Elasticity of Demand

Anything is assumed to be elastic when it expands or contracts as a result of the

respective application or withdrawal of an external force. Elasticity of demand is the
degree of the responsiveness of quantity demanded of a commodity to change in its
price, income of the consumer, prices of related commodities and change in the other
factors determining demand. Based on the degree of the responsiveness, demand
becomes elastic or inelastic.

Price Elasticity of Demand

The elasticity of demand is commonly referred as the price elasticity of demand.

Price elasticity of demand is the degree of the responsiveness of quantity demanded of
a commodity to a change in its price. In other words price elasticity of demand is
defined as the ratio of the percentage change in quantity demanded to a percentage
change in price. This can be written as;

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑

Ep =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒

The coefficient of price elasticity of demand is written as follows.

𝚫𝑸 𝚫𝑷 𝚫𝑸 𝑷 𝑷 𝚫𝑸
Ep = ÷ = × = ×
𝐐 𝐏 𝐐 𝚫𝑷 𝑸 𝚫𝑷

Ep = Coefficient of Price elasticity of demand

Q = Quantity Demanded

P = Price

∆Q/Q = Relative Change in quantity demanded

∆P/P = Relative Change in Price

The Coefficient of price elasticity of demand will be always negative, because price
and quantity demanded always moves in opposite direction. However in economics
the absolute value (value without the negative sign) of the price elasticity of demand is

1
used. If the percentage change in quantity demanded and prices are known, then the
value of the coefficient of price elasticity of demand can be calculated. The value of
the coefficient of price elasticity of demand varies between zero to infinity.

Diagrammatic Explanation of Price Elasticity of Demand

The concept of price elasticity of demand can be illustrated with the help of the
following diagram.

The curves A and C in the diagram represent the demand for apple in the
market A and C. At price OP the demand for apple in the market A is OB and that of
in the market C is ON. When the price falls from OP to OP1 the demand for Apple in
the market A expands from OB to OB1, i.e. by BB1, while the demand for Apple in the
market C expands from ON to ON1, i.e. by NN1. Due to a fall in price the expansion
of demand is greater in market C than in Market A. In other words the price elasticity
of demand for Apple is greater in market C than in market A.

2
 Kinds/ Types/ Degrees of Elasticity of Demand

Price elasticity of demand will be different for different commodities. Some

commodities have more elastic demand while others have relatively less elastic
demand. Evan for the same commodity elasticity may be different in different times.
The coefficient value of the price elasticity of demand varies between zero to infinity.
And based on the degrees of elasticity, there are five kinds of price elasticity of
demand.

1. Perfectly Elastic Demand

Demand is said to be perfectly elastic, if a change in price leads to infinite
changes in the quantity demanded. In this case a small rise in price causes the
quantity demanded to fall to zero and a small fall in price causes an infinite
increase in the quantity demanded. Therefore, if the demand is perfectly elastic
the demand curve will be horizontal straight line and the value of the
coefficient is infinite, i.e. e=∞.

2. Perfectly Inelastic Demand

Demand is said to be perfectly inelastic when the quantity demanded remains
the same irrespective of any rise or fall in the price of a commodity. That
means the change in price does not influence the quantity demanded. In this
case the value of the elasticity is equal to zero (e=0). If the demand is perfectly
inelastic the demand curve will be vertical straight line.

3
3. Unitary Elastic Demand (Elasticity Equal to Unity)
Demand is said to be unitary elastic if the percentage change in quantity
demanded is exactly equal to the percentage change in price. if the demand is
unitary elastic a fall in price leads to equal and proportionate increase in the
quantity demanded and vice versa. When demand is unitary elastic the value of
the elasticity coefficient is equal to one (e=1). And in this case the demand
curve will be a rectangular hyperbola.

4. Elastic Demand
Elastic demand is a situation when the proportionate change in quantity
demanded is greater than the proportionate change in price. when the demand
is elastic a fall in price leads to more than proportionate rise in the quantity

4
 demanded. In this case the value of the elasticity coefficient is greater than
one, i.e. e>1. In this case the demand curve will be much flatter and downward
sloping one.

5. Inelastic demand
If the proportionate change in quantity demanded is greater than the
proportionate change in price the demand said to be is inelastic. When the
demand is inelastic a fall in price leads to less than proportionate rise in
quantity demanded and vice versa. In this case the value of the elasticity
coefficient is less than one, i.e. e<1.

