Elasticity of Demand

Elasticity of Demand

Elasticity – the concept • The responsiveness of one variable to changes in another  • When price rises, what happens to demand? • Demand falls BUT! • How much does demand fall?

Elasticity – the concept • If price rises by 10% - what happens to demand? • We know demand will fall • By more than 10%? • By less than 10%? • Elasticity measures the extent to which demand will change

DEMAND ANALYSIS AND ELASTICITY OF DEMAND “The elasticity of demand measures the responsiveness of the quantity demanded of a good, to change in its price, price of other goods and changes in consumer’s income.” income.” Elasticity of Demand are of four types. 1.Price elasticity of demand. a.

Perfe erfec ctly tly elas elasttic dem deman and. d. (I (Infin nfinit ite) e)

b.

Perfe erfec ctly tly inela nelast stiic dem deman and d ( Zero Zero))

c.

Unitary elastic demand (One One)

d.

Highly elastic demand 

e.

Less elastic demand.

2.Income elasticity of demand. 3.Cross elasticity of demand. 4.Advertisement elasticity of sales.

Elasticity • Price Elasticity of Demand  – The responsiveness of demand to changes in price  – Where % change in demand is greater than % change in price – elastic  – Where % change in demand is less than % change in price - inelastic

Elasticity The Formula: % Change in Quantity demanded  ___________________________ Ped = % Change in Price If answer is between 0 and -1: the relationship is inelastic If the answer is between -1 and infinity: the relationship is elastic Note: PED has – sign in front of it; because as price rises demand falls and vice-versa (inverse relationship between price and demand)

Elasticity Price (Rs) •

The demand curve can be a range of  shapes each of which is associated with a different relationship between price and the quantity demanded.

Quantity Demanded

Price Elasticity of Demand • From Formula Ep = % Change in Qd % Change in Price • If Price Elasticity of Demand > 1, demand is elastic • If Price Elasticity of Demand = 1, demand is unit elastic • If Price Elasticity of Demand < 1, demand is inelastic

Demand Elasticity • Elastic Demand – When % Change in Quantity Demanded > % Change in Price • Unit Elastic Demand – When % Change in Quantity Demanded = % Change in Price • Inelastic Demand – When % Change in Quantity Demanded < % Change in Price • Perfectly Elastic Demand – When Quantity Demanded Changes by a very large percentage in response to an almost zero Change in Price • Perfectly Inelastic Demand – When the Quantity Demanded remains constant as Price changes

Price Elasticity of demand and Total Revenue • TR=P X Q  X Q • If Ed>1, then %ΔQd>%ΔP. TR is increasing as the price falls. • If Ed 1

Qu a n tity d e m a n d e d c h a n g e s p ro p o rtio n a te ly more more than pri price chang es : %∆Qd > %∆P.

Ela s ti tic

Ed < 1

Qu a n tity d e m a n d e d c ha ha n g e es s pr p ro p o r rttio na na te ly les s than pr price changes : %∆Qd < %∆P.

In e la la s ti tic

Ed = 1

Qu a n tity d e m a n d e d c ha ha n g e es s p ro p o r rttio na na te ly to price change: %∆Qd = %∆P.

Un it e la la s ti tic

Qu an an ti tity d e ma m a nd nd e d is is e x tr tre m e ly ly re re s p o n s iv iv e to e ven ve ry s mall mall change s in pri price .

P e rf rfe c tl t ly e la la s ti t ic

Qu a n tity d e m a n d e d d o e s n o t c h a n g e a s pri price changes .

P e rfe c tly in e la s ti tic

Ed =

 

Ed = 0

Trans ranspar pare ency ncy 1818- 3

Price Elasticity of demand Price Elasticity of Demand Exhibit Exhibit 2 (1 of 3) Price

Part (a)

Price

Part (b) Ed < 1 Ine las tic tic

Ed > 1 Elas Elas tic tic P2 P1

P2

10 %

10 %

P1 D 20 %

4% D

0

Trans ranspare parency 1818- 4

Q2 Q1 Quantity Demanded

0

Q2 Q1 Quantity Demanded

Price Elasticity of demand demand Price Elasticity of Demand Exhibit Exhibit 2 (2 of 3) Part (c (c )

