Concept of Tax

Concept of Tax

A tax is a compulsory levy and liability imposed upon the tax assesses, who may be an individual, group of individual or other legal entities, It is a liability to pay on account of the fact that the tax assesses have income of the specified amount from specified source, or own specified tangible or intangible property, or carry-on certain economic activities which have been legally accepted as criterion for taxation. The taxpayers are to pay taxes irrespective to any direct return or benefit of goods and services from the government. In other words, there is no quid pro quo in taxation.

Features of Tax

  1. Taxes are the main source of government revenue.
  2. Tax is the compulsory contribution.
  3. Tax is imposed only by the government.
  4. Tax is a legal receipt.
  5. There is no quid pro quo in taxation.
  6. Tax payment involves sacrifice by the taxpayers.
  7. Tax is paid out of taxpayers’ income.
  8. Receipt from tax is spent for social welfare.
  9. Tax is one of the fiscal instruments.

Government Revenue

Concept of Government Revenue

The income of government from all sources is generally called government revenue or receipt. But Dalton has defined public income in a broad and narrow sense as public receipt and public revenue. Accordingly, public receipt includes all incomes of the government. Whereas, public revenue includes income from taxes, prices of goods and services supplied by enterprises, revenue from administrative services and gifts and grants.

According to Sundharam & Andley, public revenue may be categorized as:

Study of Public Finance

Significance and scope of government involvement in economic decisions depends upon the political ideology of government structure and roles to a great extent. History has revealed that there have been three types of economic systems.

In a capitalistic economy economic decisions (and thereby the economic activities) are done by the private sector. Each economic unit operates in accordance with the economic rationality being guided by the market mechanism with an objective of income maximizing criteria. In such system government has only limited role, mainly as the facilitator and regulator.

A communist (controlled) economy is dominated by the state where economic decisions and activities would not be guided only by the economic maximizing criteria. Market mechanism is assigned a marginal role. 

In a mixed economy there is the co-existence of both the private and public sectors in economic activities. Government is to perform the role of an investor, facilitator and regulator. However, in modern times, almost all countries have mixed economy where the scope and involvement of public and private sector may vary. It is fairly common to justify the need for and presence of government involvement and intervention in economic activities besides the fundamental (basic) functions.

Public sector economics or Public finance deals with the questions of collective wants (i.e. the wants of the community as a whole) and their satisfaction. Public finance aims at maximizing social welfare or social benefits by efficient use of social goods. Collective wants are those which are demanded by all members of the community in equal or, more or less equal measure. Defense, education, public health, infrastructural facilities like power, transportation and communications, etc. are examples of the collective wants. Goods and services produced to satisfy collective wants are known as social goods. The features of social goods are: 
  • Social goods are not divisible;
  • There is some compulsion in providing social goods; and
  • There is no exclusion in social goods.
The grounds for state involvement and interference in economy are: 
  1. Distortions in production structure and failure to create reasonable employment by market mechanism;
  2. Need for the maintenance of economic stability with control of trade cycles (mainly in the developed countries); and
  3. To promote the rate of economic growth and distributive justice {mainly in the developing countries).

CONCEPT OF PUBLIC FINANCE

Consumer’s Surplus

Consumer’s surplus, the concept was introduced by A. J. Dupit, a French engineer in 1844. But he could not have developed it. The credit goes to Alfred Marshall for developing this concept. Marshall first named this concept as ‘consumer’s rent’ in his book ‘Pure Theory of Domestic Value’ and later renamed consumer’s surplus in the book ‘Principles of Economics’. Prof. K. E. Boulding has named it ‘Buyer’s Surplus’.

In our daily expenditure, we find generally that the satisfaction derived from a commodity is higher than the price we pay for the commodity. So, we are prepared to pay more than we actually have to pay. In other words, consumer’s surplus is the difference between what we are prepared to pay and what we actually pay. As for example, we are prepared to pay $12 per kilo for apple, but the actual price in the market is $10 per kilo. Hence, consumer’s surplus is 12 – 10 = $2. Another way to explain the concept is that consumer’s surplus is the total utility minus total amount spent.

According to Marshall – “The excess of the price which the consumer would be willing to pay rather than go without the thing over that which he actually does pay is the economic measure of his surplus satisfaction. It may be called consumer’s surplus.”

In the words of Watson and Getz – “The difference between the amount a consumer would pay for the quantity of a commodity bought and the amount the consumer does pay is called consumer’s surplus.”

