By Muhammad Shahid Iqbal

1
By Muhammad Shahid Iqbal
Engineering Economics

• Module No. 04
• Elasticity and Its Applications (Quantitative
  Demand Analysis)

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Elasticity of Demand

• We know, from the Law of Demand, that price and
  quantity demanded are inversely related.
• Now, we are going to get more specific in
  defining that relationship, allows us to
  analyze demand and supply with greater precision.
  
• We want to know just how much will quantity
  demanded change when price changes? That is what
  elasticity of demand measures.
• It is a measure of how much buyers and sellers
  respond to changes in market conditions
• Price elasticity of demand is a measure of how
  much the quantity demanded of a good responds to
  a change in the price of that good.
• Price elasticity of demand is the percentage
  change in quantity demanded given a percent
  change in the price.

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Elasticity of Demand

• The above formula usually yields a negative
  value, due to the inverse nature of the
  relationship between price and quantity demanded.
• How Do We Interpret the Price Elasticity of
  Demand?
• A good economist is not just interested in
  calculating numbers. The number is a means to an
  end
• in the case of price elasticity of demand it is
  used to see how sensitive the demand for a good
  is to a price change.
• The higher the price elasticity, the more
  sensitive consumers are to price changes.
• A very low price elasticity implies just the
  opposite, that changes in price have little
  influence on demand.

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Elasticity of Demand

• We can read it as the percentage change in
  quantity for a 1 change in price
• Thus, if Ed 2, that means in that part of the
  demand curve, a 1 change in price will cause a
  2 change in quantity demanded. Or if we
  extrapolate, a 2 change in price will cause a 4
  change in quantity demanded, and so on.

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Degrees of Ed

• Perfectly Inelastic
• Ed ? in Qd
• ? in P
• Ed 0___
• ? in P
• Ed 0 it is also called zero
  elasticity

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Degrees of Ed

• Perfectly elastic demand
• Ed ? in Qd
• ? in P
• Ed ? in Qd
• 0
• Ed 8

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Degrees of Ed

• Relatively Inelastic or Inelastic
• Ed ? in Qd
• ? in P
• Ed lt 1 (in absolute value)
• ? in Qd lt ? in P
• For every 1 change in P, Qd changes by less than
  1
• Quantity demanded does not respond strongly to
  price changes.

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Degrees of Ed

• Relatively elastic or elastic Demand
• Ed ? in Qd
• ? in P
• Ed gt 1 (in absolute value)
• ? in Qd gt ? in P
• For every 1 change in P, Qd changes by more than
  1 (in opposite direction)

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Degrees of Ed

• Unitary Elastic Demand
• Ed ? in Qd
• ? in P
• Ed 1 (in absolute value)
• ? in Qd ? in P
• For every 1 change in P, Qd changes by 1 (in
  opposite direction)
• Quantity demanded responds strongly to changes in
  price.

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Elasticity of Demand and Its Determinants

• Availability of Close Substitutes
• Necessities versus Luxuries
• Definition of the Market
• Time Horizon

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Elasticity of Demand and Its Determinants

• Availability of Substitutes
• The more choices that are available, the more
  elastic is the demand for a good. (and vice
  versa)
• If the price of Pepsi goes up by 20, one can
  always purchase Coke, 7-Up and so forth.
• One's willingness and ability to postpone the
  consumption of Pepsi and get by with a "lesser
  brand" makes the PED of Pepsi relatively elastic.

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Elasticity of Demand and Its Determinants

• Amount of Consumers Budget
• The less expensive a good is as a fraction of our
  total budget, the more inelastic the demand for
  the good is (and vice versa).
• Most consumers have both the willingness and
  ability to postpone the purchase of big ticket
  items.
• If an item constitutes a significant portion of
  one's income, it is worth one's time to search
  for substitutes.
• A consumer will give more time and thought to the
  purchase of a 3000 television than a 1 candy
  bar, so demand for the former will be more
  elastic than demand for the latter.

