Unit 3: Demand and Supply

(Market) analysis - II
Elasticity of demand
• Elasticity of demand refers to how much the quantity demanded of a
good or service changes in response to a change in its price or other
factors like income or the price of related goods.
• It essentially measures the responsiveness of demand to these
changes.
THE ELASTICITY OF DEMAND

1. Price elasticity of demand;

2. Income elasticity of demand; and
3. Cross-elasticity of demand, i.e., demand elasticity with reference to
price of substitutes and complementary goods
PRICE ELASTICITY OF DEMAND

• The price elasticity of demand is defined as the degree of

responsiveness or sensitiveness of demand for a commodity to the
change in its price.
• The price elasticity of demand, i.e., the responsiveness of demand for
a commodity to change in its price, is measured as the percentage
change in the quantity demanded divided by the percentage change
in the price.
• The price elasticity measure is, always reported with a negative sign
just to indicate inverse relationship between the price change and the
quantity demanded.
Interpreting the figure for elasticity
• Elasticity is measured in proportionate or percentage terms
• It allows comparison of changes in two qualitatively different things,
which are thus measured in two different types of unit: i.e. it allows
comparison of quantity changes with monetary changes.
• It is the only sensible way of deciding how big a change in price or
quantity is.
The sign (positive or negative)
• Demand curves are generally downward sloping.
• This means that price and quantity change in opposite directions.
• A rise in price (a positive figure) will cause a fall in the quantity
demanded (a negative figure).
• Similarly, a fall in price will cause a rise in the quantity demanded.
• when working out price elasticity of demand, we either divide a
negative figure by a positive figure, or a positive figure by a negative.
• Either way, we end up with a negative figure.
Ways of measuring price elasticity of demand
• Arc elasticity of demand
• Point elasticity of demand
Arc elasticity of demand

• When price elasticity of demand is measured between any

two finite points on a demand curve, it is called arc elasticity.
• price elasticity measured for a considerably high change in
price is called arc elasticity of demand.
Change in Price and Arc Elasticity Coefficient
The movement from point J to K on the demand curve
PM shows a fall in price of commodity from Rs 25 to Rs
15 and the consequent increase in demand from 30 to
50 units. Here, ΔP = 25 − 15 = 10 and ΔQ = 30 − 50 =
−20. The arc elasticity between points J and K (moving
from J to K ) can be measured as
Interpretation of Price Elasticity

• The elasticity coefficient (1.66) means that a 1 per cent

decrease in price of commodity X would result in a 1.66 per
cent increase in demand for it
Limitation of Arc method of measuring Price Elasticity of
Demand
• measure of arc elasticity can be mistaken to be the price elasticity of
demand curve PM between points J and K, irrespective of the
direction of change in price, whereas this elasticity coefficient is
relevant only for the fall in the price not for the rise in price.
Limitation of Arc method of measuring Price Elasticity of Demand

