Demand and Elasticity of Demand

Amandeep VermaAssistant Professor in Economics

MEANING OF DEMAND “The demand for anything, at a given price, is the amount of

it, which will be bought per unit of time, at that price.” Benham

“By demand we mean the various quantities of a given commodity or service which consumers would buy in one market in a given period of time at various prices.”

Bobber Requisites:a. Desire for specific commodity.b. Sufficient resources to purchase the desired commodity.c. Willingness to spend the resources.d. Availability of the commodity at (i) Certain price (ii) Certain place (iii) Certain time.

KINDS OF DEMAND1. Individual demand2. Market demand3. Income demand- Demand for normal goods (price –ve, income +ve)- Demand for inferior goods (eg., coarse grain) 4. Cross demand- Demand for substitutes or competitive goods (eg.,tea & coffee, bread

and rice)- Demand for complementary goods (eg., pen & ink) 5. Joint demand (same as complementary, eg., pen & ink) 6. Composite demand (eg., coal & electricity) 7. Direct demand (eg., ice-creams) 8. Derived demand (eg., TV & TV mechanics) 9. Competitive demand (eg., desi ghee and vegetable oils) 10.Demand of unrelated goods

FACTORS AFFECTING DEMAND Prices of Goods Income of Consumer Prices of Related Goods Population Tastes, Habit Expectation about future prices Climatic Factors Demonstration Effect Distribution of national income

DEMAND SCHEDULE Demand Schedule: a tabular presentation showing different quantities

of a commodity that would be demanded at different prices. Types of Demand Schedules

Individual Demand schedule Market Demand SchedulePrice A1 502 403 304 20

Price

A B C M.S

1 50 45 40 1352 40 30 38 1083 35 20 30 854 20 15 25 60

DEMAND CURVE The Graphical Representation of Demand Schedule is called a Demand

Curve. It is of two types: Types of Demand Curve

Y Y Price Less Flatter Price More

Flatter

O Demand X O Demand X

Individual DC Market DC

DEMAND CURVE Movement along demand curve Vs. Shift in demand curve: Distinction between change in quantity demanded and change in

demand.

A. Change in quantity demanded – When quantity demanded changes ( rise or fall ) as a result of change in price alone, other factors remaining the same.

Contraction/fall in quantity demanded Extension/Rise in quantity demanded

The change is depicted/ represented by the movement up or down on a given demand curve. This does not require drawing a new demand curve.

FIGURE 2.2 SHIFTS IN THE DEMAND CURVEAN INCREASE IN DEMAND IS REPRESENTED BY A RIGHTWARD, OUTWARD, SHIFT IN THE DEMAND CURVE,FROM D1TO D2. A DECREASE IN DEMAND IS REPRESENTED BY A LEFTWARD, OR INWARD, SHIFT IN THEDEMAND CURVE, FROM D1 TO D3.

THE LAW OF DEMAND Prof. Samuelson: “Law of demand states that people will buy more at

lower price and buy less at higher prices, others thing remaining the same.”

Ferguson: “According to the law of demand, the quantity demanded varies inversely with price”.

Chief Characteristics:1. Inverse relationship.2. Price independent and demand dependent variable.3. Income effect & substitution effect. Assumptions: No change in tastes and preference of the consumers. Consumer’s income must remain the same. The price of the related commodities should not change. The commodity should be a normal commodity

THE LAW OF DEMAND

P

Q

A

B

P

Q

D1D2

CHANGE IN PRICE=

change in quantity demanded

CHANGE IN OTHER=change in demand

P1

P2

Q1 Q2

THE LAW OF DEMAND

P

Q

D1D2

CHANGE IN OTHER=change in demand

DETERMINANTS OF DEMAND

• Change in consumer tastes• Change in people’s income• normal goods• inferior goods• Change in Population• Change in Habits• Government Policies• Income distribution• Change in price of related goods• Consumer expectations with regard to future prices• Advertisement Expenditure

Dx= a-bPx

Dx= Demand for X commdityA= constant B= SlopePx= price of X commodity

Price Demand0 102 124 146 168 1810 2012 22

Why demand curve slopes downwards?

