Elasticity of Demand

Elasticity of Demand is the responsiveness of demand to change in price.

There are basically three types of elasticity

1. Price Elasticity of Demand
2. Income Elasticity of Demand
3. Cross Elasticity of Demand

Is the responsiveness of demand to change in price level. It measures responsiveness of potential buyer to change in price.

Price elasticity can be measured by the help of the following formula:

$\text{P.E.D} = \frac{\text{Percentage Change in Demand}}{\text{Percentage Change in Price}} = \frac{\Delta Q_d}{\Delta P_d}$

Price elasticity is always negative

Interpretation of price elasticity of demand

1. Perfectly inelastic (P.E.D = 0) This means that change in price has no effect of quantity demand.

2. Inelastic (P.E.D < 1)

   This means that a big change in price bring about a small change in demand

3. Unitary (PED = 1)

   This means that a change in price result into the equal change in demand

4. Elastic (PED > 1)

   This means that a small change in price result into a big change in demand

5. Perfect elastic (PED = ∞)

   This means that price is not changing (fixed) but quantity demanded in changing.

PED can be elastic or inelastic depending on the following factors

1. Degree of availability of close substitutes

   If a commodity has many close substitutes, its price elasticity of demand will be elastic as consumer can easily move over to other alternative. However on the other side, if commodities have few substitutes its demand will be inelastic.

2. Proportion of income spent on a good

   If the commodity takes a large percentage of someone's income, its demand will be price elastic as increase in the price can easily be felt. However if a commodity takes a small percentage of someone's income eg. Match box its demand will be price inelastic.

3. The level of Income

   With the high level of income demand will be price inelastic since increase in the price can easily be absorbed. On the other hand with the lower level of income the demand will be low hence price is inelastic.

4. Time period

   In the short run demand would be price inelastic as the answer will not be able to gain enough market information e.g. the prices of other completing goods. However in the long run demand would be price elastic as the consumer would have gain enough market information.eg. The price of substitutes.

5. The degree of necessity

   If the commodity is a necessity its demand would be price inelastic as a person cannot easily do without them on the other hand, the luxurious goods have elastic demand.

6. Habit

   For goods with addiction in their consumption eg. Cigarettes, alcohol, their demand is price inelastic, however those goods with no addiction use their demand is price elastic

7. Durability of a commodity

   Durable goods such as furniture have inelastic demand, since they can stand for a long period of time after has been bought on the other hand, on durable goods have elastic demand.

1. To the primary decision

   P.E.D is important to business in pricing decision making in order to maximize total revenue (TR). Therefore it is on the basis of the price elasticity of demand of the commodity that is selling will decide whether to increase or reduce the price (P) in order to maximize total revenue as below

When PED is perfectly inelastic he should increase the price to earn revenue since demand will remain exactly the same.

When P.E.D is inelastic, the business should decrease the price in order to earn total revenue because at such high price, demand will remain almost the same.

When price elasticity of demand is unitary the business should leave the price the same. Since increase or decrease in the price will lead to the total revenue to be the same.

When P.E.D is elastic a businessman should reduce the price in order to earn more revenue because decrease in price spark off a big increase in demand.

2. To a monopoly

   when carrying out price discrimination the monopolist considers the price elasticity of demand in the market in order to decide in which market to charge a high price and in which to charge low price. In that market where price is elastic, he should charge a low price and, in that market, where price is inelastic, he should charge a high price.

3. Wage determination

   Elasticity of demand for labor is important in wage determination in such a way that when demand for labor in a firm is inelastic, trade unions and laborers can easily succeed in bargaining for high wages than when the elasticity of demand of labor is elastic.

4. Government in taxation

   The government uses the concept of price elasticity of demand in determining which commodity to levy high tax and which to levy low taxes in order to collect more revenue. Those goods whose demand is price inelastic e.g. Cigarettes, alcohol etc. The government will levy high taxes however for the goods whose demand is price elastic the government will levy law taxes.

5. Determination of incident of a tax

   Determination of the incident of a tax between producer and the buyer is on the basis of the price elasticity of demand of the commodity as below. Demand for the commodity is price in elastic the bigger the burden is borne by the buyer and the small one by the producer. If elasticity of demand is century the burden shared equally between the producer and the buyer. If demand for the commodity is price elastic the smaller burden shared equally between the producer and the buyer. If demand for the commodity is price the smaller burden is borne by the buyer and the bigger burden is borne by the producer.

