Business Economics

UNIT-05

Elasticity of Demand and Supply

Semester-01
Master of Business Administration
Business Economics

UNIT

05 Elasticity of Demand and Supply

Names of Sub-Units

Concept of Elasticity; Types of Elasticity of Demand; Degrees of Price Elasticity;

Measurement of Price Elasticity; Income Elasticity of Demand; Types of Income Elasticity

of Demand; Cross-Elasticity of Demand; Types of Cross-Elasticity of Demand.

Overview
This unit explores the elasticity of demand and supply, focusing on price, income, and cross-

elasticity. It covers how changes in these factors affect consumer behavior and market
dynamics, with detailed discussions on types and measurements of elasticity. Students will

gain insights into predicting and interpreting market responses to economic variables and
policy changes.

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Learning Objectives

In this unit, you will learn to:

 Understand the concept of elasticity and its importance in economics.

 Analyze the different types of demand elasticity and their implications for businesses.

 Calculate and interpret price elasticity of demand using various methods.

 Identify the relationship between income levels and consumer demand through
income elasticity.

 Explore the competitive relationships between goods using cross-elasticity of demand.

Learning Outcomes

At the end of this unit, you would:

 Ability to analyze market dynamics and consumer behavior through elasticity

concepts.

 Proficiency in calculating and interpreting price elasticity to optimize pricing strategies.

 Understanding the impact of income changes on consumer demand patterns.

 Recognition of substitute and complementary goods and their implications for market
competition.

 Competence in applying elasticity concepts to real-world business scenarios.

Pre-Unit Preparatory Material

 https://www.noaa.gov/

 https://www.nist.gov/

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Table of Topics

5.1 Introduction to Elasticity

5.2 Types of Demand Elasticity

5.3 Degrees and Measurement

5.4 Types of Income Elasticity

5.5 Cross-Elasticity

5.6 Types of Cross-Elasticity

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5.1 Introduction to Elasticity:

Elasticity in economics refers to the responsiveness of quantity demanded or supplied

to changes in price, income, or other factors. It measures how much one variable

changes in response to a change in another variable.

Importance of Elasticity:

1. Price Setting: Understanding elasticity helps businesses set optimal prices for
their products. For elastic goods, businesses may need to lower prices to

increase sales, while for inelastic goods, they can raise prices without losing
many customers.

2. Government Policies: Policymakers use elasticity to design effective policies,

such as taxation and subsidies, to address issues like market inefficiencies,

income distribution, and externalities.

3. Consumer Behavior: Consumers use elasticity to make purchasing decisions.

For example, they may prioritize purchasing necessities with inelastic demand
over luxury items with elastic demand when facing budget constraints.

Types of Elasticity:

1. Price Elasticity of Demand (PED): Measures the responsiveness of quantity

demanded to changes in price.

2. Price Elasticity of Supply (PES): Measures the responsiveness of quantity

supplied to changes in price.

3. Income Elasticity of Demand (YED): Measures the responsiveness of quantity

demanded to changes in income.

4. Cross-Elasticity of Demand: Measures the responsiveness of quantity

demanded of one good to changes in the price of another good.

Elasticity and Market Behavior:

 Elastic Demand: When the percentage change in quantity demanded is greater

than the percentage change in price.

 Inelastic Demand: When the percentage change in quantity demanded is less
than the percentage change in price.

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Business Economics

 Unitary Elasticity: When the percentage change in quantity demanded is equal

to the percentage change in price.

Understanding these concepts of elasticity helps economists and businesses analyze

market behavior, predict consumer responses to price changes, and formulate

effective strategies.

5.2 Types of Demand Elasticity:

Demand elasticity refers to the sensitivity of the quantity demanded of a good or

service to changes in various factors such as price, income, or the price of related

goods. In this section, we explore different types of demand elasticity:

5.2.1 Price Elasticity of Demand (PED):

Price elasticity of demand measures how the quantity demanded of a good or service
changes in response to a change in its price. It is calculated as the percentage change

in quantity demanded divided by the percentage change in price.

 Elastic Demand (PED > 1): When the percentage change in quantity

demanded is greater than the percentage change in price. In elastic demand,

consumers are highly responsive to price changes, and a small change in price
leads to a proportionately larger change in quantity demanded.

 Inelastic Demand (PED < 1): When the percentage change in quantity
demanded is less than the percentage change in price. In inelastic demand,

consumers are less responsive to price changes, and a change in price leads to
a proportionately smaller change in quantity demanded.

 Unitary Elasticity (PED = 1): When the percentage change in quantity

demanded is equal to the percentage change in price. This indicates

proportionate responsiveness of quantity demanded to price changes.

