OMTEX CLASSES: Elasticity of Demand

"Price elasticity is a concept for measuring how much the quantity demanded responds to changing price."

Teaching Points

3.1 Introduction

3.2 Concept of Elasticity of Demand

3.3 Types of Elasticity of Demand

3.4 Type of Price Elasticity of Demand

3.5 Measurement of Price Elasticity of Demand

3.6 Factors Affecting Elasticity of Demand

3.7 Significance of Price Elasticity of Demand

Teaching Objectives

To enable the students to know and understand the concept of Elasticity of Demand

'The best way to escape from a problem is to solve it.'

3.1 Introduction

The law of demand show that there is an inverse relation between price and quantity demanded i.e. when price falls demand is more and when price rises demand is less. The law of demand does not explain the extent of change in demand due to a change in price. In other words the law of demand fails to explain quantitative relation between price and demand. Therefore, Dr. Alfred Marshall explained the concept of elasticity of demand.

3.2 Concept of Elasticity of Demand

The term elasticity means responsiveness or sensitivity. The concept of elasticity of demand measures the responsiveness of quantity demanded to a change in price.

According to Prof. Marshall

"Elasticity of demand is great or small according to the amount demand which increases much or little for a given fall in price, and quantity demanded decreases much or little for a given rise in price."

According to P.A. Samuelson

"Price elasticity is a concept for measuring how much the quantity demanded responds to changing price."

It is clear from the above definitions that elasticity of demand is a technical term which describes the responsiveness of change in the quantity demanded to a fall or rise in its price. In other words it is the ratio of percentage change in quantity. demanded of a commodity to a percentage change in pike.

3.3 Types of Elasticity of Demand

Following are three types of elasticity of demand.

1. Price Elasticity of Demand: Dr Marshall has defined price elasticity of demand as below:

"Price elasticity of demand is a ratio of proportionate changes in the quantity demanded of a commodity to a given proportionate change in its price."

Thus, pride elasticity is responsiveness of change in demand due to a change in price only. Other factors such as income, population, tastes, habits, fashions, prices of substitute and complementary goods are assumed to be constant. Therefore, price elasticity of demand is written as:

DQ = Change in quantity demanded. It is measured as the difference between new quantity demanded (Say Q1) and old quantity demanded (Q)

Thus DQ = Q1 - Q

DP = Change in price. It is measured as the difference between new price (P1) and old price (P)

Thus DP = P1 - P

Price elasticity of demand may have five values infinite, zero, unit, greater than one and less than one.

2. Income elasticity of demand

Income elasticity of demand may be defined as the degree of responsiveness of quantity demanded to change in incomer only. Other factors including price remain unchanged. It is written as -

quantity demanded, Y means income, D delta stands for a change). Income elasticity of demand is positive, when demand increases with increasing income. Income elasticity of demand is negative when, quantity demanded decreases with increase in income. In case of normal goods income elasticity of demand is of inferior goods, income, elasticity of demand is negative Income elastioity of demand can be zero, one, greater than one, and less than one.

3. Cross elasticity of demand

Cross elasticity of demand is found in case of substitute goods as well as complimentary goods and non-related goods. In the case of substitute goods change in the price of one good, affects the demand for another good. For example, if the price of tea rises, the demand for coffee will rise. So, cross elasticity of demand refers to change in quantity demanded of one commodity, due to change in the price of another commodity. Symbolically Proportionate change in the demand of

Ec = DA/DB (Here A is original commodity and B is price of another related substitute commodity)

3.4 Types of Price Elasticity of Demand

1. Infinite / Perfectly Elastic Demand

When a change in price leads to infinite change in quantity demanded, it is known as, infinite elastic demand. When demand is infinite elastic, demand curve is horizontal straight line parallel to X axis. Symbolically Ed = a, Perfectly elastic demand is only a theoretical possibility.

Infinite/Perfectly Elastic Demand Curve

2. Perfectly Inelastic -Demand

Irrespective of change in price, demand remains the same, if is called as perfectly inelastic demand. For example, as shown in the figure at price OP demand is OD, whereas at price OP1 (Higher) and OP2 (Lower) the demand is OD only. It means demand does not change at all. When demand is perfectly inelastic the demand curve is represented by a vertical straight line parallel to Y axis as shown in diagram. Symbolically, Ed=O.

In practice such situation occurs occasionally such as demand for salt.

Perfectly Inclastic Demand Curve

Fig. No. 3.6

3. Unitary Elastic Demand

When a change in price leads to proportionate change in quantity demanded then demand is unitary elastic. For example, if price falls by 50% the demand will rise by 50%. In figure the change in price is PP1 and change in demand is QQ1. Both the change are equal to each other. So the demand curve DD1, shows unitary elastic demand.

