In this article we will discuss about:- 1. Definitions of Elasticity of Demand 2. Determinants of Elasticity of Demand 3. Elasticity of Demand on a Linear Demand Curve 4. Types 5. Factors Affecting 6. Measurement 7. Importance 8. Formulas 9. Diagrams.
Definitions of Elasticity of Demand:
The law of demand simply tells the change in amount of commodity demanded with the change in price of the commodity. In other words, law of demand simply tells only the direction of change in demand. Law of demand fails to explain how much demand for commodity will rise in response to fall in the price of the commodity.
The economists have developed a new concept known as elasticity of demand. In simple words, it tells how much change in demand will occur due to change in price. Different economists have defined elasticity of demand in their own way.
According to Prof. Lipsey, “elasticity of demand may be defined as the ratio of percentage change in demand to percentage change in price.”
In the words of Robinson’s, “elasticity of demand at any price is the proportional change of amount purchased in response to a small change in price.”
In the words of Dr. Marshall, “elasticity of demand may be defined as the percentage change in the quantity demanded divided by the percentage change in price.”
According to Boulding, “price elasticity of demand measures the responsiveness of quantity demanded to the change in price.”
Thus, the price elasticity of demand measure the proportionate change in quantity demanded of a commodity to a given change in its price.
It may be written as:
where, Ed is the coefficient of price elasticity of demand,
P is original price,
Q is original demand,
∆P is the change in price,
∆Q is the change in quantity demanded.
The elasticity of demand is influenced by large number of factors.
Some of these important factors are discussed below:
The goods having substitutes have generally elastic demand. For example, in case of tea and coffee, cold drinks, etc. With the change in prices of the substitutes, people shift to other brands. On the other hand, goods having no close substitute command more price. The reason being, people have no other choice in this case. Thus, goods having substitutes have generally elastic demand.
2. Proportion of Income Spend:
The amount of income spends on the commodity also determines the elasticity of demand for the product. If small amount of money is spent on the commodity the demand for such commodity is always inelastic. On the other hand, commodity demand is elastic if large amount of money is spend on the commodity.
Time period under consideration also influences the elasticity of demand. In short period, the demand, for the commodity is generally inelastic because it is difficult for the consumers to adjust themselves in short period, when there is change in prices.
On the other hand, in long period, the demand for the commodity is elastic. The reason being, the consumer tries to adjust himself in the long period. Moreover, in the long period, the consumer also tries to change his habits, etc.
4. Postponement of Demand:
If the demand for the commodity can be postponed, the demand for the commodity is elastic. On the other hand, if demand cannot delayed, the demand for such commodities are inelastic.
For example, the demand for luxuries is generally elastic, because the purchase decision for these commodities can be postponed, whereas in case of essential commodities, it is inelastic. The reason being, the demand for these commodities cannot be postponed, even when there is a steep rise in prices of these commodities.
Elasticity of Demand on a Linear Demand Curve:
1. Elasticity and Price:
The price elasticity of demand is generally different at different points of the demand curve. Let us take for instance a linear demand curve (Fig. 3.14). Here the slope of the demand curve which is the denominator in the Samuelson-Holt formula is constant by definition. Only the slope of the diagonal declines as we move down the demand curve. Since the numerator falls while the denominator is constant, by the Samuelson-Holt formula, |εd| declines as we move down a linear demand function. On linear demand functions, the |εd| is lower at lower prices and at higher quantities.
The Marshall formula can also be used to reach the same conclusion. The tangent of a linear demand curve coincides with it and extends to touch the axis. Hence, at any point of the linear demand curve, the lower segment by the upper segment will give us the |εd|. At the mid-point of the tangent, A, the lower segment equals the upper segment. Hence here the |εd| is equal to one.
Technically, we say that demand is unitary elastic at A. Since the lower segment is larger than the one above A, the |εd| is greater than one above A. Technically, we say that demand is elastic above A. Below A, for analogous reasons, the |εd| is less than one. In this case we say that demand is inelastic below A. Thus the term, ‘unitary’ elasticity of demand, separates ‘elastic’ from ‘inelastic’ demand.
2. Elasticity and Slope:
At any point on the demand curve, the elasticity of demand varies inversely with its slope. This can be explained using the Samuelson-Holt formula. At any given point, the slope of the diagonal, which is the numerator, is fixed. Hence, if the slope of the demand curve (which is the denominator) increases, the elasticity of demand can only fall, and conversely. This is illustrated by Fig. 3.15, where the demand curve is rotated clockwise at the point A. Since the rotation increases the slope of the demand curve, the price elasticity of demand at A falls.
