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Unit2
Unit2
Structure:
2.1 Introduction Objectives 2.2 MeaningandlawofDemand 2.2.1 2.2.2 2.2.3 Exceptions ShiftsinDemand DeterminantsofDemand SelfAssessmentQuestions1 2.3 ElasticityofDemand 2.3.1 2.3.2 2.3.3 2.3.4 2.3.5 2.3.6 2.3.7 2.3.8 2.3.9 2.3.10 MeaningandkindsofElasticityofDemand PriceElasticityofDemandandDegreesofpriceElasticity DeterminantsofPriceElasticityofDemand MeasurementofPriceelasticityofDemand IncomeElasticityofDemand CrossElasticityofDemand AdvertisingElasticityofDemand SubstitutionElasticityofDemand PracticalImportanceofElasticityofDemand SelfAssessmentQuestions.2 Summary TerminalQuestions. AnswertoSAQs&TQs
DemandAnalysis
2.1 Introduction
DemandandSupplyarethetwomainconceptsinEconomics.Expertsareoftheopinionthatentire subject of economics can be summarized in terms of these two basic concepts. Hence the knowledgeaboutdemandandsupplyareofgreatimportancetoastudentofEconomics.
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2.2MeaningOfDemand
Thetermdemandisdifferentfromdesire,want,willorwish.Inthelanguageofeconomics,demand hasdifferentmeaning.Anywantordesirewillnotconstitutedemand Demand=Desiretobuy +Abilitytopay +Willingnesstopay The term demand refers to total or given quantity of a commodity or a service that are purchasedbytheconsumerinthemarketataparticularpriceandataparticulartime Thefollowingaresomeoftheimportantqualificationsofdemand Itisbackedupbyadequatepurchasingpower. Itisalwaysataprice. Itshouldalwaysbeexpressedintermsofspecificquantity Itiscreatedinthemarket. Itisrelatedtoaperson,placeandtime.
Consumers create demand. Demand basically depends on utility of a product. There is a direct relationbetweenthetwoi.e.,highertheutility,higherwouldbedemandandlowertheutility,lower wouldbethedemand. IndividualDemandSchedule Thedemandscheduleexplainsthefunctionalrelationshipbetweenpriceandquantityvariations,It isalistofvariousamountsofacommoditythataconsumeriswillingtobuy(andsosellerto sell)atdifferentpricesatoneinstantoftime. Itisnecessarytonotethatthedemandscheduleis
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prepared with referenceto theprice of the given commodityalone. We ignore the influence of all other determinants of demand on the purchase made by a consumer. The following individual demandscheduleshowsthatpeoplebuymorewhenpriceislowandbuylesswhenpriceishigh. Price(inRs.) 5.00 4.00 3.00 2.00 1.00 MarketDemandSchedule When the demand schedules of all buyers are taken together, we get the aggregate or market demand schedule. In other words, the total quantity of a commodity demanded at different pricesinamarketbythewholebodyconsumersataparticularperiodoftimeiscalledmarket demandschedule. Itreferstotheaggregatebehavioroftheentiremarketratherthanmeretotaling of individual demand schedules. Market demand schedule is more continuous and smooth when comparedtoanindividualdemandschedule. Price (Rs.) 5.00 4.00 3.00 2.00 1.00 100 200 300 400 500 200 300 400 500 600 300 400 500 600 700 A B C TotalMarket Demand 600 900 1200 1500 1800 QuantitydemandedinUnits 200 300 400 500 600
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3. Ithelpstostudytheeffectoftaxesonthetotaldemandforgoodsinthemarket. 4. Ithelpstoforecastthepercentageofprofitsduetovariationinpricesandtoarrangeproduction wellinadvance. 5 Ithelpsthemonopolisttomanipulatepricestostimulatedemandforaproduct. 6. Ithelpsthemanagerstoestimateitsproductionplaninaccordancewiththemarketdemand. DemandCurve A demand curve isa locus of points showing variousalternativepricequantity combinations. In short,thegraphicalpresentationofthedemandscheduleiscalledasademandcurve.
