Micro Economics

2. Introduction
The law of demand states that when the price
of a commodity falls, the quantity
demanded of that commodity will increase,
i.e. it explains only the direction of change
in demand and not the extent of change.
This deficiency is removed by the concept
of elasticity of demand.

3. Meaning of Elasticity
The term elasticity was developed by Alfred Marshall,
and is used to measure the relationship between price
and quantity demanded.
Elasticity means responsiveness.
Elasticity of demand refers to the responsiveness of
quantity demanded of a commodity to change in its
determinant.

4. Kinds of Elasticities of Demand
In view of its major determinants, economists usually
consider three important kinds of elasticities of
demand :
i) Price elasticity
ii)Income elasticity of demand
iii)Cross price elasticity/ Cross elasticity

5. Importance of the concept
‘ELASTICITY’
This concept plays a crucial role in business-decisions
regarding fixing of price with a view to make larger
profit.
For instance, when the cost of production increases, the
firm would want to pass the rising cost on to the
consumer by raising the price
OR
Firms may decide to change the price even without any
change in the cost of production.

6. Contd…
This would be beneficial depending on:
a) The price elasticity of demand for the product.
b) Price elasticity of demand for its substitutes, because
when the price of a product increases the demand for its
substitutes increases automatically even if their prices
remain unchanged.
Raising the price will be beneficial only if:
a) Demand for a product is less elastic.
b)Demand for its substitutes is much less elastic

7. Price Elasticity Of Demand Definition
The change in the quantity demanded of a product due to
a change in its price is known as Price elasticity of
demand.
In other words it is a proportional change in the
quantity demanded to a proportional change in
price.
EP=
Proportionate change in quantity demanded
Proportionate change in price

8. Degrees Of Price Elasticity Of Demand
1) Perfectly elastic demand
2) Relatively elastic demand
3) Elasticity of demand equal to unity
4) Relatively inelastic demand
5) Perfectly inelastic demand

9. Perfectly elastic demand
y
Perfectly elastic
demand curve
P
R
I
D
C
E
0
D
When the
demand for a
product changes
–increases or
decreases even
when there is no
change in price,
it is known as
perfect elastic
x
demand.

10. y
P
Relatively elastic
demand curve
R
D
I
C
E
D
0
demand
x
When the
proportionate
change in
demand is more
than the
proportionate
changes in price,
it is known as
relatively elastic
demand.

11. y
D
P
R
Elasticity of
demand equal
to unity curve
I
C
E
D
0
demand
x
When the
proportionate
change in
demand is equal
to proportionate
changes in price,
it is known as
unitary elastic
demand

12. Y
D
Relatively inelastic
demand curve
P
R
I
C
E
D
O
demand
X
When the
proportionate
change in demand
is less than the
proportionate
changes in price, it
is known as
relatively inelastic
demand

13. Y
D
P
R
I
C
When a change in
price, howsover
Perfectly inelastic
large, change no
demand curve
changes in quality
demand, it is known
as perfectly inelastic
demand
E
0
D
demand
X

14. Y
P
R
D
I
C
E
D3
D4
0
D5
DEMAND
WHERE
D1) Perfectly elastic
demand
D1 D2)Relatively elastic
demand
D2 D3)Elasticity of demand
equal to unity
D4)Relatively inelastic
demand
X
D5)Perfectly inelastic
demand

15. Measurement Of Price Elasticity
Of Demand
Important methods to measure the elasticity
of demand are: Proportional or percentage method
Expenditure or Outlay method
Geometric or point method
Arc Elasticity of demand

16. Percentage method or proportionate method

17. Example:
At Rs. 46 per unit , the demand for a commodity is 30
units. If the price increases from Rs. 46 to Rs. 50 per unit,
the demand decreases from 30 units to 15 units. The
price elasticity of demand is:

18. Total Expenditure or Total Outlay
Method
Total expenditure on the commodity is measured as the product
of price and quantity (Total expenditure = P × Q) when price
changes, total expenditure (TE) on the commodity may
increase, decrease or remain constant.
Note the following situations:
(i) If, TE remains constant even after change in , price elasticity
of demand is said to be equal to unity
(ii) If TE increases following a fall in P, and TE decreases following
a rise in P (so that P and TE move in the opposite direction),
price elasticity of demand is said to be greater than unity . Ed>1
(iii) If TE increases following an increase in P and TE decreases
following a decrease in P (so that and TE move in the same
direction), price elasticity of demand is said to be less than
unity. Ed<1 .

