Unit-II ELASTICITY OF DEMAND

Meaning of Elasticity of Demand

Till now we were concerned with the law of demand states that when the price of good
falls, consumers demand more units of the good. The law of demand tells us ‘the direction of
changes in prices and quantities demanded’. But how much the quantity changes with the
change in price is not mentioned in the law of demand. This is explained in the elasticity of
demand. It is important and useful to have an index which would indicate just how much
responsive quantity demanded is to a change in price.

The relationship between small changes in prices and consequent changes in the amount
demand is known as the elasticity of demand. This tell us “The Rate of Change”. The elasticity
of demand shows “The Extent of Response” in demand to the change in price. It tells “The
Quantum of change in demand to the change in price”. The difference lies in the degree of
response of demand which can be found out by comparing percentage changes in prices and
quantities demanded. Here lies the concept of elasticity.

Definition Elasticity of Demand

It was ‘Marshall’ who introduced this concept of ‘Elasticity of Demand’ in economic

theory. Elasticity of demand is defined as the responsiveness of the quantity demanded of a
good to changes in one of the variables on which demand depends or we can say that it is the
percentage change in quantity demanded divided by the percentage in one of the variables on
which demand depends. These variables are price of the commodity, price of the related
commodities, income of the consumers and other various factors on which d emand depends.

• According to Marshal “The Elasticity or responsiveness of demand in a market is great

or small according to the amount demanded increases much or little for a given fall in
the price and diminishes much or little for a given rise in price”
• According to Stonier and Hague “Elasticity of demand is therefore, a technical term
used by the economics to describe the degree of responsiveness of the demand for a
commodity to a fall in its price”.
• According to J.M. Keynes “The elasticity of demand is a measure of the relative change
in quantity to a relative change in price”.
• According to Kenneth Boulding “The elasticity of demand measures the responsiveness
of demand to changes in price”.
 It is clear from the definitions that the elasticity of demand is primarily related to extension
or contraction of demand for a fall or rise in price. Marshall used this concept only to price
changes. Hence this concept has been referred to as “Price Elasticity of Demand” .

In simple words, price elasticity of demand is ‘the ratio of percentage change in quantity
demanded to the percentage change in price’. Marshall was the first economist to give a clear
formulation of price elasticity “As the ratio of a relative change in quantity to a relative change
in price”.

If E stands for elasticity then,

E = Relative change in quantity

Relative change in price

Price elasticity of demand is the ratio of proportionate change in the quantity demanded
of a commodity to given proportionate change in its price. This means:

Where,
ΔQ = Q1 –Q0,
ΔP = P1 – P0,
Q1= New quantity,
Q2= Original quantity,
P1 = New price,
P0 = Original price
E or elasticity of demand in the calculation is also called coefficient of elasticity of
demand. If E is greater than one then, the demand is said to be elastic. If E is equal to one then,
demand is unity and if E lesser than one then demand is inelastic.
Example: Let us suppose that price of a good falls from Rs.10 per unit to Rs.9 per unit
in a day. The decline in price causes the quantity of the good demanded to increase from 125
units to 150 units per day. The price elasticity using simplified formula will be as below:
Δq = 150 -125 = 25
 Δp = 10 – 9 = 1
Original Quantity = 125
Original Price = Rs. 10
⸫ Ed = 25/1 x 10/125 = 2
The elasticity coefficient is greater than one. Therefore, the demand for the good is elastic.

CONCEPT OF ELASTICITY
Elasticity of demand is an important variation on the concept of demand. “Demand can be
classified as elastic, inelastic or unitary”.

✓ An Elastic Demand is one in which the change in quantity demanded due to a change
in price is large.
For example, with an elastic demand is consumer durables goods. These are items that
are purchased infrequently, like a washing machine or an automobile, and can be
postponed if price rises. For example, automobile rebates have been very successful in
increasing automobile sales by reducing price. Close substitutes for a product affect the
elasticity of demand. It another product can easily be substituted for your product,
consumers will quickly switch to the other product if the price of your product rises or
the price of the other product declines. For example, beef, pork and poultry are all meat
products. The declining price of poultry in recent years has caused the consumption of
poultry to increase, at the expense of beef and pork. So products with close substitutes
tend to have elastic demand.
✓ An Inelastic Demand is one in which the change in quantity demanded due to a change
in price is small. a change in price results in only a small change in quantity demanded.
In other words, the quantity demanded is not very responsive to changes in price.
For examples of this are necessities like food and fuel. Consumers will not reduce their
food purchases if food prices rise, although there may be shifts in the types of food they
purchase. Also, consumers will not greatly change their driving behavior if gasoline
prices rise.
✓ Unitary If the elasticity coefficient is equal to one, demand is unitarily elastic. For
example, a 10% quantity change divided by 10% price change is one. This means that
a one percent change in quantity occurs for every one percent change in price.
TYPES OF ELASTICITY OF DEMAND

