The Law of Demand tells us that as the price of a commodity falls, the quantity demanded increases, and vice versa. But, it does not state by how much the quantity demanded increases as a result of a certain fall in the price or by how much the quantity demanded decreases as a result of a rise in price. In other words, the law of demand tells us only the direction of change, but not the rate at which the change takes place.
Price Elasticity of Demand (or Elasticity of Demand, as it is customarily known) tells us the extent of such change. Elasticity of demand can be defined as “the degree of responsiveness of quantity demanded to a change in price”
The price elasticity of demand may be measured by the following formula: Proportionate change in the quantity demandedep = _______________________________________ OR Proportionate change in price Change in quantity demanded ________________________ Quantity demanded = _______________________________________ Change in price _____________ Price
(Q2 - Q1) _________ Q1 ep = _____________________ (P2 - P1) ________ P1 where Q1 stands for quantity demanded before price change Q2 stands for quantity demanded after price change P1 stands for price charged before price change P2 stands for price charged after price change
Illustration Quantity demanded before price change (Q1) = 4,000 Quantity demanded after price change (Q2) = 5,000 Price charged before price change (P1) = 20 Price charged after price change (P2) = 18 Find the price elasticity of demand.
(5,000 – 4,000) ____________ 4,000 ep = ___________________ = - 2.5 (18 – 20) ________ 20 The price elasticity is negative emphasizing the inverse relationship between price and demand. However, the minus sign is omitted from the final result as the inverse relationship is implied.
When the change in price is more, the following method of calculation of elasticity of demand would be more appropriate: Q2 – Q1 __________ Q2+Q1 Q2 – Q1 _____ _______ 2 Q2 + Q1 ep = __________________ = _____________ P2 – P1 P2 – P1 ___________ ______ P2+P1 P2 + P1 _____ 2
Applying the above formula, the result of the problem given above will be as under: 1,000 _____ 9,000 1/9 ep = __________ = ______ = - 2.11 -2 - 1/19 ___ 38 A one per cent reduction in price will result in a 2.5% increase in the quantity demanded according to the first formula and 2.1% increase according to the second formula.
Perfectly elastic demand In this case, no reduction in price is needed to cause an increase in demand. The firm can sell the quantity it wants at the prevailing price but none at all at even a slightly higher price. Perfectly inelastic demand In this case, a change in price, howsoever large, causes no change in quantity demanded.
Demand with unity elasticity In this case, a given proportionate change in price causes an equal proportionate change in the quantity demanded. Relatively elastic demand In this case, a reduction in price leads to more than proportionate change in demand. Relatively inelastic demand In this case, a decline in price leads to less than proportionate increase in demand.
The demand for necessities is generally inelastic because the consumption of a necessary article does not change much with a change in price. Example: Salt. The demand for luxuries changes much due to a price change and is therefore elastic. Example: silk saree.
A commodity having a variety of uses has a comparatively elastic demand. Example – Steel. Steel can be used for many purposes. A slight fall in steel price will bring forth demand from many quarters and hence demand is elastic. A commodity having a limited use will have a comparatively inelastic demand.
A commodity having a number of substitutes has relatively elastic demand because if its price rises, its consumption can be curtailed in favor of the substitutes. For example, if city bus fare rises, people will use electric train.
People with high incomes are less affected by price changes than people with low incomes. A rich man will not curtail consumption of fruits and or milk even if their price rises significantly. But, poor man will curtail the extent of consumption. Hence, demand for fruits and milk is inelastic for the rich but elastic for the poor.
Where an individual spends only a small part of his income on the commodity, the price change does not materially affect his demand for the commodity. e.g. salt, match box, etc. and the demand is inelastic .
The urgency of demand tends to cause inelastic demand. e.g. cigarette, liquor, etc.
The more durable and repairable a commodity, the higher is its elasticity of demand. e.g. shoes.
If the frequency of purchase of a product is very high, its demand is likely to be more price elastic than in the case of a product which is purchased less often.
Cross elasticity of demand may be defined as ‘the proportionate change in the quantity demanded of a particular commodity in response to a change in the price of another related commodity’. The effect of a change in the prices of related goods upon the demand for a particular commodity may be determined by measuring the ‘cross elasticity of demand’.
Let u suppose, the price of one commodity, say Z is the independent variable whereas the quantity of another commodity, say X, is the dependent variable. The cross elasticity of demand can be measured by the following formula: Proportionate change in the quantity purchased of X ec = __________________________________________ Proportionate change in the price charged for Z If cross elasticity is positive, the goods are said to be substitutes; if negative, the goods are complements.
Income elasticity of demand may be defined as the degree of responsiveness of quantities demanded to a given change in income. Income elasticity of demand can be measured by the following formula:
Proportionate change in quantities demanded ey = ______________________________________ or Proportionate change in income Q2 – Q1 _______ Q1 = ______________________ Y2 – Y1 ______ Y1where Q1 stands for quantities demanded before the change in income Q2 stands for quantities demanded after the change in income Y1 stands for the income before change Y2 stands for the income after change
Illustration: Suppose a consumer, when his income is Rs.10,000, purchases 10 Kgs of sugar. If his income goes up to Rs.11,000, he is prepared to purchase 12 Kgs. of sugar. Find out the income elasticity of demand.
Zero income elasticity A change in income will have no effect on the quantity demanded. e.g. Salt. Negative income elasticity An increase in income may lead to a reduction in the quantities demanded. Such goods are called inferior goods. e.g. An increase in income might lead to shift is demand from beedis to cigarettes.
Positive income elasticity An increase in income may lead to an increase in the quantity demanded. Such goods are called superior goods. Positive income elasticity can be of three types
Unity elasticity The elasticity is unity when an increase in income leads to a proportionate change in the quantity demanded. More than unity elasticity The elasticity is more than unity when an increase in income leads to a more than proportionate change in quantity demanded. Articles of luxury fall in this category. Less than unity elasticity Elasticity is less than unity when the increase in income leads to a less than proportionate change in the quantity demanded. Articles of necessities characterize this category. e.g. Wheat and rice.
The expansion of demand by means of advertisement and other promotional efforts may be measured by advertising elasticity of demand (also called promotional elasticity). The promotional elasticity measures the responsiveness of demand to changes in advertising or other promotional expenses.
The formula for measurement of Advertising elasticity of demand is given below: Proportionate change in sales ea = ______________________________ Proportionate change in advertisement expenditure
Type of commodity Advertising elasticity will tend to be higher for luxuries than for necessities; also higher for new products than for old ones. Market share The larger the firm’s market share, the lower the advertising elasticity of demand and vice versa.
Rivals’ reactions If rivals react by increasing their promotional spending, the expenditure will tend to cancel each other out, reducing advertising elasticity of demand. State of economy If economic conditions are good and households have a high degree of discretionary income, they are more likely to respond to advertising.