19. Price Elasticity
of Demand (Ed)
P
TE
Ed = 1
Rises or falls
No change
Ed >1
Rises
Decreases
Falls
Increases
Rises
Increases
Falls
Decreases
Ed < 1

21. Example:
When price of a good falls from Rs. 8 per unit to Rs. 7
per unit, its demand rises from 12 units to 16 units.
The elasticity of demand is measured as under.
Price (Rs)
Demand (in
units)
Total
Expenditure
(Rs.)
8
12
96
7
16
112
Since, total expenditure increases with fall in price,
elasticity of demand is greater than unity. It is a
situation of elastic demand.

22. Example
Quantity
Total Expenditure
Demanded (Q)
(P x Q)
18
3
54
15
4
60
12
5
60
9
6
54
Price (P
e>1
e=1
e <1

25. The Arc Elasticity of demand
The arc elasticity of demand refers to the relationship between changes in
price and the subsequent change in quantity demanded.
Qo is the initial quantity demanded.
Q1 is the new quantity demanded.
Po is the initial price.
P1 is the new price.

27. Factors Affecting Price Elasticity Of
Demand
Nature of the Commodity
Availability of Substitutes
Variety of uses of commodity
Postponement
Influence of habits
Proportion of Income spent on a commodity
Height of price and range of prices

28. Factors Affecting Price Elasticity Of
Demand
Income Groups
Elements of time
Pattern of income distribution
Recurrence of demand
Time
Complimentary goods
Durability of the commodity

29. Practical Importance of the Concept of
Price Elasticity Of Demand
The concept is helpful in taking Business Decisions
Importance of the concept in formatting Tax Policy of
the government
For determining the rewards of the Factors of
Production
To determine the Terms of Trades Between the Two
Countries

30. Practical Importance of the Concept of Price
Elasticity Of Demand
Determination of Rates of Foreign Exchange
In economic Analysis ,the concept of price elasticity
of demand helps in explaining the irony of poverty in
the midst of plenty.

32. Types Of Income Elasticity Of Demand
Positive Income elasticity of demand
Negative Income elasticity of demand
Zero Income elasticity of demand

33. Y
D
Income
P
A
O
D
B S
Quantity Demanded
X

34. Positive Income elasticity of demand
Income Elasticity Equal to Unity or
One
Income Elasticity Greater Than Unity
Or One
Income Elasticity Less Than Unity or
One

35. Price
P
A
Total Revenue
B
S
Quantity Demanded (000s)

36. D
Income
Y
O
D
Quantity Demanded
X

37. Y
F
E
Income
C
D
B
A
O
Quantity Demanded
X

38. Proportionate change in Demand
Income Elasticity Of Demand =
Proportionate change in Income
i.e.
∆q
Income Elasticity Of Demand =
Q
X
y
∆Y

39. Measurement Of Income Elasticity Of
Demand
Here , ∆q = Change in the quantity
demanded.
Q = Original quantity demanded.
∆y = Change in income.
Y = Original income.
For e.g. ,when Income of the consumer =
2,500/- , he purchases 20 units of X, when
income = 3,000/- he purchases 25 units of X

40. Measurement Of Income Elasticity Of
Demand
Thus
Income Elasticity of Demand
∆q
∆y
X
=
Y
Q
= (5/20) X (2500/500)
= 1.25
therefore here the IED is 1.25 which is more
than one.