The following are the main types of Elasticity of Demand

I. Price Elasticity of Demand

Price elasticity of demand expresses the response of quantity demanded of a good to change
in its price, given the consumer’s income, his tastes and prices of all other goods. In other
words, it is measured as percentage change in quantity demanded divided by the percentage
change in price, other things remaining equal. That is

Different commodities have different price elasticities. Some commodities have more
elastic demand while others have relative elastic demand. Basically, the price elasticity of
demand ranges from zero to infinity.

Based on these the following are the main types of price elasticity of demand. They are:
a) Perfectly Elastic Demand or Infinitely Elastic Demand (Ep = ∞): The demand is
said to be perfectly elastic when a slight change in the price of a commodity causes a
major change in its quantity demanded. Such as, even a small rise in the price of a
commodity can result into fall in demand even to zero. Whereas a little fall in the price
can result in the increase in demand to infinity. In perfectly elastic demand the demand
curve is a straight horizontal line.

The figure shows that at the price OP, the demand is infinite. A slight rise in price will
contract the demand to zero. A slight fall in price will attract more consumers but the
elasticity of demand will remain infinite. But in real world, the cases of perfectly elastic
demand are exceedingly rare and are not of any practical interest.
b) Perfectly Inelastic Demand (Ep = O): Perfectly inelastic demand is opposite to
perfectly elastic demand. Under the perfectly inelastic demand, irrespective of any rise
or fall in price of commodity, the quantity demanded remains the same. The elasticity
of demand in this case will be equal to zero.
 In the figure, DD shows the perfectly inelastic demand. At price OP, the demand is OQ.
Now the price falls to OP1, the demand remains the same. Even if the price rises to OP 2,
the demand still remains the same. But this is also a rare case.
c) Unitary Elastic Demand (Ep =1): The demand is unitary elastic when the
proportionate change in the price of a product results in the same change in the quantity
demanded. In the figure, DD demand curve represents unitary elastic demand. Here the
shape of the demand curve is a rectangular hyperbola. When price is OP0, and the
quantity demanded is OQ 0. Now price falls to OP1, and the quantity demanded increases
to OQ1 which shows that area under the curve is equal to one.

Thus, these are some of the types of the price elasticity of demand that helps the firms
to price their product in accordance with the demand patterns of an individual which
changes with the change in the price of the commodity.

d) Relatively Elastic Demand (Ed>1): It refers to a situation in which a small change in

price leads to a big change in quantity demanded. In such a case elasticity of demand is
said to be more than one. This is illustrated in the figure:
 DD is the demand curve which indicates that when price is OP1, the quantity demanded
is OQ0. Now the price falls form OP1 to OP2, and the quantity demanded increases form
OQ0 to OQ1 i.e. quantity demanded changes more than the change in price. The slope
will be gentle.

e) Relatively Inelastic Demand (Ed <1): When the proportionate change in the demand
for a product is less than the proportionate change in the price, the demand is said to be
relatively inelastic demand. It is also called as the elasticity less than unity, i.e. 1. Here
the demand curve is rapidly sloping, which shows that the change in the quantity from
OQ0 to OQ1 is relatively smaller than the change in the price from OP1 to Op 2.
 II. INCOME ELASTICITY OF DEMAND

The relation between changes in income of the consumer and consequent change in the
quantity demanded is expressed through the concept of income elasticity of demand.
According to Stonier and Hague, “Income elasticity of demand shows the way in which
a consumer’s purchase of any good changes as a result of change in his income”.
The income is the other factor that influences the demand for a product. Hence, the
degree of responsiveness of a change in demand for a product due to the change in the income
is known as income elasticity of demand. The formula to compute the income elasticity of
demand is:

For most of the goods, the income elasticity of demand is greater than one indicating
that with the change in income the demand will also change and that too in the same direction,
i.e. more income means more demand and vice-versa.

