Elasticity 1


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Elasticity 1

  1. 1. Elasticity: Concept, Measurement and Determinants Dadhi Adhikari Kathmandu College of Management 20th Sept, 2007
  2. 2. Meaning of Elasticity • Let Y=f(x) • Elasticity of Y with respect to X is defined as percentage change in Y due to one percent change in X • Mathematically ∞ ≅ ∆ ∆ == x x x x x x Q P Q P P% Q% dP dQ P Q inchange inchange E
  3. 3. Price Elasticity of Demand • Responsiveness of quantity demanded of a commodity to change in its own price x x Q P dP dQ E =
  4. 4. Types of price elasticity 1. Perfectly elastic demand E=∞ 2. Relatively elastic demand E>1 3. Unitary elastic demand E=1 4. Relatively inelastic demand E<1 5. Perfectly inelastic demand E=0 D D
  5. 5. How to measure? • Point Elasticity: If price change is very small then point elasticity is the appropriate measure of elasticity. Point elasticity measures the elasticity at particular point of demand curve. • Here price elasticity of demand at point A is given by x x Q P dP dQ E = APx QX B C At point B, elasticity = infinity At point C, elasticity = zero Hence price elasticity varies along a linear demand curve
  6. 6. How to measure? • Arc Elasticity: If price change is relatively large then Arc Elasticity is appropriate measure P1 P2 Q1 Q2 A B 12 12 12 12 * QQ PP PP QQ E + + − − =
  7. 7. Sign of Price Elasticity of Demand • Sign of price elasticity of demand is always negative due to demand law. However we always take absolute value to explain the elasticity of demand. • Sign is positive for Giffen goods
  8. 8. Determinants of Price Elasticity of Demand • Availability of substitute: elastic • Time horizon: in long run demand is elastic • Habit: inelastic • Definition of market: Narrowly defined market =>elastic demand • Necessities vs luxuries: Necessities => inelastic demand
  9. 9. Income elasticity of demand incomeYHere Q Y == dY dQ E 1.Income elasticity is positive for Normal goods and negative for inferior goods 2. Income elasticity of demand is greater than one for luxuries and less than one for necessities.
  10. 10. Cross elasticity of demand x y y x xy Q P dP dQ E *= Cross elasticity is positive for substitute and negative for complementary goods
  11. 11. Numerical example • Let the demand equation is Q=60 – 10 P. Find the price elasticity of demand when price increases from Rs 2 to Rs 3