Elasticity of Demand

Elasticity of Demand

The Law of Demand explains the direction of change in demand due to change in the price. It fails to explain the rate of change in demand due to a given change in price. Elasticity of demand explains the rate of change in quantity demanded due to a given change in price.

“Elasticity of demand is, therefore, a technical term used by the Economists to describe the degree of responsiveness of the Quantity demand for a commodity to a change in its price”.

- Stonier And Hague

Elastic demand or More Elastic demand

Demand for a commodity is said to be “Elastic” when the quantity demanded increases by a large amount due to a little fall in the price and decreases by a large

amount due a little rise in the price. To be more scientific, Elastic demand is called as “More Elastic Demand”.

1. Types of Elasticity of Demand

Price Elasticity of Demand

Price elasticity of demand is commonly known as elasticity of demand. This is because price is the most influential factor affecting demand. “Elasticity of demand measures the responsiveness of the quantity demanded to changes in the price”.

1. Price Elasticity of Demand: The price elasticity of demand, commonly known as the elasticity of demand refers to the responsiveness and sensitiveness of demand for a product to the changes in its price. In other words, the price elasticity of demand is equal to

where, ΔQ = Q₁ –Q₀, 

ΔP = P₁ – P₀, 

Q₁= New quantity,

Q₀= Original quantity, 

P₁ = New price, 

P₀ = Original price.

2. Income Elasticity of Demand: The income is also a 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.

3. Cross Elasticity of Demand: The cross elasticity of demand refers to the percentage change in quantity demanded for one commodity as a result of a small change in the price of another commodity. This type of elasticity usually arises in the case of the interrelated goods such as substitutes and complementary goods. The cross elasticity of demand for goods X and Y can be expressed as: 

4. Advertising Elasticity of Demand: The responsiveness of the change in demand due to the change in advertising or other promotional expenses, is known as advertising elasticity of demand. It can be expressed as:

2. Levels or Degrees of Price Elasticity of Demand

Definition: The Price Elasticity of Demand is commonly known as the elasticity of demand, which refers to the degree of responsiveness of demand to the change in the price of the commodity.

1. Perfectly Elastic Demand (Ep = ∞):

The demand is said to be perfectly elastic when a slight change in the price of a commodity causes an infinite change in its quantity demanded. Such as, even a small rise in the price of a commodity can result in greater fall in demand even to zero. In some cases a little fall in the price can result in the increase in demand to infinity. In perfectly elastic demand the demand curve is a horizontal straight line parallel to x axis.

2. Perfectly Inelastic Demand (Ep =0):

When there is no change in the demand for a product due to the change in the price, then the demand is said to be perfectly inelastic. Here, the demand curve is a vertical straight line which shows that the demand remains unchanged irrespective of change in the price., i.e. quantity OQ remains unchanged at different prices, P1, P2, and P3.

3. Relatively Elastic Demand (Ep>1):

The demand is relatively elastic when the proportionate change in the demand for a commodity is greater than the proportionate change in its price. Here, the demand curve is gradually sloping which shows that a proportionate change in quantity from 5 to 10 is greater than the proportionate change in the price from 11 to 10. Change in demand is:

10–5/5 × 100 = 100%

Change in price =10%. Hence, it is more elastic demand.

4. Relatively Inelastic Demand (Ep<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. 

It is also called as the elasticity less than unity. Here the demand curve is steeply 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 Op2.

5. Unitary Elastic Demand (Ep =1): 

The demand is unitary elastic when the proportionate change in the price of a product results in the same propionate change in the quantity demanded. Here the shape of the demand curve is a rectangular hyperbola, which shows that area under the curve is equal to one.

Here OP₀ R₀Q₀ = OP₁ R₁Q₁

3. Determinants of Elasticity of Demand

There are many factors that determine the degree of price elasticity of demand. Some of them are described below:

a. Availability of Substitutes:

If close substitutes are available for a product, then the demand for that product tends to be very elastic. If the price of that product increases, buyers will buy its substitutes; hence fall in its demand will be very large. Hence, price elasticity will be larger. Eg. Vegetables.

For salt no close substitutes are available. Hence even if price of salt increases the fall in demand may be zero or less. Hence salt is price inelastic.

b. Proportion of consumer’s income spent’ if smaller proportion of consumer’s income is spent on particular commodity say X, price elasticity of demand for X will be smaller. Take for example salt, people spend very small proportion of their income on salt. Hence, salt will have small elasticity of demand, or inelastic.

c. Number of uses of commodity:

If a commodity is used for greater number of uses, its price elasticity will also be larger. For example, milk is used as butter milk, curd, ghee and for making ice cream etc. Hence, even the small fall in the price of milk, will tempt the consumers to use more milk for many purposes. Hence milk has greater price elasticity of demand.

d. Complementarity between goods:

For example, along with petrol, lubricating oil is also used for running automobiles. Here, a rise in the price of lubricating oil may not reduce the demand for lubricating oil. Hence, the complementary good, here, lubricating oil, will be price inelastic.

e. Time: In the long run, the price elasticity of demand for many goods will be larger.

This is so because, in the long run many substitutes can be discovered or invented.

Therefore, the demand is generally more elastic in the long run, than in the short run.

In the short run bringing out new substitutes is difficult.

4. Measurement of Elasticity of Demand

There are three methods of measuring price elasticity of demand.

1. The Percentage Method

It is also known as ratio method, when we measure the ratio as:

2. Total Outlay Method

Marshall suggested that the simplest way to decide whether demand is elastic or inelastic is to examine the change in total outlay of the consumer or total revenue of the firm.

Total Revenue = ( Price x Quantity Sold)

TR = (P x Q)

Where there is inverse relation between Price and Total Outlay, demand is elastic. Direct relation means inelastic. Elasticity is unity when Total Outlay is constant.

3. Point or Geometrical Elasticity

When the demand curve is a straight line, it is said to be linear. Graphically, the point elasticity of a linear demand curve is shown by the ratio of the segments of the line to the right and to the left of the particular point.

Where ‘e_p’ stands for point elasticity, ‘L’ stands for the lower segment and ‘U’ for the upper segment.

5. Importance of Elasticity of Demand

The concept of elasticity of demand is of much practical importance.

1.        Price fixation: Each seller under monopoly and imperfect competition has to take into account elasticity of demand while fixing the price for his product. If the demand for the product is inelastic, he can fix a higher price.

2.        Production: Producers generally decide their production level on the basis of demand for the product.

3.        Distribution: Elasticity of demand also helps in the determination of rewards for factors of production.

4.        International trade: Elasticity of demand helps in finding out the terms of trade between two countries. Terms of trade depends upon the elasticity of demand for the goods of the two countries.

5.        Public finance: Elasticity of demand helps the government in formulating tax policies. For example, for imposing tax on a commodity.

6.        Nationalization: The concept of elasticity of demand enables the government to decide over nationalization of industries.