Consumer’s Surplus

Units of orange
P ($)
MU
CS
1
2
3
4
5
6
5
5
5
5
5
5
10
9
8
7
6
5
5
4
3
2
1
0
PU = 6
TE = 30
TU = 45
15

Suppose that the price per unit of orange is $5. The consumer purchases six units of orange. He purchases up to the point where marginal utility is just equal to price. Now comparing total utility with the total cost (expenditure) we can get consumer’s surplus as:

Total utility = sum of marginal utilities
= $10 + 9 + 8 + 7 + 6 + 5 = $45

Total cost = sum of cost of each unit
= $5 x 6 = $30

Consumer’s surplus = Total utility – total cost
= $45 - $30 = $15

The total utility derived by the consumer from 6 units of orange is $45, but the consumer has paid only $30. So, he gets the consumer’s surplus of $15. Hence, the consumer’s surplus is the difference between what the consumer would be willing to pay ($45) and what he actually has to pay ($30). The concept of consumer’s surplus can be illustrated by the help of a figure below.
Consumer's Surplus
In the figure, the addition of the six rectangles reflecting the marginal utilities gives total utility. The area of the large rectangle OPE 6 (p x q) represent the total cost. The striped area (between price line and demand schedule) that remains after subtracting total cost from total utility is the consumer’s surplus.

The first unit costs $5 but MU or the price willing to pay is worth $10. So, CS = $5. The second unit also costs $5, but MU is worth $9. So, CS = $4 and so on. Adding excess of utility over cost on each unit purchased, we get $15. The area between price line and demand schedule shows this. There is no surplus on the last unit purchased. Because, the consumer purchases up to the point where marginal utility of the last unit is equal to price.

This concept can be presented in simple way by the help of a smooth demand curve as shown in the figure below. Here we assume that the commodity is divisible into small units so that smooth demand curve can be drawn.
Consumer's Surplus
The consumer purchases 6 units at a price of $5 per unit. Consumer’s surplus is the triangular area PTE between the demand curve and the price line. It is equal to the areas of rectangle above the price line in figure. But due to the use of smaller and smaller units, we get smooth line rather than discrete steps. In figure, the total utility from OQ units is OTEQ and the total cost is OPEQ. The difference PTE is consumer’s surplus.

Law of Substitution

The law of substitution was at first pointed bout by H. H. Gossen. Hence, this law is called Gossen’s Second Law. This law is also known as law of equi-marginal utility and law of maximum satisfaction. 

We know that human wants are unlimited whereas the means to satisfy those wants are limited. So a consumer tries to get maximum satisfaction out if his expenditure. For this he allocates his expenditure among several uses in such a way so as to maximize satisfaction. According to Watson and Getz –“The best, or optimum allocation is one that causes the marginal utilities in each use to be equal”. He will get maximum satisfaction only when he obtains equal marginal utilities from the consumption of different commodities. If this does not happen, the consumer can improve his satisfaction by reducing expenditure in one use and expanding in another words, he substitutes one commodity for another until the marginal utilities from all commodities are equal. This law can be illustrated by the help of a table below.

Law of Substitution
Units
MU of Orange
MU of Apple
1
2
3
4
5
6
10
8
6
4
2
0
8
6
4
2
0
-2

Suppose that the consumer has $7 to spend on orange and apple. The price of orange is $1 per unit. The utility obtained from different units of orange and apple is presented in table. According to the law, the consumer will purchase that unit of orange and apple, which gives him maximum satisfaction. He will therefore, purchase 4 units of orange and 3 units of apple. The marginal utilities of both orange and apple are same, i.e. 4. He derives total utility = 10 + 8 + 6 + 4 = 28, 8 + 6 + 4 = 18 = 46. So, the total utility is equal to 46.

Any other combination or arrangement will not give him so much satisfaction or utility. As for example, if he purchases 3 units of orange and 4 units of apple, total utility will be equal to only 44 which is less than 46. In brief, the consumer obtains maximum satisfaction when marginal utilities from all goods purchased are equal.

The law of equi-marginal utility can be illustrated by the help of figure below. In the figures below, OX axis represents units of money and OY axis represents marginal utility. Suppose that money can be spent on commodities apple and orange. MUA and MUO curves relate to commodity apple and orange respectively. The shapes of curve MUA indicates that the desire for commodity apple is stronger. This means that the marginal utility of any quantity of money in commodity orange is greater than that of the same quantity in commodity apple. Because MUO curve is farther from the vertical axis than MUO curve. Likewise MUO curve begins from the vertical axis at a higher point than does curve MUA.
Equimarginal Principle
Now suppose that the consumer has $7 to spend on apple and oranges. In the figure, the best allocation is $3 in commodity apple and $4 in commodity orange. Because, with these quantities, the marginal utilities are equal in both commodities, i.e. PM = P’M’. Hence, this is the best allocation of money. Any other combination will give less total satisfaction.

If $4 is devoted to commodity apple and $3 to commodity orange, the gain would be the area between 3 and 4 under MU curve in commodity apple. But there would be loss of area between 3 and 4 under MU curve in commodity orange. It is clear that the loss of utility from reduced consumption of orange is greater than the gain of utility from increased consumption of apple. Hence the total utility of new combination is less. Any other allocation will make a loss in utility greater than gain in utility.

