In the previous lesson, we discussed the Law of Demand and how changes in denad work. Elasticity of demand measures how sensitive demand is to a change in price, income, or the price of another good. This is a very heavily tested topic in CMA Foundation MCQs — especially the formulas, values, and the total outlay method.
What is Elasticity of Demand?
- Elasticity = degree of responsiveness of demand to a change in its determinants
- It tells us by how much demand changes when price, income, or related good prices change
- There are three types of elasticity of demand
| Type | Measures | Formula |
|---|---|---|
| Price Elasticity (Ep) | Response of demand to change in price | Ep = (dq/q) ÷ (dp/p) |
| Income Elasticity (Ey) | Response of demand to change in income | Ey = (dq/q) ÷ (dy/y) |
| Cross Elasticity (Ec) | Response of demand for X to change in price of Y | Ec = (dqx/qx) ÷ (dpy/py) |
1. Price Elasticity of Demand (Ep)
Ep = Proportionate change in demand ÷ Proportionate change in price
5 Values of Price Elasticity:
| Value | Type | Meaning | Example | Curve |
|---|---|---|---|---|
| Ep = ∞ | Perfectly elastic | Demand changes without any price change | — | Horizontal (parallel to X axis) |
| Ep = 0 | Perfectly inelastic | Price changes but demand stays constant | Salt, life-saving drugs | Vertical (parallel to Y axis) |
| Ep > 1 | Relatively elastic | Small price change → large demand change | Luxury goods | Flatter slope |
| Ep < 1 | Relatively inelastic | Large price change → small demand change | Necessities | Steeper slope |
| Ep = 1 | Unitary elastic | % change in demand = % change in price | Comfort goods | Rectangular hyperbola |
Methods of Measuring Price Elasticity
1. Percentage Method
Ep = % change in quantity demanded ÷ % change in price
- Most straightforward method
- Used when percentage changes are directly given
2. Total Outlay Method (Total Expenditure Method)
Based on the relationship between price change and total spending (Price × Quantity):
| Price change | Total Outlay change | Elasticity |
|---|---|---|
| Price falls → Total outlay rises | OR Price rises → Total outlay falls | Ep > 1 (Elastic) |
| Price changes → Total outlay stays same | Ep = 1 (Unitary) | |
| Price falls → Total outlay falls | OR Price rises → Total outlay rises | Ep < 1 (Inelastic) |
Example table:
| Price | Demand | Total Outlay | Elasticity |
|---|---|---|---|
| 9 | 40 | 360 | — |
| 8 | 50 | 400 | Ep > 1 (outlay rising as price falls) |
| 7 | 60 | 420 | Ep > 1 |
| 6 | 70 | 420 | Ep = 1 (outlay constant) |
| 5 | 80 | 400 | Ep < 1 (outlay falling as price falls) |
| 4 | 90 | 360 | Ep < 1 |
3. Point Method
Used to measure elasticity at a specific point on the demand curve:
Ep = Lower segment ÷ Upper segment
| Point on curve | Ep value |
|---|---|
| Midpoint | Ep = 1 |
| Above midpoint | Ep > 1 |
| Below midpoint | Ep < 1 |
| Top of curve | Ep = ∞ |
| Bottom of curve | Ep = 0 |
4. Arc Method
Used when there are large changes in price and demand (between two points, not at one point):
Ep = [(q2 − q1) ÷ (q1 + q2)] ÷ [(p2 − p1) ÷ (p1 + p2)]
2. Income Elasticity of Demand (Ey)
Ey = Proportionate change in demand ÷ Proportionate change in income
5 Values of Income Elasticity:
| Value | Type | Meaning |
|---|---|---|
| Ey = ∞ | Perfectly elastic | Demand changes without income change |
| Ey = 0 | Perfectly inelastic | Income changes but demand stays same |
| Ey > 1 | Relatively elastic | Small income change → large demand change |
| Ey < 1 | Relatively inelastic | Large income change → small demand change |
| Ey = 1 | Unitary elastic | % change in demand = % change in income |
Important additional rule for income elasticity:
| Good type | Income Elasticity sign |
|---|---|
| Normal / Superior goods | Positive (Ey > 0) |
| Inferior goods | Negative (Ey < 0) |
3. Cross Elasticity of Demand (Ec)
Ec = Proportionate change in demand for X ÷ Proportionate change in price of Y
| Good type | Cross Elasticity sign | Reason |
|---|---|---|
| Substitute goods (tea & coffee) | Positive (Ec > 0) | Price of Y rises → demand for X rises |
| Complementary goods (car & petrol) | Negative (Ec < 0) | Price of Y rises → demand for X falls |
Determinants of Elasticity of Demand
| Determinant | More Elastic | Less Elastic |
|---|---|---|
| Nature of good | Luxury goods | Necessity goods |
| Availability of substitutes | Many substitutes available | No substitutes |
| Variety of uses | Multiple uses (e.g. electricity) | Single use |
| Postponability | Purchase can be postponed | Cannot be postponed (e.g. medicines) |
| Durability | Perishable goods | Durable goods |
Importance of Elasticity of Demand
| Area | How elasticity is used |
|---|---|
| Business pricing | Elastic demand → lower price; Inelastic demand → higher price |
| Monopoly pricing | Higher price in inelastic market; lower price in elastic market |
| Factor pricing | Inelastic factor demand → higher factor price |
| International trade | Inelastic exports → favourable terms of trade |
| Government policy | Helps decide which industries need state control |
Key Concepts to Remember
- Three types: Price elasticity, Income elasticity, Cross elasticity
- Perfectly elastic → horizontal curve; Perfectly inelastic → vertical curve
- Unitary elastic price demand curve is a rectangular hyperbola
- Total outlay method: outlay rises as price falls → elastic; outlay constant → unitary; outlay falls as price falls → inelastic
- Point method: Ep = Lower segment ÷ Upper segment
- Arc method used for large price changes
- Normal goods → positive income elasticity; Inferior goods → negative income elasticity
- Substitute goods → positive cross elasticity; Complementary goods → negative cross elasticity
- Necessities → inelastic; Luxuries → elastic; Comfort goods → unitary elastic
Note to Students: These notes are designed for quick revision and MCQ preparation. For detailed explanation with examples, watch our YouTube video lessons. Use these notes alongside practice questions and the full PDF for complete exam preparation.
Practice MCQs for Lesson 1.3 Part 2
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Download the Full Practice PDF for more questions, better exam-level practice, and to avoid common mistakes. (This also supports the creation of more free tests like this.)
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