Elasticity of Demand

Elasticity of Demand

Elasticity is a standard measure of the degree of responsiveness (or sensitivity) of one variable to changes in another variable. Elasticity of Demand measures the degree of responsiveness of demand for a commodity to a given change in any of the independent variables that influence demand for that commodity, such as price of the commodity, price of the other commodities, income, taste, preferences of the consumer and other factors. Responsiveness implies the proportion by which the quantity demanded of a commodity changes, in response to a given change in any of its determinants .

Elasticity of Demand

Four major types of elasticity:

Price

elasticity,

Income
Cross

elasticity,
(or promotional) elasticity.

elasticity

Advertising

Price Elasticity of Demand

Price is most important among all the independent variables that affect the demand for any commodity.

Hence Price elasticity of demand ( ep or e) is considered to be the most important of all types of elasticity of demand.

Price elasticity of demand means the sensitivity of quantity demanded of a commodity to a given change in its own price.

Degrees of Price Elasticity

Perfectly elastic demand ep= (in absolute terms). Unlimited quantities of the commodity can be sold at the prevailing price A negligible increase in price would result in zero quantity demanded Horizontal demand curve Perfectly inelastic demand The other extreme of the elasticity range ep=0 (in absolute terms) Quantity demanded of a commodity remains the same, irrespective of any change in the price Such goods are termed neutral Vertical demand curve
Price

Q
1

Q
1

Quanti ty

D Pric e
P1 P
2

Q
1

Quanti ty

Degrees of Price Elasticity

Highly elastic demand

Price
P1 P2

Proportionate change in quantity demanded is more than a given change in price ep >1 (in absolute terms) Such goods are called luxuries Proportionate change in price brings about an equal proportionate change in quantity demanded ep =1 (in absolute terms). Demand curves are shaped like a rectangular hyperbola, asymptotic to the axes Proportionate change in quantity demanded is less than a proportionate change in price ep <1 (in absolute terms) Such goods are called necessities

Unitary elastic demand

O
Price P1 P2 D

Q1

Q2

Quantity

D O Q1 Q2 D P1 P2 Quantity

Relatively inelastic demand

Price

Q1 Q2

Quantity

Methods of Measuring Elasticity

Ratio (or Percentage) Method

The most popular method used to measure elasticity Elasticity of demand is expressed as the ratio of proportionate change in quantity demanded and proportionate change in the price of the commodity It allows comparison of changes in two qualitatively different variables

It helps in deciding how big a change in price or quantity is

Proportion ate change in quantity demanded of commodity X Proportion ate change in price of commodity X
Q2 Q1 / Q1 P2 P1 / P1

ep =

ep=

where Q1= original quantity demanded, Q2= new quantity demanded, P1= original price level, P2= new price level

Methods of Measuring Elasticity

Contd

Point Elasticity Method

Elasticity measured at a point of demand curve is referred as point elasticity of demand.

For nonlinear demand curve we need to apply calculus to calculate point elasticity. As changes in price become smaller and approach zero, the ratio Q becomes equivalent to the first order P dQ derivative of the demand function with respect to price dP Point elasticity can be expressed as:
ep
=

dQ / Q dP / P

dQ . dP

P Q

Methods of Measuring Elasticity

Contd

Arc Elasticity Method

Used

when the available figures on price and quantity are discrete, and it is possible to isolate and calculate the incremental changes. It is used to find the elasticity at the midpoint of an arc between any two points on a demand curve, by taking the average of the prices and quantities. This method finds wider applications, as it reflects a movement along a portion (arc) of a demand curve
ep =
Q2 Q1 (Q1 Q2 ) / 2

P2 P1 ( P1 P2 ) / 2

Q2 Q1 Q1 Q2

P P2 1 P2 P 1

Methods of Measuring Elasticity

Contd

Total Outlay Method (Marshall)

Elasticity is measured by comparing expenditure levels before and after any change in price, i.e. whether the new expenditure is more than, or less than, or equal to the initial expenditure level. Helps a seller in taking a decision to raise price only if: Reduction in quantity demanded does not reduce total revenue or Reduction in price increases the quantity demanded to the extent that total revenue also increases.

