Elasticity Of Demand

Earlier we have discussed the law of demand and its determinants. It tells us only the direction of
change in price and quantity demanded. But it does not specify how much more is purchased
when price falls or how much less is bought when price rises. In order to understand the
quantitative changes or rate of changes in price and demand, we have to study the concept of
elasticity of demand.

Meaning And Definition

The term elasticity is borrowed from physics. It shows the reaction of one variable with
respect to a change in other variables on which it is dependent. Elasticity is an index of
reaction.

In economics the term elasticity refers to a ratio of the relative changes in two quantities. It
measures the responsiveness of one variable to the changes in another variable.

Elasticity of demand is generally defined as the responsiveness or sensitiveness of demand

to a given change in the price of a commodity. It refers to the capacity of demand either to
stretch or shrink to a given change in price. Elasticity of demand indicates a ratio of relative
changes in two quantities.ie, price and demand.

According to prof. Boulding. “Elasticity of demand measures the responsiveness of demand

to changes in price”.

In the words of Marshall,” The elasticity (or responsiveness) of demand in a market is

great or small according to as the amount demanded much or little for a given fall in price,
and diminishes much or little for a given rise in price” 2

Kinds of elasticity of demand

Broadly speaking there are five kinds of elasticity of demand. We shall discuss each one of them
in some detail.

Price Elasticity Of Demand

Price elasticity of demand is one of the important concepts of elasticity which is used to describe
the effect of change in price on quantity demanded. In the words of

Prof. .Stonier and Hague, price elasticity of demand is a technical term used by economists to
explain the degree of responsiveness of the demand for a product to a change in its price. Price
elasticity of demand is a ratio of two pure numbers, the numerator is the percentage change in
quantity demanded and the denominator is the percentage change in price of the commodity. It is
measured by using the following formula.
It implies that at the present level with every change in price, there will be a change in demand
four times inversely. Generally the co-efficient of price elasticity of demand always holds a
negative sign because there is an inverse relation between the price and quantity demanded.

Original demand = 20 units original price = 6 – 00

New demand = 60 units New price = 4 – 00

In the above example, price elasticity is – 6.

The rate of change in demand may not always be proportionate to the change in price. A small
change in price may lead to very great change in demand or a big change in price may not lead to
a great change in demand. Based on numerical values of the co-efficient of elasticity, we can
have the following five degrees of price elasticity of demand.

Different Degree of Price Elasticity of Demand

1. Perfectly Elastic Demand: In this case, a very small change in price leads to an infinite
change in demand. The demand cure is a horizontal line and parallel to OX axis. The
numerical co-efficient of perfectly elastic demand is infinity (ED=00)
1. Perfectly Inelastic Demand: In this case, whatever may be the change in price, quantity
demanded will remain perfectly constant. The demand curve is a vertical straight line and
parallel to OY axis. Quantity demanded would be 10 units, irrespective of price changes
from Rs. 10.00 to Rs. 2.00. Hence, the numerical co-efficient of perfectly inelastic
demand is zero. ED = 0

2. Relative Elastic Demand: In this case, a slight change in price leads to more than
proportionate change in demand. One can notice here that a change in demand is more
than that of change in price. Hence, the elasticity is greater than one. For e.g., price falls
by 3 % and demand rises by 9 %. Hence, the numerical co-efficient of demand is greater
than one.
 3. Relatively Inelastic Demand In this case, a large change in price, say 8 % fall price,
leads to less than proportionate change in demand, say 4 % rise in demand. One can
notice here that change in demand is less than that of change in price. This can be
represented by a steeper demand curve. Hence, elasticity is less than one.

In all economic discussion, relatively elastic demand is generally called as ‘elastic demand’ or
‘more elastic’ demand while relatively inelastic demand is popularly known as ‘inelastic
demand’ or ‘less elastic demand’.

4.Unitary elastic demand: In this case, proportionate change in price leads to equal
proportionate change in demand. For e.g., 5 % fall in price leads to exactly 5 % increase in
demand. Hence, elasticity is equal to unity. It is possible to come across unitary elastic demand
but it is a rare phenomenon.
Out of five different degrees, the first two are theoretical and the last one is a rare possibility.
Hence, in all our general discussion, we make reference only to two terms-relatively elastic
demand and relatively inelastic demand.

Determinants Of Price Elasticity Of Demand

The elasticity of demand depends on several factors of which the following are some of the
important ones.

