Lecture 4


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Lecture 4

  1. 1. Lecture 4Elasticity of Demand
  2. 2. Meaning of Elasticity• There is inverse relationship between demand and price – A change (rise or fall) in price leads generally to a change in (contraction or extension) of demand• This attribute of demand by virtue of which stretches or contracts under the pressure of price change is called Elasticity of demand• Elasticity of demand is the measure of the responsiveness of demand to changing prices
  3. 3. Elastic & Inelastic Demand• A change in demand is not always propionate to change in price – A small change in price may lead to a great change in demand – On the other hand, there is a possibility same change in price may lead to a small change in demand• In the case where change in small change in price lead to great change then it is called elastic demand – E.g. tv sets, DVD player• Whereas, big change in price leading to small change in demand is called inelastic demand – E.g salt, bread
  4. 4. Different cases of Elasticity• Perfectly Elastic or infinite elasticity• Perfectly Inelastic or Zero elasticity• Relatively elastic• Relatively inelastic• Unit elasticity
  5. 5. Infinite Elasticity• Infinite elastic demand curve is parallel to x-axis• It shows that even a small reduction in price may lead to unlimited extension in demand
  6. 6. Zero Elasticity• The demand curve is vertical straight line. It is parallel to Y-axis.• It shows that how much price rise or fall demand of the commodity remains the same
  7. 7. Relatively Elastic• By relatively elastic demand we mean that with increase or decrease in price quantity change is relatively high
  8. 8. Relatively Inelastic• By relatively inelastic demand we mean with decrease or increase in price increase or decrease of demand is relatively less
  9. 9. Unit Elasticity• When there is similar increase quantity demanded due to change in price then it is called unit elasticity• The curve which we derive is called equilateral or rectangular hyperbola
  10. 10. Relationship of Elasticity with Law of DMU• Marginal Utility varies with supply – It falls when the supply is increased and rises when the supply contracts• Fall in MU does not occur at uniform rate in all commodities• For example in case of salt, we soon get fed up and the MU falls very rapidly while in case of luxuries MU comes down gradually
  11. 11. Types of Elasticity• Price Elasticity• Income Elasticity• Cross Elasticity
  12. 12. Price Elasticity• Price elasticity measures responsiveness of potential buyers to change in price• It is the ratio of percentage change in quantity demanded in response to a percentage change in price• Price Elasticity PE= Proportionate change in amount demanded Proportionate change in price PE=∆q/q ÷ ∆p/p
  13. 13. Income Elasticity• Income elasticity is a measure of responsiveness of potential buyers to change in income• Income Elasticity IE=Proportionate change in the quantity purchased Proportionate change in income IE= ∆q/q ÷ ∆y/y
  14. 14. Cross Elasticity• Cross elasticity shows change in demand of one product due to change in price of other• Cross elasticity CE= Proportionate change in purchase of commodity X Proportionate change in price of commodity Y CE= ∆qx/qx ÷ ∆py/py
  15. 15. Substitution Elasticity• We make use of MRS discussed in IC Analysis• The elasticity of substitutions shows to what extent one commodity can be substituted for another without making any change in the total level of satisfaction derived by the consumer• The elasticity of substitution of two goods is the measure of the ease or difficulty with which one commodity can be substituted for another• There are two extremes: – The elasticity of substitution may be infinite • The goods which are perfect substitues – The elatsticity of substitution may be zero • Goods are not substitutes at all. They have to be used in fixed proportion • Between these two limits there can be various degrees of substitution
  16. 16. Substitution Elasticity• When the substitution of one good for another is difficult – A small change in the ratio of the two goods will bring about a great change in their marginal rate of substitution• When the substitution of one good for another is easy – A small change in their proportion with the consumer will not make much change in their MRS
