BBA-I & BCCA-II;BusinessEconomics_ElasticityofDemand

Elasticity of Demand:

Introduction:

Elasticity is a common concept that economists, Business people and others rely upon for the measurement between two variables say for example the ratio of percentage change in quantity demanded to percentage change in some other factor like Price or Income.

The concept of price-elasticity of demand was first of all introduced in economics  by Dr. Marshall. In simple words, price elasticity of demand is the ratio of percentage change in quantity demanded to the percentage change in price. In other words, price elasticity of demand is a measure of the relative change in quantity purchased of a good in response to a relative change in its price. It is, thus a rate at which the demand changes to the given change in prices. So, it means the rate or the degree of response in demand to the change in price. Thus, the co-efficient of price-elasticity of demand can be expressed as under:

Definitions of Price Elasticity of Demand:

The concept of price elasticity of demand has been defined by different economists as

under :

According to Alfred Marshall: "Elasticity of demand may be defined as the percentage change in quantity demanded to the percentage change in price."

According to A.K. Cairncross : "The elasticity of demand for a commodity is the rate at which quantity bought changes as the price changes."

According to J.M. Keynes : "The elasticity of demand is a measure of the relative change in quantity to a relative change in price."

According to Kenneth Boulding : "Elasticity of demand measures the responsiveness of demand to changes in price."

DEGREES OF PRICE ELASTICITY:

Different commodities have different price elasticities. Some commodities have more elastic demand while others have relative elastic demand. Basically, the price elasticity of demand ranges from zero to infinity. It can be equal to zero, less than one, greater than one and equal to unity.

According to Dr. Marshall : "The elasticity or reponsiveness of demand in a market is great or small according as the amount demanded increases much or little for a given fall in price and diminishes much or little for a given rise in price."

However, some particular values of elasticity of demand have been explained as under ;

1. Perfectly Elastic Demand:

Perfectly elastic demand is said to happen when a little change in price leads to an infinite change in quantity demanded. A small rise in price on the part of the seller reduces the demand to zero. In such a case the shape of the demand curve will be horizontal straight line as shown in figure:

The figure shows that at the ruling price OP, the demand is infinite. A slight rise in price will contract the demand to zero. A slight fall in price will attract more consumers but the elasticity of demand will remain infinite. But in real world, the cases of perfectly elastic demand are exceedingly rare and are not of any practical interest.

1. Perfectly inelastic Demand:

Perfectly inelastic demand is opposite to perfectly elastic demand. Under the perfectly inelastic demand, irrespective of any rise or fall in price of a commodity, the quantity demanded remains the same. The elasticity of demand in this case will be equal to zero.In diagram, DD shows the perfectly inelastic demand. At price OP, the quantity demanded is OQ. Now, the price falls to OP, from OP1, demand remains the same. Similarly, if the price rises to OP2 the demand still remains the same. But just as we do not see the example of perfectly elastic demand in the real world, in the same fashion it is diffcult to come across the cases of perfectly inelastic demand because even the demand for bare essentials of life does show some degree of responsiveness to change in price.

1. Unitary Elastic Demand. The demand is said to be unitary elastic when a given proportionate change in the price level brings about an equal proportionate change in quantity demanded, The numerical value of unitary elastic demand is exactly one i.e., ed = 1. Marshall calls it unit elastic.
   
   
   In figure, DD demand curve represents unitary elastic demand. This demand curve is called rectangular hyperbola. When price is OP, the quantity demanded is OQ1.
   
   
   Now price falls to OP1, the quantity demanded increases to OQ1. The shaded area in the fig. equal in terms of price and quantity demanded denotes that in all cases price elasticity of demand is equal to one.

4. Relatively Elastic Demand:
Relatively elastic demand refers to a situation in which a small change in price leads to a big change in quantity demanded. In such a case elasticity of demand is said to  be more than one. This has been shown in figure.
In fig, DD is the demand curve which indicates that when price is OP the quantity demanded is OQ1, Now the price falls from OP to OP1, the quantity demanded increases from OQ1 to OQ2 i.e. quantity demanded changes more than the change in price.

