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Elasticity of Demand
“Elasticity” is a standard measure of the degree of
responsiveness (or sensitivity) of one variable to changes in
another variable.
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.
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
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.
Four major types of elasticity:
Price elasticity,
Income elasticity,
Cross elasticity
Advertising (or promotional) elasticity.
O D
Q1 Q2 Quantity
Methods of Measuring Elasticity
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
Price Ed = 1
E
Ed <1
Ed = 0
B
Quantity
Arc Elasticity
It measures the responsiveness of demand between
two points on the demand curve such as X and Y. In
other words it is a measure of average elasticity i.e. the
elasticity at the midpoint of the chord that connects
the two points on the demand curve defined by the
initial and new price levels.
Methods of Measuring Elasticity
Contd…
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.
Degrees
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)
Income Elasticity of Demand (ey)
ey measures the degree of responsiveness of demand for a
good to a given change in income, ceteris paribus.
Degrees:
Positive income elasticity
Demand rises as income rises and vice versa
Normal good
Inferior good
Cross Elasticity of Demand
ec measures the responsiveness of demand of one
good to changes in the price of a related good
Degrees
Negative Cross Elasticity
Complementary goods
Positive Cross Elasticity
Substitute goods
Promotional Elasticity of Demand
Price,
Till ep>1 MR is positive Revenue
and TR is rising ep=
∞ ep>1
At the midpoint of the
demand curve, ep=1 ep=1
ep<1
and MR is equal to 0
and TR is at its peak ep=0
O
When ep<1, MR is Price, MR
Quantity
falling.
MR= AR[1- 1/ep]
O
TR Quantity
Importance of Elasticity
Determination of price
Elasticity is the basis of determining the price of a product keeping
its possible effects on the demand of the product in perspective
Basis of price discrimination
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
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.