Degrees

When demand is elastic, a decrease in price will result in an increase in the revenue (sales). When demand is inelastic, a decrease in price will result in a decrease in the revenue (sales). When demand is unit-elastic, an increase (or a decrease) in price will not change the revenue (sales)

Determinants of Price Elasticity of Demand

Nature of commodity
Necessities

are relatively price luxuries are relatively price elastic

inelastic,

while

Availability and proximity of substitutes

Price

elasticity of demand of a brand of a product would be quite high, given availability of other substitute brands a commodity can be put to more than one use, it would be relatively price elastic

Alternative uses of the commodity

If

Determinants of Price Elasticity of Demand

Proportion of income spent on the commodity

The greater the proportion of income spent on a commodity, the more sensitive would the commodity be to price Reason is income effect Demand for any commodity is more price elastic in the long run Perishable commodities like eatables are relatively price inelastic in comparison to durable items Items of intoxication and addiction are relatively price inelastic

Time

Durability of the commodity

Items of addiction

Revenue and Price Elasticity of Demand

For relatively inelastic demand, a change in price would have a greater effect on revenue than a change in quantity demanded AR is same as the price of the product
Demand

curve is also the AR curve of the firm.

Marginal Revenue is the revenue a firm gains in producing one additional unit of a commodity

Revenue and Price Elasticity of Demand

Till ep>1 MR is positive and TR is rising At the midpoint of the demand curve, ep=1 and MR is equal to 0 and TR is at its peak When ep<1, MR is negative MR= AR[1- ep]

Price, Revenue ep= ep>1 ep=1 ep<1 O Price, Revenue MR ep=0 Quantity

TR

Quantity

Income Elasticity of Demand (ey)

ey measures the degree of responsiveness of demand for a good to a given change in income, ceteris paribus.

ey =

Proportion ate change in quantity demanded of commodity X Proportion ate change in income of consumer

Degrees:

Positive income elasticity Demand rises as income rises and vice versa Normal good Negative income elasticity Demand falls as income rises and vice versa Inferior good

Cross Elasticity of Demand

ec measures the responsiveness of demand of one good to changes in the price of a related good

Proportion ate change in quantity demanded of commodity X ec = Proportion ate change in price of commodity Y

Degrees Negative Cross Elasticity

Complementary goods

Positive

Cross Elasticity

Substitute goods

Promotional Elasticity of Demand

Advertising (or promotional) elasticity of demand (ea) measures the effect of incurring an expenditure on advertising, vis--vis an increase in demand, ceteris paribus. Some goods (like consumer goods) are more responsive to advertising than others (like heavy capital equipments).

ea =

Proportion ate change in quantity demanded (or sales) of commodity X Proportion ate change in advertising expenditur e

Degrees ea>1 Firm should go for heavy expenditure on advertisement. ea <1 Firm should not spend too much on advertisement

Importance of Elasticity

Determination of price

Elasticity is the basis of determining the price of a product keeping its possible effects on the demand of the product in perspective Products having elastic demand may be sold at lower price, while those having inelastic demand may be sold at high prices

Basis of price discrimination

Determination of rewards of factors of production

Factors having inelastic demand are rewarded more than factors that have relatively elastic demand.
Goods having relatively elastic demand are taxed less than those having relatively inelastic demand.

Government policies of taxation

Summary
Elasticity of demand measures the degree of responsiveness of the

quantity demanded of a commodity to a given change in any of the independent variables that influence demand for that commodity. Price elasticity of demand (ep) measures the degree of responsiveness of the quantity demanded of a commodity to a given change in its price, other things remaining the same. By the percentage method ep is expressed as the ratio of proportionate change in quantity demanded and proportionate change in price of the commodity. As per the total outlay method elasticity is measured by comparing expenditure levels before and after any change in price, i.e. whether the new expenditure is more than, or less than, or equal to the initial expenditure level. Arc elasticity is used to calculate price elasticity of demand at the midpoint of an arc between any two points on the demand curve, by taking the average of the prices and quantities; point elasticity can be approximated by calculating the arc elasticity for a very small arc on the demand curve.

Summary

If the demand curve is a straight line, price elasticity of demand at different points of the demand curve can be calculated by the ratio of the lower segment and upper segment of the demand curve. MR= AR[1- ep] Income elasticity of demand (ey) measures the degree of responsiveness of the quantity demanded of a commodity to a given change in consumers income. For normal goods ey is positive; for neutral goods ey is zero; for inferior goods ey is negative. Cross elasticity of demand (ec) shows how changes in prices of other goods would affect the demand for a particular good. For substitutes ec is positive; and for complements ec is negative. Advertising (or promotional) elasticity of demand (ea) measures the effect of incurring an expenditure on advertising of a firm on the demand for its product at constant price. Elasticity is used for determination of right price by seller and for taxation by government.