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Elasticity of Demand

The document discusses various concepts related to elasticity of demand, including: 1) Price elasticity of demand measures the responsiveness of quantity demanded to a change in price. Demand is elastic if a small price change leads to a large quantity change, and inelastic if a large price change leads to a small quantity change. 2) Cross elasticity measures responsiveness of demand for one good to price changes of another good. Income elasticity measures responsiveness of demand to changes in consumer income. 3) Factors like availability of substitutes, nature of the good, and proportion of income spent influence price elasticity. Goods with more substitutes or that are luxuries tend to have more elastic

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15 views29 pages

Elasticity of Demand

The document discusses various concepts related to elasticity of demand, including: 1) Price elasticity of demand measures the responsiveness of quantity demanded to a change in price. Demand is elastic if a small price change leads to a large quantity change, and inelastic if a large price change leads to a small quantity change. 2) Cross elasticity measures responsiveness of demand for one good to price changes of another good. Income elasticity measures responsiveness of demand to changes in consumer income. 3) Factors like availability of substitutes, nature of the good, and proportion of income spent influence price elasticity. Goods with more substitutes or that are luxuries tend to have more elastic

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Elasticity of Demand

• The law of demand indicates only the direction of change in quantity


demanded of a commodity in response to a change in its price.

• This does not tell us by how much or to what extent the quantity
demanded of a good will change in response to a change in its price.

• The concept of elasticity of demand refers to the degree of


responsiveness of quantity demanded of a good to a change in its
price, consumers’ income and prices of related goods.
I. Price elasticity,

II. Income elasticity, and

III. Cross elasticity.


Price Elasticity of Demand
• Price elasticity of demand relates to the degree of responsiveness of
quantity demanded of a good to the change in its price.
• Price elasticity of demand is defined as the ratio of the percentage
change in quantity demanded of a commodity to a given percentage
change in price.
• When the percentage change in quantity demanded a commodity is
greater than the percentage change in price that brought it about, price
elasticity of demand (ep) will be greater than one and in this case
demand is said to be elastic.

• When a given percentage change in price of a commodity leads to a


smaller percentage change in quantity demanded, elasticity will be less
than one and demand in this case is said to be inelastic.
Perfectly Inelastic and Perfectly Elastic Demand

• Perfectly Inelastic: In this case, changes in price of a commodity does


not affect the quantity demand of the commodity at all.
• Demand curve is a vertical straight line.
• Perfectly Elastic: The second extreme situation is of perfectly elastic
demand in which case demand curve is a horizontal straight line.
• This horizontal demand curve for a product implies that a small
reduction in price would cause the buyers to increase the quantity
demanded from zero to all they wanted.
Arc and Point Elasticity
• When price elasticity of demand is measured between any two finite
points on a demand curve, it is called arc elasticity.
• Elasticity measured at a point on the demand curve is called point
elasticity.
• When change in price is significantly high, it shows a movement from
one point on the demand curve to another point, making an arc.
Therefore, the price elasticity measured for a considerably high
change in price is called arc elasticity of demand.
• And, when price elasticity is measured for very small changes in price
it is called point elasticity
Price Elasticity Varies Along the Demand Curve
Determinants of Price Elasticity of Demand