  17. 17. Elasticity of substitution• Elasticity of substitution E= Δ(qx/qy) ÷ Δ(ΔY/ΔX) qx/qy ΔY/ΔX qx/qy= the original proportion between quantities of goods X and Y Δ(qx/qy) = small change in the proportion of goods X and Y ΔY/ΔX = MRS of X for Y Δ(ΔY/ΔX)= the change in the MRS of X for Y
  18. 18. Relationship between PE, IE and SE• ep=K.Xei+(1-KX)es – ep= price elasticity of demand – ei= income elasticity of demand – es= Substitution elasticity of demand – KX is the proportion of the consumer’s income spent on commodity X• In the above equation KXei shows the influence of income effect on the price elasticity of demand• (1-KX)es shows the substitution effect. A fall in price of X will lead to its substitution for other goods
  19. 19. Factors Determining Price Elasticity of Demand• Necessaries – Elasticity of price of necessaries e.g. salt, wheat, may be inelastic• Luxuries – Demand for luxuries e.g. refrigerator, TV, car, is elastic• Proportion of Total Expenditure – If a consumption of good absorbs only a small proportion of total expenditure e.g. salt etc. the demand will not be much affected by price• Substitutes – Elasticity also depends on availability of substitutes e.g tea and coffee• Goods having several Uses – Demand of good having several uses is elastic e.g. coal
  20. 20. Factors Determining Price Elasticity of Demand• Joint Demand – E.g. carriages become cheap but price of horses continues to rule high demand of carriages will not go up.• Goods the use of which can be postponed – E.g. building a house, a furniture etc. can be postponed due to wait till fall in its prices• Level of prices – If some thing is very expensive its little decrease in price will not do much. Similarly if some thing is too cheap its demand will also not increase much as people would have bought• Market Imperfections – The consumer may not be aware of the change in prices in the market• Technological factors – E.g Tonga and car
  21. 21. Measurement of Elasticity• Total Outlay Method• Proportional Method• Geometrical Method
  22. 22. Total Outlay Method• According to this method, we compare the total outlay of the purchaser (or total revenue i.e. total value of sales from the seller’s point of view) before and after the variations in price• Elasticity of demand is expressed in three ways – Unity • It is unity, when, the price has changed, the total amount spent remains the same • The rise in price is exactly balanced by reduction in purchases and vice versa – Greater than unity • Elasticity is greater than unity, (the demand is elastic) between two prices • When the price falls, total amount spent increases and vice versa – Less than unity • Elasticity is less than unity, (the demand is inelastic), if with a rise in price total amount spent increases and with decrease in price total amount spent decreases
  23. 23. Example Price of Pencil Per Quantity Total Outlay Dozen (Rs.) Demanded (Revenue)1 8 3 242 7 4 283 6 5 304 5 6 305 4 7 286 3 8 24Between S No. 1 and 2, and 2 and 3 price elasticity is greater than unityBetween S No. 3 and 4, price elasticity is unityBetween S No. 4 and 5, and 5 and 6 price elasticity is less than unity
  24. 24. Proportional Method• In this method, we compare the percentage change in price with the percentage change in demand• Price elasticity = Proportionate change in amount demanded Proportionate change in Price = change in demand + change in price amount demanded Price
  25. 25. Geometrical Method: Point Elasticity• This method tells us how to measure elasticity of demand at any point on demand curve
  26. 26. Arc Elasticity• We express the price change as a proportion of the average of the initial price and change in price• Arc Elasticity =Δq/Δp X p/q
  27. 27. Practical Applications• Taxation – More revenue if tax is collected from the goods which demand is inelastic• Monopoly Price – More price incase of inelastic demand• Output – Demand of consumer and market e.g. newspaper• Wages – If DD of any particular labour is inelastic, it is easy to raise wages• Effect on the economy – The working of economy is affected by the nature of consumer demand – Producer’s demand for different factors of production also affect the economy• Economic Policies – In regulation of economy it helps• International Trade – The nature of demand for the internationally traded goods is helpful in determining the quantum of gain accruing to the respective countries