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4. What is meant by elasticity of demand? How do we measure it?

DEMAND – ELASTICITY

Introduction of elasticity of demand

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.

Elasticity of demand means the degree of responsiveness of demand due to change in


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.

Definition of elasticity of demand

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.

Different types of elasticity of demand:

1). Price elasticity of demand


2). Income elasticity of demand
3). Cross elasticity of demand

1). Price elasticity of demand (PED)

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.

E (d) = Relative change in quantity / 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.

PED = Proportionate change in quantity demanded / Proportionate change in price

= [( Q2 – Q1)/ Q1] / [( P2 – P1)/ P1]

= [▲ Q / Q ] / [▲ P / P]

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

Ep = Price elasticity, P = Price, Q = Quantity, ▲ Delta for change

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.

Ex: 80% increase in demand as result of 20% fall in price

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.

Different degrees (or) Types of price elasticity of demand:-


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 .

Price elasticity of demand has 5 degrees of elasticity


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.

Measurement of price elasticity of 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

1). Total Expenditure or Out lay 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.

Total Expenditure = Price per unit X Total quantity purchased

According to this method the elasticity is 3 types


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)

S.NO PRICE DEMAND TOTAL EXPENDITURE /


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

S.NO PRICE DEMAND TOTAL EXPENDITURE /


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.

2). Perfect inelastic demand

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.

3). Relative 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.

The formula to measurement of elasticity = % change in the quantity demanded


% 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

We can expand = Change in quantity / original quantity


Change in price / Original price

= [OQ1 – OQ ] / OQ
[OP1 – OP] / OP

At A point elasticity = 90 – 40 / 40 = 50/ 40 = 1.25/ -0.5 = - 2.5 = 2.5


3–6/6 -3/6

At B point elasticity = 40 – 90 / 90 = 50/ 90 = -0.55/ 1 = - 0.55 = 0.55


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

The length of the demand curve is assumed to be 3 inches

A
P2
Price P

P1

O X
Quantity (demand) B

1). Elasticity at Point P = PB / AP = 1 ½ / 1 ½ = 1 (Unitary elasticity of demand)


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.

The formula for arc elasticity of demand is as follows:

ARC Elasticity = [{Q1 – Q2}/ {Q1+Q2}] / [{P1 – P2}/ {P1+P2}]

= Change in demand / old demand+ new demand


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.

ARC E d = 100 /300 = 1/3 / 1/5 = 1/3 X 5/1 = - 1.66 = 1.66

D
Y
P2 – 15 a

P
b
Price P1 – 10 D

Q

O 100 200
Demand X

Income Elasticity of Demand (IED):-

Income Demand: demand for a commodity is influenced by the income of a consumer.


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

Income demand curve

4000

Income 3000

2000

1000
D
1 2 3 4
Quantity

Income demand elasticity

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.

Hence, income elasticity of demand shows the change in quantity demanded


as a result of a change in income.

The following formula helps to measure

Percentage change in Demand


I E D (E y) = ------------------------------------ = ▲D
Percentage change in Income ▲I

Types of Income Elasticity Demand:-

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

Relatively Income Elasticity Demand:- If a proportionate change in Income brings about a


more than proportionate change in demand is greater than One.

Relatively Income Inelasticity Demand:- If a proportionate change in Income brings about


less change in demand.
Y
E≤1
Negative E=1

Zero E≥1
Income
O X
Quantity

Cross Elasticity of Demand:-

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

Cross elasticity of demand


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”.

The formula for calculating cross elasticity of demand.

Percentage change in quantity demand of commodity A


CEO (Ec) = --------------------------------------------------------------------
Percentage change in the price of B

Change in quantity of commodity A / A product old demand


= ------------------------------------------------------------------------
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.