1. Relatively Inelastic Demand.

Under the relatively inelastic demand a given percentage change in price produces a relatively less percentage change in quantity demanded. In such a case elasticity of demand is said to be less than one as shown in figure.

All the five degrees of elasticity of demand have been shown in figure. On OX axis, quantity demanded and on OY axis price is given. It shows:

1.  AB---Perfectly Inelastic Demand

2. CD — Perfectly Elastic Demand

3. EQ — Less Than Unitary Elastic Demand

4. EF — Greater Than Unitary Elastic Demand

5. MN — Unitary Elastic Demand

FACTORS DETERMINING PRICE ELASTICITY OF DEMAND:

The factors that determine elasticity of demand are numberless. But the most important among them are the nature, uses and prices of related goods and the level of income. They are stated below:

I. Nature of the commodity: Generally, all commodities can be dividend into three

categories i.e.

(i) Necessaries of Life. For necessaries of life the demand is inelastic because people buy the required amount of goods whatever their price. For example, necessaries such as rice, salt, cloth are purchased whether they are dear or cheap.

(ii) Conventional Necessaries. The demand for conventional necessaries is less elastic or inelastic. People are accustomed to the use of goods like intoxicants which they purchase at any price. For example, drunkards consider opium and wine almost as a necessity as food and water. Therefore, they buy the same amount even when their prices are higher and highest.

(iii) Luxury Commodities. The demand for luxury is usually elastic as people buy more of them at a lower price and less at a higher price. For example, the demand of luxuries like silk, perfumes and ornaments increases at a lower price and diminishes at a higher price. Here, we must keep in mind that luxury is a relative term, which varies from person to person, place to place and from time to time. For example, what is a luxury to a poor man is a necessity to the rich. The luxury of the past may become a necessity of today. Similarly a commodity which is a necessity to one class may be a luxury to another. Hence, the elasticity of demand in such cases should have to be carefully expressed.
2. Substitutes. Demand is elastic for those goods which have substitutes and inelastic for those goods which have no substitutes. The availability of substitutes, thus, determines the elasticity of demand. For instance, tea and coffee are substitutes. The change in the price of tea affects the demand for coffee. Hence, the demand for coffee and tea is elastic.

3. Number of Uses. Elasticity of demand for any commodity depends on its number of uses. Demand is elastic; if a commodity has more uses and inelastic if it has only one use. As coal has multiple uses, if its price falls it will be demanded more for cooking, heating, industrial purposes etc. But if its price rises, minimum will be demanded for every

purpose.

4. Postponement. Demand is more elastic for goods the use of which can be postponed.

 silk is, therefore, elastic. Demand is inelastic for those goods the use of which is urgent and, therefore, cannot be postponed. The use of medicines cannot be put off. Hence, the demand for medicines is inelastic.

5. Raw Materials and Finished Goods. The demand for raw materials is inelastic but the demand for finished goods is elastic. For instance, raw cotton has inelastic demand but cloth has elastic demand. In the same way, petrol has inelastic demand but car itself has only elastic demand.

6. Price Level. The demand is elastic for moderate prices but inelastic for lower and higher prices. The rich and the poor do not bother about the prices of the goods that they buy. For example, rich buy Benaras silk and diamonds etc. at any price. But the poor buy coarse rice, cloth etc. whatever their prices are.

7. Income Level. The demand is inelastic for higher and lower income groups and elastic for middle income groups. The rich people with their higher income do not bother about the price. They may continue to buy the same amount whatever the price. The poor people with lower incomes buy always only the minimum requirements and, therefore, they are induced neither to buy more at a lower price nor less at a higher price. The middle income group is sensitive to the change in price. Thus, they buy more at a lower price and less at higher price.

8. Habits. If consumers are habituated of some commodities, the demand for such commodities will be usually inelastic. It is because that the consumer will use them even

their prices go up. For example, a smoker does not smoke less when the price of cigarette goes up.

9. Nature of Expenditure. The elasticity of demand for a commodity also depends as to how much part of the income is spent on that particular commodity. The demand for such commodities where a small part of income is spent is generally highly inelastic i.e. newspaper, boot-polish etc. On the other hand, the demand of such commodities where a significant part of income is spent, elasticity of demand is very elastic.

