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 .

Concepts of Elasticity:
 Own price elasticity is:
– percentage change in quantity demanded, divided by percentage
change in price:
 If demand is price-elastic, revenue increases with lower prices.
 If demand is price-inelastic, revenue decreases with lower prices
 Cross-price elasticity of demand between substitutes is positive
 Income-elasticity determines how demand changes with customers’
incomes. For most goods income-elasticity is positive.
 Advertising elasticity is important in deciding on advertising budgets. It
is positive. As the level of advertising increases, we would expect
advertising elasticity to fall.

Price-elasticity of demand
The price-elasticity of demand varies between zero and infinity (0 ≤ ep ≤ ∞).

Determinant of Price Elasticity of Demand

The price-elasticity of demand for a product within this range will depend on
the following factors:
1. Availability of Substitutes for the product . This is one of the most important
determinants of the price-elasticity of demand for a product. The higher the
degree of closeness between the commodity and its substitutes, the greater the
price-elasticity of demand for the commodity.
2. Nature of the Commodity. Commodities can be grouped as luxuries, comforts,
and necessities. The demand for luxury goods is more price-elastic than the
demand for necessities and comforts. This is so because the consumption of
luxury goods can be dispensed with or postponed when their prices rise. On the
other hand, the consumption of necessities cannot be postponed and hence,
their demand is price-inelastic. Comforts have more elastic demand than
necessities, and less elastic demand than luxuries.
3. Weightage in the Total Consumption. The proportion of income which
consumers spend on a particular commodity influences the elasticity of demand
for such commodity. The larger the proportion of income spent on a commodity,
the greater will be the elasticity of demand for such commodity, and vice versa.
4. Time factor in adjustment of Consumption pattern. Price-elasticity of demand
depends on the time consumers need to adjust their consumption pattern to a
new price. The longer the adjustment time, the greater the price-elasticity of
demand.
5. Range of Commodity Use. The range of uses of a given commodity can affect
the elasticity of demand for such commodity. The wider the range of use of a
product, the higher the elasticity of demand for such product. Electricity, for
example, has a wide range of use including, lighting, cooking, and industrial
activities. The demand for electricity therefore has greater elasticity.

Cross-Elasticity of Demand
The cross-elasticity (or cross-price elasticity) can be defined as the
degree of responsiveness of demand for a commodity to the changes in price of
its substitutes and complementary goods. The formula for measuring the
cross-elasticity of demand for a commodity, X, can be written as:

Use of Cross Elasticity:

The cross-elasticity of demand can be used to identify substitute and
complementary goods for a given commodity. If the cross-price elasticity
between two goods is positive, the two goods may be considered as substitutes
to one another. The greater the cross price elasticity coefficient, the closer the
substitute. Similarly, if the cross-price elasticity is negative, the two goods may
be considered as complements. The higher the negative cross-elasticity
coefficient, the higher the degree of complementarity.

The concept of cross-elasticity is important in pricing decisions. If the

cross-elasticity in response to the price of substitutes is greater than 1, it would
not be advisable to increase the price. Reducing the price, instead may prove
beneficial. If the price of the complementary good is rising, it would be beneficial
to reduce the price of the commodity.

Determinants of Cross Elasticity:

– substitutes or complements,and how close?
– An industry is a group of firms producing products with high
positive cross-elasticities

Income-Elasticity

In economics, income elasticity of demand measures the

responsiveness of the demand for a good to a change in the income of the
people demanding the good, holding all prices constant. It is calculated as the
ratio of the percentage change in demand to the percentage change in income.
For example, if, in response to a 10% increase in income, the demand for a good
increased by 20%, the income elasticity of demand would be 20%/10% = 2.

Income elasticity of demand measures the relationship between a

change in quantity demanded and a change in income. The basic formula for
calculating the coefficient of income elasticity is:

Percentage change in quantity demanded of good X divided by the percentage

change in real consumers' income

Nature of commodity and Income Elasticity

Normal goods have a positive income elasticity of demand so as income rise

more is demand at each price level. We make a distinction between normal
necessities and normal luxuries (both have a positive coefficient of income
elasticity).

Necessities have an income elasticity of demand of between 0 and +1. Demand

rises with income, but less than proportionately. Often this is because we have
a limited need to consume additional quantities of necessary goods as our real
living standards rise. The class examples of this would be the demand for fresh
vegetables, toothpaste and newspapers. Demand is not very sensitive at all to
fluctuations in income in this sense total market demand is relatively stable
following changes in the wider economic (business) cycle.

Luxuries on the other hand are said to have an income elasticity of demand >
+1. (Demand rises more than proportionate to a change in income). Luxuries
are items we can (and often do) manage to do without during periods of below
average income and falling consumer confidence. When incomes are rising
strongly and consumers have the confidence to go ahead with “big-ticket” items
of spending, so the demand for luxury goods will grow. Conversely in a
recession or economic slowdown, these items of discretionary spending might
be the first victims of decisions by consumers to rein in their spending and
rebuild savings and household financial balance sheets.

Determinants of Income Elasticity:

Type of good

• necessities - salt, drinking water, zero elasticity

• luxuries, zero at low levels of income then high when
income thresholds exceeded
 • inferior goods - negative, purchase less as income rises -
bus travel, low-grade margarine, paraffin

Advertising elasticity of demand

Advertising elasticity of demand is the measure of how advertising affects the

demand of a certain product. It is the percentage change in the sales of the
advertised product as opposed to the percentage change in its advertising
expenses.

Summary
If the demand curve is a straight line, price elasticity of demand at
different points of the demand curve can be calculated by the ratio of the lower
segment and upper segment of the demand curve.
Income elasticity of demand (ey) measures the degree of
responsiveness of the quantity demanded of a commodity to a given change in
consumer’s income. For normal goods ey is positive; for neutral goods ey is zero;
for inferior goods ey is negative.
Cross elasticity of demand (ec) shows how changes in prices of other
goods would affect the demand for a particular good. For substitutes ec is
positive; and for complements ec is negative.
Advertising (or promotional) elasticity of demand (ea) measures the
effect of incurring an “expenditure” on advertising of a firm on the demand for
its product at constant price.
Elasticity is used for determination of right price by seller and for
taxation by government.