The following are the Various Types of Income Elasticity:

➢ Zero Income Elasticity: The increase in income of the individual does not make any
difference in the demand for that commodity. (Ei = 0)
➢ Negative Income Elasticity: The increase in the income of consumers leads to less
purchase of those goods. (Ei < 0).
➢ Unitary Income Elasticity: The change in income leads to the same percentage of
change in the demand for the good. (Ei = 1)
➢ Income Elasticity is Greater than 1: The change in income increases the demand for
that commodity more than the change in the income. (Ei > 1)
➢ Income Elasticity is Less than 1: The change in income increases the demand for the
commodity but at a lesser percentage than the change in the Income. (Ei < 1).

III. CROSS ELASTICITY OF DEMAND

The cross elasticity of demand refers to the change in quantity demanded for one
commodity as a result of the change in the price of another commodity. This type of elasticity
usually arises in the case of the interrelated goods such as substitutes and com plementary
goods. The quantity demanded of a particular commodity varies according to the price of other
commodities. Cross elasticity measures the responsiveness of the quantity demanded of a
commodity due to changes in the price of another commodity.

The responsiveness of the quantity of one commodity demanded to a change in the price
of another good is calculated with the following formula.

The two commodities are said to be complementary, if the price of one commodity falls,
then the demand for other increases, on the contrary, if the price of one commodity rises the
demand for another commodity decreases.

For example

➢ Petrol and Car are complementary goods. if two goods are complementary to
each other then negative income elasticity may arise.
➢ While the two commodities are said to be substitutes for each other if the price
of one commodity falls, the demand for another commodity also decreases, If
two goods are substitutes then they will have a positive cross elasticity of
demand. the demand for tea increases when the price of coffee goes up.
➢ If two commodities are unrelated goods, the increase in the price of one good
does not result in any change in the demand for the other goods. For example
the price fall in Tata salt does not make any change in the demand for Tata
Nano.

IV. ADVERTISING ELASTICITY OF DEMAND

It refers to the relationship between advertising and the quantity demanded, otherwise
known as “Promotional Elasticity of Demand”. The responsiveness of the change in demand
to the change in advertising or rather promotional expenses, is known as advertising elasticity
of demand. In other words, the change in the demand as a result of the change in advertisement
and other promotional expenses is called as the advertising elasticity of demand.
 It can be expressed as

Numerically,

Where,
Q1 = Original Demand
Q2= New Demand
A1= Original Advertisement Outlay
A2 = New Advertisement Outlay

These are some of the important types of elasticity of demand that helps in
understanding the criteria of demand for the goods and services and the factors that influence
the demand.

MEASUREMENT OF ELASTICITY OF DEMAND

I) Total Expenditure Method.

II) Proportionate Method.

III) Point Method

IV) Arc Method

V) Revenue Method
 I) TOTAL EXPENDITURE METHOD

Dr. Marshall has evolved the total expenditure method to measure the price elasticity of
demand. According to this method, elasticity of demand can be measured by considering the
change in price and the subsequent change in the total quantity of goods purchas ed and the
total amount of money spent on it.

Total Outlay = Price X Quantity Demanded

There are Three Possibilities:

a) If with a fall in price (demand increases) the total expenditure increases or with a rise
in price (demand falls), the total expenditure f alls, in that case the elasticity of demand
is greater than one i.e. ED > 1. Table. 1 shows that when price is Rs. 10 the quantity
demanded is 1 unit and total expenditure is 10. Now price falls from Rs. 10 to Rs. 6,
the quantity demanded increases from 1 to 5 units and correspondingly the total
expenditure increases from Rs. 10 to Rs. 30. Thus it is clear that with the fall in price,
the total expenditure increases and vice-versa. So, elasticity of demand is greater than
one or ED >1.

b) If with a rise or fall in the price (demand falls or rises respectively), the total expenditure
remains the same, the demand will be unitary elastic or ED = 1. Table. 1 shows that If
price is Rs. 6, demand is 5 units so the total outlay is Rs. 30. Now price falls to Rs. 5,
the demand increases to 6 units but the total expenditure remains the same i.e., Rs. 30.
Thus it is clear that with the rise or fall in price, the total expenditure remains the same.
The elasticity of demand in this case is equal to one or ED = 1.

c) If with a fall in price (Demand rises), the total expenditure also falls, and with a rise in
price (Demand falls) the total expenditure also rises, the demand is said to be less classic
or elasticity of demand is less than one (ED < 1). Table. 1 shows that If price is Rs. 5,
demand is 6 and total outlay is Rs. 30. Now price falls from Rs. 5 to Re. 1. The demand
increases from 6 units to 10 units and hence the total expenditure falls from Rs. 30 to
Rs. 10. Thus it is clear that with the fall in price, the total exp enditure also falls and
vice-versa. In this case, the elasticity of demand is less than one or ED <1.
This can be expressed with the help of a Chart.