5
These are the five kinds of price elasticity of demand.

Factors Determining the Price Elasticity of Demand

The price elasticity of demand depends upon number of factors and they are
explained below.

1. Availability of Close Substitutes

One of the important factors that affect the price elasticity is the availability of
close substitutes. The price elasticity of demand for a commodity is likely to
be higher if the commodity has a large number of close substitutes and vice
versa. A fall in the price of a substitute good while the price of other good
remaining same leads to an increase in the demand for the former in more than
proportionate to change in price. For example tea and coffee
2. Use of the Commodity
The price elasticity of demand for a commodity will be much higher if it has a
good number of uses. If the commodity is having a few uses demand is likely
to be inelastic.
3. Expenditure on the Commodity
If the households spends good part of their income on a particular commodity,
its price elasticity of demand will be much higher. On the other hand if the
amount spent on a commodity is very low, the price elasticity of demand for
that commodity will be much lower.
4. Level of Price
If the prevailing price of a commodity is very high, demand will be very
sensitive to change in price. On the other hand if the existing rate is very low,
the price elasticity of demand for that commodity will be much lower.
5. Income of the Household
If the level of income of the household is comparatively high, change in the
price of most of the commodities will have no response on the quantity
demanded.
6. Nature of the Commodities

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 Price elasticity of demand is also influenced by the nature of the commodity.
Usually the demand for necessities is inelastic and for comforts and luxuries,
elastic. Durable goods whose purchase can be postponed have elastic demand.
Too costly and too cheap goods have inelastic demand. Similarly the
complimentary goods have inelastic demand.
7. Change in Fashion
Price elasticity of demand is also influenced by change in fashion. If a
particular commodity goes out of fashion, demand may decrease even if the
price is lowered. On the other hand if some commodity turns to be fashionable,
its demand will increase even if the price rises.
8. Time
The elasticity of demand also varies with the time period. The longer the
period of time, the more elastic is the demand for the commodity and vice
versa. Demand is less elastic in the short run because the consumers do not get
time to adjust to some price changes while in the long run its possible to adjust
to price change.

7
 Methods of Measuring Price Elasticity of Demand

Price elasticity of demand is the degree of the responsiveness of the quantity

demanded of a commodity to change in price. In order to measure the price elasticity
of demand the following methods can be adopted.

 Percentage Method
 Expenditure/Outlay Method

1. Percentage Method
According to this method the price elasticity of demand can be measured by
dividing percentage change in quantity demanded of a commodity by
percentage change in price.

𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑸𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝑫𝒆𝒎𝒂𝒏𝒅𝒆𝒅

Ed =
𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑷𝒓𝒊𝒄𝒆

The coefficient of price elasticity of demand is written as follows.

𝚫𝑸 𝚫𝑷 𝚫𝑸 𝑷 𝑷 𝚫𝑸
Ed = ÷ = × = ×
𝐐 𝐏 𝐐 𝚫𝑷 𝑸 𝚫𝑷

Ed = Coefficient of Price elasticity of demand

Q = Quantity Demanded

P = Price

∆Q/Q = Relative Change in quantity demanded

∆P/P = Relative Change in Price

Based on the value of the coefficient the price elasticity of demand can be
classified into five categories.
a. Perfectly Elastic Demand (Ed = ∞): Quantity responds enormously to
to change in price.

8
 b. Perfectly Inelastic Demand (Ed = 0): Quantity demanded does not
change to a change in price.
c. Elastic Demand (Ed>1): Percentage change in quantity demanded is
greater than the percentage change in price.
d. Inelastic Demand (Ed<1): Percentage change in quantity demanded is
less than the percentage change in price.
e. Unitary Elastic Demand (Ed=1): The percentage change in quantity
demanded is exactly equal to the percentage change in price.
2. Expenditure Method
This is a contribution of Alfred Marshall to Economic theory. This method
takes into the consideration the change in price and consequent change in the
total amount of money spent on it. By comparing the total expenditure of a
consumer before and after the price change, it can be calculated whether the
demand for the product is elastic, inelastic or unitary elastic. Total expenditure
equals price times quantity (PxQ).
a. Elastic Demand (Ed>1): Demand is said to be elastic if an decrease in
the price of a commodity results in an increase in total expenditure on
that commodity and an increase in the price of a commodity leads to a
reduction in total expenditure on that commodity. In this case the price
and total expenditure moves in opposite direction.
b. Inelastic Demand (Ed<1): Demand is said to be inelastic if an decline
in the price of a commodity leads to a decline in total expenditure on
that commodity and an increase in the price of a commodity leads to an
increase in total expenditure on that commodity. In this case the price
and total expenditure moves in same direction.
c. Unitary Elastic Demand (Ed=1): Demand is unitary elastic if a
change in price does not result in a change in total amount spent on it
even though the demand for the commodity changes.

