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INTRODUCTION
Demand is desire backed by willingness to pay and ability to
pay i.e. a wish to have a commodity does not become demand. A
person wishing to have a commodity should be willing to pay for it
and should have ability to pay for it. Thus a desire becomes demand
if it is backed by willingness to pay and ability to pay. Demand is
meaningless unless it is stated with reference to a price.
Decisions regarding what to produce, how to produce and for
whom to produce are taken on the basis of price signals coming from
the market. The law of demand explains inverse relationship
between price and quantity demanded. When price falls quantity
demanded of that commodity will increase. The deficiency of law of
demand is removed by the concept of elasticity of demand.
MEANING AND DEFINITION
OF
ELASTICITY OF DEMAND
The term elasticity was developed by Alfred Marshall, and is
used to measure the relationship between price and quantity
demanded. The law states that the price of a commodity falls, the
quantity demanded of that commodity will increase, i.e. it explains
only the direction of change in demand and not the extent of change.
This deficiency is removed by the concept of elasticity of demand.
Elasticity means responsiveness. Elasticity of demand refers
to the responsiveness of quantity demanded of a commodity to
change in its price.
According to E.K. Estham, elasticity of demand is a measure of the
responsiveness of quantity demanded to a change in price.
IMPORTANCE
OF
THE CONCEPT ELASTICITY
The concept f elasticity of demand plays a crucial role in business-
decisions regarding fixing of price with a view to make larger profit. For
instance, cost of production is increasing the firm would want to pass the rising
cost on to the consumer by raising the price. Firms may decide to change the
price even without any change in the cost of production. But whether raising
price following the rise in cost or otherwise proves beneficial depends on:
a) The price elasticity of demand for the product, i.e. how high or low is the
proportionate change in its demand in response to a certain percentage change in its
price.
b) Price elasticity of demand for its substitutes, because when the price of a
product increases the demand for its substitutes increases automatically even if their
prices remain unchanged.
Raising the price will be beneficial only if:a) Demand for a product is less elasticb) Demand for its substitutes is much less elastic.
Elasticity of demand establishes the quantitative relationship between
quantity demanded and price or other demand determinants.
TYPES OF ELASTICITY
These are three types of elasticity:-
1. Price elasticity
2. Income elasticitya. Zero income elasticity
b. Negative income elasticity
c. Positive income elasticity
3. Cross elasticity
1. Price Elasticity
Price elasticity of demand may be defined as the degree of
responsiveness of quantity demanded of a commodity in response to change in
its price i.e. it measures how much a change in price of a good affects demand
for that good, all other factors remaining constant. It is calculated by dividing the
proportionate change in quantity demanded by the proportionate change in
price.
EP= Proportionate change in quantity demandedProportionate change in price
2. Income elasticity
Income elasticity of demand measures how much a change in income affects
demand for that commodity if the price and other factors remains constant.
EY= Proportionate change in quantity demandedProportionate change in income
A product with an income elasticity of more than one will experience a
growth in demand that is higher than growth in consumers income. Luxury
goods tend to have relatively high income elasticity. Low quality goods have
negative income elasticities, as people stop buying them when they can afford
to.
There are three types of income elasticity
Zero income elasticity Here a change in income will have no effect of quantity demanded. For example: - salt, matches, cigarettes.
Negative income elasticity Here an increase in income leads to a decrease in quantity demanded. This happens in inferior goods.
Positive income elasticity In this an increase in income will leads to an increase in quantity demanded. For most goods income elasticity is positive.
3. Cross elasticity
This measures the change in demand for a commodity due to change in
price of another commodity.
ED= Percentage change in quantity demanded of commodity APercentage change in price of commodity B
If the goods having substitutes the cross elasticity is positive i.e. an
increase in the price of X will result in an increase in sales of Y. If the goods are
complementary and increase in the price of one commodity will depress the
demand for the other. So cross elasticity will be negative. If the goods are
unrelated cross elasticity will be zero. Because however much the price of one
commodity increased demand for the other will not be affected by that increase.
There exist another two types elasticity viz.
Elasticity of price expectation and
Advertisement elasticity
4. Advertisement elasticity or Promotional elasticity
The expenditure n advertisement and other sales promotion activities
does help in promoting sales, but not in the same degree at all levels of the total
sales. The concept of advertisement elasticity is useful in determining the
optimum level of advertisement expenditure. It may be defined as, the
responsiveness of demand t to changes in advertising or other promotional
expenses.
