VIT-BS VIT-BS BATCH 1BATCH 1

ELASTICITY OF DEMANDELASTICITY OF DEMAND

BYBY::SANGAM KUMARSANGAM KUMARB.AMRICK SINGHB.AMRICK SINGHPUNEET KUMARPUNEET KUMAR

ElasticityElasticity is a measure of the is a measure of the responsiveness of one variable to responsiveness of one variable to another.another.

The greater the elasticity, the The greater the elasticity, the greater the responsiveness.greater the responsiveness.

The Concept of Elasticity The Concept of Elasticity

LAW OF DEMANDLAW OF DEMAND

Law of demand states that if price of Law of demand states that if price of commodity increases quantity demanded commodity increases quantity demanded will falls and vice versa.will falls and vice versa.

Law of demand indicates only direction of Law of demand indicates only direction of change in quantity demanded in response change in quantity demanded in response to change in price but ELASTICITY OF to change in price but ELASTICITY OF DEMAND states with how much or to what DEMAND states with how much or to what extent the quantity demanded will change extent the quantity demanded will change in response to change in price in response to change in price

ELASTICITY OF DEMAND: ELASTICITY OF DEMAND: MEANINGMEANING

- Percentage change in quantity - Percentage change in quantity demanded divided by percentage demanded divided by percentage

change in price.change in price.-BY MARSHALL BY MARSHALL

-Measures the responsiveness of Measures the responsiveness of quantity demanded of a good to the quantity demanded of a good to the

change in its price. change in its price. ––BY BOULDINGBY BOULDING

Ed = % change in quantity demanded Ed = % change in quantity demanded divided by %change in price divided by %change in price

Price Elasticity of DemandPrice Elasticity of Demand A measure of how much the quantity A measure of how much the quantity

demanded of good responds to a change in demanded of good responds to a change in the price of that goodthe price of that good

Computed as the percentage change in Computed as the percentage change in quantity demanded divided by the quantity demanded divided by the percentage change in price. percentage change in price.

We know if we raise a price, the Qd will We know if we raise a price, the Qd will decline, but we don’t know how much.decline, but we don’t know how much.

Elasticity answers the “how much” question.Elasticity answers the “how much” question. In Business, we want to know the In Business, we want to know the

relationship between Qd and Pricerelationship between Qd and Price Ep = Ep = % Change in Quantity Demanded% Change in Quantity Demanded

% Change in Price% Change in Price

Calculating Percentage ChangeCalculating Percentage Change

Percentage Change measures how Percentage Change measures how much a value has changed from one much a value has changed from one time period to anothertime period to another

There are two methods of calculating There are two methods of calculating the percentage changethe percentage change• Simple MethodSimple Method• Midpoint MethodMidpoint Method

Calculating Percentage ChangeCalculating Percentage Change For Example, if a firm’s sales for the current For Example, if a firm’s sales for the current

month amounted to $100 million and the month amounted to $100 million and the previous month, the same firm’s sales were previous month, the same firm’s sales were $90 million. What was the percentage change?$90 million. What was the percentage change?

Simple MethodSimple MethodPercentage Change = Percentage Change = Current Value-Previous Current Value-Previous

ValueValue Previous ValuePrevious Value

or, or, = = $100m - $90 m $100m - $90 m = = $10m$10m = 11.1% = 11.1%$90m$90m $90m $90m

Very Common Usage, especially in the Very Common Usage, especially in the business worldbusiness world

Calculating Percentage ChangeCalculating Percentage Change Midpoint MethodMidpoint Method

Percentage Change = Percentage Change = Current Value – Previous Current Value – Previous ValueValue

(Current Value + Previous (Current Value + Previous Value)/ 2Value)/ 2

Or, = Or, = $100m -$90m$100m -$90m = = $10m$10m = = 10.5%10.5%

($100m + $90m)/2 $95m ($100m + $90m)/2 $95m

The midpoint method is the better method The midpoint method is the better method because it gives similar results whether because it gives similar results whether we are measuring forward or backwardwe are measuring forward or backward

Determinants Of Elasticity of Determinants Of Elasticity of DemandDemand

From Formula Ep = From Formula Ep = % Change in Qd% Change in Qd % Change in Price% Change in Price

If Price Elasticity of Demand > 1, demand is If Price Elasticity of Demand > 1, demand is elasticelastic

If Price Elasticity of Demand = 1, demand is If Price Elasticity of Demand = 1, demand is unit elasticunit elastic

