Chapter-8

The concepts of ‘price’, ‘income’ and ‘cross-elasticities of demand’:

Price elasticity of demand (PED):
Price elasticity of demand (PED) measures the responsiveness of quantity demanded to
a change in price.

Different types of Price elasticity of demands:

Perfectly Elastic Demand:
Perfectly elastic demand occurs when a minor change in the price of a product
produces a large change in its demand.
In the case of completely elastic demand, a tiny increase in price leads to a drop in
demand to zero, whereas a small decrease in price generates an increase in demand to
infinity. The demand is completely elastic in this instance, or e = 0.
Perfectly inelastic Demand:
Completely inelastic demand occurs when there is no change in a product’s demand in
response to a price adjustment.
The numerical value for perfectly inelastic demand (e=0) is zero.
Relatively Elastic Demand:
Relatively elastic demand occurs when the proportionate change in demand exceeds
the corresponding change in the price of a product.
Relatively elastic demand has a numerical value ranging from one to infinity i.e. (e>1).
Relatively Inelastic Demand:
Relatively inelastic demand occurs when the percentage change in demand created is
smaller than the percentage change in a product’s price.
For example, if the price of a product rises by 30% and demand falls by only 10%, the
demand is said to be relatively inelastic.
The numerical value of moderately elastic demand varies from zero to one. Marshall
defines moderately inelastic demand as elasticity less than one (e<1).

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Unitary Elastic Demand:
When a proportionate change in demand results in the same change in product price,
the demand is said to be unitary elastic.
Unitary elastic demand has a numerical value of one (e=1).
Interpretation of numerical values of price elasticity of demand:
 If PED= ∞ Perfectly elastic demand
 If PED <1 Price elastic demand
 If PED=1 Unitary elastic demand
 If PED<1 Price inelastic demand
 If PED=0 Perfectly inelastic demand
Example of Price Elasticity of Demand:
To calculate the elasticity of demand, consider this example:
Suppose that the price of apples falls by 6% from $1.99 a bushel to $1.87 a bushel. In
response, grocery shoppers increase their apple purchases by 20%. The elasticity of
apples is thus: 0.20 ÷ 0.06 = 3.33. The demand for apples is quite elastic.
 As a rule of thumb, if the quantity of a product demanded or purchased changes
more than the price changes, then the product is considered to be elastic (for
example, the price goes up by 5%, but the demand falls by 10%).
 If the change in quantity purchased is the same as the price change (say, 10% ÷
10% = 1), then the product is said to have unit (or unitary) price elasticity.
 Finally, if the quantity purchased changes less than the price (say, -5%
demanded for a +10% change in price), then the product is deemed inelastic.

Factors that affect price elasticity of demand:

Availability of Substitutes:
The more easily a shopper can substitute one product for another, the more the price
will fall, demand will be more elastic.
For example, in a world in which people like coffee and tea equally, if the price of
coffee goes up, people will have no problem switching to tea, and the demand for
coffee will fall. This is because coffee and tea are considered good substitutes for each
other.
Urgency/Necessity:
The more discretionary a purchase is, the more its quantity of demand will fall in
response to price increases. That is, the product demand has greater elasticity. That
means, if the product is necessary, demand will be inelastic.

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The less discretionary a product is, the less its quantity demanded will fall. Inelastic
examples include luxury items that people buy for their brand names. Addictive products
are quite inelastic, as are required add-on products, such as inkjet printer cartridges.
Duration of Price Change:
The length of time that the price change lasts also matters. Demand response to price
fluctuations is different for a one-day sale than for a price change that lasts for a season
or a year.
Clarity of time sensitivity is vital to understanding the price elasticity of demand and for
comparing it with different products. Consumers may accept a seasonal price
fluctuation rather than change their habits.
Income elasticity of demand (YED):
Income elasticity of demand (YED) measures the responsiveness of quantity demanded
to a change in income.

Cross (price) elasticity of demand (XED):

Cross (price) elasticity of demand (XED) measures the responsiveness of quantity
demanded for one good to a change in the price of another good.