The total utility of any quantity is always the area under the marginal utility curve. When marginal utilities in two commodities are equal, total utility or the entire shaded area in the figure is at a maximum. Any change in allocation of $7 can only reduce total utility.

The equi-marginal principle can be generalized. Any decision maker can obtain maximum return from a given quantity of a resource that has two or more uses of the allocated units of resources in such a way that the marginal returns in each use are equal.

Limitations of the Law of Substitution

There are several limitations of this law, which can be explained as follows:
  1. Increase of marginal returns: For this law to hold, marginal returns must diminish as more and more units of a resource are applied to any one of its uses. Hence, this law may not apply if the marginal utility increases instead of diminishing.
  2. Custom and fashion: When people are influenced by traditions, custom and fashion, they may not behave rationally. They do not try to spend so as to maximize satisfaction. This implies that they spend more where marginal utility is less.
  3. Ignorance: The ignorance of people prevents them from making good uses of money. They cannot judge where utility is higher or where utility is lower. They cannot maximize satisfaction by equalizing marginal utilities in all uses.
  4. Unlimited resources: This law has no use in case of goods available in unlimited quantity. As for example, the free gift of nature like sunshine, air is found in abundance. People need not make rational use of them.
  5. Indivisibility: Some durable consumer goods like motorcar, TV, refrigerator, smartphone is indivisible. For this law to hold goods should be divisible and substitutable. Hence, this law cannot be applied effectively in case of the indivisible goods.
  6. Instability in prices: The consumer may be able to adjust expenditure so as to maximize satisfaction in case of the frequent changes in prices. Because, utility is always weighted in terms of prices of goods.

Importance of the law of substitution

The resources are always limited with the people. So, they should make the best use of available resources. Due to this, the law of substitution has great practical importance. The importance of this law can be explained as follows:
  • Consumption: This law is of special significance to the consumers. The consumers have limited money income. But their wants are unlimited. Hence, they should make the best use of money so as to maximize satisfaction. They should substitute the goods with low utility by goods with high utility.
  • Production: This law holds goods even in production. The aim of a firm or producer is to maximize profit. For this he should select the best combinations of factors of production. He should spend more on the factors, which yield highest returns. He should substitute one factor for another till the marginal productivity of all the factors is equal.
  • Exchange: This law has significance even in exchange. The exchange, in reality, is the substitution of one commodity for other. People get money by selling vegetable. They buy clothes with that money. So, clothes has greater marginal utility to them than vegetable. They have in fact, substituted clothes for vegetable.
  • Distribution: One of the important theories of distribution is that factors of production should be rewarded on the basis of their marginal productivity. A firm uses each factor to the point where the marginal productivity of a factor is equal to the marginal product of other factors. This implies the substitution of one factor for other.
  • Public Finance: This law is relevant even in the field of public finance. The public expenditure is made to as to maximize social welfare. Hence, the government diverts resources from less productive to the more productive sectors. The government imposes more taxes to the rich than to the poor, so that the burden of taxation is equal. Likewise, the government spends more on welfare of the poor than the rich so that benefit of expenditure is equal.

In this way, the law of substitution has wide application in all branches of economic theory. Besides, it has also practical significance. The men follow this law either consciously or unconsciously. As opined by Chapman- “We are not compelled to distribute all income according to the law of satisfaction as a stone thrown into the air is compelled to fall back to earth. But as a matter of fact, we do it in a certain rough fashion because we are reasonable.”

Law of Diminishing Marginal Utility

The law of diminishing marginal utility expresses the universal human experience. This law was at first pointed out by H. H. Gossen. So, this law is known as Gossen’s First Law. This law was developed by W. S. Jevons in England and by Karl Menger in Austria about the same time (1871) and modified by Alfred Marshall. This law states that if a person consumes more and more units of a commodity, its marginal utility declines. In other words, larger the stock possessed by a person, the smaller the utility he derives from an additional unit of the commodity.

According to Marshall, “The additional benefit which a person derives from a given increase of his stock of anything diminishes with the growth of the stock that he has.”

In the words of K. E. Boulding, “As a consumer increases the consumption of any one commodity, keeping constant the consumption of all other commodities, the marginal utility of the variable commodity must eventually decline.”
The law can be express in another way as well. As opined by Watson and Getz, “The more you have of anything, the less important to you is any one unit of it.” So, when a consumer gets more and more unit of a commodity he puts it to less and less urgent uses. We can illustrate it by the help of W. J. Baumol’s interesting example. If a man has a cake, he gives it to his child. If he has two cakes, he gives the second cake to his wife. If he has three cakes, he keeps the third one for himself and if he has four cakes, he gives the fourth one to his mother-in-law. This clearly indicates the declines in marginal utility of cake.

