ELASTICITY OF DEMAND

Introduction

            The law of demand explains the inverse relationship between the price and the quantity demanded. A fall in price leads to increase in purchases and an increase in prices lead to decrease in purchase. Thus, the law of demand only indicates the direction of change, on account of a change in the prices. It does not specify the rate at which the demand changes, in response to a change in the price.

            The concept of the elasticity of demand, not only indicates the direction of change, but also the rate of change in the quantity demanded, in response to a change in the price. Thus, price elasticity of demand may be defined as the rate of change in the quantity demanded, in response to a given change in the price of a commodity. The price elasticity of demand can be calculated by the formula.

                                   

Percentage change in quantity demanded

                        Ep =                                                                                (Ep = price elasticity)

                                                Percentage change in price

Kinds of Elasticity

            Depending upon the nature of the product, market conditions, type of consumers and other factors, the elasticity of demand for a product may be very high or very low. Based on the degree responsiveness of the quantity demanded to a change in price, elasticity of demand can be of five kinds.

Perfect Elastic

            Here, the quantity demanded may increase, even when the price remains unchanged. Suppose that quantity demanded increases by 5%, even when there is no change whatsoever in the price, then the demand for the given product is said to be perfectly elastic. Thus theoretically, in the case of a product whose demand curve is perfectly elastic, consumers may be willing to buy infinite quantity of the product for a given price.

 

Percentage change in quantity demanded                   5%

                        Ep =                                                                              =                    = infinity

                                                Percentage change in price                                 0

            Products, which are perfectly elastic, are rare to find in reality. They exist only in theory. In the graph, for a given P₁, quantity demanded is infinite. Elasticity of demand or e_p =

            From the graph, it may be observed that, the change in quantity demanded can be infinite, even when the price remains the same. This is depicted by a demand curve DD, which is perfectly elastic, horizontal and parallel to the X-axis.

Relatively Elastic

            Here the price elasticity of a product is greater than unity. When the proportionate change in demand is greater than the proportionate change in the price, then the elasticity may be greater than one and the product is said to be Relatively elastic.

            Let us assume that the change in demand is 10%, but the change in price is only 5%. The Elasticity of demand is 2, i.e. 10/2 = 2. Thus Ep > 1.

            From the graph it may be observed that the change in quantity demanded (Q₁ Q₂) is greater than the change in quantity demanded (P₁ P₂). The demand curve DD is more of less flat curve, indicating that, even a small change in the price, will have a tremendous impact on the demand.

 

Unit elasticity of demand

            Here, the proportionate change in the demand is equal to the proportionate change in the price. Ep = 1. Let us assume that the change in price 5% and the resultant change in demand is also 5% then Ep = 5% / 5% = 1

 

Perfectly inelastic demand

            In this case, even a large change in the price does not bring about any change in the quantity demanded. In other words, the demand remains the same, irrespective of the changes in price level.

From the graph, it may be observed that a substantial change in price PP₁, has brought about no change in demand. The demand curve, here is a vertical straight line, parallel to the Y-axis. The price elasticity, E_p, is thus, equal to zero.

Relatively inelastic demand

            In this case, a big change in the price, bring about only a small change in the quantity demand. In the graph below, it may be observed that a big price change PP₂ has lead to only a marginal increase in demand QQ₂. Ep < 1. The demand curve DD₁ is more or less vertical and it has a steep slope.

                                 

Factors Determining Elasticity of Demand

1.      Necessaries Inelastics: For necessaries and conversational necessaries, the demand is inelastic; Example Salt, tobacco.

2.      Luxuries – Elastic: For luxuries, demand is comparatively elastic, Example: Radio.

3.      Substitutes – Elastic: For substitutes the demand is elastic: The demand for a commodity is said to be elastic if the commodity has substitutes. Example: Coffee and Tea

4.      Goods with Several Uses – Elastic: Demand for goods having several uses in elastic Example: Coal

5.      Postponable Uses – Elastic: Demand for goods the use of which can be postponed is elastic Example: Umbrella.

6.      Level in Prices: Elasticity also depends on the level of prices. If the price is either too high or too low, the demand will be inelastic. Examples: Diamonds, safety pins.

7.      Proportion of Consumer’s Income Spent on the Commodity: The proportion of total expenditure devoted to a commodity is small, the demand for it tends to be inelastic. Example: Proportion of expenditure on ink is quite small and consequently the demand for this is inelastic.

