Page 52 - DECO101_MICRO_ECONOMICS_ENGLISH

Unit 4: Elasticity of Demand

Notes

Task A fi rm has just increased its price by 5 per cent over last year’s price and it was
found that quantity sold remained the same. The firm comes to you and wants to know its

elasticity of demand. How would you calculate it? What additional information would you
search for before you did your calculation?

4.2 Price Elasticity of Demand

The concept of price elasticity of demand is a numerical measure of the extent to which quantity
demanded responds to a change in price, other determinants of demand being kept constant.

Example: If the price of cold drinks fell by 20% and the price of salt fell by 20%, the
increase in quantity demanded due to equal changes in prices would be different for salt and cold
drinks. Thus salt and cold drinks are said to have a different price elasticity of demand.
Price elasticity of demand, e , measures the degree to which the quantity demanded responds to
p
a change in price when all other factors that influence demand such as tastes or income are kept

constant. In the example, it is extremely likely that the percentage increase in quantity demanded
would be much more for cold drinks than for salt, even though the percentage decreases in price
are the same. Thus price elasticity of demand allows us to compare the sensitivity of the demand
for various goods for the same changes in price. From the defi nition
% change in quantity demanded
e =
p % change in price
Let us consider a commodity X. If its price rose, then the percentage change in price would be
positive (since the new price is greater than the old price). This means that the denominator
in the expression for e would be positive. However, the quantity demanded would fall and
p
the percentage change in quantity demanded would be negative. Hence the numerator in the
expression would be negative.
Thus, for most goods as quantity demanded and price have an inverse relationship, e is likely
p
to be negative. However, by placing a minus sign in the formula we make e positive. The reason
p
is that we want to equate “more elastic” with “more responsive”.
Example: Let two commodities X and Y have elasticities of +10 and +0.5 (calculated
after multiplying by (–1) in accordance with the formula). The demand for commodity X is more
responsive to price changes than is the demand for commodity Y, and X has a larger elasticity
since +10 is greater than +0.5. Hence “more elastic” is equated with “more responsive”.

!

Caution However, if we did not multiply by (–1), the two elasticities would be –10
and –0.5. Since –0.5 is greater than –10 we would be likely to say that Y has a greater
elasticity than X (when in fact it is the other way round). Hence without multiplying by (–1)
we would not be able to substitute “more elastic” for “more responsive”.
The factors that govern the price elasticity of demand are:
1. The number and closeness of substitutes: The more and the better the substitutes, the
greater is the price elasticity of demand. For example, if the price of “chocolate” ice cream

rose by a small amount, consumers would readily switch to other flavours of ice cream
such as “strawberry” or “butter-scotch”. Thus, for a small percentage change in price, there
would be a large percentage change (decrease) in quantity demanded. Hence “chocolate”

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