1. Nature of the Commodity

Commodities coming under the category of necessaries and essentials tend to be inelastic
because people buy them whatever may be the price. For example, rice, wheat, sugar, milk,
vegetables etc. on the other hand, for comforts and luxuries, demand tends to be elastic e.g., TV
sets, refrigerators etc.

2. Existence of Substitutes

Substitute goods are those that are considered to be economically interchangeable by

buyers. If a commodity has no substitutes in the market, demand tends to be inelastic because
people have to pay higher price for such articles. For example. salt, onions, garlic, ginger etc. In
case of commodities having different substitutes, demand tends to be elastic. For example,
blades, tooth pastes, soaps etc.

3. Number of uses for the commodity

Single-use goods are those items which can be used for only one purpose and multiple-use
goods can be used for a variety of purposes. If a commodity has only one use (singe use
product) then in that case, demand tends to be inelastic because people have to pay more prices if
they have to use that product for only one use. For example, all kinds of. eatables, seeds,
fertilizers, pesticides etc. On the contrary, commodities having several uses, [multiple –use-
products] demand tends to be elastic. For example, coal, electricity, steel etc.

4. Durability and reparability of a commodity

Durable goods are those which can be used for a long period of time. Demand tends to be
elastic in case of durable and repairable goods because people do not buy them frequently. For
example, table, chair, vessels etc. On the other hand, for perishable and non- repairable goods,
demand tends to be inelastic e.g., milk, vegetables, electronic watches etc.

5. Possibility of postponing the use of a commodity

In case there is no possibility to postpone the use of a commodity to future, the demand tends to
be inelastic because people have to buy them irrespective of their prices. For example,
medicines. If there is possibility to postpone the use of a commodity, demand tends to be elastic
e.g., buying a TV set, motor cycle, washing machine or a car etc.

6. Level of Income of the people

Generally speaking, demand will be relatively inelastic in case of rich people because any
change in market price will not alter and affect their purchase plans. On the contrary, demand
tends to be elastic in case of poor.

7. Range of Prices

There are certain goods or products like imported cars, computers, refrigerators, TV etc, which
are costly in nature. Similarly, a few other goods like nails; needles etc. are low priced goods. In
all these case, a small fall or rise in prices will have insignificant effect on their demand. Hence,
demand for them is inelastic in nature. However, commodities having normal prices are elastic in
nature.

8. Proportion of the expenditure on a commodity

When the amount of money spent on buying a product is either too small or too big, in that case
demand tends to be inelastic. For example, salt, newspaper or a site or house. On the other hand,
the amount of money spent is moderate; demand in that case tends to be elastic. For example,
vegetables and fruits, cloths, provision items etc.

9 Habits

When people are habituated for the use of a commodity, they do not care for price changes over
a certain range. For example, in case of smoking, drinking, use of tobacco etc. In that case,
demand tends to be inelastic. If people are not habituated for the use of any products, then
demand generally tends to be elastic.

10. Period of time

Price elasticity of demand varies with the length of the time period. Generally speaking, in the
short period, demand is inelastic because consumption habits of the people, customs and
traditions etc. do not change. On the contrary, demand tends to be elastic in the long period
where there is possibility of all kinds o f changes.

11. Level of Knowledge

Demand in case of enlightened customer would be elastic and in case of ignorant customers, it
would be inelastic.

12. Existence of complementary goods

Goods or services whose demands are interrelated so that an increase in the price of one of
the products results in a fall in the demand for the other. Goods which are jointly demanded
are inelastic in nature. For example, pen and ink, vehicles and petrol, shoes and cocks etc have
inelastic demand for this reason. If a product does not have complements, in that case demand
tends to be elastic. For example, biscuits, chocolates, ice0creams etc. In this case the use of a
product is not linked to any other products.

13.Purchase frequency of a product If the frequency of purchase is very high, the demand
tends to be inelastic. For e.g., coffee, tea, milk, match box etc. on the other hand, if people buy a
product occasionally, in that case demand tends to be elastic for example, durable goods like
radio, tape recorders, refrigerators etc.

Thus, the demand for a product is elastic or inelastic will depend on a number of factors.

Measurement of price elasticity of demand

There are different methods to measure the price elasticity of demand and among them the
following two methods are most important ones.

1. Total expenditure method.

2. Point method.

3. Arc method.
1. Total Expenditure Method

Under this method, the price elasticity is measured by comparing the total expenditure of
the consumers (or total revenue i.e., total sales values from the point of view of the seller)
before and after variations in price. We measure price elasticity by examining the change in
total expenditure as a result of change in the price and quantity demanded for a commodity.

