Lecture-11

Demand Analysis
Learning Objective : Elasticity of demand-price, income and
cross elasticity estimation point and arc elasticity
Elasticity of demand:
Elasticity of demand refers the degree of responsiveness of quantity demanded
to changes in variables such as price, income, tastes and preferences, price of
substitutes etc. Elasticity is simply a ratio between a cause and an effect, always
in percentage. The percentage change in effect is divided by percentage change in
cause.

Types of elasticity:
Price elasticity
Income elasticity and
Cross elasticity.
I.

Price elasticity of demand

It is a measure of change in quantity of a commodity demanded in response to
change in the price of that commodity

Percentage change in quantity demanded

--------------------------------------------------Percentage change in price

Example:
Suppose the price of Apple falls from Rs.10 to Rs.8 and the quantity demanded
rises from 30 to 40Apple; find out the price elasticity of demand. Then

5
3

=
=
=1.667

This means that for one per cent change, there is 1.667 per cent change in quantity
demand.

Degrees of Price elasticity of demand:

Price elasticity of demand is classified into five types:

a) Perfectly elastic
b) Perfectly inelastic
c) Unitary elastic
d )Greater than unitary elastic
e) Less than unitary inelastic
Perfectly elastic demand or infinite elasticity: Even a very small change in
price leads to a very large change in quantity demanded it is said to be perfectly
elastic. A perfectly elastic demand is one in which any quantity will be bought at
the prevailing price, but any rise in price will cause quantity demanded to fall to
zero.

Perfectly inelastic demand (p=0): If demand remains unchanged to any

amount of change in price, demand is said to be perfectly inelastic.

 Unitary elastic demand (Equal to one): When numerical value of elasticity of

demand is equal to one is known as unitary elastic demand. It means that both
price and quantity demanded change in the same proportion.

Greater than unitary elastic, elastic demand (greater than one):

Demand is said to be elastic when the numerical value of elasticity is greater
than one or unity. It means that percentage change in quantity demanded is
larger than the percentage change in price.

 Less than unitary elastic, inelastic demand (less than one): If the numerical
value of elasticity of demand is less than one or unity, it is called inelastic
demand. I.e. percentage change in quantity demanded is lesser than the percentage
change in price.

.
ii) Income Elasticity of demand: It is the magnitude of change in quantity demanded
in response to change in the income of the consumer. It is calculated by the formula.
Percentage change in quantity demanded
4

= ------------------------------------------------Percentage change in income

Luxuries have high income elasticity and necessaries have low income elasticity

iii)

Cross elasticity of demand :

It is a measure of change in quantity demanded in
response to change in prices of other related commodities
c

Percentage change in quantity demanded

---------------------------------------------------------------Percentage change in price of related good

In case of substitutes, (Tea and Coffee) the cross elasticity of demand is positive
and large. In case of complementary goods (Tea and Sugar) the rise in price of
one commodity brings about the fall in the demand of the other (Eg. Car and
Petrol) and hence it is negative.

Measurement of Price elasticity of demand:

There are five methods of measuring price elasticity of demand. These are
1. Total expenditure method
2. Percentage method
3. Point method
4. Arc elasticity method
5. Revenue method
Total expenditure method:
This method was developed by Dr. Marshall. According to this method in order
to measure the elasticity of demand it is essential to know how much and in what
direction the total expenditure has changed as a result of change in the price of a
commodity.
Price Elasticity

How total expenditure changes as result

of price change
Price rise
Price decrease
Total
expenditure Total
expenditure
increases
decreases
No change in total expenditure
Total
expenditure Total
expenditure
decreases
increases

Less than unitary or inelastic

Unitary elastic
Elastic or greater than unitary

This method can also be explained with the following diagram.

 In this figure total expenditure is shown on X-axis and price on Y-axis. EP is the
total expenditure curve. The BC segment of this curve shows the unitary elasticity
as when price rises from P2 to P3 total expenditure remains the same. Similarly,
EB segment shows the greater than unitary elasticity since as the price increases
from P3 to P4 total expenditure decreases from P3B to P4A. PC segment of the
expenditure curve shows less than unitary elasticity as when price increases from
P1 to P2 total expenditure increases from P1D to P2C.
Prof. Leibhafasky has made use of the following formulae to measure price
elasticity of demand form total expenditure method.
Ed = 1 - Exp./ D0 P where
Exp = change in expenditure
D0= initial demand
P = change in price
Suppose P=Rs 10
P1= Rs 20
Then Ed

D0 = 50
D1 = 40

Exp. = 10X50= 500

Exp. =20X40 =800

= 1- 300/ 50X 10= 1- 3/5

= 2/5= 0.40 i.e. less than unitary.

Questions
1. As a result of fall in the price, total expenditure increases, elasticity of demand is
a) One
b) Greater than one
6

c) Less than one

d) All of the above
2 As a result of increase or fall in the price, total expenditure increases, elasticity of
demand is
a) One
b) Greater than one
c) Less than one
d) All of the above
3As a result of increase or fall in the price, total expenditure remains constant, elasticity
of demand is
a) One
b) Greater than one
c) Less than one
d) All of the above
4. In case of substitutes, the cross elasticity of demand is
a) Positive
b) Negative
c) Zero
d) One
5. Income elasticity of demand is positive for
a) Superior goods
b) Inferior goods
c) Normal goods
d) All of the above
Answers
1 b)
2 c)
3 a)
4 a)
5a)