Showing posts with label Elasticity of Demand. Show all posts
Showing posts with label Elasticity of Demand. Show all posts

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.
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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.
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Cross Elasticity of Demand: Proportionate change in demand with change in price

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 = Î”qx/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 = Î”qx/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.
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Elasticity of Demand: Types of Price 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 = Î”q/Δp x p/q

Where Ep = elasticity of price, P = price, Î” = 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 = Î”q/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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Uses of Price Elasticity of Demand in Managerial Decision-making

The concept of price elasticity of demand has important practical applications in managerial decision-making. A business man has often to consider whether a lowering of price will lead to an increase in the demand for his product, and if so, to what extent and whether his profits would increase as a result thereof. Here the concept of elasticity of demand becomes crucial.

Knowledge of the nature of the elasticity of demand for his products will help a business to decide whether he should cut his price in a particular case. Such knowledge would also help a businessman to determine whether and to what extent the increase in costs could be passed on to the consumer. In general for items those whose demand is elastic it will pay him to charge relatively low prices, while on those whose demand is elastic, it would be better off with a higher price. A monopolist would not be able to increase his price if the demand for his product is elastic.

In practice, an accurate estimate of the probable response of volume of sales to price changes is extremely difficult. Moreover, the cost of the statistical analysis required may in some cases, exceed the benefit especially when uncertainty is great or when the volume is too small to provide a reason also return on the amount spend on research. The subjective judgment of certain managers, beyond on years of experience, sometimes exceeds in accuracy the best of the present statistical techniques. Uses of price elasticity can be point out as below:

1. Price Distribution

A monopolist adopts a price discrimination policy only when the elasticity of demand of different consumers or sub-markets is different. Consumers whose demand is inelastic can be charged a higher price than those with more elastic demand.

2. Public Utility Pricing

In case of public utilities which are run as monopoly undertakings e.g. elasticity of water supply railways postal services, price discrimination is generally practiced, charging higher prices from consumers or users with inelastic demand and lower prices in case of elastic demand.

3. Joint Supply

Certain goods, being products of the same process are jointly supplied, e.g. wool and mutton. Here if the demand for wool is inelastic compared to the demand for mutton, a higher price for wool can be charged with advantage.

4. Super Markets

Super markets are a combined set of shops run by a single organization selling a wide range of goods. They are supposed to sell commodities at lower prices than charged by shopkeepers in the bazaar. Hence, price policy adopted is to charge slightly lower price for goods with elastic demand.

5. Use of Machine

Workers often oppose use of machines out of fear of unemployment. Machines need not always reduce demand for labor as this depends on price elasticity of demand for the commodity produced. When machines reduce costs and hence price of products, if the products demand is elastic, the demand will go up, production will have to be increased and more workers may be employed for the product is inelastic, machines will lead to unemployment as lower prices will not increase the demand.

6. Factor Pricing

The factors having price inelastic demand can obtain a higher price than those with elastic demand. Workers producing products having inelastic demand can easily get their wages raised.

7. International Trade

(a) A country benefits from exports of products as have price inelastic demand for a rise in price and elastic demand for a fall in price. 
(b) The demand for imports should be inelastic for a fall in price and elastic for a rise in price. 
(c) While deciding whether to devalue a country’s currency or not, price elasticity of demand for a country’s exports would be an important factor to be taken into consideration. If the demand is price elastic, it would lead to an increase in the country’s exports and devaluation would fail to achieve its objective.

8. Shifting of Tax Burden

It is possible for a business to shift a commodity tax in case of inelastic demand to his customers. But if the demand is elastic, he will have to bear the tax burden himself, otherwise demand for his goods will go down sharply.

9. Taxation Policy

Government can easily raise tax revenue by taxing commodities which are price inelastic.
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