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Elasticity of Demand

# Elasticity of Demand

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01/08/2013

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# Page |1 ASSINGMENT: A.

Define the concepts of ‘Own Price Elasticity of Demand ‘, ‘Cross Price Elasticity of Demand’ and ‘Income Elasticity of Demand’. SOLUTION: Elasticity of demand measures the extent to which the quantity demanded of a commodity increases or decreases in response to increase or decrease in any of its quantitative determinates. As we know that, demand for the commodity mainly depends upon its price, income of the consumer or price of related goods. Thus, by elasticity of demand, we mean the extent to which the quantity demanded of a commodity changes with change in its price or income of the consumer or price of related goods. In the words of Dooley, “the elasticity of demand measures the responsiveness of the quantity demanded of a good, to change in its price, price of other goods and changes in consumer’s income.” Accordingly, elasticity of demand can be of three types: 1. Price elasticity of Demand (Own Elasticity of Demand) 2. Income Elasticity of Demand 3. Cross elasticity of Demand Price (Own) Elasticity of Demand: Price elasticity of demand is defined as the percentage change in quantity demanded of a product due to the percentage change in its price, other things remaining constant. It can also be denoted as: Ep = Percentage change in quantity demanded / Percentage change in price Assume that the demand for petrol reduces by 2% as a result of an increase in petrol prices by 10%. The price elasticity of demand for petrol is:

Sujeet Kumar | MBA 1st Semester Roll No 25

Page |2 -2% / 10% = - 0.20 Let us assume that a wholesaler of biscuits knows that the price elasticity of demand for biscuits remains unchanged at -1.5. The price of the biscuit increases by 20%. We can determine the decrease in quantity demanded due to the increase in price. Percentage change in quantity demanded = -1.5 * 20% = -30% Income Elasticity of Demand: An increase in real income increases the demand for products, other factors remaining the same. Income elasticity of demand for a product is the percentage change in demand for that product divided by the percentage change in the consumer’s income (d Y). The income elasticity of demand of a product X can be mathematically denoted as: EY = (% change in the quantity demanded of product X) / (% change in the income of the consumer) = (dQX/QX) / (dY/Y) = (dQX* Y) / (dY/QX) Products and services with income elasticity above one are called Income Elastic. For example, air travel, restaurant meals, movies, and other entertainment are services on which people spend a lot with an increase in income. Products and services with income Elasticity between zero and one are called inelastic goods. For example, in developed countries like the US, clothing, alcoholic beverages, and newspapers are examples of products for which a rise in income generates little additional consumption. The demand for certain products and services reduces when there is an increase in income. These are known as inferior products having negative income elasticity. Examples of inferior products are low-end brands of household products and coarse cereals. Sujeet Kumar | MBA 1st Semester Roll No 25

Page |3 Cross Elasticity of Demand: Cross Elasticity of Demand is the ratio of percentage change in the quantity demanded for one product to a percentage change in the price of another related product, other factors remaining constant. Crossprice elasticity can be positive or negative, based on the change in the price of a substitute or complementary products. If the two products are good substitutes, the value of cross-elasticity will be positive. If they are complementary products, the value of cross-elasticity of demand will be negative, because change in price of one product causes opposite change in the quantity demanded of the other product. For example, let us consider two close substitute products: Pepsi and Coke. If the price of Pepsi increases significantly, its consumers may switch to Coke. The change in the price of Pepsi and demand for Coke are moving in the same direction and hence the cross elasticity is positive. On the other hand, complementary products like tea and sugar have negative cross elasticity. If the price of sugar increases, the demand of sugar as well as tea comes down. Since the price of sugar increases while demand of tea decreases i.e. they move in opposite direction, their cross elasticity would be negative. Let us assume that the quantity demanded for two products X and Y are Q1 and Q2 and they are priced at P1 and p2 respectively. The cross elasticity of demand of product X is the percentage change in the quantity demanded due to the percentage change in price. This can be mathematically denoted as: Ecp = (%change in the quantity demanded of product X) / (%change in the price of product Y) = (dQ1/Q1) / (dP2/P2) = (dQ1* P2) / (dP2/Q1) A. Explain the importance of ‘Elasticity of Demand’. SOLUTION: Sujeet Kumar | MBA 1st Semester Roll No 25

