Elasticity of Demand Lecture Plan n n Objectives

Elasticity of Demand

Lecture Plan n n Objectives Elasticity of demand Price elasticity of demand Degrees of price elasticity of demand Methods of measuring elasticity Revenue and price elasticity of demand Income elasticity of demand Cross elasticity of demand Promotional elasticity of demand Importance of elasticity

Objectives n n n To understand the meaning of responsiveness of demand to changes in determinants of demand. To lay down the degrees of responsiveness of demand. To discuss various types of elasticities of demand. To learn how to measure elasticity by various methods. To understand the relevance and application of elasticities of demand

Elasticity of Demand n “Elasticity” is a standard measure of the degree of responsiveness (or sensitivity) of one variable to changes in another variable. n Elasticity of Demand measures the degree of responsiveness of demand for a commodity to a given change in any of the independent variables that influence demand for that commodity, such as price of the commodity, price of the other commodities, income, taste, preferences of the consumer and other factors. n Responsiveness implies the proportion by which the quantity demanded of a commodity changes, in response to a given change in any of its determinants.

Elasticity of Demand n Mathematically, it is the percentage change in quantity demanded of a commodity to a percentage change in any of the (independent) variables that determine demand for the commodity. n Four major types of elasticity: n ¨ Price elasticity, ¨ Income elasticity, ¨ Cross elasticity ¨ Advertising (or promotional) elasticity. In order to assess the impact of one variable on demand, we assume other variables as constant (ceteris paribus)

Price Elasticity of Demand Price is most important among all the independent variables that affect the demand for any commodity n Hence price elasticity of demand ( “ep” or “e”) is considered to be the most important of all types of elasticity of demand. n Price elasticity of demand means the sensitivity of quantity demanded of a commodity to a given change in its own price. n

Degrees of Price Elasticity Slope of demand curve is used to display price elasticity of demand Perfectly elastic demand n ep=∞ (in absolute terms). n Horizontal demand curve n Unlimited quantities of the commodity can be sold at the prevailing price n A negligible increase in price would result in zero quantity demanded n n n Perfectly inelastic demand The other extreme of the elasticity range ep=0 (in absolute terms) Vertical demand curve Quantity demanded of a commodity remains the same, irrespective of any change in the price Such goods are termed neutral. Price P D O Q 1 Q 2 Quantity D Price P 1 P 2 O Q 1 Quantity

Degrees of Price Elasticity Contd. Highly elastic demand n n n Proportionate change in quantity demanded is more than a given change in price ep >1 (in absolute terms) Demand curve is flatter Unitary elastic demand n n n Proportionate change in price brings about an equal proportionate change in quantity demanded ep =1 (in absolute terms). Demand curves are shaped like a rectangular hyperbola, asymptotic to the axes Relatively inelastic demand n n n Proportionate change in quantity demanded is less than a proportionate change in price ep <1 (in absolute terms) Demand curve is steep Price D P 1 P 2 D O Price Q 1 Q 2 Quantity D P 1 P 2 O Q 1 Q 2 D Quantity

Factors Influencing Elasticity of Demand n n n n n Nature of commodity Availability of substitutes Number of uses Consumer’s income Proportion of expenditure (Income spent) Durability of the commodity Habit Time Possibility of postponement

Methods of Measuring Elasticity n Ratio (or Percentage) Method The most popular method used to measure elasticity Elasticity of demand is expressed as the ratio of proportionate change in quantity demanded and proportionate change in the price of the commodity ¨ It allows comparison of changes in two qualitatively different variables ¨ ¨ ¨ It helps in deciding how big a change in price or quantity is ep= n where Q 1= original quantity demanded, Q 2= new quantity demanded, P 1= original price level, P 2= new price level

Methods of Measuring Elasticity Contd… n Point Elasticity Method ¨ n n n Elasticity measured at a point of demand curve is referred as point elasticity of demand. For nonlinear demand curve we need to apply calculus to calculate point elasticity. As changes in price become smaller and approach zero, the ratio becomes equivalent to the first order derivative of the demand function with respect to price Point elasticity can be expressed as: ep = = .

Methods of Measuring Elasticity Contd… n Arc Elasticity Method ¨ Used when the available figures on price and quantity are discrete, and it is possible to isolate and calculate the incremental changes. ¨ It is used to find the elasticity at the midpoint of an arc between any two points on a demand curve, by taking the average of the prices and quantities. ¨ This method finds wider applications, as it reflects a movement along a portion (arc) of a demand curve ep = = / .

The arc elasticity of demand refers to the relationship between changes in price and the subsequent change in quantity demanded n The arc elasticity formula is used if the change in price is relatively large. It is more accurate a measure of elasticity than simple ''price elasticity''. n

n If the arc or price elasticity of demand is greater than 1, demand is said to be elastic. The demand curve has a ''flat'' appearance.

Solution:

n Remember, we ignore the minus sign when calculating price elasticity. When the price of CDs falls from $30 to $20, and the quantity sold increases from 6 per year to 12 per year, the price elasticity of demand is 1. 67: CDs are price elastic over this price range.

Example Arc Elasticity n Consider the market for music CDs. When the price of CDs is $30 per unit, consumers buy 6 per year. When the price falls to $20 per unit, consumers buy 12 per year.

