Elasticity of Demand

Market demand
• Sum of individual demand for a product at a
price per unit of time
 DEMAND SCHEDULE

quantity demanded market demand

price A B C A+B+C
25 0 0 0 0

20 5 0 0 5
15 10 5 0 15
10 15 10 5 30
5 20 15 10 45
0 25 20 15 60
 DEMAD FUNCTION
• The quantitative relationship between Dx and
Px (demand and price of commodity x) is
known demand function can be expressed as
• Dx = a-bPx
a= constant denoting the total demand of a
product at zero price
• b = ∆D/∆P Change in demand in response to
change in price
• Demand function depends on the nature of
demand price relationship
• Common forms of demand function are
a. linear demand function
b. Non linear demand function
In linear demand function
• ∆D/∆P is constant
• Function results in a linear demand curve
 Example
• Assume that in a estimated demand function
a = 100 and b = 5
Then demand function can be written as
Dx = a-bPx
Dx = 100 – 5P
price D = 100 - 5P

0 100

5 75

10 50

15 25

20 0
 NON LINEAR DEMAND FUNCTION
• When the slope of demand curve changes all
along the curve

• Dx = aPx-b
 Short term demand function
• Individual or market demand for a product is
determined by price of the product by
assuming all the other determinants constant
 Long term demand function
Demand for a product depends on the all the
determinants of a product
Demand depends on
• Price the commodity X(Px)
• Consumers money income(M)
• Price of its substitutes y (Py)
• Price of complementary items (Pc)
• Consumers taste(T)
• Advertisements expenditure (A)
• Dx = a + b Px + cm +dPy +gPc + ja
• a = constant term
• b,c,d,g,j coefficients in relation between Dx
and independent variables
 Elasticity of Demand
• Responsiveness or relative change of one
dependent variable against change in the
independent variable
• Elasticity of demand explains how demand
changes for change in one of the factors of
demand
• Elasticity of supply explains how supply changes
for change in one of the factors of supply
When firms decide to change the price of item

• Cost of production increases

• without increase in Cost of production
 Price elasticity of demand
• The price elasticity of demand (PED) measures the
percentage change in quantity demanded by consumers
as a result of a percentage change in price. It is calculated
by dividing the % change in quantity demanded by the %
change in price, represented in the PED ratio.
• Price elasticity of demand (PED) measures the
responsiveness of demand after a change in price.
• EP= Price elasticity of demand
• q= Original quantity demanded
• ∆q = Change in quantity demanded
• p= Original price
• ∆p = Change in price
  Importance of elasticity of demand
• Business decision: This concept helps the seller in deciding the price of
the commodity. He fixes less price for the product that has more elastic
demand and vice-versa.
• Monopolist: Where the elasticity of demand is less, the monopolist
fixes more price of the commodity and vice-versa.
• Determination of factor price: Factors that have elastic demand also
have higher prices and vice-versa.
• International trade: A country whose demand for exports is inelastic, it
enjoys favorable terms of trade. On the other hand, if the demand for
exports is more elastic than imports, they shall have unfavorable terms
of trade.
• Government: It helps the government to decide to declare which
industries as public utilities and the take them over and operate them.
Types or degrees of price elasticity of demand

