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Demand is desire backed by willingness to pay and ability to pay i.e. a wish to have a commodity does not become demand. A person wishing to have a commodity should be willing to pay for it and should have ability to pay for it. Thus a desire becomes demand if it is backed by willingness to pay and ability to pay. Demand is meaningless unless it is stated with reference to a price.
Decisions regarding what to produce, how to produce and for whom to produce are taken on the basis of price signals coming from the market. The law of demand explains inverse relationship between price and quantity demanded. When price falls quantity demanded of that commodity will increase. The deficiency of law of demand is removed by the concept of elasticity of demand.
MEANING AND DEFINITION OF ELASTICITY OF DEMAND
The term elasticity was developed by Alfred Marshall, and is used to measure the relationship between price and quantity demanded. The law states that the price of a commodity falls, the quantity demanded of that commodity will increase, i.e. it explains only the direction of change in demand and not the extent of change. This deficiency is removed by the concept of elasticity of demand. Elasticity means responsiveness. Elasticity of demand refers to the responsiveness of quantity demanded of a commodity to change in its price. According to E.K. Estham, “elasticity of demand is a measure of the responsiveness of quantity demanded to a change in price”.
IMPORTANCE OF THE CONCEPT ‘ELASTICITY’
The concept f elasticity of demand plays a crucial role in businessdecisions regarding fixing of price with a view to make larger profit. For instance, cost of production is increasing the firm would want to pass the rising cost on to the consumer by raising the price. Firms may decide to change the price even without any change in the cost of production. But whether raising price following the rise in cost or otherwise proves beneficial depends on: a) The price elasticity of demand for the product, i.e. how high or low is the
proportionate change in its demand in response to a certain percentage change in its price. b) Price elasticity of demand for its substitutes, because when the price of a
product increases the demand for its substitutes increases automatically even if their prices remain unchanged. Raising the price will be beneficial only if: a) b) Demand for a product is less elastic Demand for its substitutes is much less elastic. Elasticity of demand establishes the quantitative relationship between quantity demanded and price or other demand determinants.
TYPES OF ELASTICITY
These are three types of elasticity:-
a. b. c.
Price elasticity Income elasticity
Zero income elasticity Negative income elasticity Positive income elasticity
1. Price Elasticity Price elasticity of demand may be defined as the degree of responsiveness of quantity demanded of a commodity in response to change in its price i.e. it measures how much a change in price of a good affects demand for that good, all other factors remaining constant. It is calculated by dividing the proportionate change in quantity demanded by the proportionate change in price. EP= 2. Income elasticity Income elasticity of demand measures how much a change in income affects demand for that commodity if the price and other factors remains constant. Proportionate change in quantity demanded Proportionate change in price
Proportionate change in quantity demanded Proportionate change in income
A product with an income elasticity of more than one will experience a growth in demand that is higher than growth in consumer’s income. Luxury goods tend to have relatively high income elasticity. Low quality goods have negative income elasticities, as people stop buying them when they can afford to. There are three types of income elasticity – Zero income elasticity – Here a change in income will have no effect of quantity demanded. For example: - salt, matches, cigarettes. Negative income elasticity – Here an increase in income leads to a decrease in quantity demanded. This happens in inferior goods. Positive income elasticity – In this an increase in income will leads to an increase in quantity demanded. For most goods income elasticity is positive. 3. Cross elasticity This measures the change in demand for a commodity due to change in price of another commodity. ED= Percentage change in quantity demanded of commodity A Percentage change in price of commodity B If the goods having substitutes the cross elasticity is positive i.e. an increase in the price of X will result in an increase in sales of Y. If the goods are complementary and increase in the price of one commodity will depress the demand for the other. So cross elasticity will be negative. If the goods are unrelated cross elasticity will be zero. Because however much the price of one commodity increased demand for the other will not be affected by that increase.
