UNIT2
Elasticity of Demand
Sometimes, demand is greatly responsive to change in price, at other times; it may not be so responsive. The extent of variation in demand is technical expressed as ‘Elasticity of demand’.
Definition-
According to Alfred Marshall, “The elasticity of demand is great or small according to the amount demanded which increases much or little for a given fall in price, and quantity demanded decreases much or little for a given rise in price.”
The concept of elasticity of demand refers to the responsiveness of demand for a commodity to changes in its determination. There are as many kinds of elasticity of demand as its determinants. Economists usually consider three important kinds of elasticity of demand.
1) Price elasticity of demand
2) Income elasticity of demand
3) Cross- elasticity of demand
1) Price Elasticity of demand:
It means the responsiveness of quantity demanded of a commodity to A CHANGE in its PRICE, The price elasticity of demand (Ep) is given by the percentage change in the quantity demanded of commodity divided by the percentage change in its price, it is stated as:
Proportionate change in quantity demanded
Price Elasticity of Demand (Ep) =
Proportionate change in price
Symbolically it can be written as follows-
Ep = 
Ep = 
Ep = 
Q = Change in quantity Q = Original Quantity
P = Change in price P = Original Price
Types of Price elasticity of Demand:
Demand may be either elastic or inelastic. The demand which responds greatly to a change in price is called Elastic demand. The demand which not very sensitive to change in price is called inelastic demand.
The price elastic of demand is classified into five types:
1) Unit elastic demand: When change in price bring about exactly proportionate in quantity demand the demand is unit elastic demand, i.e. Elasticity of demand = 1. For e.g. – If price falls by 5% then demand rises by 5%. In this diagram when price falls OP to OP1, demand rises from OQ to OQ1 in the same proportion. ED = 1
2) Relatively elastic demand: When small change in price bring about more then, proportionate change in quantity demanded, there is said to be relatively more elastic demand. Elasticity of demand >1. In this diagram when price falls from OP to OP1, demand extends from OQ to OQ1. This is relatively more in proportion to change in price. For e.g. - In case of fruits, milk, vegetable, etc.
3) Relatively inelastic demand: When small change in price bring about less then proportionate change in quantity demanded, there is said to be relatively less elastic demand. Elasticity of demand < 1 In this diagram when price falls from OP to OP1, demand extends from OQ to OQ1. This is relatively less in proportion to change in price. Ed < 1
4) Perfectly elastic demand: Demand is said to be perfectly elastic when at a given price, quantity demand goes on increasing infinitely. In such case demand curve is horizontal straight line and parallel to X – axis as shown in the diagram. Elasticity of demand = ∞ In this diagram, when price is OP Quantity demand increase. It is shown by DD curve which is horizontal & parallel to X – axis. Ed = ∞
5) Perfectly inelastic demand: when change in price has no effect on quantity demanded, the demand is perfectly inelastic demand. In such case demand curve is vertical straight line and parallel to Y – axis as shown in the diagram. Elasticity of demand = 0. For e.g. – Commodity like salt which is of absolute necessity has no effect which change in price. A 10% fall in price bring about no change in demand. In this diagram, when price is increasing OP to OP1 the demand for remain the same at OQ and hence demand curve is vertical straight line. Ed = 0
Key Points: - Unit elastic, Relatively elastic, Relatively elastic, Relatively Inelastic, Perfectly Elastic, Perfectly Inelastic. |
Measurement of Price Elasticity of Demand:
There are three methods of measuring price elasticity of Demand:
1] Total Expenditure / Total Revenue method
2] Percentage / proportional method
3] Point / Geometric method
1] Total Expenditure / Total Revenue method:
We can know elasticity of demand by comparing the change in total expenditure due to change in price.
Total Expenditure = Price X Quantity Demanded
Marshall point out that-
1) If because of fall in price, we buy more but total expenditure remains the same, elasticity of demand is said to be unit elastic or Ed = 1.
2) If because of fall in price, we buy more and total expenditure rises or vice versa, elasticity of demand is said to be greater than one or Ed > 1.
3) If because of fall in price, we buy more but total expenditure falls on vice versa, elasticity of demand is said to be less than one or Ed < 1.
