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Elasticity of Demand – Meaning, Types, Measurement

The elasticity of demand is the measurement of change in the demand for a commodity in response to a certain change in its price.

Symbolically,

where

Ed = Elasticity of Demand

P = Original Price

Q = Original Quantity

∆P = Change in Price

∆Q = Change in Quantity

The four types of Elasticity of Demand

  1.  Price Elasticity (Ep)
  2.  Income Elasticity (Ey)
  3.  Cross Elasticity (Ec)
  4. Arc Elasticity (Ea)

The five types of price elasticity

  1. Perfectly Elastic (e= alpha)
  2.  Perfectly Inelastic (e=0)
  3.  Unitary Elastic (e=1)
  4.  Relatively Elastic (elasticity is more than 1)
  5.  Relatively Inelastic (elasticity is less than than 1)

 Price Elasticity of Demand:

It is the relationship between change in the demanded quantity of a commodity and any proportionate change in its price.

Price Elasticity of Demand = Proportionate change in quantity demanded upon Proportionate change in price multiplied by 100

Price elasticity of demand is also calculated with the following formulaPrice Elasticity of Demand

 There are five types of price elasticity of demand

  1.   Unitary Elastic Demand        (E = 1)
  2.  Perfectly Elastic Demand      (E = infinity)
  3.  Relatively Elastic Demand     (E > 1)
  4.  Perfectly Inelastic Demand   (E = 0)
  5.  Relatively Inelastic Demand  (E < 1)

Income Elasticity of Demand

It is the proportionate change in the demanded quantity of a commodity relative to the proportionate change in consumers’ incomes.

It can be obtained by proportionate change in demand upon proportionate change in income multiplied by 100

It can also be obtained by an alternate formula shown below

In the formula

Edi  = Price elasticity of Demand

∆Q = Quantity change in Demand

∆Y = Income change in consumers

Y = Original Income

Q = Original Quantity DemandedIncome Elasticity of Demand

Considerations

Comfort Goods

If the proportionate expenditure on the consumption of a commodity remains unchanged even with a change in the consumers’ incomes, the income elasticity of the commodity is said to be unitary.

For example, a consumer spends 15% of his income on milk and continues to spend the same part of his income even after an increase in income, the income elasticity of demand for milk will be unitary (e= 1).

Luxury Goods

If the proportionate expenditure on the consumption of a commodity increases with an increase in consumers’ income, the income elasticity of demand of that commodity will be more than unit.

Necessary GoodsCross Elasticity of Demand

If the proportionate spending on the consumption of a commodity decreases with an increase in consumers’ income, the income elasticity of demand for that commodity is less than unit.

Superior Goods

If the income elasticity of demand is positive, consumers will purchase greater quantities of the commodity than they did before.

Inferior Goods

If the income elasticity of demand is negative, consumers will purchase lower quantities of the commodity than they did before.

Cross Elasticity of Demand

It measures the proportionate change in demand for commodity X in response to a proportionate change in the price of a related commodity Y.

Cross Elasticity of Demand = Proportionate change in Demand of X commodity upon Proportionate change in the price of Y commodity multiplied by100

It can also be expressed as:

Cross Elasticity of Demand

Considerations

There are two types of demand cross elasticity based on the type of goods, complementary goods and substitute goods.

Substitute Goods

Examples of Substitute goods include as tea & coffee, jaggery & sugar. For such goods, cross elasticity of demand is positive, that is, an increase in the price of a commodity leads to a decrease in demand, but demand for the substitute will increase and vice versa. For example, Pepsi and Coca Cola.

Complementary goods

Examples of complementary goods include scooter and petrol, pen and ink. For such goods, cross elasticity of demand is negative. With an increase in the price of a commodity, the demand for its complementary goods decreases and vice versa. For example, Car and Petrol.

Cross elasticity is zero when goods are independent of each other.

For example, Car and Clothing.

Arc Elasticity of Demand

It measures the elasticity of demand between two points on the demand curve.

The mathematical formula for arc elasticity of demand can be expressed as:

Arc Elasticity of Demand

Promotional Elasticity of Demand

Also called Advertisement Elasticity of Demand, it is a measure of the elasticity of demand due to advertisements and other related promotional efforts. It is always positive.

