CA Foundation Business Economics Study Material – Elasticity of Demand

CA Foundation Business Economics Study Material Chapter 2 Theory of Demand and Supply – Elasticity of Demand

Elasticity of Demand

• Elasticity of demand is defined as the responsiveness or sensitiveness of the quantity demanded of a commodity to the changes in any one of the variables on which demand depends.
• These variables are price of the commodity, prices of the related commodities, income of the consumers and many other factors on which demand depends.
• Accordingly, we have price elasticity, cross elasticity, elasticity of substitution, income elasticity and advertisement elasticity.
• Unless mentioned otherwise, it is price elasticity of demand which is generally referred.

Price Elasticity of Demand

• Price elasticity measures the degree of responsiveness of quantity demanded of a commodity to a change in its price, given the consumer’s income, his tastes and prices of all other goods.
• It reflects how sensitive buyers are to change in price.
• Price elasticity of demand can be defined “as a ratio of the percentage change in the quantity demanded of a commodity to the percentage change in its own price”.
• It may be expressed as follows:
  
• Rearranging the above expression we get:
  
• Since price and quantity demanded are inversely related, the value of price elasticity coefficient will always be negative. But for the value of elasticity coefficients we ignore the negative sign and consider the numerical value only. .

The value of elasticity coefficients will vary from zero to infinity.

• When the coefficient is zero, demand is said to be perfectly inelastic.
• When the coefficient lies between zero and unity, demand is said to be inelastic.
• When coefficient is equal to unity, demand has unit elasticity.
• When coefficient is greater than one, demand is said to elastic.
• In extreme cases co-efficient could be infinite.

The degrees (types) of price elasticity of demand

Price elasticity measures the degree of responsiveness of quantity demanded of a commodity to a change in its price. Depending upon the degree of responsiveness of the quantity demanded to the price changes, we can have the following kinds of price elasticity of demand.

1. Perfectly Inelastic Demand: (E_p = 0):

When change in price has no effect on quantity demanded, then demand is perfectly inelastic. E.g. – If price falls by 20% and the quantity demanded remains unchanged then,
E_p = 0/20 = 0. In this case, the demand curve is a vertical straight line curve parallel to y-axis as shown in the figure.
The figure shows that, whatever the price, quantity demanded of the commodity remains unchanged at OQ.

2. Perfectly Elastic Demand: (E_p = ∞):

When with no change in price or with very little change in price, the demand for a commodity expands or contracts to any extent, the demand is said to be perfectly elastic. In this case, the demand curve is a horizontal and parallel to X-axis.
The figure shows that demand curve DD is parallel to X-axis which means that at given price, demand is ever increasing.

3. Unit Elastic Demand: (E_p = 1):

When the percentage or proportionate change in price is equal to the percentage or proportionate change in quantity demanded, then the demand is said to be unit elastic. E.g. If price falls by 10% and the demand rises by 10% then, Demand Curve DD is a rectangular hyperbola curve suggesting unitary elastic demand.
E_p = 10/10 = 1

4. Relatively Elastic Demand: ( E_p > 1):

When a small change in price leads to more than proportionate change in quantity demanded then the demand is said to be relatively elastic E.g. If price falls by 10% and demand rises by 30% then, E_p  = 30/10 = 3 > 1. The coefficient of price elasticity would be somewhere between ONE and INFINITY. The elastic demand curve is flatter as shown in figure.

Demand curve DD is flat suggesting that the demand is relatively elastic or highly elastic. Relatively elastic demand occurs in case of less urgent wants or if the expenditure on commodity is large or if close substitutes are available.

5. Relatively Inelastic Demand: (E_p < 1):

When a big change in price leads to less than proportionate change in quantity demanded, then the demand is said to be relatively inelastic. E.g. If price falls by 20% and demand rises by 5% then, E_p  = 5/20 = 5 < 1 The coefficient of price
elasticity is somewhere between ZERO and ONE. The demand curve in this case has steep slope.

Demand curve DD is steeper suggesting that demand is less elastic or relatively inelastic. Relatively inelastic demand occurs in case compulsory goods ie. necessities of life.

Measurement of price elasticity of demand

The different methods of measuring price elasticity of demand are:

1. The Percentage or Ratio or Proportional Method,
2. The Total Outlay Method,
3. The Point or Geometrical Method, and
4. The Arc Method.

