Elasticity of Demand
The relative responsiveness of a supply or a demand curve in respect to price is referred as elasticity of demand. If the curve is more elastic then it means the more quantity will be changed in respect to price change.
If the percentage change in quantity demanded is divided by the percentage change in one of the variable which affect the demand, then it is called ‘elasticity of demand’. Also, you have to know about the theory of demand.
Types of Elasticity of Demand
- Price Elasticity of Demand
- Income Elasticity of Demand
- Cross Elasticity of Demand
- Advertising and Promotional Elasticity of Demand
1. Price Elasticity of Demand
Price elasticity of demand denotes the change in quantity demanded of goods with respect to a change in price, given that the consumer’s income, his tastes and prices of all other goods.
According to Prof. Lipsey, “Elasticity of demand may be defined as the ratio of the percentage change in demand to the percentage change in price.” Thus, price elasticity of demand is the ratio of percentage change in amount demanded to a percentage change in price. It may be written as:
Price Elasticity (Ep) =% Change in quantity demanded / % Change in prices
Ep = Change in quantity/Original quantity × Original Price/ Change in price
Ep = Price elasticity,
Q = Quantity,
P = Price,
∆Q = Change in quantity demanded,
∆P = Change in price.
Types/Degrees of Price Elasticity
Price elasticity of demand is classified into five categories:
a. Perfectly Elastic Demand (E = infinity)
If the demand for a commodity changes even though there is no change in price then demand is called perfectly elastic. It also indicates that if a very small change is done in price then quantity demanded would changes indefinitely and due to this reason seller would not change the price.
In Graph, straight-line parallel to X-axis denotes the demand curve. The figure shows that at the current price OD, any amount of the commodity can be sold which indicate the perfect elastic demand or E = infinity .
b. Perfectly Inelastic Demand (E=0)
In case of perfectly inelastic demand, the demand for a commodity does not change even though there is change (increase or decrease) in price. In real life it is very difficult to find the practical example of perfectly inelastic demand. Let us consider that the price of any commodity is decreased by 40% but there is no change in quantity demand, then it is said to be a perfectly inelastic demand. In Graph, an increase or decrease in price of a commodity is followed by absolutely no decrease or increase in the quantity demanded. Thus elasticity becomes zero i.e., E = 0.
c. Unitary Elastic Demand (E = 1)
If the change in demand is exactly equivalent to the change in price then demand of that product is known as unitary elastic demand. In this case the demand curve is represented by a rectangular hyperbola.
d. Elastic Demand (E>1)
If the percentage change in price is less than the percentage change in quantity demanded then price elasticity of demand is greater than one. This is known as elastic demand.
e. Inelastic Demand (E<1)
In case of inelastic demand, percentage change in demand for a commodity is less than the percentage change (increase or decrease) in price. Price elasticity of demand is less than one. This is referred as inelastic demand.
Measurement of Price Elasticity of Demand
There are five methods to measure the price elasticity of demand.
a. Total Outlay Method
Total expenditure method was developed by Dr. Marshall to measure the price elasticity of demand. According to this method, measurement of price elasticity of demand is based on the change in total outlay or total expenditure in respect to a change in the price of the commodity.
Total Outlay = Price x Quantity Demanded.
This elasticity of demand can be of three types:
i) Unitary Elasticity: Price elasticity of demand is unitary in the condition when total expenditure does not change with change in price of the commodity. In other words, if change in quantity is equivalent to the change in the price then price elasticity of demand is called unitary.
ii) Elastic Demand: If a small change in price leads to a relatively large change in the quantity demanded then demand is elastic.
iii) Inelastic Demand: If a small change in price leads to a relatively smaller change in the quantity demanded then demand is inelastic.
b. Proportionate Method
The ratio of percentage change in the amount demanded and percentage change in price of the commodity is as price elasticity of demand”. It is also known as the Percentage Method, Flux Method, Ratio Method, and Arithmetic Method.
c. Point Method or Geometric Method
This method was also developed by Marshall and a straight line demand curve taking into consideration to measure the elasticity of demand on different points of demand curve. It is opposite of proportionate method. To measure the elasticity of demand we take a straight line demand curve as shown in Graph, AB is the demand curve.
