ELASTICITY OF DEMAND

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.

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.

Kinds of Elasticities of Demand

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

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.

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

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

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

Perfectly elastic demand

y P R I D Perfectly elastic demand curve

C
E

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.

Relatively elastic demand

y P R I C E D D Relatively elastic demand curve

demand

When the proportionate change in demand is more than the proportionate changes in price, it is known as relatively elastic demand.

Elasticity of demand equal to unity

y P R I C E Elasticity of demand equal to unity curve D

D
0 x

demand

When the proportionate change in demand is equal to proportionate changes in price, it is known as unitary elastic demand

Relatively inelastic demand

Y

D
P R

Relatively inelastic demand curve

I
C E

When the proportionate change in demand is less than the proportionate changes in price, it is known as relatively inelastic demand

D
O X demand

Perfectly inelastic demand

Y D P R

I
C E

When a change in price, howsover Perfectly inelastic large, change no demand curve changes in quality demand, it is known as perfectly inelastic demand

D demand

ALL KINDS OF DEMAND CAN BE SHOWN IN ONE DIAGRAM AS FOLLOW

Y P R D

I
C E D4 0 D5 DEMAND X D3

D1
D2

WHERE D1) Perfectly elastic demand D2)Relatively elastic demand D3)Elasticity of demand equal to unity D4)Relatively inelastic demand D5)Perfectly inelastic demand

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

Percentage method or proportionate method

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:

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 .

Price Elasticity of Demand (Ed) Ed = 1 Ed >1 Rises

P Rises or falls

TE No change Decreases

Falls
Ed < 1 Rises

Increases
Increases

Falls

Decreases

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) 12 16 Total Expenditure (Rs.) 96 112

8 7

Since, total expenditure increases with fall in price, elasticity of demand is greater than unity. It is a situation of elastic demand.

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

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.

The arc elasticity formula is used if the change in price is relatively large. It is more accurate a measure of elasticity than simple ''price elasticity''. If the arc or price elasticity of demand is greater than 1, demand is said to be elastic. The demand curve has a ''flat'' appearance. If the arc or price elasticity of demand is less than 1, demand is said to be inelastic. The demand curve has a ''steep'' appearance.

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

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

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

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.

Income Elasticity Of Demand

Types Of Income Elasticity Of Demand

Positive Income elasticity of demand Negative Income elasticity of demand Zero Income elasticity of demand

Positive Income elasticity of demand

Y
D

P A Income D

B S Quantity Demanded

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

Negative Income elasticity of demand

Price P

Total Revenue
B S

Quantity Demanded (000s)

ZeroY Income elasticity of demand

D

Income
O

D Quantity Demanded

All Income Graphs Representation

Y F

E
Income C B A D

Quantity Demanded

Measurement Of Income Elasticity Of Demand

Proportionate change in Demand Income Elasticity Of Demand = Proportionate change in Income

i.e. q Income Elasticity Of Demand = Q

y Y

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

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.

Factors Affecting Income Of Demand

Income Itself Only.
Price Of the Commodity

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 the help of IED

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.

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

Measurement Cross Elasticity of Demand

Proportionate change in Demand for product X
Cross Elasticity of Demand = Proportionate change in Price of product Y p y

i.e.

Cross Elasticity of Demand = qx Qx

Py

Cross Elasticity of Demand For Y Substitutes D

Price of Y

D O X

Demand for X

Cross Elasticity of Demand For Complementary Products Y

D

Price of Y

D O Demand for X X

Cross Elasticity of Demand For Neutral Products Y

D Price of Y O

Demand for X

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

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 .

Advertising Elasticity of Demand

Proportionate change in Demand for product
Advertising Elasticity of Demand = Proportionate change in Advertising expenditure

i.e.

Advertising Elasticity of Demand =

qx

Relationship Between Advertising Expenditure and Sales Y

S Sales S

Advertising Expenditure

Factors Affecting Advertising Elasticity Of Demand

The stage of the Products Market

Development . Reaction of market Rival Firms. Cumulative Effect of Past Advertisement. Influence of Other Factors.

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.

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.

Elasticity of Supply

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)

Elasticity of Supply

1.

2. 3.

A suppliers responsiveness Elasticity of Supplyto a price change is called _________________ (think like a supplier/seller) 3 Factors that will determine a products elasticity Availability of resources required to make the product Amount of time required to make the product Skill level of the worker needed to make the product

Elastic Supply

1. 2. 3.

A product has elastic supply when a price 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

Slope of an Elastic supply curve

changes a lot. This creates a flatter curve.
P

Remember, if the price changes, the quantity supplied

P2 P1

Q1

Q2

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

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