Page 71 - DECO405_MANAGERIAL_ECONOMICS

Managerial Economics

Notes 5.1 Concept of Elasticity

The law of demand tells us that consumers will respond to a price decline by buying more of a
product. It does not, however, tell us anything about the degree of responsiveness of consumers
to a price change. The contribution of the concept of elasticity lies in the fact that it not only tells
us that consumer's demand responds to price changes but also the degree of responsiveness of
consumers to a price change. Figure 5.1 shows two demand curves. Let D be the demand for
a
cheese in Switzerland and D be the demand for cheese in England.
b
Figure 5.1

At a price of $10, the quantity demanded in both countries is 60. When the price falls from $10 to
$5, the quantity of cheese demanded increases in both. However, for the same change in price,
from $10 to $5, the change in quantity demanded increases more in England compared to
Switzerland. In other words, for the same decrease in price in the two countries, the quantity
demanded responds more in England than in Switzerland.

We would describe the above situation by saying that the demand for cheese is more elastic in
England than in Switzerland. Elasticity, then, is first another word for "responsiveness".
Elasticity of demand is important primarily as an indicator of how total revenue changes when
a change in price induces changes in quantity along the demand curve. The total revenues of the
firm will equal the price changed times the quantity sold (TR = P x Q). Naturally, total revenues
received by firms are equal to total spending by consumers. If consumers buy 50 units at $10
each, then the total revenue will be $500. By simple multiplication, total revenue can always be
calculated for each point in a demand schedule or diagram.

5.1.1 Classification of Demand Curves according to their Elasticities

Depending on how the total revenue changes, when price changes we can classify all demand
curves in the following five categories:

1. Perfectly inelastic demand curve
2. Inelastic demand curve
3. Unitary elastic demand curve
4. Elastic demand curve
5. Perfectly elastic demand curve

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