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ELASTICITY OF DEMAND

The law of demand explains the direction of a change as it states that with a rise in price the demand contracts and with a fall in price it expands. However, it fails to explain the extent or magnitude of a change in demand with a given change in price. The concept of the elasticity of demand has great significance as it explains the degree of responsiveness of demand to a change in price Definition Demand elasticity is the degree of responsiveness of demand to the change in its various determinanants. Types 1. 2. 3. 4. Price Elasticity Income elasticity Cross elasticity Advertisement elasticity

I.

PRICE ELASTICITY OF DEMAND

Definition and Explanation: The concept of price elasticity of demand is commonly used in economic literature. Price elasticity of demand is the degree of responsiveness of quantity demanded of a good to a change in its price. Precisely, it is defined as: "The ratio of proportionate change in the quantity demanded of a good caused by a given proportionate change in price".
Formula:

The formula for measuring price elasticity of demand is: Price Elasticity of Demand = Percentage in Quantity Demand Percentage Change in Price Kinds Of Price Elasticity Of Demand 1. Perfectly elastic demand An infinite demand at the given price is a case of perfectly elastic demand and the demand curve is horizontal, meaning that only one price is possible. At the price quantity demanded could be any quantity for one unit to millions of units . ep =

2. perfectly in elastic demand When demand is perfectly in elastic, the quantity doesnt change as the price changeas, so the demandf curve is vertical at the fixed quantity. The price elasticity demand is zero. Example : medicines such as insulin for diabetics- that have no substitutes. Salt, etc.,

3.

Unit elastic demand

When the proportion of change in demand is exactly the same as the change in price, the demand is said to be unit elastic. The numerical value of unit elastic is exactly one. Examples: housing,

3. Unitary Elastic
Y p1 p

Ed = 1

d1

4. Relatively elastic demand When the proportion of change in quantity demanded is greater than that of price, the demand i s considered to be relatively in elastic. Here, a small change in price causes a more than proportionate change in the quantity demanded. The elasticity demand is greater than one. Example: Gold, air travel etc.,

4. Relatively more Elastic


Y p1 p

Ed > 1

d1

5. Relatively in elastic demand

5. Relatively less Elastic


Y p1 p

Ed < 1

d1

When a changes in price of a commodity produces a less than proportionate change in the quantity demandd, we say that, the demand is relatively in elastic. The elasticity of demand is leass than one. Example: inferior goods. II. Income Elasticity of demand

It measures the responsiveness of demand to change in income, indicating how much more or less of a particular product is purchased as a result of changes in income

It is a measure of the responsiveness of quantity demanded to changes in income, holding all other variables in general demand function constant. It is computed as the percentage change in the quantity demanded divided by the percentage change in income.

Income Elasticity of Demand = Percentage Change in QuantityDemanded Percentage Change in Income Types

1. Zero Income elasticities Here changes in inome doesnot change the demand for a product. That is , Goods consumers regard as necessities tend to be income Examples include food, fuel, clothing, utilities, and medical services. inelastic

2. Positive income elasticity An increase in income results in an increase in demand. Demand for superior goods increases when income increases. Goods consumers regards as luxuries tend to be income elastic. Examples include sports cars, expensive foods etc.,

3. Negative income elasticity An increase in income of a consumer causes a decrease in the quantity demanded by him. These types of goods are called inferior goods. For example: an increase in income encourages a consumer to shift his demand from used cars to new car.

Thus inferior goods have negative income elasticity.

III.

Cross price elasticity

Cross elasticity of demand is the degree of responsiveness of a commodity to the change in the price of its substitutes and complimentary goods. It may be defined as the ratio of proportionate change of quantity demanded of commodity X to a given proportionate change in price of related commodity Y. ec = percentage change in quantity demanded of X -----------------------------------------------------Percentage change in the price of Y The substitute goods have positive cross elasticity because the increase in the price of one product (coffee) increases the demand for other goods ( tea) Complimentary goods have negative cross elasticity because an increase in the price of one type of goods (milk or sugar) decreases the demand for its complementary goods (tea). Calculating Price elasticity of Demand

There are two ways of measuring price elasticity point method and arc method 1. Point elasticity method This method is used to measure elasticity of demand for small change in price. This method is used to measure the effect of a minute change in price. E = Q/ P x P/Q E = price elasticity P = change in price Q = change in quantity

P = original Price Q = Original quantity

When the price rises, the quantity demanded decreases along the demand curve. Price and quantity always change in opposite directions. So to compare the percentage change in the price and the percentage change in the quantity demanded, we ignore the minus sign and use the absolute values. Point elasticity = elasticity estimated at a point on the demand curve Example:

Yesterday, the price of envelopes was $3 a box, and Julie was willing to buy 10 boxes. Today, the price has gone up to $3.75 a box, and Julie is now willing to buy 8 boxes. Is Julie's demand for envelopes elastic or inelastic? What is Julie's elasticity of demand? To find Julie's elasticity of demand, we need to divide the percent change in quantity by the percent change in price. Solution E = Q/ P x P/Q Q = new quantity old quantity = 8-10 = -2 P = $3.75 $ 3 =$ .75 P = $3 Q = 10 E = -2/ .75 x $3 /10 = .079 As it is less than unity, it is inelastic demand. 2. Arc Elasticity

It is used to measure the elasticity of demand over a substantial range of the demand curve rather than at a point on it. The change in price is so big that it keeps the two points on the demand curve quite apart.

Arc elasticity = elasticity estimated over a range of prices and quantities along a demand curve

Ep = Q Q1 P-P1

P + P1 Q + Q1

Q = Original quantity demanded Q1 = new quantity demanded P = original price P1 = New price Example:

The price of a commodity is$60 and quantity demanded at that price is $100 units. When the price falls to$40. the demand increases to 120 units. Calculate the price elasticity of demand.

Ep = Q Q1 P-P1 Q = 100 UNITS

P + P1 Q + Q1

Q1 = 120 units P = $60 P1 = $40 Ep = 100 120 x $60 - $40 $60 +$ 40 100+120

= -20/20 x 100/ 220 = .83 Arc elasticity of demand = .13 The commodity is inelastic.( elasticity is less than 1 )