10. Distribution of Income. If the income is uniformly distributed in the society, a small change in price will affect the demand of the whole society and the demand will be elastic. In case of unequal distribution of income and wealth, a change in price will hardly influence the poor section of the society and the demand will be relatively inelastic.

11. Influence of Diminishing Marginal Utility. We know that utility falls when we consume more and more units but not in a uniform way. In case utility falls rapidly, it means that the consumer has no other near substitutes. As a result, demand is inelastic. Conversely, if the utility falls slowly, demand for such commodity would be elastic and raises much for a fall in price.

MEASUREMENT OF PRICE ELASTICITY OF DEMAND

There are five methods to measure the price elasticity of demand.

1. Total Expenditure Method.

2. Proportionate Method.

3. Point Elasticity of Demand.

4. Arc Elasticity of Demand.

5. Revenue Method.

Total Expenditure Method

Dr. Marshall has evolved the total expenditure method to measure the price elasticity of demand. According to this method, elasticity of demand can be measured by considering the change in price and the subsequent change in the total quantity of goods purchased and the total amount of money spend on it.

Total Outlay = Price x Quantity Demanded.

There are three possibilities:

(i) If with a fall in price (demand increases) the total expenditure increases or with a rise

in price (demand falls) the total expenditure falls, in that case the elasticity of demand is

greater than one i.e. (Ed >1.)

(ii) If with a rise or fall in the price (demand falls or rises respectively), the total

expenditure remains the same, the demand will be unitary elastic i.e. (Ed = 1).

(iii) with a fall in price (Demand rises), the total expenditure also falls, and with a rise in

price (Demand falls) the total expenditure also rises, the demand is said to be less elastic

or elasticity of demand is less than one i.e. (Ed <1).

Table Representation: The method of total expenditure has been explained with the help

of Table:

1. More Elastic Demand. When price is Rs. 10 the quantity demanded is 1 unit and total expenditure is 10. Now price falls from Rs. 10 to Rs. 6, the quantity demanded increases from 1 to 5 units and correspondingly the total expenditure increases from Rs. 10 to Rs. 30. Thus it is clear that with the fall in price, the total expenditure increases and viceversa.

So elasticity of demand is greater than one or Ed > 1.

2.Unitary Elastic Demand. If price is Rs. 6, demand is 5 units so the total outlay is Rs. 30. Now price falls to Rs. 5, the demand increases to 6 units but the total expenditure remains the same i.e., Rs. 30. Thus it is clear that with the rise or fall in price, the total expenditure remains the same. The elasticity of demand in this case is equal to one or Ed = 1.

3.Less Elastic Demand. If price is Rs. 5, demand is 6 and total outlay is Rs. 30. Now price falls from Rs. 5 to Re. 1. The demand increases from 6 units to 10 units and hence the total expenditure falls from Rs. 30 to Rs. 10. Thus it is clear that with the fall in price, the total expenditure also falls and vice-versa. In this case, the elasticity of demand is less.

Diagrammatic Representation:

Measurement of price elasticity through total expenditure method can be shown with the help of fig.In the figure total expenditure has been shown on X-axis and price on Y-axis.

Line TT' is the total expenditure line. When price of the commodity falls from OP to OP1 total expenditure increases from OM1 to OM2. The elasticity of demand is greater than one as is shown in TB portion of the figure. Now, suppose that the price of the commodity decreases from OP1 to OP3 the total expenditure falls from OM2 to OM. This is shown in T'C part of the figure which represents the less than unity elasticity of demand. In the same way, BC part of the figure represents the unit elasticity of demand. Thus it is clear that the changes in total expenditure due to changes in price also affect the elasticity of demand.

Proportionate Method

This method is also associated with the name of Dr. Marshall. According to this method, "price elasticity of demand is the ratio of percentage change in the amount demanded to the percentage change in price of the commodity." It is also known as the Percentage Method, Flux Method, Ratio Method, and Arithmetic Method.

Arc Elasticity of Demand:

According to Prof. Baumol: "Arc elasticity is a measure of the average responsiveness to price change exhibited by a demand curve over some finite stretch of the curve".