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Elasticity of Demand and Its Determinants

• Time
• The longer the time frame is, the more elastic
  the demand for a good is (and vice versa).
• The more time a consumer has to search for
  substitute goods, the more elastic the demand.

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Elasticity of Demand and Its Determinants

• Necessities vs. Luxuries
• The more necessary a good is, the more inelastic
  the demand for the good (and vice versa).
• With a true necessity a consumer has neither the
  willingness nor the ability to postpone
  consumption.
• There are few or no satisfactory substitutes.
• Insulin is the ultimate necessity, so the demand
  for it is inelastic.

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Elasticity of Demand and Its Determinants

• Availability of information concerning substitute
  goods
• The easier it is for a consumer to locate the
  substitute goods, the more willing he will be to
  undertake the search, and the more elastic demand
  will be.
• an attachment to a certain brandeither out of
  tradition or because of proprietary barrierscan
  override sensitivity to price changes, resulting
  in more inelastic demand

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Total Revenue and Elasticity of Demand
Price of Pen (P) Quantity Demanded (Q) T. Expenditures or Revenue (PxQ) Price Elasticity of Demand
5.00 30 150 -
4.75 40 190 E gt1
4.50 50 225 Egt1
4.25 60 255 Egt1
4.00 75 300 Egt1
3.75 80 300 E1
3.50 84 294 Elt1
3.25 87 282.75 Elt1
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Total Revenue and Elasticity of Demand

• When the price elasticity of demand for a good
  is perfectly inelastic (Ed 0), changes in the
  price do not affect the quantity demanded for the
  good raising prices will cause total revenue to
  increase.
• When the price elasticity of demand for a good is
  relatively inelastic (0 lt Ed lt 1), the percentage
  change in quantity demanded is smaller than that
  in price. Hence, when the price is raised, the
  total revenue rises, and vice versa.
• When the price elasticity of demand for a good is
  unitary elastic (Ed 1), the percentage change
  in quantity is equal to that in price, so a
  change in price will not affect total revenue.
• When the price elasticity of demand for a good is
  relatively elastic (Ed gt 1), the percentage
  change in quantity demanded is greater than that
  in price. Hence, when the price is raised, the
  total revenue falls, and vice versa.

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Income Elasticity of Demand

• Income elasticity of demand (EdY) measures how
  much the quantity demanded of a good responds to
  a change in consumers income.
• It is computed as the percentage change in the
  quantity demanded divided by the percentage
  change in income.
• EdY D in Qd
  D in Y

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Income Elasticity of Demand

• Typically, if our income rises, we buy more and
  visa versa. These types of goods are called
  normal goods.
• EdY gt 0 - normal good
• A necessity good is a good whose quantity
  demanded is not very sensitive to income changes
• In other words, we buy it no matter what happens
  to our income.
• If a goods elasticity is 0 lt EdY lt 1 then it is
  a necessity good.
• A luxury good is one that we buy a lot of when
  our income goes up and we cut back on
  significantly when our income goes down.
• If a goods elasticity is EdY gt 1, then it is a
  luxury good.
• If a goods elasticity is EdY lt 0 it is an
  inferior good

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Cross Price Elasticity of Demand

• Another type of elasticity is the Cross Price
  Elasticity. This gets at how changes in price of
  one good can effect the demand of another
• Cross Price Elasticity of Demand (E1,2)
• Cross price elasticity of demand measures the
  percentage change in demand for a particular good
  caused by a percent change in the price of
  another good.
• It measures the responsiveness of quantity
  demanded of good one when the price of good 2
  changes.
• E1,2 ? in Qd of Good 1
• ? in P of Good 2

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Cross Price Elasticity of Demand

• This relationship is called substitutes and can
  be seen when E1,2 gt 0.
• This relationship is called complements and can
  be seen when E1,2 lt 0