• Perfectly elastic
• Perfectly inelastic
• Unitary elastic
• Relatively elastic
• Relatively inelastic
•1. Perfectly elastic ( PED = ∞):
•The demand is said to be perfectly elastic when a small rise in price would
result in a fall in demand to zero, while a small fall in price results in demand
to become infinite. Therefore, It is also known as infinite elasticity. It is a
theoretical concept only as it has no importance in the practical world.
•This can be shown by a straight-line demand curve parallel to the horizontal
axis.
•Example:
• Suppose the price of a commodity is rs 10 and its demand is 50 units. As
the price falls to Rs 9, its demand increases to infinity.
In fig, the x-axis shows the quantity demanded
and the y-axis shows the price. Dd curve is the
demand curve. The initial demand at price P is Q
units. When the price is slightly decreased, it
leads to an increase in demand by a large amount
i.e. Q1. It shows a perfectly elastic demand.
2. Perfectly inelastic (PED=0):
When demand doesn’t change with change in price( whether rising or fall),
then demand is said to be perfectly inelastic. It implies that the demand
remains constant for any value of the price. Hence, It is rarely found in real
but the closest example we can take is water and other necessity goods.
 It is represented by a straight line parallel to the vertical axis.
Example:
 Suppose the price of a bottle of water is Rs. 15 and its demand is 200
units. As the price increases to Rs 20, the demand remains constant at 200
units. It implies the demand is perfectly inelastic.
• In fig, the x-axis shows the quantity demanded
and the y-axis shows the price. Dd is the
demand curve. At the price P, the quantity
demanded is Q units. As the price increases to
P1, there is no effect on the quantity demanded.
It remains constant at the initial quantity Q. This
implies that the demand is perfectly inelastic.
3. Unitary elastic ( PED = 1):
The demand can be said as unitary elastic when the
percentage change in quantity demanded is equal to the
percentage change in price. It is also known as unitary
elasticity. It is an imaginary concept as rarely found in the
practical world.
Example:
 Suppose, the price of a commodity is Rs. 50 and the quantity
demanded in a specific market is 200 units. As the price
increases to Rs. 60, its demand declines to 160 units. It
implies the unitary elastic demand.
In fig, the X-axis shows the quantity demanded
and the Y-axis shows the price. Dd is the demand
curve. At the price P, the quantity demanded is Q
units. As the price increases to P1, the quantity
demanded decreases to Q1 by an equal
proportion. It implies that the demand is unitary
elastic.
4. Relatively Elastic ( PED > 1):
Relatively elastic demand occurs when a proportionate change in
demand is greater than the proportionate change in price. It means
that there will be a greater change in demand due to a small change
in price. It is also known as highly elastic demand and more than
unitary elastic demand.
Example:
Suppose, the price of a commodity is Rs. 40 and the quantity
demanded is 20 units. As the price declines to Rs 30, its demand
increases to 30 units. It implies a relatively elastic demand.
In fig, the X-axis shows the quantity demanded and
the Y-axis shows the price. Dd is the demand curve.
At the price P, the quantity demanded is Q units. As
the price is increased to P1, the quantity demanded is
decreased to Q1 units. Here, the change in price is
less than the change in quantity demanded.
Therefore, it can be said as perfectly elastic demand.
5.Relatively inelastic demand ( PED <1):
The demand can be said as relatively inelastic when a
proportionate change in quantity demanded is less than
proportionate change in price. It means that the greater
change in price leads to a smaller change in demand.
Example:
 Suppose, the price of a commodity is Rs 10 and the
quantity demanded is 20 units. As the price increases to
Rs 15, the quantity demanded declines to 15 units. It
implies a relatively inelastic demand.
In fig, the X-axis shows the quantity demanded and
the Y-axis shows the price. Dd is the demand curve.
At the price P, the quantity demanded is Q units. As
the price increases to P1, the quantity demanded
falls to Q1 units. Here, the change in price is more
than the change in quantity demanded. Therefore,
it shows a relatively inelastic demand.
 METHODS FOR MEASURING PRICE
ELASTICITY
Methods of Measuring Price Elasticity of Demand
There are basically four ways by which we can
measure price elasticity of demand. These
methods are
• Percentage method
• Total outlay method
• Point method
• Arc method
 Percentage Method
Percentage method is one of the commonly used
approaches of measuring price elasticity of
demand under which price elasticity is measured
in terms of rate of percentage change in quantity
demanded to percentage change in price.
According to this method, price elasticity of
demand can be mathematically expressed as
Calculation of Price Elasticity of Demand
• When the price of a commodity was Rs 10 per
unit, its demand in the market was 50 units
per day. When the price of the commodity fell
to Rs 8, the demand rose to 60 units. Here,
price elasticity of demand can be calculated as
Unlike price elasticity of supply, price elasticity of
demand is always a negative number because
quantity demanded and price of the commodity
share inverse relationship. This means, higher
the price, lower will be the demand, and lower
the price, higher be the demand of the
commodity.
 Total Outlay Method
Total outlay method, also known as total
expenditure method of measuring price
elasticity of demand was developed by Professor
Alfred Marshall. According to this method, price
elasticity of demand can be measured by
comparing total expenditure on a commodity
before and after the price change.
 Arc elasticity of demand
• measures elasticity between two points on a curve
– using a mid-point between the two curves.
• On most curves, the elasticity of a curve varies
depending on where you are. Therefore elasticity
needs to measure a certain sector of the curve.
Calculating Arc Elasticity of Demand
• To calculate arc elasticity of demand we first take
the midpoint in between.
• The mid point of Q = (80+88)/2 = 84
• The mid-point of P =(10+14)/2 =12
•  
• % change in Q = (14-10)/12  = 0.3333
• % change in price = 88-80/84 = -0.9524
• PED = 0.333/-0.9524 = -0.35
• Comparison with measuring elasticity as point A to B
• If we calculated elasticity from point A to B. We would take the starting
point as the reference.
• The % change in Q would be 8/88 = 10%
• The % change in Price would be 4/10 = -40%
• Therefore PED would be 10/-40 = -0.25
 Point Elasticity of Demand

