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Elasticity of Demand • The law of demand says that when the price of a product increases the quantity demanded falls, other things remaining the same. • But this information is not or practical use as it gives only an idea of the change in demand for a given change in price.
Elasticity of Demand • Knowing the magnitude of this change- the extend to which the quantity demanded of a product or related products or due to the rise or fall in the prices of the same products helps managers to forecast the market trends for the future.
Elasticity of Demand • Prof. Alfred Marshall has developed the concept of elasticity of demand. • It measures the ratio of the relative change in Price and Quantity demand.
Elasticity of Demand • Elasticity is a ‘measure of responsiveness’. • It measures the ratio of the relative change in the dependent variable (quantity) to the relative change in an independent variable (Price)
Kinds of Elasticity of Demand • Price Elasticity • Income Elasticity • Cross Elasticity • Advertising Elasticity
Price Elasticity • Price Elasticity of demand is commonly know as “elasticity of demand”. • It is a measure of the responsiveness of the quantity demanded of a good to a change in its price. • It measures the nature and percentage of the relationship between changes in quantity demanded of a good and changes in its price.
Price Elasticity It is calculated as
Price Elasticity • price elasticity of demand (Ep) is given by the percentage change in the quantity demanded of the commodity divided by the percentage change in its price, holding constant all the other variables in the demand function.
Price Elasticity ▲Q ----- Q ▲Q P • Ep = -------- = ------- . -- • ▲P ▲P Q • ----- • P
Price Elasticity • The numerical value of price elasticity may range between zero and infinity. • The price elasticity is always negative because of the inverse relationship between Q and P implied in the law of demand. • However, traditionally the negative sign is omitted while writing the formula for elasticity.
Assume that the demand for petrol reduces by 2% as a result of an increase in petrol prices by 10%. The price elasticity of demand for petrol is : • -2% / 10% = =0.20
Problem • Let us assume that a wholesaler of biscuits knows that the price elasticity of demand for biscuits remains unchanged at -1.5. The price of biscuits increases by 20%. Calculate the decrease in quantity demanded due to the increase in price.
Types of Price Elasticity • Perfectly Elastic Demand • Perfectly Inelastic Demand • Unit Elasticity Demand • Relatively Elastic Demand • Relatively inelastic Demand
Perfectly Elastic Demand • It refers to the demand for a good or service can vary significantly due to the price. • A good with a perfectly elastic demand has a price elasticity of demand of infinity.(E = ∞) . • The consumer will buy all the quantity of the commodity at this price and nothing else at some other price. (Demand for Jewelry) • The demand curve is a horizontal line, parallel to the quantity demanded axis (X-axis).
Example • the demand for Quad D paper clips is perfectly elastic. The Quad D company sells all of the paper clips that it wants at a specific price. • If Quad D lowers the price of its paper clips by an infinitesimally small amount, then an infinite number of buyers who might have bought the other paper clips buy Quad D paper clips instead.
If Quad D should raise the price of its paper clips by an infinitesimally small amount, then buyers buy paper clips made by other companies. • They have no reason to raise their price because they can sell all that they want at the existing price.
Example - 2 • The airline industry is very elastic because all airlines offer a very similar service (getting passengers from point A to point B). • For the most part, an airline company can't have prices that are significantly different from those of its competitors because this can result a huge loss of business to competitors.
Perfectly Elastic Demand • if you can charge slightly less than your competitors, and still make a profit, you will find your customers will attempt to buy as much as you can produce. • Under perfectly elastic demand, elasticity of a good or service can vary according to the amount of close substitutes
Perfectly Inelastic Demand • It refers to the demand for a good are unaffected when the price of that good or service changes. • When a price change has no effect on the demand of a good or service, it is considered perfectly inelastic.
Perfectly Inelastic Demand • An example of perfectly inelastic demand would be a life saving drug that people will pay any price to obtain. • Even if the price of the drug were to increase dramatically, the quantity demanded would remain the same. • Another example is demand for Salt
Perfectly Inelastic Demand Curve • The perfectly inelastic demand curve is a vertical line and parallel to Y axis. • It shows that the elasticity demand is infinitely inelastic (E= 0)
Unitary Elastic Demand • The percentage change in quantity demanded is equal to the percentage change in price. • The proportionate change in price causes an equal proportionate change in the quantity demanded. • The demand curve is Rectangular hyperbola. • The value of unit elasticity is E = 1
Unitary Elastic Demand • In Unitary elastic demand quantity changes at the same rate as price. • The changes occurred in price is equal to the changes occurred in quantity demanded.
Relatively Elastic Demand • The change in price causes more than proportionate change in the quantity demanded. • Quantity changes faster than price. • The price elasticity of demand is greater than one. • The Value is E > 1
Relatively Inelastic Demand • The price elasticity of demand is less than one. • The changes in price causes a less than proportionate change in the quantity demand. • As the price of the product rises (falls), the quantity demand of that product falls (rises) less than the price changes. • The value is E = 1
