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.

Amity School of BusinessPrice Elasticity

Methods of calculating Price elasticity of demand

1. Percentage Method:

(% change in Qty demanded)

Ep = _________________________

(% change in price)

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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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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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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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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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

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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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

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

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.