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Elasticity of Demand, Price Elasticity, Income Elasticity, Cross Elasticity, Advertising Elasticity, Uses of Elasticity in managerial decisions,

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Elasticity of demand

  1. 1. ELASTICITY OF DEMAND Prof. Shampa Nandi
  2. 2. Law of Demand Law of Demand states that if price of commodity increases quantity demanded will falls and if price of commodity falls quantity will increases. Law of demand indicates only direction of change in quantity demanded in response to change in price but ELASTICITY OF DEMAND states with how much or to what extent the quantity demanded will change in response to change in any determinants.
  3. 3. ELASTICITY - The Concept • If price rises by 10% - what happens to demand? • We know demand will fall. • By more than 10% ? • By less than 10% ? • Elasticity measures the extent to which demand will change.
  4. 4. Meaning & Definition of Elasticity of Demand Elasticity of Demand measures the extent to which quantity demanded of a commodity increases or decreases in response to increase or decrease in any of its quantitative determinants. So, we have several types of elasticity of demand according to the source of the change in the demand. For example, if the price is the source of the change, we have the “price elasticity of demand”. “The elasticity (or responsiveness) of demand in a market is great or small according as the amount demanded increases much or little for a given fall in price, and diminishes much or little for a given rise in price”. – Dr. Marshall.
  5. 5. Elasticity of Demand According to the source of the change, the following types of elasticity of demand can be mentioned: • Price Elasticity of Demand • Cross Elasticity of Demand (the elasticity in relation to the change of the price of other good and services) • Income Elasticity of Demand • Advertisement Elasticity of Demand (the elasticity in relation to the advertisement expenditure) According to the degree of the change in the demand, the elasticity can be classified in: • Perfectly Elastic • Relatively Elastic • Unitary Elasticity • Relatively Inelastic • Perfect Inelastic
  6. 6. Price Elasticity of Demand Price Elasticity of demand is a measurement of percentage change in demand due to percentage change in own price of the commodity. The price elasticity of Demand may be defined as the ratio of the relative change in demand and price variables. e= Percentage/Proportional Change in Quantity Demanded Percentage/Proportional Change in Price
  7. 7. Price Elasticity of Demand
  8. 8. Degree of Price Elasticity of Demand Five cases of elasticity of demand are studied depending upon their degree: • Perfectly Elastic • Perfectly Inelastic • Unitary Elastic • Relatively Elastic • Relatively Inelastic
  9. 9. Perfectly Elastic Demand When a small change in price of a product causes a major change in its demand, it is said to be perfectly elastic demand. In perfectly elastic demand, a small rise in price results in fall in demand to zero, while a small fall in price causes increase in demand to infinity. A perfectly elastic demand refers to the situation when demand is infinite at the prevailing price. In perfectly elastic demand, a small rise in price results in fall in demand to zero, while a small fall in price causes increase in demand to infinity. The degree of elasticity of demand helps in defining the shape and slope of a demand curve. Therefore, the elasticity of demand can be determined by the slope of the demand curve. Flatter the slope of the demand curve, higher the elasticity of demand.
  10. 10. Perfectly Inelastic Demand A Perfectly inelastic demand is one in which a change in price causes no change in quantity demanded. It is a situation where even substantial changes in price leave the demand unaffected. It can be interpreted from Figure that the movement in price from OP1 to OP2 and OP2 to OP3 does not show any change in the demand of a product (OQ). The demand remains constant for any value of price. Perfectly inelastic demand is a theoretical concept and cannot be applied in a practical situation. However, in case of essential goods, such as salt, the demand does not change with change in price. Therefore, the demand for essential goods is perfectly inelastic.
  11. 11. Unitary Elastic Demand • When the proportionate change in demand produces the same change in the price of the product, the demand is referred as unitary elastic demand. The numerical value for unitary elastic demand is equal to one (ep=1). • The demand curve for unitary elastic demand is represented as a rectangular hyperbola.
