ECONOMICS

ELASTICITY OF DEMAND

INTRODUCTION

The law of demand tells us the direction of change in the demand due to a certain change in price.
According to law of demand, if the price increases, the demand declines and if the price decreases the
demand increases.

But, the law is unable to tell us that how much change in the demand will take place due to certain
change in price.

As we know, quantity demanded depends on following three factors:-

Price

Quantity demanded Income

Substitutary + complementary

Elasticity of demand prefers to the degree of responsiveness of quantity demanded of a good to a

change in its price, income or price of relative goods.

Accordingly, there are three kinds of demand elasticity –

1. Price elasticity
2. Income elasticity
3. Cross elasticity

1. Price elasticity of demand-

It expresses the response of quantity demanded of a good to change in its price, given the
consumer’s income, his taste and price of all other goods constant.
Proportionate change in quantity demanded
Price elasticity = --------------------------------------------------------
Proportionate change in price
 change in quantity demanded/quantity demanded
= ---------------------------------------------------------------------------
Change in price/price

ΔQ/Q ΔQ P
= -------------- = ------x ------
ΔP/P ΔP Q

TYPES OF PRICE ELASTICITY

There are 5 types of price elasticity of demand:-

1-Perfectly elastic demand- In perfectly elasticity demand, a small rise in price results in fall
In demand to zero; while a small fall in price causes to increase its demand to infinity.

2-Perfectly inelastic demand-It is one when there is no change produced in demand of

product with change in its price.

3-Relatively elastic demand- It refers to demand when the proportionate change produced
in demand is greater than the proportionate change in price of product.

4- Relatively inelastic demand- It means when percentage ( % ) change in demand is less

than the percentage ( % ) change in price of product.

5- Unitary elastic demand- When the proportionate change in demand produces the same
change in price of product, the demand is referred as unitary elastic demand.

FACTORS AFFECTING THE PRICE ELASTICITY OF DEMAND

1- Nature of commodity- In case of necessary goods demand is inelastic and in case of

comfort goods, demand is elastic.
2- Availability of substitutes- If substitute of product is available, demand for product is
elastic.
3- Different uses of commodity- If the product has different uses, demand will be elastic. If
the product has single use, its demand will be inelastic.
4- Postponement of uses- If the use of the product can be postpone, its demand will be
elastic.
5- Income of consumer- With vey high income and very low income, demand will be
inelastic and if there is middle income group, person demand will be elastic.
6- Habitual necessities- Cigarette and liquor.
7- Prevailing price level of the commodity
 Ex-diamond and salt
8- Time permit
9- Joint demand
Ex-car and petrol.

IMPORTANCE OF PRICE ELASTICITY OF DEMAND

1- Price elasticity provides relevant information regarding price and volume of output.
Elastic demand-Lower price
Inelastic demand  High price

2-PRICE DISCRIMINATION- A monopolist adopts a price discriminatory policy when

demand elasticity from different consumers or sub markets is different. Those
consumers whose demand is inelastic can be charged a higher price than those with
more elastic demand.

3-PRICE DISCRIMINATION IN CASE OF JOINT SUPPLY- Jointly supplied goods are

those which are the products of the same production process; For ex- Wool and
Mutton.
The price discrimination of these joint products become a little difficult due to joint
case of production. In such cases, the concept of price elasticity of demand comes to
our help. If the demand for the wool and mutton is inelastic as compared to the
demand for the mutton, a higher price of wool is charged and a lower price for
mutton.

4- EXPLAINATION OF THE PARADOX OF POVERTY OF FARMERS-

The income of farmers are lower in a year of exceptionally good harvest compared
to the incomes in a year when the harvest is poor. This is called paradox of poverty.
It is said that good harvest brings poverty to the farmer. This paradox is easily
explained by the inelastic nature of demand for most agricultural product since, the
demand is inelastic. Price of agricultural product are lower when when their supply
is high.

5- DETERMINATION OF SALE POLICY FOR SUPER MARKET

Super markets are a combined set of shops run by a single organization. These
markets are supposed to sell commodities at lower prices than are charged by
shopkeepers in the bazaar. The cost of marketing have also to be covered.
Therefore, the policy adopted in the super market is to charge a slightly lower price
for goods whose demand is quite. As a result of the greater sales, the costs are
easily covered.
6- EFFECT OF USE OF MACHINES OR LABOUR EMPLOYMENT
 Price elasticity is useful I knowing the effect of introduction of machinery in
factories. Workers often oppose the use of machines fearing unemployment.
Machines do not always reduce the demand for labour. It all depends on the price
elasticity of demand, for their production. In some cases, where machines reduce
costs and prices of products with elastic demand, the amount demanded may go up.
As a result, production may have to be increased and more workers employed. On
the opposite, if the demand for the production is inelastic, machines will replace the
workers and create unemployment.