Two polar cases of the relation between the slope of the demand curve and the elasticity of demand are instructive. First, when the demand curve is vertical (D2), its slope is infinite at all points. As a result, the price elasticity of demand on the curve is zero everywhere. No change in price has any effect on quantity demanded. The second instance is that of a horizontal demand curve (D0). Here the slope of the demand curve is zero everywhere. Hence the elasticity of demand is infinite and quantity demanded is very volatile. At a slightly higher price, the quantity demanded will dwindle to nothing, whereas, it is indefinitely large at the going price and below.
The demand curve (D1) which slopes down to the right is the golden mean. It represents consumer behaviour that is neither as rigid as depicted by the vertical demand curve, nor as volatile as suggested by the horizontal demand curve. This intermediate kind of consumer behaviour is naturally characterized by an elasticity of demand that is positive but not infinitely large, i.e. 0 < |εd| < ∞.
Types of Elasticity of Demand:
The following are the types of elasticity of demand mentioned in the economic literature:
1. Income Elasticity of Demand:
It refers to proportionate change in quantity demanded to proportionate change in income.
The income elasticity of demand has five degrees:
It means with change in income the demand for the commodity remains constant. It can be explained with the help of the Figure 3.6.
The Figure 3.6 depicts zero income elasticity of demand. On X-axis quantity demanded and on Y-axis income have been taken. DD is the demand curve, which is parallel to Y-axis. It shows that when income of the consumer increases from 0A to 0A1, the demand for the commodity remains constant, i.e., 0M. In this case Ey = 0.
(ii) Negative Income Elasticity:
It means consumer buys less amount of commodity with increase in their income. It means proportionate change in quantity demanded is less than proportionate change in income.
The above Figure shows the negative income elasticity of demand. It clearly reveals that change in quantity demanded (M0M1) is less than change in income of the consumer (A0A1). It means the relative change in quantity demanded is less than the relative change in income.
It means proportionate change in quantity is equal to proportionate change in income. It can be explained with the help of the Figure 3.8.
The Figure 3.8 highlights that change in quantity (M0M1) and income (A0A1) is almost same. Income elasticity of demand is unity in this case.
It means the amount of quantity demanded is more than increase in income. The goods with high income elasticity are usually articles of luxuries. The value of income elasticity is greater than one in this case.
In this Figure, DD is the demand curve, which is positively sloped. The demand curve DD clearly reveals that change in quantity demanded (M0M1) is greater than change in income of the consumer (A0A1). Income elasticity in this case is greater than one.
It means increase in quantity demanded is less than increase in income. In other words consumer demands less commodity with increase in income.
The Figure 3.10 shows low income elasticity, it clearly reveals that change in quantity demanded (M0M1) is less than change in income of the consumer (A0A1). It means relative change in quantity demanded is less relative change in income.
2. Cross Elasticity of Demand:
In real life, we find large number of goods having close substitutes such as tea and coffee, soft drinks, etc. With the change in the prices of the commodities having close substitutes, the demand for these commodities also changes. Large number of goods are also complementary in nature.
It means both the goods are demanded jointly such as car and petrol, etc. The increase in price of one commodity leads to decline in the demand for other commodity. Under both these situations, it becomes essential to understand the effect of change in prices of these commodities on the quantity demanded.
The cross elasticity of demand can be expressed in the form of following formula:
Ec is the coefficient of cross elasticity of demand,
Px is the original price of commodity x,
Py is the original price of commodity y,
∆Py is the change in price of y,
∆QX is the change in quantity demanded of x.
The value of cross elasticity of demand can be positive, negative and zero.
The cross elasticity of demand in these cases has been explained below:
It refers to a situation in which increase in price of one commodity the demand for other commodity increases such as tea and coffee.
It can be explained with the help of following Figure:
In the above Figure, demand curve DD in case of substitutes is positive. It means when price of coffee increases, the demand for tea (close substitute) increases. When price of the coffee increases from 0P0 to 0P1, the quantity demanded of tea rises from 0Q0 to 0Q1.
In case of complementary goods, the cross elasticity of demand is negative. It means with increase in price of one commodity, the demand for other commodity declines.
This phenomenon can be expressed in the above diagram. The Figure highlights that when price of the commodity is 0P0 the quantity demand is 0Q0. When price of the commodity say petrol increases, the quantity demanded of cars and scooters declines. Thus, cross-elasticity of demand for complementary goods is negative.