Total expenditure = Price per unit x Total quantity purchased

Price in (Rs.) Qty Demanded Total expenditure Nature of PED

I Case 5.00 2000 10000
4.00 3000 12000 >1
2.00 7000 14000
II Case 5.00 2000 10000
4.00 2500 10000 =1
2.00 5000 10000
III Case 5.00 2000 10000
4.00 2200 8000 <1
2.00 4200 8400

Note:

1. When new outlay is greater than the original outlay, then ED > 1.

2. When new outlay is equal to the original outlay then ED = 1.

3. When new outlay is less than the original outlay then ED < 1.

Graphical Representation
From the diagram it is clear that

1. From A to B price elasticity is greater than one.

2. From B to C price elasticity is equal than one.

3. From C to D price elasticity is lesser than one.

Note :

 It is to be noted that when total expenditure increases with the fall in price and decreases
with a rise in price, then the PED is greater that one.
 When the total expenditure remains the same either due to a rise or fall in price, the PED
is equal to one.
 When total expenditure, decrease with a fall in price and increase with a rise in price,
PED is said to be less than one.

2. Point Method:

Prof. Marshall advocated this method. The point method measures price elasticity of demand. at
different points on a demand curve. Hence, in this case attempt is made to measure small changes in
both price and demand. It can be explained either with the help of mathematical calculation or with the
help of a diagram or graphic representation.

Mathematical Illustrations

Points price is Rs Demand in units

A 10 – 00 40
B 09 – 00 46

In order to measure price elasticity at two points, A and B, the following formula is to be adopted.

In order to find out percentage change in demand, the formula is –

In order to find out percentage change in price, the following formula is employed-
It is clear that on any straight line demand curve, price elasticity will be different at different
points since the demand curve represents the demand schedule and the demand schedule has
different elasticity’s at various alternatives prices.

Graphical representation

The simplest way of explaining the point method is to consider a linear or straight- line demand
curve. Let the straight – line demand curve be extended to meet the two axis X and Y when a
point is plotted on the demand curve, it divides the curve into two segments. The point elasticity
is measured by the ratio of lower segment of the demand curve below the given point to the
upper segment of the curve above the point. Hence.

In short, e = L / U where e stands for Point elasticity, L for lower segment and U for upper
segment.

In the diagram AB is the straight line demand curve and P is a given point. PB is the lower
segment and PA is the upper segment.
 In the diagram, AB is the straight-line demand curve and P is a give point PB is the lower
segment and PA is the upper segment.

E = L / U = PB / PA

If after the actual measurement of the two parts of the demand curve, we find that

PB = 3 CMs and PA = 2 CMs then elasticity at Point P is 3 / 2 = 1.5

If the demand curve is non–linear then we have to draw a tangent at the given point extending it
to intersect both axes. Point elasticity is measure by the ratio of the lower part of the tangent
below that given point to the upper part of the tangent above the point. Then, elasticity at point P
can be measured as PB / PA.

In case of point method, the demand function is continuous and hence, only marginal changes
can be measured. In short, Ep is measured only when changes in price and quantity demanded
are small.

3. Arc Method

This method is suggested to measure large changes in both price and demand. When elasticity is
measured over an interval of a demand curve, the elasticity is called as an interval or Arc
elasticity. It is the average elasticity over a segment or range of the demand curve. Hence, it
is also called as average elasticity of demand.

The following formula is used to measure Arc elasticity.

Illustration

P1 = original price 10 – 00. Q1 = original quantity = 200 units

P2 = New price 05 – 00 Q2 = New quantity = 300units

By substituting the values in to the equation, we can find out Arc elasticity of demand.

In the diagram, in order to measure arc elasticity between two points M & N on the demand
curve, one has to take the average of prices OP1 and OP2 and also the average quantities of Q1
& Q2.

Practical application of price elasticity of demand

1. Production planning

It helps a producer to decide about the volume of production. If the demand for his products is
inelastic, specific quantities can be produced while he has to produce different quantities, if the
demand is elastic.

2. Helps in fixing the prices of different goods

It helps a producer to fix the price of his product. If the demand for his product is inelastic, he
can fix a higher price and if the demand is elastic, he has to charge a lower price. Thus, price-
increase policy is to be followed if the demand is inelastic in the market and price-decrease
policy is to be followed if the demand is elastic. Similarly, it helps a monopolist to practice price
discrimination on the basis of elasticity of demand.

3. Helps in fixing the rewards for factor inputs

Factor rewards refers to the price paid for their services in the production process. It helps
the producer to determine the rewards for factors of production. If the demand for any factor unit
is inelastic, the producer has to pay higher reward for it and vice-versa.