All three elasticity of demand situations can also be explained in the

following table.

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 Price in Rs. Quantity Expenditure Quantity Expenditure Quantity Expenditure
demanded of on X demanded of on Y demanded of on Z
commodity X commodity Y commodity Z

5 11 55 12 60 15 75
4 12 48 15 60 22 88
3 14 42 20 60 32 96
2 20 40 30 60 50 100
1 30 30 60 60 110 110
The table shows that the commodity X is inelastic, commodity Y is Unitary
elastic and the Commodity Z is elastic.

3. Graphical Method (Straight Line Method)

The price elasticity of demand on a downward sloping straight line demand
curve is different at different points. Elasticity of demand at any point on the
demand curve is calculated by dividing the lower portion of the demand curve
by the upper portion. In other words the elasticity of demand at any one point
is the ratio of the lower part of the straight line demand to the upper part. This
can be explained in the following figure.

In the figure price is measured on the Y axis and quantity demanded on

the X axis. Along the downward sloping demand curve, the elasticity of
demand is different at different points. At the midpoint (at point B) on the

10
demand curve, elasticity is equal to unity, because at this point the lower
portion of the demand curve is exactly equal to the upper portion (BD/BE = 1).
Above the midpoint the coefficient of the price elasticity of demand is greater
than one, i.e. elastic, because at any point above the midpoint the lower part of
the demand curve is greater than the upper part (eg. AD/AE >1). Demand
curve is inelastic below the midpoint because the lower part is shorter than the
upper part (CD/CE <1). At the point where the demand curve cut at price axis,
i.e. at point E, the price elasticity of demand is equal to infinity (perfectly
elastic). In the same manner at the point where the demand curve cut the
quantity axis, the price elasticity of demand is equal to zero (perfectly
inelastic). Thus it is understood from the table that as the demand curve moves
downward the elasticity of decreases and vice versa. Along the straight line
demand curve, elasticity is greater than one above the midpoint and less than
one below the midpoint.

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Problems

Problem 1

Suppose a household demands 10kg of apples at a price of Rs. 90 for each kg. If the
price falls to Rs. 75 per kg, it demands 15kgs. Estimate the elasticity of demand for
apple for that household.

𝑃 Δ𝑄 90 5
Ed = x = x =3
𝑄 Δ𝑃 10 15

Problem 2

From the table, calculate the price elasticity of demand from the movement A to B, B
to C and C to D.

Point Price Quantity

A 20 15
B 25 28
C 10 42
D 5 55

A to B

𝑷 𝚫𝑸 𝟐𝟎 𝟏𝟑
Ed = x = x = 3.46
𝑸 𝚫𝑷 𝟏𝟓 𝟓

B to C

𝑷 𝚫𝑸 𝟐𝟓 𝟏𝟒
Ed = x = x = 1.512
𝑸 𝚫𝑷 𝟐𝟖 𝟓

C to D

𝑷 𝚫𝑸 𝟏𝟎 𝟗
Ed = x = x = 0.432
𝑸 𝚫𝑷 𝟒𝟐 𝟓

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 Point Elasticity of Demand

Price elasticity of demand at a specific point on the demand curve is known as the
point elasticity of demand. This is obtained by dividing the lower portion of the
demand curve by the upper portion of the demand curve.

The figure shows that at the midpoint the price elasticity of demand is equal to one,
above the midpoint it is greater than one (elastic) and below the midpoint it is inelastic
(less than one). Suppose the demand is curve linear, the elasticity of demand at any
point can be measured by drawing a tangent line and then divide the lower part of the
tangent line by the upper part. This is shown in the following figure.

In the figure elasticity at the point of P is given as PN/PM

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 Arc Elasticity of Demand

Arc elasticity of demand is the coefficient of price elasticity of demand

between two points on a demand curve. It is the average elasticity over the arc on a
same demand curve. Because it uses average price and average quantity in
calculating the percentage change in price and the percentage change in quantity.
Elasticity is measured on the midpoint of the arc by using following formula.