Factors Affecting Elasticity of Demand
In fact, several factors are to be considered before deciding whether a demand for a particular commodity is inelastic, relatively elastic or highly elastic.
1. Nature of Commodity:
The demand for the items of necessities (i.e. essential items) is generally less elastic. Such commodities are bought in certain fixed quantities irrespective of their prices. The demand for wheat and rice will remain practically the same. In the similar way, the demands for the items of comforts are relatively elastic, whereas for luxuries, the demands are highly elastic.
The demand for an electric fan (a commodity of comfort) is relatively elastic while the demand of a car (an item of luxury) is highly elastic. With minor changes in prices, more people are motivated to avail the advantage of fulfilling their demands.
When a commodity is a necessity like food grains, vegetables, medicines, etc., its demand is generally inelastic as it is required for human survival and its demand does not fluctuate much with change in price. When a commodity is a comfort like fan, refrigerator, etc., its demand is generally elastic as consumer can postpone its consumption.
2. Proportion of Total Expenditure Involved:
When the expenditure made for a particular commodity, is a small portion of the total expenditure, the demand will generally be inelastic or less elastic. The consumer will not get affected by small price change so the demand of the commodity will not be altered. The newspaper and the matchbox belong to such type of commodity.
On the other hand, the demand for milk is elastic, because it absorbs a good proportion of total expenditure. Its demand is more when prices are low.
3. Availability of Substitutes:
The commodities, for which other substitutes are available in the market, have more elastic demands as compared to commodities without proper substitutes. A good example is that of tea, for which coffee is generally available as a substitute. A change in the price of tea causes almost proportional change in its demand. Contrary to the above, the common salt has no substitute and so any increase or decrease in the price of salt does not affect its demand.
4. Multipurpose Use of Commodity:
If any commodity can be used for several purposes, its demand is generally elastic. As compared to this, the commodity, having one or two uses only has less elastic demand. For example, the electricity has many types of uses and when its price rises, people get encouraged to use it less. On the contrary, a pair of shoes or a shirt has a specific use only and so its demand is less elastic.
5. Price Level:
When the price of a commodity is very high or very low, the demand is generally less elastic or inelastic. For example- a car is priced at about Rs. 2 lakh and a change of price by Rs. 500 will have almost no effect on its demand. Similarly, needles, shirt-buttons and matchboxes are cheap commodities and even 100% changes in the price of these goods do not affect the demand to any noticeable degree.
However, the commodities having moderate prices have an appreciable change in demand with changes in prices. For example- woolen clothes, raincoats, etc., belong to the category of commodities having moderate price and the demand of such items is relatively elastic.
6. Habit, Taste and Customs of the People:
Some people have a habit of using a particular type or variety of commodity or have a preferential taste for it. Like a person who smokes and is addicted to it or a person who is an alcoholic will buy it, even if the prices go higher. These addictive commodities can also be called as conventional necessities.
Besides, some commodities are consumed because of prevailing customs in the society. Such commodities generally have inelastic demands. These will be consumed irrespective of price variations. Commodities which have become habitual necessities for the consumers, have less elastic demand.
It happens because such a commodity becomes a necessity for the consumer and he continues to purchase it even its price rises. Alcohol, tobacco, cigarettes, etc., are some examples of habit forming commodities.
7. Possibilities of Postponement of Consumption (or Use):
If the use of a commodity cannot be postponed or deferred, its demand is usually inelastic or less elastic. For example- as the consumption of salt or sugar cannot be postponed, its demand is usually inelastic.
If the rates of cement rise then people can postpone their plans to build a house, so its demand is elastic, but the elasticity of food grains is inelastic, as we cannot avoid its use. Commodities with urgent demand like lifesaving drugs, have inelastic demand because of their immediate requirements.
8. Complementary (Joint) Demand:
There are certain commodities that are demanded jointly such as car and petrol or mobile phone and mobile connections (SIM). In this case the demand of one would depend upon the elasticity of demand of the other commodities i.e., if the demand of car is inelastic, the demand for petrol would also be inelastic.
9. Distribution of Income:
The elasticity of demand depends upon the income of the purchaser and the distribution of income in the society. The people who are rich, may not be affected by the price change. They would continue to buy the same amount irrespective of the price, so their demands are inelastic. On the contrary, the poor section will contract their requirements and buy the minimum amount, so their demands are elastic.
However, when there is an equal distribution of income in the society, then the demand will be completely elastic because, everybody will get affected by the price change.
