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BRIAN ROPI ELASTICITY OF DEMAND NOTES LOWER SIX 2022

ELASTICITY 0F DEMAND
Meaning of Elasticity of demand
Demand for a commodity is affected by many factors such as its price, price of
related goods, income of its buyer, tastes and preferences etc. Elasticity means
degree of response. Elasticity of demand means degree of responsiveness of
demand. Demand for a commodity responds to change in price, price of related
goods, income etc.

There are three types of elasticity of demand which measure how the quantity demanded
responds to changes in the key influences on demand that is price, price of related
products and income and therefore we have:

1. Price elasticity of demand

2. Cross elasticity of demand
3. Income elasticity of demand

With elasticity of demand we will be concerned not only with the direction of change in
demand but also the size of the change (that is. the magnitude of the change).

Price elasticity of demand (PED)

PED measures the responsiveness of demand for a product following a change in its own price.
The formula for calculating the co-efficient of elasticity of demand is:

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Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount
you buy falls from 10 to 8 cones then your elasticity of demand would be calculated as:

% change in quantity demanded = (Qd2 – Qd1) / Qd1 = (60 – 40) / 40 = 0.5

% change in price = (P2 – P1) / P1 = (8 – 10) / 10 = -0.2

Thus, PED = 0.5 / -0.2 = 2.5

Since changes in price and quantity nearly always move in opposite directions, economists
usually do not bother to put in the minus sign. We are concerned with the co-efficient of
elasticity of demand.

Why should we ignore the 'minus sign' in the price elasticity of demand formula?

We know from the downward sloping demand curve that price and quantity demanded are
inversely related (demand law). This means that the price elasticity coefficient of demand will
always yield a negative number. For example, if price declines, then quantity demanded will
increase. This means that the numerator in our formula positive and denominator negative,

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yielding a negative coefficient. Conversely, for an increase in price, the coefficient will also
be negative.

This negative sign is usually ignored and it is simply presented the absolute value of the
elasticity coefficient to avoid an ambiguity which might otherwise arise. It can be confusing
to say that an elasticity coefficient of '- 4' is greater than one of '- 2', this possible confusion is
avoided when we say a coefficient of 4 indicates greater elasticity than one of 2. Hence, we
ignore the minus sign in the coefficient of price elasticity of demand and merely show the
absolute value.

Computing the price elasticity of demand using the midpoint formula

The midpoint formula is preferable when calculating the price elasticity of demand because it
gives the same answer regardless of the direction of the change.

Example; If the price of a product decreases from $10 to $8, leading to an increase in quantity
demanded from 40 to 60 units, then the price elasticity of demand can be calculated as:

Understanding values for price elasticity of demand

If PED = 0 then demand is said to be perfectly inelastic. This means that demand does
not change at all when the price changes – the demand curve will be vertical. For
example if prices increase from $4 to $5 quantity demanded will remain at 100 units as
illustrated below.

Perfectly Inelastic Demand

Price
D

An increase in price from

$4 to $5 leaves the
$5 Quantity Demanded
unchanged at 100

$4

100 Quantity Demanded

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perfectly inelastic demand

If PED is between 0 and 1 the percentage change in demand is smaller than the percentage
change in price), then demand is inelastic. Producers know that the change in demand will be
proportionately smaller than the percentage change in price. The demand for necessary goods
like medicines and food items etc. is less than unit elastic. The amount consumed does not
vary very much with price, this can be illustrated as follows:

Inelastic Demand

Price D

P3

P3

Q2 Q1 Q3 Quantity Demanded

Inelastic demand

Examples of goods/services with Inelastic Demand

- Habit forming goods-e.g. drugs, cigarettes.

- Goods/services that are considered necessary- e.g. bread, potatoes, rice,
electricity, cooking oil.
- Products that are used in conjunction with other, more expensive goods.
Complimentary goods/service- e.g. petrol/car, spare parts for vehicles,
driving licenses, motor vehicle registration, car insurance.
- Goods/services that make-up a relatively small part of income e.g.
matches, ballpoint pens. o Agricultural goods, exports of LDCs. Most
important.