We know that , Ep =P.∆Q /Q.∆P
*Point Elasticity of Demand = Lower Segment of Demand Curve / Upper Segment of Demand Curve
d. Arc Method
According to Professor Baumol, “Arc elasticity is a measure of the average responsible to price change exhibited by a demand curve over some finite stretch of the curve”. This method of measuring elasticity of demand is also known as “Average Elasticity”.
*Arc Elasticity of Demand (EA) = Change in Demand or Original Demand + New Demand / Change in Price or Original Price + New Price
e. Revenue Method
This method was given by Mrs. Joan Robinson. She suggested that elasticity of demand can be measured on the basis of average revenue and marginal revenue. Therefore, the income that a firm obtains by selling its products is called its revenue. When total revenue is divided by the number of units sold then it is called average revenue. Marginal revenue is referred as the additional revenue that will be generated by increasing product sales by one unit.
ED = AR/AR-MR
Determinants of Price Elasticity of Demand
a. Availability of Substitutes
The availability of substitutes of a commodity is the important determinant of the demand elasticity for that commodity. If the substitutes are very close then the elasticity of demand would be greater for the commodity. For example, Coke and Pepsi may be considered as a close substitute for each other. On the other hand, soap and toothpaste do not have their close substitutes and price-elasticity is lower for these two goods.
b. Position of a Commodity in a Consumer’s Budget
The elasticity of demand is also affected by the proportion of income which consumers spend on a particular commodity. If the proportion of income spent on a particular commodity. If the proportion of income spent on a commodity is very high then its demand will be elastic. For example: salt, matches, toothpastes, etc., are demand inelastic products because a household spend only a very small proportion of consumer’s income on each of them.
c. Nature of the Need that a Commodity Satisfies
The demand for luxurious goods is price elastic and demand for necessary goods is price inelastic. Therefore, the demand for air-conditioner is relatively elastic, and the demand for food and housing is inelastic.
d. Number of Uses to which a Commodity can be Put
The wider the range of alternative uses of a product, the higher the elasticity of its demand and vice versa. For example, milk has several uses. If the price of milk decreases then it can be used for various purposes such as preparation of curd, cream, ghee and sweets.
e. Possibilities of Postponing the Consumption
There are various commodities to which consumption cannot be postponed even for any period of time. For example, food grains, salt, sugar, and medicines, etc., are included in this category. The demand for these commodities is generally inelastic because there is no option for the consumer to postpone the consumption. Consumers have to maintain their consumption level even in case of price rise.
f. Joint Demand
If the demand of two goods are combined then the demand of one good varies with the demand of other goods. In such case, the elasticity of demand of the good determine the elasticity of the other good which is more important. For example, the elasticity of demand for car will depend considerably on the elasticity of demand for fuel.
g. Consumer Habits
If a consumer is a habitual consumer of a commodity then the demand for this type of commodity will be inelastic at any price change.
h. Tied Demand
The demand for those goods which are tied to other goods is generally inelastic as against those whose demand is of autonomous nature.
i. Price Range
The demand of the goods have inelastic which are very costly or high range but those goods which lies in the middle range have elastic demand.
The price elasticity of demand may be elastic for a given brand of product. If the price increase then people start to buy products of other brand and it is called substitution effect. For example, if the price of Bajaj bikes increases, the consumer will buy the Honda bikes.
k. Distribution of Income
The demand for various goods is elastic in the case when a country has equal power distribution. It is almost equal because there is a huge number of middle class person whose purchasing power is almost equal.
Use of Price Elasticity of Demand in Managerial Decision Making
a. Determination of Price Policy
For deciding the price of any product, a businessman considers the elasticity of demand for the product. He should consider for a product that if price of the product decreases then demand of the product increases or not? If demand of the product increases due to decrease in price then he should consider that up to what extent the price should decrease and resulting this profit will be increase or not.
b. Shifting of Tax Burden
The producer can shift the burden of indirect tax on the consumer and at what extent it is shifted to the consumer by increasing the product price, is decided on the basis of the elasticity of demand.
c. Taxation and Subsidy Policy
If the demand of a product is inelastic then the government can impose higher taxes and collect more revenue. On the other hand, if the demand of a product is elastic then the government can impose higher taxes and as a result, the sale of the product will decrease.
d. Importance in International Trade
The concept of elasticity of demand is very important in various aspects of international trade. The elasticity of demand for exports and imports of the country is the basis of the success of the devaluation policy to correct the adverse balance of payment.
