By Muhammad Shahid Iqbal

By Muhammad Shahid Iqbal

Module No. 04Module No. 04Elasticity and Its Applications (Quantitative Demand Analysis)

Engineering

Economics

Elasticity of Demand

We know, from the Law of Demand, that price and quantity demanded are inversely related.

Now, we are going to get more specific in defining that relationship, … allows us to analyze demand and supply with greater precision.

We want to know just how much will quantity demanded change when price changes? That is what elasticity of demand measures.

It is a measure of how much buyers and sellers respond to changes in market conditions

Price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good.

Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price.


The above formula usually yields a negative value, due to the inverse nature of the relationship between price and quantity demanded.

How Do We Interpret the Price Elasticity of Demand? A good economist is not just interested in calculating numbers.

The number is a means to an end; in the case of price elasticity of demand it is used to see how

sensitive the demand for a good is to a price change. The higher the price elasticity, the more sensitive consumers are

to price changes. A very low price elasticity implies just the opposite, that

changes in price have little influence on demand.

P rice e las tic ity o f d em an d =P ercen tag e ch an g e in q u an tity d em an d ed

P ercen tag e ch an g e in p rice

We can read it as the percentage change in quantity for a 1% change in price

Thus, if Ed = 2, that means in that part of the demand curve, a 1% change in price will cause a 2% change in quantity demanded. Or if we extrapolate, a 2% change in price will cause a 4% change in quantity demanded, and so on.


Degrees of Ed

Perfectly Inelastic• Ed = % Δ in Qd % Δ in P• Ed = 0___

% Δ in P• Ed = 0 it is also called zero elasticity

Perfectly elastic demandEd = % Δ in Qd % Δ in PEd = % Δ in Qd

0Ed = ∞

Degrees of Ed

Relatively Inelastic or Inelastic

Ed = % Δ in Qd % Δ in P

Ed < 1 (in absolute value)

% Δ in Qd < % Δ in P For every 1% change in P, Qd

changes by less than 1% Quantity demanded does not

respond strongly to price changes.

Degrees of Ed

Relatively elastic or elastic Demand

Ed = % Δ in Qd

% Δ in P

Ed > 1 (in absolute value)

% Δ in Qd > % Δ in P For every 1% change in P,

Qd changes by more than 1% (in opposite direction)

Degrees of Ed

Unitary Elastic Demand

Ed = % Δ in Qd

% Δ in P

Ed = 1 (in absolute value)

% Δ in Qd = % Δ in P For every 1% change in P,

Qd changes by 1% (in opposite direction)

Quantity demanded responds strongly to changes in price.

Degrees of Ed

Availability of Close Substitutes Necessities versus Luxuries Definition of the Market Time Horizon

Elasticity of Demand and Its Determinants

Availability of Substitutes• The more choices that are available, the more elastic

is the demand for a good. (and vice versa) • If the price of Pepsi goes up by 20%, one can always

purchase Coke, 7-Up and so forth. • One's willingness and ability to postpone the

consumption of Pepsi and get by with a "lesser brand" makes the PED of Pepsi relatively elastic.


Amount of Consumers Budget• The less expensive a good is as a fraction of our total

budget, the more inelastic the demand for the good is (and vice versa).

• Most consumers have both the willingness and ability to postpone the purchase of big ticket items.

• If an item constitutes a significant portion of one's income, it is worth one's time to search for substitutes.

• A consumer will give more time and thought to the purchase of a $3000 television than a $1 candy bar, so demand for the former will be more elastic than demand for the latter.


Time• The longer the time frame is, the more elastic the

demand for a good is (and vice versa).• The more time a consumer has to search for substitute

goods, the more elastic the demand.


Necessities vs. Luxuries• The more necessary a good is, the more inelastic the

demand for the good (and vice versa).• With a true necessity a consumer has neither the

willingness nor the ability to postpone consumption.• There are few or no satisfactory substitutes. • Insulin is the ultimate necessity, so the demand for it

is inelastic.


Availability of information concerning substitute goods The easier it is for a consumer to locate the substitute

goods, the more willing he will be to undertake the search, and the more elastic demand will be.

an attachment to a certain brand—either out of tradition or because of proprietary barriers—can override sensitivity to price changes, resulting in more inelastic demand


Price of Pen (P) Quantity Demanded (Q)

T. Expenditures or Revenue

(PxQ)

Price Elasticity of Demand

5.00 30 150 -

4.75 40 190 E >1

4.50 50 225 E>1

4.25 60 255 E>1

4.00 75 300 E>1

3.75 80 300 E=1

3.50 84 294 E<1

3.25 87 282.75 E<1

Total Revenue and Elasticity of Demand

When the price elasticity of demand for a good is perfectly inelastic (Ed = 0), changes in the price do not affect the quantity demanded for the good; raising prices will cause total revenue to increase.

When the price elasticity of demand for a good is relatively inelastic (0 < Ed < 1), the percentage change in quantity demanded is smaller than that in price. Hence, when the price is raised, the total revenue rises, and vice versa.

When the price elasticity of demand for a good is unitary elastic (Ed = 1), the percentage change in quantity is equal to that in price, so a change in price will not affect total revenue.

When the price elasticity of demand for a good is relatively elastic (Ed > 1), the percentage change in quantity demanded is greater than that in price. Hence, when the price is raised, the total revenue falls, and vice versa.

Total Revenue and Elasticity of Demand

Income elasticity of demand (EdY) measures how much

the quantity demanded of a good responds to a change in consumers’ income.

It is computed as the percentage change in the quantity demanded divided by the percentage change in income.

EdY = % in Qd

% in Y

Income Elasticity of Demand

Typically, if our income rises, we buy more and visa versa. These types of goods are called normal goods.

EdY > 0 - normal good

A necessity good is a good whose quantity demanded is not very sensitive to income changes

In other words, we buy it no matter what happens to our income.

If a good’s elasticity is 0 < EdY < 1 then it is a necessity good.

A luxury good is one that we buy a lot of when our income goes up and we cut back on significantly when our income goes down.

If a good’s elasticity is EdY > 1, then it is a luxury good.

If a goods elasticity is EdY < 0 it is an inferior good

Income Elasticity of Demand

Another type of elasticity is the Cross Price Elasticity. This gets at how changes in price of one good can effect the demand of another

Cross Price Elasticity of Demand (E1,2) Cross price elasticity of demand measures the percentage

change in demand for a particular good caused by a percent change in the price of another good.

It measures the responsiveness of quantity demanded of good one when the price of good 2 changes.

E1,2 = % ∆ in Qd of Good 1

% ∆ in P of Good 2

Cross Price Elasticity of Demand

This relationship is called substitutes and can be seen when E1,2 > 0.

This relationship is called complements and can be seen when E1,2 < 0

Cross Price Elasticity of Demand

By Muhammad Shahid Iqbal

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