There are several reasons for the decrease in marginal utility. They are:
a) Physical and psychological: The consumption or possession of too many units of a commodity brings physical satisfaction. The response to a repeated stimulus diminishes.

b) Possibility of having everything: If a consumer could have everything he wants free of cost, he would choose those quantities of each good that would make the marginal utility of each one zero. This implies that he would maximize total utility for each goods. Marginal utility therefore, would have to diminish to get to zero.

c) Several uses of commodity: Each commodity may have several uses. Each consumer ranks the uses. If the consumer has one unit of a commodity, he puts it to most important use. If he has more units, he puts them to less and less important uses. Marginal utility diminishes, because of the successively less important uses of additional quantities of a commodity.

This law can be illustrated by the help of a table and diagram as shown below:
Marginal and Total Utility
Units of Orange
Marginal Utility
Total Utility
1
2
3
4
5
6
7
8
10
8
6
4
2
0
-2
-4
10
18
24
28
30
30
28
24

The table shows that as the consumer consumes more and more units of orange, the additional utility obtained from successive units goes on declining. It means that the marginal utility declines. As for example, marginal utility from first unit is equal to 10, from 2nd unit is 8, from 3rd unit is 6 and so on. Marginal utility at of 6th unit is zero. The zero marginal utility means that the consumer has all he want of the commodity. He does not want another unit. If he further consumes, marginal utility will be negative or the commodity will have dis-utility. Negative marginal utility means that the consumer has so many units of same thing. He would rather like to have fewer.
Diminishing Marginal Utility
In the figure, OX axis represents quantity (units) of orange and OY axis represents marginal utility. If we join points of marginal utility and quantity combination from point A to F, we get marginal utility curve MU. The MU curve slopes downwards to the right. This means that marginal utility goes on declining. The consumer gets marginal utility equal to 10 from 1st unit, 8 from 2nd unit, 6 from 3rd unit and so on. Marginal utility derived from 6th unit is zero and from 7th unit marginal utility is negative.

Exceptions/ Limitations or Assumptions of Law of Diminishing Marginal Utility

There are should exist certain conditions for the law of diminishing utility to hold. In the absence of these conditions, the law does not apply. The law does not apply in the following conditions.
  1. Similar units: The different units of a commodity should be similar or homogeneous. If the consumer is supplied with superior quality after consumption of first, his marginal utility will increase.
  2. Suitable units: The units of commodity consumed by a consumer should be suitable. It must not be too small. Hence, the units of the commodity must be relevantly defined. The law holds good for a pair of shoes, but not for a single shoe. Likewise, if a man is very thirsty and he gets only a glass of water, the 2nd glass of water will yield him more utility than the first. “In fact this law begins to operate only after certain point, called the ‘origin’ until the origin is reached-that is, until the minimum amount of commodity that can be used effectively has been used – successive increments will show decreasing utility.”
  3. Suitable period: There must not be time-gap in the consumption of different units. If a man takes ‘lunch’ in the morning and ‘dinner’ in the evening, his marginal utility will not diminish. Hence, the commodity must be consumed continuously.
  4. Change in taste: The law holds for individual commodity desired by an individual consumer with given tastes. But if the taste of the consumer changes during the process of consumption, and he likes the commodity more, then the marginal utility of any unit of that commodity increases.
  5. Rare collection: The law may not hold in case of rare collection. The persons with habit of collecting coins, stamps are never satisfied. But it does not mean that the law does not hold. Because, the man does not like to collect same type of article over and over again.
  6. Normal persons: The person should be normal for this law to hold good. The law does not apply to misers, drunkards and gamblers.
  7. Fashion, habit and income: The fashion, habit and income of the consumer must remain same. If a dress, out of fashion comes to the fashion, a nonsmoking man develops habit of smoking or a man unable to purchase motorbike is able to purchase, the marginal utility of the dress, cigarettes and motorbike increase respectively.
  8. Indivisible goods: According to the law, marginal utility diminishes when the commodity is bought in small units, such as orange, biscuit, milk and so on. Such commodities are said to be divisible. But the law is silent as to the commodities that are brought one at a time at long intervals. Such commodities are indivisible goods such as automobile, T.V. set, refrigerator etc. Likewise, the law is silent about the marginal utility of the commodities that are usually purchased once in a lifetime.
Despite the aforementioned exceptions, this law is regarded universal in its application and is a general law of life. There is hardly any situation under which this law does not apply. As for example, we don’t like to hear the same music, see the same movie over and over again. In fact, this law applies to everything.

Importance of Law of Diminishing Marginal Utility

The law of diminishing utility has both theoretical and practical importance as follows:
  1. Basis of other laws: Some of the laws of economics and laws of consumption are based on this law. As for example, the law of demand, law of maximum satisfaction, law of consumer’s surplus is based on this law.
  2. Theory of taxation: This law also serves as the basis of theory of taxation. The more tax is imposed on the rich while less tax is imposed on the poor. Because, the utility of money is less to the rich and more to the poor.
  3. Advocacy of equal distribution of income and wealth: People advocate equal distribution of income and wealth among the people of the country. Because the poor people get more utility from money whereas the rich people get less utility from money.
  4. Determination of market price: This law is also useful in determination of market price. The increase in stock of a commodity gives less utility. Hence the people can be induced to buy more only by lowering price. In other words, when supply increases, price falls.
  5. Regulates daily expenditure: This law regulates the daily expenditure of people. People do not spent all their money in same commodity. They spend part of their money in buying other commodities.