  12. 12. Relatively Elastic Demand Relatively elastic demand refers to the demand when the proportionate change produced in demand is greater than the proportionate change in price of a product. Mathematically, relatively elastic demand is known as more than unit elastic demand (ep>1). For example, if the price of a product increases by 20% and the demand of the product decreases by 25%, then the demand would be relatively elastic. In this the demand is more responsive to the change in price
  13. 13. Relatively Inelastic Demand Relatively inelastic demand is one when the percentage change produced in demand is less than the percentage change in the price of a product. For example, if the price of a product increases by 30% and the demand for the product decreases only by 10%, then the demand would be called relatively inelastic. The numerical value of relatively elastic demand ranges between zero to one (ep<1). Marshall has termed relatively inelastic demand as elasticity being less than unity.
  14. 14. The different types of price elasticity of demand are summarized in Table
  15. 15. Flatter the slope of the demand curve, higher the elasticity of demand.
  16. 16. Measurement of Price Elasticity of Demand Measurement of Price Elasticity of Demand Total Expenditure Method Proportionate Method Point Elasticity of Demand Arc Elasticity of Demand
  17. 17. 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 purchased and the total amount of money spent on it. Total Outlay/ Total Expenditure = Price X Quantity Demanded There are three possibilities: If with a fall in price (demand increases) the total expenditure increases or with a rise in price (demand falls), the total expenditure falls, in that case the elasticity of demand is greater than one i.e. ED > 1. 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. 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).
  18. 18. Total Expenditure Method Table shows that when the price falls from Rs. 9 to Rs. 8, the total expenditure increases from Rs. 180 to Rs. 240 and when price rises from Rs. 7 to Rs. 8, the total expenditure falls from Rs. 280 to Rs. 240. Demand is elastic (Ep > 1) in this case. When with the fall in price from Rs. 6 to Rs. 5 or with the rise in price from Rs. 4 to Rs. 5, the total expenditure remains unchanged at Rs. 300, i.e., Ep = 1. When the price falls from Rs. 3 to Rs. 2 total expenditure falls from Rs. 240 to Rs. 180, and when the price rises from Re. 1 to Rs. 2 the total expenditure also rises from Rs. 100 to Rs. 180. This is the case of inelastic or less elastic demand, Ep < 1. Price Rs Per Kg Quantity in Kgs TE in Rs Ep 1 2 (1x2=3) 9 20 180 >>1 8 30 240 7 40 280 6 50 300 =1 5 60 300 4 70 300 3 80 240 <<1 2 90 180 1 100 100
  19. 19. Summarized Relationship In Total Expenditure Method Price TE Ep Falls Rises >>1 Rises Falls Falls Unchanged =1 Rises Unchanged Falls Falls <<1 Rises Rises
  20. 20. Example Price (P) Quantit y (Q) Exp. (PxQ) Price (P) Quantit y (Q) Exp. (PxQ) Price (P) Quantit y (Q) Exp. (PxQ) 2 300 600 2 300 600 2 300 600 4 150 600 4 100 400 4 200 800 6 100 600 6 50 300 6 150 900 P E (No Effect) E=1 P E E>1 P E E<1
  21. 21. Question Ques 1: Price(1) = 2, Quantity (1) = 10 Price (2) = 4, Quantity (2) = 5 E = ?
  22. 22. Solution Price Quantity Expenditure 2 10 20 4 5 20 P E (No Effect) E=1
  23. 23. Percentage or 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 the proportionate change in quantity demanded to proportionate change in price. It is also known as the Percentage Method, Flux Method, Ratio Method, and Arithmetic Method. Its formula is as under:
  24. 24. Formula Ep = Percentage Change in Quantity Demanded Percentage Change in the Price of the good
  25. 25. Percentage or Proportionate Method (Ex 1) Calculate the Price Elasticity of demand if the price fell by 10% causing the demand to rise from 800 to 850 units. Solution:
  26. 26. Percentage or Proportionate Method (Ex 2) When Price of Commodity is Rs. 1, then Consumer spends Rs. 80 & If the price of commodity is Rs. 20 then consumer spends Rs. 96. Calculate the Elasticity of demand with Percentage Method.
