Elasticity of Demand PDF

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tenien to boththe qus: howthe elfucten dungd 4 Sheu the eet ELASTICITY OF DEMAND CHAPTER its determinants commodity to a changein any of of other 4.1 INTRODUCTION price of the commodity, price namely It is a commodities arnd income of the consumers. the law of As explained in the last chapter, sensitive the quantity demanded demand states that the amount demanded of a measure of how the factors by the price is to change in any of of a commodity commodity is influenced significantly price, prices of other of the commodity.But the law of demand tells us influencing demand like its of change in demand for consumer'sincome. only aboutthe direction goods and change in in esponse to change in types of elasticity of There are as many its price. a commodity and change of economic variables It simply states that change in price demand as there are types opposite in quantity demanded move in the However, there are of demand makes a determining the demand. direction. Thus, the lavw of demand, namely does not tell us about three main types of elasticity statement only. It of demand, 2. Cross qualitative elasticity demanded 1. Price elasticity of change in quantity elasticity of demand. the magnitude In other words, to a change in price. of demand, 3. Income in response it does not tell us by what amount the quantity Elasticity of Demand demanded of a commodity will change in response to a change in its price. The extent to which the Income Cross Price demand for different commodities responds to price Elasticity Elasticity changes differs. For example, the demand for a Elasticity of Demandof Demandof Demand good like salt is not affected much by a change in its price. On the other hand, a change in the price of Of these three types of elasticities, price goods like colour televisions or cars is likely to have elasticity of demand is the most important. a large influence on demand. This information its Therefore, we shall discuss price elasticity about the extent to which demand responds to a of demand in detail and cross elasticity of change in the price (or any other factor affecting demand and income elasticity of demand will demand), is provided by elasticity of demand. be discussed briefly. Elasticity of demand makes a quantitative statement. The credit for introducing the concept of elasticity 4.3 PRICE ELASTICITY OF DEMAND of demand in economic theory goes to the great In this chapter, we demand is a measure of how Price elasticity of economist Alfred Marshall. discuss various facets of elasticity of demand. much the quantity demanded of a commodity Dedenthu tm astiy a changes when its price changes. Price elasticity emand may be defined as the degree op 4.2 MEANING AND TYPES OF responsiveness quantity demanded of a ofÍ ELASTICITY OF DEMAND commodity in response to a change in its price. In general, elasticity of demand refers to the degree By degree here we mean the rate of change. of responsiveness of quantity demanded of aTheretore, more precisely, price elasticity of chamg n quautitydamond  demand refers to the ratio of the but nothing change in the quantity price demanded percentage Can get at a particular then of a to a given percentage comnmodity at higher price, change in its at all a slightly of demand for a price. Thus: the price elasticity to be infinite. In this cOmmodity is said price of a Percentage changein quantity fallin the demanded case, a very small to increase Percentagechange in the demand price Commodity causes Where e, to infinity (o). A demand curve of infinite denotes price elasticity of demand. or completely elasticity is known as perfectly curve. In this case, demand elastic demand 4.3.1 Classification of straight Price Elasticity- is perfectly elastic. A horizontal Degrees of Price D, in Fig. 1 (ii), which Elasticity of Demand line demand curve of The degree perfectly responsiveness of the is parallel to X-axis, illustrates a demanded of commodity to a changein quantity elastic demand. At price OP, nothing is its price may differ. To explain this phenomenon of demanded, but at a slightly lower price OP ofelasticity, degree economistsexpress price elasticity large quantity is demanded. domand of an infinitely in terms of its numerical value. upper limit of price Thus, This is the extreme or of price elasticity demand may be Cases of perfectly elastic demand its expressed elasticity. value terms of numerical value. The of price elasticity of demand numerical are extremely rare. idd ne given Poro toinfinity. In terms ranges from 3. Unitary Elastic Demand: When a of its numerical value a (ie.,degree of elasticity), there are five different þercentage change in the price of an equivalent percentage kinds of price elasticity of demand. commodity causes change in demanded, then the the quantity 1. Perfectly Inelasti When said tobe unitary quantity demanded of a commodity does elasticity of demand is fall in the price not respond to achange in its price, then (or one). For example, if a C-0 the elasticity of demand is zero. In this of the commodity by 10 per cent causes of case, the quantity demanded remains the an increase in the amount purchased same, irrespective of any rise or fall in by 10 per cent, the elasticity of demand it the price of the commodity. No matter is equal to one. A demand curve having what the price is, the