Elasticity of Demand PDF

Elasticity of Demand LEARNING 0BJECTIVES 4.1 Introduction 4.5 Relationship between Price Elasticity of Demand an...

Elasticity of Demand LEARNING 0BJECTIVES 4.1 Introduction 4.5 Relationship between Price Elasticity of Demand and Total Expenditure 4,2 Concept of Elasticity of Demand 4.6 Degrees of Price Elasticities of Demand 4.3 Price Elasticity of Demand 4.7 Factors Affecting Price Elasticity of 4.4 Percentage Method for Measuring Price Demand Elasticity of Demand 4.8 Solved Practicals 4.1 INTRODUCTION In the previous chapter, we studied that according to »Law of Demand', quantity demanded increases with fall in price and decreases with rise in price. The law of demand gives us the direction of change in the quantity demanded as a result of a change in price, but it does not specify the magnitude, amount or the extent by which the quantity demanded changes with a change in its price. In brief, it does not indicate, 'how much change' in the quantity demanded due to change in price. Therefore, the concept of 'Elasticity of Demand' was developed to measure the magnitude of change in the quantity demanded. For More Clarity Suppose, price of computer falls by 20%. According to Law of demand, the quantity of computers demanded will increase due to fall in its price. However, it does not indicate, by how much quantity demanded of computers will increase. In such cases, the concept of Elasticity of Demandbecomes important as it helps in knowing "how much" MOncept of elasticity was developed by Prof. Marshall in his book 'Principles of Economics'. Now-a-days, this concept has great importance in economic theory as well as in applied economics. 4.1 4.2 demanlindelal d s th omofclastuitu ot Tit us ELASTICITY OF DEMAND 4.2 CONCEPT OF of lactors likeocangein itso toracommoityisallecledby anumber InTkmand (he income of consume, change in lhe prices ofrelated goods, ete. Elsticity af refers tothe percentage changein demanlfor acommodity with respect to percenlage demandfor thal commodity. factors aftecting IM any of the calculated as: Flasticity of deand can be l'ercentage Change in Demand for X affecting the Elastiily of Demand lecentage Change in afactor Demand loX quanlifiable Out of various determinants of demand, there are 3 goods;(3) Income of the determinants ol der related commodily: (2) P'rice (1) Price ofthe given claslicity of demand: of consuNer S have 3 dimensions of demand refers to Price clasticity ol demand: Price elasticily of the in perpricecenlaofgethed 1. percentage change the demand for a commodity with respect to in commodity. referssto the elasticily of demand: Cross elasticity of demand percentage chan 2. Cross price of a rebat demand for acommodity with respect lo percentage change in the (substitute good or complementary good). refers to the percentaoo-4. 3. Inconme clasticity of demand: Income elasticity of demand of cons in demand for acommodity with respect lo percentage change in the income Cross and lncome Elasticity of Demand are beyond the scope of syllabus. So, present chapter delt with Price Elasticity of Demand: 4.3 PRICE ELASTICITY OF DEMAND Price Elasticity of Demand means the degree of responsiveness of demand for a commodityu reference to change in the price ofsuch commodity. For example, if price elasticity of den: is (-) 2, it means that one percent fall in price leads to 2 percent rise in demand or one pere rise in price leads to 2percent fall in demand. Some Noteworthy Points about Price Elasticity of Demand " It establishes aquantitative relationship between quantity demanded of a commodity a price, while other factors remain constant. " Higher the numerical value of elasticity, larger is the cffect of a price change on the que demanded. " For certain goods, achangein price leads to a greater change in the demand, wheres some cases, there is a small change in demand due to " For example, if prices of two commodities 'x and 'y' change rise by in10% price. and their demands by 20% and 5% respectively, then commodity 'x is said to be more elastic asScompared commodity 'y'. 