Elasticity of demand

The elasticity of demand is defined as the rate of change in quantity demanded for a given change in price.

It is primarily related to extension or contraction of demand for a fall or rise in price.

Hence, this is called price elasticity of demand. But there are other factors which influence elasticity of

demand and accordingly we have three types of elasticity of demand.

a) price elasticity of demand

b) income elasticity of demand and

c) cross elasticity of demand

Price elasticity of demand Price elasticity of demand is the ratio of proportionate

change in the quantity demanded of a given commodity to a given proportionate change in its price.

The term ‘E’ gives the coefficient of price elasticity of demand.

If E is greater than one, the demand is said to be elastic. If E is less than one, the demand is said to be inelastic and if

E is equal to one, the demand is unitary. The terms elastic and inelastic are only relative terms. Based

on the elasticity we have five types of demand.

Perfectly of infinitely elastic demand

When a small change in price of a good causes more than a proportionate change (in both ways) in the quantity it is called perfectly or infinitely elastic demand.

The demand curve will be a horizontal line, parallel to the X- axis in the graph.

Perfectly inelastic demand

When a change in price causes no change in quantity, it is called perfectly inelastic demand.

The demand curve will be a vertical line.

Relatively elastic demand

When a small change in price causes a big change in quantity, it is called relatively elastic demand.

The coefficient of elasticity is more than one. The demand curve is a downward sloping curve.

Relatively inelastic demand

When a larger change in price causes a smaller change in quantity, it is called relatively inelastic demand.

The coefficient of elasticity is less than one. The demand curve will be steeper than the normal relatively elastic demand curve.

Unit elasticity of demand

When a change in price causes an exact change in quantity demanded of a commodity, it is called unit elasticity of demand.

The coefficient of elasticity is equal to one. The demand curve slopes more or less uniformly.

We generally come across the above types of demand but the perfectly inelastic and unitary elastic demand curves are rare.

Measurement of price elasticity of demand

Alfred Marshall explains the concept of elasticity of demand and three methods are used for its measurement viz, Point method, ARC method and Total outlay method.

Point Method In this method, the elasticity of demand is found

out at a particular point in the demand curve. For example, at the middle point of the straight

line demand curve, elasticity is equal to unity at the higher points of the demand curve, to the left of the middle point, elasticity is more than unity;

At lower points, to the right of the middle point elasticity is less than unity;

Elasticity is infinity at the point, where the demand curve coincides with the Y- axis and the elasticity is zero at the point where the demand curve coincides with the X-axis.

ARC method

The point method considers minute changes in price and demand which is not realistic.

In reality, we come across demand schedules with gaps in prices and quantities.

Hence the point method has become absolute. The ARC method is a better method for

measuring demand elasticity using the following formula.

ARC method

Arc Elasticity of demand = ∆q ÷ ∆ p (q1 + q2 ) (p1 + p2)

2 2 Where ∆q = change in quantity ∆p = change in price q1 = original quantity

q2 = new quantity

p1 = original price

p2 = new price

Total expenditure or outlay method

In this method, we consider the change in price and the consequent change in demand for a product in relation to the total amount of money spent by the consumer on the product.

The drawback of this method is that we may not know exactly the value of ‘E’ in numerical terms. The classification can be simply made as elastic or inelastic or unitary demand

Income elasticity of demand

The income elasticity of demand is the ratio of proportionate change in the quantity demanded of a commodity to a given proportionate change in the income of the consumer.

Ey = Percentage change in quantity demanded Percentage change in income

there,

Ey = income elasticity of demand

There are five kinds of income elasticity of demand.

Zero income elasticity of demand

It occurs when a given increase in consumer’s money income fails to lead to any increase in the quantity demanded of a commodity

Negative income elasticity of demand

It happens when an increase in the consumer’s money income is accompanied by a fall in the quantity of goods purchased. It is more relevant to the inferior goods

Unitary income elasticity of demand

When the proportion of the consumer’s income spent on the goods is exactly the same both before and after the rise in income, then it is called unitary income elasticity of demand.

Income elasticity of demand greater than one

In this case, the consumer spends a greater proportion of money income on the commodity as he/she becomes richer.

Income elasticity of demand less than one

It occurs when the proportion of consumer’s money income spent on the commodity falls when his/her income increases.

For example, the expenditure on necessaries do not increase proportionately with increase in income.

Cross elasticity of demand

The degree of change in demand for a product as a result of change in the price of another product is known as cross elasticity of demand.

It shows how the demand for a commodity depends on the prices of related commodities which may be substitutes or complements.

The formula for cross elasticity of demand is as follows:

Importance of demand elasticity 

The concept of demand elasticity has enormous significance in economics as it finds application in production, price fixation, price stabilization, distribution, international trade, foreign exchange rate determination and public finance.

An understanding of elasticity of demand is required to frame economic policies also.

 

Engel's law

Consumption is a function of income. Among others, income and standard of living influence demand for a commodity.

The Engels of law of consumption, postulated by Dr. Ernest Engels in 1857, explains consumption pattern with reference to income.

According to the Engel’s law, as the family income increases, (i) the percentage expenditure on food and other necessaries decreases, (ii) the percentage expenditure remains almost constant in the case of clothing, fuel and light and (iii) the percentage expenditure on comforts and luxuries such as education, health, recreation, tends to increase.

The law explains that rich people will be spending smaller percentage of their income on necessaries of life, while they spend larger percentage on comforts and luxuries. The key word in the law is percentage expenditure and not the absolute expenditure.