Chapter IX Elasticity of demand

1. Meaning of elasticity Elasticity is a measure of the sensitivity of one variable to another. Especially it is a number, which tell us the percentage change that will occur in one variable in response to a one percent change in another variable. There are 5 types of elasticity. These are (i) Perfect Elasticity or Infinite Elasticity, (ii) Perfectly Non-elasticity or Zero Elasticity, (iii) Relative Elasticity, (iv) Relative Non-elasticity and (v) Unit Elasticity. Perfect Elasticity or Infinite Elasticity In the case of Perfect Elasticity or Infinite Elasticity, even with a slight change in one variable causes infinite non-proportional change in other variable. It occurs, if, for example, only a very negligible decrease in price have such an effect the demand increase infinitely and with a negligible slight increase in price drops the demand to zero (Figure 14). In practice such cases never occur.
Y Price D Figure 14 D Y Price D Figure 15

X 0 Quantity/ Demand

X Quantity/ Demand

Perfectly Non-elasticity or Zero Elasticity In the case of Perfectly Non-elasticity or Zero Elasticity, what ever change in one variable is, the other variable remain unchanged. This happens in the case of the demand of salt. If the price of salt decreases, it demand does not increases (Figure 15). Relatively Elastic

A change is Relatively Elastic, if the change in one variable has bigger effect on the other variable (Figure 16). That means, the price sinks only slightly, but the demand increases more sharply. Relative Non-elasticity A change is Relatively Non-Elastic, if the change in one variable has relatively smaller effect on the other variable (Figure17). That means, the price decrease is bigger but the demand increases only slightly.
Y Price Figure 16 Y Price Figure 17

X 0 Quantity /Demand

X Quantity /Demand

Unit Elasticity When change in one variable has always the same amount of impact on the other variable, then the object is Unit Elastic. Say, sinks the cigarette price per packet TK 1, the demand increases 1%, sinks the price per packet TK 2, the demand increase is 2%, in this case the demand of cigarette is said to be unit elastic. 2. Meaning of elasticity of demand We have studied the law of demand and we have seen that there is an inverse relation between demand and price. A change in price leads generally to a change of demand. The property of demand, by virtue of which it increases or decreases under the pressure of a change in price, is called Elasticity of Demand. The term elasticity of demand expresses the degree of correlation between demand and price. It is the rate at which the quantity demanded varies with a change in price. 2.1 Relation of elasticity of demand with the law of diminishing marginal utility The concept of elasticity of demand is connected with the law diminishing marginal utility. We know that marginal utility varies with supply. It falls when the

supply increases and increases when the supply contracts. But the fall of marginal utility does not occur at a uniform rate in all commodities. In the case of salt, the marginal utility is inelastic. In the case of luxury goods, the marginal utility comes down with the fall of the pride gradually.

3.Types of elasticity of demand There are three types of elasticity of demand. These are (i) price elasticity, (ii) income elasticity and (iii) cross elasticity. 3.1 Price elasticity of demand Price elasticity measures responsiveness of potential buyers to the change in price. Price elasticity is the ratio of percentage change in the quantity demanded in response to a percentage change in the price. Putting it in mathematically term, it means:
Price elasticity of demand = ( q/q) ( p/p) Where q is the quantity, q is the change in quantity, p is the price and p is the change in price.

3.2 Income elasticity of demand Income elasticity of demand of demand shows how the quantity demanded changes when the income of the purchaser changes, but the price of the commodity remains the same. Income elasticity of demand for a good is the ratio of the percentage change in the amount spent on the commodity to a percentage change in the consumers income, price of the commodity remains the same. Mathematically:
Income elasticity of demand = ( q/q) ( y/y) Where q is the quantity, q is the change in quantity, y is the income of the consumer and p is the change in the income of the consumer.

Income elasticity of demand is equal to unit, i.e. one, when the proportion of income spent on a good remain the same even though the income has increased. Income elasticity of demand is said to be greater than unit, i.e. one, when the

proportion of income spent on a good increases as income increases. Income elasticity of demand is said to be less than unit, i.e. one, when the proportion of income spent on a good decreases as income increases. Income elasticity of demand is zero, when change in income makes no change in the demand. Income elasticity of demand is said to be negative, income increases but demand decreases. 3.3 Cross elasticity of demand When a change in the price of a good causes a change in the demand of another good, it called cross elasticity of demand. This type of elasticity arises in the case inter-related goods, which are complementary or substitution able. Mathematically it is expressed and calculated by following formula:
Cross elasticity of demand = ( qa/qa) ( pb/pb) Where qa is the quantity of the commodity of the good A, qa is the change in quantity, pb is the price of the good B and pb is the change in the price of the goods, which is substituted and price has been changed in response to price change of the good A.