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If PED = 1 (The percentage change in demand is exactly the same as the percentage change
in price), then demand is said to unit elastic. Using a midpoint formula a 25% rise in price
would lead to a 25% contraction in demand leaving total spending by the same at each price
level. A change in price will lead to the same change in the amount demanded.

Unitary Elastic Demand

Price
D

A 25% increase in price from $4

to $5 leads to a proportionate
reduction in Quantity Demanded
$5 i.e. 25% from 100 to 75.

$4

75 100 Quantity Demanded

Unitary elastic demand

If PED > 1, then demand responds more than proportionately to a change in price i.e.
demand is elastic. For example using midpoint formula a 22% increase in the price of a good
might lead to a 67% drop in demand. The price elasticity of demand for this price change is –
3. Even small changes in prices lead to big changes in demand.

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Elastic Demand
Price

A 25% increase in price from

D $4 to $5 leads to a reduction
in Quantity Demanded by
50% i.e. from 100 to 50.
$5

$4

50 100 Quantity Demanded

Fig. 14.6 Elastic demand

Examples of goods/services with Elastic Demand

 Goods/services having close substitutes which buyers find acceptable- e.g.
butter/margarine.
 Goods/services that are durable - e.g. Televisions, cars & furniture.
 Goods/services that take-up a higher proportion of income - e.g. luxuries,
holidays.
Perfectly elastic demand
Exist when the quantity demanded changes by a very large percentage in response to an
almost zero percentage change in price as shown below

Perfectly Elastic Demand

Price

At any price above $4,

quantity demanded is Zero

At exactly $4 consumers
$4 D will buy any quantity

At any price below $4,

quantity demanded is infinite

Quantity Demanded

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Perfectly elastic demand

The perfectly Elastic Demand diagram is summarised in a table as shown below

Summary of degree of price elasticity of demand (PED)

If PED > 1 Elastic Demand

If PED < 1 Inelastic Demand

If PED = 1 Unitary Elastic Demand

If PED = 0 Perfectly Inelastic Demand

If PED = ∞ Perfectly Elastic Demand

What Determines Price Elasticity of Demand?

A good example is the demand for transport services at peak times, the demand for public
transport becomes inelastic and higher prices are charged by public transport companies who
can then achieve higher revenues and profits.
Availability of close substitutes in the market
The more elastic is the demand for a product because consumers can more easily switch
their demand if the price of one product changes relative to others in the market. People
“have” to get to work for example, a latter bus is not a good substitute as you get there
late, so the demand is inelastic. The huge range of package holiday tours and
destinations make this a highly competitive market in terms of pricing – many holiday
makers are price sensitive, so demand is elastic. You can always go somewhere else on
holiday.

The cost of switching between different products

There may be significant transactions costs involved in switching between different
goods and services. In this case, from shifting from public transport you would need to
buy a car for example, find a parking space near work and so on, therefore demand
tends to be relatively inelastic.

Nature of commodity
All necessities like salt, cooking oil, mealie meal that have no substitutes/or less
substitutes will have an inelastic demand. People have to purchase such commodities
for their sustenance. Therefore, there will be some demand despite the changes in price.
Demand for luxury goods, on the other hand, will be elastic. If prices of such
commodities rise even a little, consumers refrain to buy. At the same time a little
lowering of price of such commodities attract a large number of consumers.

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The percentage of a consumer’s income allocated to spending on the good

The elasticity of demand is also influenced by the percentage of income spent on the
purchase of a commodity. If the percentage is very less than the demand will be
inelastic. For instance, we spend a very less amount of our total money income on things
like matches, pens and pencils. If prices of such commodities rise also, demand
decreases by a smaller margin. Thus, demand of such goods is inelastic.
The time period allowed following a price change
Demand tends to be more price elastic, the longer that we allow consumers to respond
to a price change by varying their purchasing decisions. In the short run, the demand
may be inelastic, because it takes time for consumers both to notice and then to respond
to price fluctuations. Back to the public transport example, it takes time to buy a car and
so on. Transport operators put their prices up and over time people would drift to cars
away from public transport.