4.3 ftlasticityDEMAND w25 quantity the change values lasticty considered metrcc demanded demand the sinphPrce in Putting OF Tros are of ELASTICITY derrarded (20 elasticity considered. mear E method. QuantityPricedemand Flastieit and dem percentaze Quantity Price Initial = hey 'fluz Methot change uantity inPrice Initial proportionate Change are pnice in and uentity New price tandui, PRICEf 100 demandotmeasurement eiasticity of in Charge 1 get = in ratin (4P) = changes are MEASURING us in we Q P AP and n wds knnn prite the charge Percentage Price(P) Price Original the method, percentage price the erad these freasuring as alsa measuredPercentage denandedin into to in price. Change Converted percentage changesrelating f stated, whnever FOR method "lasticity is the =Q,-0 dernandedMethod. concepts flastirityemard Chapter METHOD elasticity is in Quantity absolute illustrations tfThis change = -P be demanded Percentage rethd Marshall. (E.) (aQ) Price P of alsoformula Quantity Method.important as Dermand shortered MetMathod'hematial percentaze method, inchangeQuantitychange in = (aP) can following therwisa Lnles oERCENTAGE cornmon Profbyintroduedthis, rnethod 30,100 Price Method Proportionate Quantity underProportionate Dermand' "mst toAcording the sP Q the some vf Percentage Iercentage New that the ünderstand to Elasticity inChange Change irnes in in percentage in Price Change 4 and Initial noted of thise enanded 2.3 heip Where Q- 0= in be eta, 3 the h 1. 2 : 4 The 1. here  Elasticity of Demand 4.3 Chapter4.I'iceis most important determinant of demand. So, price elasticity of demand is the times shortened as Elasticity of Demand' or Demand Elasticity' or simply 'Elasticity'. otherwise stated, whenever these words are used, they mean 'Price Elasticity of Unless Demand'. ogRCENTAGE METHOD FOR MEASURING PRICE ELASTICITY OF DEMAND This method was mnost common method for measuring price elasticity of demand (E). Th Itis the Method' introducedby] Prof. Marshall. This method is alsoknown as Flux Method' or'Proportionate or MathematicalMethod'" tothis method, elasticity is measured astheratio ofpercentage changein the quantity According in the yrice deutanded to percentage change (E,) = - Percentage change in Quantity demanded Elasticity of Demand Percentage change in Price IWhere: Quantity demandedChangein Quantity (4Q) x 100 1. Percentage change in Initial Quantity (Q) =Q, -0 2 Change in Quantity (AQ) Change in Price (AP) -x Percentage change in Price = 100 3 Original Price (P) -P 4. Change in Price (4P) =P, Proportionate Method method can also be converted into the proportionate method. Putting the values The percentage of 1.2,3 and 4in the formula of percentage method, we get: AQ Ax 100 AP x 100 AP P P AP Where: Q= Initial Quantity demanded Q, = New Quantity demanded P = Initial Price sQ =Change in the Quantity demanded P = New Price AP = Change in Price must be noted that under Percentage Method, percentage changes in price and demand are considered, iereas, in Proportionate Method, absolute changes in price and demand are considered. USunderstand some important concepts relating to the measurement of price elasticity of demand, Wwith the help of the following illustrations: llustration1. 4.4 Calculatepriceelasticityofdemandif demandincreases from. units Sclory ic from 10to?8. in price due to fall Solution: case will be: demandin thegiven demanded Elasticityof Percentage changein Quantity (E;) = Percentage change in Price ElasticityofDemand Change in Quantity (4Q) demanded = Initial Quantity (Q) -x 10 Quantity Percentagechangein (5-4) 100 = 25% 4 Change in Price (AP) x 100 Percentage change in Price = Initial Price (P) =8-1O) x 100 = -20% 10 numerical or absolutevalue is taken) only 070- 1.25 (or 1.25 as E - 20% lgnored (ignoring exceptione tn Negative Sign may be always a negative number of price elasticity of demand is and quantity demanded. So, neoztives The coefficient between price demand) because of inverse relationship law of more common th implied. elasticity. It is sign is always writing the value of ignored while and positie However, minus siqn is often it is (-)1.25. So, negative sign can be