Proportionate change in salesProportionate change in advertising and other promotional expenditure
5. Elasticity of price expectations
The price expectation elasticity refers to the expected change in future
price as a result of change in current price of a product.
pf / pf pf pc
pc/pc pc pf
Where Pc and Pf are current and future price. The coefficient ex gives
the measure of expected percentage change in future price as a result of 1
percent change in present price. If ex > 1 it indicates the future change in price
will be greater than the present change in price. If ex=1, it indicates that the
future change in price will be equal to the change in current price. In ex > 1, the
sellers will sell more in the future at higher prices.
EA =
ex = == x
FACTORS INFLUENCING
PRICE ELASTICITY OF DEMAND
1. Nature of commodity
Elasticity depends on whether the commodity is a necessity, comfort or
luxury. Necessities of life have inelastic demand and comforts and luxuries
have elastic demand.
2. Availability of substitutes
Goods with substitutes have elastic demand and goods without
substitutes have inelastic demand. For example: coffee and tea are substitutes.
If price of tea increases, people may switch over to coffee. If price of coffee
raises people may shift to tea. The demand of salt is inelastic.
3. Uses of the commodity
Certain goods can be put to many uses. Example electricity. Such
goods have elastic demand because as the price decreases, they will be put to
more uses.
4. Proportion of income spent on commodity
For some goods, consumers spend only a small part of their income. The
demand will be inelastic. For eg: - salt and matches
5. Price of goods
Generally cheap goods have inelastic demand and expensive goods
have elastic demand.
6. Income of consumers
Very rich people have inelastic demand for goods and poor people have
elastic demand. Because rich people will buy the commodity at all levels of
prices where poor people there is a change in quantity of consumption
according to change in price.
7. Time period
Elasticity would be more in the long run than in the short run. Because in
the long run consumers can adjust their demand by switching over to cheaper
substitutes. Production of cheaper substitutes is possible only in the long run.
8. Distribution of income and wealth in the society
If there is unequal distribution of income, the demand of commodities will
be relatively inelastic. If the distribution of income and wealth in the society is
equal there will be elastic demand for commodities.
DEGREES OF ELASTICITY
Since the responsiveness of quantity demanded varies from commodity
to commodity and from market to market, it is important to study the degrees of
price elasticity. We can identify five degrees of elasticity. They are: -
1. Perfectly elastic demand
2. Perfectly inelastic demand
3. Unitary elastic demand
4. Relatively elastic demand
5. Relatively inelastic demand
1. Perfectly elastic demand
Perfectly elastic demand is the situation where a small change in price
causes a substantial change in quantity demanded i.e. a slight decline in price
causes an infinite increase in quantity demanded and a slight increase in price
leads to demand contracting to zero. The demand is hypersensitive and the
elasticity of demand is infinite. Demand curve becomes a horizontal straight line
parallel to x-axis.
Qty demanded
2. Perfectly inelastic demand
It is the situation where changes in price cause no change in quantity
demanded. Quantity demanded is non-responsive or inelastic. Demand curve is
a vertical line parallel to Y-axis and the elasticity of demand is zero.
Quantity demanded
It is clear that the price is OP or OP1 or OP2. The quantity demanded remains unchanged at OM.
P2
P1
P
M
Y
0
Pric
eD
X
ep = 2Pr
ice
ep = 0
3. Unitary elastic demand
It refers to that situation where a given proportionate change in price is
accompanied by an equally proportionate change in quantity demanded. For
example, if price changes by 10%, quantity demanded also changes by 10%.
ep= 10/10 = 1
ie; elasticity will be equal to one. The demand curve is a rectangular hyperbola.
Quantity demanded
N1N
Y
X0
D
D
P
P1Pric
e
ep =1
4. Relatively elastic demand
Demand is said to be relatively elastic when a given proportionate
change in Price causes a more than proportionate change in quantity
demanded.
Quantity demanded
N1N
Y
X0
D
D
P
P1Pric
e
ep >1
5. Relatively Inelastic demand
Demand is relatively inelastic when a given proportionate change in
price causes a less than proportionate change in quantity demanded. Demand
curve will be a very steep curve. Elasticity is less than 1. For example, If price
changes by 20% quantity demanded changes by 10%
Then ep = 10/20 = .5 ie; ep
MEASUREMENT OF
ELASTICITY OF DEMAND
Important methods to measure the elasticity of demand are: -
1. Proportional or percentage method
2. Expenditure or Outlay method
3. Geometric or point method
These are the commonly used methods.