Symbolically, Ed- 1.

Unitary Elastic Demand Curve

Fig. No. 3.7

When the demand curve slopes steadily towards the X axis or is a rectangular hyperbola demand is unitary elastic.

4. Relatively Elastic Demand

When proportionate change in demand is greater than the change in price, the demand is said to be relatively elastic, for example, if price falls by 50% the demand rises by 75%. In the figure, change in demand QQ1 is greater than the change in price PP1. Hence, the demand curve DD1 shows elastic demand.

Symbolically, Ed >1.

Relatively Elastic Demand Curve

Fig. No. 3.8

In this type the slope of demand curve is flatter.

5. Relatively Inelastic Demand

When percentage change in demand is less than percentage change in price, the demand is relatively inelastic. For example, if price falls by 50%, the demand will rise by 25%, i.e., less than percentage change in price. In the above figure, the change in price is from OP to OP1 is greater than change is demand from OQ to OQ1.

Relatively Inelastic Demand Curve

Fig. No. 3.9

Therefore, DD is the demand curve which represents inelastic demand.

Symbolically, Ed < 1.

The slope of demand curve is steeper.

3.5 Measurement of Price Elasticity of Demand

Price elasticity of demand is measured with the help of the following three methods.

1) Ratio or Proportional Method

This ratio method of measuring elasticity of demand is also known as Arithmetic or Percentage method also. This method is developed by Dr. Marshall. In this method we consider percentage change in quantity demanded and divide it by percentage change in the price of the commodity.

Thus

Numerical Illustration

Table No.3.4

Ratio or Proportional Method

Price of X	Demand (Units)
200	1000
100	1500

Price of commodity X falls from Rs. 200/- to Rs. 100/- and quantity demanded increases from 1000 units to 1500 units. Here percentage change in demand is 50, whereas percentage change in price is also 50. Therefore, 50%, / 50% = 1, which, means Ed is unitary or one, in this example.

2) Total Expenditure Method

The name of Dr. Marshall is associated with this method. This method is also known as Total Expenditure Method Total Revenue Method. In this method, statistics of total expenditure is used to find out elasticity of demand. Total expenditure at the original price and total expenditure at the new price is compared with each other, and we come to know the elasticity of demand.

When price falls or rises, total expenditure does not change or remains constant, demand is unitary elastic.

When price falls, total expenditure increases or price rises and total expenditure decreases, demand is elastic or elasticity of demand is greater than one.

When price falls and total expenditure decreases or price rises and total expenditure increases, demand is inelastic or elasticity of demand is less than one. Measurement of elasticity of demand with the help of total, expenditure method can be better understood with the help of the following example.

Table No. 3.5 - Total Expenditure Method

	Price (Rs.)	Demand (Units)	Total Outlay (Rs.)	Elasticity of Demand
A	10 8	12 15	120 120	Unitary or 1
B	10 8	12 20	120 160	Elastic or > 1
C	10 8	12 14	120 112	Inelastic or < 2

In example A, original price is Rs. 10 per unit and demand is 12 units. Therefore total expenditure incurred is Rs. 120/-. Price falls to the level of Rs. 8/- and demand rises up to15 units. But total expenditure is still Rs. 120/-. In this case, total outlay does not change even though there is change in price. Therefore, demand is unitary elastic.

In example B, at the price Rs. 10/-, 12 units are demanded. So total original expenditure is Rs. 120/-. Price falls to Rs. 8/- per unit and demand rises to the level of 20 units. Therefore, total expenditure incurred on commodity rises to Rs. 160/-. Total expenditure under this new condition of change in price, is greater than original expenditure. Hence, in this example, demand is elastic or elasticity of demand is greater than one.

In example C, original total outlay is Rs. 120/- with a change in price to Rs. 8/- per unit, demand expands to the extent of 14 units. Nevertheless, total expenditure Rs. 112/-, which is less than original expenditure. Therefore, in this example demand tends to be inelastic or elasticity of demand is less than one.

3) Point Elasticity Method or Geometric Method

The proportional method and total outlay method enable us to measure elasticity of demand at a given point on the demand curve. Therefore, Dr. Marshall has developed yet another method to measure elasticity of demand, which is known as Point or Geometric method. At any point on demand curve elasticity of demand is measured with the use of the following formula.

With the help of the following example, we can understand how to measure elasticity of demand at a point on, linear demand curve.

