The effect of price and The effect of price and incomeincomeon demand quantitieson demand quantities

ELASTICITY OF ELASTICITY OF DEMANDDEMAND

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ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP

MODULE B, B.COM, BBA, MBA & PIPFA.MODULE B, B.COM, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D,

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FRESH CLASSESFRESH CLASSES ICMAP STAGE 1,2 & 3ICMAP STAGE 1,2 & 3 FUNDAMENTALS OF FA,COST FUNDAMENTALS OF FA,COST

ACCOUNTING ,APPRAISAL & ACCOUNTING ,APPRAISAL & FAFA

INDIVIDUAL & GROUPSINDIVIDUAL & GROUPS

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FRESH CLASSES OF MA FRESH CLASSES OF MA ECONOMICS EXTERNAL ECONOMICS EXTERNAL KU JUST AFTER KU JUST AFTER ANNOUNCEMENT OF ANNOUNCEMENT OF RESULTRESULT

55

The price elasticity of The price elasticity of demanddemand

…measures the sensitivity of the quantitydemanded of a good to a change in its price

It is defined as:

% change in quantity demanded% change in price

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Elastic demandElastic demand

ELASTIC demandELASTIC demand when the price elasticity is more negative when the price elasticity is more negative

than -1than -1 i.e. when the % change in quantity i.e. when the % change in quantity

demanded exceeds the change in pricedemanded exceeds the change in pricee.g. if quantity demanded falls by 7% in response e.g. if quantity demanded falls by 7% in response

to a 5% increase in priceto a 5% increase in priceelasticity is -7 elasticity is -7 5 = -1.4 5 = -1.4

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Inelastic demandInelastic demand

INELASTIC demandINELASTIC demand when the price elasticity lies between -1 and when the price elasticity lies between -1 and

00 i.e. when the % change in quantity i.e. when the % change in quantity

demanded is smaller than the change in demanded is smaller than the change in pricepricee.g. if quantity demanded falls by 3.5% in e.g. if quantity demanded falls by 3.5% in

response to a 5% increase in priceresponse to a 5% increase in priceelasticity is - 3.5 elasticity is - 3.5 5 = - 0.7 5 = - 0.7

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Unit elastic demandUnit elastic demand

UNIT ELASTIC demandUNIT ELASTIC demand when the price elasticity is exactly -1when the price elasticity is exactly -1 i.e. when the % change in quantity i.e. when the % change in quantity

demanded is equal to the change in pricedemanded is equal to the change in pricee.g. if quantity demanded falls by 5% in response e.g. if quantity demanded falls by 5% in response

to a 5% increase in priceto a 5% increase in priceelasticity is - 5 elasticity is - 5 5 = - 1 5 = - 1

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Price elasticity Price elasticity for a linear demand curvefor a linear demand curve

The price elasticity varies along the length of a straight-line demand curve.

Demand

Unit elasticityElastic

Inelastic

Quantity

Pri

ce

1010

What determines the price elasticity?What determines the price elasticity?

The ease with which consumers can The ease with which consumers can substitute another good.substitute another good.

EXAMPLE:EXAMPLE: consumers can readily substitute one brand of consumers can readily substitute one brand of

detergent for another if the price risesdetergent for another if the price rises so we expect demand to be so we expect demand to be elasticelastic but if but if allall detergent prices rise, the consumer cannot detergent prices rise, the consumer cannot

switchswitch so we expect demand to be so we expect demand to be inelasticinelastic

1111

Elasticity is higher in the long runElasticity is higher in the long run

In the short run, consumers may not be In the short run, consumers may not be able (or ready) to adjust their pattern of able (or ready) to adjust their pattern of expenditure.expenditure.

If price changes persist, consumers are If price changes persist, consumers are more likely to adjust.more likely to adjust.

Demand thus tends to beDemand thus tends to be more more elastic elastic in the long runin the long run but relatively but relatively inelastic inelastic in the short run.in the short run.

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Elasticity and revenueElasticity and revenueWhen price is changed, the impact on a firm’s total revenue (TR) will depend upon the price elasticity of demand.

For a priceincrease

For a pricedecrease

Demand iselastic

TRdecreases

TRincreases

Demand isunit elastic

TR doesnot change

TR doesnot change

Demand isinelastic

TRincreases

TRdecreases

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Elasticity and tube faresElasticity and tube fares

Passengers can use buses, taxis, cars etcPassengers can use buses, taxis, cars etc so demand may be so demand may be elasticelastic (e.g. - 1.4) (e.g. - 1.4) and an increase in fares will reduce the number of and an increase in fares will reduce the number of

journeys demanded and total spendingjourneys demanded and total spending

If passengers do If passengers do notnot have travel options have travel options demand may be inelastic (e.g. - 0.7)demand may be inelastic (e.g. - 0.7) so raising fares will have less effect on journeys so raising fares will have less effect on journeys

demandeddemanded and revenue will improveand revenue will improve

How should tube fares be changed to increase revenues?

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The cross price elasticity of demandThe cross price elasticity of demand

The cross price elasticity of demand for good iwith respect to the price of good j is :

% change in quantity demanded of good i % change in the price of good j

This may be positive or negativeThe cross price elasticity tends to be negative if two goods are substitutes: e.g. tea and coffee

The cross price elasticity tends to be positiveif two goods are complements e.g. tea and milk.

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The income elasticity of demandThe income elasticity of demand

The income elasticity of demand measuresthe sensitivity of quantity demanded to a change in income:

% change in quantity demanded of a good% change in consumer income

The income elasticity may be positive or negative.

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Normal and inferior goodsNormal and inferior goods A NORMAL GOOD has a positive income elasticity of A NORMAL GOOD has a positive income elasticity of

demanddemand an increase in income leads to an increase in the quantity an increase in income leads to an increase in the quantity

demandeddemanded e.g. dairy producee.g. dairy produce

An INFERIOR GOOD has a negative income elasticity of An INFERIOR GOOD has a negative income elasticity of demanddemand an increase in income leads to a fall in quantity demandedan increase in income leads to a fall in quantity demanded e.g. coale.g. coal

A LUXURY GOOD has an income elasticity of demand A LUXURY GOOD has an income elasticity of demand greater than 1greater than 1 e.g. winee.g. wine

1717

Income and the demand Income and the demand curvecurve

For an increase in income:

Quantity

Pri

ce

D0

NORMAL GOOD INFERIOR GOOD

Quantity

D0P

rice

D1

Demand curvemoves to the right

D1

Demand curve moves to the left

1818

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