  27. 27. Percentage or Proportionate Method (Ex 2) Solution: Price Expenditure Quantity 1 80 80 2 96 48
  28. 28. Point Method or Geometrical Method Measures the price Elasticity of demand of different points on the demand curve . This method was also suggested by Dr. Marshall Used only with the reference to a linear demand curve. Elasticity of demand at a point =
  29. 29. Point Method or Geometrical Method
  30. 30. Arc Method We have studied the measurement of elasticity at a point on a demand curve. But when elasticity is measured between two points on the same demand curve, it is known as arc elasticity. In the words of Prof. Baumol, “Arc elasticity is a measure of the average responsiveness to price change exhibited by a demand curve over some finite stretch of the curve.” Any two points on a demand curve make an arc.
  31. 31. Arc Method The area between P and M on the DD curve in Figure 11.4 is an arc which measures elasticity over a certain range of price and quantities. On any two points of a demand curve the elasticity coefficients are likely to be different depending upon the method of computation.
  32. 32. Why there is need of Arc Method?
  33. 33. Arc Method Consider the price-quantity combinations P and M as given in Table. Demand Schedule Point Price Quantity P 8 10 M 6 12
  34. 34. Arc Method As per Percentage Method: If we move from P to M, the elasticity of demand is: If we move in the reverse direction from M to P, then Thus this method of measuring elasticity at two points on a demand curve gives different elasticity coefficients because we used a different base in computing the percentage change in each case. To avoid this discrepancy, elasticity for the arc method has been developed
  35. 35. Arc Method Formula For Arc Method: Where, P1 = Original Price P2 = New Price Q1 = Original Quantity Demanded Q2 = New Quantity Demanded
  36. 36. Arc Method On the basis of formula, we can measure arc elasticity of demand when there is a movement either from point P to M or from M to P. From P to M at P, p1 = 8, q1, =10, and at M, P2 = 6, q2 = 12 Applying these values, we get Thus whether we move from M to P or P to M on the arc PM of the DD curve, the formula for arc elasticity of demand gives the same numerical value.
  37. 37. INCOME ELASTICITY OF DEMAND
  38. 38. Income Elasticity of Demand Income elasticity of demand is the degree of responsiveness of quantity demanded of a commodity due to change in consumer’s income, other things remaining constant. In other words, it measures by how much the quantity demanded changes with respect to the change in income. The income elasticity of demand is defined as the percentage change in quantity demanded due to certain percent change in consumer’s income.
  39. 39. Expression of Income Elasticity of Demand Where, •EY = Elasticity of demand •q = Original quantity demanded •∆q = Change in quantity demanded y = Original consumer’s income •∆y= Change in consumer’s income
  40. 40. Example to Explain Income Elasticity of Demand Suppose that the initial income of a person is Rs.2000 and quantity demanded for the commodity by him is 20 units. When his income increases to Rs.3000, quantity demanded by him also increases to 40 units. Find out the income elasticity of demand. Solution: Here, q = 100 units ∆q = (40-20) units = 20 units y = Rs.2000 ∆y =Rs. (3000-2000) =Rs.1000 Hence, an increase of Rs.1000 in income i.e. 1% in income leads to a rise of 2% in quantity demanded.
