Elasticity of Demand

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ELASTICITY OF DEMAND Demand varies with price. But the variation is not uniform in all cases. Sometimes demand is greatly responsive to price and at times nominal or not so responsive. Economists use the term “Elasticity” for this response. To measure the E of D , 2 variables are considered- Demand and Determinants of demand. For Measuring the E coefficient , thus a ratio is made of the two variables. E of D= % change in qt. demanded / % change in determinant of demand There are 3 elasticities of D Price E Income E Cross Price E or just Cross Elasticity

Price Elasticity of Demand:

Price Elasticity of Demand The price elasticity of demand (PED) is an elasticity that measures the nature and percentage of the relationship between changes in quantity demanded of a good and changes in its price , other determinants remaining constant. The extent of response of demand for a commodity to a given change in price, other demand determinants remaining constant , is PE of D. It is the ratio of the relative change in demand and price variables.

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The co-efficient of price elasticity (e) is measured as: E = Since relative change of variables can be measured either in terms of % change or proportional change, the PE co-efficient can be measured alternatively as E = % change in Qt. demanded % change in price Proportional change in Qt. demanded Proportional change in price Q/Q P/P = Q/Q X P/P or Q/ P = P/Q Where Q= original demand (q1) P= the original price(p1) Q = the change in demand = new D(Q2)-old demand(Q1) Thus Q= Q2-Q1 P = P2-P1

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P = P2-P1 = 21-20 =1 P=P1=20 Q= Q2- Q1 = 96-100= -4 Q=Q1=100 E = -4/100X20/1= 4/5= -0.8 EOD is less than 1. (minus sign ignored) P of Apples (Rs) Qt. Demanded (kg) 20 (P1) 100(Q1) 21 (P2) 96(Q2)


Deductions Depending upon the magnitudes and proportional changes involved in data on demand and prices, one may obtain various numerical values of co-efficient of PE, ranging rom zero to infinity. When PE Co-efficient is > than unity (e>1), it is said to be price elastic. If e<1, the product is considered to be price inelastic. This knowledge is very useful in determining pricing policy and other business decisions.

Types of Price Elasticity:

Types of Price Elasticity Marshal suggested a 3-fold classofocation of types of PED Unit EOD (e=1) Elastic D (e>1) Inelastic D (e<1) Modern Economist have stated 5 kinds of PE Perfectly Elastic D Perfectly Inelastic D Relatively Elastic D Unitary elastic D Relatively Inelastic D

Price Elasticity of Demand:

Price Elasticity of Demand Numerical Value Terminology Description E= infinity Perfectly (or infinitely) Elastic D Consumers have infinite demand at a particular price and none at all at an even slightly higher than this given price. E=0 Perfectly (or completely) Inelastic D D remains unchanged , whatever be the change in price. E>1 Relatively Elastic D Qt. demanded changes by a large percentage as does price E<1 Relatively Inelastic D Qt. demanded changes by a smaller percentage as does price E=1 Unitary Elastic D Qt. demanded changes by exactly the same percentage as does price.

Perfectly E Demand (e=infinity):

Perfectly E Demand (e=infinity) An endless demand (infinite) demand at the given price is PED. With Slight increase in price of a commodity, the stops buying it. But the decrease in price the demand curve will shift downwards. PED is a theoretical extremity, hardly encountered in practice. D curve is straight horizontal line P increases D= 0 P1 P2 P D1D1 DD Price Qt Purchased/unit of time

Perfectly Inelastic Demand (e=0):

Perfectly Inelastic Demand (e=0) When demand of a commodity shows no response at all to a change in Price, the demand remains same. D Curve is straight vertical line. Again a theoretical consideration but salt has PID as it is an absolute necessity. P1 P3 P2 DD Price Qt Purchased/unit of time

Relatively Elastic D or More Elastic Demand (e>1):

Relatively Elastic D or More Elastic Demand (e>1) When the proportion of change in the qt. demanded is greater than that of the price, the demand is said to be relatively elastic. The numerical value lies between 1 and infinity. Represented by gradually sloping rather flatter D curve. Realistic and practical concept. P1 P2 DD Price Qt Purchased/unit of time M1 M2

Relatively Inelastic D or Less Elastic Demand (e<1):

Relatively Inelastic D or Less Elastic Demand (e<1) When the proportional of change in the quantity demand is less than that of price, the D is relatively inelastic. Numerical values lies between 0 and 1. Demand curve is rapidly sloping , rather steeper curve. Realistic and practical concept. P1 P2 DD Price Qt Purchased/unit of time M1 M2

Unitary Elastic Demand (e=1):

Unitary Elastic Demand (e=1) When the proportion of change in demand is exactly the same as the change in price, the D is said to be unitary elastic. Numerical value of UE=1. D curve would be rectangular hyperbola. P1 P2 DD Price Qt Purchased/unit of time M1 M2

Factors Influencing EOD:

Factors Influencing EOD Nature of Commodity : Luxury, comfort and necessity goods. Luxury and comfort goods are price elastic. Ex: Radio, furniture, car, etc. Necessity goods are price inelastic Ex: Food grains, cloth, salt, etc. Availability of substitutes : Commodities having close substitutes - D = elastic Ex: Tea, coffee, coke No substitutes – D = inelastic Ex: salt, potatoes, onion. Number of Uses: Single (less elastic) and multi-use goods (high elastic). Ex: coal is used by railways (inelastic) and consumers as fuel (elastic)

