ELASTICITY OF DEMAND

Subject : Business Economics Submitted to : Shri S.C.V. Sarma Submitted by : Kapil Dube Class : 1st Semester MBLA Roll No. : 5

Nalsar University of Law, Hyderabad.

Table of Content

1. Introduction

1.1 1.2 1.3 1.4 1.5 1.6

Introduction Research objectives Research Hypotheses Research Methodology Research Plan/Scheme Research Scope and Limitations

2. Elasticity of Demand 2.1 Meaning of Elasticity 2.2 Mathematical Definition 2.3 Elasticities of demand 2.4 Ranges of Elasticity 2.5 Relationship Between Elasticity and Revenue (or Consumers Expenditures)

3. Factors determining elasticity of demand 4. Importance of elasticity of demand 5. Conclusion 6. Bibliography

CHAPTER - 1 INTRODUCTION

The degree to which demand for a good or service varies with its price. Normally, sales increase with drop in prices and decrease with rise in prices. As a general rule, appliances, cars, confectionary and other non-essentials show elasticity of demand whereas most necessities (food, medicine, basic clothing) show inelasticity of demand (do not sell significantly more or less with changes in price). Also called price demand elasticity. The quantity of a commodity demanded per unit of time depends upon various factors such as the price of a commodity, the money income of the prices of related goods, the tastes of the people, etc., etc.

Whenever there is a change in any of the variables stated above, it brings about a change in the quantity of the commodity purchased over a specified period of time. The elasticity of demand measures the responsiveness of quantity demanded to a change in any one of the above factors by keeping other factors constant. When the relative responsiveness or sensitiveness of the quantity demanded is measured to changes, in its price, the elasticity is said be price elasticity of demand.

1.2 Research objectives

1) To understand the role of elasticity of demand. 2) To study the economics and its School of thought 3) To understand the factors of elasticity of demand. 4) To study the types of elasticity of demand. 5) To study the factors differentiating elasticity of demand.

1.3 Research Hypotheses

1) Why elasticity of demand is important? 2) What does it show? 3) How is it usefeul?

1.4 Research Methodology

The sources of data relied on include both primary and secondary sources. The materials used for this research project includes, Articles and books. The research-methodology adopted is mainly Non-doctrinal and descriptive.

1.5 Research plan

The Research is divided into Headings and Sub-headings. The headings give the essence of the particular topic and the sub-headings explain the topic in detail.

1.6 Research scope and limitation

The research scope is limited due to the research methodology adopted by the researcher.

CHAPTER - 2 ELASTICITY OF DEMAND

2.1 Meaning of Elasticity In economics, elasticity is the measurement of how changing one economic variable affects others. For example:

"If I lower the price of my product, how much more will I sell?" "If I raise the price, how much less will I sell?" "If we learn that a resource is becoming scarce, will people scramble to acquire it?"

In more technical terms, it is the ratio of the percentage change in one variable to the percentage change in another variable. It is a tool for measuring the responsiveness of a function to changes in parameters in a unitless way. Frequently used elasticities include price elasticity of demand, price elasticity of supply,income elasticity of demand, elasticity of substitution between factors of production and elasticity of intertemporal substitution. Elasticity is one of the most important concepts in neoclassical economic theory. It is useful in understanding the incidence of indirect taxation, marginal conceptsas they relate to the theory of the firm, and distribution of wealth and different types of goods as they relate to the theory of consumer choice. Elasticity is also crucially important in any discussion of welfare distribution, in particular consumer surplus, producer surplus, or government surplus. In empirical work an elasticity is the estimated coefficient in a linear regression equation where both the dependent variable and the independent variable are innatural logs. Elasticity is a popular tool among empiricists because it is independent of units and thus simplifies data analysis. Generally, an elastic variable is one which responds a lot to small changes in other parameters. Similarly, an inelastic variable describes one which does not change much in response to changes in other parameters. A major study of the price elasticity of supply and the price elasticity of demand for US products was undertaken by Hendrik S. Houthakker and Lester D. Taylor.

2.2 Mathematical Definition

The definition of elasticity is based on the mathematical notion of point elasticity. In general, the "x-elasticity of y", also called the "elasticity of y with respect to x", is:

The approximation becomes exact in the limit as the changes become infinitesimal in size. The absolute value operator is for simplicity generally the sign of the elasticity is understood as being always positive or always negative. However, sometimes the elasticity is defined without the absolute value operator, when the sign may be either positive or negative or may change signs. A context where this use of a signed elasticity is necessary for clarity is the cross-price elasticity of demand the responsiveness of the demand for one product to changes in the price of another product; since the products may be either substitutes or complements, this elasticity could be positive or negative.