Y D
10
A B C E F
Price
8 6 4 2
D X
0 100200300400500
Demand
It represents the functional relationship between quantity demanded and prices of a given commodity.Thedemandcurvehasanegativeslopeoritslopedownwardstotheright.Thenegative slopeofthedemandcurveclearlyindicatesthatquantitydemandedgoesonincreasingaspricefalls andviceversa. TheLawOfDemand It explains the relationship between price and quantity demanded of a commodity. It says that demandvariesinverselywiththeprice.Thelawcanbeexplainedinthefollowingmanner: Other things being equal, a fall in price leads toexpansion in demand andarise in price leads to contraction in demand. The law can be expressed in mathematical terms as Demand is a decreasingfunctionofprice.Symbolically,thusD=F(p)where,DrepresentDemand,Pstandsfor
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PriceandFdenotestheFunctionalrelationships.Thelawexplainsthecauseandeffectrelationship betweentheindependentvariable[price]andthedependentvariable[demand].Thereisnorulethat aconsumerhastobuymorewheneverpriceofthecommodityfallsandviceversa.Thelawexplains only the general tendency of consumers while buying a product. Thus, the law does not have universalvalidity. Aconsumerwouldbuymorewhenpricefallsduetothefollowingreasons: 1. Aproductbecomescheaper.[Priceeffect] 2. Purchasingpowerofaconsumerwouldgoup.[Incomeeffect] 3. Consumerscansavesomeamountofmoney. 4. Cheaperproductsaresubstitutedforcostlyproducts[substitutioneffect]. ImportantFeaturesofLawofDemand 1. Thereisaninverserelationshipbetweenpriceanddemand. 2. Priceisanindependentvariableanddemandisadependentvariable 3. Itisonlyaqualitativestatementandassuchitdoesnotindicatequantitativechangesinpriceand demand. 4. Generally,thedemandcurveslopesdownwardsfromlefttoright. TheoperationofthelawisconditionedbythephraseOtherthingsbeingequal.Itindicatesthat given certain conditions certain results would follow. The inverse relationship between price and demandwouldbevalidonlywhentastesandpreferences,customsandhabitsofconsumers,prices ofrelatedgoods,andincomeofconsumerswouldremainsconstant.
2.2.1 ExceptionsToTheLawOfDemand
Generally speaking, customers would buy more when price falls in accordance with the law of demand. Exceptions to lawof demand states that with a fall in price, demand also falls and withariseinpricedemandalsorises. Thiscanberepresentedbyrisingdemandcurve.Inother words,thedemandcurveslopesupwardsfromlefttoright.Itisknownasanexceptionaldemand curveorunusualdemandcurve. ItisclearfromthediagramthataspricerisesfromRs.4.00toRs.5.00,quantitydemanded alsoexpandsfrom10unitsto20units.
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Y D
5.00
Price
4.00 D
10
20
Demand
Followingaretheexceptiontothelawofdemand 1.GiffensParadox A paradox is a foolish or absurd statement, but it will be true. Sir Robert Giffen, an Irish Economists, with thehelpof his ownexample (inferior goods) disproved the law ofdemand. The GiffensparadoxholdsthatDemandisstrengthenedwithariseinpriceorweakenedwithafall in price. He gave the exampleof poor people of Ireland who were using potatoes and meat as dailyfoodarticles.Whenpriceofpotatoesdeclined,customersinsteadofbuyinggreaterquantities ofpotatoesstartedbuyingmoreofmeat(superiorgoods).Thus,thedemandforpotatoesdeclinedin spiteoffallinitsprice. 2.Veblenseffect ThorsteinVeblen,a noted AmericanEconomist contends that there are certain commodities which are purchased by rich people not for their direct satisfaction, but for their snob appeal or ostentation.Veblenseffectstatesthatdemandforstatussymbolgoods wouldgoupwith a ariseinpriceandviceversa.Incaseofsuchstatussymbolcommoditiesitisnotthepricewhichis importantbutthe prestige conferredby that commodityona person makes himtogofor it. More commonlycitedexamplesofsuchgoodsarediamondsandpreciousstones,worldfamouspaintings, commoditiesusedbyworldfigures,personalitiesetc.Therefore,commoditieshavingsnobappeal aretobeconsideredasexceptionstothelawofdemand. 3.Fearofshortage When seriousshortages are anticipated by the people, (e.g., during the warperiod) they purchase moregoodsatpresenteventhoughthecurrentpriceishigher.