This method can be explained with the help of following Table:
Case | Price (Rs.) | Quantity Demanded | Total Expenditure | Elasticity of Demand |
Case I | 4 | 5 | 20 | Ed = 1 |
1 | 20 | 20 | ||
Case II | 4 | 4 | 16 | Ed > 1 |
1 | 24 | 24 | ||
Case III | 4 | 8 | 32 | Ed < 1 |
1 | 16 | 16 |
2] Percentage or Proportional method:
It is based on the definition of demand Elasticity of Demand is equal to the ratio of percentage change in quality demanded to percentage change in the price. It is stated as:
Percentage change in quantity demanded
Elasticity of Demand =
Percentage change in price of commodity
In terms of symbol it is expressed as:
Ep = 
Ep = 
Ep = 
Q = Change in quantity Q = Original Quantity
P = Change in price P = Original Price
This can be explained with the help of following examples:
Price | Quantity |
50 | 10 |
40 | 15 |
Ep = 
= 5 X 50
10 10
= 250
100
2.5
This answer is greater than one therefore,
Ed > 1
3) Point or Geometric Method:
Marshall also suggested Geometrical method to measure price elasticity at a point on the demand curve. This is explained with respect to linear and non-linear demand curve.
a) Linear demand curve: In this method demand curve is linear curve which meets the two axis as follows:
For this following formula is used:
Lower segment of demand curve L PB
Elasticity of Demand = = =
Upper segment of demand curve U PA
If PB = PA then Ed = 1
If PB > PA then Ed > 1
If PB < PA then Ed < 1
If PB = 0 then Ed = 0
If PA = 0 then Ed = ∞
Key Points: - Total expenditure, Percentage, Geometric Method. |
|
Income Elasticity of demand: In refers to the extent to which demand for a commodity changes due to changes in Income of the consumer, other factors including price remaining the same. It is expressed with the help of an equation as follows:
Percentage change in quantity demanded
Income Elasticity of Demand = Percentage change in Income
Cross Elasticity of demand: It refers to change in the demand for a good as a result of change in price of other goods. If goods ‘X’ and ‘Y’ are substitutes goods when price of ‘X’ falls, demand for ‘X’ will rise and for ‘Y’ will fall without the rise in the price of ‘Y’.
There fare change in the demand for one goods due to the change in the price of other goods called Cross Elasticity of Demand. It is expressed with the help of an equation as follows-
Percentage change in quantity demanded of ‘X’
Cross Elasticity of Demand = Percentage change in price of ‘Y’
Key Points: - Price, Income, Cross. |
The term revenue refers to income obtained by the firm through sale of goods and services at different prices
Definition
In the words of Dooley, ‘the revenue of a firm is its sales, receipts or income’.
Revenue are of 3 types as given below
- Income received by the seller after selling the output is called total revenue
- “Total revenue is the sum of all sales, receipts or income of a firm.” Dooley
- TR = Q x P
Where,
TR – Total Revenue
Q – Quantity of sale (units sold)
P – Price per unit of output
2. Average Revenue
Where, AR – Average Revenue, TR – Total Revenue – Total units sold
3. Marginal revenue
Elasticity of demand
The elasticity (or responsiveness) 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”. – Dr. Marshall.
Elasticity means sensitivity of demand to the change in price.
The formula for calculating elasticity of demand is:
EP = proportional changes in quantity demanded/proportional changes in price
Relationship between average revenue, marginal revenue, and price elasticity of demand
At any level of output, relationship between elasticity of demand, average revenue and marginal revenue is very useful.
The average revenue curve of a firm is same as the demand curve of a consumer for the firms’ product. Thus, elasticity of demand on any point on a consumer’s demand curve is same as the elasticity of demand on the firm’s average revenue curve.
The relationship is expressed in the formula.
AR = MR or MR = AR (e/(e-1))
where,
AR = Average Revenue,
MR = Marginal Revenue and
‘e’ = price elasticity of demand.
AR and MR refers to average revenue and marginal revenue curves. Elasticity of demand on the average revenue curve at point R= RT/RS
In triangles PSR and MRT,
∟SPR = ∟RMT (right angles)
∟SRP = ∟RTM (corresponding angle)
Therefore, ∟PSR = ∟MRT
Therefore, triangles PSR and MRT are similar.