7-USE OF CONCEPT IN FACTOR PRICING

Price of factors of production may use with the inelastic demand. Ex- workers
producing petro products, their wages raised as a result for a fall in prices.

8- USE IN INTERNATIONAL TRADE

A country benefits from such exports where elasticity of demand is inelastic for a
rise in price and for import opposite happens.

9-IMPORTANCE IN TAXATION POLICY

Finance Minister takes those commodities whose demand is inelastic for increment in
TE and TR. Similarly, in levying indirect taxes, Finance Minister takes those commodities
which are having inelastic demand for rich section so that, burden falls to them.

10- PRICING POLICY FOR PUBLIC UTILITIES

CROSS ELASTICITY OF DEMAND

The change in demand for one good in response to change in price of another good
represents the cross elasticity of demand of one good for other.

Proportionate change in quantity demanded

Coefficient of cross elasticity of demand = -------------------------------------------------
Of X for Y Proportionate change in price of good
 ΔQx/Qx ΔQx Py
ec = -------------- = ------x ------
ΔPy/Py ΔPy Qx

The cross elasticity of demand between the two substitute goods is positive, i.e. in
response to rise in price of one good, the demand for other good raises.
The cross elasticity of demand between two complementary good is negative,
i.e. rise in price of one good decrease in demand of other.

CLASSIFICATION OF COMMODITIES THROUGH CROSS ELASTICITY

1-Substitute goods- Cross elasticity of demand for substitute goods such as Tea
or Coffee is positive, because a rise in the price of tea will raise the demand for
the coffee. The rise in demand for coffee as a result of the rise in price of tea will
give a coefficient of cross elasticity.

2-Complementary goods- Milk and sugar are example of complementary goods.

When the price of milk rises, its demand falls; Since sugar is used along with milk,
demand for sugar will also fall. The value of cross elasticity in this case will be
negative because the price of milk and the demand for sugar move in opposite
direction.

3-Independent goods- Such goods as eggs and diesel engines have no price
relationship with one another. If the egg go cheaper; the demand for the diesel
engine remains the same or unaffected. The laws of cross elasticity in such cases
is zero( 0 ).; these are therefore called independent goods.

INCOME ELASTICITY OF DEMAND

It shows the degree of responsiveness of quantity demanded of good to a small change
in income of consumer.
 Proportionate change in purchase of good
Income elasticity = -------------------------------------------------------------
Proportionate change in income

ΔQ/Q ΔQ y
CI = --- x ---- = ----- X------
Δy/y Δy Q

THREE TYPES OF INCOME ELASTICITY

1-ZERO INCOME ELASTICITY

Zero income elasticity of demand for a good implies that a given increase in income
does not at all lead to an increase in any quantity of good.
Ex- salt or other necessaries

1- POSITIVE INCOME ELASTICITY

It means an increase in income leads to the increase in quantity demanded of goods.
Ex- normal and superior goods.

3-NEGATIVE INCOME ELASTICITY

It means an increase in income leads to fall in quantity demanded of the goods.
Ex- Inferior goods

An engel curve shows the relationship between the quantity demanded of good and
level of consumer income.
1- Necessaries- The income elasticity is positive but less than one(1).
2- Luxuries-Income elasticity is greater than one(1). Income elasticity of a luxury
good increases at higher levels of income.
3- Inferior goods- Income elasticity is negative. An inferior goods behave like
necessity in initial ranges of income and therefore the slope of its engel curve is
initially positive but after a particular level it went backward.

IMPORTANCE OF INCOME ELASTICITY OF DEMAND

1- USE IN CAPITALIST ECONOMIES- In U.S.A. , Income Elasticity of consumption

expenditure is used relating to income elasticity. Income elasticity is
concerned with the physical unit of goods purchased, while income
sensitivity tells us about change in dollar expenditure.
Telephone services, automobiles, air transportation have high income
sentivities and white shoes, clothing, dental care have low income sensitivity.

2- IMPORTACE IN PLANNED DEVELOPING ECONOMIES- In less developed

countries, like India, as level of living rises, demand for some commodities is
expected to go up much faster than the demand for others. Generally, as
income rises, there is a shortage of food which when not satisfied leads to
inflation. If planner know the income elasticity of demand of at least the
goods and services of general use stops can be taken to balance demand and
supplies by introducing special control.

INCOME ELASTICITY DEPENDS ON THREE( 3 ) FACTORS-

1- NATURE OF NEED THAT THE COMMODITY CAUSES

2- INITIAL LEVEL OF INCOME OF THE COUNTRY
3- TIME PERIOD