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UNIT II

2.1 Elasticity of Demand

ELASTICITY THE CONCEPT


The responsiveness of one variable to changes in
another
When price rises, what happens to demand?

BUT!

How

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Demand

falls

much does demand fall?

ELASTICITY THE CONCEPT


If price rises by 10% - what happens to demand?
We know demand will fall

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By

more than 10%?


By less than 10%?

Elasticity measures the extent to which demand


will change

ELASTICITY - TYPES
1.

3.

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2.

Price elasticity of demand


Income elasticity of demand
Cross elasticity

PRICE ELASTICITY OF DEMAND

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Price elasticity of demand is the percentage


change in quantity demanded given a percent
change in the price.
It is a measure of how much the quantity
demanded of a good responds to a change in the
price of that good.
The responsiveness of demand to change in price

ELASTICITY

Price Elasticity of Demand

% change in demand is greater than %


change in price elastic
Where % change in demand is less than % change
in price - inelastic

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Where

COMPUTING THE PRICE


ELASTICITY OF DEMAND
The

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price elasticity of demand is computed as the


percentage change in the quantity demanded
divided by the percentage change in price.

Price Elasticity = Percentage Change in Qd


of Demand
Percentage Change in Price

PERFECTLY INELASTIC DEMAND ELASTICITY EQUALS 0


Price

Demand
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5
1. An
increase
in price... 4

Quantity
100
2. ...leaves the quantity demanded unchanged.

INELASTIC DEMAND - ELASTICITY


IS LESS THAN 1
Price
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1. A 25% 5
increase
in price... 4
Demand

Quantity
90 100
2. ...leads to a 10% decrease in quantity.

UNIT ELASTIC DEMAND ELASTICITY EQUALS 1


Price
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1. A 25% 5
increase
in price... 4
Demand

Quantity
75
100
2. ...leads to a 25% decrease in quantity.

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ELASTIC DEMAND - ELASTICITY

GREATER THAN 1

IS

Price
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5
1. A 25%
increase
in price... 4

Demand

Quantity
50
100
2. ...leads to a 50% decrease in quantity.

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PERFECTLY ELASTIC
DEMAND -ELASTICITY EQUALS
INFINITY
Price

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1. At any price
above 4, quantity
demanded is zero.
Demand

4
2. At exactly 4,
consumers will
buy any quantity.
3. At a price below 4,
quantity demanded is infinite.

Quantity

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Ed = Infinity Rare Possibility


Ed = 0 Salt
Ed > 1 Realistic concept
Ed < 1 Realistic concept
Ed =1 - Theoretical

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DETERMINANTS OF PRICE
ELASTICITY OF DEMAND

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Demand tends to be more inelastic:


If the good is a necessity.
If the time period is shorter.
The smaller the number of close substitutes.
Cannot be postponed
Little income is spent on the goods
Price level High & low
Joint goods
If have less uses
Habits

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DETERMINANTS OF PRICE ELASTICITY


OF DEMAND
Demand tends to be more elastic :
the good is a luxury.
The longer the time period.
The larger the number of close substitutes.
Can be postponed
More income is spent on the goods
Price level Moderate
Not a Joint good
If have more uses
Habits

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If

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REVIEW QUESTION

Cooking gas
Cigarettes
T.V.
Diamonds
Washing Machines

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Will the demand be Elastic or inelastic for


the following products and why?

1.

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Petrol price has increased, but Mr. Guptas family


is spending less on petrol. What can we infer
about the elasticity of demand for petrol by his
family?

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INCOME ELASTICITY OF DEMAND


o

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Income elasticity of demand 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.

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COMPUTING INCOME ELASTICITY

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Income Elasticity =
of Demand

Percentage Change
in Quantity Demanded
Percentage Change
in Income

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INCOME ELASTICITY OF DEMAND


1.

3.

4.
5.

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2.

When the income elasticity of demand is =1


(normal good), consumers increase their
purchases of the good as their incomes rise (e.g.
automobiles, clothing).
When the income elasticity of demand is >1
(luxury good), consumers increase their purchases
of the good more than proportionate to the income
increase (e.g. A tour to Europe, cars).
When the income elasticity of demand is negative
(inferior good), consumers reduce their purchases
of the good as their incomes rise (e.g. potatoes,
Jowar, Bajra).
Yed < 1 Essential goods like food grains
Yed = 0 Salt, Match box

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CROSS PRICE ELASTICITY OF


DEMAND
The

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responsiveness of demand of one good to


changes in the price of a related good either
a substitute or a complement
E c = % Quantity of X
% Price of Y

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CROSS- PRICE ELASTICITY OF


DEMAND
Elasticity

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of demand with respect to the price


of a complementary good
Ced < 0 - This elasticity is negative because
as the price of a complementary good rises,
the quantity demanded of the good itself falls.
Example

software is complementary with computers.


When the price of software rises the quantity
demanded of computers falls.

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SUBSTITUTE GOODS - CED > 0


Elasticity

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of demand with respect to the price


of a substitute good
This elasticity is positive because as the price
of a substitute good rises, the quantity
demanded of the good itself rises.
Example

hockey is substitute for basketball.


When the price of hockey tickets rises the
quantity demanded of basketball tickets rises.

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UNRELATED GOODS CED = 0

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Change in the price of razor blade and the


demand for petrol

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IMPORTANCE OF ELASTICITY
1.

3.
4.
5.

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2.

Useful to a producer to fix the price of the


product Charges for telephone calls in the
day time is fixed according to the elasticity
of demand Hotels, Air- lines etc.
Useful in determining factor prices
Useful to Finance Minister while imposing
taxes
Useful in determining the terms of trade
between two countries
Paradox of poverty

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REVIEW QUESTION 1.

Kelvinator and Godrej refrigerators


Tables and chairs
Maruti car and Railway tickets

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Would you expect the cross Ed to be positive,


negative or zero for each of the following pairs of
products

Explain WHY?

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2. Investigating the demand for textile in India, a


researcher observed that demand for textiles tends to
rise by 1.5 % with 1 % decrease in the price of textiles;
with the rise in 1 % of per capita GDP, the demand for
textiles rise by 0.45 % and when the food prices increase
by 1 % the demand for textiles contracts by 0.93 %.
Identify the type of demand elasticity's in this case and
define them.
Which type of elasticity the textile mills should consider
significant for business development?
How much rise in sales is expected, during a festival
season by offering 20 % discount by textile mills show
rooms?

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METHODS OF MEASUREMENT 1.

3.

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2.

Percentage Method
Total Expenditure Method
Geometrical / Point Method

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PERCENTAGE METHOD

Ed =

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In this method, Ed is measured by dividing the


percentage change in demand by the percentage
change in price
% change in demand
-----------------------------% change in price

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TOTAL EXPENDITURE / OUTLAY


METHOD

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In this method, the change in price and the


consequent change in the total amount of money
spent on it, are considered.

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Part

Price
Per kg.
(Rs.)

Quantity
Total
Value of price Relation
Demanded Expenditure elasticity
between price
(in kgs)
(Rs.)
and
Total
Expenditure

10
9
8
7

1
2
3
4

10
18
24
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Greater
unity

than Inverse

II

6
5

5
6

30
30

Equal to unity

III

4
3
2
1

7
8
9
10

28
24
18
10

Less than unity Positive

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Constant

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GEOMETRICAL / POINT METHOD


In this method, we measure elasticity of demand,
at any point on the demand curve.
Ed = Lower part of the demand curve
---------------------------------------Upper part of the demand curve

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