Price

Ed = 1 Unit Elas Elas tic P2 P1

10 % D 10 %

0

Transpar nspare ency 1818- 5

Q2 Q1 Quanti Quantity ty Demand e d

Price Elasticity of demand Price Elasticity of Demand Exhibit 2 (3 of 3) Pa rt (d)

Price

Price

Part Part (e ) D

P2 P1

Ed = 0 Pe rfec tly tly Ine las tic tic

Ed = ∞ Pe rfec tly tly Elas Elas tic tic 1%

0

Trans ranspa pare renc ncy y 1818-

P2 D

Q1 Quantity Demanded

6

P1

0

10 %

Q1 Quantit Quantity y Demand e d

Price Elasticity of demand

• The Determinants of price elasticity of demand:  – 1) The availability availability of substitutes  – 2) The time it takes for consumers to adjust their behavior  in response to a change in price  – 3) The proportion of the expenditure in the budget of the consumer   – 4) Necessity vs. Luxury

Income elasticity of demand

 E  y =

% ∆ Qd  %∆ Y 

Y

≡

income

At a given price, how much will the quantity demanded change when the incomes of  consumers change? Not a movement along the demand curve but a shift in the demand curve.

Cross elasticity of demand

 E  xy  x y =

%∆ Qd x

Substitute goods

Complementary goods

%∆ P  y

The responsiveness of consumers to changes in the price of a related good.

Exy is a positive coefficient.

Exy is a negative coefficient.

Price elasticity of supply

 E  s =

%∆ Qs %∆ P 

The responsiveness of  suppliers (producers) to price changes.  E  A movement along the supply curve.

The elasticity of supply coefficient is positive (the law of supply).

Determinants of price elasticity of  supply • 1) The availability of resource inputs (the elasticity of supply of the factors of production). • 2) The The time period under consideration. As time passes supply becomes more elastic.

Elasticity Price Total revenue is price x quantity sold. In this example, TR = Rs 5 x 100,000 = Rs 500,000. This value is represented by the grey shaded rectangle.

Rs 5

Total Revenue

Quantity Demanded (000s)

Elasticity Price •

Rs 5

If the firm decides to decrease price to (say) Rs 3, the degree of  price elasticity of the demand curve would determine the extent of the increase in demand and the change therefore in total revenue.

Rs3

Total Revenue D 100

140

Quantity Demanded (000s)

Elasticity Price (Rs)

Producer decides to lower price to attract sales

10

% Δ Price = -50% % Δ Quantity Demanded = +20% Ped = -0.4 (Inelastic) Total Revenue would fall

5

Not a good move! D 5 6

Quantity Demanded

Elasticity Price (Rs)

Producer decides to reduce price to increase sales % Δ in Price = - 30% % Δ in Demand = + 300% Ped = - 10 (Elastic) Total Revenue rises

10

Good Move!

7

D

5

Quantity Demanded

20

Elasticity • If demand is price elastic: • Increasing price would reduce TR (%Δ Qd > % Δ P) • Reducing price would increase TR (%Δ Qd > % Δ P)

• If demand is price inelastic: • Increasing price would increase  TR (%Δ Qd < % Δ P) • Reducing price would reduce

Elasticity • Income Elasticity of Demand:  – The responsiveness of demand to changes in incomes

• Normal Good – demand rises as income rises and vice versa • Inferior Good – demand falls as income rises and vice versa

Elasticity • Income Elasticity of Demand: • A positive sign denotes a normal good

• A negative sign denotes an inferior good

Elasticity • For example: • Yed = - 0.6: Good is an inferior good but inelastic – a rise in income of 3% would lead to demand falling by 1.8% • Yed = + 0.4: Good is a normal good but inelastic – a rise in incomes of 3% would lead to demand rising by 1.2% • Yed = + 1.6: Good is a normal good and elastic – a rise in incomes of 3% would lead to demand rising by 4.8% • Yed = - 2.1: Good is an inferior good and elastic – a rise in incomes of 3% would lead to a fall in demand of 6.3%

Elasticity • Cross Elasticity: • The responsiveness of demand of one good to changes in the price of a related good – either  a substitute or a complement c omplement