If Price Elasticity of Demand < 1, demand isIf Price Elasticity of Demand < 1, demand isinelasticinelastic

Demand ElasticityDemand Elasticity Elastic Demand – When % Change in Quantity Elastic Demand – When % Change in Quantity

Demanded > % Change in PriceDemanded > % Change in Price Unit Elastic Demand – When % Change in Unit Elastic Demand – When % Change in

Quantity Demanded = % Change in PriceQuantity Demanded = % Change in Price Inelastic Demand – When % Change in Inelastic Demand – When % Change in

Quantity Demanded < % Change in PriceQuantity Demanded < % Change in Price Perfectly Elastic Demand – When Quantity Perfectly Elastic Demand – When Quantity

Demanded Changes by a very large Demanded Changes by a very large percentage in response to an almost zero percentage in response to an almost zero Change in PriceChange in Price

Perfectly Inelastic Demand – When the Perfectly Inelastic Demand – When the Quantity Demanded remains constant as Price Quantity Demanded remains constant as Price changeschanges

Perfectly Elastic Demand Curve

Quantity

D

14

8

6

4

2

10 15 20 25 305

12

10

The elasticity of a perfectly elastic demand curve is infinity

Perfectly Inelastic Demand Curve

Quantity

D

30

25

20

15

10

5

5 10 15 20 25

The elasticity of a perfectly inelastic demand curve is 0

Relativity Elasticity of Demand Curves

Quantity

D1

D2

Elasticity of Straight Line Demand Curve

Quantity

D

11

10

9

8

7

6

5

4

3

2

1

0

Very elastic

e = 6.33

Slightly elastic

Unit elastic

Slightly inelastic

Veryinelastic

e = .29

e = 1.0

0 1 2 3 4 5 6 7 8 9 10 11

Significance of Price Elasticity Significance of Price Elasticity of Demandof Demand

Profit maximization requires that business set a Profit maximization requires that business set a price that will maximize the firm’s profitprice that will maximize the firm’s profit

Elasticity tells the firm how much control it has Elasticity tells the firm how much control it has over using price to raise profitover using price to raise profit

If Ep > 1, then the % Change in Qd > % Change If Ep > 1, then the % Change in Qd > % Change is Price and demand is said to be elasticis Price and demand is said to be elastic• An increase in price will reduce total revenueAn increase in price will reduce total revenue• A decrease in price will increase total revenueA decrease in price will increase total revenue

Significance of Price Elasticity Significance of Price Elasticity of Demandof Demand

If Ep < 1, then the % change in Qd < % change in If Ep < 1, then the % change in Qd < % change in price, and demand is said to be inelasticprice, and demand is said to be inelastic• An increase in price will increase total revenueAn increase in price will increase total revenue• A decrease in price will decrease total revenueA decrease in price will decrease total revenue

If Ep = 1, then the % change in Qd = % change in If Ep = 1, then the % change in Qd = % change in Price, and demand is said to be unit elasticPrice, and demand is said to be unit elastic• An increase in price will have no impact on total An increase in price will have no impact on total

revenuerevenue• A decrease in price will have no impact on total A decrease in price will have no impact on total

revenuerevenue

Price Elasticity of Demand Price Elasticity of Demand InfluencesInfluences

Substitute Product Availability (key determinant) Substitute Product Availability (key determinant)

-- Luxury or Necessity (Ep for luxury items is >) -- Luxury or Necessity (Ep for luxury items is >) -- How narrowly it is defined (coffee is inelastic -- How narrowly it is defined (coffee is inelastic but tea may have more substitutes and but tea may have more substitutes and therefore is more elastic)therefore is more elastic)-- Time elapsed since price change (>time, -- Time elapsed since price change (>time, >elasticity; more time to find substitutes or >elasticity; more time to find substitutes or manage consumption)manage consumption)

Income EffectsIncome Effects-- The greater the proportion of income spent-- The greater the proportion of income spent

on the good, greater a price change impacts on the good, greater a price change impacts Quantity DemandedQuantity Demanded

Advertising

Purpose – Product Differentiation (Branding) To make the demand for a product greater To make the demand for a product more

inelastic

D D

Elasticity ThoughtsElasticity Thoughts

Demand Curve Slope and Elasticity (Steeper the Demand Curve Slope and Elasticity (Steeper the slope, lower the elasticity) slope, lower the elasticity)

