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Elasticity of Demand: Meaning, Determinants and Importance

Meaning
Prof. Alfred Marshall developed the popular concept of elasticity of demand in his book Principles of Economics. Before him, the elasticity concept was used by Say, Whewell and Moffat. Elasticity is a word, which means responsiveness. A rubber band responds to a pull and springs back when it is released. It is elastic. In economics, elasticity expresses the responses of a dependent variable to a change in an independent variable. Demand and supply extend and contract under the influence of such forces as price changes. Law of demand and elasticity of demand The law of demand simply states other things remaining the same, when the price falls demand expands and vice versa. But it does not explain by how much the quantity demanded increases or decreases, as a result of a certain fall or rise in the price of the commodity. To put it in other words, the law of demand simply states the direction of change and not the rate of change. Elasticity of demand expresses the degree of correlation between the demand and price. It measures the ratio of the relative change in the dependent variable (quantity) to the relative change in an independent variable (price). Price elasticity of demand is therefore a technical term used by economists to describe the degree of responsiveness in demand for a commodity to a change in its price.

Factors determining elasticity of demand


The elasticity of demand depends upon the following factors: 1. The existence of substitutes The more substitutes there are for a product, the greater the price elasticity of demand; for example tea, coffee, cold drinks etc. 2. Alternative uses of the commodity More numerous the uses, higher the elasticity. 3. The importance of the commodity in the consumers total budget. Goods that represent a small fraction of the consumers budget are more inelastic in demand. Examples are salt, match box, pepper etc. 4. The time period under consideration Demand elasticity tend to be greater in the long run because persons find more substitutes for a good as time goes by. 5. Nature of the commodity

In general, luxury goods are price elastic, while necessities are price inelastic. Foreign travel is an example of a luxury good. 6. Habitual necessaries Tobacco and alcohol are price inelastic. The prices of these goods are rising periodically but their demand has not diminished. 7. Joint demand In the case of joint demand, the demand of the good varies along with the demand of the other good. For example, the elasticity of demand for petrol will depend considerably on the elasticity of demand for cars. 8. Consumers income Generally, the demand for the poor man is more elastic than the rich man. 9. Possibility of postponement The demand for goods which can be deferred for sometime is relatively elastic., examples., Woollen clothes, shoes etc. 10. Recurrence of demand If the demand for a commodity is of a recurring nature, its price elasticity will be higher.

Importance of elasticity of demand


Prof. P.A. Samuelson condemns the concept of elasticity as essentially arbitrary and a more or less useless concept. To use his own words Not only are elasticity expressions more or less useless, but in more complicated systems they become an actual nuisance. But it has both theoretical and practical importance in the spheres of finance, trade and commerce. In the words of Keynes, In provision of terminology and apparatus to aid thought, I think Marshall did greater service by the explicit introduction of the idea of elasticity. 1. Paradox of poverty The concept of elasticity of demand explains the paradox of poverty in the midst of plenty. Bumper crop, instead of bringing prosperity, may spell disaster if the demand for the commodity is inelastic. The simple reason is that a bumper crop, by lowering prices, may bring is less revenue to the farmers. 2. Price decisions While fixing the price of a commodity, sellers, always take the help of the price elasticity of demand for their products. If the demand is less elastic, price will tend to be higher. If the demand is elastic, a lower price is fixed. 3. Monopoly price