Linear Demand Curve

Fig. No. 3.10

In the above figure DD is, demand curve and we assume that its length is 6 cm. At Point P, demand is infinite elastic, whereas at point P4 elasticity of demand is zero. Therefore, we have to measure elasticity of demand on points, P1, P2 and P3

At point P1, elasticity of demand = lower segment of the demand curve below the given point P2 P4 ÷ Upper segment of the demand curve above the point is P1 P. Therefore, Ed = P1 P4 ÷ P1P. Ed>1. It means demand is elastic or elasticity of demand is greater than one at point.

Similarly, by using the above given formula, we can measure elasticity of demand at point P2 and P3. At point P2 , demand is unitary elastic. It means elasticity of demand is equal to one whereas at point P3 demand is less than one.

Non-Linear Demand Curve

Fig. No 3.11

If the demand curve is non-linear, then a tangent is, drawn to the demand curve at the given point. The tangent should touch both the axes - OX axis and OY axis. The price elasticity is measured by the ratio of lower segment to the upper segment.

3.6 Factors Determining Elasticity of Demand

Following are the factors which influence Elasticity of Demand

1. Nature of Commodities: Commodities may be either necessaries or, luxuries. Normally, elasticity of demand for necessaries is inelastic and for luxurious demand tends to the elastic.

2. Durability : The demand for durable goods is elastic, whereas the demand for perishable goods is inelastic.

3. Substitute Goods : Availability of substitutes also determine Elasticity of Demand. The larger the number of substitutes for a commodity in the market, demand tends to the more elastic.

4. Uses of a Commodity : When commodity can be put to several uses. its demand is elastic. The demand for electricity is elastic.

5. Price : Goods, which are very highly priced or very low price demand, is normally inelastic. e.g. Demand for match box is inelastic.

6. Habits : Habits influence Elasticity of Demand. The demand, which satisfy the habits, is normally inelastic. For instance, the demand for cigarettes is inelastic. Also consumption of essential goods cannot be postponed therefore demand for them is inelastic.

7. Income of Consumer : When income level is high demand is normally inelastic, and demand is elastic at a very low level of income.

8. Proportion of Income Spent : When proportion of income spent is large demand for goods tend to the inelastic. For instance, demand for food grains is inelastic.

9. Complementary Goods : By and large, demand for complementary goods is inelastic. Because complementary goods such as motor car and petrol are demanded jointly.

3.7 Significance 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 consumers exploitation government can either subsidise or nationalise them. Which shows need of government monopoly.

Q.1 Fill in the blanks with appropriate alternative given in the brackets.

1. The demand for salt is .................. (elastic/inelastic/infinite elastic/unitary elastic)

2. Income elasticity of demand for inferior goods is ................. (positive/ negative/zero/greater than one).

3. Perfectly elastic demand curve is ..................... (horizontal to OX axis/ horizontal to OY axis/flatter/steeper)

4. Cross elasticity of demand is applicable to .......................... goods. (unrelated/ substitute/inferior/natural)

5. The slope of demand curve is ..................... in case of inelastic demand.(flatter/steeper/horizontal/vertical)

B. Match the following

Group "A" Group "B"

1. Car and petrol a. Elastic demand

2. Point method b. Complementary,

3. Necessary goods c. Geometric method

d. Inelastic demand

C. State whether the following statements are TRUE and FALSE

1. Demand for luxuries is elastic.

2. Perfectly inelastic demand curve is parallel to the X axis.

3. Total outlay is price multiplied by quantity.

4. Unitary Elastic Demand rarely occurs in practice.

5. Concept of Elasticity of Demand is useful for finance minister.

Q.2 A Define or explain the following concepts: 1,

1. Cross Elasticity Demand

2. Unitary Elastic Demand

3. Income Elasticity of Demand

4. Elastic Demand

B. Give reasons or explain the following statements:

1. Demand for necessaries is inelastic.

2. Demand for habitual; goods is inelastic.

3. Concept of Elasticity of Demand helps trade union leaders.

4. Demand for the commodity having multiple uses has elastic demand.

5. Demand for goods having snob appeal has inelastic demand.

Q.3 A. Distinguish between

1. Perfectly elastic demand and perfectly inelastic demand.

2. Relatively, elastic demand and relatively inelastic demand.

B. Writes short notes on:

1. Geometric method

2. Ratio method

Q.4 Answer the following questions:

1. Explain the concept of Elasticity of Demand.

2. Explain the importance of concept of Elasticity of Demand for international trade.

Q.5 State with reasons whether you agree or disagree with the following statement.

1. Various factors influence Elasticity of Demand.

2. Total outlay method is one of the methods of measuring Elasticity of Demand.

Q.6 Answer the detail:

1. Explain, Ratio method and Geometric method of measuring Elasticity of Demand.

2. What are the types of Price Elasticity of Demand ?

Project :

Study the responsiveness of demand for commodities like salt, matchboxes, candles, television, foodgrains with respect to income level of five families.