8.      Habit and Fashion: Demand for those goods which are habitually consumed or which are in fashion is inelastic. Example: Particular brand of a cigarette.

9.      Time: Elasticity varies with the length of time periods. In the larger period of time, demand is more elastic. In the short period of time, demand is less elastic or inelastic.

Measurement of Elasticity Demand

            A manager who wishes to take pricing decisions may be keen on measuring the price elasticity of demand for the product that he produces. This is important because it enables him to know, what would be the change in demand, if he were to effect a change in the price. The graphical depiction of the elasticity of demand gives an approximate picture. In order to know the exact change in demand as a consequence of a change in the price, it is important to measure the elasticity of demand for the given product. Alfred Marshall, the economist who gave the concept of elasticity of demand, has also elaborated on three methods, through which elasticity of demand could be measured. The three different methods are a) Outlay method b) Point or geometric method c) Arc method.

Outlay Method

            Under this method, we measure the outlay or the expenditure incurred on the product to obtain a measure of the elasticity of demand. Price Elasticity of demand for a product can be greater than one, equal to one or lesser than one, depending upon the expenditure incurred in response to changes in price.

1) Price elasticity of demand is greater than one (Ep > 1): When the expenditure incurred on a given product increases in response to a decrease in price, then the elasticity of demand is said to be greater than one. The example illustrate the case.

Price (Rs.)	Quantity (Q)	Expenditure	Ep
20 16 10	5 8 14	100 128 140	Ep > 1.

Price elasticity is equal to one (Ep = 1): When the expenditure incurred on a given product remains unchanged in response to a decrease in the price of the product, then the price elasticity of the given product equals (Ep = 1). The example illustrates the case.

Price (Rs.)	Quantity (Q)	Expenditure	Ep
20 16 10	4 5 8	80 80 80	Ep = 1.

Price elasticity is less than one (Ep < 1): When the expenditure incurred on a given product decreases in response to a decrease in the price, then the price elasticity of the product is lesser than one, or the product is relatively price inelastic Ep < 1. The example illustrates the case.

Price (Rs.)	Quantity (Q)	Expenditure	Ep
20 16 10	3 3.5 5	60 56 50	Ep < 1.

In all the three cases, it may be noted that, the demand nevertheless increases in response to a decrease in the price. However, the rate of change in the demand, in response to a decrease in the price, is different in the three cases. In the first case, the expenditure incurred increases. The increase in the quantity demanded in response to a change in the price is significant, so much so that there is an increase in the expenditure incurred on the product.

In the second case, the increase in demand is apparent but the increase is not significant enough to bring about an increase in the expenditure incurred on the product. The expenditure incurred on the product remains the same just as it was before the decrease in the price.

In the third case, the increase in the demand is so marginal that there is actually a decrease in the expenditure incurred. The three cases, which show the impact of price on expenditure, have been depicted graphically in Figure 5.6

 

In the graph, the total outlay or expenditure is measured on the X axis and price is measured on the Y axis. When price falls from P₁ to P₂, the expenditure incurred increases from E₁ to E₂. Therefore, this is a case where the price elasticity of demand is greater than one (Ep>1). When price falls from P₂ to P₃, the expenditure remains the same and therefore, this is a case of unitary elasticity (Ep =1). When price falls from P₃ to P₄, we notice that the expenditure actually decreases and therefore, this is a case where the elasticity of demand is less than one (Ep<1).

            This method, which is called Total outlay method, Revenue method or Expenditure method, classifies demand into three types. It does not enable us to measure the elasticity of demand accurately in numerical terms. Nevertheless, it is an approximate measure of the elasticity of demand.

Point Method or Geometric Method

            A Geometrical way of measuring the elasticity at any point on a demand curve has also been illustrated by Alfred Marshall. Consider the straight – line demand curve in the Figure below. For any point P on the demand curve the price elasticity of demand can be illustrated as follows.

 

                                   

The demand curve is extended to meet the two axes. P divides the demand curve into two segments.

   lower segment of the demand curve                        PB

                        Ep =                                                                              = 

                                       upper segment of the demand curve                         PA

            If the demand curve is not a straight line, the same method may be used by drawing a tangent to the curve at the required point. Thus, for the non – linear demand curve illustrated below, a tangent line AB is drawn at point P on the demand curve.

