ELASTICITY OF DEMAND

Demand varies with price. But the variation is not uniform in all cases. Sometimes demand is greatly responsive to price and at times nominal or not so responsive. Economists use the term Elasticity for this response. To measure the E of D , 2 variables are considered Demand and Determinants of demand.

For Measuring the E coefficient , thus a ratio is made of the two variables. E of D= % change in qt. demanded / % change in determinant of demand There are 3 elasticities of D
Price E Income E Cross Price E or just Cross Elasticity

Price Elasticity of Demand

The price elasticity of demand (PED) is an elasticity that measures the nature and percentage of the relationship between changes in quantity demanded of a good and changes in its price, other determinants remaining constant. The extent of response of demand for a commodity to a given change in price, other demand determinants remaining constant , is PE of D. It is the ratio of the relative change in demand and price variables.

 The co-efficient of price elasticity (e) is measured as:

E=

% change in Qt. demanded % change in price

Since relative change of variables can be measured either in terms of % change or proportional change, the PE co-efficient can be measured alternatively as
Proportional change in Qt. demanded Proportional change in price

E=

Q/Q Q/ P

P/P = =

Q/Q X or P/Q

P/P

Where Q= original demand (q1) P= the original price(p1) Q = the change in demand = new D(Q2)-old demand(Q1) Thus Q= Q2-Q1 P = P2-P1

P = P2-P1 = 21-20 =1 P=P1=20 Q= Q2- Q1 = 96-100= -4 Q=Q1=100 E = -4/100X20/1= 4/5= -0.8 EOD is less than 1. (minus sign ignored)

P of Apples (Rs)

Qt. Demanded (kg)

20 (P1) 21 (P2)

100(Q1) 96(Q2)

Deductions
Depending upon the magnitudes and proportional changes involved in data on demand and prices, one may obtain various numerical values of co-efficient of PE, ranging rom zero to infinity. When PE Co-efficient is > than unity (e>1), it is said to be price elastic. If e<1, the product is considered to be price inelastic. This knowledge is very useful in determining pricing policy and other business decisions.

Types of Price Elasticity

Marshal suggested a 3-fold classofocation of types of PED
Unit EOD (e=1) Elastic D (e>1) Inelastic D (e<1)

Modern Economist have stated 5 kinds of PE

Perfectly Elastic D Perfectly Inelastic D Relatively Elastic D Unitary elastic D Relatively Inelastic D

Price Elasticity of Demand

Numerical Value E= infinity Terminology Perfectly (or infinitely) Elastic D Description Consumers have infinite demand at a particular price and none at all at an even slightly higher than this given price. D remains unchanged , whatever be the change in price. Qt. demanded changes by a large percentage as does price Qt. demanded changes by a smaller percentage as does price

E=0

Perfectly (or completely) Inelastic D

E>1

Relatively Elastic D

E<1

Relatively Inelastic D

E=1

Unitary Elastic D

Qt. demanded changes by exactly the same percentage as does price.

Perfectly E Demand (e=infinity) An endless demand (infinite) demand at the given price is PED. With Slight increase in price of a commodity, the stops buying it. But the decrease in price the demand curve will shift downwards. PED is a theoretical extremity, hardly encountered in practice. D curve is straight horizontal line

P1 Price P P2

P increases D= 0 DD

D1D1

Qt Purchased/unit of time

Perfectly Inelastic Demand (e=0)

When demand of a commodity shows no response at all to a change in Price, the demand remains same. D Curve is straight vertical line. Again a theoretical consideration but salt has PID as it is an absolute necessity.
DD P1 Price P2 P3

Qt Purchased/unit of time

Relatively Elastic D or More Elastic Demand (e>1) When the proportion of change in the qt. demanded is greater than that of the price, the demand is said to be relatively elastic. The numerical value lies between 1 and infinity. Represented by gradually sloping rather flatter D curve. Realistic and practical concept.

P1 Price

P2

DD

M1

M2

Qt Purchased/unit of time

Relatively Inelastic D or Less Elastic Demand (e<1) When the proportional of change in the quantity demand is less than that of price, the D is relatively inelastic. Numerical values lies between 0 and 1. Demand curve is rapidly sloping , rather steeper curve. Realistic and practical concept.

P1 Price

P2 DD M1 M2

Qt Purchased/unit of time

Unitary Elastic Demand (e=1) When the proportion of change in demand is exactly the same as the change in price, the D is said to be unitary elastic. Numerical value of UE=1. D curve would be rectangular hyperbola.

P1 Price P2 DD

M1

M2

Qt Purchased/unit of time

Factors Influencing EOD

Nature of Commodity: Luxury, comfort and necessity goods. Luxury and comfort goods are price elastic. Ex: Radio, furniture, car, etc. Necessity goods are price inelastic Ex: Food grains, cloth, salt, etc. Availability of substitutes:
Commodities having close substitutes - D = elastic Ex: Tea, coffee, coke No substitutes D = inelastic Ex: salt, potatoes, onion.

Number of Uses: Single (less elastic) and multi-use goods (high elastic). Ex: coal is used by railways (inelastic) and consumers as fuel (elastic)

 Consumers Income:
Larger Income-demand for overall commodities- relatively inelastic. Millionaire rarely affected. Redistribution of income in favour of low income people may tend to make demand for some goods relatively elastic.