  41. 41. Types of Income Elasticity of demand Types of Income Elasticity of Demand Positive Income Elasticity Of Demand E>0 Income Elasticity Greater than Unity E>1 Income Elasticity Equal to Unity E=1 Income Elasticity Less than Unity E<1 Negative Income Elasticity Of Demand E<0 Zero Income Elasticity E=0
  42. 42. 1. Positive income elasticity of demand (EY>0) If there is direct relationship between income of the consumer and demand for the commodity, then income elasticity will be positive. That is, if the quantity demanded for a commodity increases with the rise in income of the consumer and vice versa, it is said to be positive income elasticity of demand. For example: as the income of consumer increases, they consume more of superior (luxurious) goods. On the contrary, as the income of consumer decreases, they consume less of luxurious goods. Positive income elasticity can be further classified into three types: •Income Elasticity Greater than Unity E>1 •Income Elasticity Equal to Unity E=1 •Income Elasticity Less than Unity E<1
  43. 43. (A) Income elasticity greater than unity (EY > 1) If the percentage change in quantity demanded for a commodity is greater than percentage change in income of the consumer, it is said to be income greater than unity. For example: When the consumer’s income rises by 3% and the demand rises by 7%, it is the case of income elasticity greater than unity. In the given figure, quantity demanded and consumer’s income is measured along X-axis and Y-axis respectively. The small rise in income from OY to OY1has caused greater rise in the quantity demanded from OQ to OQ1 and vice versa. Thus, the demand curve DD shows income elasticity greater than unity.
  44. 44. (B) Income elasticity equal to unity (EY = 1) If the percentage change in quantity demanded for a commodity is equal to percentage change in income of the consumer, it is said to be income elasticity equal to unity. For example: When the consumer’s income rises by 5% and the demand rises by 5%, it is the case of income elasticity equal to unity. In the given figure, quantity demanded and consumer’s income is measured along X-axis and Y-axis respectively. The small rise in income from OY to OY1 has caused equal rise in the quantity demanded from OQ to OQ1 and vice versa. Thus, the demand curve DD shows income elasticity equal to unity.
  45. 45. (C) Income elasticity less than unity (EY < 1) If the percentage change in quantity demanded for a commodity is less than percentage change in income of the consumer, it is said to be income greater than unity. For example: When the consumer’s income rises by 5% and the demand rises by 3%, it is the case of income elasticity less than unity. In the given figure, quantity demanded and consumer’s income is measured along X-axis and Y-axis respectively. The greater rise in income from OY to OY1has caused small rise in the quantity demanded from OQ to OQ1 and vice versa. Thus, the demand curve DD shows income elasticity less than unity.
  46. 46. 2. Negative income elasticity of demand ( EY<0) If there is inverse relationship between income of the consumer and demand for the commodity, then income elasticity will be negative. That is, if the quantity demanded for a commodity decreases with the rise in income of the consumer and vice versa, it is said to be negative income elasticity of demand. For example: As the income of consumer increases, they either stop or consume less of inferior goods. In the given figure, quantity demanded and consumer’s income is measured along X-axis and Y-axis respectively. When the consumer’s income rises from OY to OY1 the quantity demanded of inferior goods falls from OQ to OQ1 and vice versa. Thus, the demand curve DD shows negative income elasticity of demand.
  47. 47. 3. Zero income elasticity of demand ( EY=0) If the quantity demanded for a commodity remains constant with any rise or fall in income of the consumer and, it is said to be zero income elasticity of demand. For example: In case of basic necessary goods such as salt, kerosene, electricity, etc. there is zero income elasticity of demand. In the given figure, quantity demanded and consumer’s income is measured along X-axis and Y-axis respectively. The consumer’s income may fall to OY1 or rise to OY2 from OY, the quantity demanded remains the same at OQ. Thus, the demand curve DD, which is vertical straight line parallel to Y-axis shows zero income elasticity of demand.
  48. 48. CROSS ELASTICITY OF DEMAND
  49. 49. Cross Elasticity of Demand The measure of responsiveness of the demand for a good towards the change in the price of a related good is called cross price elasticity of demand. It is always measured in percentage terms. With the consumption behavior being related, the change in the price of a related good leads to a change in the demand of another good. Related goods are of two kinds, i.e. substitutes and complementary goods.
