Elasticity of Demand

Elasticity of Demand Elasticity of demand refers to the sensitivity of demand to a change in any of the factors that govern demand.

Elasticity of Demand Among the factors that influence the demand for a product are: the price of the good income the price of other goods. Using these three factors we deal with three forms of elasticity of demand: Price Elasticity of Demand (PED) Income Elasticity of Demand (YED) Cross Elasticity of Demand (CED)

Price Elasticity of Demand (PED) Price elasticity of demand (PED) measures the relationship between a change in the price of a product and the resulting change in demand for that product. It can be: Elastic: the change in price causes a more than proportionate change in demand. Inelastic: the change in price causes a less than proportionate change in demand. Equal to unity: demand changes in such a way that there is no change in the total income from the sale of the product (Normal Goods).

Measurement of PED  PED is measured by using the following formula: Where: P1 = the original price of the good P2 = the new price of the good Q1 = the original quantity demanded Q2 = the new quantity demanded Delta Q = the change in quantity demanded Delta P = the change in price P1 + P2 Q1 + Q2 Q P 

Application of PED Formula (1) A negative (–) number means the product is a normal good. When the price of a normal good goes up (i.e. + change P) the quantity demanded goes down (i.e. – change in Q) and vice versa. Applying the formula, this gives: – Q + P + Q – P Each gives a negative number or

Application of PED Formula (2) A positive (+) number means the product is a Giffen good. When the price of a Giffen good goes up (i.e. + change P) the quantity demanded goes up (i.e. + change in Q) and vice versa. Applying the formula, this gives: + Q + P – Q – P Each gives a positive number or

Application of PED Formula (3) If the result is > +1 or > –1 then the PED is elastic.

Application of PED Formula (4) If the result is < +1 or < –1 then the PED is inelastic.

Application of PED Formula (5) If the result is = +1 or = –1 then the PED is equal to unity.

Application of PED Formula (6) The value of the number in the answer (ignoring the + or – sign) indicates the relationship between the change in price and the resulting change in demand. That is, you multiply the percentage change in price by the number in the answer to get the percentage change in demand.

Luxury goods, e.g. foreign holidays. Elastic Demand Curve The Price Elasticity of Demand for this product is elastic. The change in price causes a more than proportionate change in demand. Degree of slope > 45º. Luxury goods, e.g. foreign holidays. Price Quantity P1 Q1 D P2 Q2

Inelastic Demand Curve The price elasticity of demand for this product is inelastic. The change in price has caused a less than proportionate change in demand. Degree of slope < 45º. Necessities, e.g. Domestic use of electricity. Price Quantity P1 Q1 D P2 Q2

“Luxury/necessities”, e.g. a freezer. Equal to Unity Curve The price elasticity of demand for this product is equal to unity. The price change has caused demand to change in direct proportion to the change in price. Degree of slope = 45º. “Luxury/necessities”, e.g. a freezer. Price Quantity P1 Q1 D P2 Q2

Relationship between degree of PED and change in TR (1) When PED is elastic, price and total revenue (TR) change in opposite directions. Example: Assume that PED = –2 P1 = €3 and Q1 = 100 The TR is €3,000 The price increases by 20%, thus demand will go down by 40%. P2 = €3.60 and Q2 = 60 The new TR is €216

Relationship between degree of PED and change in TR (2) When PED is inelastic, price and total revenue (TR) change in the same direction. Example: Assume that PED = –0.5 P1 = €3 and Q1 = 100 The TR is €300 The price increases by 20%, thus demand will go down by 10%. P2 = €3.60 and Q2 = 90 The new TR is €324

Relationship between degree of PED and change in TR (3) When PED is equal to unity, a change in price will have no effect on total revenue (TR). Example: Assume that PED = –1 P1 = €4 and Q1 = 800 The TR is €3,200 The price increases and demand will go down. P2 = €8 and Q2 = 400 TR is still €3,200 4 + 8 800 + 400 –400 +4 12 1200 –100 +1  =  = –1

Giffen goods and change in TR The three previous statements apply to normal goods only. For Giffen goods, price and total revenue always change in the same direction regardless of the degree of PED. The demand for Giffen goods goes up when their price is increased. As price increases more goods are sold at a higher price therefore TR must also increase. The same logic applies to a decrease in price.

Exceptional PEDs (1) Price Quantity D P1 Q1 P2 In this case any change in price between P1 and P2 will have no effect on the amount demanded. Thus the PED is perfectly inelastic (or = zero).