The mathematical formula for promotional elasticity of demand is expressed as:

Promotional Elasticity of Demand

Degrees or Types of Elasticity of Demand

Demand for certain commodities is more elastic than that for other commodities, that is, the effects of change in price elasticity of demand are not equal.

The elasticity of demand is divided into 5 types: ‘Elasticity of demand’ here refers only to ‘Price elasticity of demand’.

1. Perfectly Elastic Demand

This is said to be when the demand for a commodity increases or decreases to any extent without any change or only a small change in its price. It is an imaginary concept. In real life, no commodity has perfectly elastic demand. The concept can be explained only with the help of an imaginary demand schedule and curve:

As an example, we can see the quantity demanded is changing while the price remains fixed at 10. Such demand is perfectly elastic demand.

Let us understand Perfectly Elastic Demand through a graph

Perfectly Elastic Demand

When the demand of a commodity keeps on changing even if there is no change in its price, it is called perfectly elastic demand. The demand curve is horizontal straight line. This concept is not practical

2. Highly Elastic Demand

This is said to be when a proportionate change in demand for a commodity is higher than the proportionate change in its price. Example: Demand for luxurious goods.

For instance, if there is 2% increase in the price of a commodity and its demand decreases by 10%, the demand for said commodity is highly elastic.

As an example, we can see that when the price falls by 20% from 10 rupees to 8, there is a change in quantity demanded from 100 to 140 which is basically equal to a rise of 40%. As you can understand, change in quantity demanded is more than the change in price

Highly Elastic Demand

Let us summarize Highly Elastic Demand through a graph

When the proportionate change in demand is more than the proportionate change in the price of the commodity, it is called highly elastic demand

3. Elastic Demand

When a proportionate change in the demand for a commodity equals a proportionate change in its price, the demand for that commodity is said to be elastic. The Demand for comfort goods is a good example of elastic demand.

Elastic Demand

For instance, if there is an increase in the price of a commodity and its demand decreases by 10%, it is called unitary elastic demand.

As an example, the price falls from 10 to 8 which is a fall of 20%, and in proportion the quantity also increased by exactly 20% from 100 to 120.

When proportionate change in demand and proportionate change in price are equal it is called elastic demand.

4. Less Elastic Demand

When a proportionate change in the demand for a commodity is less than the proportionate change in its price, the demand for that commodity is less elastic. Example: Demand for necessities.

For instance, if there is a 20% increase in the price of a commodity, while the demand for it decreases by 5%, demand for the commodity is less elastic.

Less Elastic Demand

As an example, we can see that price falls by 20% from 10 to 8, demand only increases by 5% from 100 to 105.

When proportionate change in demand is less than the proportional exchange in the price of commodity, it is called less elastic demand.

5. Perfectly Inelastic Demand

If the demand for a commodity does not change, irrespective of changes in its price, the commodity is said to have perfectly inelastic demand.

For instance, demand for salt, food grains and medicine is unaffected by price.

As an example, we can see that when price keeps on falling from 10 to 8 and then to 6, there is absolutely no change in the quantity demanded of the goods.

When there is no change in demand irrespective of any change in price of commodity, it is called perfectly inelastic demand.

Methods for Measuring Elasticity of Demand

There are three methods for measuring the price elasticity of demand

  1. Total Revenue or Total Outlay method
  2. Proportionate or Percentage method
  3. Point Method/Geometric Method

Total Revenue or Total Outlay Method

Total Revenue or Total Outlay Method

A commodity’s elasticity of demand is calculated by measuring the effect of a certain change in its price on the total expenditure (outlay).

Total outlay refers to a consumer’s total expenses on the purchase of a commodity.

Total outlay = Quantity purchased × Price of the commodity

1. Total Revenue or Total Outlay Method

This method can be illustrated as follows

Unitary Demand Elasticity (edp = 1)

It occurs when the total outlay does not change with a change in a commodity’s price. If the price falls, the consumer will increase the quantity of consumption such that the total outlay on the commodity remains the same, and vice versa.

Relatively Elastic Demand or More than Elastic Demand (edp>1)

It occurs when a consumer’s total outlay on the consumption of a particular commodity increase with a fall in its price, and vice versa.

Relatively Inelastic Demand or Less than Elastic Demand (edp<1)

It occurs when a consumer’s total outlay on the consumption of a particular commodity increases with an increase in its price, and vice versa.

2. Proportionate or Percentage Method

This method improves over the outlay method, which does not provide a numerical measurement of the elasticity of demand.

