VARIOUS METHODS OF PRICE ELASTICITY OF DEMAND

Submitted to

Ms. ANJU BATRA

(FACULTY, MBA)

Submitted by

MUHAMMAD SALIM 07217003909

MBA 1ST SEMESTER

PRICE ELASTICITY OF DEMAND The relative response of a change in quantity demanded to a change in price. More specifically the price elasticity of demand is the percentage change in quantity demanded due to a percentage change in price. This notion of elasticity captures the demand side of the market. A comparable elasticity on the supply side is the price elasticity of supply. Other notable demand elasticities are income elasticity of demand and cross elasticity of demand. The price elasticity of demand reflects the law of demand relation between price and quantity. An elastic demand means that the quantity demandedis relatively responsive to changes in price. An inelastic demand means that the quantity demanded is not very responsive to changes in price. Suppose, for e ample, that the price of hot fudge sundaes increases by !" percent #say $%."" to $%.%"&. The higher price is bound to cause the quantity demanded to decline. The price elasticity of demand answers the question' (ow much) *f the quantity demanded decreases by more than !" percent #say from !"" hot fudge sundaes to +" hot fudge sundaes&, then demand is elastic. *f the quantity demanded decreases by less than !" percent #say from !"" hot fudge sundaes to ,, hot fudge sundaes&, then demand is inelastic. A Summary Formula The price elasticity of demand is often summari-ed by this handy formula' percentage change in quantity demanded price elasticity of demand . percentage change in price According to the law of demand, higher demand prices are related to smaller quantities demanded. As such, the numerator and denominator of this formula always have opposite signs//if one is positive, the other is negative. *f the demand price increases and the percentage change in price is positive, then the quantity demanded decreases and the percentage change in quantity demanded is negative. 0hen calculated, the price elasticity of demand, therefore, is always negative. (owever, it is often convenient to ignore the negative sign when evaluating the relative response of quantity demanded to price. 1or e ample, quantity demanded is very responsive to price if a !" percent increase in price induces a +" percent decrease in quantity demanded. This generates a large 2negative number,2 which is actually a small 2value.2 To avoid the possible confusion over a big number being a small value, the negative value of the price elasticity of demand is generally ignored and focus is placed on the absolute magnitude of the number itself. Slope and Elasticity The price elasticity of demand is related to, but different from, the slopeof the demand curve. 3onsider the formula for calculating the slope of the demand curve. 3hange in price slope . 3hange in quantity demanded 4ow consider the formula for calculating the price elasticity of demand. price elasticity of demand . percentage change in quantity demanded percentage change in price

The key differences between these are' 1irst, price is in the numerator and quantity is in the denominator for slope. *n contrast, quantity is in the numerator and price is in the denominator for elasticity. At the very least, slope is the inverse of elasticity. 0hen one is bigger the other is smaller.

Second, slope is calculated using the measurement units for price and quantity. *n contrast, elasticity is calculated using percentage changes. As such, slope includes the measurement units #such as dollars per hot fudge sundae&, whereas elasticity is 5ust a number with no measurement units. The value of slope changes if the measurement units change #such as cents versus dollars&. 4ot so for elasticity. 6lasticity is in relative values not absolute measurement units.

T ree Determinants Three factors that affect the numerical value of the price elasticity of demand are the availability of substitutes, time period of analysis, and proportion of budget. A given good can have a different price elasticity of demand if these determinants change. A!aila"ility o# Su"stitutes' The ease with which buyers can find substitutes/in/ consumption affects the price elasticity of demand. The general rule is that goods with a greater availability of substitutes is more sensitive to price changes. 0ith more substitutes available, buyers can easily respond to price changes. 3onsider, for e ample, Auntie 4oodles 1ro-en Macaroni 7inner, an en5oyable, nutritious, and satisfying meal. 8nfortunately for the Auntie 4oodles company, it is one of thousands of comparable food products on the market. The number of available substitutes makes the price elasticity of demand e tremely elastic. Time Period o# Analysis' The longer the time period of analysis, the more responsive quantities are to price changes. 9rief periods do not allow buyers the time needed to ad5ust their consumption decisions to price changes. 9uyers need time to find substitutes/in/consumption. :onger time periods allow buyers the time needed to find alternatives. 1or e ample, the demand for ;M 3able Television is not very elastic. <iven the lack of close substitutes, buyers continue to buy even though prices rise, especially for brief periods like a few months. (owever, given enough time #years) decades)& buyers are able to seek out alternatives such as satellite dishes, and thus change their quantity demanded of cable television, resulting in a more elastic demand. Proportion o# $ud%et' The price elasticity of demand depends on the proportion of the budget that buyers devote to a good. The rule is this' The larger the portion, the more responsive quantity demanded is to price changes. A house, for e ample, is a 9*< budget item for most normal human beings. A relatively small change, say ! percent on a $!"",""" house, can make a 9*< difference in the buyer=s decision to buy. As such, relatively small changes in price are likely to induce relatively large changes in quantity demanded.