Methods of Measuring Elasticity Contd… n Total Outlay Method (Marshall) Elasticity is measured by comparing expenditure levels before and after any change in price, i. e. whether the new expenditure is more than, or less than, or equal to the initial expenditure level. ¨ Helps a seller in taking a decision to raise price only if: n Reduction in quantity demanded does not reduce total revenue or n Reduction in price increases the quantity demanded to the extent that total revenue also increases. ¨ ¨ Degrees n n n When demand is elastic, a decrease in price will result in an increase in the revenue (sales). When demand is inelastic, a decrease in price will result in a decrease in the revenue (sales). When demand is unit-elastic, an increase (or a decrease) in price will not change the revenue (sales)

Determinants of Price Elasticity of Demand n Nature of commodity ¨ Necessities are relatively price inelastic, while luxuries are relatively price elastic n Availability and proximity of substitutes ¨ Price elasticity of demand of a brand of a product would be quite high, given availability of other substitute brands n Alternative uses of the commodity ¨ If a commodity can be put to more than one use, it would be relatively price elastic

Determinants of Price Elasticity of Contd… Demand n Proportion of income spent on the commodity The greater the proportion of income spent on a commodity, the more sensitive would the commodity be to price ¨ Reason is income effect ¨ n Time ¨ n Durability of the commodity ¨ n Demand for any commodity is more price elastic in the long run Perishable commodities like eatables are relatively price inelastic in comparison to durable items Items of addiction ¨ Items of intoxication and addiction are relatively price inelastic

Revenue and Price Elasticity of Demand n n For relatively inelastic demand, a change in price would have a greater effect on revenue than a change in quantity demanded AR is same as the price of the product ¨ Demand n curve is also the AR curve of the firm. Marginal Revenue is the revenue a firm gains in producing one additional unit of a commodity

Revenue and Price Elasticity of Demand Contd… n n Till ep>1 MR is positive and TR is rising At the midpoint of the demand curve, ep=1 and MR is equal to 0 and TR is at its peak n When ep<1, MR is negative and TR is falling. n MR= AR[1 - ep] Price, Revenue ep=∞ ep>1 ep=1 ep<1 ep=0 O Price, Revenue O Quantity MR TR Quantity

Income Elasticity of Demand (ey) ey measures the degree of responsiveness of demand for a good to a given change in income, ceteris paribus. n n Degrees: Positive income elasticity n Demand rises as income rises and vice versa n Normal good ¨ Negative income elasticity n Demand falls as income rises and vice versa n Inferior good ¨

Cross Elasticity of Demand n ec measures the responsiveness of demand of one good to changes in the price of a related good n Degrees ¨ Negative Cross Elasticity n Complementary goods ¨ Positive Cross Elasticity n Substitute goods

n Degrees ¨ Zero Cross Elasticity

Promotional Elasticity of Demand n n n Advertising (or promotional) elasticity of demand (ea) measures the effect of incurring an “expenditure” on advertising, vis-à-vis an increase in demand, ceteris paribus. Some goods (like consumer goods) are more responsive to advertising than others (like heavy capital equipments). Degrees ¨ ea>1 n Firm should go for heavy expenditure on advertisement. ¨ ea <1 n Firm should not spend too much on advertisement

Importance of Elasticity n Determination of price ¨ n Basis of price discrimination ¨ n Products having elastic demand may be sold at lower price, while those having inelastic demand may be sold at high prices Determination of rewards of factors of production ¨ n Elasticity is the basis of determining the price of a product keeping its possible effects on the demand of the product in perspective Factors having inelastic demand are rewarded more than factors that have relatively elastic demand. Government policies of taxation ¨ Goods having relatively elastic demand are taxed less than those having relatively inelastic demand.

Summary ¨ ¨ ¨ Elasticity of demand measures the degree of responsiveness of the quantity demanded of a commodity to a given change in any of the independent variables that influence demand for that commodity. Price elasticity of demand (ep) measures the degree of responsiveness of the quantity demanded of a commodity to a given change in its price, other things remaining the same. By the percentage method ep is expressed as the ratio of proportionate change in quantity demanded and proportionate change in price of the commodity. As per the total outlay method elasticity is measured by comparing expenditure levels before and after any change in price, i. e. whether the new expenditure is more than, or less than, or equal to the initial expenditure level. Arc elasticity is used to calculate price elasticity of demand at the midpoint of an arc between any two points on the demand curve, by taking the average of the prices and quantities; point elasticity can be approximated by calculating the arc elasticity for a very small arc on the demand curve.

Summary ¨ ¨ ¨ If the demand curve is a straight line, price elasticity of demand at different points of the demand curve can be calculated by the ratio of the lower segment and upper segment of the demand curve. MR= AR[1 - ep] Income elasticity of demand (ey) measures the degree of responsiveness of the quantity demanded of a commodity to a given change in consumer’s income. For normal goods ey is positive; for neutral goods ey is zero; for inferior goods ey is negative. Cross elasticity of demand (ec) shows how changes in prices of other goods would affect the demand for a particular good. For substitutes ec is positive; and for complements ec is negative. Advertising (or promotional) elasticity of demand (ea) measures the effect of incurring an “expenditure” on advertising of a firm on the demand for its product at constant price. Elasticity is used for determination of right price by seller and for taxation by government.