1. Proportional method or Percentage method
Under this method the elasticity of demand is measured by the ratio
between the proportionate or percentage change in the quantity demanded and
proportionate or percentage change in price. It is also known as formula
method.
Ep= Proportionate change in quantity demanded
Proportionate change in price
q p q p
p q q p
=
=
X
ep is the price elasticity
q is the change in quantity demanded
p is the change in price
q is the initial quantity
p is the initial price
For example:Price of A Quantity demanded of A 5 10
4 15
When price of A is Rs.5 quantity demanded is 10. When price falls to Rs.4
quantity demanded rises to 15.
Here p = 1, q= 5
Initial price = 5, Initial quantity = 10
ep = p q
q p
= 5 X 5
10 1
= 2.5
Elasticity is greater than one (relatively elastic) if price elasticity is equal
to one, it is unitary elastic demand. If elasticity is less than one, it is relatively
inelastic demand. If elasticity is more than one, it is relatively elastic demand. If
elasticity is zero, it is perfectly inelastic demand. If elasticity is infinity, it is
perfectly elastic demand.
2. Expenditure or Outlay method
By this method elasticity is measured by estimating the change in price
that leads to a change in quantity demanded causes changes in total
X
expenditure incurred on commodity. According to sellers total expenditure
means total revenue. So this method is also known as total revenue method.
By looking at variation in total expenditure, price elasticity can be calculated.
Price (PQuantity
Demanded (Q)
Total Expenditure
(P x Q)18
15
12
9
3
4
5
6
54
60
60
54
In this table a fall in price leads to a more than proportionate increase in
quantity demanded increase in total expenditure. Conversely, a fall in price
leads to a less than proportionate increase in quantity demanded results in
decrease in total expenditure. A fall in price leads to a proportionate increase in
quantity demanded result in total expenditure remaining constant.
e > 1
e=1
e 1
e = 1
e
Total Expenditure
In this figure price is on the vertical axis and total expenditure on horizontal
line. As the price falls and total outlay increases, elasticity is greater than 1. We
find elasticity greater than 1 in the CB portion of the total outlay curve. In BA,
total expenditure remains the same while price is falling. Therefore elasticity is
equal to 1. In AL the price is falling and total expenditure is also falling. From A
to L the curve is bending towards the origin. So elasticity is less than one
If total expenditure increases, elasticity >1
If total expenditure decreases, elasticity
Then the point at which elasticity is to be known has to be marked on
demand curve dividing it into upper segment and lower segment.
ep = lower segmentupper segment
Qty demanded
4. Arc method
Arc method is not so important that it is applicable only when there are very
small change in price and demand.
ep=0
ep1
ep=2
e
a
X0
Y
PRIC
E
Using of Elasticity Concept in Business
We are the company which produce a commodity x. We earn maximum
profit by selling 80% of commodities at the rate of Rs.20/-.
STAGE I At the time of commencement
Qty
Suddenly we have to face a decline in demand. Demand falls by 10% and
the current demand deceases from 80% to 70%..
STAGE II Decrease in demand
Qty
At this time we have to reduce the price by Rs. 18/- instead of Rs. 20/- to
increase the demand and demand increases from 70% to 75%.
70
80
20
0 X
D
DPR
ICE
80
20
0 X
D
D
PRIC
E
STAGE III Current position of our company
Qty
Reasons for decline in demand
There are certain reasons for the sudden decline of demand for our
commodity.
1. Availability of cheap substitutes
The main reason is the availability of cheap substitutes in the market i.e.
more substitutes is available in the market at low price. So that people buy
more of that commodity and because the demand for our commodity falls.
Substitution effect means change in demand due to substituting one commodity
for another.
70D1
75 80
20
0 X
D
D
PRIC
E
D1
When price of a commodity falls the cheaper commodities will be substituted
in the place of dearer commodities. Thus price of the commodity falls more of it
will be demanded and the consumer uses it as a substitute for high priced
commodities.
2. Lack of Advertisement
Lack of Advertisement is also a reason for the declining demand for goods.