MEAS&REMENT OF ELASTICITY OF DEMAND '( PERCENTA)E MET*OD The credit for measuring the elasticity of demand by this method goes to 1lu . That is why, it is sometimes called 1lu >s percentage method. According to this method, elasticity of demand is the ratio of the percentage #or proportionate& change in quantity demanded to a percentage #or proportionate& change in its price. price elasticity of demand . percentage change in quantity demanded percentage change in price

?roportional change in quantity can be e pressed as quantity demanded.

where q! is the initial and q% is the new

?roportional change in price is similarly

@ where ?! is initial and ?% is the new price.

6lasticity ratio e is therefore, *f symbols q and ? are used for small variations in quantity and price respectively then,

4ote that 7q A 7p is in the limit derivative or marginal change and pAq is the reciprocal of average change, therefore

:et>s illustrate this. *n our demand schedule e ample above, when price changes from % to B units, the quantity demanded changes from ; to ! units. Substituting these values we have'

Alternati!e ?erfectly 6lastic Delatively 6lastic 8nit 6lastic Delatively *nelastic ?erfectly *nelastic A Ran%e o# Elasticity

Coe##icient +E( 6.C !E6EC 6.! "E6E! 6."

The price elasticity of demand is commonly divided into one of five elasticity alternatives//perfectly elastic, relatively elastic, unit elastic, relatively inelastic, and perfectly//depending on the relative response of quantity to price. These five alternatives form a continuum of possibilities. The chart to the right displays the five alternatives based on the coefficient #6&. The negative value obtained when calculating the price elasticity of demand is ignored.

Per#ectly Elastic' The top of the chart begins with perfectly elastic, given by 6 . C. ?erfectly elastic means an infinitesimally small change in price results in an infinitely large change in quantity demanded. Relati!ely Elastic' The second category is relatively elastic, in which the coefficient of elasticity falls in the range ! E 6 E C. 0ith relatively elastic demand, relatively small changes in price cause relatively large changes in quantity. Fuantity is very responsive to price. The percentage change in quantity is greater than the percentage change in price. (ere a !" percent change in price leads to more than a !" percent change in quantity demanded #maybe something %" percent&. &nit Elastic' The third category is unit elastic, in which the coefficient of elasticity is 6 . !. *n this case, any change in price is matched by an equal relative change in quantity. The percentage change in quantity is equal to the percentage change in price. 1or e ample, a !" percent change in price induces a equal !" percent change in quantity demanded. 8nit elastic is essentially a dividing line or boundary between the elastic and inelastic ranges. Relati!ely Inelastic' The fourth category is relatively inelastic, in which the coefficient of elasticity falls in the range " E 6 E !. 0ith relatively inelastic demand, relatively large changes in price cause relatively small changes in quantity. Fuantity is not very responsive to price. The percentage change in quantity is less than the percentage change in price. *n this case, a !" percent change in price induces less than a !" percent change in quantity demanded #perhaps only + percent&. Per#ectly Inelastic' The final category presented in this chart is perfectly inelastic, given by 6 . ". ?erfectly inelastic means that quantity demanded is unaffected by any change in price. The quantity is essentially fi ed. *t does not matter how much price changes, quantity does not budge.

,( TOTAL O&TLAY MET*OD Total outlay method refers to the total e penditure on the good after its price 3hanges. Total outlay is obtained by multiplying the number of units sold by the price of a product i.e. #Total revenue . Total unit sold G price&

Sr.

Price (Rs.)

Quan i ! "# $an%"es &e$an&e& in

T" a' "u 'a!