• Availability of Substitutes:
• The closer the substitute, the greater the price elasticity of demand for a
commodity.
• For instance, coffee and tea may be considered as close substitutes for
one another. If price of one of these goods (say, coffee) increases, then
the demand for coffee decreases more heavily.
• The reason is that the other commodity (tea) becomes relatively cheaper.
• Therefore, consumers buy more of the relatively cheaper good (tea) and
less of the costlier one. The elasticity of demand for both these goods
will be higher.
• The wider the range of the substitutes, the greater the elasticity.
• For instance, soaps, toothpastes, cigarettes, etc. are available in
different brand names, each brand being a close substitute for the
other, all other things remaining the same.
• Therefore, the price elasticity of demand for each brand will be much
greater than the generic commodity.
• On the other hand, sugar and salt do not have their close substitute and
hence their price elasticity is lower.
• Nature of Commodity:
• Price elasticity of demand depends also on the nature of a commodity.
• Commodities can be grouped broadly as luxuries, comforts and
necessities, on the basis of the degree of intensity of the need they
satisfy.
• Demand for luxury goods (e.g., air conditioners, costly TV sets, cars,
and decoration items) is more elastic than the demand for other kinds
of goods because consumption of luxury goods can be postponed
when their price rises.
• On the other hand, consumption of necessities (e.g., sugar, clothes,
vegetables, and electricity, medicines) cannot be postponed and hence
their demand is inelastic.
• Demand for comforts is generally more elastic than that for necessities
and less elastic than the demand for luxuries.
• Commodities may also be classified as durable goods and non-durable
goods.
• Demand for durable goods is more elastic than that for non-durable goods
—mainly necessities because when the price of the former increases,
people either get the old one repaired instead of replacing it or buy a
‘second-hand’.
• Proportion of Income Spent:
• If proportion of income spent on a commodity is very small, its
demand will be inelastic, and vice versa.
• Classic examples of such commodities are salt, matches, books,
toothpastes, which claim a very small proportion of consumers’
income.
• Demand for these goods is generally inelastic because increase in the
price of such goods does not substantially a ffect consumer’s budget.
• Time Factor.
• Price elasticity of demand for high-price goods depends also on the
time consumers can take to adjust their consumption expenditure to
buy a new commodity—the shorter the time taken, the greater the
elasticity.
• Consumers are able to adjust their expenditure pattern to price changes
over a short period of time.
• For instance, if price of TV sets is decreased, demand will
immediately increase if people possess excess purchasing power and
require a short time to take decision.
• But, if not, then people may not be able to adjust their expenditure
pattern over a short period of time to buy a TV set at the (new) lower
price.
• If consumption adjustment takes a long period, it creates uncertainty
and makes elasticity lower.
• Range of Alternative Uses of a Commodity.
• The wider the range of alternative uses of a product, the higher the
elasticity of its demand for decrease in price and the lower elasticity
for rise in price.
• Decrease in the price of a multi-use commodity encourages the
extension of their use.
• Therefore, the demand for such a commodity generally increases more
than the proportionate decrease in its price.
• For instance, milk can be taken as it is, it may be converted into curd,
cheese, ghee and butter milk.
• The demand for milk will, therefore, be highly elastic.
• Similarly, electricity can be used for lighting, cooking, heating and for
industrial purposes.
• Therefore, demand for electricity is highly elastic, especially for
decrease in price.
• Reverse is the case for rise in their price.
Cross Elasticity of Demand
• Cross-Elasticity is the measure of responsiveness of demand for a
commodity to the changes in the price of its substitutes and
complementary goods.
• For instance, cross-elasticity of demand for tea (T) is the percentage
change in its quantity demanded due to a change in the price of its
substitute, coffee (C).
Numerical Example

• If price of coffee rises from Rs. 45 per pack to Rs. 55 per pack of 250
grams and as a result the consumers demand for tea increases from
600 packs to 800 packs of 250 grams, then find the cross elasticity of
demand of tea for coffee.

• Mid-point method (large change in price)


Income Elasticity of Demand
• Income elasticity of demand shows the degree of responsiveness of
quantity demanded of a good to a small change in income of
consumers.
• The income elasticity of demand may be defined as the ratio of the
proportionate change in the quantity purchased of a good to the
proportionate change in income.
Income Elasticity, Normal Goods and Inferior Goods

• Significance of zero income elasticity of demand.


• It implies that a given increase in income does not at all lead to any
increase in quantity demanded of the good.
• In other words, zero income elasticity signifies that quantity demanded
of the good is quite unresponsive to changes in income.
• Besides, zero income elasticity is significant because it represents a
dividing line between positive income elasticity on the one side and
negative income elasticity on the other.
• When income elasticity is more than zero (i.e., positive), then an
increase in income leads to the increase in quantity demanded of the
good.
• Goods having positive income elasticity are known as normal goods.
• On the other side, there are all those goods which have income
elasticity less than zero (i.e., negative) and in such cases increase in
income leads to the fall in quantity demanded of the goods.
• Goods having negative income elasticity are known as inferior goods.
Income Elasticity, Luxuries and Necessities
• Significance of unitary income elasticity of demand.

• When income elasticity of demand for a good is equal to one, then


proportion of income spent on the good remains the same as
consumer's income increases.

• Income elasticity of unity also represents a useful dividing line.


• If the income elasticity for a good is greater than one, the proportion
of consumer’s income spent on the good rises as consumer's income
increases, i.e., that good bulks larger in consumer's expenditure as he
becomes richer.
• Luxury
• On the other hand, if income elasticity for a good is less than one, the
proportion of consumer's income spent on it falls as his income rises,
i.e., the good becomes relatively less important in consumer's
expenditure as his income rises.
• Necessity
Price Elasticity of Supply
• Price elasticity of supply is the measure of responsiveness of the
quantity supplied of a good to the change in its market price.
• The coefficient of price elasticity of supply (e p) is the measure of
percentage change in the quantity supplied of a good due to a given
percentage change in its price.
Application of Demand, Supply and Elasticity
1. How imposition of a commodity tax affects price, production and
consumption of a commodity;
2. Who bears the burden of a commodity tax—buyers, sellers, or both?
3. How a subsidy granted by the government affects production and
consumption of a commodity and who benefits from the subsidy—buyers
or sellers;
4. When the price of a commodity is controlled by the government, how it
affects the production and consumption of the commodity; and
5. How import tariffs affect imports and how export subsidies a ffect exports,
and how and to what extent consumption and production of imported and
exported goods are affected.
Imposition of a Commodity Tax
Incidence of Tax

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