• Point elasticity of demand is the ratio of

percentage change in quantity demanded of a
good to percentage change in its price
calculated at a specific point on the demand
curve.
 Factors affecting Price Elasticity of Demand

1)Nature of Commodity :  

• The price elasticity of demand varies with the nature of
the commodities. Ordinally, the price elasticity of demand
for necessity goods like salt, sugar, matchboxes etc. is less
than unity. It is because any change in the price of these
commodities doesn’t affect the demand as consumers will
buy these commodities irrespective of change in price. On
the other hand, the price elasticity of demand for luxury
goods such as gold, jewellery and air conditioner etc.
is greater than unity. 
2) Availability of Substitutes : 
Commodities having substitutes available in the market at
reasonable prices have elastic demand. Substitute goods
refer to the goods which can be used in place for each other
such as tea and coffee, Oreo and Hide n Seek Biscuits,
sandals and chappals etc. A little fall in the price of one
substitute goods results in more demand for it.
Consequently, the demand for substitute goods is elastic. For
instance, if the price of tea falls, people will start demanding
more of it whereas less of coffee. On the other hand, goods
with no substitutes have inelastic demand.
3) Goods with different Uses :
Goods which can be used for many purposes contain elastic demand. A rise in
the price of a commodity leads to a decrease in the usage of that commodity.
For Example, the milk is used to drink and to make tea, cheese, curd and lassi.
If the price of milk is increased, it will be used for drinking purpose only and so
its demand for other less essential uses will fall considerably.
4) Income of consumer:
The price elasticity of demand varies with the income of the consumers. For
the high and low-income group, the demand is inelastic whereas, for middle-
income group people, the demand is elastic. This is so because any change in
price leads to contraction or extension of demand by middle group people. On
the other hand, it has very little effect on the demand for high and low-income
group people.
5) Habit of Consumers: 
The goods like cigarettes, alcohol, coffee etc. for which consumers become habitual, have inelastic demand. Any change
in the prices of these commodities results in no change in its demand.
6) Price Level: 
The commodities having high prices such as jewellery, air conditioners, gold and low prices like newspapers have
inelastic demand. The change in prices of these commodities leads to a little change in demand. On the other hand,
medium-priced goods such as clothes, television etc have elastic demand. A little change in the prices of these goods
has a great impact on their demand.
7) Time Period:
Demand for any commodity is inelastic for a shorter period of time whereas elastic for longer period of time. This is so
because the tastes, preferences and habits of consumers change in long run. In other words, the rise in the price of a
commodity will lead to contraction of demand and Fall in price leads to an extension of demand in long run.
8) Joint Demand: 
The complementary goods such as car and petrol, ink and pen, camera and film etc. have inelastic demand. A rise in the
price of petrol may not contract if there is no fall in the demand for cars.
9) Peak and Off-Peak demand : 
The demand for commodities during peak times is inelastic and during off-peak times, it is more elastic. This pattern is
particularly applicable in the case of transport and hotels accommodation facilities.
10) Proportion of Income Spent on a commodity :
The commodities such as toothpaste, boot polish etc. on which a small proportion of income is spent have inelastic
demand. Any change in the price of these goods doesn’t affect their demand whereas for the goods on which a large
proportion of income is spent, have elastic demand such as clothes, food etc.. The change in prices of these goods has
great impact on its demand.
11) Postponement of Use :
The commodities for which demand can be postponed, have elastic demand. For instance, if demand for building
houses is postponed then demand for building material such as bricks, cement lime and sand etc will become elastic. On
the other hand, the commodities for which demand cant be postponed like food when hungry or drink when thirsty,
have inelastic demand.
Cross elasticity of demand
• Definition: The measure of responsiveness of
the demand for a good towards the change in
the price of a related good is called cross price
elasticity of demand. It is always measured in
percentage terms.
• If XED > o, then the two goods are substitutes.
For example: Coke and Pepsi
• If XED < o, then they are complements. For
example: Bread and Butter
• If XED  = 0, then they are unrelated. For
example: Bread and Soda
•  
•  
 Types of Cross Elasticity of Demand

Positive cross elasticity of demand (EC>0)

If rise in price of one good leads to rise in
quantity demanded of other good of a similar
nature and vice versa, it is known as positive
cross elasticity of demand. Positive cross
elasticity exists between two goods which are
substitutes of each other.
 