𝑸𝟏−𝑸𝟐 𝑷𝟏−𝑷𝟐 𝚫𝑸 𝚫𝑷 𝚫𝑸 (𝐏𝟏+𝐏𝟐)/𝟐

Arc Ed = 𝟏 ÷𝟏 = ÷ = x
(𝑸𝟏+𝑸𝟐) (𝑷𝟏+𝑷𝟐) (𝐐𝟏+𝐐𝟐)/𝟐 (𝐏𝟏+𝐏𝟐)/𝟐 (𝐐𝟏+𝐐𝟐)/𝟐 𝚫𝑷
𝟐 𝟐

𝚫𝑸 (𝐏𝟏+𝐏𝟐)
= 𝚫𝑷 x (𝐐𝟏+𝐐𝟐)

This is also shown in the following figure.

Here Arc elasticity is the elasticity of demand between two point on the same
demand curve, i.e. between A and B.

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 Income Elasticity of demand

Income elasticity of demand is the degree of the responsiveness of quantity demanded

of a commodity to a change in income. In other words income elasticity of demand is
the ratio of percentage change in quantity demanded of a commodity to the percentage
change in Income.

𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒅𝒆𝒎𝒂𝒏𝒅𝒆𝒅

Ey = 𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒑𝒓𝒊𝒄𝒆

𝚫𝑸 𝚫𝒀 𝚫𝑸 𝒀 𝒀 𝚫𝑸
Ey = ÷ =  𝚫𝐘 = 𝑸  𝚫𝒀
𝐐 𝐘 𝐐

Where Ey is the coefficient of income elasticity of demand

Y is income

Q is quantity demanded

The coefficient of the income elasticity of demand may be positive, negative or

zero depending upon the nature of a commodity. If an increase in income leads to an
increase in demand for a commodity, the income elasticity coefficient for the
commodity will be positive. A commodity whose income elasticity coefficient is
positive is known as normal goods. On the other hand, if an increase in income leads
to a fall in the demand for a commodity; its income elasticity coefficient is negative.
Such commodity is known as inferior good. If the quantity of a commodity purchased
remains unchanged regardless of a change in income, the income elasticity of demand
is zero.

Normal goods are of three types; necessaries, comforts and luxuries. The
normal goods whose income elasticity varies between zero to one is known as
necessaries and they are inelastic in demand. Because in this case increase in income
is more proportionate than the increase in the quantity demanded. Normal good
whose income elasticity is greater than one is known as Luxury good and they are
having elastic demand. In this case the change in demand is more proportionate than

15
the change in income. And finally the normal goods whose income elasticity is equal
to one is known as comforts and they are unitary elastic. In this case both the income
and quantity demanded changes in same proportion.

The coefficient of income elasticity of demand in the case of inferior goods is

negative. Because, in this case the consumer will reduce the consumption of such
commodities as income increases. Goods for which consumption decreases in
response to a rise in income are known as inferior goods. In other words inferior
goods are those goods which are less bought at higher income and more bought at
lower income. Goods with negative income elasticities are called inferior goods.
Thus it is clear that the nature of the commodity is the major factor that determines
income elasticity. Other determinants of income elasticity of demand are time period,
demonstration effect, frequency of increase in income etc.

Problems

Problem – 1:

A household demands 30Lts. Of milk per month when its monthly income was Rs.
3000/-. When income income increases to Rs. 3500/- per month, the demand for milk
also increases to 40 Lts. Per month. Calculate income elasticity of demand.

𝑌 Δ𝑄 3000 10
Ey =  =  =2
𝑄 Δ𝑌 30 500

Problem – 2

Calculate the income elasticity of demand from the point A to B, B to C and C to D.

Point Price Quantity

A 500 30
B 1000 70
C 1500 90
D 2000 80

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A to B
500 40
Ey =  = 1.33
30 500

B to C
1000 20
Ey =  = 0.57
70 500

C to D
1500 −10
Ey =  = -0. 33
90 500

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 Cross Elasticity of Demand

Cross elasticity of demand is the degree of the responsiveness of quantity

demanded of a commodity to change in the price of related commodities. In other
words it is the ratio of percentage change in quantity demanded of one commodity to
percentage change in the price of related commodity.

𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒒𝒖𝒂𝒏𝒕𝒊𝒕𝒚 𝒅𝒆𝒎𝒂𝒏𝒅𝒆𝒅 𝒐𝒇 𝒂 𝒄𝒐𝒎𝒎𝒐𝒅𝒊𝒕𝒚

CEd =
𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒑𝒓𝒊𝒄𝒆 𝒐𝒇 𝒓𝒆𝒍𝒂𝒕𝒆𝒅 𝒄𝒐𝒎𝒎𝒐𝒅𝒊𝒕𝒚

The coefficient of cross elasticity of demand for two commodities X and Y can
be explained mathematically in the following manner.

𝚫𝑸𝑿 𝚫𝑸𝒀 𝚫𝑸𝑿 𝑸𝒀 𝚫𝑸𝑿 𝑸𝒀

CEd = ÷ =  = 
𝑸𝑿 𝐐𝐘 𝑸𝑿 𝚫𝐐𝐘 𝚫𝑸𝒀 𝐐𝐗

Where, ∆QX = Change in quantity of X

∆QY = Change in quantity of Y

QX = Initial quantity of X

QY = Initial quantity of Y

The Coefficient value of Cross elasticity of demand varies between minus

infinity to plus Infinity. The complimentary goods have negative cross elasticity and
the substitute goods have positive cross elasticity. When commodities are unrelated
cross elasticity is equal to zero.

Cross Elasticity of Demand for Substitute Goods

A substitute good is a good that can be used in place of another. In other words
substitute goods are those goods that can easily replace one another in consumption.
The cross elasticity of demand for two goods varies between zero to positive infinity.
That means if two goods are substitutes, an increase in the price of one lead to an

18
increase in the demand for another. If two goods are perfect substitute, the cross
elasticity of demand is infinite. As the substitutability of two goods reduce, the
coefficient value of Cross elasticity of demand also reduces.

Cross Elasticity of Demand for Complimentary Goods

Complement goods are those goods that are demanded together. There is no
use of one good without the other. For example, pen and ink. If two goods are
complimentary, an increase in the price of one commodity leads to a decrease in the
demand for another commodity. That means complimentary goods have negative
cross elasticity. If two goods are perfect complimentary, the coefficient value of cross
elasticity of demand is equal to negative infinity.

19
 Revenue

Revenue is the income earned by a producer or a firm from the sale of given
output. It can be obtained by multiplying price and quantity demanded or quantity sold
out. A demand curve provides both. Therefore demand curve is also known as the
revenue curve of the firm. Following are the various revenue concepts.

Total Revenue (TR)

It is the total income received by a firm or industry from the sale of its product. It can
be obtained by multiplying price per unit of output with number of units sold out.

TR = PQ

Where, P = Price

Q = Quantity

Average Revenue

Average Revenue is the revenue per unit of output sold out. It can be calculated by
dividing total revenue with number of units sold. Average revenue and price are
same if the product is sold at same price. Or in the absence of price discrimination
average revenue is equal to price. The curve which relates average revenue to output
is the same thing as the demand curve that relates price to output. And therefore
demand curve of a producer is his average revenue curve.
𝑻𝑹 𝑷𝑸
AR = =
𝑸 𝑸

Marginal Revenue

Marginal Revenue is the addition to total revenue by the sale of an additional

unit of output. In other words it is the income earned from the sale of the last unit of
output. The slope of the total revenue curve is determined by the marginal revenue.
Marginal revenue can be calculated by using following formula;
∆𝑻𝑹
MR =
∆𝑸

Where, ∆TR = Change in total revenue

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 ∆Q = Change in quantity.

The following table shows the relationship between TR, AR and MR.

Unit of the Total Revenue Average Revenue Marginal Revenue

Product (TR) (AR) (MR)
1 10 10 10
2 16 8 6
3 21 7 5
4 24 6 3
5 24 4.8 0
6 21 3.5 -3

The table shows that AR and MR are same for the first unit of output sold. But
after that both the AR and MR decline continuously and the decline in MR is faster
than the decline in AR. This can also show graphically.

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 The above figure shows that both the marginal and average revenue curves
continuously fall. As long as MR curve is positive, TR curve continuously increases.
When TR curve reached maximum, MR becomes zero. When marginal revenue curve
become negative, TR curve starts falling.