An alternative method to avoid this problem is to use point elasticity

DEGREES (TYPES) OF PRICE ELASTICITY OF
DEMAND
• Perfectly inelastic demand (ed = 0) :
• The demand for a commodity is called perfectly inelastic when
quantity demanded does not change at all in response to change in its
prices
Perfectly inelastic demand
• E.g: Life-saving medication for which there is no substitute and the
patient cannot survive without it, regardless of price.
Inelastic Demand (Relatively InElastic)
• Less than unit elastic demand (ed < 1) :
• The demand for a commodity is called less than unit elastic or
relatively inelastic when the percentage change in quantity
demanded is less than the percentage change in price of the
commodity
InElastic Demand (Relatively InElastic)
• Necessities with few substitutes (e.g., essential medicines like insulin,
basic food staples like rice or bread, gasoline, water).
• If the price of insulin increases by 10%, demand might only fall by 2%.
Unitary Elastic Demand
• Unit elastic demand (ed = 1):When percentage change in quantity
demanded of a commodity equals percentage change in its price, the
demand for the commodity is called unit elastic
• A product where a 10% price increase leads to a 10% decrease in
quantity demanded. This is often a theoretical benchmark.
Elastic Demand (Relatively Elastic)
• More than unit elastic demand (ed >1)
• When the percentage change in quantity demanded of a commodity
is more than the percentage change in its price, the demand for the
commodity is called more than unit elastic or highly Elastic
Elastic Demand (Relatively Elastic)
• Luxury goods (e.g., designer handbags, high-end electronics,
vacations), goods with many close substitutes (e.g., a specific brand of
coffee when many other brands are available).
• If the price of a luxury car increases by 10%, demand might fall by
20%.
• Airline tickets: When prices rise, people may choose to drive, take a
train, or postpone their trips.
Perfectly Elastic Demand
• Perfectly elastic demand (ed = infinity):The demand for the
commodity is called perfectly elastic when its demand expands or
contracts to any extent without or very little change in its price
Perfectly Elastic Demand
• A minuscule or zero change in price leads to an infinite change in quantity
demanded. Consumers are extremely sensitive to price changes.
• This is a theoretical concept rarely observed in reality.
• Ed = ∞
• A very specific brand of sugar in a perfectly competitive market, where a
tiny price increase would cause all consumers to switch to a competitor's
identical sugar.
• Paper Clips: A standard, unbranded paper clip is a good example. If one
manufacturer slightly raises the price, consumers will switch to another
brand.
DETERMINANTS OF PRICE ELASTICITY OF DEMAND
• Availability of Substitutes:
• The closer the substitute, the greater the price elasticity of demand for
a commodity.
• coffee and tea may be considered as close substitutes for one
another. If price of one of these goods (say, coffee) increases, then
the demand for coffee decreases more heavily---reason –other
commodity (tea) becomes relatively cheaper.
• wider the range of the substitutes, the greater the elasticity
• soaps, toothpastes, cigarettes, etc. are available in different brand
names, each brand being a close substitute for the other, all other
things remaining the same
DETERMINANTS OF PRICE ELASTICITY OF DEMAND
• Nature of Commodity
• Price elasticity of demand depends also on the nature of a commodity.
• Commodities can be grouped broadly as luxuries, comforts and necessities,
on the basis of the degree of intensity of the need they satisfy
• Demand for luxury goods (e.g., air conditioners, costly TV sets, cars, and
decoration items) is more elastic than the demand for other kinds of goods
because consumption of luxury goods can be postponed when their price
rises.
• Demand for comforts is more elastic than that for necessities and less
elastic than the demand for luxuries
• consumption of necessities (e.g., sugar, clothes, vegetables, and electricity)
DETERMINANTS OF PRICE ELASTICITY OF DEMAND
• Proportion of Income Spent
• If proportion of income spent on a commodity is very small, its
demand will be inelastic, and vice versa.
• Examples-salt, matches, toothpastes, which claim a very small
proportion of consumers’ income.
• Demand for these goods is generally inelastic because increase in the
price of such goods does not substantially affect consumer’s budget.
Income elasticity of demand
• Income elasticity of demand is the relative responsiveness of quantity
demanded of a commodity to changes in income of the consumer
demanding the commodity.
• It is the proportional or percentage change in quantity demanded of a
commodity divided by the proportional change in income of the
consumers demanding the commodity.
• The major determinant of income elasticity of demand is the degree of
‘necessity’ of the good.
• Normal goods: Goods whose demand increases as consumer incomes increase.
They have a positive income elasticity of demand.
• Luxury goods will have a higher income elasticity of demand than more basic
goods.
• Inferior goods: Goods whose demand decreases as consumer incomes increase.
Such goods have a negative income elasticity of demand.
Cross-Elasticity of Demand
• Cross-Elasticity is the measure of responsiveness of demand for a
commodity to the changes in the price of its substitutes and
complementary goods
• cross-elasticity of demand for tea (T ) is the percentage change in its
quantity demanded due to a change in the price of its substitute,
coffee (C).
Cross-Elasticity of Demand
the cross-elasticity with respect to demand for tea and
price of coffee is given as follows

cross-elasticity of demand for coffee (Q ) with respect to

c

price of tea (P ) can be expressed as

t
Cross-Elasticity of Demand
• when two goods are substitutes for each other, their demand has a positive
cross-elasticity because increase in the price of one increases the demand
for the other.
• the demand for complementary goods has negative cross-elasticity, for
increase in the price of a good decreases the demand for its
complementary goods
• if cross-elasticities between any two goods are positive, the two goods can
be treated as substitutes for each other.--- higher the cross-elasticity, the
closer the substitute
• if cross-elasticity of demand for any two related goods is negative,
• the two may be considered as complementary for each other: the higher
the negative cross-elasticity, the higher the degree of complementarity
PRICE ELASTICITY OF SUPPLY
• Price elasticity of supply is the measure of responsiveness of the
quantity supplied of a good to the change in its market price.
• The coefficient of price elasticity of supply (ep) is the measure of
percentage change in the quantity supplied of a good due to a given
percentage change in its price.
DEGREES OF PRICE ELASTICITY OF SUPPLY
Perfectly inelastic supply
• Supply of a commodity is said to be perfectly inelastic when the
quantity supplied of a commodity does not change at all in response
to change in price of the commodity.
• It means that the price of the commodity may increase or decrease
but its quantity supplied remained the same.
• In such cases the price elasticity of supply is zero and supply curve is a
vertical line parallel to y-axis.
Inelastic or less than unit elastic supply
• When the percentage change in quantity supplied of a commodity is
less than the percentage change in its price, the supply of the
commodity is said to be inelastic or less than unit elastic.
• It happens generally in case of perishable goods as it is very difficult
to store them.
Unitary elastic supply
• When the percentage change in quantity supplied of a commodity is
equal to percentage change in its price, the supply of the commodity
is said to be unitary elastic.
• It means if the price of the commodity increases by 50 per cent its
quantity supplied will also increase by 50 percent.
Elastic or more than unit elastic supply
• When the percentage change in quantity supplied of a commodity is
greater than the percentage change in its price, the supply of the
commodity is said to be greater than unit elastic.
• It happens in case of durable goods because if the price falls they can
be easily stored for future sale.
Perfectly elastic supply
• When the quantity supplied of a commodity expands or contracts to
any extent without any change or with an infinitely small change in its
price, the supply of the commodity is called perfectly elastic.
• Its supply curve is a horizontal line parallel to x-axis