There exist another two types elasticity viz. Elasticity of price expectation and Advertisement elasticity 4. Advertisement elasticity or Promotional elasticity The expenditure n advertisement and other sales promotion activities does help in promoting sales, but not in the same degree at all levels of the total sales. The concept of advertisement elasticity is useful in determining the optimum level of advertisement expenditure. It may be defined as, “the responsiveness of demand t to changes in advertising or other promotional expenses”. EA = Proportionate change in sales Proportionate change in advertising and other promotional expenditure
5. Elasticity of price expectations The price expectation elasticity refers to the expected change in future price as a result of change in current price of a product.
pf / pf pc/pc
pf x pc
Where Pc and Pf are current and future price. The coefficient ex gives the measure of expected percentage change in future price as a result of 1 percent change in present price. If ex > 1 it indicates the future change in price will be greater than the present change in price. If ex=1, it indicates that the future change in price will be equal to the change in current price. In ex > 1, the sellers will sell more in the future at higher prices.
FACTORS INFLUENCING PRICE ELASTICITY OF DEMAND
1. Nature of commodity Elasticity depends on whether the commodity is a necessity, comfort or luxury. Necessities of life have inelastic demand and comforts and luxuries have elastic demand. 2. Availability of substitutes Goods with substitutes have elastic demand and goods without substitutes have inelastic demand. For example: coffee and tea are substitutes. If price of tea increases, people may switch over to coffee. If price of coffee raises people may shift to tea. The demand of salt is inelastic. 3. Uses of the commodity Certain goods can be put to many uses. Example – electricity. Such goods have elastic demand because as the price decreases, they will be put to more uses. 4. Proportion of income spent on commodity For some goods, consumers spend only a small part of their income. The demand will be inelastic. For eg: - salt and matches
5. Price of goods Generally cheap goods have inelastic demand and expensive goods have elastic demand. 6. Income of consumers Very rich people have inelastic demand for goods and poor people have elastic demand. Because rich people will buy the commodity at all levels of prices where poor people there is a change in quantity of consumption according to change in price. 7. Time period Elasticity would be more in the long run than in the short run. Because in the long run consumers can adjust their demand by switching over to cheaper substitutes. Production of cheaper substitutes is possible only in the long run. 8. Distribution of income and wealth in the society If there is unequal distribution of income, the demand of commodities will be relatively inelastic. If the distribution of income and wealth in the society is equal there will be elastic demand for commodities.
DEGREES OF ELASTICITY
Since the responsiveness of quantity demanded varies from commodity to commodity and from market to market, it is important to study the degrees of price elasticity. We can identify five degrees of elasticity. They are: 1. 2. 3. 4. 5. Perfectly elastic demand Perfectly inelastic demand Unitary elastic demand Relatively elastic demand Relatively inelastic demand
1. Perfectly elastic demand Perfectly elastic demand is the situation where a small change in price causes a substantial change in quantity demanded i.e. a slight decline in price causes an infinite increase in quantity demanded and a slight increase in price leads to demand contracting to zero. The demand is hypersensitive and the elasticity of demand is infinite. Demand curve becomes a horizontal straight line parallel to x-axis.
ep = 2
2. Perfectly inelastic demand
It is the situation where changes in price cause no change in quantity demanded. Quantity demanded is non-responsive or inelastic. Demand curve is a vertical line parallel to Y-axis and the elasticity of demand is zero.
ep = 0
It is clear that the price is OP or OP1 or OP2. The quantity demanded remains unchanged at OM.
3. Unitary elastic demand It refers to that situation where a given proportionate change in price is accompanied by an equally proportionate change in quantity demanded. For example, if price changes by 10%, quantity demanded also changes by 10%.
∴ ep= 10/10 = 1
ie; elasticity will be equal to one. The demand curve is a rectangular hyperbola.
4. Relatively elastic demand
Demand is said to be relatively elastic when a given proportionate change in Price causes a more than proportionate change in quantity demanded.
5. Relatively Inelastic demand Demand is relatively inelastic when a given proportionate change in price causes a less than proportionate change in quantity demanded. Demand curve will be a very steep curve. Elasticity is less than 1. For example, If price changes by 20% quantity demanded changes by 10% Then ep = 10/20 = .5 Y D ie; ep<1
Quantity demanded Of the five degrees of elasticity perfectly elastic and perfectly inelastic are extreme cases i.e. rarely found in actual life. Unitary elasticity, relatively elastic and relatively inelastic demand are the most widely used price elasticties.