Revenue and Elasticity of Demand

Revenue is the income earned by a producer or a firm from the sale of given
output. Revenue earned by the producer from the sale of output also depends upon the
elasticity of demand. In other words, the elasticity concepts can also be explained in
connection with revenue function of concepts. The relationship between total revenue
and marginal revenue in connection with price elasticity of demand is explained as
follows.

Total Revenue and Price Elasticity of Demand

The price elasticity of demand and total revenue of the firm is closely related.
Total revenue is equal to price multiplied by quantity (TR = PQ). The relationship
between TR and price elasticity can be explained using an example. Suppose a firm
produces and sells a commodity called X. If the firm decide to reduce the price of the
commodity X by one percent, then its impact on revenue depends upon the price
elasticity. If price elasticity is equal to unity, a fall in price by one percent will cause
the quantity demanded to rise by one percent and leaving total revenue unchanged. A
decrease in total revenue associated with a fall in price is offset by an increase in the
demand for that commodity.

If price elasticity is greater than one, a price fall leads an increase in total
revenue. This happens because an increase in total revenue associated with an
increase in the quantity demanded of the commodity will be greater than a decrease in
total revenue associated with a fall in price. On the other hand, if price elasticity is
less than one, a fall in price leads to a decrease in total revenue. Because an increase

22
in total revenue due to an increase in demand is less than a decrease in total revenue
associated with a fall in price.

Marginal Revenue and Price Elasticity of Demand

The relationship between marginal revenue and price elasticity of demand is

expressed as follows.

1
MR =P (1 – )
𝑒

When elasticity of demand is equal to infinity (horizontal demand curve)

marginal revenue equals price.

1
MR = P (1- ) = P (1-0) = P
∞

When elasticity of demand is equal to unity or equal to one, marginal revenue equals
zero

1
MR = P (1- ) = P (0)= 0
1

When elasticity of demand is greater than one, marginal revenue will be positive. If
elasticity of demand is equal to 3, then MR is;

1 2 2
MR = P (1- ) = P [ ]=[ ]P
3 3 3

If the demand is inelastic, the MR will be negative. Suppose the elasticity of demand
is equal to 0.5, then MR will be;

1
MR = P (1- ) = P (1-2) = P(-1) = -P
0.5

23
 TR, MR and Price Elasticity of Demand

The relationship between total revenue, marginal revenue and price elasticity of
demand can be explained using following diagram.

The upper part of the figure represents total revenue and lower part of the
figure explains the nature of average revenue and marginal revenue. Total revenue
curve initially increases, then reaches maximum and starts declining. Both the
average and marginal revenue curves continuously slops downward from left to right.
Since price is equal to average revenue, the demand curve is the average revenue
curve. Above midpoint of the demand curve it is elastic and below midpoint of the
demand curve it is inelastic. And at the midpoint it is unitary elastic.

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 The figure shows that as long as the demand curve is elastic total revenue curve
is continuously increasing and marginal revenue is positive. That means total revenue
increases as quantity demanded increases. When the elasticity of demand is equal to
unity (e=1), total revenue reaches its maximum and marginal revenue becomes zero.
If the elasticity of demand is less than one (inelastic portion of the demand curve),
total revenue decreases as quantity demanded increases and the marginal revenue
becomes negative. In other words in inelastic portion of the demand curve total
revenue curve slops downward. Thus throughout the elastic portion of the demand
curve, a decline in price is associated with a rise in total revenue and positive marginal
revenue. Throughout the inelastic portion of the demand curve, a decline in price is
associated with a fall in total revenue and negative marginal revenue.

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Use (Importance/ Applications) Price Elasticity of Demand

Price elasticity of demand is the degree of the responsiveness of quantity

demanded of a commodity to change in its price. The concept of price elasticity of
demand has many applications. It is used in business, economics and even in the
policy formulation of the Governments. Following are the various applications of
price elasticity of demand.