1. The Percentage Method
This method is based on the definition of elasticity of demand. The coefficient of price elasticity of demand is measured by taking ratio of percentage change in demand to the percentage change in price. Thus, we measure the price elasticity by using the following formula

• If the coefficient of above ratio is equal to ONE or UNITY, the demand will be unitary.
• If the coefficient of above ratio is MORE THAN ONE, the demand is relatively elastic.
• If the coefficient of above ratio is LESS THAN ONE, the demand is relatively inelastic.

2. The Total Outlay or Expenditure Method or Seller’s Total Revenue Method

The total outlay refers to the total expenditure done by a consumer on the purchase of a commodity. It is obtained by multiplying the price with the quantity demanded. Thus,
Total Outlay (TO) = Price (P) × Quantity (Q)
TO = P × Q
In this method, we measure price elasticity by examining the change in total outlay due to change in price.
Dr. Alfred Marshall laid the following propositions:

• When with the change in price, the TO remains unchanged, E_p = 1.
• When with a rise in price, the TO falls or with a fall in price, the TO rises, E_p > 1.
• When with a rise in price, the TO also rises and with a fall in price, the TO also falls, E_p > 1

However, total outlay method of measuring price elasticity is less exact. This method only classifies elasticity into elastic, inelastic and unit elastic.
The exact and precise coefficient of elasticity cannot be found out with this method.

3. The Point Method or Geometric Method

• The point elasticity method, we measure elasticity at a given point on a demand curve.
• This method is useful when changes in price and quantity demanded are very small so that they can be considered one and the same point only.
• E.g. If price of X commodity was Rs. 5,000 per unit and now it changes to Rs. 5002 per unit which is very small change. In such a situation we measure elasticity at a point on
  
• Diagrammatically also we can find elasticity at a point by using the formula—
  

Figure:

• The figure shows that even though the shape of the demand curve is constant, the elasticity is different at different points on the curve.
• If the demand curve is not a straight line curve, then in order to measure elasticity at a point on demand curve we have to draw tangent at the given point and then measure elasticity using the above formula.
• We can also find out numerical elasticities on different points.

4. The Arc Elasticity Method

• When there is large change in the price or we have to measure elasticity over an arc of the demand curve, we use the “arc method” to measure price elasticity of demand.
• The arc elasticity is a measure of the “average elasticity” ie. elasticity at MID-POINT that connects the two points on the demand curve.
• Thus, an arc is a portion of a curved line, hence a portion of a demand curve. Here instead of using original or new data as the basis of measurement, we use average of the two.
  
• The formula used is
  

Determinants of price elasticity of demand

Price elasticity of demand which measures the degree of responsiveness of quantity demanded of a commodity to a change in price (other things remaining unchanged) depends on the following factors:—

1. Nature of commodity:

• The demand for necessities of life like food, clothing, housing etc. is less elastic or inelastic because people have to buy them whatever be the price.
• Whereas, demand for luxury goods like cars, air-conditioners, cellular phone, etc. is elastic.

2. Availability of Substitutes:

• If for a commodity wide range of close substitutes are available ie. if a commodity is easily replaceable by others, its demand is relatively elastic. E.g. Demand for cold drinks like Thumbs-up, Coca-cola, Limca, etc.
• Conversely, a commodity having no close substitute has inelastic demand. E.g. Salt (but demand for TATA BRAND SALT is elastic.)

3. Number of uses of a commodity:

• A commodity which has many uses will have relatively elastic demand.
  E.g. Electricity can be put to many uses like lighting, cooking, motive-power, etc. If the price of electricity falls, its consumption for various purposes will rise and vice versa.
• On the other hand if a commodity has limited uses will have inelastic demand.

4. Price range:

• If price of a commodity is either too high or too low, its demand is inelastic but those which are in middle price range have elastic demand.

5. Position of a commodity in the budget of consumer:

• If a consumer spends a small proportion of his income to purchase a commodity, the demand is inelastic. E.g. Newspaper, match box, salt, buttons, needles.
• But if consumer spends a large proportion of his income to purchase a commodity, the demand is elastic E.g. Clothes, milk, etc.

6. Time period:

• The longer any price change remains the greater is the price elasticity of demand.
  On the other hand, shorter any price change remains, the lesser is the price elasticity of demand. .

7. Habits:

• Habits makes the demand for a commodity relatively inelastic. E.g. A smoker’s demand for cigarettes tend to be relatively inelastic even at higher price.

8. Tied Demand (Joint Demand):

• Some goods are demanded because they are used jointly with other goods. Such goods normally have inelastic demand as against goods having autonomous demand.
  E.g. Printers & Cartridges.