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Consumer’s Income: Larger Income-demand for overall commodities- relatively inelastic. Millionaire –rarely affected. Redistribution of income in favour of low income people may tend to make demand for some goods relatively elastic. Height of Price and Range of Price change: In luxury goods , for a small change in price, the demand is inelastic. If large change in price then D is elastic. Perishable goods: change in P – D is inelastic (potatoes, onions) Proportion of expenditure: Cheap or small expenditure items tend to have more demand inelasticity than expensive or large expenditure items Ex: Fortnightly cine goer, Alternate day cine goer. Durability of Commodity : Durable goods: D inelastic in short run. Perishable goods: D- elastic. Ex: Milk, Vegetables

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Habit: E< 1. Ex: Cigarettes- inelastic demand Complementary goods : Goods jointly demanded have less elasticity (Inelasticity ): Ex: Ink, Pen. Time : In SR –D is less elastic. In LR –D is more elastic. D for certain goods can be postponed in SR but has to be satisfied in LR. Recurrence of Demand : D of a commodity is of recuring nature, its PE is higher. Ex: Pizza, Buger, etc. But less for goods purchased only once. Ex: Bicycles, Tape recorders. Possibility of postponement : If the purchase is postponed, D will be elastic. Ex: Cement, Bricks, etc In consumption goods- Inelastic

Practical Applications of PED:

Practical Applications of PED Production Planning Helps in fixing the prices of different goods Helps in fixing the rewards of factor inputs Helps in determining the foreign exchange rates Helps in determining the terms of trade Helps in fixing the rate of taxes Helps in Declaration of Public Utilities Poverty in the Midst of Plenty

Income Elasticity:

Income Elasticity Income is a major determinant of D for a number of goods. D= f(m) IED measures the degree of responsiveness of demand for a good to changes in the consumer’s income. DEF: The IE is defined as a ratio percentage or proportional change in the quantity demanded to the % or proportional change in income.

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IE= coefficient is thus measured as IE = % change in Qt. demanded % change in income Em= % Q/ M = Q/Q X M/ M or Q/ M = M/Q Where Q= original demand (q1) M= Initial Income (M1) Thus Q= Q2-Q1 M = M2-M1

Types of IE:

Types of IE Unitary ED (Em=1) IE of D > unity (Em>1) IE of D <unity (Em<1) Zero Income Elasticity of demand. (Em=0) -ve IED (Em<0) Income D2- em>1 D1-em=1 D3-em>1 D4-em=0 D5 –em<0 Demand IE helps us in classifying the goods: When em is +ve, G = normal type. When em is -ve, inferior goods. Bajra, jowar When em is +ve and greater than 1 , G = luxury. Ex: TV When em is +ve but less than 1 , G = Essential good. Ex: food grains When em=0, G = neutral. Ex: salt, mach box, etc IE >1 : Superior Goods IE>=0 and <= 1: Normal Goods IE<0 : Inferior Goods

Determinants of IED:

Determinants of IED Nature of the Product Level of Income in a country Time Period

Practical Applications of IE:

Practical Applications of IE Rate of Growth of the firm Housing Development Strategies Ensuring Stability in Production Long term Business Planning Production Planning and Market Strategy

Cross Elasticity of Demand:

Cross Elasticity of Demand Def : The cross elasticity of demand reers to the degree of responsiveness of demand for a commodity to a given change in the price of some related commodity. The cross elasticity of D between any 2 goods X and Y is measures by dividing the proportionate change in the quantity demanded of X by the proportionate change in the price of Y. +ve CED between 2 goods = substitutes. -ve CED between 2 goods= complementary CED= Prop or % change in D for X Prop or % change in Price of Y Ec or Exy= Qx /Qx Py/Py= Qx/ Py X Py/Qx Where Qx = change in qt. D for commodity X Qx= Initial D for X Py, Initial Price of Y Py=change in price of Y

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Substitutes Unrelated Complementary D for comm X Exy > 0 D for comm X D for comm X Exy < 0 Exy = 0 P of Y P of Y P of Y Substitutes – High and Positive CED Complementary- Negative CED Independent – Zero CED

Practical Applications of CED:

Practical Applications of CED HLL, the leading FMCG manufacturer offers several soaps for the middle income segment- Hamam , Lux , Breeze, Liril , Lifebuoy Gold, etc. These soaps are goods substitutes for each other and therefore CED between them is very high. If HLL increases the price of Lux significantly, the D for Lux goes down and the D for other soaps like Breeze, Liril increases. Considering CED, HLL will be fixing appropriate prices for all its soaps in such a way that any increase or decrease in the price of a product should have + ve influence on the organization’s profits. Firms producing similar kinds or products and services, i.e operating in same industry have + ve CED.P&G and HLL have a PED between each other in fabric and home care products. Hence , if HLL plans to increase the price of Surf, a washing detergent, the demand for P&G’s similar products like Ariel and Tide will increase.

Advertising or Promotional EOD:

Advertising or Promotional EOD Qx = f(A) Qx= D for product X measured through Qt. sold in the market. A= Adv. Expenditure of the firm Ea = % or Prop change in sales % or prop change in advt. expenditure Ea = % Q / % A = ( Q/ A) X (A/Q) Q= Qt. of sales A = amount of adv. expenditure Determinants: Effect of time Stages of Product Advertising by competitors

Practical Application of AEOD:

Practical Application of AEOD Determining the level of Prices Formulating Appropriate sales promotional strategy Manipulating the sales

Practical Application of EOD:

Practical Application of EOD To businessmen: Pricing Policy To the govt and Finance Minister- Fiscal Policy and Taxation International Trade- Export and Import Policies. To Policy Makers: Mystery of how farmers may remain poor despite a bumper crop. (Paradox of Plenty) To Trade Unionists: For wage bargaining.

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