In a highly competitive market advertisement is very important and it also affect
the change in demand. The main objective of advertisement is to create
additional demand by attracting more consumers to our product. So we must
advertise well to increase our demand of our product.
3. Technological progress
Technological progress also affect demand for a commodity. Inventions and
discoveries bring new things in the market. So people will not demand older
things. So we must use more technological devices to improve the demand for
our product.
4. Lack of demonstration
Lack of demonstration also brings out our commodity to a fall in demand i.e.
people get motivated or they were attracted by the demos given by us and they
will buy that product not because of their increase in income or it becomes a
cheaper product but their neighbour or relatives bought it. Tendency of the
consumer to imitate others will help us to increase the demand for our
commodity.
5. Free goods
More Free goods are given by other producer to attract consumers and that
will affect the demand of our product. So we also gave more free goods than
the other companies.
Because of these reasons we must forced to reduce the price of our
commodity to increase our commodities demand. For this we must know the
different market conditions and the factors affecting demand for a commodity.
DETERMINANTS OF DEMAND
1. Price of a commodity
Price of the commodity is the most important factor that determine demand.
An increase in price of a commodity leads to a reduction in demand and a
decrease in price leads to an increase in demand.
2. Price of related goods
Demand for a commodity depends on Price of related goods also. Related
goods include both substitutes and complementary goods.
Substitutes are those goods which can be used one another or the goods
with same use are substitutes. e.g.:- tea and coffee.
When price of tea falls demand for coffee also falls. Because when price of
tea falls people buy more tea and less coffee.
Complementary goods are those goods which can be used only jointly. e.g.:
- car, petrol or pen, ink. When price of a commodity raises demand for its
complementary goods falls. If x and y are complementary goods we cannot use
x without y. When price of x raises demand for x falls and y cannot be used
without x and demand for y also falls.
3. Income of the consumer
Income of the consumer and demand for a commodity are positively related.
For normal goods when income increases demand also increases and vice
versa. But for inferior goods there is a negative relationship between income
and demand. So when income increases, demand decreases.
Taste and Preferences of consumers
Taste and Preferences of consumers also brings out changes in demand for
a commodity. Tendency to imitate other fashions, advertisements etc affect
demand for a commodity. It change from person to person, place to place and
time to time.
4. Rate of Interest
Higher will be demanded at lower rates of interest and lower will be
demanded at higher rate of interest.
5. Money supply
Demand is positively related to money supply. If the supply of money
increases people will have more purchasing power and hence the demand will
increase and vice versa.
6. Business condition
Trade cycles or business cycles also demand for a commodity. Demand will
be high during boom period and low during depression.
7. Distribution of income
Distribution income in the society also affects the demand of commodity. If
there is equal distribution of income demand for necessary goods and comforts
will be greater. If there is an unequal distribution of income demand of comforts
and luxuries will be greater.
8. Government policy
Government policy also affects the demand of commodities. For example, if
heavy taxes are imposed on certain goods, the demand will decrease. On the
other hand, if government announces tax concessions for certain commodities,
their demand will increase.
9. Consumers expectations
Consumers expectation about a further rise or fall in future price will affect
the demand of a commodity. If consumers expect a rise in the price of a
commodity in the near future, they may purchase large quantity even though
there is some rise in the price. When the price of a commodity decreases,
people expect a further fall in price and postpone their purchase. Similarly, if
consumers believe that their incomes will rise in the near future they are more
inclined to buy more expensive items today. So these expectations changes the
demand for goods.
CONCLUSION
In the project regarding the elasticity of demand, we discuss different
degrees, types and measurement of elasticity. Applying the theory of elasticity
we have to increase our demand of our commodity. But this increase in demand
will not lead to an increase in cost of production. When cost of production
increases automatically we must sacrifice the rate of profit that we earn. So we
must take some strategic decisions to improve our quality of our commodity and
thereby increase profit, increase in demand and also we have to reduce the
cost of production.
Although most businessmen are very much aware of the elasticity of
demand of the goods they make, the use of precise estimates of elasticity of
demand will add precision to their business decision i.e. the theory of elasticity
of demand is very useful at the time of taking tactical decisions by the top
management. So this project is much useful to us to know how elasticity
influences the working of business and even in our day to day life.
INTRODUCTIONMEANING AND DEFINITION OF
ELASTICITY OF DEMAND1. Price Elasticity2. Income elasticity3. Cross elasticity
Reasons for decline in demand