 

Applying the same formula the point elasticity of demand can be measured as follows.

lower segment of the tangent line                               PB

                        Ep =                                                                              = 

                                     upper segment of the tangent line                              PA

            It should be noted that for any demand curve, elasticity of demand may vary at different points. This can be illustrated by the graph below.

 

 

            In the graph, there are three points. The first point P₁ is at the upper end of the demand curve. The second point P₂ is at the centre of the demand curve, dividing the demand curve into two equal segments. The third point P₃ is at the lower end of the demand curve. When the demand curve is extended to the axis, we obtain a demand curve AB.

            Thus elasticity of demand at point P₁ = P₁B/ P₁A. At this point Ep > 1.

            Thus elasticity of demand at point P₂ = P₂B/ P₂A. At this point Ep = 1.

            Thus elasticity of demand at point P₃ = P₃B/ P₃A. At this point Ep < 1.

Arc Elasticity

            The student has so far studied two different methods that give only an approximate measure of the elasticity of demand. The Expenditure method and the point method give only an approximate measure of price elasticity. Moreover, the point method give different results for the same change in the price. The ‘Arc Method’ for measuring price elasticity of demand, on the other hand gives the result in numerical terms and is more accurate.

 Types of Elasticity

            We may distinguish between the three types of elasticities, viz., Price Elasticity, Income Elasticity and Cross Elasticity.

Price Elasticity

            Price elasticity measures responsiveness of potential buyers to changes in price. It is the ratio of percentage change in quantity demanded in response to a percentage change in price.

Income Elasticity

            Income Elasticity is a measure of responsiveness of potential buyers to change in income. It shows how the quantity demanded will change when the income of the purchaser changes, the price of the commodity remaining the same. It may be defined thus: The Income Elasticity of demand for a good is the ratio of the percentage change in the amount spent on the commodity to a percentage change in the consumer’s income, price of commodity remaining constant. Thus,

                                    Proportionate change in the quantity purchased

Income Elasticity = 

                                                Proportionate change in Income

while prices remain constant.

            It is equal to unity or one when the proportion of income spent on a good remains the same even though income has increased.

            It is said to be greater than unity when the proportion of income spent on a good increase as income increases.

            Generally speaking, when our income increases, we desire to purchase more of the things than we were previously purchasing unless the commodity happens to be an “inferior” good. Normally, then since the income effect is positive, income elasticity of demand is also positive.

            It is zero income elasticity of demand when change in income make no change in our purchases, and it is negative when with an increase in income, the consumer purchases less e.g., in the case of inferior goods.

            It may be carefully noted that for any individual seller or firm, the demand for the product is highly elastic even though the demand for the product as a whole may be inelastic. By lowering he price, as compared with his rivals, the seller can infinitely increase the demand for his product. The demand curve will thus be a horizontal line.

            Both elasticities, viz., price elasticity and income elasticity, are valuable aids in the measurement of demand for different commodities. As much they are also helpful in measuring the incidence of taxation.

Cross Elasticity

            Here, a change in the price of one good causes a change in the demand for another. Cross – elasticity of Demand for X and Y

Proportionate change in purchases of commodity X

            =

Proportionate change in the price of commodity Y

            This type of elasticity arises in the case of inter – related goods such as substitutes and complementary goods.

Practical Importance of Elasticity of Demand

1.      It guides the businessman in fixing the prices of his goods. If the demand for a commodity is elastic, he can raise the price. If it is elastic, he has to bring down the price.

2.      The finance Minister has to keep in mind the elasticity of demand for a commodity before imposing a tax. The finance minister must levy tax on such commodities, for which the demand is less elastic.

3.      The government has to take into account the elasticity of demand for a product, before imposing price control on it.

4.      In the case of joint product, separate cost or productions of the two commodities are not ascertainable. In such cases, price of each will depend on the elasticity of demand of each. Example : Paddy and straw.

5.      The transport authorities also fix the prices for their various services after considering the elasticity of demand.

6.      It is used in the calculation of terms of trade. It is possible to calculate the terms of trade between countries only by taking into account the elasticities of demand.

7.      Elasticity can influence wages. If demand for a particular type of labour is inelastic, the trade unions can easily get their wages raised.

8.      The rates of exchange between currencies are fixed depending on the elasticity, of demand for currencies in the exchange market.

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