10. Durability of the Goods:
In case of durable goods or a product which has a long life, the price change would not affect the demand very much, e.g. people buy new furniture only when the old one is worn out, and so the durable goods have low elasticity of demand.
Measurement of Elasticity of Demand (Formulas):
The following are the measurements suggested by the economists to measure the elasticity of demand:
Total expenditure method first of all was used by Dr. Marshall. According to this method, elasticity of demand can be measured with the help of direction of change in amount of expenditure incurred on the commodity with the change in price of the commodity. The value of elasticity of demand equal to one, less than one or more than one, will be determined by amount of expenditure incurred on the commodity.
According to this method, the demand for the commodity is more elastic, when with fall in the price of the commodity, the total outlay or expenditure on the commodity increases.
If the total expenditure on the commodity remains unchanged with the change in price, the elasticity of demand in this case will be unity. Elasticity of demand will be less than one when fall in the price of the commodity, total expenditure also declines.
This can be explained with the help of following table and diagram:
The above table shows that initially with decline in price of the commodity, total expenditure increases. The elasticity of demand in this case is greater than one. When the price of the commodity declines from Rs. 10 to Rs. 7, the total expenditure on the commodity increases from Rs. 10 to Rs. 28. When price of the commodity declines from Rs. 6 to Rs. 5, total expenditure on the commodity remains unchanged. The elasticity of demand in this case is equal to 1.
Total expenditure on commodity reduces, when the price of the commodity further declines. In this case, elasticity of demand is less than one. In this Table when price of the commodity declines from Rs. 4 to Rs. 1, the total expenditure reduces from Rs. 28 to Rs. 10. The behaviour of demand curve in this case has been shown in the Figure 3.13.
On X-axis, total expenditure has been taken and on Y-axis price. ABCD is the demand curve which has been derived from the data contained in above Table 3.1. AB segment of demand curve shows the elasticity of demand greater than one, BC part depicts elasticity of demand equal to one and CD part highlights elasticity of demand less than one.
AB part of the Figure depicts that with fall in price, total expenditure increases. BC part shows that total expenditure remains constant with change in price. CD part shows that with fall in price of the commodity total expenditure declines.
This method is also developed by Dr. Marshall. In this method, elasticity of demand is measured at the different points on the straight line demand curve. This method is used to measure elasticity of demand more frequently. In this method a straight line demand curve is taken, which touches X and Y axis.
In Figure 3.14, AB is demand curve, which is touching X and Y-axis.
The elasticity of demand at different points of demand curve can be measured through the following formula:
Let us suppose, the length of demand curve AB is 8 cm. The length of AD, DC, CE and EB parts of demand are 2 cm each.
Now let us suppose the elasticity of demand at the midpoint of the demand curve, i.e.:
Similarly, at point A, Ed is equal to infinite. At point B, Ed is equal to zero.
The elasticity of demand has a lot of significance to businessmen, policy-makers and general public. All important decisions regarding price, output and expenditure are determined by the elasticity of demand. Thus, the elasticity of demand has significance while taking rational decisions.
Businessmen takes into consideration elasticity of demand of their product while fixing the prices of their commodities. Businessman fixes high price of products having inelastic demand. The reason being, the consumer has to buy that commodity even commodity commands high price. On the other hand, low price will be fixed for commodity having elastic demand. Because commodity having elastic demand will fetch revenue when business fix low price of the commodity.
The prices of factors of production are also fixed on the basis of its elasticity of demand. The factors having inelastic demand in the market will get higher prices as compared to factors having elastic demand. For example, highly skilled persons enjoy higher price on account of inelastic demand of their services. On the other hand, unskilled workers due to excess availability in the market fetches low prices.
The country stands to gain in the international trade, when country exports more commodities having inelastic demand in the international market.
The elasticity of demand also guides the finance minister while imposing taxes on different commodities. More taxes are imposed on commodities having inelastic demand and less amount of taxes are levied on commodities possessing more elastic demand. The reason being, when more taxes are imposed on commodities having less elastic demand, the demand for such commodities do not decline considerably.
On the other hand, if higher taxes are levied on commodities having elastic demand, the demand for such type of commodities decline to a large extent. The revenue in this case also declines. Thus, finance minister takes into consideration elasticity of demand while imposing taxes on the commodities.
Joint products are those products which are produced in a single production process. For example, rice and husk mutton and skin, etc. Production of these commodities occurs simultaneously. The prices of these joint products are determined on the basis of elasticity of demand. In case of rice and husk, demand for rice being inelastic, it is fixed at higher price, whereas husk having elastic demand fix at low price.