If the monopolist fails to know the elasticity of demand for his product, he would not be able to optimize his profits in the market. Elasticity of demand is used in measuring the degree of monopoly power. Price discrimination is profitable when elasticities are different in different markets. The monopolist will fix a higher price in the inelastic market and a lower price in the elastic market. If the demand curves are iso-elastic in all markets, it is not profitable to practice price discrimination. Similarly, for practicing dumping, the concept of elasticity is of great help. 4. Pricing of joint products Some products like wheat and straw, mutton and wool, cotton and cotton seed are jointly produced. It is difficult to calculate their cost of production separately. The producer in such a case fixes a higher price for the product whose demand is inelastic and a lower price for the product having an inelastic demand. 5. Policy of devaluation The policy of devaluation will be successful only when the country possesses a perfect knowledge of the elasticities of its exports and imports. Devaluation makes export of goods cheaper in terms of foreign currency. Exports can bring more revenue only when the foreign demand for our product is elastic. 6. Trade unions and wages Trade unions can raise wages for its members only if the demand for their products is inelastic. Likewise, if the demand for a particular type of labor is relatively inelastic, it is easy to raise wages. 7. Pricing in public utilities Public utilities such as supply of water, electricity, transport, postal services etc. are provided by public enterprises. The demand for the goods and services of these institutions is relatively inelastic, since they are vital necessities for daily life. In a welfare state, therefore, the government should nationalize and control these services. Moreover, the government charge different rates for different uses on the basis of elasticity of demand and try to cover the losses from one group of users by the gains reaped from the other group. 8. Taxation The finance minister has to consider the elasticity of demand while selecting commodities for taxation. If the demand for a commodity is fairly elastic, an increase in tax rate will, reduce the quantity consumed drastically, and as a result the revenue will decrease. That is why generally taxes are levied on commodities like sugar, cigarettes etc., which have an inelastic demand. 9. Incidence of taxes The concept of elasticity is of much help in explaining the incidence of indirect taxes like sales tax and excise duty. In the case of inelastic demand, the consumers have to buy the product and must pay the tax. 10. There are many other real world examples emphasizing the importance of the concept

The oil producing nations, for example, have been able to increase their total revenue by cutting down the production of oil, because of an inelastic demand for oil.

Different types of Elasticity of Demand


After knowing what is demand and what is law of demand, we can now come to elasticity of demand. Law of demand will tell you the direction i.e. it tells you which way the demand goes when the price changes. But the elasticity of demand tells you how much the demand will change with the change in price to demand to the change in any factor. Different types of Elasticity of Demand: 1. Price Elasticity of Demand 2. Income Elasticity of Demand 3. Cross Elasticity of Demand 4. Advertisement Elasticity of Demand 1. Price Elasticity of Demand: We will discuss how sensitive the change in demand is to the change in price. The measurement of this sensitivity in terms of percentage is called price Elasticity of Demand. According to Marshall, Price Elasticity of Demand is the degree of responsiveness of demand to the change in price of that commodity. Types of Price Elasticity of Demands: a) Perfectly Elastic b) Perfectly Inelastic c) Relatively Elastic d) Relatively Inelastic e) Unit Elasticity Factors influencing Price Elasticity of Demand: a) Nature of Commodity b) Availability of Substitutes c) Number of Uses d) Durability of commodity e) Consumers income

Practical significance of Price Elasticity of Demand: a) Importance to the business b) Important to Government 2. Income elasticity of demand: In economics, the income elasticity of demand measures the responsiveness of the quantity demanded of a good to the change in the income of the people demanding the good. It is calculated as the ratio of the percent change in quantity demanded to the percent change in income. For example, if, in response to a 10% increase in income, the quantity of a good demanded increased by 20%, the income elasticity of demand would be 20%/10% = 2. 3. Cross elasticity of demand: In economics, the cross elasticity of demand and cross price elasticity of demand measures the responsiveness of the quantity demand of a good to a change in the price of another good. It is measured as the percentage change in quantity demanded for the first good that occurs in response to a percentage change in price of the second good. For example, if, in response to a 10% increase in the price of fuel, the quantity of new cars that are fuel inefficient demanded decreased by 20%, the cross elasticity of demand would be -20%/10% = -2. 4. Advertisement Elasticity of Demand: The degree of responsiveness of quantity demanded to the change in the advertisement expense of expenditure. Ea= Change in quantity demanded x original advertisement expenses Change in advertisement expenses original quantity demanded Important factors influencing Advertisement: 1. Promotional elasticity of demand will be affected, depending on whether it is a new product or the product with a growing market. 2. The amount a competitor reacts to the firms advertisement. 3. The time interval between the advertisement expensed or expenditure and the unresponsiveness of the sales. 4. The influence of non-advertisement determinants of demands such as trends, price, income etc. Uses of Advertisement Elasticity of Demands: 1. It helps the manager to decide the advertisement expense. If the advertisement is more

than one, which means incremental revenue exceeds incremental expenses, then increased expenditure on advertisement can be justified. 2. The fire should observe the saturation point, where advertisement pays nothing or does not help in increasing sales revenue.

Types of Elasticity of Demand


1) Elastic: The % change in quantity > % change in price.

From the diagram below we see a small change in price brings about a large change in the quantity demanded. This happens when there are many substitutes in the marketplace.