Whether the good is subject to habitual consumption

When this occurs, the consumer becomes much less sensitive to the price of the good
in question. Examples such as cigarettes and alcohol and other drugs come into this
category. This is also why firms spend vast amounts on building brand images.

Peak and off-peak demand

Demand tends to be price inelastic at peak times – a feature that suppliers can take
advantage of when setting higher prices. Demand is more elastic at off-peak times,
leading to lower prices for consumers. Consider for example the charges made by car
rental firms during the course of a week, or the cheaper deals available at hotels at
weekends and away from the high-season. Bus fares are also high at peak times during
the day.

The breadth of definition of a good or service

If a good is broadly defined, then the demand for petrol or meat, demand is often fairly
inelastic. But specific brands of petrol or beef are likely to be more elastic following a
price change.

The durability of goods

Goods which can be used more than once are called durable goods. They are likely to
have more elastic demand. Non-durable goods are likely to have inelastic demand.

Possibility of postponement of consumption

If there is a possibility of postponement of consumption of a commodity then demand

will be elastic otherwise inelastic. Demand for certain goods can be postponed for some

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time such as computers, printers and scanners. People may wait till they become
cheaper. Therefore, their demand is elastic. But the demand for food or electricity
cannot be postponed. As such their demand is inelastic.

The number of possible uses

A commodity has high price elasticity of demand (or elastic demand) if it can be put
into so many uses. With such a commodity, if the price changes, the response of quantity
demanded to the price change becomes significant when changes in quantity demanded
for each use are put together. For instance, a commodity such as sugar is used for direct
consumption, baking break and cake, making jam, etc. Thus the demand for sugar may
be fairly elastic.

The Price Elasticity of Demand for a Straight Line Demand Curve

The price elasticity of demand is not the same along a downward sloping straight line demand
curve. For a linear demand curve sloping downward from left to right, the price elasticity of
demand starts from infinity (∞) at the point where the demand curve cuts the price axis and
falls as we move downward to the right along the curve to zero at the point where the demand
curve cuts the quantity axis.

Elasticity of demand the gradient of the curve

At the price intercept, demand is perfectly elastic. At the mid-point of the demand curve,
demand is unit elastic. At the quantity intercept, demand is perfectly inelastic. Between the
price intercept and mid-point of the demand curve, demand is elastic while between the mid-
point and the quantity intercept, demand is inelastic.

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Price Elasticity of Demand and Total Revenue

A firm‘s total revenue (TR) is the amount of money it makes from selling its goods (TR = P x
Q). For example a firm that sells 100 units of a good at $10 each will have a TR = 100 x $10
= $1000.

The effects of a change in good price on the total revenue of a firm depends on whether the
demand for the good is elastic or inelastic. When demand is elastic an increase in the price of
a good will cause a decrease in total revenue as illustrated below and a decrease in price will
cause an increase in total revenue. When demand is inelastic for example necessities an
increase in the price of a good will increase total revenue as illustrated below and a decrease
in price will decrease total revenue.

Elasticity of Demand and Total Revenue

– -Elastic Demand

An increase in price from

Price Price $4 to $5 results in a
decrease in Total Revenue
from $200 to $100
D D
$5
$4

Revenue Revenue
$200 D $100 D

50
Quantity 20 Quantity
Demanded Demanded

Fig. 14.10 Elasticity of demand and total revenue

Elasticity of Demand and Total Revenue – Inelastic Demand

Price Price
An increase in price from
$1 to $3 results in an
D D increase in Total Revenue
from $100 to $240

$3

Revenue
$1 $240
Revenue
$100 D D
100 Quantity 80 Quantity
Demanded Demanded

Fig. 14.11 Elasticity of demand and total revenue

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When a good has elasticity of demand which is unity, a decrease or increase in price of
good leaves TR unchanged. As the price of a good/service changes up or down, how
TR will change depends on the PED of the good/service. This can be summarized in the
table below:

Elasticity of demand and total revenue

Elasticity If Price: Then Total

Coefficient Revenue Will:
ep = 0 Increases Increase
Decreases Decrease
ep < 1 Increases Increase
Decreases Decrease
ep = 1 Increase No change
Decrease No change
ep > 1 Increase Decrease
Decrease Increase
ep = ∞ Increase Decrease to zero
Decrease Infinite increase, depending
on size of the market

The diagram below illustrates the relationship between price elasticity of demand and total
revenue.