Knowledge of the concept of elasticity of demand and the factors that may change it is of great IMPORTANCE in practical life. The concept of elasticity of demand is helpful to-

1. Business Managers as it helps then to recognise the effect of price change on their total sales and revenues. The objective of a firm is profit maximization. If demand is ELASTIC for the product, the managers can fix a lower price in order to expand the volume of sales and vice versa.
2. Government for determining the prices of goods and services provided by them. E.g.- transport, electricity, water, cooking gas, etc. It also helps governments to understand the nature of response of demand when taxes are raised and its effect on the tax revenues. E.g.- Higher taxes are imposed on the goods having INELASTIC DEMAND like cigarettes, liquor, etc.

Income Elasticity of Demand

• The income elasticity of demand measures the degree of responsiveness of quantity demanded to changes in income of the consumers.
• The income elasticity is defined as a ratio of percentage change in the quantity demanded to the percentage change in income.
  
  

The income elasticity of demand is POSITIVE for all normal or luxury goods and the income elasticity of demand is NEGATIVE for inferior goods. Income elasticity can be classified under five heads:-

1. Zero Income Elasticity:
   • It means that a given increase in income does not at all lead to any increase in quantity demanded of the commodity.
   • In other words, demand for the commodity is completely income inelastic or E_y = 0
   • Commodities having zero income elasticity are called NEUTRAL GOODS.
   • E.g. – Demand in case of SALT, MATCH BOX, KEROSENE OIL, POST CARDS, etc.
2. Negative Income Elasticity:
   • It means that an increase in income results in fall in the quantity demanded of the commodity or E_y < 0.
   • Commodities having negative income elasticity are called INFERIOR GOODS.
   • E.g. – Jawar, Bajra, etc.
3. Unitary Income Elasticity:
   • It means that the proportion of consumer’s income spent on the commodity remains unchanged before and after the increase in income or E_y = 1. This represents a useful dividing line.
4. Income Elasticity Greater Than Unity:
   • It refers to a situation where the consumers spends GREATER proportion of his income on a commodity when he becomes richer. E_y > 1,
   • E.g. In the case of LUXURIES like cars, T.V. sets, music system, etc.
5. Income Elasticity Less Than Unity:
   • It refers to a situation where the consumer spends a SMALLER proportion of his income on a commodity when he becomes richer. E_y < 1,
   • E.g. In the case of NECESSITIES like rice, wheat, etc.

Cross elasticity of demand

• Many times demand for two goods are related to each other.
• Therefore, when the price of a particular commodity changes, the demand for other commodities changes, even though their own prices have not changed.
• We measures this change under cross elasticity.

The cross elasticity of demand can be defined “as the degree of responsiveness of demand for a commodity to a given change in the price of some RELATED commodity” OR “as the ratio of percentage change in quantity demanded of commodity X to a given percentage change in the price of the related commodity Y”. Symbolically:

Cross elasticity of demand can be used to classify goods as follows:-

1. Substitute Goods: E.g.: Tea and Coffee. The cross elasticity between two substitutes is always POSITIVE. If cross elasticity is infinite, the two goods are perfect substitute and if it is greater than zero but less than infinity, the goods are substitutes.
   
2. Independent Goods: E.g.: Pastry and Scooter. The two commodities are not related. The cross elasticity in such cases is ZERO.
3. Complementary Goods: E.g.: Petrol and Car. If the price of petrol rise, its demand falls and along with it demand for cars also falls. The cross elasticity in such cases is NEGATIVE
   

Advertisement or Promotional Elasticity of Demand

• Demand of many goods is also influenced by advertisement or promotional efforts.
• It means that the demand for a good is responsive to the advertisement expenditure incurred by a firm.
• The measurement of the degree of responsiveness of demand of a good to a given change in advertisement expenditure is called advertisement or promotional elasticity of demand.
• It measures the percentage change in demand to a give ONE PERCENTAGE change in advertising expenditure. It helps a firm to know the effectiveness of its advertisement campaign.
• Advertisement elasticity of demand is POSITIVE. Higher the value, higher is change in demand to change in advertisement expenditure.
  

The value of advertisement elasticity varies between zero and infinity. If-

• E_a = 0, no change in demand to increase in advertisement expenditure
• E_a > 0 but < 1, less than proportionate change in demand to a change in advertisement expenditure
• E_a = 1, change in demand is equal to change in advertisement expenditure
• E_a > 1, higher rate of change in demand than change in advertisement expenditure