Xed =

% Δ Price of good X  __________________ % Δ Price of good Y

Elasticity • Goods which are complements: complements :  – Cross Elasticity will have negative sign (inverse relationship between the two)

• Goods which are substitutes: substitutes :  – Cross Elasticity will have a positive sign (positive relationship between the two)

Elasticity Advertising elasticity of demand

Determinants of Elasticity • Time period – the longer the time under  consideration the more elastic a good is likely to be • Number and closeness of substitutes – the greater the number of substitutes, the more elastic • The proportion of income taken up by the product – the smaller the proportion the more inelastic • Luxury or Necessity - for example, addictive drugs

Importance of Elasticity • Relationship between changes in price and total revenue • Importance in determining what goods to tax (tax revenue) • Importance in analysing time lags in production • Influences the behaviour of a firm

DETERMINANTS OF PRICE ELASTICITY OF DEMAND 1.

Availability of Substitutes-the higher the degree of closeness of the substitutes, the greater the elasticity of demand for the commodity .

2.

Nature of Commodity-luxuries, comforts and necessities. necessities.

3.

Weightage in in th the to total co consumption-if proportion of income spent on a commodity is large, its demand will be more elastic and vice versa. versa .

4.

Time Time fact factor or in adju adjust stme ment nt of cons consum umpt ptio ion n patt patter ern n-the time consumers need to adjust their consumption pattern to a new price: the longer the time allowed, the greater the elasticity.

5.

Range of commodity use-the wider the range of the uses of a product, the higher the elasticity of demand for the decrease in price.

6.

Proportion of of ma market su supplied-if less than half of the market is supplied at  the ruling price, price elasticity of demand will be higher than 1 and if  more than half of the market is supplied then elasticity will be less than 1.

MANAGERIAL USES OF ELASTICITY OF DEMAND 1.

Dete Determ rmin inat atio ion n of Pric Price e Unde Underr Mono Monopo poly ly-a -a)) If the the dema demand nd for for his his product is elastic he will earn more profit by fixing a low price. Low price means large sales and hence, large total revenue. b) If the demand is inelastic, he will be in a position to fix up high price.

2.

Basi Basis s of of Pric Price e Dis Discr crim imin inat atio ionn- When When a mon monop opol olist ist sell sells s his his prod produc uctt at at different prices, it is called price discrimination. On the basis of  elasticity he can charge various prices from the customers.

3.

Dete Determ rmin inat atio ion n of of Wag Wages es-I -Iff the the dema demand nd for for lab labou ourr in in an an ind indus ustr try y is is elastic, strikes and other trade union tactics will not be of any avail in raising wages.

4.

Adva Advant ntag age e to Fin Finan ance ce Min Minis iste terr-a) a) Tax Taxes es on on good goods s havi having ng ela elast stic ic demand will yield less revenue. It is because of the fact that taxes will raise their prices and thus bring down their demand and finally it means less revenue, b) Goods having inelastic demand are taxed at a higher rate. No doubt the price of the goods will rise on account of  these taxes but there will be little fall in their demand.

5.

Determination of Prices of Public Utilities-Where the demand for services is inelastic, a high price is charged, while in the case of elastic demand a lower price is charged. That is why, household consumers are charged a high rate of electricity than industrial or agricultural ag ricultural customers.

6.

Inte Intern rnat atio ional nal Tra Trade de-T -Tho hose se exp expor orts ts with with inel inelas asti tic c deman demand d will will fetch fetch hig high h price.

7.

The The know knowle ledg dge e of inco income me ela elasti stici city ty can can be be usef useful ul in in fore foreca cast stin ing g dema demand nd,, when a change in personal incomes is expected. It thus helps in avoiding over production or under production.

8.

The The conc concep eptt of cro cross ss ela elasti stici city ty is is of vita vitall impo import rtan ance ce in cha chang ngin ing g pric price e of  products having substitutes and complementary goods. If cross elasticity in response to the price of substitutes is greater than 1, it would be inadvisable to increase the price; rather, reducing the price may prove more benecial.

Relationship between AR, MR, TR and Elasticity of Demand

Relationship between TR, AR and MR(As discussed in the class) Utility analysis and Indifference Curve analysis discussed in the class