
fall to zero.
 Perfectly Elastic Demand

Price When the demand curve is flat,

demand is perfectly elastic

Quantity
33
A perfectly elastic demand curve is horizontal at the
market price. A business has a perfectly elastic
demand curve if it is a small producer and has
virtually no impact on the product’s market price.
These companies are “price takers”. In other words,
companies must “take it or leave it,” meaning that
they either accept the market price or choose not to
sell their product. At a higher price, the company will
not have any sales because there are too many
competitors offering the same product at a lower
price. At the market or lower price, the company will
sell everything. However, there is not a reason to
offer a lower price because the producer is able to
sell out at the higher market price.
 Elastic Demand

Price
• If e>1 we say that
demand is elastic
A small %p
leads to a large %q • %Dq >%Dp
• Demand is very
D
responsive to price

• Kit Kat chocolate bar. If Kit Kats

increase, people will switch to
alternative types of chocolate
bar.
Quantity
35
 Inelastic Demand

Price
A large %p…
• If e < 1 we say that
leads to a
demand is inelastic
small %q

• %Dq<%Dp

• Demand is very
D
unresponsive to price
Quantity
36
 Examples of inelastic demand
• Petrol
• Cigarettes
• Salt
• A good produced by a monopoly
 Factors that make demand inelastic
• No substitutes.
• Little competition.
• Bought infrequently.
• Small percentage of income spends on good
Elasticity Along a Linear Demand Curve

Price • Consider the following

linear demand curve
• The slope of this
100

80
demand curve is one
60

40

20

D
20 40 60 80 100
Quantity
40
Elasticity Along a Linear Demand Curve

Price • What is the price

e =∞ elasticity of demand at
A
100
point A?
80
– e =(1/slope)(p/q)
60
=(1/1)(100/0)
40
=∞
20

D
20 40 60 80 100
Quantity
41
Elasticity Along a Linear Demand Curve

Price • What is the price

elasticity of demand at
100
point B?
80
– h=(1/slope)(p/q)
60
η =0 =(1/1)(0/100)
40
=0
20 B

D
20 40 60 80 100
Quantity
42
Elasticity Along a Linear Demand Curve

Price • What is the price

elasticity of demand at
100 point C?
80
E =1 • C is the midpoint of
60
50
C the demand curve
40 – e=(1/slope)(p/q)
20 =(1/1)(50/50)
50 D =1
20 40 60 80 100
Quantity
43
Elasticity Along a Linear Demand Curve

• Top half of the demand is

Price
elastic
elastic
100 demand
• Lower half of the demand
80
unit-elastic curve is inelastic
60

inelastic • At the midpoint demand is

40 demand unit-elastic
20

D
20 40 60 80 100
Quantity
44
 Income Elasticity of Demand

• The demand for a good will change if there is a change

in consumers` income.
• Income elasticity of demand is a measure of how much
the quantity demanded of a good responds to a change
in consumers’ income.
Types of Income Elasticity
• Positive income elasticity
• Negative income elasticity

Positive Income Elasticity

Demand increases with a arise in consumers’ income
(Ex) superior OR Normal goods

Negative Income Elasticity

Demand decreases with a arise in consumers’ income
(Ex) inferior goods
ZERO Income Elasticity

When the demand for commodity does not respond to

changes in income of the consumer, the income
elasticity of demand is zero.

(Ex) Very cheap commodity: salt, post card,

newspaper, candles, and buttons
Positive Income Elasticity can be divided into 3
categories:

1. Income inelastic EY < 1

2. Unit income elasticity EY

3. Income elastic EY > 1

 Income inelastic - EY < 1
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 income inelastic

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.
 Income elastic - EY > 1
Income elasticity greater than 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 elastic.

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.
 Income elasticity equal to unity (EY = 1)

• 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 is 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.
 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.

For example:
As the income of consumer increases, they either stop or
consume less of inferior goods.
 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.
 Cross Elasticity of Demand

The quantity demanded of a particular good varies

according to the price of other goods

Cross elasticity of demand is a measure of how much the

quantity demanded of one good responds to a change in
the price of another good.

Percentage Change in Demand of X

Ec =
Percentage Change in Price of Y
 Kinds of Cross Elasticity of Demand
 Positive cross elasticity
 Negative cross elasticity
 Zero cross elasticity
 Positive Cross Elasticity

• When goods are substitute of each other then cross

elasticity of demand is positive.

• In other words, when 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.
 Negative Cross Elasticity
• 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.
 Zero Cross Elasticity
• Cross elasticity of demand is zero when two goods
are not related to each other.

• For instance, increase in price of car does not effect

the demand of cloth. Thus, cross elasticity of demand
is zero.
Advertising Elasticity of Demand [AED]
Measures the responsiveness of changes in the
quantity demanded to changes in the level of
advertising. It is calculated using the following
formula.

Percentage Change in Demand

Ea =
Percentage Change in expenditur e on advetiseme nts
If Ea > 1, it implies a relatively elastic demand
an increase in the level of advertising will cause a
proportionately greater increase in the demand for the
good.

If Ea < 1, it implies a relatively inelastic demand

an increase in the level of advertising will cause a
proportionately smaller increase in the demand for the
good.
 Elasticity and Firms

 Change by a particular amount and particular

direction is very useful in managerial decision
making.