4. Helps in determining the foreign exchange rates

Exchange rate refers to the rate at which currency of one country is converted in to the
currency of another country. It helps in the determination of the rate of exchange between the
currencies of two different nations. For e.g. if the demand for US dollar to an Indian rupee is
inelastic, in that case, an Indian has to pay more Indian currency to get one unit of US dollar and
vice-versa.

5. Helps in determining the terms of trade

It is the basis for deciding the ‘terms of trade’ between two nations. The terms of trade implies
the rate at which the domestic goods are exchanged to foreign goods. For e.g. if the demand
for Japan’s products in India is inelastic, in that case, we have to pay more in terms of our
commodities to get one unit of a commodity from Japan and vice-versa.

6. Helps in fixing the rate of taxes

Taxes refer to the compulsory payment made by a citizen to the government periodically
without expecting any direct return benefit from it. It helps the finance minister to formulate
sound taxation policy of the country. He can impose more taxes on those goods for which the
demand is inelastic and fewer taxes if the demand is elastic in the market.

7. Helps in Declaration of Public Utilities

Public utilities are those institutions which provide certain essential goods to the general
public at economical prices. The Government may declare a particular industry as ‘public
utility’ or nationalize it, if the demand for its products is inelastic.

1. Poverty in the Midst of Plenty:

The concept explains the paradox of poverty in the midst of plenty. A bumper crop of rice or
wheat instead of bringing prosperity to farmers may actually bring poverty to them because the
demand for rice and wheat is inelastic. Thus, the concept of price elasticity of demand has great
practical application in economic theory.
INCOME ELASTICITY OF DEMAND

Income elasticity of demand may be defined as the ratio or proportionate change in the
quantity demanded of a commodity to a given proportionate change in the income. In short,
it indicates the extent to which demand changes with a variation in consumers income. The
following formula helps to measure Ey.

Original demand = 400 units Original Income = 4000-00

New demand = 700 units New Income = 6000-00

Generally speaking, Ey is positive. This is because there is a direct relationship between income
and demand, i.e. higher the income; higher would be the demand and vice-versa. On the basis of
the numerical value of the co-efficient, Ey is classified as greater than one, less than one, equal to
one, equal to zero, and negative. The concept of Ey helps us in classifying commodities into
different categories.

1. When Ey is positive, the commodity is normal [used in day-to-day life]

2. When Ey is negative, the commodity is inferior.

3. When Ey is positive and greater than one, the commodity is luxury.

4. When Ey is positive, but less than one, the commodity is essential.

5. When Ey is zero, the commodity is neutral e.g. salt, match box etc.

Cross Elasticity Of Demand

It may be defined as the proportionate change in the quantity demanded of a particular

commodity in response to a change in the price of another related commodity.

In the words of Prof. Watson cross elasticity of demand is the percentage change in quantity
associated with a percentage change in the price of related goods.
Generally speaking, it arises in case of substitutes and complements. The formula for calculating
cross elasticity of demand is as follows.

Ec = Percentage change in quantity demanded commodity X

Percentage change in the price of Y

Price of Tea rises from Rs. 4-00 to 6 -00 per cup

Demand for coffee rises from 50 cups to 80 cups.

Cross elasticity of coffee in this case is 1.6.

It is to be noted that-

1. Cross elasticity of demand is positive in case of good substitutes e.g. coffee and tea.

2. High cross elasticity of demand exists for those commodities which are close substitutes. In
other words, if commodities are perfect substitutes For example Bata or Corona Shoes, close up
or pepsodent tooth paste, Beans and ladies finger, Pepsi and coca cola etc.

3. The cross elasticity is zero when commodities are independent of each other. For example,
stainless steel, aluminum vessels etc.

4. Cross elasticity between two goods is negative when they are complementary. In these cases,
rise in the price of one will lead to fall in the quantity demanded of another commodity For
example, car and petrol, pen and ink.etc.

Advertising or Promotional Elasticity Of Demand.

Most of the firms, in the present marketing conditions spend considerable amounts of money on
advertisement and other such sales promotional activities with the object of promoting its sales.

Advertising elasticity refers to the responsiveness demand or sales to change in advertising

or other promotional expenses.

The formula to calculate the advertising elasticity is as follows.

Original sales = 10,000 units original advertisement expenditure = 800-00

New sales = 50,000 units new advertisement expenditure = 2000-00

In the above example, advertising elasticity of demand is 1.67. it implies that for every one time
increase in advertising expenditure, the sales would go up 1.67 times Thus, Ea is more than one.