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4.Fearoffutureriseinprice Ifpeopleexpectfuturehikeinprices,theybuymoreeventhoughtheyfeelthatcurrentpricesare higher.Otherwise,theyhavetopayastillhighpriceforthesameproduct. 5.Speculation Speculationimpliespurchaseorsaleofanassetwiththehopethatitspricemayriseoffall and make speculative profit. Normally speculation is witnessed in the stock exchange market. Peoplebuymoresharesonlywhentheirpricesshowarisingtrend.Thisisbecausetheygetmore profit,iftheyselltheirshareswhenthepricesactuallyrise.Thus,speculationbecomesanexception tothelawofdemand. 6Conspicuousnecessaries Conspicuous necessaries are those items which are purchased by consumers even though theirpricesarerisingonaccountoftheirspecialusesinourmodernstyleoflife. In case of articles like wrist watches, scooters, motorcycles, tape recorders, mobile phones etc customersbuymoreinspiteoftheirhighprices. 7.Emergencies Duringemergencyperiodslikewar,famine,floodscyclone,accidentsetc.,peoplebuycertainarticles eventhoughthepricesarequitehigh. 8.Ignorance Sometimespeoplemaynotbeawareofthepricesprevailinginthemarket.Hence,theybuymoreat higherpricesbecauseofsheerignorance. 9.Necessaries Necessariesarethoseitemswhicharepurchasedbyconsumerswhatevermaybetheprice. Consumerswouldbuymorenecessariesinspiteoftheirhigherprices.
2.2.2ChangesOrShiftsInDemand
It is to be clearly understood that if demand changes only because of changes in the price of the givencommodityinthatcasetherewouldbeonlyeitherexpansionorcontractionindemand.Bothof themcanbeexplainedwiththehelpofonlyonedemandcurve.Ifdemandchangesnotbecauseof pricechangesbutbecauseofotherfactorsorforces,theninthatcasetherewouldbeeither
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increaseordecreaseindemand.Ifdemandincreases,therewouldbeforwardshiftinthedemand curvetotherightandifdemanddecreases,thentherewouldbebackwardshiftinthedemandcure.
Y D D Price
2
1 D
Forward Shift
1 D
Backward Shift
2 D
D X
Demand 2.2.3DeterminantsOfDemand(Factorsthataffectorinfluencethedemand)
Demandforacommodityorserviceisdeterminedbyanumberoffactors.Allsuchfactorsarecalled asdemanddeterminants. 1. Price of the given commodity, prices of other substitutes and/or complements, future expected trendinpricesetc. 2. GeneralPricelevelexistinginthecountryinflationordeflation. 3. Levelofincomeandlivingstandardsofthepeople. 4. Size,rateofgrowthandcompositionofpopulation. 5. Tastes,preferences,customs,habits,fashionandstyles 6. Publicity,propagandaandadvertisements. 7. Qualityoftheproduct. 8. Profitmarginkeptbythesellers. 9. Weatherandclimaticconditions. 10. Conditionsoftradeboomorprosperityintheeconomy. 11. Terms&conditionsoftrade. 12. Governmentspolicytaxation,liberalorrestrictivemeasures. 13. Levelofsavings&patternofconsumerexpenditure. 14. Totalsupplyofmoneycirculationandliquiditypreferenceofthepeople. 15. Improvementsineducationalstandardsetc.
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Thus,severalfactorsareresponsibleforbringingchangesinthedemandforaproductinthemarket. Abusinessexecutiveshouldhavetheknowledgeandinformationaboutallthesefactorsandforces inordertofinalizehisownproductionmarketingandotherbusinessstrategies. Demandfunction Thelawofdemandanddemandscheduleexplainsonlythepricequantityrelations.Itisnecessary tonotethatmanyfactorsandforcesaffectthedemand.Itthesefactorsarerelatedtodemand,the demandscheduleistransformedintoademandfunction. The demand function for a product explains the quantities of a product demanded due to differentfactorsotherthanpriceinthemarketataparticularpointoftime Demand function is a comprehensive formulation which specifies the factors that influence the demandforaproductotherthanprice.Mathematically,ademandfunctioncanberepresentedinthe followingmanner. Dx = f(Ps,Pc,Ep,Y,Ey,T,W,A,U..etc).Where, Dx= DemandforcommodityX Pc = Priceofthecomplements Y = Incomeoftheconsumer T = Tastesandpreferences A = Advertisementanditsimpact. Ps=Priceofthesubstitutes Ep=Expectedfutureprice Ey=Expectedincomeinfuture W=Wealthoftheconsumer U=Allotherdeterminants
The knowledge of demand function is more important for a firm than the law of demand. Demand function explains the various factors and forces other than price that would affect the demandforacommodityinthemarket.Inaccordancewithchangesindifferentfactorsorforces,a firm can take suitable measures to prepare its production, distribution and marketing programs scientifically. SelfAssessmentQuestions1 1. Inatypicaldemandschedulequantitydemandedvaries___________withprice. 2. IncaseofGiffensgoods,priceanddemandgointhe______directions. 3. Ifdemandchangesasaresultofpricechanges,thanitisacaseof_____and____in demand. 4. Lawofdemandisa_________statement. 5. Demandfunctionismuchmore_______thanlawofdemand. 6. IncaseofVeblengoods,afallinpriceleadstoa_______indemand.
