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DEMAND – ELASTICITY

The law of demand studies the inverse relationship between demand and price at low

price demand will be more and at high price demand is low. It tells us only the direction of

change in price and quantity of demand. The concept of elasticity of demand is one of the

original contribution of Dr. Marshall. He studied the concept of elasticity of demand only

with reference to price changes. But income & cross elasticity of demand fall outside the

scope of his study.

price. If a small change in price a large change in demand or consequent change in demand is

known as elasticity of demand. A small change in price results in a large change in demand,

then the demand is elastic. A large change in price results only a small or slight change

(effect) of demand, the demand is inelastic.

Difference between law of demand and principles of elasticity of demand brings clear

understanding of elasticity of demand. The law demand tells only the direction of change in

price and quantity demanded, but the concepts of demand elasticity clearly explain how much

change are happened in demand due to changes in price. The expression “how much is

important” this indicated the concept of elasticity of demand is basically a question of

measurement.

Dr. A. F. Marshall defines “The elasticity of demand in a market is great or small according

to the amount demanded increases much or little for a given fall in the price, and diminishes

much or little for a given rise in price”

From the above definition, it is clear elasticity of demand is primarily related to extension or

contraction of demand for a fall or rise in price. Hence it is referred to as price elasticity of

demand.

2). Income elasticity of demand

3). Cross elasticity of demand

Price elasticity of demand is one of the important concepts of elasticity which is used to

describe the effects of change in price on quantity demanded. The measure of relative

responsiveness of quantity demand to price along a given demand curve is known as price

elasticity of demand (PED). Marshall had given a clear formulation of price elasticity as the

ratio of a relative change in quantity to a relative change in price.

(Or)

E(d) = Q / P

Price elasticity of demand in the ratio of proportionate change in the quantity demand of a

given commodity to a proportionate change in its price.

= [▲ Q / Q ] / [▲ P / P]

Therefore E (Pd) = [▲ Q / Q] [P / ▲ P]

Generally the co-efficient of price elasticity of demand holds a negative sign, because there is

an inverse relation between the price and quantity demanded.

The elasticity of demand = 80 / -20 = - 4, for sake of convenience we ignore the negative

sign and take into account only the numerical value of the elasticity. Elasticity of demand is

linked to law of demand and demand curve is always negatively sloped downward; hence the

sign of elasticity will also be negative. For studying the negative will be ignored.

Marshall studies the concept of elasticity only with reference to price change. In the

case of price elasticity if a change in price brings about a change in demand .

1). Perfectly elastic demand: - It means a change in price above a particular level causes the

quantity demanded to be infinity (œ)

A change in price below a particular level causes an infinite increase in the quantity

demand. For perfectly elastic demand, demand curve is horizontal straight line parallel to X –

aces. It indicates infinity (œ) elastic

D D

Price

O Q X

Quantity

2). Perfectly inelastic demand :- In this case what ever may be the change in price, the

quantity demanded will be remain the same, mean that there will constant demand.

It means elasticity of demand is Zero (0), Price elasticity of demand curve is vertical

straight line parallel to Y– aces. It indicates Zero (0) inelastic.

d

P

Price

O Q X

Quantity

When price increases from op to op1 the quantity demand is remain same, elasticity is “Zero”

3). Unitary elasticity of demand: If a proportionate change in price exactly brings about the

same proportionate change in demand. It means elasticity of demand is “one” - 1. The

demand curve is rectangular hyperbole.

Y D

Price

P1 D

O q1 X

q Quantity

When price falls to OP to OP1, quantity demanded increases form OQ to OQ1,. Thus a

change in price has resulted in an equal change in the quantity demanded. So price elasticity

of demand is equal to Unity.

4). Relatively elasticity of demand: If a proportionate change in price brings about a more

than proportionate change in demand. It mean elasticity of demand is more than one (>1).

The demand curve is represented by a gradually sloping demand curve.

Ex: Change in price 25%, demand will be 50% = 50/25 = 2 >1

Y D

P

P1

Price D

O Q Q1 X

Quantity

When price falls from op to op1 the amount demanded increases form oq to oq1, a small

change is the price leads to a higher increase in the demand.