Price e'as ici ! "# &e$an&

N". I () (* II () (* III () (*

uni s *++ ,++ *++ *)+ *++ *(+ ,+++ ,/++ ,+++ ,+++ ,+++ *)*+ E- 1 ( E-0 ( E- . (

6p H! if total outlay of a commodity increases after a fall in price of a commodity then price elasticity of demand is elastic. ?rice elasticity is grater than one over ?F range of the curve. 6p.! if total outlays remains constant, even after a fall in price of commodity, then, it is the case of unit elastic demand, price elasticity or demand over FD range of the curve is equal to one. 6p E ! if the total outlay decreases, after a fall in price then the elasticity of demand is less than one. ?rice elasticity is less than one over DS range of demand curve. -( POINT MET*OD 0hen we measure elasticity of demand at a point on linear demand curve which intersects both a es, it is linear demand curve which measuring elasticity of demand. The demand curve has a negative slops but price elasticity varies from point to point. 6p . :ower segment of demand curve 8pper segment of demand curve

7! 7% is straight line demand curve. 0hen price decreases from O?! to O?% demand e tends from O F! to O F%. :et us consider two points on demand curve i.e M! and M% to measure elasticity of demand through point method. 6p . proportionate change in demand . ?roportionate change in price *n This fig 6p . F! F% ?! ?% G O?! OF! #!& IF G ? I? F

As per the fig. q!q% . 4M%, ?!?% . M! 4, O? !. M!F!, OF! . ?!M! 6?. 4M% G M!F! M!4 OF! #%&

(ence, 4M% . F!7% M!4 Substitute, F!7% F!M! 0e get 6p. F!7% G M!F! 6? . F!7% OF! 4ow OF! is equal to ?!M! then 6p. F!7% ?!M! M!F! OF! M!F! in place of 4M% in equation #%& M!4

Taking F!7% and ?!M! as the base we have tow triangles I ?!M!7! and I F!7%M! by geometrical rules these tow triangles are equal. Therefore their sides are proportionate 0e can state 6p. F!7% . M!F! . M!7% ?!M! ?!7! M!7!

6p. M! 7% . :ower segment of he demand of point M! M!7! 8pper segment of the demand of point M!

6lasticity of point M! .

M!7% M!7!

Thus elasticity of demand varies from point to point on a straight line demand curve. 6lasticity will gradually decrease as we move towards 7% as the lower segment will become smaller. .( ARC MET*OD Are elasticity of demand measures the price elasticity of demand over a range on the demand curve rather than a point on demand curve. *n reality we often come across a situation where price changes are substantial.

*f price of commodity G is Ds. + then +"" units of G goods are sold. 0hen price falls to Ds. ; the J"" units are sold. Arc elasticity of demand is worked as under

IMPORTANCE OF ELASTICITY OF DEMAND FOR T*E MANA)ERS There is need to understand price elasticity of demand for the goods they sell in order to decide on optimal pricing policy. *f demand were relatively elastic, the firm would know that lowering the price would e pand the volume of sales thus increasing total revenue. On the other hand, if demand were relatively inelastic the firm could increase the price, which would also lead to an increase in total revenue. Awareness of the elasticity of demand in different price ranges is important for determining the best pricing policy and in deciding whether to change prices. To that e tent, business often engage in statistical market research in order to determine consumer preferences, and in particular, the price elasticity of demand for the product. ?rice elasticity of demand describes the way in which the demand for a product response to a change in its price. *f small change in price leads to a large change to a demand, a product is said to be highly price elastic. Many consumer goods such as calculators, 7K7 players and washing machine are price elastic. *f the demand for a product shows little response to change in price, the product is said to be price inelastic. 6ssential goods such as basic foods #e.g. bread, medicine& and fuel tend to be price inelastic. Degarding the importance of the concept of elasticity of demand, it must be pointed out that the concept is useful to the business managers as well as government managers. 6lasticity measures help the sales manager in fi ing the price of his product. The concept is also important to the economic planners of the country. *n trying to fi the production target for various goods in a plan, a planner must estimate the likely demand for goods at the end of the plan. This requires the use of income elasticity concept. The price elasticity of demand as well as cross elasticity would determine the substitution between goods and hence useful in fi ing the output mi in a production period. The concept is also useful to the policy makers of the government, in particular in determining ta ation policy, minimum wages policy, stabili-ation programmer for agriculture, and price policies for various other goods #where administered prices are used&. The managers are concerned with empirical demand estimates because they provide summary information about the direction and proportion of change in demand, as a result of a given change in its e planatory variables. 1rom the standpoint of control and management of e ternal factors, such empirical estimates and their interpretations are therefore, very relevant. *n market economics consumer can e ercise their rights to buy whatever they want however consumer will only purchase certain goods in certain quantities at certain prices, if there is price change, quantity demanded will ad5ust correspondingly. This is where price elasticity of demand comes in, measuring the responsiveness of the quantity demanded to changes in price using methods such as the total outlay method. 1inally, this information is important to business, which need to find their optimal pricing policy in order to achieve their goal of business of ma imi-e the profits.