In the above figure, quantity demanded for Coke and price of Pepsi are measured along X-
axis and Y-axis respectively. When the price of Pepsi increases from OP to OP1, quantity
demanded for coke rises from OQ to OQ1 and vice versa. Thus, the demand curve DD shows
positive cross elasticity of demand.
 Negative cross elasticity of demand (EC<0)
Two goods which are complementary have
negative cross elasticity of demand. If the rise in
price of one good leads to fall in quantity
demanded of its complementary good and vice
versa, it is known as negative cross elasticity of
demand.
In the above figure, quantity demanded for Tea and price of Sugar are measured along X-
axis and Y-axis respectively. When the price of Sugar increases from OP to OP1, quantity
demanded for Tea falls from OQ to OQ1 and vice versa. Thus, the demand curve DD shows
negative cross elasticity of demand.
 Importance of Cross Elasticity of Demand:

• The concept of cross elasticity of demand is of great importance in managerial

decision mak­ing for formulating proper price strategy. Multi-product firms
often use this concept to measure the effect of change in price of one product
on the demand for other products.
For example, Maruti Udyog Ltd. produces Maruti Vans, Alto and Maruti SX-4.
These products are good substitutes of each other and therefore cross elasticity
of demand between them is very high. If Maruti Udyog decides to lower the price
of Alto, it will significantly affect the demand for Maruti Vans and Maruti SX-4. So
it will formulate a proper price strategy fixing appropriate price for its various
products.
• Second, the concept of cross elasticity of demand is frequently used in defining
the boundaries of an industry and in measuring interrelationship between
industries. An industry is defined as a group of firms producing similar products
(that is, products with a high positive cross elasticity of demand.
For example cross elasticity of demand between Maruti SX-4, Hyndui’s Verna,
Tata’s Indigo is positive and quite high. 
• It so happens that in order to reduce
competition that one dominant firm
producing a product with high cross elasticity
of demand with the products of other firms
tries to take over them and thereby establish a
monopoly, or various firms producing close
substitutes with high cross elasticity of
demand try to merge with each other to form
a cartel to enjoy monopolistic profits.
 Uses

• Companies utilize the cross elasticity of demand

to establish prices to sell their goods.
a. Products with no substitutes have the ability to be
sold at higher prices because there is no cross-elasticity of
demand to consider.
b. if the cross elasticity is greater than one increase is
price is not beneficial ,instead reducing the price may prove
beneficial
c. Additionally, complementary goods are strategically
priced based on cross-elasticity of demand. For example,
printers may be sold at a less price with the
understanding that the demand for future
complementary goods, such as printer ink, should increase.
• If accurate measures of cross elasticity's are
available, firm can forecast the demand for its
product and can adopt necessary steps
against changing prices of substitutes and
complements.
 Income elasticity of demand
• Price elasticity of demand (PED) measures the
responsiveness of demand after a change in
income.
 Determinants of Income Elasticity of Demand

Degree of Luxury
The ep for a good will be higher the more luxurious the good.
Conversely, the ep for a good will be lower the less luxurious the
good. For example, the ep for high-end private cars is higher than
those for mid-range and low-end private cars as high-end private
cars are more luxurious than mid-range and low-end private cars.
Level of Income
The ep for a good will be higher the lower the level of income.
Conversely, the ep for a good will be lower the higher the level of
income. For example, the ep for private cars in the Philippines is
higher than that in Singapore as the level of income in the
Philippines is lower than that in Singapore.
There are two types of normal goods: necessity and luxury
• If the ep for a good is positive, the good is a normal good. A normal
good is a good whose demand rises when consumers’ income rises.
• . A necessity is a normal good with a ep between zero and one. In
other words, the demand for a necessity is income inelastic. An
example of a necessity is agricultural products.
• A luxury is a normal good with a ep greater than one. In other words,
the demand for a luxury is income elastic. An example of a luxury is
private cars.
• If the ep for a good is negative, the good is an inferior good. An
inferior good is a good whose demand falls when consumers’
income rises. An example of an inferior good is public transport.
 Types of Income Elasticity of Demand