5). Relatively inelasticity of demand: If a proportionate change in price brings about a less

than proportionate change in demand. It mean elasticity of demand is less than one (<1). The

demand curve is represented by a gradually sloping demand curve.

Ex: Change in price 50%, Demand will be 25%: 25/50 = 0.5 <1

Y D

P

P1

Price

D

O Q Q1 X

Quantity

When price falls from op to op1 the amount demanded increases form oq to oq1, a large

change is the price leads to a smaller increase in the demand.

For practical purpose, it is not enough to know whether the demand is elastic or inelastic. It is

more useful to find out what exact the demand is elastic or inelastic. There are different

methods to measure the price elasticity of demand and among them the following 3 methods

are generally used.

1). Total Expenditure or Out lay method

2). Point method

3). Arc method

This method is given by Alfred Marshall. Under this method the total expenditure of a

commodity will be compared. In this method elasticity can be measured by comparing the

total expenditure on the commodity before and after change in price.

1). Relatively elastic demand

The demand is said to be elastic or greater than one when the total expenditure

increases as the price falls. When the total expenditure decreases as the price rise.

The measurement of 3 types of elasticity may be seen the following table and figure

(Demand schedule showing elasticity greater, unit and less than unit)

REVENUE

1 1.50 3 4.50

2 1.25 4 5.00

3 1.00 5 5.00

4 0.75 6 4.50

5 0.60 7 4.20

6 0.50 8 4.00

In the above table between S. No 1 and 2 cases the demand is elastic. Because when price fall

1.50 to 1.25, the demand increases from 3 to 4 units. We can see conversely also S.no 2 and 1

REVENUE

1 1.50 3 4.50

2 1.25 4 5.00

Y D

1.50

1.25

Price D

O 4.50 5.00 X

Total outlay

In the above chart and table represents, when price falls the total outlay increases. Therefore

elasticity of demand is grater than unity.

In the above table between S.No. 2 and 3 cases the demand is unitary. As price falls, the

quantity demand increases, but the total outlay remains constant at Rs. 1.20, Hence elasticity

of demand is inelastic

Y

D

1.25

Price

1.00

O 5.00 X

Total outlay

When price falls from Rs. 1.25 to 1.00 the total outlay is same i.e Rs. 5.00. Therefore

elasticity of demand is inelastic.

Y D

0.75

0.60

Price

0.40

D

O X

4 4.20 4.50

Total outlay

Here the total outlay is declining even though quantity demanded is increasing. Hence

demand is said to be inelastic. It is coefficient is less than one.

We can summarize the total outlay method as follows. In the above table as

price falls demand increases, but the total outlay remains constant at Rs. 5/-, hence elasticity

of demand is equal to unity. In case of demand for 3units and 4 units at the price of Rs. 1.50/-

and 1.25/- the total outlay increases from 4.50/- to 5.00/-. Therefore elasticity of demand is

greater than unity. In case of s.no 4, 5, &6 the outlay is declining even though quantity

demand is increasing (6,7,&8 units) and the total outlay is decreasing Rs.4.50/-,4.20,& 4.00.

Hence demand is said to be inelastic and elasticity is coefficients is less than one.

The relationship between total outlay and elasticity of demand my be shown

diagrammatically.

Price ≥1

=1

≤1

O X

Total outlay

2). Point Method (or) Geometrical Method:

Point method is exact method to measure elasticity. Alfred Marshal takes a straight line

demand curve intercepted by both the axes and measures price elasticity at any point on the

demand curve.

% change in the price

We can explain the point method with following table and diagram

POINTS PRICE QUANTITY

(Rs) (Units)

A 6.00 40

B 3.00 90

Y

A D

Upper segment

P

D

Lower segment

O Quantity B X

In the straight line, demand curve is extended to meet the two axis. Point “ P” divides the

demand curve into two segments. Point elasticity at point “P” is calculated by the ratio of

lower segment of the curve below the given point to upper segment point.