Diagram 1: 2) Inelastic: It is the reverse of elastic.

The % change in quantity < % change in price.

From the diagram below we see a large change in price brings about a small change in the quantity demanded. This happens when there are few substitutes in the marketplace, and the good is an essential commodity. Thus even if prices go up, we cannot reduce consumption by a lot.

Diagram 2: 3) Unit elasticity: The % change in quantity = % change in price.

From the diagram below we see a change in price brings about an exact change in the quantity demanded. A 2% change in price brings about a 2% change in quantity demanded

Diagram 3: 4) Perfectly elastic: The % change in price is zero.

At the market going price P*, the quantity demanded is infinite. So by the formula of elasticity: Ed (perfectly elastic) = (% change in Qd) (% change in price) =0 =

Diagram 4: 5) Perfectly inelastic: The % change in quantity is zero.

At any price, the quantity demanded is the same. The consumption of this commodity is fixed, and not dependent on price. Think of our oxygen consumption. Even if you charge a price, any price, the quantity consumed cannot be changed So by the formula of elasticity: Ed (perfectly inelastic) = (% change in Qd) (% change in price) =0 =0

Price elasticity of demand


Formula: Ed = (% change in Qd) (% change in price) 1) If Ed>1 its elastic demand. This happens when the numerator (% change in Qd)> denominator (% change in price) 2) If Ed=1 its unit elastic demand. This happens when the numerator (% change in Qd)= denominator (% change in price) 3) If Ed<1 its inelastic demand. This happens when the numerator (% change in Qd)< denominator (% change in price) 4) If Ed=0 its perfectly inelastic demand. This happens when the numerator (% change in Qd) is equal to zero (i.e., there is no change in quantity demanded), due to a change in the denominator (% change in price) 5) If Ed= its perfectly elastic demand. This happens when there is a change in the numerator (% change in Qd), but no change in the denominator (% change in price is equal to zero) Example 1: Let us say the change in price is 2 %, and the resultant change in Qd is 2%.

Thus Ed = 2/2 = 1. (Unit elasticity)


Example 2: Let us say the change in price is 4.5 %, and the resultant change in Qd is 2%.

Thus Ed = 2/4.5 = 0.44. (Inelastic)


Example 3: Let us say the change in price is 2.2 %, and the resultant change in Qd is 5.32%.

Thus Ed = 5.32/2.2 = 2.41. (Elastic)


Example 4: Let us say the change in price is 8.72 %, and the resultant change in Qd is 0 %.

Thus Ed = 0/8.72 = 0 (perfectly inelastic)


Example 5: Let us say the change in price is 0 % (meaning there is no change in price), but the Qd changes by 9.99%

Thus Ed = 9.99/0 = (perfectly elastic)


Example 6: Let us say the change in price is 8.72 %, and the resultant change in Qd is 5.87%.

Thus Ed = 5.87/8.72 = 0.67. (Inelastic)


Example 7: Let us say the change in price is 13.65 %, and the resultant change in Qd is 9.99%.

Thus Ed = 9.99/13.65 = 0.73. (Inelastic)


Example 8: Let us say the change in price is 13.65 %, and the resultant change in Qd is 13.65%.

Thus Ed = 13.65/13.65 = 1. (Unit elasticity)


Example 9: Let us say the change in price is 1.22 %, and the resultant change in Qd is 1.22%.

Thus Ed = 1.22/1.22=1 (Unit elasticity)


Example 10: Let us say the change in price is 3.22 %, and the resultant change in Qd is 1.22%.

Thus Ed = 3.22/1.22=2.63 (Inelastic)


Example 11: Let us say the change in price is 18.72 %, and the resultant change in Qd is 0 %.

Thus Ed = 0/18.72 = 0 (perfectly inelastic)


Example 12: Let us say the change in price is 0 % (meaning there is no change in price), but the Qd changes by 29.99%

Thus Ed = 29.99/0 = (perfectly elastic)


Example 13: Let us say the change in price is 13.22 %, and the resultant change in Qd is 18.22%.

Thus Ed = 13.22/18.22=0.72 (Elastic)

Example 14: Let us say the change in price is 3.15 %, and the resultant change in Qd is 6.89%.

Thus Ed = 6.89/ 3.15 = 2.18. (Elastic)