  50. 50. Cross Elasticity of Demand In case the two goods are substitutes for each other like tea and coffee, the cross price elasticity will be positive, i.e. if the price of coffee increases, the demand for tea increases. On the other hand, in case the goods are complementary in nature like pen and ink, then the cross elasticity will be negative, i.e. demand for ink will decrease if prices of pen increase or vice-versa. It can be expressed as:
  51. 51. Cross Elasticity of Demand Definition: “The cross elasticity of demand is the proportional change in the quantity of X good demanded resulting from a given relative change in the price of a related good Y” Ferguson “The cross elasticity of demand is a measure of the responsiveness of purchases of Y to change in the price of X” Leibafsky In case the two goods are substitutes for each other like tea and coffee, the cross price elasticity will be positive, i.e. if the price of coffee increases, the demand for tea increases. On the other hand, in case the goods are complementary in nature like pen and ink, then the cross elasticity will be negative, i.e. demand for ink will decrease if prices of pen increase or vice-versa.
  52. 52. Cross Elasticity of Demand Substitute Goods: In case the two goods are substitutes for each other like tea and coffee, the cross price elasticity will be positive, i.e. if the price of coffee increases, the demand for tea increases. Complementary Goods: On the other hand, in case the goods are complementary in nature like pen and ink, then the cross elasticity will be negative, i.e. demand for ink will decrease if prices of pen increase or vice-versa.
  53. 53. Types of Cross Elasticity of Demand Types of Cross Elasticity of Demand Positive Negative Zero
  54. 54. Positive Cross Elasticity of Demand When goods are substitute of each other then cross elasticity of demand is positive. In other words, when an increase in the price of Y leads to an increase in the demand of X. For instance, with the increase in price of tea, demand of coffee will increase. In figure quantity has been measured on OX-axis and price on OY-axis. At price OP of Y-commodity, demand of X-commodity is OM. Now as price of Y commodity increases to OP1 demand of X-commodity increases to OM1 Thus, cross elasticity of demand is positive.
  55. 55. Negative Cross Elasticity of Demand In case of complementary goods, cross elasticity of demand is negative. A proportionate increase in price of one commodity leads to a proportionate fall in the demand of another commodity because both are demanded jointly. In figure quantity has been measured on OX-axis while price has been measured on OY-axis. When the price of commodity increases from OP to OP1 quantity demanded falls from OM to OM1. Thus, cross elasticity of demand is negative.
  56. 56. Zero Cross Elasticity of Demand Cross elasticity of demand is zero when two goods are not related to each other. For instance, increase in price of car does not effect the demand of cloth. Thus, cross elasticity of demand is zero.
  57. 57. Advertising and Promotional Elasticity of Demand
  58. 58. Advertising Elasticity of Demand Advertising elasticity of demand refers to the proportionate change in demand of a commodity due to proportionate change in advertising expenses. Advertising elasticity is a measure of an advertising campaigns effectiveness in generating sales. Formula:
  59. 59. Types Of Advertising Elasticity of Demand •Perfectly Elastic Advertising elasticity •Perfectly Inelastic Advertising Elasticity •Highly Elastic Advertising Elasticity •Unitary Elastic Advertising Elasticity •Highly Inelastic Advertising Elasticity
  60. 60. Perfectly Elastic AED When the demand for a product changes – increases or decreases even when there is no change in x advertising expense. Perfectly elastic curve Expense D demand
  61. 61. Perfectly Inelastic AED When a change in advertising expense , doesn’t lead to any change in quantity demanded , it is known as perfectly inelastic demand. D demand Perfectly inelastic curve AdvertisingExpense
  62. 62. Relatively Elastic AED When the proportionate change in demand is more than the proportionate changes in advertising expense , it is known as relatively elastic Relatively elastic curve AdvertisingExpense demand
  63. 63. Unitary Elastic AED When the proportionate change in demand is equal to proportionate changes in advertising expense price, it is known as unitary elastic demand. Unitary AED demandAdvertising Expense
  64. 64. Relatively Inelastic AED When the proportionate change in demand is less than the proportionate changes in advertising expense , it is known as relatively inelastic demand Relatively inelastic demand curve demand AdvertisingExpense
  65. 65. Uses of Elasticity of Demand for Managerial Decision Making
  66. 66. 1. Determination of Price The primary objective of any firm is to earn profit or increase revenue. Therefore, increasing price of its products to maximize profit is one of the primary concerns of producers. However, during the course of increasing price, the producers must not forget that demand and price share inverse relationship. They must be aware that demand falls with rise in price. And thus, they must increase price of their commodity to that level where their desired or optimal profit is still achievable.