Height of Price and Range of Price change:

In luxury goods , for a small change in price, the demand is inelastic. If large change in price then D is elastic. Perishable goods: change in P D is inelastic (potatoes, onions)

Proportion of expenditure:
Cheap or small expenditure items tend to have more demand inelasticity than expensive or large expenditure items

Durability of Commodity:
Durable goods: D inelastic in short run. Perishable goods: D- elastic. Ex: Milk, Vegetables

 Habit:
E< 1. Ex: Cigarettes- inelastic demand

Complementary goods:
Goods jointly demanded have less elasticity (Inelasticity ):

Ex: Ink, Pen.

Time :
In SR D is less elastic. In LR D is more elastic. D for certain goods can be postponed in SR but has to be satisfied in LR.

Recurrence of Demand:
D of a commodity is of recuring nature, its PE is higher. Ex: Pizza, Buger, etc. But less for goods purchased only once.

Ex: Bicycles, Tape recorders.

Possibility of postponement:
If the purchase is postponed, D will be elastic.

Ex: Cement, Bricks, etc

In consumption goods- Inelastic

Practical Applications of PED

Production Planning Helps in fixing the prices of different goods Helps in fixing the rewards of factor inputs Helps in determining the foreign exchange rates Helps in determining the terms of trade Helps in fixing the rate of taxes Helps in Declaration of Public Utilities

Income Elasticity
Income is a major determinant of D for a number of goods. D= f(m) IED measures the degree of responsiveness of demand for a good to changes in the consumers income. DEF: The IE is defined as a ratio percentage or proportional change in the quantity demanded to the % or proportional change in income.

 IE= coefficient is thus measured as % change in Qt. demanded IE =

% change in income

Em= % Q/ M

Q/ =

M = or M/Q

Q/Q X M/

Where Q= original demand (q1) M= Initial Income (M1) Thus Q= Q2-Q1 M = M2-M1

Types of IE
Unitary ED (Em=1) IE of D > unity (Em>1) IE of D <unity (Em<1) Zero Income Elasticity of demand. (Em=0) -ve IED (Em<0)
IE >1 : Superior Goods IE>=0 and <= 1: Normal Goods IE<0 : Inferior Goods

D5 em<0 D4-em=0 D3-em>1 D1-em=1

Income

D2- em>1

Demand IE helps us in classifying the goods: When em is +ve, G = normal type. When em is -ve, inferior goods. Bajra, jowar When em is +ve and greater than 1 , G = luxury. Ex: TV When em is +ve but less than 1 , G = Essential good. Ex: food grains When em=0, G = neutral. Ex: salt, mach box, etc

Determinants of IED

Nature of the Product Level of Income in a country Time Period

Practical Applications of IE
Rate of Growth of the firm Long term Business Planning Production Planning and Market Strategy Ensuring Stability in Production Housing Development Strategies

Cross Elasticity of Demand

Def: The cross elasticity of demand reers to the degree of responsiveness of demand for a commodity to a given change in the price of some related commodity. The cross elasticity of D between any 2 goods X and Y is measures by dividing the proportionate change in the quantity demanded of X by the proportionate change in the price of Y. +ve CED between 2 goods = substitutes. -ve CED between 2 goods= complementary

CED= Prop or % change in D for X Prop or % change in Price of Y

Ec or Exy= Qx /Qx Py/Py= Qx/ Py X Py/Qx

Where Qx = change in qt. D for commodity X Qx= Initial D for X Py, Initial Price of Y Py=change in price of Y

Substitutes

Complementary

P of Y

P of Y

Ex y>

xy E

<

D for comm X

D for comm X Unrelated

Substitutes High and Positive CED ComplementaryNegative CED Independent Zero CED

P of Y

D for comm X

Exy = 0

Practical Applications of CED

HLL, the leading FMCG manufacturer offers several soaps for the middle income segment-Hamam, Lux, Breeze, Liril, Lifebuoy Gold, etc. These soaps are goods substitutes for each other and therefore CED between them is very high. If HLL increases the price of Lux significantly, the D for Lux goes down and the D for other soaps like Breeze, Liril increases. Considering CED, HLL will be fixing appropriate prices for all its soaps in such a way that any increase or decrease in the price of a product should have +ve influence on the organizations profits. Firms producing similar kinds or products and services, i.e operating in same industry have +ve CED.P&G and HLL have a PED between each other in fabric and home care products. Hence , if HLL plans to increase the price of Surf, a washing detergent, the demand for P&Gs similar products like Ariel and Tide will increase.

Advertising or Promotional EOD

Qx = f(A) Qx= D for product X measured through Qt. sold in the market. A= Adv. Expenditure of the firm
Determinants:

Effect of time Stages of Product Advertising by competitors

Ea

% or Prop change in sales

% or prop change in advt. expenditure Ea = % ( Q/ Q/ % A= A) X (A/Q)

Q= Qt. of sales A = amount of adv. expenditure

Practical Application of AEOD

Determining the level of Prices Formulating Appropriate sales promotional strategy Manipulating the sales

Practical Application of EOD To businessmen: Pricing Policy To the govt and Finance Minister- Fiscal Policy and Taxation International Trade- Export and Import Policies. To Policy Makers: Mystery of how farmers may remain poor despite a bumper crop. (Paradox of Plenty) To Trade Unionists: For wage bargaining.