same quantity unitary elasticity over itswhole range is is demanded. It is a case of perfectly shown in Fig. 1 (iii). Demand curve D, AOXinelastic demand. A demand curve of has unitary elasticity at all the pointson zero elasticity is known as perfectly or the curve. Such a curve is known as a completely inelastic demand curve. This rectangular hyperbola curve. (In mathematics, is illustrated in Fig. 1 (i). Vertical straight a rectangular hyperbola curve is a curve line demand curve D,, which is parallel in which the total area of rectangles at to Y-axis, is perfectly inelastic demand different points on the curve is same. Such curve. The amount purchased remains towards the X-axis and the a curve extends OQirrespective of whether price is OP or Y-axis in a uniform way, but never touches OP,. Cases of perfectly inelastic demand are very rare even in the case of the basic them.) Therefore, the demand curve necessities of life like food as demand for representing unitary elasticity of demand even basic changesbecause necessities also on each of its point assumes the shape of of a change in their price. However,in a rectangular hyperbola.Cases of unitary case of 1life-saving medicines the demand elastic demand are very rare indeed. for such medicines is perfectly inelastic. 4. ElasticDemand: When the percentage 2. Perfectly Elastic Demand: When consumers change in the quantity demanded of a are prepared to purchase all that they comnodity exceeds the percentagechange JDELASTICITY OF DEMAND 55  D Quantity Quantity Perfectly ineiastic Perfectly elastic P P Price 1 Qo Q1 Quantity () 1 Quantity e ()Unitary elastic (iv) e, Varies Fig. 1 Degrees of Price Elasticity of Demand in itš price, the elasticity of demand that demand for this good is relatively is greater than unitary. The elasticity inelastic. For instance, if a fall in the price of demand here is greater than unity. of a commodity by 10 per cent leads to Demand is said to be relatively elastic an increase in quantity demanded by 8 here. For example, if a fall in the price per cent, the demand is inelastic. Demand of the commodity by 10per cent causes curve D, is inelastic between C and D an increase in amount demanded by because the percentage charnge in quantity 15 per cent, the demand is said to be demanded from OQ, to OQ, is smaller than elastic. Generally, the demand for luxury the percerntage change in price from OP, to goods is elastic in nature. In Fig. 1 (iv) OP Generally, the demand for necessities demand curve D, is elastic between A is relatively inelastic. and B because the percentage change in Table 4.1 summarises the description of these quantity demanded from OQ, to OQ, five types of elasticity of demand. is relatively larger than the percentage It should be noted that the demand curve need change in price from OP, to OP,. not have the same elasticity over its entire range. 5. Inelastic Demand: Demand is inelastic A demand curve is more elastic at the when the percentage change in upper the quantity range and less elastic at the demanded lower range. As we of a commodity less than the shall explain later, a is percentage change downward sloping straight in its price. The elasticity line demand curve has elasticity that varies of demarnd here is less than unity. We say from infinity at the price axis to zeroatthe quantity axis 56 FRANK ISCEONOMICS-XH  Table 4.1: Types of Elasticity Description andtheir Types of Numerical Elasticitty Value of Description Elasticity 1. Perfectlye, zero Inelastic Quantity Arc does not demanded Point change as price 2 Inelastic changes. Quantity demanded changes by a smaller percentage than Quantity change in price. 3.Unitary Flg. 2 Point and Arc Elasticities |Quantity elastic demanded changes exactly at the demand curve, we call it point elasticity. The same rate as in change concept of point elasticity is useful when price. changes in price and quantity are infinitely 4. Elastic e, >1 Quantity demanded small. The method used for measuring point changes by a elasticity is called 'Point Method' larger percentage than (ii) Arc Elasticity: When elasticity of demand change in price. is measured over a finite range or 'arc 5. Perfectly Consumers are of a demand curve, it is called arc elastic prepared to buy all elasticity of demand. An arc is the portion they can get at between two demand curve. points on a some price but none at When changes in price and quantity are all significantly large, they show a movement at a slightly higher from one point on the demand curve to price. another point, making on arc. Accordingly, arc elasticity is a measure of the elasticity It is only in the three exceptional cases illustrated between two points on the demand curve. in panels ), (i) and (ii) of Fig. 1 that demand For example, the measure of elasticity Curve has the same elasticity throughoutits between point R and R, on the demand length. curve DD isthe measure of arc elasticity. 