That is demand elasticity at Point “P” = Lower segment Area / Upper segment Area

= PB / PA

Change in price / Original price

= [OQ1 – OQ ] / OQ

[OP1 – OP] / OP

3–6/6 -3/6

6–3/3 3/3

The simplest way of explaining the point method is to consider a linear (or) straight line

demand curve. 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 lower segment of the demand curve below the

given point to the upper segment curve above the point.

Hence the Price elasticity by point Method = Lower segment of the demand curve =L

Upper segment of the demand curve U

A

P2

Price P

P1

O X

Quantity (demand) B

2). Elasticity at Point P1 = P1B / AP1 = 2 / 1 = 2 (Relatively elasticity of demand)

3). Elasticity at Point P2 = P2B / AP2 = 3 / 0 = æ (Perfect elastic of demand)

4). Elasticity at Point P3 = P3B / AP3 = 1 /3 = 1> 2 (Relatively inelastic of demand)

5). Elasticity at Point P4= P4B / AP4 = 0 / 3 = 0 (Perfect inelastic of demand)

3) Arc Method:-

When price and quantity changes are large, then we measure elasticity over an arc of the

demand curve rather than at any specific point on it. The formula for measuring is different

from that of the point method.

Instead of taking the old and new prices and quantities, the average of both is taken in this

method. Thus Arc elasticity is called as average elasticity.

Any two points of the demand curve make an arc. An arc is a curved line of the selection (or)

segment of a demand curve.

Change in price / old price + new price

Q1 – Q2 ÷ P1 – P2 = Q/ (Q1+Q2) ÷ P / (P1+P2)

Q1+Q2 P1 + P2

Q1= Old demand Q2= New demand P1= Old price P2= New price

Example = P1 = 10 , P2 = 15; Q1 = 200 Kg. , Q2 = 100 Kg.

D

Y

P2 – 15 a

P

b

Price P1 – 10 D

Q

O 100 200

Demand X

Income demand refers to the quantity of a commodity purchased by a consumer at different

levels of income. In this case, the demand schedule indicates income on the one side and

corresponding quantity demand on the other.

Income demand Schedule

Income ( Rupees) Quantity demanded ( liters )

1000 1

2000 2

3000 3

4000 4

4000

Income 3000

2000

1000

D

1 2 3 4

Quantity

Income is one of the elements that impacts on the demand for a commodity. Income

Elasticity Demand may be defined as the ration (or) proportionate change in the quantity

demand of a commodity to a given proportionate change in income. In short, it indicates the

extent to which demand changes with a variation in consumers income.

as a result of a change in income.

I E D (E y) = ------------------------------------ = ▲D

Percentage change in Income ▲I

Depends upon changes in Income and changes in demand we can classify the income

elasticity of demand into the following types.

Perfectly Income Elasticity Demand:- A small change in Income of the consumer will

causes an infinite increase in the quantity demand. Infinite

Perfectly Income Inelasticity Demand:- In this case whatever may be the changes in the

Income of a consumer, quantity demanded will remain perfectly constant. Zero

Unitary Income Elasticity:- The proportionate change in Income exactly bring about the

same proportionate change in demand. One

more than proportionate change in demand is greater than One.

less change in demand.

Y

E≤1

Negative E=1

Zero E≥1

Income

O X

Quantity

Cross demand refers to the quantity of commodity A purchased by the consumers at various

prices of commodity of B. There is a close relationship between goods. They are either

substitutes or complements.

D D

P2 P2

P1 P1

Price of Price of

Tea D Bread D

O Q1 Q2 X O Q1 Q2 X

Demand for coffee Demand for Butter& Jam

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

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

According to Point Watson “Cross elasticity of demand is the rate of change in quantity

associated with a change in the price of related goods”.

CEO (Ec) = --------------------------------------------------------------------

Percentage change in the price of B

= ------------------------------------------------------------------------

Change in B product price / B product price.

If A and B products demand are in the same direction those goods are called substitutes. If

both are in different direction they are complement product.

Cross Elasticity of demand is positive in case of good substitutes... High cross elasticity of

demand exists for those commodities, which are close substitutes.

If A B are perfectly substitute products the Cross elasticity will be infinite.

If A B are not perfectly substitute product the Cross elasticity demand is zero.

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