Price Elasticity of Demand

3. Point Method/ Geometric Method

A particular point is decided on a straight-line demand curve to measure the elasticity of demand. The demand in the lower part of the demand curve is divided by that in the upper part of the curve.

Price Elasticity of Demand

If, Lower segment = upper segment: Demand has unitary elasticity

Lower segment > upper segment: Demand has more than unitary elasticity

Lower segment < upper segment: Demand has less than unitary elasticity

Determinants of Elasticity of Demand

1. Nature of Commodity

  • Demand of necessity goods is inelastic. E.g. salt, medicines.
  • Demand of comfort goods is elastic. E.g. milk, fruits.
  • Demand of luxurious goods is highly elastic.

2. Substitute Goods

  • If a close substitute for a commodity is available in the market, its demand will be elastic. E.g. soap, toothpaste.
  • If a close substitute for a commodity is not available in the market, its demand will be inelastic.

3. Different Uses of Commodity

  • If a commodity can be put to several uses, its demand will be elastic. E.g. Electricity.
  • If a commodity can be used only for few purposes, its demand will be less elastic or inelastic.

4. Price of a Commodity

  • Commodities that are priced very high or very low have relatively inelastic demand.
  • Demand for moderately priced goods tends to be elastic. E.g. Cloth

5. Effect of Nature and Habits of Consumers

Demand for commodities of habit is generally inelastic as a consumer purchases these irrespective of higher price. E.g. a chain smoker’s demand for cigarettes.

6. Distribution of Wealth:

  • If wealth distribution is unequal in society, demand for commodities will be less elastic because it divides society into rich and poor.
  • If wealth distribution is equal, the demand for commodities will be elastic.

7. Complementary Goods

Demand for complementary goods is inelastic. E.g. car & petrol.

8. Time Effect

  • Commodities are inelastic in the short run because substitution of one commodity by another is not very easy.
  • In the long run, consumers may start to use substitute goods, making the demand of almost all commodities tends to be elastic.

Relationship Between Price Elasticity and Total Revenue

Understanding the relationship between price elasticity of demand and total revenue helps firms in making pricing decisions.

A firm’s total revenue (TR) is given by the product of the price (P)and quantity (Q).

TR = P into Q

This relationship is further explained below.

When the demand is elastic (Ep>1)

A fall in price leads to an increase in total revenue and vice versa

This happens because price and total revenue move in opposite directions.

When the demand is inelastic (Ep <1)

A fall in price leads to decrease in total revenue and vice versa

This happens because price and total revenue move in same direction

And in the case of unitary demand (Ep = 1)

A fall or rise in price does not change Total revenue at all

In unitary demand cases, Total Revenue remains unchanged with changes in price.Relation Between Elasticity of Demand and Average & Marginal Revenues

Under imperfect competition, as a seller increases sales by lowering a product’s price, the firm’s average revenue (AR) and marginal revenue (MR) will fall.

MR falls aster than AR, and therefore, the marginal revenue curve will lie below the average revenue curve.

To explain graphically,

When the AR and MR curves fall downward in a straight line, the MR curve lies half-way between the AR curve and the Y-axis.

The average revenue curve of a firm is the same as the demand curve of the consumer for the firm’s product.

Therefore, the demand elasticity at any point on the demand curve is the same as the demand elasticity at the given point on the firm’s AR curve.

The elasticity of demand at C = Average Revenue divided by (Average Revenue – Marginal Revenue)

Elasticity on AR
MR
TR
Conclusion
Elastic
Positive
Increases
Marginal Revenue is positive when demand is elastic
Unit
Zero
Constant
Marginal Revenue is zero when demand is unit elastic
Inelastic
Negative
Decreases
Marginal Revenue is negative when demand is inelastic
  • understand the relationship further through the components involved.
    When the demand is Elastic
  • The Marginal revenue is Positive
  • Due to this the Total revenue Increases
  • Hence, Marginal Revenue is positive when demand is elastic
  • In the case of unitary demand
  • The Marginal revenue is Zero
  • This puts the Total revenue at constant
  • This essentially means that Marginal revenue is zero when demand is unit elastic
  • When the demand is inelastic
  • The Marginal revenue is negative
  • Due to this the Total revenue decreases
  • This brings to us the conclusion that Marginal Revenue is negative when demand is inelastic