1. Income effect

2. Substitution effect

3. Diminishing Marginal Utility

4. Increase in number of consumer

5. Alternative uses

Definition: “Elasticity of demand is defined as the responsiveness of the quantity demanded of a good to changes in one of the variables on which demand depends.”

These variables are price of the commodity, prices of the related commodities, income of the consumer & other various factors on which demand depends. Thus, we have Price Elasticity, Cross Elasticity, Elasticity of Substitution & Income Elasticity. It is always price elasticity of demand which is referred to as elasticity of demand

A. Price ElasticityMeasures how much the quantity demanded of a good changes when its price changes.

OrIt may be defined as “Percentage Change in Quantity demanded over

percentage change in price”

FACTORS AFFECTING ELASTICITY OF DEMAND

1. Availability of substitutes2. Postponement of consumption3. Proportion of expenditure (needles: inelastic; TV: elastic)4. Nature of the commodity (necessity vs. luxury;

durability/reparability eg., shoes)5. Different uses of the commodity (paper vs. ink)6. Time period (elastic in the long term)7. Change in income (necessaries: inelastic; milk and fruit for a rich

man)8. Habits9. Joint demand10. Distribution of income11. Price level (very costly & very cheap goods: inelastic)

Exceptions:• Inferior goods• Articles of snob appeal. (exception: Veblen goods, eg.,

diamonds)• Expectation regarding future prices (shares, industrial

materials)• Emergencies• Quality-price relationship• Conspicuous necessities.• Ignorance• Change in fashion, habits, attitudes, etc.. Importance:• Price determination.• To Finance Minister• To farmers• In the field of Planning.

PRICE ELASTICITY Price Elasticity • Elastic Demand or more than 1 – When quantity demanded

responds greatly to price changes• Inelastic Demand or less than 1 – When quantity demanded

responds little to price changes.• Unitary Elastic – When quantity demanded responds equally to

the price changes.• Perfectly inelastic or 0 elastic demand• Perfectly elastic or infinite elastic demand

Economic factors determine the size of price elasticity for individual goods. Elasticity tends to be higher when the goods are luxuries, when substitutes are available and when consumer have more time to adjust their behavior.

CALCULATING PRICE ELASTICITY PED = % Change in Qty Demanded % Change in Price

Points to Remember:• We drop the minus sign from the numbers by treating

all % changes as positive. That means all elasticity’s are positive, even though prices and quantities move in the opposite direction because of the law of downward sloping demand.

• Definition of elasticity uses percentage changes in price and demand rather than actual changes. That means that a change in the units of measurement does not affect the elasticity. So whether we measure price in Rupees or paisa, the price elasticity stays the same.

SOME BUSINESS APPLICATIONS OF PRICE ELASTICITY• Price discrimination• Public utility pricing (electricity, railway)• Joint supply (wool and mutton)• Super markets • Use of machines (lower cost of production for elastic)• Factor pricing (workers producing inelastic demand

products)• International trade (devalue when exports are price-

elastic)• Shifting of tax burden (shift commodity tax when demand

is inelastic)• Taxation policy

ELASTICITY & REVENUE:• When demand is price inelastic, marginal revenue is negative and a

price decrease reduces total revenue.• When demand is price elastic, marginal revenue is positive and a price

decrease increases total revenue.• In the borderline case of unit elastic demand, marginal revenue is 0

and a price change leads to no change in the total revenue.

B. Income Elasticity of Demand: Is the degree of responsiveness of quantity demanded of a good to a small change in the income of the consumer.

• If the proportion of income spent on a good remains the same as income increases, then income elasticity for the good is equal to one.

• If the proportion spent on a good increases, then the income elasticity for the good is greater than one.

