Page 78 - DECO405_MANAGERIAL_ECONOMICS

Unit 5: Elasticity of Demand

Notes

Notes Some important factors that determine the elasticity of demand are:
1. Luxury or Necessity Goods: Luxury goods tend to have an elastic demand, while
necessity goods have an inelastic demand. Purchasers can stop buying the luxury
goods when their prices rise.
2. Percentage of Income: Big items in a budget tend to have a more elastic demand than
small items. For example consumers may be affected by a 1 per cent rise or fall in
price of a flat but are insensitive to such fluctuations in pens.
3. Substitutes: Items that can be substituted easily have a more elastic demand than
those that cannot.
4. Time: The demand for a product becomes more elastic the longer the time period
under consideration. It takes time to decide about another product before buying it
as one develops a habit of using a particular product.

5.2 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 cigarettes 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
cigarettes. Thus salt and cigarettes 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 cigarettes 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 definition:

% 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) and the denominator in the expression
for e would be positive. However, the quantity demanded would fall and the percentage
p
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, cetris paribus,
e is always likely to be negative.
p
!

Caution However by placing a minus sign in the formula we make e positive. The
p
reason is that we want to equate "more elastic" with "more responsive". For 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". However, if

LOVELY PROFESSIONAL UNIVERSITY 73