Similar to the types of price elasticity of

demand, the degree of responsiveness of
demand with a change in consumer’s income is
not always the same.
• Positive income elasticity of demand
• Negative income elasticity of demand
• Zero income elasticity of demand
 Positive income elasticity of demand

• When a proportionate change in the income

of a consumer increases the demand for a
product and vice versa, income elasticity of
demand is said to be positive. In case of
normal goods, the income elasticity of
demand is generally found positive, which is
shown in Figure.
Three types of positive income elasticity of demand
Unitary income elasticity of demand
Less than unitary income elasticity of demand
More than unitary income elasticity of demand
• Unitary income elasticity of demand
The income elasticity of demand is said to be unitary when a proportionate change in a
consumer’s income causes proportionate change in the demand for a product. For example,
if there is 25% increase in the income of a consumer, the demand for milk consumption
would also be increased by 25%. Thus ey = 25/25 =1.
• Less than unitary income elasticity of demand
The income elasticity of demand is said to be less than unitary when a proportionate change
in a consumer’s income causes comparatively less increase in the demand for a product. For
example, if there is an increase of 25% in consumer’s income, the demand for milk is
increased by only 10%. Thus ey = 10/100 = 0.1 < 1.
• More than unitary income elasticity of demand
The income elasticity of demand is said to be more than unitary when a proportionate
change in a consumer’s income causes a comparatively large increase in the demand for a
product. For example, if there is an increase of 25% in consumer’s income, the demand for
milk is increased by only 35%. Thus ey = 35/25 = 1.4 > 1.
• Negative income elasticity of demand
When a proportionate change in the income of
consumer results in a fall in the demand for a product
and vice versa, the income elasticity of demand is said
to be positive. It generally happens in the case of
inferior goods.

For example, consumers may prefer small cars with a

limited income. However, with a rise in income, they
may prefer using luxury cars.
• Zero income elasticity of demand
When a proportionate change in the income of a
consumer does not bring any change in the
demand for a product, income elasticity of
demand is said to be zero. It generally occurs for
utility goods such as salt, kerosene, electricity.
Figure 5.15 shows the zero income elasticity of
demand:
Factors Affecting Income Elasticity of Demand

• Income of consumers in a country

• Nature of products
• Consumption pattern
 Income of consumers in a country
• In any country, the income level of consumers is not
the same. Therefore, consumers spend on the basis of
not only on their need but also their purchasing
capacity. The purchasing capacity of consumers
increases with a rise in their income.
• For example, a consumer with a low income may
prefer using public transport for commuting. However,
with a rise in income, he/she may buy a two-wheeler
for the same purpose.
• Nature of products
The nature of products being consumed by consumers also has an
important influence on income elasticity.
For example, basic goods used on a day to day basis, such as salt, sugar,
and cooking oil, is elastic. Even with a rise in the income of a consumer,
the demand for such products does not change and remain inelastic.
• Consumption pattern
With a rise in income, people quickly change their consumption patterns.
For example, people may start buying high priced products with an
increase in their income. This leads to an increase in the demand for the
products in the market. However, once the consumption pattern is
established, it becomes difficult to lower the demand in case of a
decrease in income.
For example, a consumer may buy a two-wheeler that runs on petrol as a
result of a rise in his/her income. However, over a period of time, in case
his/her income falls, it will be difficult for him to reduce the consumption
of petrol.
 Importance
• The concept of income elasticity is important for decision
making both by business firms and industries. First, the firms
producing products which have a high income elasticity have
great poten­tial for growth in an expanding economy.
For example, if for a firm’s product income elasticity of demand is
greater than one; it means that it will gain more than
proportionately to the increase in national income. Thus firms
which are producing products having high income elasticity are
more interested in forecasting the level of aggregate economic
activity (i.e., level of national income) because the demand for
their products will greatly depend on the level of overall economic
activity.
• to share the benefits of increasing national
income firms currently producing products
with low income elasticity would try to enter
the industries demand for whose products is
highly income elastic as this would ensure
better growth opportunities
• The knowledge of income elasticity of demand
also plays a significant role in designing
market­ing strategies of the firms. If income of
people is an important determinant of
demand for a product, the firms producing
product with high income elasticity of demand
will be located in those areas or set up their
sales outlets in those cities or regions where
incomes are increasing rapidly.