Theory of Consumer Behavior

Theory of Consumer Behavior

Those who buy goods and services for their own consumption are called consumers in economics. The study of the behavior of the individual consumer is called the theory of consumer behavior. There are two approaches to the theory of consumer behavior i.e. consumer behavior – cardinal utility and ordinal utility. The concept of cardinal utility was popularized by the classical economists of late 18th and 19th centuries. The 20th century version of this theory is known as neo-classical utility theory. The concept of ordinal utility was popularized by the economists like J. R. Hicks and R.G.D. Allen. The cardinal theory assumes that utility is measurable like 1, 2, and 3. But the supporters of ordinal theory assume that ‘Quantities of utility are inherently immeasurable, theoretically and conceptually as well as practically.’ According to them utilities or satisfaction can be only ranked as 1st, 2nd, 3rd and so on. Both these theory study about consumer behavior.

An important common feature of these two approaches is that they assume that the consumer behaves rationally. It means, “The consumer calculates deliberately, chooses consistently, and maximizes utility.” The consumer attempts to maximize satisfaction from given amount of money. When they succeed we say that they have achieved optimum position.

Total Utility and Marginal Utility

The power of a commodity to satisfy human wants is called utility. The satisfaction that consumer derives from the goods they buy is called their utility. A consumer may like orange more than mango. Because, orange has more utility. This property is common to all commodities wanted by a person. Hence, utility resides in the minds of the computer. The consumer knows the utility by introspection.

The concept of utility is ethically neutral. If someone wants it, a good or service has utility for that person. The consumption of drug may be harmful or immoral. But it has a utility, since it satisfies the want of a consumer.

The word ‘marginal’ has been used in economic theory for many decades. It means the rate of change of total. Hence, marginal utility means utility derived from the marginal or last unit. 

According to Watson and Getz- “The marginal utility (MU) of any quantity n is the total utility (TU) of that quantity minus the total utility of one less. Thus, MU of n = TU of n – TU of (n – 1)”

On the other hand, total utility is the utility derived from total units consumed. As quantity consumed increases, total utility increase. Because two units of a commodity yield more utility, three unit yield still more and so on. Marginal utility is defined as the net addition made to total utility by the consumption of additional unit. The concept of total utility and marginal utility can be illustrated by the help of a table below.

Total Utility and Marginal Utility
Units of Orange
Marginal Utility
Total Utility
1
2
3
4
5
6
10
8
6
4
2
0
10
18
24
28
30
30

The table shows that the marginal utility derived from 1st unit of orange is 10, from 2nd is 8, from 3rd is 6 and so on. Likewise, the total utility from 1st unit is 10, from second is 18, from 3rd is 24 and so on.

As the quantity increases, TU increases. But TU increases at a diminishing rate. The successive increases become smaller and smaller.

The relation between total utility and marginal utility has been shown in the figure below:
Total Utility and Marginal Utility
In the upper part of the figure, TU is the total utility curve. The total utility curve is upward sloping but the amount of the rise is less and less as more and more are consumed. Thus the marginal utility curve is declining: each successive consumption adds to total utility but each adds less than their predecessor. Hence, the TU curve shows how total utility continues to increase as more and more units are added. The lower part of the figure shows only the increase in total utility. So, MU is the marginal utility curve. It shows the marginal utilities of different units of the commodity. When the total utility is maximum (30) at point M, marginal utility is zero at point N.