Diagrammatic Representation:

The total expenditure can be explained with the help of Fig. 7.

Downward sloping (from A to D), (ii) Vertical (from D to G), (iii) Upward sloping (G to J).

i. Downward Sloping Curve:

If the price- total expenditure curve slopes downward from left to right, it means the
elasticity of demand is greater than one. As we see in the diagram that when price falls from
Rs. 10 to Rs. 5 the total expenditure increases from Rs. 10 to Rs. 30. It means, there is opposite
relationship between price and total expenditure. The elasticity of demand in this case is greater
than one. Thus the curve from A to D represents the elasticity greater than one or ED >1.
 ii. Vertical Curve.

If price-total expenditure curve is vertical or parallel to 7-axis, it means that with fall in
price from Rs. 6 to Rs. 5 the total expenditure remains the same. Thus if total expenditure does
not change with the rise or fall in price, the elasticity of demand will be equal to one. Thus by
joining points D and G we get vertical curve showing elasticity of demand equal to one or
Ed =1.

iii. Upward Sloping Curve:

If price-total expenditure curve rises upward from left to right, it means the elasticity of demand
is less than one. In the diagram, we find that when price falls from Rs. 5 to Re. 1the total
expenditure also falls from Rs. 30 to Rs. 10. It means by joining G, H, I, J we get an upward
sloping curve showing elasticity of demand less than one or ED < 1. Thus it is clear that the
changes in total expenditure due to changes in price also affect the elasticity of demand.

II. PROPORTIONATE METHOD

This method is also associated with the name of Dr. Marshall. According to this method,
“price elasticity of demand is the ratio of percentage change in the amount demanded to the
percentage change in price of the commodity.”

It is also known as the Percentage Method, Flux Method, Ratio Method, and Arithmetic
Method. Its formula is as under:

Implications:
ADVERTISEMENTS:

➢ This method should be used when there is a very small change in price and quantity
demanded.
 ➢ The coefficient of price elasticity of demand is always negative. It is because when
price changes, demand changes in the opposite direction. But by convention, we ignore
negative sign.

➢ The elasticity of demand is relative. It is not expressed in any unit rather expressed in
percentage or infractions.

III. POINT METHOD

This method was also suggested by Marshall and it takes into consideration a straight-
line demand curve and measures elasticity at different points on the curve. This method has
now become very popular method of measuring elasticity. In this we take a straight-line
demand curve, which connects the demand curve with both the axes OX and OY. In the
diagram OX axis represents the quantity demanded and OY axis represents the price.

❖ Case (i) Linear Demand Curve:

In Fig. 8 RS is a straight-line demand curve. Initially, price is OP or QA and OQ or PA is
the initial demand. At OP’ new price the demand is OQ’. At point R elasticity of demand can
be measured with the following formula.
 ❖ Case (ii) Non-Liner Demand Curve:
It is possible that the demand curve is not a straight line but a curve. Even then the above
technique shall be applicable. The only change to be made is that a tangent is drawn on the
demand curve at a point at which we want to measure elasticity of demand.

ADVERTISEMENTS:

In Fig 10 DD1 is the demand curve and we draw a line RS to measure the elasticity of
demand. At point A demand curve DD1 and RS line touches each other. Therefore, both have
same slope. Therefore, a point A, elasticity of demand is Ed = AS/AR

IV. ARC METHOD

“Arc elasticity is a measure of the average responsiveness to price change exhibited by a

demand curve over some finite stretch of the curve” Prof. Baumol.

“Arc elasticity is the elasticity at the mid-point of an arc of a demanded curve” Watson

ADVERTISEMENTS:

“When elasticity is computed between two separate points on a demand curve, the
concept is called Arc elasticity” - Leftwitch
 V. REVENUE METHOD

Mrs. Joan Robinson has given this method. She says that elasticity of demand can be
measured with the help of average revenue and marginal revenue. Therefore, sale proceeds that
a firm obtains by selling its products are called its revenue. However, when total revenue is
divided by the number of units sold, we get average revenue. On the contrary, when addition
is made to the total revenue by the sale of one more unit of the commodity is called marginal
revenue. Therefore, the formula to measure elasticity of demand can be written as,

EA = A/ A-M
Where Ed represents elasticity of demand, A = average revenue and M = marginal
revenue. This method can be explained with the help of a diagram 12.
ADVERTISEMENTS:

In this diagram 12, revenue has been shown on OY- axis while quantity of goods on
OX-axis. AB is the average revenue or demand curve and AN is the marginal revenue curve.
At point P on demand curve, elasticity of demand is calculated with the formula,

In this way, value of Ep is one which means that price elasticity of demand is unitary.
Similarly, if it is more than one, price elasticity of demand is greater than one and if it is less
than one, price elasticity of demand is less than unity.