2.3 Elasticities of demand

Price elasticity of demand

Price elasticity of demand measures the percentage change in quantity demanded caused by a percent change in price. As such, it measures the extent of movement along the demand curve. This elasticity is almost always negative and is usually expressed in terms of absolute value (i.e. as positive numbers) since the negative can be assumed. In these terms, then, if the elasticity is greater than 1 demand is said to be elastic; between zero and one demand is inelastic and if it equals one, demand is unit-

elastic. A perfectly elastic demand curve is horizontal (with an elasticity of infinity) whereas a perfectly inelastic demand curve is vertical (with an elasticity of 0).

Income elasticity of demand

Income elasticity of demand measures the percentage change in demand caused by a percent change in income. A change in income causes the demand curve to shift reflecting the change in demand. IED is a measurement of how far the curve shifts horizontally along the X-axis. Income elasticity can be used to classify goods as normal or inferior. With a normal good demand varies in the same direction as income. With an inferior good demand and income move in opposite directions.

Cross price elasticity of demand

Cross price elasticity of demand measures the percentage change in demand for a particular good caused by a percent change in the price of another good. Goods can be complements, substitutes or unrelated. A change in the price of a related good causes the demand curve to shift reflecting a change in demand for the original good. Cross price elasticity is a measurement of how far, and in which direction, the curve shifts horizontally along the x-axis. A positive cross-price elasticity means that the goods are substitute goods.

Cross elasticity of demand between firms

Cross elasticity of demand for firms, sometimes referred to as conjectural variation, is a measure of the interdependence between firms. It captures the extent to which one firm reacts to changes in strategic variables (price, quantity, location, advertising, etc.) made by other firms.

2.4 Ranges of Elasticity

If the price elasticity of demand comes out greater than 1 (as in the example above), then consumers are very responsive to price changes. In this case, a price increase of 1% makes consumers cut back the amount they buy by more than 1%; a price decrease of 1% makes consumers increase the amount they buy by more than 1%. In this situation, consumers are flexible in the amount they buy when it comes to price changes; we say they have an elastic demand. If the price elasticity of demand comes out less than 1, then consumers are very inflexible with respect to price changes. A price increase of 1% makes consumers cut back the amount they buy, but only by a little, less than 1%; a price decrease of 1% makesconsumers buy more, but only by a little, less than 1%. In this situation, consumers are inflexible when it comes to price changes; we say they have an inelastic demand. If the price elasticity of demand comes out equal to 1, then the percent changes in price and quantity demanded are equal. A price increase of 1% makes consumers cut back the amount they buy by 1%; a price decrease of 1% makes consumers buy 1% more. In this situation, demand is called unit elastic. ed > 1 means demand is elastic. ed = 1 means demand is unit elastic. ed < 1 means demand is inelastic.

2.5 Relationship Between Elasticity and Revenue (or Consumers Expenditures)

Elasticity is important in determining whether a change in the price of a good will increase or decrease the total revenues of firms selling the good. In this discussion, keep in mind that revenues are not the same as profits. Maximizing revenues is not the same thing as maximizing profits. When you just look at revenues, you are ignoring costs. Suppose ed =5, so demand is elastic. This tells the seller that if they lower prices 1%, the quantity demanded will increase by 5%. A seller can increase revenue by lowering prices when demand is elastic, because the increase in revenue from consumers buying more of the good will exceed the decrease in revenue from each consumer paying a lower price. On the other hand, if the seller increases prices, revenues will fall. Note: Ignoring sales tax, revenues are equal to consumers expenditures. Therefore, a question about elasticity could ask you about either revenue or consumers expenditures, since they are considered the same in this context. This means that for ed = 5, a fall in price will increase both revenue and consumers expenditures. If ed = 1, a small change in price will keep revenue (and consumer expenditures) the same. However, for a big change in price, the elasticity will actually change from 1. (This will be explained in more detail below). Now say ed = 0.25, so that demand is inelastic. The seller can increase revenue (and consumer expenditures) by raising price. The seller can increase prices by 1%, and consumers will only buy 0.25% less, so revenue will increase. If the seller decreased prices, revenue would decrease. In this situation, the seller should increase prices to
9

increase revenues. If demand is inelastic, why not keep increasing prices forever? The answer is that elasticity will change. Elasticity is not constant along a demand curve. In other words, elasticity is not the same as the slope. (The slope is always the same along a straight-line demand curve.) The bottom part of a demand curve tends to be inelastic, and the top tends to be elastic. Also, a steeper demand curve tends to be more inelastic, and a flatter demand curve tends to be more elastic.

