Elasticity of Demand

A chai stall raises the price of a cup from ₹10 to ₹12. Will it take in more money, or less? That depends on how many customers walk away, and elasticity is the number that answers it.

If a small change brings a large change in quantity, demand is elastic. If a large change brings only a small change, it is inelastic. There are three measures, one for each kind of change.

Back to the chai stall. At ₹10 it sells 200 cups a day and takes ₹2,000. At ₹12, a 20% rise, two things could happen:

• Sales fall to 150 cups, a 25% fall. PED = −25 ÷ 20 = −1.25, elastic. Takings fall to ₹1,800.
• Sales fall to 180 cups, a 10% fall. PED = −10 ÷ 20 = −0.5, inelastic. Takings rise to ₹2,160.

Don't confuse elasticity with slope. Slope compares raw changes, such as cups per rupee. Elasticity compares percentages. Along a straight-line demand curve the slope is the same everywhere, but elasticity is high at high prices and low at low prices.

Elastic: buyers react more than the price moved. Inelastic: they react less.

Measure the same price change from two ends and you can get two different answers. The four methods below exist to settle which number to use.

1. Proportionate (percentage) method. It measures from the starting price and quantity.

It is simple, but the answer depends on the direction of the change. For the chai stall, ₹10 to ₹12 with sales falling from 200 to 150 gives −1.25. The reverse move, ₹12 to ₹10 with sales rising from 150 to 200, gives −2.

2. Point method. At a point on a straight-line demand curve, elasticity equals the lower segment ÷ upper segment of the line, measured from that point to the two axes. It is 1 at the midpoint, infinite where the line meets the price axis, and 0 where it meets the quantity axis. Use it when you have a demand line and want the elasticity at one price.

3. Arc (midpoint) method, for a stretch of the curve between two points:

Averages make the answer the same in both directions. For the chai stall: (−50 ÷ 175) ÷ (2 ÷ 11) = −0.286 ÷ 0.182 = −1.57, whichever way the price moved.

4. Total outlay (expenditure) method, Alfred Marshall's: watch what happens to total spending, P × Q, when price changes. A kirana store sells 100 packets of biscuits a day at ₹20, taking ₹2,000. At ₹18 it sells 130 and takes ₹2,340. Spending rose as the price fell, so demand is elastic.

Where it breaks. The total outlay method shows only whether demand is elastic, unitary or inelastic, not the exact value. The point method assumes a straight line, which real demand rarely is.

For exams. Expect an arc calculation with numbers, and the total outlay table as a reasoning question. A unitary demand curve is a rectangular hyperbola, since spending stays the same at every price.

Real goods sit between two extremes that almost never occur. Knowing the five reference points makes everything in between easy to place.

Don't read elasticity from steepness alone. Comparing two curves, flatter means more elastic only at the same price and quantity. Along one straight line, elasticity changes from point to point.

Flat is elastic. Steep is inelastic.

A rise in the price of salt barely changes how much people buy. A small discount on one phone brand can move its sales sharply. Five things explain the difference.

• Substitutes: the more close substitutes, the more elastic the demand. One brand of tea has many; tea as a whole has few. So demand for a single brand is far more elastic than for the category.
• Nature of the good: necessities are inelastic, luxuries elastic (salt and insulin against a foreign holiday).
• Share of income: things that take a big share of a budget are more elastic than small purchases (a two-wheeler against a box of matches).
• Time: demand grows more elastic over time, as people adjust. When petrol prices rise, people still commute next week; over some years, some switch to CNG, electric vehicles or the metro.
• Durability: a durable purchase can be put off, so demand is more elastic (a refrigerator against bread).

Other factors: goods with many uses, such as electricity, have more elastic demand; purchases that can be postponed are more elastic than urgent ones such as medicines; habit makes demand inelastic, as with tobacco; and richer buyers react less to a given price change.

Where it breaks. The factors can pull in opposite directions. Petrol is a necessity with few substitutes in the short run, yet it takes a large share of a commuter's budget. Only data shows which wins.

A firm raises its price and sales fall. Was that a mistake? Elasticity turns the question into arithmetic.

Pricing. With elastic demand, a price cut raises revenue. With inelastic demand, a price rise raises revenue. For the chai stall that keeps 180 of its 200 customers at ₹12, the rise pays; if only 150 stay, it does not.

Taxation. Governments raise more revenue by taxing goods with inelastic demand, because sales fall little. That is one reason tobacco products in India are taxed at the highest GST rates.

Cross elasticity guides bundling of complements (a printer and its ink), analysis of competition from substitutes, and revenue forecasts when a competitor changes its price. For two perfect substitutes the cross elasticity tends to infinity. Income elasticity supports market segmentation and shows which products will grow as incomes rise.

Where it breaks. Elasticity is measured at one time, at one price, with other things held equal. Competitors may follow a price change, tastes shift, and a short-run elasticity can mislead a long-run decision.

In practice. Firms estimate elasticity from past promotions, price tests in a few markets, and surveys. Online sellers can test two prices on similar customers at the same time.