MEASUREMENT OF ELASTICITY OF DEMAND
Important methods to measure the elasticity of demand are: 1. 2. 3. Proportional or percentage method Expenditure or Outlay method Geometric or point method
These are the commonly used methods. 1. Proportional method or Percentage method Under this method the elasticity of demand is measured by the ratio between the proportionate or percentage change in the quantity demanded and proportionate or percentage change in price. It is also known as formula method. Ep= Proportionate change in quantity demanded Proportionate change in price
∆p p ∆q ∆p
ep is ∆ q is ∆p q p For example: is is is
the price elasticity the change in quantity demanded the change in price the initial quantity the initial price Quantity demanded of A 10 15
Price of A 5 4 quantity demanded rises to 15. Here ∆ p = 1, Initial price = 5, ep = p X q = 5 10 = 2.5 X ∆q ∆p 5 1
When price of A is Rs.5 quantity demanded is 10. When price falls to Rs.4 ∆ q= 5 Initial quantity = 10
Elasticity is greater than one (relatively elastic) if price elasticity is equal to one, it is unitary elastic demand. If elasticity is less than one, it is relatively inelastic demand. If elasticity is more than one, it is relatively elastic demand. If elasticity is zero, it is perfectly inelastic demand. If elasticity is infinity, it is perfectly elastic demand. 2. Expenditure or Outlay method By this method elasticity is measured by estimating the change in price that leads to a change in quantity demanded causes changes in total
expenditure incurred on commodity. According to seller’s total expenditure means total revenue. So this method is also known as total revenue method.
By looking at variation in total expenditure, price elasticity can be calculated.
Price (P 18 15 12 9
Quantity Demanded (Q) 3 4 5 6
Total Expenditure (P x Q) 54 60 60 54 e>1 e=1 e <1
In this table a fall in price leads to a more than proportionate increase in quantity demanded increase in total expenditure. Conversely, a fall in price leads to a less than proportionate increase in quantity demanded results in decrease in total expenditure. A fall in price leads to a proportionate increase in quantity demanded result in total expenditure remaining constant. Y A e>1 B e=1
C e<1 X
In this figure price is on the vertical axis and total expenditure on horizontal line. As the price falls and total outlay increases, elasticity is greater than 1. We find elasticity greater than 1 in the CB portion of the total outlay curve. In BA, total expenditure remains the same while price is falling. Therefore elasticity is equal to 1. In AL the price is falling and total expenditure is also falling. From A to L the curve is bending towards the origin. So elasticity is less than one If total expenditure increases, elasticity >1 If total expenditure decreases, elasticity<1 If total expenditure remains constant, elasticity=1
3. Geometric method or Point or Straight line method This method is used to measure the change in quantity demanded in response to a very small change in price. If demand curve is a straight line, elasticity at any point on the straight line can be calculated using the point method. When demand curve is a horizontal straight line parallel to x axis elasticity is equal to infinity. It is perfectly elastic demand. When demand curve is a vertical straight line parallel to y axis elasticity is equal to zero. It is perfectly inelastic demand. For calculating elasticity at any point on a downward slopping demand curve, we have to extend the demand curve to touch the x axis and y axis.
Then the point at which elasticity is to be known has to be marked on demand curve dividing it into upper segment and lower segment. ep = lower segment upper segment
Y a ep=2
ep>1 ep=1 ep<1
4. Arc method Arc method is not so important that it is applicable only when there are very small change in price and demand.
Using of Elasticity Concept in Business
We are the company which produce a commodity x. We earn maximum profit by selling 80% of commodities at the rate of Rs.20/-. STAGE I – At the time of commencement D 20
Suddenly we have to face a decline in demand. Demand falls by 10% and the current demand deceases from 80% to 70%.. STAGE II – Decrease in demand D
At this time we have to reduce the price by Rs. 18/- instead of Rs. 20/- to increase the demand and demand increases from 70% to 75%.
STAGE III – Current position of our company D D1 20
70 75 80 Qty
Reasons for decline in demand
There are certain reasons for the sudden decline of demand for our commodity. 1. Availability of cheap substitutes The main reason is the availability of cheap substitutes in the market i.e. more substitutes is available in the market at low price. So that people buy more of that commodity and because the demand for our commodity falls. Substitution effect means change in demand due to substituting one commodity for another.