4. Measurement of elasticity of demand For practical purpose it is not enough to know whether the demand is elastic or inelastic, it is rather more useful to find to what extent is the demand elastic? For that purpose it is essential to measure elasticity of demand. There are three for measurement of elasticity of demand. These are: (a) (b) (c) Total outlay method, Proportional method, and Geometric method 4.1 Total outlay method Outlay is the expenditure of the purchaser. In Total outlay method, the total outlay, i.e. the expenditure of the consumer, which is the total value of sales, before and after the price change is compared (see Table 4 below). The table shows that the total outlay per packet cigarette is increased TK 4, as the price per packet has sunk TK 1.00, and so on.
Table 4: Changes of price and demand per packet cigarette

Phases of Changes 1 2 3 4 5 6

Price per packet (TK) 8.00 7.00 6.00 5.00 4.00 3.00

Quantity demanded (packet) 3 4 5 6 7 8

Total outlay 24.00 28.00 30.00 30.00 28.00 24.00

In total outlay method, elasticity of demand is expressed in three ways (i) unitary (unit) elasticity, (ii) greater than unit elasticity and (iii) less than unit elasticity. Unitary elasticity It is unitary (unit) elasticity, when even though the price has changed, the total amount spent, i.e. total outlay remain the same (Table 4/ Phase 4). Greater than unitary elasticity The elasticity is said to be greater than unitary elasticity, when with fall of price the total outlay increases or the total outlay decreases when the price falls (Table 4/ Phase 2 and 3). Less than unitary elasticity The elasticity is said to be less than unitary elasticity, when the total outlay, i.e. total amount spent increases with a rise in the price and decreases with the fall of the price (Table 4/ Phase 5 and 6). Elasticity is a warning signal for the businessman. It tells him that in the case of inelastic demand reduction in price will only reduce his income and increase in price will increase it. The effect will be opposite if the demand is elastic. 4.2 Proportional method In Proportional method the percentage change in demanded quantity is compared with the percentage change in price. And the elasticity is the ratio of the percentage change in quantity demanded to percentage change in price.
Elasticity of demand = ( q/q) ( p/p) Where q is the quantity, q is the change in quantity, p is the price and p is the change in price.

Suppose the price of a particular brand of radio falls from TK 500 to TK 400, i.e 20%. Suppose, as a result the demand of the radio has increased from 400 sets to 600 sets 50%. So the elasticity of the demand in this case is 50% 20%, i.e. 2.50%. 4.3 Geometric method In this method, the demand curve of the studied commodity is drawn to calculate elasticity of the commodity, then any point on the curve is the elasticity of that commodity with respective price. Let us draw the demand curve for the commodity Q (Figure 18/below). Then the elasticity of the commodity Q on point P1 = DxP1 DP1. And the elasticity of the commodity Q on point P2 = DxP2 DP2 (Figure 18/below). The curve shows that the elasticity at a lower point on the curve is less that the elasticity at higher point, for our example, the elasticity P2 lager than P1.

Y D P2

Figure - 18

P1 Dx 0 X

5. Practical application of elasticity of demand The concept of elasticity of demand has important practical implication for government financial and development policies. Important of them are following. Importance of elasticity of demand for taxation policy On basis of the analysis of elasticity, the government could be surer of the revenue (earnings). If taxes for those commodities are set, for which the demand is inelastic, revenue could be more correctly calculated. Then though setting tax for

such commodities could increase price, but the demand of these commodities remains nearly unchanged, and hence revenue could the more correctly estimated. Importance of elasticity of demand for monopoly and monopoly price Because of the knowledge of elasticity of demand, the businessman, especially the monopoly, has the opportunity to study and consider the nature of demand while fixing price. In the case the demand is inelastic, a price rise causes demand fall and smaller sell. If, on the other hand, the demand is elastic and our monopoly lower the price, this stimulates demand and increases profit. Importance of elasticity of demand for joint products The concept elasticity of demand for joint products is important for the producers of joint products, then it explains that the demand of such goods is relatively inelastic. The price increase one of the good of the joint products could lower its demand. So, the producers of such goods are aware off that the price of such goods should change at the time to insure market share.

Importance of elasticity of demand for increasing profit On the basis of the concept of elasticity of demand the manufacturer can calculate the elasticity of their products and determine that if the price is lowered the demand and hence profit increase. This helps the out to increase and the capacity fully to utilise. Importance of elasticity of demand for wages Analysis of elasticity of demand has also importance for wages. Then, if demand for a particular type of labour is relatively inelastic, it is relatively easy to raise wages, but not otherwise. The concept of elasticity of demand help understand poverty in plenty The concept of elasticity of demand helps understand the paradox of poverty in the midst plenty and take remedial measure. If, as for example, the elasticity of demand for wheat is unity, the incomes of the growers would remain same, even though the harvest good. Paradoxically, the growers profit from the price increase

in the years of bad harvest, which compensates the loss of bumper production in the years of good harvest. So, the concept of elasticity of demand provides opportunity for the government to take note of the degree of elasticity of demand for particular crops and ensure appropriate steps in order to ensure stable income of the farmers and welfare of the society. The concept of elasticity of demand help understanding the economy and select respective policy The economic activity is determined by total national demand, which affects the total national production and services and hence the national employment, income and all other related categories. So, the concept of elasticity of demand helps understanding the functioning of the economy and provides necessary inside that appropriate development policy could be introduced to ensure higher demand. The concept of elasticity of demand helps foreign trade Like in home market, the concept of elasticity of demand helps estimating elasticity of demand in foreign market, which helps export sector to plan their production. This helps reducing over production risk and maximising gain.

The concept of elasticity of demand helps fixing favourable exchange rate The concept of elasticity of demand provides instrument to calculate elasticity export and import, which important for fixing favourable exchange rate. As for example, export is inelastic, lowering the exchange rate brings no gain. Then it makes indeed the export cheap, but as the export volume can not be increased, because the export demand is inelastic, so the export income can not increased. Besides, in the case of the elasticity of export demand, the calculation of elasticity helps determining how far the exchange should be changed to ensure maximum gain. However, for exchange rate, the elasticity of import is also to consider. If the import is inelastic, devaluation brings no import increase. But, if import is elastic, for devaluation the elasticity of import must be carefully calculated and considered. K.K Dewett Page 57-72