5.2.2 Income Elasticity of Demand (YED):

Income elasticity of demand measures how the quantity demanded of a good or
service changes in response to changes in consumer income. It is calculated as the

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percentage change in quantity demanded divided by the percentage change in

income.
 Normal Goods (YED > 0): Goods for which demand increases as consumer

income increases. They have a positive income elasticity of demand.

 Inferior Goods (YED < 0): Goods for which demand decreases as consumer

income increases. They have a negative income elasticity of demand.

 Necessities (YED = 0): Goods for which demand remains constant regardless

of changes in consumer income. They have a zero income elasticity of demand.

5.2.3 Cross-Elasticity of Demand:

Cross-elasticity of demand measures how the quantity demanded of one good

changes in response to a change in the price of another good. It is calculated as the

percentage change in quantity demanded of one good divided by the percentage

change in the price of another good.

 Substitute Goods (Positive Cross-Elasticity): Goods for which an increase in

the price of one leads to an increase in demand for the other.

 Complementary Goods (Negative Cross-Elasticity): Goods for which an

increase in the price of one leads to a decrease in demand for the other.
 Unrelated Goods (Zero Cross-Elasticity): Goods for which changes in the

price of one have no effect on the demand for the other.

5.3 Degrees of Price Elasticity:

Price elasticity of demand measures the responsiveness of quantity demanded to

changes in price. In this section, we explore the various degrees of price elasticity:

Perfectly Elastic Demand:

 Demand is perfectly elastic when a small change in price leads to an infinite

change in quantity demanded. In other words, consumers are extremely

sensitive to price changes, and any increase in price will result in consumers
buying none of the good.

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Elastic Demand:

 Elastic demand occurs when the percentage change in quantity demanded is

greater than the percentage change in price. Goods with elastic demand have

a PED greater than 1. Consumers are relatively responsive to price changes, and
a small increase in price leads to a larger decrease in quantity demanded, and

vice versa.
Unitary Elastic Demand:

 Unitary elastic demand occurs when the percentage change in quantity

demanded is equal to the percentage change in price. Goods with unitary

elasticity have a PED equal to 1. In this case, the increase or decrease in price
results in a proportionate change in quantity demanded.

Inelastic Demand:
 Inelastic demand occurs when the percentage change in quantity demanded is

less than the percentage change in price. Goods with inelastic demand have a
PED less than 1. Consumers are relatively unresponsive to price changes, and a

change in price leads to a smaller change in quantity demanded.

Perfectly Inelastic Demand:

 Demand is perfectly inelastic when a change in price does not affect the
quantity demanded at all. In other words, consumers are completely insensitive

to price changes, and the quantity demanded remains constant regardless of

price.

5.4 Measurement of Price Elasticity:

Price elasticity of demand (PED) measures the responsiveness of quantity demanded

to changes in price. There are several methods used to calculate price elasticity, each
providing insights into consumer behavior and market dynamics. Here, we explore the

primary methods for measuring price elasticity:

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5.4.1 Percentage Method:

The percentage method, also known as the point method or arc elasticity, calculates
price elasticity by comparing the percentage change in quantity demanded to the

percentage change in price between two points on a demand curve. The formula for
the percentage method is:

This method is useful for calculating elasticity between two specific price and quantity
combinations, providing a snapshot of consumer responsiveness within a given price

range.
5.4.2 Midpoint Method:

The midpoint method, also known as the arc elasticity formula or the average method,
calculates price elasticity by using the midpoint between two price-quantity

combinations to determine percentage changes. The formula for the midpoint method
is:

This method is preferred when dealing with non-linear demand curves or when the

initial and final quantities and prices are significantly different.

5.4.3 Total Expenditure Method:

The total expenditure method examines changes in total expenditure resulting from
price changes to determine elasticity. It observes whether total revenue increases,

decreases, or remains constant following a change in price.

 Elastic Demand: When price increases, total revenue decreases, and vice versa.

 Inelastic Demand: When price increases, total revenue increases, and vice
versa.

 Unitary Elasticity: When price changes, total revenue remains constant.

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5.5 Types of Income Elasticity:

Income elasticity of demand (YED) measures the responsiveness of quantity demanded

to changes in consumer income. Different types of income elasticity provide insights

into how consumer demand for various goods and services changes as income levels
fluctuate. Here, we discuss the three main types of income elasticity:

5.5.1 Positive Income Elasticity (YED > 0):

Positive income elasticity occurs when the quantity demanded of a good increases as

consumer income rises. Goods with positive income elasticity are considered normal
goods, indicating that they are perceived as desirable or essential as consumers'

incomes increase. Examples include luxury goods, such as high-end electronics,

vacations, and gourmet food items. As consumers' purchasing power grows, they are

more likely to spend on these goods, leading to an increase in demand.