Page |4 Elasticity of demand plays an important role in the pricing decisions of business organizations and the government when it regulates prices. It also helps in judging the effect of devaluation of currency on export earnings of a country. In the following paragraphs, various applications and uses of elasticity of demand are explained: 1. Pricing decisions of business organizations: Before taking any decision regarding pricing of a product, a business organization has to consider the price elasticity of demand for that product. The reason to consider price elasticity is because the change in the price of product would change the quantity demanded of that product depending on its coefficient of price elasticity. An increase in the price of a product forces the consumer to consume that product in lesser quantity, which in turn reduces the overall revenue of a firm from that product if it has a high coefficient of price elasticity. If the product is of inelastic in nature, an increase in price will have a positive effect on the total revenue of the firm. Thus, price elasticity plays an important role in fixing the price of a product. 2. Diversification Strategies formulation: The knowledge of cross elasticity of demand is very important in managerial decision making for developing an appropriate price strategy. Firms selling multiple products use cross elasticity of demand to analyze the effect of change in the price of one product to the demand of others. For example, Hindustan Lever Limited (HLL), the leading fast-moving consumer goods manufacturer offers several soaps for the middle income segment – Hamam, Lux, Breeze, Liril, Lifebuoy Gold, etc. These soaps are good substitutes for each other and therefore cross elasticity of demand between them is high. If HLL increases the price of Lux significantly, the demand for Lux goes down while the demand for other soaps like Breeze or Liril will increase. So considering the cross elasticity of demand, HLL will be fixing appropriate prices for all its soaps. Thus, cross elasticity of demand helps an organization to price its products in such a way that any increase or decrease in the price of a product should have positive influence on the organization’s profits. Sujeet Kumar | MBA 1st Semester Roll No 25

Page |5 3. Competitive Strategies formulation: Firms producing similar kinds of product and services i.e. operating in the same industry having a positive cross elasticity of demand. For example, P&G and HLL are having a positive cross elasticity of demand 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&G’s similar products like Ariel and Tide will increase. 4. Marketing and Production Decision making: In developing country like India, having scarce resources, Income Elasticity of Demand helps firms to decide what to produce. Normally, developing economics face frequent fluctuations in business cycle. The demand for luxury products fluctuates very much during different phases of business cycles. During boom period, demand for luxury products increases significantly and declines sharply during recessionary period. Taking into account the income elasticity of a product, managers of a firm can decide what to produce. The firms producing products, which have high income elasticity, have great potential for growth in a growing economy. For example, if a firm’s product income elasticity of demand is greater than one, it means that it will gain more than proportionately to increase in national income. Hence, firms producing products having high-income elasticity are more interested in forecasting the level of national income. The concept of income elasticity of demand also helps a firm to decide its location and to develop its marketing strategies. For example, the firm producing products having high-income elasticity of demand will try to locate its retail outlets where the incomes of consumers are increasing rapidly. Moreover, these firms will direct their advertisement to those segments of people having high incomes. A. What are the factors which determine the ‘Price Elasticity’ of a product? SOLUTION: Following factors determine the price elasticity of demand: • Nature of Commodity: Sujeet Kumar | MBA 1st Semester Roll No 25

Page |6 Ordinarily, necessaries like salt, kerosene oil, matchboxes, textbooks, seasonal vegetables, etc have less than unitary elastic (inelastic) demand. Luxuries, like air conditioner, costly furniture, fashionable garments, etc. have greater than unitary elastic demand. The reason being that change in their prices has a great effect on their demand. Comforts like milk, transistors, cooler, fans, etc. have neither very elastic nor very inelastic demand. Jointly demanded goods (Complementary goods) like, car and petrol, pen and ink, camera and film, etc have ordinarily inelastic demand. For example, rise in price of petrol will not reduce its demand if the demand for cars has not decreased. • Availability of Substitutes: Demand for those commodities which have substitutes (for example, tea has its substitute in coffee, orange juice has its substitute in lime juice) are relatively more elastic. The reason being that when the price of commodity falls in relation to its substitute, the consumers will go in for it and so its demand will increase. Commodities having no substitutes like cigarettes, liquor, etc. have inelastic demand. • Different uses of Commodity: Commodities that can be put to a variety of uses have elastic demand. For instance, elasticity has multiple uses. It is used for lighting, room heating, airconditioning, cooking etc. If the tariff of electricity increases, its use will be restricted to important purposes like lighting. It will be withdrawn from less important uses. On the other hand, if a commodity such as paper has only a few uses, its demand is likely to be inelastic. • Postponement of the use: Demand will be elastic for those commodities whose consumption can be postponed. For instance, demand for constructing a house can be postponed. As a result, demand for bricks, cements, sand, gravel, etc will be elastic. Conversely, goods whose demand cannot be postponed, their demand will be inelastic. • Income of consumer: Sujeet Kumar | MBA 1st Semester Roll No 25

Page |7 People whose income is very high or very low, their demand will ordinarily be inelastic. Because rise or fall in price will have little effect on their demand. Conversely, middle income groups will have elastic demand. • Habits of consumer: Goods to which a person becomes accustomed or habitual will have inelastic demand like cigarette, coffee, tobacco, etc. It is so, because a person cannot do without them. • Proportion of Income spent on a commodity: Goods on which a consumer spends a very small proportion of his income, e.g., toothpaste, boot-polish, newspaper, needles, etc will have an inelastic demand. On the other hand, goods on which the consumer spends a large proportion of his income, e.g., cloth, scooter, etc. their demand will be elastic. • Price level: Elasticity of demand also depends upon the level of price the concerned commodity. Elasticity of demand will be high at higher level of price of the commodity and low at the lower level of the price. • Time period: Demand is inelastic in short period but elastic in long period. It is so because in long-run, a consumer can change his habits more conveniently than in the short period.

Sujeet Kumar | MBA 1st Semester Roll No 25

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