ignored than to say that say that elasticity is 1.25 taken. number can be easily to4 units. Calculale 8 to 10, the demand falls fromn5 units lllustration 2. When price rises from demand. price elasticity of Solution: demand will be: of In the given case, elastiity Percentage change in Quantity demanded Elasticity of Demand (E) = Percentage Change in Price demanded = Change in Quantity (AQ) x 100 Percentage change in Quantity Initial Quantity () (4-5) x 100 = -20% 5 25% Percentage change in Price = Change in Price (AP) x 100 = (10-8) x 100 = Initial Price (P) 8  flasticity of Denand 4.5 apter 4 20% 0.8 25% 1 and2 Observations about llustrations mportant Values:; Elasticity shouldalways be mcasured and compared considerthe Absolute AlwaEs (ignoringthe negative sign), notin algebraicterms. So, elasticity of- 1.25 L absoluteterms be higher than - 0.8 in the 2nd illustration. n jllustration istaken to tnthe 1st Example: Suppose, E,of two ggoods Xand Yare (-) 3 and (-) 4 respectively. In One More, elastic because one percent change in price results in 4percent Good Yis more sucha demandfor Y, while only 3 percent case, changein demand for good X. is not affected by changein by percen tage change: Price elasticity of demand affected Elasticityis demand or price. Rather, its value is influenced by percentage change changein absolute demand. or 1 and 2nd illustration, change in quantity demanded (1 unit) and inprice example,in both However, price elasticity in the illustration (- 1.25) is For ( 2) is same. happens because in the 1s illustration, price 2nd illustration (-0.8). It changein thatin the d whereas, in the 2nd illustration, demand difterentfrom by25%band price changes by 20%, demandchanges pricechangesby25%. hangesby 20%and Free'measure of price and Elasticityisa 'Unit elasticity of demand is a pure number and is independent price of Thecoefficient demanded is measured in kilograms or quantityunits. affected whether the quantity elasticityis not dollars. It means, measured in rupees or demanded and whether price is change in price and quantity tonnes considers percentage that of expensive.thappens because elasticity sensitivity of inexpensive goods like needle. and price.e we caneasily compare So, goodslikegold. OF DEMAND AND TOTAL BETWEEN PRICE ELASTICITY A5 RELATIONSHIP EXPENDITURE expenditure made on the good are greatly agood and the total Treprice elasticityof demandforbecomes on the expenditure important to determine the effect rclzted to each other. At times, it good. na good due to change in price of the demand for the good are inversely related to each the Ne knowthat the price of a good and change in price (i.e. price elasticity of demand) the.So. responsiveness of demand in relation to tarmines the change in expenditure. demand is elastic, a fall in the price of a. tasticity is more than One (E, > 1): When hand, when price Omtnodity results in increase in total expenditure on it. On the other demand, price eses, total expenditure decreases. It means. in case of highly elastic ind total expenditure move in the opposite directions.  Elastic Demand 4.6 Table 4.1: Highly Quantity Total Expenditure in Price (inunits) (Price xQuantity) 100 S00 140 560 fall in price 4 expenditurerises with E, > 1becausetotal demand is inelastic, a fall In Table 4.1, When than One (E, < 1): Onthe eother hand, in the Elasticityis less expenditureon it. when prik demand,ppirciceeinandre,. 2. fallintotal less elastic commodity leads to increases. It means,in case of expenditure also direction. total same the expendituremovein Demand Elastic Table 4.2: Less Total Expenditure (in ) Quantity (Price xQuantity) Price (in units) 500 (in 2) 100 480 5 120 also falls with fall in price. because total expenditure In Table 4.2, E, 1 as'Total by Prof. Marshall. This method is also known this Outlay Method'orTotal Revenue Method! Under (in )Price method, price elasticity is measured by comparing Total Expenditure (TE) on the commodity before and after the E,=1 change in price. It has three possibilities: (0 E,>1,ifTE is inversely related to the price. (ü) E, Highly Elastic E,>1) in Price