4.3.2 Methods of Measurement of The arc elasticity of demand can be Price Elasticity of Demand measured by 'Percentage Method and Total Elasticity of demand for Expenditure Method. different goods is Thus,there are three methods of measurement different. It is important to measure elasticity of of price elasticity of demand. These are: demand in order to compare elasticity of demand Be of different goods. The measurement of elasticity 1. Percentage or Proportionate method 2. Total expenditure method of demand can be looked at from two viewpoints: 3. Point method or Geometric ) point elasticity, and arc elasticity. method. Pint It is important to note that while the formula () When price elasticity of for pointelasticity of demand is appropriatefor demand is measured at a particular point very small changes in price and quantity, the a demand curve, it is called point formula for arc elasticity of demand is more elasticity. In Fig. 2, if we want to measure appropriate for large changes in price and the elasticity of demand at point R on the quantity. Sbayht OF DEMAND 57 du  some textbooks prefer to put a negative sign Percentage or Proportionate Method In this method, price elasticity of demand is in front of the formula measured by theratio of percentage changein slope of the demand the quantity demanded to a percentage change in view of the negative the elasticity of demand is inthe the commodity. Thus: curve. Note that The slope of the demand. price of not the same as the absoluta Percentage change in quantity demanded curve divides the slope of the demand Percentage change in price change in change in price by the absolute Change in Quantity Demanded x100 AP where as elasticity depends on i.e. Initial Quantity quantity, Change in Price change in quantity and price, Le. x100 the percentage Initial Price P,AQ AP AQ100 of the percentage AQ AP Another important feature of demand =AP P method of measuring price elasticity x 100 units of not depend on the P P AQ P is that it does measurement of quantity of demand - whether petrol- or the measure of X kg of rice or litres of AP AP Q or in US dollars price - whether in Indian rupees Thus: It is a unit-free measure becauseit uses percentage the quantity demanded. AQ P changes in prices and Therefore, we can compare the price sensitivity AP goods regardless of the demand. of demand for different of Where e, stands for price elasticity units for measuring either price or quantity. This Qstands for initial quantity indeed is a major advantage of measuremerntof P stands for price initial elasticity by percentage method. stands for change in quantity elasticity of demand AQ Example: Let us calculate AP change in price. stands for method by taking a price by using the percentage calculating While using this formulafor numerical example. of demand, we must keep one thing falls from elasticity Suppose the price of the commodity in mind, mathematically speaking,price i.e, 50to 40 and the quantity demanded increases of demand is a negative number because units to 150 units. elasticity from 100 the demand curve. In view of of negative slope of In this example, curve, the price the negative slope of the demand directions Q = 100 AQ = 150 -100 =50 and quantity change in the opposite positive P= 50 AP = 50 -40 = 10 from each other. One change will be computation AQ P 50 X 50 = 2.5 and the other negative. Hence, the always result in a AP 10 100 of elasticity of demand will While calculating price elasticity value. negative The advantage of percentage method of of demand by percentage method, common is that measuring price elasticity of demand it or standard practice is to ignore the negative and exact measure of elasticity. gives a precise we should take only the absolute demand Larger value for price elasticity of signs, i.e., and not their signs. The negative sign values more sensitive to changes indicates that demand is not prefixed with the coefficient of demand is in price; smaller value indicates that demand is avoid any mathematical ambiguity. in order to less sensitive to price changes. However, one The conventionamong economists is to simply using percentage method a number with the of the problems of refer to the elasticity as However, is that the percentage change depends on the understanding that it is negative. FRANK ISC ECONOMICS-XII 58  or the starting point. in total expenditure, Should take the leads to decrease greater than base we will be initial quantity/price or the new of demand moves quantity/price elasticity expenditure the starting point? when total case change in In of small change one,Thus, to the when thetwo points on the demand curve direction.e in the opposite greaterthan are very close to each other), it does not matter elasticity of demand is price, the change in quntity hether we take the initial quantity/price or new In this case, unitary. ofsets the change But two than demanded more if points on the demand by the demand quantity/price, Curve are quite apart from each other,i.e., when This is shown in price. graphically hanges in quantity and price are large, then schedule in Table 4.2 and he value of elasticity will differ significantly in Fig. 3. depending upon whether we take the initial or new values because the Table 4.2: Demand Schedule values percentage in both price and quantity Expenditure change will be Price Quantity Total different in the two situations (initial values or ) (Units) pew values). That is why the percerntage formula 10 600 60 of calculating elasticity has been modified to take 50 13 care of this problem. This is known as 'mid-point pel650/>1 formula' for calculating elasticity. However, this modified formula is beyond your level. elastic Total outlay Expenditure Method ntit Talute't (?) D A B 60 One of the methods of measuring the price 50 Price D elasticity of demand suggested by Marshall is the Total expenditure method'. Total expenditure Or total outlay is the expenditure incurred by X households on the purchase of a commodity. 