 With this knowledge of elasticity of demand, a

manager can use the changes to his advantage.

 Therefore it will be able to respond effectively to the

changes in the economic environment.
 Income Elasticity and Firms

• The income elasticity of demand shows the

responsiveness of demand for a particular
commodity to the variation in the consumer’s
income.

• It enables the firm to foresee the magnitude and

direction of the change in the demand for its product
with the changes in the level of consumers’ income
in the industry.
 The Concept of Income Elasticity and
National Income

• Changes in national income affect the demand for

the firm’s product.

• If product has high income elasticity will grow

faster when the economy will expand.

• Firms having low income elasticity will be less

affected by economic changes.
 Cross Elasticity and Firms

Cross Elasticity of demand become important for a

manager to develop some sort of relationship between the
demand for a commodity and the price of related goods.

Thus cross elasticity enables the firm to formulate pricing

strategy in relation to the pricing strategy of its
competitors.

Therefore cross elasticity helps in measuring the inter

relationship among different industries.
 Advertising Elasticity of Demand and the
Firms
• The promotional elasticity of demand plays an
important role in the marketing decisions of any
firm.

• A low promotional elasticity would indicate that

demand changes less as compared to a change in the
advertisement expenditure of a firm.

• Thus the manager can plan alternative marketing

approach in order to produce sales effectively.
 Elasticity and Total Expenditure

Direction of Price Direction of Total Expenditure

Price Elasticity of Demand
Change Change

Elastic Demand E > 1 Rise in price Total expenditure falls

Fall in price Total expenditure increases

Inelastic Demand E <1 Rise in price Total expenditure increases

Fall in price Total expenditure decreases

Unitary Elastic Demand E =1 Rise in price Total expenditure same

Fall in price Total expenditure same
 Relationship among Price Elasticity, Marginal
Revenue and Total Revenue

Total Revenue when Price

Price elasticity of Demand Marginal Revenue
is Reduced
Elastic Positive Increases
Unitary Zero Remains constant
Inelastic Negative Decreases
Determinants of the Price Elasticity of Demand
 Nature of the commodity
 Availability of Substitutes
 Variety of Uses
 Postponement of the Use
 Proportion of the income spent on a commodity
 Income level of the consumer
 Time period
 Joint demand
 Nature of the Commodity
1. Necessities
2. Luxuries
3. Comforts
4. Durable
5. Perishable

• A necessity that has no close substitute (salt, newspaper)

will have an inelastic demand because its consumptions
cannot be postponed

• Consumers purchase almost a fixed amount of a necessity

per unit of time whether the price” is somewhat higher or
lower.
• Demand of luxuries is relatively more elastic because
consumption of luxuries (TV. sets, decoration items) can be
dispensed with or postponed when their prices rise.

• Comforts have more elastic demand than necessities and

less elastic in comparison to luxuries.

• Commodities arc also classified as durable and perishable.

Demand for durable goods is more elastic than perishable
goods (non-durable)

• when the price of durable goods increases, people either

get the old one repaired or buy a second hand
 Availability of Substitutes

• A commodity has elastic demand if there are close

substitutes of it. A small rise in the price of a commodity
having close substitute will force the buyers to reduce the
consumption of the commodity in favor of substitutes.

• If no substitutes are available, demand for goods tends to

be inelastic. Demand for salt is highly inelastic because it has
no substitute.
 Variety of Uses
• The elasticity of demand also depends on the number of uses of
the commodity

• if the commodity is used for a single purpose, then the change in

the price will affect the demand for commodity only in that use,
and thus the demand for that commodity is said to be inelastic

• If the product has several uses, such as raw material coal, iron,
steel, etc., then the change in their price will affect the demand
for these commodities in its many uses. Thus, the demand for such
products is said to be elastic.
 Postponement of the Use
• If the use or purchase of a commodity can be postponed
for some times, then the demand of such commodity will
be elastic. For example, if cement, bricks, wood and
other building materials

• If the demand for a particular product cannot be

postponed then, the demand is said to be inelastic. Such
as, Wheat is required in daily life and hence its demand
cannot be postponed
 Proportion of the income spent on a commodity

• The elasticity of demand for a product is determined by the proportion

of income spent by the individual on that product.

• The demand for such goods is inelastic on which a small portion of

income is spent, the items like toothpaste, shoe polish, electric bulbs
have inelastic demand as we spend a small portion of our income on
these items.

• On the other hand clothes and durable items take away a large
portion of the income. Therefore, the demand for such commodities is
elastic.
 Income level of the consumer
• The income of the consumer also affects the elasticity of
demand.

• For high-income groups, the demand is said to be less elastic

as the rise or fall in the price will not have much effect on
the demand for a product.

• In case of the low-income groups, the demand is said to be

elastic and rise and fall in the price have a significant effect
on the quantity demanded. Such as when the price falls the
demand increases and vice-versa.
 Joint demand

• Elasticity of demand for a commodity is also influenced by

the elasticity of its jointly demanded commodities.

• If the demand for pen is inelastic then the demand for ink
will be inelastic. Generally, the elasticity of jointly
demanded goods is inelastic.
 Time period
• In the short-run the demand is inelastic while in the long-run
demand is elastic.

• The reason is that in the long-run consumer can change their

habits and consumption pattern.