1. Price fixation
Price Elasticity of demand plays crucial role in determining the prices of
various commodities or in changing the prices from the existing level. Based
on the elasticity of demand the producer can estimate how price changes affect
the expenditure of the buyer revenue of the producer. Elasticity of demand for
a product is analysed in fixing prices under following conditions.
a. Monopoly Price
A monopolist can fix the price of his commodity in different markets
based on the value of elasticity of demand. If the demand for a product
is elastic in a market, monopolist can fix only lower price for his product
and if it is inelastic in another market, he can fix higher price. Thus
based on the elasticity of demand a producer can follow a discriminatory
price policy in different markets.
b. Prices of Joint Products
Joint products are those products which are produced together. In the
case of joint products it is difficult for the producer to estimate the cost
of producing each product. In such a situation it will be difficult to fix
the prices of each product separately. Thus in this situation price is
fixed on the basis of the Elasticity of demand. Joint product having
inelastic demand is charged higher price and the product having elastic
demand priced at lower level.
c. Price of Public Utilities
Price elasticity of demand concepts also use in determining the price of
public utility services. If the demand for public utility services is less

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 elastic more prices will be charged and if it is elastic lower price will be
charged. For example, the domestic demand for electricity is inelastic
and therefore state electricity boards charges higher prices.
2. Formulation of Government Policies
Another important area where the price elasticity concept can be used is in the
formulation of government policies.
a. Fixation of Tax
In the formulation of various tax policies the governments often take into
consider the elasticity concepts. Government imposes heavy tax on those
commodities whose price elasticity of demand is less than one (that means
inelastic demand). On the other hand, if the commodity upon which the tax
is to be imposed is elastic in demand, then the rate of tax will be much
lower. If the product is inelastic, any change that happens in the price is not
going to affect the demand for that commodity.
b. Protection
Granting protection to the industries by the government is also based on the
concept of price elasticity of demand. If the demand is elastic, the industry
will be unable to face foreign competition. In such case the government can
help the industry to lower its price through subsidies or raise the price of the
products of foreign firms by imposing heavy import duties on them.
c. Public Utilities
The government decision to declare certain industries as public utilities
depends upon the elasticity of demand for their products. Usually those
products whose demand is inelastic should be declared as public utilities
and these industries will be regulated by the government.
d. Formulation of Agricultural Price Policies
The government decision to fix high minimum price to farm products also
depends upon the price elasticity of demand. If the products are inelastic, it
is easy for the government to fix high minimum price for farm products.
By providing the buffer stock facility also, the government can keep part of
the crop off the markets, thereby reducing the supply of commodities

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 reaching in the market. And thus, by regulating the supply, the government
can ensure high minimum price to various farm products.
e.
3. Determination of Wage
The concept of elasticity of demand is also important in the determination of
wage of labourers. If the demand for labour in an industry is elastic, the efforts
of trade union to increase the wage for workers will not be successful. If the
demand for particular type of labour is inelastic, trade union can easily raise
wages.
4. Determining the Incidence of Taxation

The concept of the elasticity of demand, along with that of supply, is

used to determine the shifting and incidence of a tax. When a tax is imposed on
a commodity of inelastic demand, the seller can generally transfer the burden
of the tax upon the consumers by raising the price, and so the incidence of tax
falls upon the buyers. But, in the case of a tax on a commodity with elastic
demand, such a shifting of tax is not an easy task.

5. Export Earnings
The economic policies formulated for the promotion of export also
consider the price elasticity of demand. For example, the attempt of a country
to expand the physical volume of export by lowering their price will succeed
only if the demand for its export is elastic. If the demand for export is inelastic,
export earnings will decline.
6. Correction of Balance of Payment Deficit
Balance of payment deficit occurs mainly due to the excess of outflow of cash
over inflow. One of the important measures that a country can adopt to
overcome the problem of balance of payment deficit is devaluation.
Devaluation is the official reduction in the value of home currency in terms of
foreign currency. Devaluation makes export cheaper and import costlier for a
country adopting it. The success of devaluation in correcting the balance of

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 payment deficit depends upon the price elasticity of demand for export and
import. When a country devalues its currency, there will be an increase in the
export earnings, because the domestic currency becomes much cheaper.
Devaluation increases the export earnings only if the commodities exported are
highly elastic. On the other hand the success of devaluation to reduce the
import expenses also depends upon the price elasticity demand for imported
commodities.
7. Tariff Policy
Tariff is policy followed by the countries to restrict the import of commodities
with the purpose of protecting the domestic industries. Due to the imposition
of tariff imported commodities becomes more expensive and import will be
reduced. The success of tariff policy in restricting the import also depends
upon the price elasticity of demand for imported commodities. If imported
commodities are elastic, import can be restricted and if it is inelastic, tariff
policy will not have any impact on import.

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