10

CHAPTER - 3 FACTORS DETERMINING ELASTICITY OF DEMAND

Factors Affecting Demand Elasticity There are three main factors that influence a demand's price elasticity:

1. The availability of substitutes - This is probably the most important factor influencing the elasticity of a good or service. In general, the more substitutes, the more elastic the demand will be. For example, if the price of a cup of coffee went up by $0.25, consumers could replace their morning caffeine with a cup of tea. This means that coffee is an elastic good because a raise in price will cause a large decrease in demand as consumers start buying more tea instead of coffee.

However, if the price of caffeine were to go up as a whole, we would probably see little change in the consumption of coffee or tea because there are few substitutes for caffeine. Most people are not willing to give up their morning cup of caffeine no matter what the price. We would say, therefore, that caffeine is an inelastic product because of its lack of substitutes. Thus, while a product within an industry is elastic due to the availability of substitutes, the industry itself tends to be inelastic. Usually, unique goods such as diamonds are inelastic because they have few if any substitutes.

2. Amount of income available to spend on the good - This factor affecting demand elasticity refers to the total a person can spend on a particular good or service. Thus, if the price of a can of Coke goes up from $0.50 to $1 and income stays the same, the income that is available to spend on coke, which is $2, is now enough for only two rather than four cans of Coke. In other words, the consumer is forced to reduce his or her demand of Coke. Thus if there is an increase in price and no change in the amount of income available to spend on the good, there will be an elastic reaction in demand; demand will be sensitive to a change in price if there is no change in income.
11

3. The third influential factor is time. If the price of cigarettes goes up $2 per pack, a smoker with very few available substitutes will most likely continue buying his or her daily cigarettes. This means that tobacco is inelastic because the change in price will not have a significant influence on the quantity demanded. However, if that smoker finds that he or she cannot afford to spend the extra $2 per day and begins to kick the habit over a period of time, the price elasticity of cigarettes for that consumer becomes elastic in the long run.

Briefly they can be stated as :

Availability of close substitutes: When a commodity has a large number of substitutes its demand is elastic. This is so as the consumer has a large number of similar substitutes to choose from. For example if a consumer does not get one type of a soft drink there is always a substitute soft drink available. Habitual necessities: Goods which are used to satisfy the habit of a consumer have less elasticity of demand as the consumer has to purchase these goods even if their prices go up. Time period: Generally elasticity of demand occurs over a longer time period as the consumer has more time to adjust his purchases in the longer time period. Nature of the commodity: The price elasticity of demand for necessary goods is very low as they are purchased even at a higher price. However there is more elasticity of demand in the case of luxury goods as they need not be purchased for satisfying a basic essential need and their purchase can be postponed to a future day. Level of price: The very highly priced items like diamonds and low priced items like pencils have low price elasticity of demand as change in their prices has very little effect on their consumers.

12

There are a number of factors that can determine the price elasticity of demand for a good or service.

For example, the demand for luxury items tend to be more elastic than the demand for necessities. For items that are essential, you tend to be less responsive to changes in price. An example of this would be the demand for diamonds tends to be more price elastic than the demand for electricity.

Price elasticity of demand is also affected how large a percentage of your total income an item is. We tend to be more elastic in regards to price changes for items that make up a larger percentage of our incomes. For example, if the price of a pack of gum goes up by 10%, I probably wouldn't even notice. On the other hand, if the price of a car I'm considering purchasing goes up by 10%, I would definitely notice and I would probably reconsider the purchase.

A third factor that influences the price elasticity of demand is the time frame allowed for response. We tend to be more responsive to changes in price in the long run than in the short run. For example, if the price of gas were to go up overnight to $10/gallon I would still have to put gas in my car tomorrow morning because I have to go to work and I have to go to school. But if the price of gas were to stay at $10/gallon for a year, then I have more options. I could move closer to work, start carpooling, or trade in my car for a hybrid with better gas mileage so that I don't have to buy as much gas. So in the long run, demand tends to be more elastic than in the short run.

13

CHAPTER - 4 IMPORTANCE OF ELASTICITY OF DEMAND

The concept of elasticity is not just an abstract idea its practical importance is very great.

(1) Importance For Government

The concept of elasticity of demand helps the finance minister of the monopolist. When it imposes a tax. When a tax is imposed the price tends to rise. But if the demand is very elastic it will considerably fall when the price has risen and thus the government will not be able to earn expected revenue. Thus this concept of elasticity of demand helps the government to impose the tax on a commodity whose demand lass elastic and hence earn valuable revenue.

(2) Importance for Businessmen

The businessmen also take cue from the nature of demand while fixing his price. IF the demand is inelastic he knows that the people must buy such commodities. Thus he will be able to change a higher price and big profits.

(3) Importance for Monopolist

The concept of elasticity of demand is of special importance to the monopolist. He is in a position to control the price and fix high price when demand is inelastic and low price when it is elastic will bring him the maximum profit.