Hence, RT/RS = RM/SP -----------------------------------(1)
Now in triangle PSK and KRQ,
PK = KR
∟PKS = ∟RKQ (vertically opposite angles)
∟SPK = ∟KRQ (right angles)
Therefore, triangles PSK and RQK are congruent.
Hence, PS = RQ -----------------------------------(2)
From (1) and (2), we get,
Elasticity at R = (RT/RS) = (RM/SP) = (RM/RQ)
But RM/RQ = RM/(RM-RQ)
But RM = Average revenue = price
QM = Marginal revenue
Elasticity at R = Average revenue (Average revenue – Marginal revenue)
= AR/(AR-MR)
Therefore, e(AR) – e(MR) = AR
e(AR) – AR = e(MR)
AR = e(MR)/(e-1)
R = MR(e/(e-1))
MR = AR((e-1)/e)
Determinants of Price Elasticity of Demand:
1) Urgency of the want: Goods which are necessities of life will have relatively inelastic demand. Whereas less urgent wants are likely to have an elastic demand.
2) Nature of the commodity: Goods which are necessities of life will have relatively inelastic demand.
For e.g. – Food grains, cloths, salt etc. Whereas luxury goods will have relatively elastic demand. For e.g. – Diamond, jewellery, etc.
3) Availability of substitutes: A goods which has no substitutes will have relatively inelastic demand. For e.g. – Salt, Onion, Chalk etc. Whereas goods which have wide range of substitutes will have relatively elastic demand For e.g. – Demand for Mangola, Fanta, Limca, etc.
4) Number of uses of the commodity: If a commodity can be put to several uses, the demand for it is relatively elastic. For e.g. – Multipurpose goods like coal, electricity etc. will have relatively elastic demand.
5) Income: A consumer having high income has relatively inelastic demand for many goods, while a poor consumer has more elastic demand for the goods in general.
6) Proportion of Expenditure: Cheap or small expenditure items tend to have inelastic demand. For e.g. – Newspaper, whereas expensive items have elastic demand. For e.g. – TV
7) Influence of habit: When a person is habituated to consuming a certain commodity his demand for that commodity will be inelastic. For e.g. – Demand for cigarettes to a chain smoker is relatively inelastic.
8) Complementary of goods: Goods which are jointly demanded. For e.g. – Pen-Ink, Car-Petrol etc. have inelastic demand.
9) Element of time: In the short period demand for a commodity will be less elastic, whereas in the long period demand for a commodity will be more elastic because consumers may expect a further change in price so that they do not react immediately to a given change and also that people may not change their habits and preferences immediately.
Key Points: - Urgency, Nature of commodity, Substitute, Number of uses, Income, Proportion, Habit, Element of time. |
Significance or Importance of Price Elasticity of Demand:
1) Monopoly and Elasticity of Demand: The objective of a seller in monopoly market is profit maximization. Since he is a single seller in monopoly, market having total control over supply and price, he can take decisions about price policy and get more profit. If demand is inelastic for the product sold by monopolist, he will raise the price of that commodity and earn more profit.
2) Taxation Policy and Elasticity of Demand: The concept of Price Elasticity of Demand is useful to the government in the determination of taxation policy. The finance minister considers the Elasticity of Demand, while selecting goods and services for taxation. If government wants more revenue, those goods will be taxed more, for which demand is inelastic. Therefore, generally heavy taxes are imposed on goods like cigarettes, liquors and actual goods for which demand is inelastic.
3) Fixation of Wages and Elasticity of Demand: The concept of Elasticity of Demand is useful to trade unions in collective bargaining, for wage determination. When trade union leaders know that demand for their product is inelastic, they will insist for more wages to workers.
4) International Trade and Elasticity of Demand: The concept of Elasticity of Demand is useful to determine norms and conditions in international trade. The countries exporting commodities for which demand is inelastic can raise their prices. For instance, Organization of Petroleum Exporting Countries (OPEC) has increased the prices of oil several times. The concept is also useful in formulating export and import policy of a country.
5) Public Utilities: In case of public utilities like railways which have an inelastic demand, to avoid consumer’s exploitation government can either subsidize or nationalize them. This shows need government monopoly.
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