When price of a commodity falls the cheaper commodities will be substituted in the place of dearer commodities. Thus price of the commodity falls more of it will be demanded and the consumer uses it as a substitute for high priced commodities. 2. Lack of Advertisement Lack of Advertisement is also a reason for the declining demand for goods. In a highly competitive market advertisement is very important and it also affect the change in demand. The main objective of advertisement is to create additional demand by attracting more consumers to our product. So we must advertise well to increase our demand of our product. 3. Technological progress Technological progress also affect demand for a commodity. Inventions and discoveries bring new things in the market. So people will not demand older things. So we must use more technological devices to improve the demand for our product.
4. Lack of demonstration
Lack of demonstration also brings out our commodity to a fall in demand i.e. people get motivated or they were attracted by the demos given by us and they will buy that product not because of their increase in income or it becomes a cheaper product but their neighbour or relatives bought it. Tendency of the consumer to imitate others will help us to increase the demand for our commodity.
5. Free goods
More Free goods are given by other producer to attract consumers and that will affect the demand of our product. So we also gave more free goods than the other companies. Because of these reasons we must forced to reduce the price of our commodity to increase our commodities demand. For this we must know the different market conditions and the factors affecting demand for a commodity.
DETERMINANTS OF DEMAND
1. Price of a commodity Price of the commodity is the most important factor that determine demand. An increase in price of a commodity leads to a reduction in demand and a decrease in price leads to an increase in demand. 2. Price of related goods Demand for a commodity depends on Price of related goods also. Related goods include both substitutes and complementary goods. Substitutes are those goods which can be used one another or the goods with same use are substitutes. e.g.:- tea and coffee. When price of tea falls demand for coffee also falls. Because when price of tea falls people buy more tea and less coffee. Complementary goods are those goods which can be used only jointly. e.g.: - car, petrol or pen, ink. When price of a commodity raises demand for its complementary goods falls. If x and y are complementary goods we cannot use x without y. When price of x raises demand for x falls and y cannot be used without x and demand for y also falls.
3. Income of the consumer Income of the consumer and demand for a commodity are positively related. For normal goods when income increases demand also increases and vice versa. But for inferior goods there is a negative relationship between income and demand. So when income increases, demand decreases. Taste and Preferences of consumers Taste and Preferences of consumers also brings out changes in demand for a commodity. Tendency to imitate other fashions, advertisements etc affect demand for a commodity. It change from person to person, place to place and time to time. 4. Rate of Interest Higher will be demanded at lower rates of interest and lower will be demanded at higher rate of interest. 5. Money supply Demand is positively related to money supply. If the supply of money increases people will have more purchasing power and hence the demand will increase and vice versa. 6. Business condition Trade cycles or business cycles also demand for a commodity. Demand will be high during boom period and low during depression.
7. Distribution of income Distribution income in the society also affects the demand of commodity. If there is equal distribution of income demand for necessary goods and comforts will be greater. If there is an unequal distribution of income demand of comforts and luxuries will be greater. 8. Government policy Government policy also affects the demand of commodities. For example, if heavy taxes are imposed on certain goods, the demand will decrease. On the other hand, if government announces tax concessions for certain commodities, their demand will increase. 9. Consumers’ expectations Consumers’ expectation about a further rise or fall in future price will affect the demand of a commodity. If consumers expect a rise in the price of a commodity in the near future, they may purchase large quantity even though there is some rise in the price. When the price of a commodity decreases, people expect a further fall in price and postpone their purchase. Similarly, if consumers believe that their incomes will rise in the near future they are more inclined to buy more expensive items today. So these expectations changes the demand for goods.
In the project regarding the elasticity of demand, we discuss different degrees, types and measurement of elasticity. Applying the theory of elasticity we have to increase our demand of our commodity. But this increase in demand will not lead to an increase in cost of production. When cost of production increases automatically we must sacrifice the rate of profit that we earn. So we must take some strategic decisions to improve our quality of our commodity and thereby increase profit, increase in demand and also we have to reduce the cost of production. Although most businessmen are very much aware of the elasticity of demand of the goods they make, the use of precise estimates of elasticity of demand will add precision to their business decision i.e. the theory of elasticity of demand is very useful at the time of taking tactical decisions by the top management. So this project is much useful to us to know how elasticity influences the working of business and even in our day to day life.
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