Factors Determining Elasticity of Demand

It is difficult to say whether the demand for a commodity is elastic or inelastic. Whether the demand for a commodity is very elastic or less elastic depends on several factors. The main factors determining elasticity of demand can be explained as follows:
  1. Nature of commodity: The elasticity of demand depends on nature of the commodity. The goods are classified as necessary, comfort and luxury. In general, the demand for necessaries of life such as food grain, salt is inelastic. The increase in price does not reduce demand. In general, the demand for comfort and luxury such as T.V., car, smartphones is elastic. The decrease in price increases the demand for the demand these goods. But necessary and luxury are relative terms. So, for the same commodity, elasticity may differ from person to person. As for example, the demand for car is a necessary to the rich but luxury to the poor. Hence, demand for car may be inelastic for the rich and elastic for the poor.
  2. Existence of substitutes: The existence of substitutes also affects the elasticity of demand. As for example, tea and coffee are substitutes. If the price of tea increases people substitute coffee. So, the demand for tea is elastic. But the demand for the commodities having no substitute such as salt, potato, onion is relatively inelastic.
  3. Number of uses: When the commodities have several uses, the demand for such commodities is elastic. As for example, electricity. If the price of electricity fall, it is put to several uses such as in cooking, pressing clothes, using fan etc. The elasticity of demand may be different in different uses. As for example, the demand for electricity for cable car is inelastic, since it does not have alternative. But for domestic purpose such as for cooking, electricity can be substituted by gas. So, demand is elastic.
  4. Possibility of postponement: When the possibility of postponement of consumption of a commodity exists, the demand is elastic. As for example, the consumption of Coca-cola can be postponed. But in case of consumption of goods, which are urgently needed, demand will be inelastic. The consumption of rice cannot be postponed.
  5. Level of Prices: If the price is too high or too low, the demand for a commodity will be inelastic. In case of expensive goods like T.V., car, camera, phones, demand will be inelastic. This implies that a small change in price, say $100 will not have effect on demand. The demand will be elastic only if the price change is high. Likewise, the demand for low-priced goods such as salt, onion, newspaper is inelastic. A small change in price will not affect demand. Because, all might have already purchased the required quantity.
  6. Proportion of income spent: if the persons spend a small amount in a commodity, a change in its price will not affect demand or demand will be inelastic. As for example, the demand for cheaper goods such as salt, matches is inelastic. But in case of expensive commodity such as car, demand is elastic.
  7. Habit and custom: If the commodities are demanded or account of habit and custom, demand will be less elastic. As for example, the increase in price of cigarettes or wine does not reduce the demand. Likewise, due to custom, the increase in gold price does not reduce the demand for wedding ring.
  8. Consumer’s incomes: Generally, the higher a person’s income the more inelastic will be his demand for commodities. The demand of millionaire for all commodities may be unaffected by any change in price. For most people, however, choice has to be made. Lower the person’s income, the higher the need of choice.

Measurement of Price Elasticity: Total Outlay Method

In general, elasticity of demand means price elasticity. The concept of price elasticity is widely used in demand analysis. There are three methods of measuring price elasticity – total outlay method, point method and arc method. Here we concentrate only on total outlay method.

Total Outlay Method or Expenditure Method

In total outlay method, we see the change in expenditure as a result of change in price. Then on the basis of change in expenditure, we say whether the elasticity is equal to unity or greater than unity or less than unity. This can be illustrated by the help of schedule and figures.

1. Elasticity of Demand Equal to Unity (Ed = 1)
If the change in price does not change the total expenditure, the elasticity of demand is said to be equal to unity. In the table, the price falls from $10 to $9 to $8, but the total expenditure (PQ) remains unaltered at $10,000. So, the elasticity of demand is equal to unity.

Demand Schedule with Different Elasticities
Elastic Demand
Unit Elastic Demand
Inelastic Demand
P
Q
PQ (TE)
P
Q
PQ (TE)
P
Q
PQ (TE)
$10
$9
$8
1,000
2,000
3,000
10,000
18,000
24,000
10
9
8
1,000
1,111
1,250
10,000
10,000
10,000
10
9
8
1,000
1,050
1,100
10,000
9,450
8,800
Adapted from Watson & Getz: Price Theory & Its Uses

The unitary elastic demand can be illustrated by the help of a figure below.
Unitary Elastic Demand
In the figure, at initial price OP, quantity demanded is OM and total outlay (PXQ) is equal to rectangle OMRP. When the price falls to OP1, quantity demanded increases to OM1, and total expenditure is equal to rectangle OM1R1P1. The total expenditure falls by the area marked (-) and rises by the area marked (+). The area (-) is equal to area (+). So, the spending remains unaltered. In other words, new total expenditure OM1R1P1 = initial total expenditure OMRP. So, elasticity of demand is equal to unity. When the demand curve is rectangular hyperbola, the elasticity of demand on all points of it is equal to unity.

2. Elasticity of Demand Greater than Unity (Ed > 1)
If the total expenditure increases with fall in price, elasticity of demand is said to be greater than unity. As shown in table, as the price falls from $10 to $9 to $8, the total expenditure increases from $10,000 to $18,000 to $24,000. So, the elasticity of demand is greater than unity. This can be illustrated by the help of following figure.
Greater Than Unity
In the figure, the total expenditure at price OP is equal to rectangle OMRP. When price falls to OP1, the total expenditure increases to the rectangle OM1R1P1. The total expenditure falls by area marked (-), but rises by the area marked (+). The area (+) exceeds the area (-). The total spending increases. Hence, the elasticity of demand is greater than unity.

3. Elasticity of Demand Less than Unity (Ed < 1)
If the total expenditure falls with fall in price, the elasticity of demand is said to be less than unity. As shown in table, as the price falls from $10 to $9 to $8, the total expenditure falls from $10,000 to 9,450 to $8,800. Hence, elasticity of demand is less than unity. This can be illustrated by the help of a figure below.
Less Than Unity
As shown in the figure, when price is OP, the total expenditure is equal to rectangle OMRP. When price falls to OP1, the total expenditure falls to the rectangle OM1R1P1. The total expenditure falls by the area marked (-) but rises by the area marked (+). The area (+) is smaller than the area (-). The total expenditure falls. Hence, elasticity of demand is less than unity.

