Friday, February 21, 2014

ELASTICITY OF DEMAND


ELASTICITY OF DEMAND

Meaning of Elasticity

Law of demand explains the directions of changes in demand. A fall in price leads to an increase in quantity demanded and vice versa. But it does not tell us the rate at which demand changes to change in price. The concept of elasticity of demand was introduced by Marshall. This concept explains the relationship between a change in price and consequent change in quantity demanded. Nutshell, it shows the rate at which changes in demand take place.

Elasticity of demand can be defined as “the degree of responsiveness in quantity demanded to a change in price”. Thus it represents the rate of change in quantity demanded due to a change in price.

There are mainly three types of elasticity of demand:

1.      Price Elasticity of Demand.
2.      Income Elasticity of Demand. and
3.      Cross Elasticity of Demand.

Price Elasticity of Demand

Price Elasticity of demand measures the change in quantity demanded to a change in price. It is the ratio of percentage change in quantity demanded to a percentage change in price. This can be measured by the following formula.

Price Elasticity = Proportionate change in quantity demanded Proportionate change in price
OR

Ep = Change in Quantity demanded / Quantity demanded Change in Price/price

OR Ep = (Q2-Q1)/Q1
(P2-P1) /P1  ,

Where: Q1 = Quantity demanded before price change Q2 = Quantity demanded after price change P1 = Price charged before price change

P2 = Price charge after price change.

There are five types of price elasticity of demand. (Degree of elasticity of demand) Such as perfectly elastic demand, perfectly inelastic demand, relatively elastic demand, relatively inelastic demand and unitary elastic demand.

1)  Perfectly elastic demand (infinitely elastic)

When a small change in price leads to infinite change in quantity demanded, it is called perfectly elastic demand. In this case the demand curve is a horizontal straight line as given below. (Here ep= ).


2) Perfectly inelastic demand

In this case, even a large change in price fails to bring about a change in quantity demanded. I.e. the change in price will not affect the quantity demanded and quantity remains the same whatever the change in price. Here demand curve will be vertical line as follows and ep= 0
3) Relatively elastic demand

Here a small change in price leads to very big change in quantity demanded. In this case demand curve will be fatter one and ep=>1

4) Relatively inelastic demand

Here quantity demanded changes less than proportionate to changes in price. A large change in price leads to small change in demand. In this case demand curve will be steeper and ep=<1
5)  Unit elasticity of demand ( unitary elastic)

Here the change in demand is exactly equal to the change in price. When both are equal, ep= 1, the elasticity is said to be unitary.
The above five types of elasticity can be summarized as follows


SL No
type
Numerical
description
Shape of curve




expression











1
Perfectly elastic
α
infinity
Horizontal









2
Perfectly inelastic
0
Zero
Vertical









3
Unitary elastic
1
One
Rectangular






hyperbola









4
Relatively elastic
>1
More than
Flat





one










5
Relatively inelastic
<1
Less than
Steep





one






















INCOME ELASTICITY OF DEMAND
Income elasticity of demand shows the change in quantity demanded as a result of a change in consumers‟ income. Income elasticity of demand may be stated in the form of formula:

Ey = Proportionate Change in Quantity Demanded

Proportionate Change in Income

Income elasticity of demand mainly of three types:
1)  Zero income Elasticity.
2)  Negative income Elasticity
3)  Positive income Elasticity.

Zero income elasticity – In this case, quantity demanded remain the same, eventhogh money income increases.ie, changes in the income doesn‟t influence the quantity demanded (Eg.salt,sugar etc). Here

Ey (income elasticity) = 0

Negative income elasticity -In this case, when income increases, quantity demanded falls.Eg, inferior goods. Here Ey = < 0.
Positive income Elasticity - In this case, an increase in income may lad to an increase in the quantity demanded. i.e., when income rises, demand also rises. (Ey =>0) This can be further classified in to three types:

a)      Unit income elasticity; Demand changes in same proportion to change in income.i.e, Ey

= 1

b)      Income elasticity greater than unity: An increase in income brings about a more than proportionate increase in quantity demanded.i.e, Ey =>1

c)      Income elasticity less than unity: when income increases quantity demanded is also increases but less than proportionately. I.e., Ey = <1

Business decision based on income elasticity.

The concept of income elasticity can be utilized for the purpose of taking vital business decision. A businessman can rely on the following facts.

If income elasticity is greater than Zero, but less than one, sales of the product will increase but slower than the general economic growth

If income elasticity is greater than one, sales of his product will increase more rapidly than the general economic growth.