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BRIAN ROPI ELASTICITY OF DEMAND NOTES LOWER SIX 2022

On the diagram above, As the firm lowers its price, it leaves the elastic region of the demand
curve and enters the unitary elastic region. At this point, any further decreases in price will
lead to an inelastic result and revenue will fall. Firms must realize that when they are in the
elastic range of the demand curve, they must lower prices; when they are in the inelastic
range of the demand curve, they can raise prices.

The demand curve has a downward slope where the three regions of elasticity are illustrated.
The total revenue curve has a point called the maximum point. This is the area where firms’
revenues decline if surpassed.

RELATIONSHIP BETWEEN TOTAL EXPENDITURE AND PRICE ELASTICITY

OF DEMAND
We have studied that price of a good and its quantity demanded are inversely related. So,
responsiveness of demand in relation to change in price i.e. price elasticity of demand
determines the change in expenditure. We can consider the following cases:
(i) Elasticity is less than one (ed <1): When the demand for a commodity is less than unit
elastic, a fall in price leads to fall in total expenditure and a rise in price leads to rise in total
expenditure on the commodity. (Price of the commodity and total expenditure move in same
direction).See table below;

(ii) Elasticity is more than unit elastic (ed >1): When the demand for a commodity is more
than unit elastic, a fall in price leads to rise in total expenditure and a rise in price leads to a fall
in total expenditure on the commodity. (Price of the commodity and total expenditure move in
opposite direction).See table below

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(iii) Elasticity is equal to one (ed = 1): When the demand for a commodity is unit elastic, total
expenditure incurred on the commodity does not change with the change in its price. See table
below

All the three cases discussed above are shown on the diagram below

Illustration 1:
Due to 2% fall in price of good X total expenditure on good X rises by 3%. A 10 % rise in price
of good Y leads to 20 % rise in total expenditure on good Y. Using total expenditure method,
compare price elasticity of demand of good X and good Y.
Solution:
Demand for good X is more than unit elastic because price of the commodity and total
expenditure on the commodity move in opposite direction.

Demand for good Y is less than unit elastic because price of the commodity and total
expenditure on the commodity move in same direction.

Why is the demand for primary products inelastic?

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1. In the case of necessities that is goods which are required no matter what the price
is (consumption of such goods cannot be dispensed with). For example when the
price of maize rises, the quantity demanded will decrease slightly because maize
is essential to the Zimbabwean diet. This is true for all staple foods.
2. Most raw materials, except rubber have no close substitutes. So, despite changes
in price the demand for such goods will be inelastic. This is also generally true
for food.
3. When a taste or preference becomes a force of habit, it becomes very difficult to
change the habit. For instance, a person who consume rice daily will find it
difficult to switch to other types of grain. Such forces of habit will bring about
inelastic demand.
4. Most primary products are relatively cheap and consumers are not overly
bothered by changes in prices. Most vegetables, for example, do not cost more
than US$5 per kilogram. Moreover, these goods constitute only a minor portion
of one’s total expenditure, such as salt and sugar.
5. The intake of food is limited. Hence, even though the prices of primary products
may be cheap or prices may have dropped considerably, consumers will not buy
large quantities of such goods (e.g. rice) because human intake of food is limited.
6. Most primary products are produced in bulk and although the price may be cheap,
consumers would not buy in large quantities because they do not have the
facilities to store such goods.
7. Associated with the problem of storage is the problem of perishability. Most
primary products, especially agricultural goods such as eggs and fresh fish, cannot
be kept for long as they rot easily.

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