Total revenue (TR):

Revenue is the money generated from normal business operations, calculated as the
average sales price times the number of units sold.
TR=P x QS
The relationship between price elasticity of demand and total revenue:
The following table shows the relationship: PED Price rises Price falls Inelastic Total
revenue rises Total revenue falls Unitary elastic Total revenue unchanged Total revenue
unchanged Elastic Total revenue falls Total revenue rises
PED Price rises Price falls
Inelastic TR rises TR falls
Unitary elastic TR remains same TR remains same
Elastic TR falls TR rises

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Relating Elasticity to Changes in Total Revenue
Consider the price elasticity of demand for gasoline. If 1,000 gallons of gasoline were
purchased each day at a price of $4.00 per gallon; an increase in price to $4.25 per
gallon reduced the quantity demanded to 950 gallons per day. We thus had an average
quantity of 975 gallons per day and an average price of $4.125. We can thus calculate
the arc price elasticity of demand for gasoline:

Percentage change in quantity demanded = -50/975 = -5.1%

Percentage change in price=0.25/4.125=6.06%

Price elasticity of demand = -5.1%/6.06% = -.084

The demand for gasoline is price inelastic, and total revenue moves in the direction of
the price change. When price rises, total revenue rises.
Recall that in our example above, total spending on gasoline (which equals total
revenues to sellers) rose from $4,000 per day (=1,000 gallons per day times $4.00) to
$4037.50 per day (=950 gallons per day times $4.25 per gallon).

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When demand is price inelastic, a given percentage change in price results in a smaller
percentage change in quantity demanded. That implies that total revenue will move in
the direction of the price change: an increase in price will increase total revenue, and a
reduction in price will reduce it.
Consider again the example of pizza that we examined above. At a price of $9 per
pizza, 1,000 pizzas per week were demanded. Total revenue was $9,000 per week
(=1,000 pizzas per week times $9 per pizza). When the price rose to $10, the quantity
demanded fell to 900 pizzas per week. Total revenue remained $9,000 per week (=900
pizzas per week times $10 per pizza). Again, we have an average quantity of 950
pizzas per week and an average price of $9.50. Using the arc elasticity method, we can
compute:

Percentage change in quantity demanded = -100/950 = -

10.5%

Percentage change in price = $1.00/$9.50 = 10.5%

Price elasticity of demand = -10.5%/10.5% = -1.0

Demand is unit price elastic, and total revenue remains unchanged. Quantity demanded
falls by the same percentage by which price increases.
Consider next the example of diet cola demand. At a price of $0.50 per can, 1,000 cans
of diet cola were purchased each day. Total revenue was thus $500 per day (=$0.50 per
can times 1,000 cans per day). An increase in price to $0.55 reduced the quantity
demanded to 880 cans per day. We thus have an average quantity of 940 cans per day
and an average price of $0.525 per can. Computing the price elasticity of demand for
diet cola in this example, we have:

Percentage change in quantity demanded = -120/940 = -

12.8%

Percentage change in price = $0.05/$0.525 = 9.5%

Price elasticity of demand = -12.8%/9.5% = -1.3

The demand for diet cola is price elastic, so total revenue moves in the direction of the
quantity change. It falls from $500 per day before the price increase to $484 per day
after the price increase.

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How price elasticity of demand varies along a straight line demand curve:

Interpretation of numerical values of income elasticity of demand YED:

Value of YED
0< (Negative) Negative income elasticity of demand. These goods
are called inferior goods – as income rises the
demand for these products will fall
0 Perfectly income inelastic demand – a change in
real income will have no impact on demand
0 to +1 Normal good – income inelastic demand: a change
in income will lead to a less than proportionate
change in demand
>1 Normal good – income elastic demand: a change in
income will lead to a more than proportionate
change in demand
∞ Perfectly income elastic demand. That means, at
the same income level, demand could be any
amount from 0 to infinity.

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Interpretation of numerical values of cross elasticity of demand:
Value of XED
0< (Negative) Complements
>0 (Positive) Substitutes
0 Unrelated

The significance of price, income and cross-elasticities of demand for

firms, consumers and the government:
If demand is inelastic, then an increase in price leads to an increase in total revenue
and a fall in price reduces total revenue; if PED is elastic, then a rise in price reduces
total revenue and a fall in price increases total revenue. So, PED is important to firms in
determining their pricing strategy.
PED is also important to governments in terms of understanding the burden (or
incidence) of taxation on producers and consumers. The more price inelastic the good,
a greater proportion of the tax is paid by the consumer than the producer.
Similarly, for subsidies (a government grant given to producers in order to encourage
production), the more price inelastic the good, the greater the price fall for consumers.
Firms should consider the YED of products; if analysis of YED shows demand for their
product is income elastic and the economy experiences a recession, demand is likely to
fall significantly.
XED will tell a firm how demand for their own product will change following a price
change by their competitors or partners.

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