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Elasticityof Demand

The document discusses different types of elasticities of demand including price elasticity of demand, income elasticity of demand, and cross elasticity of demand. It provides definitions and formulas for calculating each type as well as examples to demonstrate elastic vs inelastic, normal vs inferior goods, and substitutes vs complements.

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Sahiti Darika
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Download as PDF, TXT or read online on Scribd
5 views

Elasticityof Demand

The document discusses different types of elasticities of demand including price elasticity of demand, income elasticity of demand, and cross elasticity of demand. It provides definitions and formulas for calculating each type as well as examples to demonstrate elastic vs inelastic, normal vs inferior goods, and substitutes vs complements.

Uploaded by

Sahiti Darika
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Elasticity of Demand – Measure of responsiveness

Elasticity of demand are measures of responsiveness of quantity demanded of a


product to different determinants of demand i.e. price, income, prices of substitute and
complements, etc. The most popular elasticity of demand is the price elasticity of demand.
There are three main types of elasticities of demand: the price elasticity of demand (so
popular that it is generally referred to as simply elasticity of demand), income elasticity of
demand and cross elasticity of demand.
There are a range of factors which affect quantity demanded either directly or
indirectly. The product’s own price is the most significant factor. Quantity demanded
increases if the price of the product decreases and vice versa. The extent of this relationship
between quantity demanded and price is measured by price elasticity of demand. Other
significant demand determinants include income level of the consumers, the prices of
substitute goods or complementary goods, etc. The income elasticity of demand measures
responsive of demand to changes in income while the cross elasticity of demand tells us
how demand changes when the prices of substitutes or complements changes.
Price elasticity of demand
Price elasticity of demand (PED) shows the relationship between price and quantity
demanded and provides a precise calculation of the effect of a change in price on quantity
demanded.

We can use this equation to calculate the effect of price changes on quantity
demanded, and on the revenue received by firms before and after any price change.
For example, if the price of a daily newspaper increases from Rs. 1.00 to Rs. 1.20, and the
daily sales fall from 500,000 to 250,000, the PED will be:
– 50 / 20 = (-) 2.5
The negative sign indicates that P and Q are inversely related, which we would
expect for most price/demand relationships. This is significant because the newspaper
supplier can calculate or estimate how revenue will be affected by this change in price. In
this case, revenue at Rs. 1.00 is Rs. 500,000 (Rs. 1 x 500,000) but falls to Rs. 300,000 after
the price rise (Rs. 1.20 x 250,000).
The range of responses
The degree of response of quantity demanded to a change in price can vary
considerably. The key benchmark for measuring elasticity is whether the co-efficient is
greater or less than proportionate.
PED can also be:
a) Zero (0), which is perfectly inelastic.
b) Less than one, which means PED is inelastic.
c) Equals to one, is called unit elasticity.
d) Greater than one, which is elastic.
e) Infinite (∞), which is perfectly elastic.
Cross elasticity of demand
Cross elasticity of demand (XED) is the responsiveness of demand for one product to
a change in the price of another product. Many products are related, and XED indicates just
how they are related.
The following equation enables XED to be calculated.

Substitutes
When XED is positive, the related goods are substitutes. For example, if the price of Coca
Cola increases from 50p to 60p per can, and the demand for Pepsi Cola increases from 1m
to 2m per year, the XED between the two products is:
The positive sign means that the two goods are substitutes, and because the coefficient is
greater than one, they are regarded as close substitutes.
Complements
When XED is negative, the goods are complementary products. The equation is the same as
for substitutes.
For example, if the price of Cinema Tickets increases from £5.00 to £7.50, and the demand
for Popcorn decreases from 1000 tubs to 700, the XED between the two products will be:

The negative sign means that the two goods are complements, and the coefficient is less
than one, indicating that they are not particularly complementary.

Income Elasticity of Demand


Income elasticity of demand (YED) shows the effect of a change in income on
quantity demanded. Income is an important determinant of consumer demand, and YED
shows precisely the extent to which changes in income lead to changes in demand. YED can
be calculated using the following equation:

Normal goods
When the equation gives a positive result, the good is a normal good. A normal good is one
where demand is directly proportional to income. For example, if, following an increase in
income from Rs. 40,000 to Rs. 50,000, an individual consumer buys 40 DVD films per year,
instead of 20, then the coefficient is: + 100+ 25=(+) 4.0
The positive sign means that the good is a normal good, and because the coefficient is
greater than one, demand for the good responds more than proportionately to a change in
income. This indicates the good is not a necessity like food, and would be considered a
relative luxury for this individual.
Inferior goods
When YED is negative, the good is classified as inferior. For example, if, following an
increase in income from Rs. 40,000 to Rs. 50,000, a consumer buys 180 loaves of bread per
year instead of 200, then the YED is:
10+ 25=(-) 0.4
The negative sign means that the good is inferior, and, because the coefficient is less
than one, demand for the good does not respond significantly to a change in income. This
indicates that the good is not particularly inferior compared with a good which has a YED
of > (-)1.

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