Exceptional PEDs (2) D Price Quantity P In this case any change in price will cause D to fall to zero. Thus PED is perfectly elastic (or equal to infinity).

Income Elasticity of Demand (YED) Income elasticity of demand (YED) measures the relationship between a change in income and the resulting change in demand. It can be: Elastic: the change in income causes a more than proportionate change in demand. Inelastic: the change in income causes a less than proportionate change in demand. Equal to unity: the change in income causes a proportionate change in demand.

Measurement of YED  YED is measured by using the following formula: Where: Y1 = the original income Y2 = the new income Q1 = the original quantity demanded Q2 = the new quantity demanded Delta Q = the change in quantity demanded Delta Y = the change in income Y1 + Y2 Q1 + Q2 Q Y 

Application of YED (1) Normal goods have a positive income effect. That is, when income goes up, the quantity demanded goes up and vice versa. Applying the formula, this gives: + Q + Y – Q – Y Each gives a positive number or

Application of YED (2) Inferior goods have a negative income effect. That is, when income goes up, the quantity demanded goes down and vice versa. Applying the formula, this gives: – Q + Y + Q – Y Each gives a negative number or

Application of YED Formula (3) If the result is > +1 or > –1 then the YED is elastic.

Application of YED Formula (4) If the result is < +1 or < –1 then the YED is inelastic.

Application of YED Formula (5) If the result is = +1 or = –1 then the YED is equal to unity.

Application of YED Formula (6) The value of the number in the answer (ignoring the + OR – sign) indicates the relationship between the change in income and the resulting change in demand. That is, you multiply the percentage change in income by the number in the answer to get the percentage change in demand.

Cross Elasticity of Demand (CED) Cross elasticity of demand measures the relationship between the change in price of one good and the resulting change in demand for another good.

Measurement of CED  Q(B) P(A)1 + P(A)2 P(A) Q(B)1 + Q(B)2 YED is measured by using the following formula: The demand for product B reacts to a change in the price of product A. Where: P(A)1 = the original price of A P(A)2 = the new price of A Q(B)1 = the original quantity of B Q(B)2 = the new quantity of B Delta Q(B) = the change in quantity of B Delta P(A) = the change in price of A P(A)1 + P(A)2 Q(B)1 + Q(B)2 Q(B) P(A) 

Concept of CED This formula measures only the CED of product B to a change in the price of product A. Product B could have a different CED to a change in the price of another product. Example: All cars are substitutes for each other. However, the demand for Toyota Corollas is very sensitive to a change in the price of Mazda 3s but not very sensitive to a change in the price of a Mercedes 300s. Therefore the CED of a product must always be stated in relation to the change in the price of another specific product.

Substitute Goods Have a Positive CED If the result of applying the formula is a positive number, then the goods are substitutes for each other. If the price of a good goes up (a + change in the price of A), there will be an increase in the demand for its substitute (a + change in the quantity of B), and vice versa. Applying this to the formula you get: = a positive number +Q(B) +P(A)

Complementary Goods Have a Negative CED When the applied formula results in a negative number it normally indicates that the goods in question are complementary goods. (In some exceptional cases it may indicate that the demand for B is derived from the demand for A.) When the price of one good goes up (i.e. a + change in the price of A), it causes a decrease in the demand for its complement (i.e. a – change in the quantity of B), and vice versa. Applying this to the formula you get: = a negative number –Q(B) +P(A)

Application of CED Formula (1) If the result is > +1 or > –1 then the CED of B is elastic in relation to a change in the price of A.

Application of CED Formula (2) If the result is < +1 or < –1 then the CED of B is inelastic in relation to a change in the price of A.

Application of CED Formula (3) If the result is = +1 or = –1 then the CED of B is equal to unity in relation to change in the price of A.

Application of CED Formula (4) The value of the number in the answer (ignoring the + or – sign) indicates the relationship between the change in the price of A and the resulting change in demand for B. That is, you multiply the percentage change in the price of A by the number in the answer to get the percentage change in demand for B.

Summary: Factors Determining the Degree of Elasticity of Demand The degree of necessity of the good. The availability of close substitutes. Fraction of income spent on the product. The durability of the product. The degree of elasticity of the more expensive good when the good is a complementary good. Time available to adjust to price change. The number of uses the product has. The effectiveness of an advertising campaign / brand loyalty.