Firms whose demand functions have high income elasticity have good growth opportunities in an expanding economy. This concept helps manager to take correct decision during business cycle and also helps in forecasting the effect of changes in income on demand.

Cross Elasticity of Demand

Cross elasticity of demand is the proportionate change in the quantity demanded of a commodity in response to change in the price of another related commodity. Related commodity may either substitutes or complements. Examples of substitute commodities are tea and coffee. Examples of compliment commodities are car and petrol. Cross elasticity of demand can be calculated by the following formula;

Cross Elasticity = Proportionate Change in Quantity Demanded of a Commodity Proportionate Change in the Price of Related Commodity

If the cross elasticity is positive, the commodities are said to be substitutes and if cross elasticity is negative, the commodities are compliments. The substitute goods (tea and Coffee) have positive cross elasticity because the increase in the price of tea may increase the demand of the coffee and the consumer may shift from the consumption of tea to coffee.

Complementary goods (car and petrol) have negative cross elasticity because increase in the price of car will reduce the quantity demanded of petrol.

The concept of cross elasticity assists the manager in the process of decision making. For fixing the price of product which having close substitutes or compliments, cross elasticity is very useful.

Advertisement Elasticity of Demand

Advertisement elasticity of demand (Promotional elasticity of demand) measure the responsiveness of demand due to a change in advertisement and other promotional expenses. This can be measured by the following formula;

Advertisement Elasticity =     Proportionate Increase in Sales
Proportionate increase in Advertisement expenditure.

There are various determinants of advertisement elasticity, they are;

1.  Type of commodity- elasticity will be higher for luxury, new product, growing product etc.,
2.      Market share – larger the market share of the firm lower will be promotional elasticity.

3.      Rival‟s reaction – if the rivals react to increase in firm‟s advertisement by increasing their own advertisement expenditure, it will reduce the advertisement elasticity of the firm.

4.      State of economy – if economic conditions are good, the consumers are more likely to respond to the advertisement of the firm.

Advertisement elasticity helps in the process of decision making. It helps to deciding the optimum level of advertisement and promotional cost. If the advertisement elasticity is high, it is profitable to spend more on advertisement. Hence, advertisement elasticity helps to decide optimum advertisement and promotional outlay.

Importance of Elasticity.

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

1.      Production- Producers generally decide their production level on the basis of demand for their product. Hence elasticity of demand helps to fix the level of output.

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

3.      Distribution- Elasticity helps in the determination of rewards for factors of production. For example, if the demand for labour is inelastic, trade union can raise wages.

4.      International trade- This concept helps in finding out the terms of trade between two countries. Terms of trade means rate at which domestic commodities is exchanged for foreign commodities.

5.      Public finance- This assists the government in formulating tax policies. In order to impose tax on a commodity, the government should take into consideration the demand elasticity.

6.      Nationalization- Elasticity of demand helps the government to decide about nationalization of industries.

7.      Price discrimination- A manufacture can fix a higher price for the product which have inelastic demand and lower price for product which have elastic demand.

8.      Others- The concept elasticity of demand also helping in taking other vital decision Eg.Determining the price of joint product, take over decision etc..
Determinants of elasticity.

Elasticity of demand varies from product to product, time to time and market to market. This is due to influence of various factors. They are;

1.      Nature of commodity- Demand for necessary goods (salt, rice,etc,) is inelastic. Demand for comfort and luxury good are elastic.

2.      Availability/range of substitutes – A commodity against which lot of substitutes are available, the demand for that is elastic. But the goods which have no substitutes, demand is inelastic.

3.      Extent /variety of uses- a commodity having a variety of uses has a comparatively elastic demand.Eg.Demand for steel, electricity etc..

4.      Postponement/urgency of demand- if the consumption of a commodity can be post pond, then it will have elastic demand. Urgent commodity has inelastic demand.

5.      Income level- income level also influences the elasticity. E.g. Rich man will not curtail the consumption quantity of fruit, milk etc, even if their price rises, but a poor man will not follow it.

6.      Amount of money spend on the commodity- where an individual spends only a small portion of his income on the commodity, the price change doesn‟t materially affect the demand for the commodity, and the demand is inelastic... (match box, salt Etc)

7.      Durability of commodity- if the commodity is durable or repairable at a substantially less amount (eg.Shoes), the demand for that is elastic.

8.      Purchase frequency of a product/time –if the frequency of purchase of a product is very high, the demand is likely to be more price elastic.

9.      Range of Prices- if the products at very high price or at very low price having inelastic demand since a slight change in price will not affect the quantity demand.

10.  Others – the habit of consumers, demand for complimentary goods, distribution of income and wealth in the society etc., are other important factors affecting elasticity.