FACTORS INFLUENCING ELASTICITY OF DEMAND

Factors which determine the price elasticity of demand for a commodity or service are
more in number. But the most important among them are the nature, uses and price of related
goods and the level of income. They are as follows:
1. Consumer Income: The income of the consumer also affects the elasticity of demand.
For high-income groups, the demand is said to be less elastic as the rise or fall in the
price will not have much effect on the demand for a product. Whereas, in case of the
low-income groups, the demand is said to be elastic and rise and fall in the price have
a significant effect on the quantity demanded. Such as when the price falls the demand
increases and vice-versa.
2. Amount of Money Spent: The elasticity of demand for a product is determined by the
proportion of income spent by the individual on that product. In case of certain goods,
such as matchbox, salt a consumer spends a very small amount of his income, let’s say
Rs 2, then even if their prices rise the demand for these products will not be affected to
a great extent. Thus, the demand for such products is said to be inelastic. Whereas foods
and clothing are the items where an individual spends a major proportion of his income
and therefore, if there is any change in the price of these items, the demand will get
affected.
3. Nature of Commodity: The elasticity of demand also depends on the nature of the
commodity. The product can be categorized as luxury, convenience, necessary goods.

• The demand for the necessities of life, such as food and clothing is inelastic as
their demand cannot be postponed.
• The demand for the Comfort Goods is neither elastic nor inelastic. As with the
rise and fall in their prices, the demand decreases or increases moderately.
 • Whereas the demand for the luxury goods is said to be highly elastic because
even with a slight change in its price the demand changes significantly. But,
however, the demand for the prestige goods is said to be inelastic, because
people are ready to buy these commodities at any price, such as antiques, gems,
stones, etc.

4. Several Uses of Commodity: The elasticity of demand also depends on the number of
uses of the commodity. Such as, if the commodity is used for a single purpose, then the
change in the price will affect the demand for commodity only in that use, and thus the
demand for that commodity is said to be inelastic. Whereas, if the product has several
uses, such as raw material coal, iron, steel, etc., then the change in their price will affect
the demand for these commodities in its many uses. Thus, the demand for such products
is said to be elastic.
5. Whether the Demand can be Postponed or not: If the demand for a particular product
cannot be postponed then, the demand is said to be inelastic. Such as, Wheat is required
in daily life and hence its demand cannot be postponed. On the other hand, the items
whose demand can be postponed is said to have elastic demand. Such as the demand
for the furniture can be postponed until the time its prices fall.
6. Existence of Substitutes: The substitutes are the goods which can be used in place of
one another. The goods which have close substitutes are said to have elastic demand.
Such as, tea and coffee are close substitutes and if the price of tea increases, then people
will switch to the coffee and demand for the tea will decrease significantly. Whereas,
if there are no close substitutes for a product, then its demand is said to be inelastic.
Such as salt and sugar do not have their close substitutes and hence lower is their price
elasticity.
7. Joint Demand: The elasticity of demand also depends on the complementary goods,
the goods which are used jointly. Such as car and petrol, pen and ink, etc. Here the
elasticity of demand of secondary (supporting) commodity depends on the elasticity of
demand of the major commodity. Such as, if the demand for pen is inelastic, then the
demand for the ink will also be less elastic.
8. Range of Prices: The price range in which the commodities lie also affects the
elasticity of demand. Such as the higher range products are usually bought by the rich
people, and they do not care much about the change in the price and hence the demand
for such higher range commodities is said to be inelastic.
 Also, the lower range commodities have inelastic demand because these are already
low priced and can be bought by any sections of the society. But the commodities in
middle range prices are said to have an elastic demand because with the fall in the prices
the middle class and the lower middle class are induced to buy that commodity and
therefore the demand increases. But however, if the prices are increased the
consumption reduces and as a result demand falls.

Thus, these are some of the important determinants of elasticity of demand that every
firm should understand properly before deciding on the price of their offering.