Introductory Economics

Elasticity of demand

Elasticity of demand:

• Elasticity of demand refers the degree of responsiveness of quantity demanded to changes in variables such as price, income, tastes and preferences, price of substitutes etc. Elasticity is simply a ratio between a cause and an effect, always in percentage. The percentage change in effect is divided by percentage change in cause.

Types of elasticity:

• Price elasticity
• Income elasticity and
• Cross elasticity.

A. Price elasticity of demand

• It is a measure of change in quantity of a commodity demanded in response to change in the price of that commodity

Percentage change in quantity demanded

є = -------------------------------------------------

Percentage change in price

Example:

• Suppose the price of Apple falls from Rs.10 to Rs.8 and the quantity demanded rises from 30 to 40Apple; find out the price elasticity of demand. Then

5

є = ------

3

= 1.667

This means that for one per cent change, there is 1.667 per cent change in quantity demand.

Degrees of Price elasticity of demand:

• Price elasticity of demand is classified into five types:

1. Perfectly elastic
2. Perfectly inelastic
3. Unitary elastic
4. Greater than unitary elastic
5. Less than unitary inelastic

1. Perfectly elastic demand or infinite elasticity: Even a very small change in price leads to a very large change in quantity demanded it is said to be perfectly elastic. A perfectly elastic demand is one in which any quantity will be bought at the prevailing price, but any rise in price will cause quantity demanded to fall to zero.

2. Perfectly inelastic demand (єp=0): If demand remains unchanged to any amount of change in price, demand is said to be perfectly inelastic.

3. Unitary elastic demand (Equal to one): When numerical value of elasticity of demand is equal to one is known as unitary elastic demand. It means that both price and quantity demanded change in the same proportion.

4. Greater than unitary elastic, elastic demand (greater than one):
Demand is said to be elastic when the numerical value of elasticity is greater than one or unity. It means that percentage change in quantity demanded is larger than the percentage change in price.

5. Less than unitary elastic, inelastic demand (less than one): If the numerical value of elasticity of demand is less than one or unity, it is called inelastic demand. I.e. percentage change in quantity demanded is lesser than the percentage change in price.

B. Income Elasticity of demand: It is the magnitude of change in quantity demanded in response to change in the income of the consumer. It is calculated by the formula.

Percentage change in quantity demanded

єi = ---------------------------------------------------

Percentage change in income

• Luxuries have high income elasticity and necessaries have low income elasticity

C. Cross elasticity of demand : It is a measure of change in quantity demanded in response to change in prices of other related commodities

Percentage change in quantity demanded

єc = ----------------------------------------------------------------

Percentage change in price of related good

• In case of substitutes, (Tea and Coffee) the cross elasticity of demand is positive and large. In case of complementary goods (Tea and Sugar) the rise in price of one commodity brings about the fall in the demand of the other (Eg. Car and Petrol) and hence it is negative.