A Units-Free Measure (% Change – Absolute Value)A Units-Free Measure (% Change – Absolute Value)

Elasticity Along a Linear Demand CurveElasticity Along a Linear Demand Curve-- Slope is constant but elasticity varies-- Slope is constant but elasticity varies

Elasticity and Total RevenueElasticity and Total Revenue-- Price and Total Revenue change in opposite -- Price and Total Revenue change in opposite directions, demand is elasticdirections, demand is elastic-- Price Change leaves Total Revenue unchanged, -- Price Change leaves Total Revenue unchanged, demand is unit elasticdemand is unit elastic-- Price and Total Revenue change in same -- Price and Total Revenue change in same direction, demand is inelasticdirection, demand is inelastic

Price Elasticity of SupplyPrice Elasticity of Supply

A measure of the extent to which the A measure of the extent to which the quantity supplied of a good changes quantity supplied of a good changes when the price of the good changes, when the price of the good changes, and all other influences on seller’s and all other influences on seller’s plans remain the same (cateris plans remain the same (cateris paribus)paribus)

Price Elasticity of SupplyPrice Elasticity of Supply

Perfectly Elastic Supply – When the quantity Perfectly Elastic Supply – When the quantity supplied changes by a very large percentage in supplied changes by a very large percentage in response to an almost zero increase in priceresponse to an almost zero increase in price

Elastic Supply – When the % change in the Elastic Supply – When the % change in the quantity supplied > the % change in the pricequantity supplied > the % change in the price

Unit Elastic Supply – When the % change in the Unit Elastic Supply – When the % change in the quantity supplied = the % change in pricequantity supplied = the % change in price

Inelastic Supply – When the % change in the Inelastic Supply – When the % change in the quantity demanded is < the % change in pricequantity demanded is < the % change in price

Perfectly Inelastic Supply – When the quantity Perfectly Inelastic Supply – When the quantity supplied remains the same as the price changessupplied remains the same as the price changes

Influences on Price Elasticity of Influences on Price Elasticity of SupplySupply

Production PossibilitiesProduction Possibilities

-- Opportunity Costs-- Opportunity Costs

constant or gently rising opportunity constant or gently rising opportunity costs costs

= elastic price elasticity= elastic price elasticity

-- Fixed Production = inelastic price -- Fixed Production = inelastic price elasticityelasticity

-- Time Elapse – longer time, > price -- Time Elapse – longer time, > price elasticityelasticity

Influences of Price Elasticity of Influences of Price Elasticity of SupplySupply

Storage Possibilities Storage Possibilities

The better the storability, the more elastic The better the storability, the more elastic is the price elasticity of supplyis the price elasticity of supply

Computing Price Elasticity of Computing Price Elasticity of SupplySupply

Percentage change in quantity suppliedPercentage change in quantity supplied

Percentage change in pricePercentage change in price

• If Price Elasticity of Supply > 1, Supply is elasticIf Price Elasticity of Supply > 1, Supply is elastic• If Price Elasticity of Supply = 1, Supply is unit If Price Elasticity of Supply = 1, Supply is unit

elasticelastic• If price elasticity of supply< 1, Supply is inelasticIf price elasticity of supply< 1, Supply is inelastic

Cross Elasticity of DemandCross Elasticity of Demand

A measure of the extent to which the A measure of the extent to which the demand for a good changes when the demand for a good changes when the price of a substitute or complement price of a substitute or complement changes, ceteris paribuschanges, ceteris paribus % Change in Quantity Demanded% Change in Quantity Demanded

% Change in Price of one of its Substitutes or complements% Change in Price of one of its Substitutes or complements

Income Elasticity of DemandIncome Elasticity of Demand

A measure of the extent to which the A measure of the extent to which the demand for a good changes when demand for a good changes when income changes, ceteris paribusincome changes, ceteris paribus

% Change in Quantity Demanded% Change in Quantity Demanded

% Change in Income% Change in Income

Income Elasticity of DemandIncome Elasticity of Demand

If income elasticity of demand > 1 the If income elasticity of demand > 1 the demand for the good is income elasticdemand for the good is income elastic

If income elasticity of demand is between If income elasticity of demand is between

0 and 1, the demand is income inelastic0 and 1, the demand is income inelastic * If income elasticity of demand < 0 the * If income elasticity of demand < 0 the

demand is negative income elasticdemand is negative income elastic