Elasticity of Demand

Session - 5
Prof. T.R. Panigrahi
REVIEW OF SUPPLY AND DEMAND
Economic analysis begins and ends with
demand and supply.
The primary importance of demand and supply
is the way they determine prices and quantities
sold in the market.
Managers are extremely interested in
forecasting future prices and output, both for
the goods and services they sell and for the
inputs they use.
Price elasticity of demand

The degree of responsiveness of change in quantity

demanded of a particular product to a unit change in price
of the same.
The percentage change in quantity demanded resulting from
1% change in price. Usually a negative figure.
(called epsilon)
Important for pricing decisions.
(notation: sometimes epsilon is written with a positive sign;
take care!)
Q
P
P
Q

The market demand curve shows the total quantity
of the good that would be purchased at each price
Quantity Demanded
Price
D
D
10000
15000
30000
20000
70000
50
250 400 600
800
Q =
150
P = - 10000
8 . 1
250
30000
*
10000
150

Q
P
P
Q

DEMAND ELASTICITY

Elasticity measures the sensitivity of the

quantity demanded to changes in the
determinants of demand (supply).
Some elasticity concepts:

price elasticity of demand

promotional elasticity of demand

cross-elasticity of demand

income elasticity of demand

elasticity of supply
Determinants of Price Elasticity of Demand
1. Nature of the commodity (Luxury, comforts, necessary)
2. The number and availability of substitutes
3. The expenditure on the commodity in relation to the
consumers budget
4. Number of uses
5. Consumers income
6. The durability of the product
7. Height of price & range of price change.
8. The length of the time period under consideration
9. Complementary goods
10. Habit
11. Consumers preferences
Types of price elasticity of demand

Perfectly elastic { = }

Relatively/more elastic { >1}

Unit elastic { = 1}

Relatively inelastic / less elastic { <1}

Perfectly inelastic { =0}

Price elasticity of demand
and gross revenues

< -1 ==> an inverse relationship between price changes

and gross revenues.

> -1 ==> a direct relationship between price changes

and gross revenues.

= -1 ==> no change in gross revenues as price changes.

Important because of pricing decisions: is it useful to raise

or lower prices?
Demand, Total Revenue, Marginal Revenue, and
Elasticity
P
r
i
c
e

a
n
d

m
a
r
g
i
n
a
l

r
e
v
e
n
u
e

(
R
s
.
)
Quantity
T
o
t
a
l

R
e
v
e
n
u
e

(
R
s
.
)
Quantity
0
p
0
D
E>1
E=1
E<1
D
MR
q
0
q
0
0
Quantity
Price
Quantity
Rupees
a
a/2b a/b
Total
Revenue
Demand
and MR
<
1
>
1

1
Total revenue, marginal revenue
and price elasticity
Marginal Revenue, price
and price elasticity

If product is price elastic ( < -1, marginal revenue must be positive)

Example: what is MR if price is Rs.10 and price elasticity is -2?
10(1+1/(-2)) = Rs.5.
Isnt this strange? Price is Rs.10, you sell one piece more, but your
revenues rise only by Rs.5 ???

What if product is very price elastic ( = ) ?

,
`

.
|
]
]
]
]

+
+ +

1
1
1
) ( .....
) (
P
dQ
dP
P
Q
P
dQ
dP
Q P MR
Q f P note
dQ
PQ d
MR
The Relationship between Elasticity
and Total Revenue
IF
DEMAND IS
P

Q

elastic if
TR
(relative

Q> relative

P)
P

Q

inelastic if
TR
(relative

Q< relative

P)
P

Q

elastic if
TR
(relative

Q> relative

P)
P

Q

inelastic if
TR

(relative

Q< relative

P)
The Cross-Elasticity of Demand
Cross-price elasticity measures the relative
responsiveness of the quantity purchased of some
good when the price of another good changes, holding
the price of the good and money income constant.
It is, therefore, the percentage change in quantity
demanded in response to a given percentage
change in the price of another good.
B
A
P
Q

%
%
AB
Cross-elasticity can be either positive or
negative.

In particular, cross-elasticity is positive for

substitutes and

Negative for complements.

Income Elasticity

Income elasticity is defined as a ratio

percentage or proportional change in the
quantity demanded to the percentage or
proportional change in income.
Y
Q

%
%
y
Categories of Income
Elasticity

Income elasticity > 1: superior goods

Income elasticity > 0, and <1: normal goods

Income elasticity < 0: inferior goods

Superior
Normal
Inferior
Q
Y

The Incidence of Taxes

effect of demand elasticity

effect of supply elasticity

Imposition of a Voluntary
Export Quota

Shift in Demand as Consumer

Tastes Change
Demand Elasticity and Tax
Incidence
More elastic demand shifts the tax
burden more to the supplier.
D
0
P
Q
D
S
D
0
P
Q
S
S
Supply Elasticity and Tax Incidence
P
P
1
P
2
P*
Q
1
Q
2
Q*
Q
D
S
S
1
S
1

S
The more elastic the supply, the more
heavily consumers will bear the burden of
the tax.
Imposition of a Voluntary Export
Quota
Q
0
P
0
P
1
P
Q
1
Q
0
D
S
0
S
1
Q
0
P
P
P
Q Q
D
S
D
a)
b) D & S of other cars
D & S of Japanese cars
in USA before 1981
Course Objectives

why demand curve slopes downward

Inverse relationship between price and

the

Quantity demanded

Substitution effect