According to Watson: "Arc elasticity is the elasticity at the mid-point of an are of a demand curve."

According to Leftwitch : "When elasticity is computed between two separate points on a demand curve, the concept is called Are elasticity." This method of measuring elasticity of demand is also known as

Where

Q1 = Original quantity demanded

Q2 = New quantity demanded

P1 = Original price

P2 = New price

This can be shown with the help of a diagram

In figure quantity is measured on X-axis while price on Y- axis. DD is the

demand curve. Now if we want to measure the arc elasticity between A and B on the

demand curve DD, we will have to take the average of prices OPl and OP2 as well as of

quantities; Q1 and Q2.

Revenue Method

Mrs. Joan Robinson has given this method. She says that elasticity of demand can be measured with the help of average revenue and marginal revenue. Therefore, a sale proceeds that a firm obtains by selling its products is called its revenue. However, when total revenue is divided by the number of units sold, we get average revenue. On the contrary, when addition is made to the total revenue by the sale of one more unit of the commodity is called marginal revenue. Therefore, the formula to measure elasticity of demand can be written as,

where Ed represents elasticity of demand, A = average revenue and M = marginal

revenue. This method can be explained with the help of diagram.

In this diagram revenue has been shown on OY-axis while quantity of goods on OXaxis.

AB is the average revenue or demand curve and AN is the marginal revenue curve.

At point P on demand curve, elasticity of demand is calculated with the formula,

In this way, if value of Ep is one it means that price elasticity of demand is unitary. Similarly, if it is more than one, price elasticity of demand is greater than one and if it is less than one, price elasticity of demand is less than unity.

INCOME ELASTICITY OF DEMAND

According to Stonier and Hague: "Income elasticity of demand shows the way in which a consumer's purchase of any good changes as a result of change in his income."

It shows the responsiveness of a consumer's purchase of a particular commodity to a change in his income. Income elasticity of demand means the ratio of percentage change in the quantity demanded to the percentage change in income. In brief income elasticity.

Degrees of Income Elasticity of Demand:

Positive income elasticity of Demand : Positive income elasticity of demand is said to occur when with the increase in the income of the consumer, his demand for goods and services also increases and vice-versa. Income elasticity of demand is positive in case of normal goods.

In fig, quantity of commodity T has been measured on X-axis and income of the consumer on Y-axis. DD is the positive income elasticity of demand curve. It slopes upward from left to right indicating that increase in income is accompanied by increase in demand of goods and services and vice-versa.

1.Income Elasticity is Unity. The change in demand is proportionate to the change in income. For example

2. Income Elasticity Greater than One. When the change in demand is more than

proportionate change in income, income elasticity of demand is greater than one or unity.

For example,

3. Income Elasticity Less than One. If change in demand is less than proportionate

change in income, income elasticity of demand is less than one or unity. For example.

(ii) Negative Income Elasticity of Demand: Negative income elasticity of demand is said to occur when increase in the income of the consumers is accompanied by fall in demand of goods and services and vice-versa. It is the case of giffen goods. In fig when income of the consumer is 01, demand for goods and services is OX. Now as the income I1 increases to I1 quantity demanded falls o to OX1. Again as the income increases to I2, quantity demanded falls to OX2. DD is the negative income elasticity of demand curve.

(iii) Zero Income Elasticity of Demand: Zero income elasticity of demand is said to exist when increase or decrease in income has no impact on the demand of goods and services.

In fig. initially when income is OI, quantity demanded is OD. Now, income increases to OI2 demand Remains constant i.e. OD. Even when income reduces to 01 , quantity demanded remains OD Generally, as income increases demand for goods increases. But in some cases, demand may not change to change in income or demand may diminish for an increase in income. The former case represents zero income elasticity. Income elasticity is zero if a change in income fails to produce any change in demand. Income elasticity is negative, if an increase in income leads to a reduction of demand. This happens only in the case of inferior goods. But in all other cases it is positive.

In short income elasticity is greater than one for luxuries but less than one for necessaries.