2. Income Elasticity of Demand
Income elasticity of demand is defined as, “the percentage change in the quantity demanded of a good divided by the percentage change in the income of the consumer”.
EY = ∆Q/∆Y × Y/Q
Ey = Income elasticity
Q = Quantity demanded
Y = Income
∆Q = Change in quantity demanded
∆Y = Change in income
Types of Income Elasticity of Demand
a. High-Income Elasticity
Income elasticity of demand is said to be high when the quantity demanded for a good increases by a larger percentage as compared with the income of the consumer.
b. Unitary Income Elasticity
Income elasticity of demand is said to be unitary when the percentage change in quantity demanded for a product is equal to the percentage change in income.
c. Low-Income Elasticity
Income elasticity of demand is said to be low when the quantity demanded for a good increases by a smaller percentage as compared with the income of consumer.
d. Zero Income Elasticity
Income elasticity of demand is said to be zero when the quantity demanded for a good remains unchanged upon the change of income.
e. Negative Income Elasticity
The income elasticity of demand is said to be negative when the quantity demanded for a good falls in response to an increase in income.
Relevance/Importance of Income Elasticity of Demand for Managers
a. Useful to Know about Stage of Trade Cycle
Income elasticity of demand for necessary goods is low. Therefore, during prosperity, the sellers of such goods will not be benefited much and during depression, they are not affected much. During prosperity, income of the consumer increase and hence, they are capable of affording goods that are more luxurious. The sellers of such goods are benefited. During depression period, demand for such goods decrease rapidly and sellers are adversely affected.
b. Useful for Demand Forecasting
The concept of income elasticity of demand can be used for forecasting demand for a product over a period. Therefore, it helps in estimating the required production level of different commodities at a certain point of time in the future. This knowledge is also important for economic planning and demand forecasting.
c. Useful for Classification of Normal and Inferior Goods
The concept of income elasticity of demand can also be used to define the normal and inferior goods. The goods whose income elasticity is positive for all level of income are termed as normal goods. On the other hand, the goods for whose income elasticity is negative beyond a certain level of income are termed as inferior goods.
d. Useful for Making Marketing Strategy
Concept of income elasticity of demand can be useful in making marketing strategy. For example, firm producing luxury items should concentrate its marketing efforts on media that reach the high-income group of the people.
3. Cross Elasticity of Demand
Cross-elasticity of demand for a good is defined as a change in demand of that good due to change in price of another good.
Ec = Percentage change in quantity demanded of good A / Percentage change in price of good B. The elasticity coefficients give significant results about the type of goods:
a. Substitute Goods
Let us consider two goods X and Y. Goods X and Y are called substitute goods if demand of X move in the same direction as a change in the price of Y. For example, Pepsi (X) and Coca Cola (Y). An increase in the price of Pepsi causes consumers to buy more Coca-Cola, resulting in a positive cross-elasticity.
b. Complementary Goods
Let us consider two goods X and Y. Goods X and Y are called complementary goods if demand of X move in the opposite direction as a change in the price of Y. For example, an increase in the price of printers will decrease the amount of ink cartridges purchased.
c. Independent Goods
Let us consider two goods X and Y. Goods X and Y are called independent goods if demand of X is unchanged as a change in the price of Y. For example, movie ticket and bread; we would not expect a change in the price of movie ticket to have any effect on purchases of bread, and vice versa.
What Does Elasticity of Demand tells us?
The elasticity of demand measures how much demand for a good changes with price changes. A good with high elasticity of demand will see a significant shift in demand in response to a slight change in price, while a good with low elasticity of demand will see only a slight growth in demand in response to a small change in price. You will have to know the demand function.
What are the 4 Types of Elasticity of Demand?
The elasticity of demand can be classified into four types: 1. Price elasticity of demand 2. Income elasticity of demand 3. Cross elasticity of demand 4. Advertising elasticity of demand
What Factors Affect Elasticity of Demand?
Several factors affect the elasticity of demand:
1. The price of the good or service
2. The availability of substitutes
3. The consumer’s income
4. The time frame
5. The necessity of the good or service.