41. Factors Affecting Income Of Demand
Income Itself Only.
Price Of the Commodity

42. Importance Of the Concept of Income
Elasticity Of Demand
In production planning and management
In forecasting demand when change in
consumers income is expected
In classifying goods as normal and inferior
In expansion and contraction of the firm
by the figure of income elasticity of
demand
Markets situations could be studied with

43. Cross Elasticity of Demand
Cross elasticity of demand expresses a
relationship between the change in the
demand for a given product in response to
a change in the price of some other product
E.g. if the X tea demand reduces
tremendously then its effect could be seen
in demand of sugar and milk.

44. Types of Cross Elasticity of Demand
Cross Elasticity of Demand Equal to Unity
or One
Cross Elasticity of Demand Greater than
Unity or one
Cross Elasticity of demand less than unity
or one

45. Cross Elasticity of Demand =
i.e.
Proportionate change in Demand
for product X
Proportionate change in Price of
product Y
Cross Elasticity of Demand = ∆qx
Qx
/
∆p y
Py

46. Y
Price of Y
D
D
O
Demand for X
X

47. D
Price of Y
Y
D
O
Demand for X
X

48. Y
Price of Y
D
O
Demand for X
X

49. Importance of Cross Elasticity Of
Demand
The concept is of very great importance in
changing the price of the products having
substitutes and complementary goods .
In demand forecasting
Helps in measuring interdependence of price
of commodity .
Multiproduct firms use these concept to
measure the effect of change in price of one
product on the demand of their other product

50. Advertising Elasticity of Demand
Advertising elasticity of demand is the
measure of the rate of change in
demand due to change in advertising
expenditure
The amount of change in demand of goods
due to advertisement is known as
Advertisement Elasticity of Demand .

51. Advertising Elasticity of Demand =
i.e.
Proportionate change in Demand
for product
Proportionate change in Advertising
expenditure
∆qx
Advertising Elasticity of Demand =
Q
÷
∆a
A

52. Y
Sales
S
S
O
Advertising Expenditure
X

53. Factors Affecting Advertising Elasticity
Of Demand
The stage of the Product’s Market
Development .
Reaction of market Rival Firms.
Cumulative Effect of Past Advertisement.
Influence of Other Factors.

54. Importance of the Advertising
Elasticity Of Demand in Business
Decisions
It is useful in competitive industries.
Though advertisement shifts the demand
curve to right path but it also increases the
fixed cost of the firm.

55. Limitation of Advertising Elasticity
of the Demand
The impact of advertising on sales is
different under different conditions, even if
other demand determinants are constant.
Like wise, it is difficult to establish any corelationship between advertising
expenditure and volume of sales when
there counter advertisements by rival firm
in the market . The effect on sales depend
on what the rivals are doing.

57. Elasticity of Supply
Elasticity of Supply: a measure of the way suppliers
respond to a change in price
Elastic: sensitive/responsive to change in price
(greater than 1)
Inelastic: not sensitive or not responsive to a change
in price (less than 1)
Unitary: Equal change in price to equal change in
supply (= to 1)

58. Elasticity of Supply
 A supplier’s responsiveness to a price change is
Elasticity of Supply
called _________________
 (think like a supplier/seller)
 3 Factors that will determine a product’s
elasticity
1. Availability of resources required to make the
product
2. Amount of time required to make the product
3. Skill level of the worker needed to make the
product

59. Elastic Supply
 A product has elastic supply when a price
1.
2.
3.
change causes a significant change in the
quantity supplied. (What would have to be true
(of a product) to allow a seller to quickly
increase production if the market price goes
up?)
Abundance of resources required to make the
product
Product can be made quickly
Low skill level of workers required

60. Slope of an Elastic supply curve

Remember, if the price changes, the quantity supplied
changes a lot. This creates a flatter curve.
P
P2
s
P1
Q1
Q2
Q

61. Inelastic Supply
A price change causes very little change in the
quantity supplied= Inelastic. This happens
because…
1.The product requires scarce resources
2. It takes a long time to make
3. It requires a high skill level of workers
examples?
Hand crafted furniture
diamonds

62. Slope of an inelastic supply curve
If the market price goes up but the supplier cannot
increase production very much, then this creates a
steeper curve.
s
P
P2
P1
Q1 Q2
Q