5.5.2 Negative Income Elasticity (YED < 0):

Negative income elasticity occurs when the quantity demanded of a good decreases
as consumer income rises. Goods with negative income elasticity are considered

inferior goods, meaning that they are perceived as less desirable or essential as

consumers' incomes increase. Examples include generic or store-brand products, used

or second-hand items, and basic staple foods. As consumers' incomes rise, they may

shift their preferences to higher-quality or more prestigious alternatives, resulting in a

decrease in demand for inferior goods.

5.5.3 Zero Income Elasticity (YED = 0):

Zero income elasticity occurs when the quantity demanded of a good remains constant

regardless of changes in consumer income. Goods with zero income elasticity are
considered necessities, meaning that they are essential for daily life and consumption

patterns remain relatively unaffected by changes in income levels. Examples include

basic food items, utilities (such as electricity and water), and healthcare services.

Regardless of whether consumers' incomes increase or decrease, the demand for

necessities remains stable.

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5.6 Cross-Elasticity of Demand:

Cross-elasticity of demand measures how the quantity demanded of one good

responds to changes in the price of another good. It provides insights into the

relationship between different goods in the market and helps businesses and
policymakers understand consumer behavior and market dynamics. Here, we discuss

the concept of cross-elasticity and its types:

5.6.1 Positive Cross-Elasticity:

Positive cross-elasticity occurs when the quantity demanded of one good increases in
response to an increase in the price of another good. Goods with positive cross-

elasticity are considered substitute goods, meaning that they can be used
interchangeably or fulfill similar needs or desires for consumers. When the price of one

substitute good rises, consumers tend to switch their purchases to the other substitute,
leading to an increase in its demand. Examples include tea and coffee, butter and

margarine, and Coke and Pepsi.

5.6.2 Negative Cross-Elasticity:

Negative cross-elasticity occurs when the quantity demanded of one good decreases

in response to an increase in the price of another good. Goods with negative cross-
elasticity are considered complementary goods, meaning that they are consumed

together or used in conjunction with each other. When the price of one
complementary good rises, consumers tend to reduce their consumption of both

goods, leading to a decrease in the demand for the complementary good. Examples
include cars and gasoline, computers and software, and printers and ink cartridges.

5.6.3 Zero Cross-Elasticity:

Zero cross-elasticity occurs when changes in the price of one good have no effect on

the quantity demanded of another good. Goods with zero cross-elasticity are
considered unrelated goods, meaning that they are not substitutes or complements

and have independent demand. Changes in the price of one unrelated good do not
influence the demand for the other unrelated good. Examples include textbooks and
bicycles, shoes and smartphones, and umbrellas and ice cream.

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Understanding the concept of cross-elasticity and its types helps businesses analyze

competitive relationships between goods, predict consumer responses to changes in

prices, and develop effective pricing, marketing, and product differentiation strategies.

It also enables policymakers to identify market dynamics, assess competition levels,

and formulate regulations to promote consumer welfare and market efficiency.

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CONCLUSION

 Elasticity of Demand and Supply focuses on elasticity concepts in economics.

 It covers price, income, and cross-elasticity of demand.

 Elasticity measures responsiveness to price, income, and related factors.

 Price elasticity classifies demand as elastic, inelastic, or unitary.

 Different methods like percentage, midpoint, and total expenditure calculate

price elasticity.

 Income elasticity identifies normal, inferior, and necessity goods.

 Cross-elasticity determines the relationship between goods as substitutes or

complements.

 Positive cross-elasticity indicates substitute goods, negative indicates

complements.

 Understanding elasticity aids in pricing, policy-making, and market analysis.

 Mastery of elasticity concepts enables informed decision-making in various

economic contexts.

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Self- Assessment questions

A. Essay Type Questions

1. How does price elasticity influence the revenue-maximizing pricing strategy

for a business?

2. Discuss the relationship between income elasticity and luxury versus necessity
goods.

3. How do complementary goods and their cross-elasticity affect market

equilibrium?

4. Analyze the impact of technological advancements on the cross-elasticity of

demand for related products.

5. Explain the concept of unitary elasticity and its significance for businesses and
policymakers.

Answers for Self- Assessment questions

A. Hints for Essay Type Questions

1. Consider the relationship between price elasticity and total revenue along the
demand curve.

2. Explore how changes in consumer income levels affect the demand for different
types of goods.

3. Investigate how changes in the price of one good impact the demand for its
complementary counterpart.

4. Look into how technological innovations alter consumer preferences and

substitute goods.

5. Highlight the significance of unitary elasticity in pricing and policy-making

decisions.

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Post Unit Learning

 https://www3.nd.edu/~cwilber/econ504/504book/outln3b.html

 https://scholar.harvard.edu/files/campante/files/polarization_inequality.pdf

Topics for Discussion Forum

 The Role of Elasticity in Pricing Strategies

 Market Competition and Substitute Goods

 Income Elasticity and Consumer Behavior

 Cross-Elasticity: Complements or Competitors?

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