Cross Elasticity of Demand

Cross Elasticity of Demand

Some goods are related to each other. So a fall in the price of a commodity causes change in the demand for other commodity. As for example, demand for tea is related to the price of substitute, coffee. When the price of coffee increases, the demand for tea increases. Hence, cross elasticity of demand means the responsiveness of quantity demanded of a commodity to the change in price of other commodity. The cross elasticity of demand is defined as the percentage in the quantity demand of good x resulting from a 2 percent change in the price of good y.
According to C. E. Ferguson, “Cross elasticity is the proportionate change in the quantity demanded of good x divided by the proportionate change in the price of y.”
The formula to calculate cross elasticity is,

Cross Elasticity = Proportionate change in quantity demanded of x/Proportionate change in price of y

Symbolically, Ec = Δqx/Δpy x Py/Qx

The concept of cross elasticity can be illustrated by the help of a numerical example. Suppose that x and y are two substitute goods. Suppose when the initial price of y is $4.50, the initial quantity of x is 60kg. Now when the price of y increases to $5, the quantity demanded of x increases to 70kg. The cross elasticity is calculated as,

Ec = Δqx/Δpy x Py/Qx 
= 10/5.0 x 4.5/60 = 3/2 = 1.5

1.5 coefficient shows that the cross elasticity is positive.

Types of Cross Elasticity

The goods may be either substitutes or complements. So the cross elasticity is of two types as follows:
1. Positive Cross Elasticity (Ec > 1)
When two goods are substitutes of each other, the cross elasticity is positive. As for example, tea and coffee. The increase in price of one commodity leads to an increase in quantity demanded of other commodity. Because, people substitute one commodity for other.
Positive Cross Elasticity
In the figure, demand curve DD shows positive cross elasticity. Because, with the increase in price X from OP to OP1, demand for Y has increased from OM to OM1.

2. Negative Cross Elasticity (Ec < 0)
When two goods are complements, cross elasticity is negative. As for example, shoe and shoelaces. The increase in price of one commodity causes fall in the quantity demanded of other commodity.
Negative Cross Elasticity
In the figure, demand curve DD shows negative cross elasticity. Because due to the increase in price of X from OP to OP1, demand for Y has declined from OM to OM1.

When the goods are not related to each other, the cross elasticity is zero. As for example, book and coat. The change in price of one does not affect the demand for other. Hence, the demand curve will be a vertical straight line. But this is not counted as cross elasticity.

Income Elasticity of Demand

Income Elasticity of Demand

The income elasticity measures the responsiveness in quantity demanded to the change in income. In other words, it measures by how much the quantity demanded changes with change in income. The income elasticity of demand is defined to be the percentage change in quantity demanded resulting from a 1 percent change in consumer’s income.

According to C. E. Ferguson, “Income elasticity of demand is the proportionate change in quantity demanded divided by proportionate change in income.”

The formula to measure income elasticity is,

Income elasticity = Proportionate change in quantity demanded/Proportionate change in income

Symbolically, 
Ey = Δq/Δy  x   y/q

Where, y denotes income

The concept of elasticity of income can be illustrated by the help of an example. Suppose that when the income is $100, demand is 25 units. Now suppose that the income increase to $150. As a result of its demand increases to 30 units. The elasticity of income is calculated as,

EyΔq/Δy  x   y/
= 5/50 x 100/25 = 2/5

The coefficient 2/5 shows that the demand is inelastic.

Types of Income Elasticity

There are three types of income elasticity in practice. They are:

1. Positive income elasticity (Ey > 0)
If the demand for the commodity increases with increase in income elasticity is said to be positive. For most commodities increase in income lead to increases in quantity demanded. Such goods are called normal goods. Normal goods have positive income elasticities.

2. Negative Income Elasticity (Ey < 0)
If the demand decreases in income, income elasticity is said to be negative. Inferior goods such as cheap foods have negative income elasticities.

3. Zero Income Elasticity (Ey = 0)
The boundary between positive and negative income elasticity is zero income elasticity. If the demand for the commodity does not change with the increase in income, income elasticity is said to be zero. This happens in case of neutral goods such as salt, matches etc.

These three types of income elasticity have been shown in a single diagram below:
Types of Income Elasticity
In the figure, demand curves show zero, positive and negative income elasticity. Good A has zero income elasticity. Good B is a normal good with a positive income elasticity. Good C is an inferior good with a negative income elasticity.