• If the proportion decreases as income rises, then income elasticity for the good is less than one.

INCOME ELASTICITY Types:• Zero• Negative• Positive (i) low (ii) unitary (iii) high

Empirical evidence suggests that income elasticity falls as income rises.

Income elasticity and business decisions1. If ei is >0 but <1, sales will increase but slower than the

general economic growth;2. If ei is >1, sales will increase more rapidly than general

economic growth Corollary: in a growing economy while farmers suffer as

their products have low income elasticity, industrialists gain as their products have high income elasticity.

Cross Elasticity: A change in the demand for one good in response to a change in the price of another good represents cross elasticity of demand of the former good for the latter good.

• If two goods are perfect substitutes for each other cross elasticity is infinite and if the two goods are totally unrelated, cross elasticity between them is zero.

• Goods between which cross elasticity is positive can be called Substitutes, the good between which the cross elasticity is negative are not always complementary as this is found when the income effect on the price change is very strong.

DEGREES OF ELASTICITY OF DEMAND Perfectly Elastic Perfectly Inelastic Unitary Elastic Relatively more elastic Relatively less elastic

1. PERFECTLY ELASTIC

dO X

Y

p

d1

Ed = ∞

2. PERFECTLY INELASTIC

p1

O X

Y

p

d

Ed = 0

3. UNITARY ELASTIC

p1

O X

Y

p

d1

Ed = 1

d

4. RELATIVELY MORE ELASTIC

p1

O X

Y

p

d1

Ed > 1

d

5. RELATIVELY LESS ELASTIC

p1

O X

Y

p

d1

Ed < 1

d

FIGURE 7.3 ELASTIC AND INELASTIC DEMANDDEMAND CURVES DIFFER IN THEIR RELATIVE ELASTICITY. CURVE D1 IS MORE ELASTIC THAN CURVE D2, INTHE SENSE THAT CONSUMERS ON CURVE D1 ARE MORE RESPONSIVE TO A GIVEN PRICE CHANGE (P2 TO P1) THAN ARE CONSUMERS ON CURVE D2.

CHANGES IN THE ELASTICITY COEFFICIENT

THE ELASTICITY COEFFICIENT DECREASES AS A FIRM MOVES DOWN THE DEMAND CURVE. THE UPPER HALF OF A LINEAR DEMAND CURVE IS ELASTIC, MEANING THAT THE ELASTICITY COEFFICIENT IS GREATER THAN ONE. THE LOWER HALF IS INELASTIC, MEANING THAT THE ELASTICITY COEFFICIENT IS LESS THAN ONE. THIS MEANS THAT THE MIDDLE OF THE LINEAR DEMAND CURVE HAS AN ELASTICITY COEFFICIENT EQUAL TO ONE.

NETWORK EFFECTS AND DEMANDAS THE PRICE FALLS FROM P3 TO P2, THE QUANTITY DEMANDED IN THE SHORT RUN RISES FROM Q1 TO Q2.HOWEVER, SALES BUILD ON SALES, CAUSING THE DEMAND IN THE FUTURE TO EXPAND OUTWARD TO, SAY, D2. THE LOWER THE PRICE IN THE CURRENT TIME PERIOD, THE GREATER THE EXPANSION OF DEMAND INTHE FUTURE. THE MORE THE DEMAND EXPANDS OVER TIME IN RESPONSE TO GREATER SALES IN THECURRENT TIME PERIOD, THE MORE ELASTIC IS THE LONG-RUN DEMAND.

METHODS OF MEASUREMENT OF ELASTICITY1. Percentage or Proportionate Method = Percentage change in demand or; Percentage change in price = Proportionate change in demand Proportionate change in price

2. Total Outlay (Expenditure) Methods TO=TQ * P ; where, TO=total outlay; TQ=total quantity; P=price of

the commodity

3. Geometric (Point) method – at any given point on the curve

= lower segment of demand curve upper segment of demand curve