CROSS ELASTICITY OF DEMAND:

It is the ratio of proportionate change in the quantity demanded of Y to a given proportionate change in the price of the related commodity X. It is a measure of relative change in the quantity demanded of a commodity due to a change in the price of its substitute complement.

It can be expressed as:

Cross elasticity may be infinite or zero. It is infinite if the slightest change in the price of X causes a substantial change in the quantity demanded of Y. It is always the case with goods which have perfect substitutes for one another.

Cross elasticity is zero, if a change in the price of one commodity will not affect the quantity demanded of the other. In the case of goods which are not related to each other, cross elasticity of demand is zero.

Types of Cross Elasticity of Demand:

1.Positive : When goods are substitute of each other than cross elasticity of demanded is positive. In other words, when an increase in the price of Y leads to an increase in the demand of X. For instance with the increase in price of a tea, demand of coffee will increase. In fig Quantity has been measured on OX axis and price on OY axis. At price OP of Y commodity, demand of X – commodity is OM. Now as price Of Y commodity increase to OP1 demand of X-commodity increases to OM1. Thus, cross, elasticity of demand is positive.

2. Negative: In case of complementary goods, cross elasticity of demand is negative. A proportionate increase in price of one commodity leads to a proportionate fall in the demand, of .another commodity because both are demanded jointly In fig.quantity has been measured on OX-axis while price has been measured on OY-axis. When the price of commodity increases from OP to OP1 quantity demanded falls from OM to OM1 Thus, cross elasticity of demand is negative.

3. Zero: Cross elasticity of demand is zero when two goods are related to each other. For instance, increase in price of car does not affect the demand of cloth. Thus, cross elasticity of demand is zero. It has been shown in fig.

Therefore, it can be concluded that cross elasticity depends upon Sustainability is perfect, cross elasticity is infinite; if on the other hand, sustainability does not exist, cross elasticity is zero. In the case of complementary goods like jointly demanded goods cross elasticity is negative. A rise in the price of one commodity X will mean not only decrease in the quantity of X but also decrease in the quantity demanded of Y because both are demanded together.

Limitations of Cross Elasticity of Demand:

The cross elasticity of demand is a useful measure of price-demand relationships between

commodities. But this concept has following two limitations.

1. Negative Cross Elasticity does not always mean complementary.

2. Cross Elasticity of Demand is only a one-way Relationship.

IMPORTANCE OF ELASTICITY OF DEMAND:

The concept of elasticity of demand is of great importance in practical life. Its

main points are given as under:

1. Useful for Business: It enables the business in general and the monopolists in particular to fix the price. Studying the nature of demand the monopolist fixes higher prices for those goods which have inelastic demand and lower prices for goods which have elastic demand. In this way, this helps him to maximise his profit.

2. Fixation of Prices: It is very useful to fix the price of jointly supplied goods. In the case of joint products like paddy and straw, the cost of production of each is not known. The price of each is then fixed by its elastic and inelastic demand.

3. Helpful to Finance Minister: It helps the Finance Minister to levy tax on goods. After levying taxes more and more on goods which have inelastic demand, the Government collects more revenue from the people without causing them inconvenience. Moreover, it is also useful for the planning.

4. Fixation of Wages: It guides the producers to fix wages for labourers. They fix high or low wages according to the elastic or inelastic demand for the labour.

5. In the Sphere of International Trade: It is of greater significance in the sphere of international trade. It helps to calculate the terms of trade and the consequent gain from foreign trade. If the demand for home product is inelastic, the terms of trade will be profitable to the home country.

6. Paradox of Poverty. It explains the paradox of poverty in the midst of plenty. A bumper crop instead of bringing prosperity may result in disaster, if the demand for it is inelastic. This is specially so, if the products are perishable and not storable.

7. Significant for Government Economic Policies. The knowledge of elasticity of demand is very important for the government in such matters as controlling of business cycles, removing inflationary and deflationary gaps in the economy. Similarly, for price stabilization and the purchase and sale of stocks, information about elasticity of demand is most useful.

8. Determination of Price of Public Utilities. This concept is significant in the determination of the prices of public utility services. Economic welfare of the society largely depends upon the cheap availability.