13 Tt is the product of the price of a commodity Quantity and the quantity demanded at that price, Fig. 3 Elastic Demand ie., TE = Px Q, where TE stands for total expenditure, P and Q stand for price and shows quantity respectively. For example, if 10units Demand schedule in Table 4.2 from 60 to of a commodity are demanded when its price is that when price falls from 600 6,the total expenditure will be 60 (i.e., 6 x 10). *50, total expenditure rises in is plotted to 650.This information According to the expenditure method, Fig. 3 to give the demand curve D,D,. elasticity of demand can be measured by considering the change in total expenditure rotal expenditure corresponding to price 60 is represented by rectangle OA, and incurred commodity as result of change in on a a the price the commodity.We compare the total of totalexpenditure corresponding to price expenditure incurred on a commodity before and R50 is represented by rectangle OB. As we can know increases after the price change and thereby about the price elasticity of demand for the good. o TEals, total expenditure from 600 to 650 (i.e., area of rectangle By using this method, we can categorise three OB is greater than the area of rectangle OA), Thus, demand curve D,D, is elastic types of elasticities: TE ro between A and B. a fall in the price 1. Elastic Demand: When Inelastic Demand: When a fall in of the commodity results in increase nejpandyu total expenditure, and a rise in the price the price of a commodity reduces Ep =l Ep 21 ELASTICITY OF DEMAND 59  total expenditure and a rise in its Table 4.4: Demand Schedule price incrcases total expenditure, price Price Quantity Total elasticitv afdemand will be less than Expenditure (Units) one. Thus, when total expendituremoves 60 10 600 in the same as change in price, direction 50 12 600 elasticity ofdemand is less than unitary. ln this case, change in price more than In Table 4.4, demand is unitary elastic as wil change in quantity. This type otfsets the fall in from 60 to 50, total expenditur price of demarnd elasticity is illustrated by remains unchanged at 600. The sarme informati the demand schedule in Table 4.3 and is conveyed graphically in Fig. 5, where th graphically in Fig. 4. demand curve D,D, is a rectangular hyperbola Tatie 4L3 Demand Schedule curve with rectangles OA and OB being equal in areas, showing that a change in the price of Price QuantityTotal Expenditure the commodity does not bring about a chan (Units) in total expenditure. 60 600 10 D 50 11 550 In Talle 4.3, demand is inelastic because ()60 with a fall in price from 60 to 50, total O 50 Price expencliture falls from T600 to 550. The same information is illustrated graphically in Fig. 4, where demand curve D,D, is inelas tic between points A and B as the area of rectangle OB is smaller than the 10 12 Quantity area of rectangle OA. Fig. 5 Unitary Elastic Demand ) Price We above in Table 45: can summarise these the following Categories of Price Elasticity of Demand in terms of Total Expenditure Table results explained 4.5: Change Types of Price Elasticity of in Price Demand Unitary 1 11ouantity Elastic (e, =1) Inelastic ) Elastic >) (e, < (e, Flg 4 Inelastie Dmand Fall in TE remains TE falls TE rises 3A Unitay Hlastic When total expenditure Price constant does not change with a change in the Rise in TE remainsTE rises TE falls price of the commodity, the elasticity of Price constant demand is equal to unitary. In this case, change in the quantity demanded just We can show the relationship between the elasticity of demand and the total expenditure offsets the change in price. This type of by in Fig. 6. Here, instead of drawing an elasticity is illustrated the demand ordinary schedule in Table 4.4 and graphically by demand curve, we have drawn the total the demand curve D,D, in Fig. 5. expenditure curve by showing total expenditure on the X-axis and price on the Y-axis. 60 FRANK ISC ECONOMICS-XIl  Zone one by: Curye can be measured below the point on Line segment the denn and curve point on B above the Line segment curve the demand Zonetwo Demand e, =1 1. Elasticity On a Straight measure price we want to Curve Suppose on a linear R of demand at point is elasticity demand curve AB. It line Or a straight line P Fig. that the lower 7 obvious from of the demand the position D segment (i.e., is RB and below the point R) Curve lying Zone three portion of e 1 because RB > RA. Point Method (Geometric Method) Similarly, if we want to measure elasticity atany other point on the demand curve, Geometrically, price elasticity of demand can be K say at K, measured with the help of what is known as KB "Point Method'. elasticity of demand According at to thismethod, price any point on the demand e at K= KA Here, e,, 1 E EA different points en a straight line demand becausethe lower curve starting from Y-axis and terminating segment is greate. than the upper at X-axis. We can easily explain that the segment,i.e., BE > EA price is elasticity points of the straight line different. This of demand at different is demand illustrated in curve Fig.8. (3) , At the mid-point D at becausethe lower D segmernt BD DA =1 upper segment, i.e., BD =equals the DA (4) Af any point below the mid-point but above B, say at C BC C = e, at CA