  67. 67. 1. Determination of Price For example: In the table given below are shown three cases (I, II & III) of a restaurant that sells burger.
  68. 68. 1. Determination of Price In the above table, we can see that when price of the burger was $10 per unit, its demand in the market were 100 units per day, causing the firm profit of $300. When the firm increased the price to $10.2, its demand fell by 10 units per day. As a result, the firm gained profit of $288, causing reduction of $12 in initial profit. In the same way, when the price is increased to $11 per unit, there is once again decrease in demand. The new demand in market is 85 units per day and the new profit is $340. From the example, it is clear that producers must always analyze elasticity of their product and must evaluate the impact of changes in price on the total revenue and profit of their firm.
  69. 69. 2. Wage Determination If a commodity is of inelastic nature, the labor can force the employer to increase their wage through extreme ways like strike. As a result, the company will have to consider the demands of labor in order to meet the demand of consumers for the inelastic goods. However, if the commodity is of elastic nature, labor unions and other associations cannot force the employers to raise wage as the producers can alter the demand of their products.
  70. 70. 3. Importance in International Trade We have already known that change in price cannot bring drastic change in demand of the product in case of inelastic commodity. But even a slight change in price can cause huge effect on demand of elastic commodity. We have also known that higher price can be charged for inelastic goods and lowest possible price must be set for elastic goods. Taking into account the above information, a country may fix higher prices for goods of inelastic nature. However, if the country wants to export its products, the nature (elasticity/inelasticity) of the commodity in the importing country should also be considered. For example: Rice maybe an inelastic product for China and thus exports around the world at the price “x”. But, if rice is price elastic in the US, China will be forced to decrease the price from the initial value of “x” to be able to sell the product in American market.
  71. 71. 4. Importance to Finance Minister Price elasticity of demand can also be used in the taxation policy in order to gain high tax revenue from the citizens. One of the ways would be for the government to raise tax revenue in commodities which are price inelastic. For example: Government could increase the tax amount in goods like cigarettes and alcohol. Given how these are the commodities people choose to purchase regardless of the price tag, the tax revenue would significantly rise. On the other hand, in case of a commodity with elastic demand high tax rates may fail to bring in the required revenue for the government.
  72. 72. 5.Price Discrimination The situation where a single group or company controls all or almost all of market for a particular good or service is called monopoly. The monopolistic market lacks competition. Thus, the goods or services are often charged high prices in such market. If the product is inelastic (less or no effect on demand with change in price), the producer can earn profit by setting high price. However, if the product is elastic (highly affected by even slightest change in price), the producer must set low or at least reasonable price so that the consumers are attracted to buy the goods. For example: Fuel is necessity of consumers. Therefore, monopolist who runs the market of fuel can generate profit even by setting high price of fuel.
  73. 73. 6. Price Determination of Joint Products Joint products are various products generated by a single production procedure at a single time. Sheep and wool, cotton and cotton seeds, wheat and hay, etc. are some examples of joint products. However, since they are two different products, we cannot sell them at the same price in the market. Price elasticity of demand plays important role in determining the prices of these joint products. Let us suppose, there has been bumper production of cotton this season. As a result, huge amount of cotton as well as cotton seeds have been produced. Cotton has wide scope in the market as it can be used for different purposes. The producers of cotton can gain maximum profit by setting high price of cotton, as demand of cotton in market is not easily altered. But cotton seeds have limited scope, so it is an elastic product. If the business does not decrease the price, then demand will be less. By setting a high price for cotton (inelastic product) and low price for cotton seeds (elastic product), the business can maximize its revenue.
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Elasticity of Demand, Price Elasticity, Income Elasticity, Cross Elasticity, Advertising Elasticity, Uses of Elasticity in managerial decisions,

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