6. Under international trade (devaluation)

   Devaluation is the deliberate action by the government to lower the value of its currency in relation to foreign currency. It aims at increasing export and reducing import, however this is only possible if the price elasticity of demand of both exports and imports is elastic.

This is the measure of degree of responsiveness of demand due to change in the consumer's level of income.

$I.E.D = \frac{\text{proportionate change in demand}}{\text{proportionate change in income}}$

Where:

• $\Delta Y$ = Changing income
• $Y_0$ = Income before change
• $Q$ = Quantity

Interpretation of income elasticity

1. YED = -ve

This means that a commodity is an inferior good whereby as the income increases quantity decreases

2. YED = +ve

This means that a commodity is a normal good therefore as the level of income increases demand increases (Articles of Ostentation)

3. YED = 0

This means that the commodity in consideration is a necessity eg.medicine etc, therefore as the level of income increase demand remains.

4. YED < 1 (inelastic income elasticity)

This means that the big change in the level of income results into small change in demand. This is applicable under necessities.

5. YED > 1 (elastic income elasticity)

This means that the small change in the level of income results into big change in demand. This is applicable for inferior goods,

This is a measure of degree of responsiveness of demand of a good due to change in price of any substitute commodity

$C.E.D = \frac{\text{Percentage change in demand for good A}}{\text{Percentage change in price of another product B}}$

Interpretation of cross elasticity of demand

1. CED = +ve

This means the commodity in consideration is a close substitute eg, beans and peas, therefore when the price of one increase, demand of the other increase and vice versa.

2. CED = -ve

This means that two commodities in consideration are complement (jointly demanded) e.g. car and petrol for such goods when the price of one increases demand for the other decrease and vice versa.

3. CED = 0

This means that the two commodities in consideration are not related at all, therefore a change in the price of one does not bring about any change in demand of the other e.g. Car and table

Arc elasticity

According to Baum, "Arc Elasticity is a measure of the average responsiveness to price change exhibited by a demand curve over some finite stretch of the curve"

Or

Arc elasticity is an estimate of the elasticity along average of demand curve. It can be calculated for both linear and non-linear demand curve using the following formula.

$\text{Arc e.d} = \frac{-\Delta Q}{\Delta P} \times \frac{P_1 + P_2}{Q_1 + Q_2}$

Or

$\text{Arc eD} = \frac{\text{difference in Q}}{\text{Sum of Q}} \times \frac{\text{difference in P}}{\text{Sum of P}}$

Therefore

$\text{Arc e.D} = \frac{q_1 - q_2}{p_1 - p_2} \times \frac{q_1 + q_2}{p_1 + p_2}$

Point elasticity

Point Elasticity of demand is measured by the slope of tangent to the demand curve at that point.

Price elasticity with complete accuracy at a point on the demand curve.

The formula for calculating point elasticity of demand is as follows:

$\text{Point ed} = \frac{-dq/q}{dp/p} = \frac{dq \times p_o}{dp \times q_o}$

There are several factors which determine the elasticity of demand.

These are the following:

1. For necessaries of life demand is less elastic.

   As regards the necessaries of life demand is less elastic because these commodities are purchased at whatever price they may be. They change in price does not matter so far as demand for such commodities is concerned. Wheat and cloth are examples of such things.

2. Demand for luxuries is more elastic.

   The demand for luxuries is more elastic in the sense that a little change in price level brings a greater change in demand. Television and video sets are examples of such things

3. For substitute demand is more elastic.

   The commodities which have their substitute, their demand is more elastic. For example, when price of tea rises, demand for tea will decrease to great extent because more coffee will be demanded.

4. Demand for goods having several uses is more elastic.

   The commodities which have various uses, they have more elastic demand. Coal is such a case when it is cheap the use for less urgent needs will extend and when its price goes to rise, it will be put only to more urgent uses and its demand will decrease to a great extent.

5. Demand for goods the use of which can be postponed.

   Demand for goods, the use of which can be postponed is more elastic 'for example, when building material is very costly, the building activities are very much reduced and vice versa.

6. Price level

   Elasticity also depends upon the price. If the price is either too high or too low, the demand will be less elastic. For example, in the case of cars and salt.