It should, however, be noticed that a good does not have to be in the same category at all levels of income. The same good may have zero income elasticity at very low level of income; positive elasticity at higher level of income and negative income elasticity at very high level of income.
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Elasticity of Demand

Elasticity of Demand

The term ‘elasticity’ denotes the quantity of a good to expand and contract. Hence, the change in quantity demanded due to change in price is called elasticity of demand. The economists like Courot, J. S. Mill, introduced the concept of elasticity of demand in economics. The credit is given to Dr. Alfred Marshall for the development of this concept.

The law of demand tells that the quantity demanded of a commodity varies inversely with price. But it does not tell how much quantity demanded changes with change in price. This task is accomplished by elasticity of demand. The elasticity of demand tells by how much the quantity demanded changes with change in price.
In the words of Alfred Marshall, “The elasticity (or responsiveness) of demand in a market is great or small according as the amount demanded increase much or little for a given fall in price and diminishes much or little for a given rise in price.”
According to Stonier and Hague, “Elasticity of demand is, therefore, a technical term used by the economists to describe the degree of responsiveness of the demand for the commodity to a fall in its price.”
In brief, elasticity of demand measures the rate of change in quantity demanded as a result of the change in price.

Kinds of Elasticity of Demand

Broadly speaking, there are three main types of elasticity of demand. They are price elasticity, income elasticity and cross elasticity.

Price Elasticity of Demand

In general, elasticity of demand means price elasticity of demand. This concept is most popular and most frequently used. Price elasticity means the responsiveness of quantity demanded to the change in price. The price elasticity of demand is defined to be the percentage change in quantity demanded resulting from 1 percent change in price. The price elasticity shows at what rate the demand changes with change in price. In the words of C. E. Ferguson, “Price elasticity is the proportionate change in quantity demanded divided by the proportionate change in price.”

The formula to find out price elasticity is,

Price elasticity = Proportionate change in quantity demanded/Proportionate change in price

Symbolically,

Ep = Δq/Δp x p/q

Where Ep = elasticity of price, P = price, Δ = small change and q = quantity. The concept of price elasticity can be illustrated by the help of a numerical example. Suppose that the original price (P1) of a commodity is $10 per unit and quantity demanded (Q1) is 2000 units. Now suppose that when price (P2) fall to $9, quantity demanded increases to 2500 units. The price elasticity is calculated as follows:

Ep = Δq/Δp x p/q

= 500/-1 x 10/2000 = -5/2 = -2.5

It shows that the quantity demanded increase by 2.5 percent with one percent fall in price. The minus sign shows the inverse relationship between price and quantity demanded. In general, this sign is not used, since the inverse relationship is an implied one. 2.5 is called co-efficient of elasticity of demand. The coefficient >1, =1, <1, =0 and = ∞ shows elastic, unitary elastic, inelastic, perfectly inelastic and perfectly elastic demand respectively.

Types of Price Elasticity

The price elasticity of demand is classified into following five parts:

1. Perfectly Elastic Demand (Ep = ∞ )
The demand is said to be perfectly elastic if the quantity demanded increases in unlimited quantity with small fall in price or quantity demanded falls to zero with a small rise in price. Such situation is rarely found in real life.
Perfectly Elastic Demand
In figure, demand curve DD is a horizontal straight line or parallel to the OX axis. It shows that the negligible change in price causes infinite rise or fall in quantity demanded.

2. Perfectly Inelastic Demand (Ep = 0)
If the demand remains constant whatever be the price, demand is said to be perfectly inelastic. The case of perfectly elastic demand is also rarely found in real life.
Perfectly Inelastic Demand
In the figure, the demand curve DD is a vertical straight line. It shows that the demand remains constant whatever be the change in price. As for example, even after the increase in price from OP to OP1 and fall in price from OP to OP2, the quantity demanded remains OM.

3. Relatively Elastic Demand (Ep > 1)
If there is a great change in demand with a small change in price, it is called relatively (more) elastic demand. The demand for luxury goods is considered to be more elastic.
Relatively Elastic Demand
In the figure, the demand curve DD is more flatter which shows that the demand is more elastic. The small fall in price from OP to OP1, has led to greater increase in demand from OM to OM1. Likewise, demand decrease more with small increase in price.

4. Relatively Inelastic Demand (Ep < 1)
If there is small change in demand with greater change in price, the demand is said to be relatively inelastic. The demand for basic goods such as salt, matches are said to be less elastic.
Relatively Inelastic Demand
In the figure, demand curve DD is steeper which shows that the demand is less elastic. The greater fall in price from OP to OP1 has caused small change in demand from OM to OM1. Likewise, great increase in price leads to small fall in demand.

5. Unitary elastic demand (Ep = 1)
If the ratio of change in demand is equal to the ratio of change in price, the demand is said to be unitary elastic. This kind of elasticity is also an imaginary one.
Unitary Elastic Demand
In the figure, demand curve DD is a rectangular hyperbola, which shows that the demand is unitary elastic. The fall in price from OP to OP1 has caused equal proportionate increase in demand from OM to OM1. Likewise, when price increase, the demand decreases in the same ratio.

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