(4) Application in Case of Joint Products

In case of joint products seperate costs are not ascertainable. Hence the producer will mostly

14

be guided by the nature of demand while fixing the price.

(5) Determinitation of Wages

The concept of elasticity of demand influences the determination of wages of a particular type of labour. If the demand of particular type of labour is inelastic trade union can easily get their wages raised. On the other hand of the demand for labour is relatively elastic trade union trade unions may not be successful in raising wages. (6) Importance for International Trade

The concept of elasticity of demand is used in calculating the terms of trade. Whenever a country fees an adverse balance of payment the government considers the elasticity of demand for the countries export and imports before devaluing its currency.

Theoretical Importance:

The concept of elasticity of demand is very useful as it has got both theoretical and practical advantages. As regards its importance in the academic interest, the concept, is very helpful in the theory of value. In the words ofKeynes:

"The concept of elasticity is so important that in the provision of terminology and apparatus to aid thought, I do not think, Marshall did any greater service than by the explicit introduction of the idea of the elasticity".

Practical Importance:

(i) Importance in taxation policy. As regards its practical advantages, the concept has immense importance in the sphere of government finance. When a finance minister levies a tax on a certain commodity, he has to see whether the demand for that commodity is elastic or inelastic.

15

If the demand is inelastic, he can increase the tax and thus can collect larger revenue. But if the demand of a commodity is elastic, he is not in a position to increase the rate of a tax. If he does so, the demand for that commodity will be, calculated and the total revenue reduced.

(ii) Price discrimination by monopolist. If the monopolist finds that the demand for his commodities is inelastic, he will at once fix the price at a higher level in order to maximize his net profit. In case of elastic demand, he will lower the price in order to increase, his sale and derive the maximum net profit. Thus we find that the monopolists also get practical advantages from the concept of elasticity.

(iii) Price discrimination in cases of joint supply. The concept of elasticity is of great practical advantage where the separate, costs of Joint products cannot be measured. Here again the prices are fixed on the principle. "What the traffic will bear" as is being done in the railway rates and fares.

(iv) Importance to businessmen. The concept of elasticity is of great importance to businessmen. When the demand of a good is elastic, they increases sale by towering its price. In case the demand' is inelastic, they are then in a position to charge higher price for a commodity.

(v) Help to trade unions. The trade unions can raise the wages of the labor in an industry where the demand of the product is relatively inelastic. On the other hand, if the demand, for product is relatively elastic, the tradeunions cannot press for higher wages.

(vi) Use in international trade. The term of trade between two countries are based on the elasticity of demand of the traded goods.

(vii) Determination of rate of foreign exchange. The rate of foreign exchange is also considered on the elasticity of imports and exports of a country. . (viii) Guideline to the producers. The concept of elasticity provides a guideline to the producers for the amount to be spent on advertisement. If the demand for a commodity is elastic, the producers shall have to spend large sums of money on advertisements for increasing the sales.
16

(ix) Use in factor pricing. The factors of production which have inelastic demand can obtain a higher price inthe market then those which have elastic demand. This concept explains the reason of variation in factor pricing.

17

CONCLUSION

Elasticity of demand, which is also called price elasticity of demand, refers to the extent of change in price of a product demanded by buyers in response to the change in its prices. It is measured as percentage change in quantity of a product demanded divided by percentage change in the price of the product. Price elasticity helps managers to understand how changes in price of a product will impact the total sales of the product. This insight helps the managers to determine the prices of different products that will yield maximum profit for their businesses. Price elasticity of demand can also be used for design of other marketing policies and strategies. For example, levels of price elasticity of demand can be used as a basis of market segment and then devising marketing mix for each segment according separately. For example , most of the airlines find that business travellers have relatively price inelastic demand, while tourist have hire price elastic demand. Airlines take advantage of these differences by offering a stable and high price to business travellers with additional facilities like incentives for total business volume and better service. In contrast they offer low prices to tourist who are able to plan their holidays well in advance. Also there is a third segment comprising of customers ready to travel on holidays at very short notice provided they are offered very low prices. This third segment is used to fill up seats in air crafts which remain unsold to the other two segments till very close to the flight time. This enables airlines to get some revenue, against spare capacity, which would have otherwise been totally wasted.

18

BIBLIOGRAPHY

List of Books:

Micro Economics: Analysis by J.V.Vashampayan Principles of Economics by K.P.M. Sundaram and M.C. Vaish Microeconomic Theory- A Mathematical Approach by James M. Henderson and Richard E.Quandt

List of Websites:

www.ingrimayne.com www.frbsf.org www.wisegeek.com www.teachingeducates.com www.bizcovering.com

19

20