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2.3
ElasticityOfDemand
Earlier we have discussed the law ofdemand and its determinants. It tells us only the directionof changeinpriceandquantitydemanded.Butitdoesnotspecifyhowmuchmoreispurchasedwhen price falls or how much less is bought when price rises. In order to understand the quantitative changes or rate of changes in price and demand, we have to study the concept of elasticity of demand.
2.3.1MeaningAndDefinition
The term elasticity is borrowed from physics. It shows the reaction of one variable with respect to a change in other variables on which it is dependent. Elasticity is an index of reaction. Ineconomicsthetermelasticityreferstoaratiooftherelativechangesintwoquantities.Itmeasures theresponsivenessofonevariabletothechangesinanothervariable. Elasticityofdemandisgenerallydefinedastheresponsivenessorsensitivenessofdemand toagivenchangeinthepriceofacommodity. Itreferstothecapacityofdemandeithertostretch orshrinktoagivenchangeinprice.Elasticityofdemandindicatesaratioofrelativechangesintwo quantities.ie, price and demand. According to prof. Boulding. Elasticity of demand measures the responsiveness of demand to changes in price.1 In the words of Marshall, The elasticity (or responsiveness) of demand in a market is great or small according to as the amount demanded muchorlittleforagivenfallinprice,anddiminishesmuchorlittleforagivenriseinprice2 Kindsofelasticityofdemand Broadlyspeakingtherearefivekindsofelasticitiesofdemand.Weshalldiscusseachoneofthemin somedetail.
2.3.2. PriceElasticityOfDemand
Priceelasticityofdemandisoneoftheimportantconceptsofelasticitywhichisusedtodescribethe effectofchangeinpriceonquantitydemanded.Inthewordsof Prof. .Stonier and Hague, price elasticity of demand is a technical term used by economists to explain the degree of responsiveness of the demand for a product to a change in its price. Price
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elasticity of demand is a ratio of two pure numbers, the numerator is the percentage change in quantitydemandedand thedenominator is the percentage change in price of the commodity. It is measuredbyusingthefollowingformula. Percentagechangeinquantitydemanded Percentagechangeinprice Demandfallsby80%,ie 80 =4 pricerisesby20%,ie+20
Ep=
Demandrisesby80%,ie+80 =4 Pricefallsby20%,ie 20
It implies that at the present level with every change in price, there will be a change in demandfourtimesinversely.Generallythecoefficientofpriceelasticityofdemandalwaysholdsa negativesignbecausethereisaninverserelationbetweenthepriceandquantitydemanded. SymbolicallyEp = D D P X D PD 406 X =6 .220
Originaldemand=20units originalprice=600 Newdemand=60unitsNewprice=400 Intheaboveexample,priceelasticityis6. The rate of change in demand may not always be proportionate to the change in price. A small changeinpricemayleadtoverygreatchangeindemandorabigchangeinpricemaynotleadtoa greatchangeindemand.Basedonnumericalvaluesofthecoefficientofelasticity,wecanhavethe followingfivedegreesofpriceelasticityofdemand.
DifferentDegreeofPriceElasticityofDemand 1. PerfectlyElasticDemand:Inthiscase,averysmallchangeinpriceleadstoaninfinitechange in demand. The demand cure is a horizontal line and parallel to OX axis. The numerical co efficientofperfectlyelasticdemandisinfinity(ED=00)
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Y Price
ED= D D
X Quantity
2. Perfectly Inelastic Demand: In this case, what ever may be the change in price, quantity demandedwillremainperfectlyconstant.Thedemandcurveisaverticalstraightlineandparallel toOYaxis.Quantitydemandedwouldbe10units,irrespectiveofpricechangesfromRs.10.00 toRs.2.00.Hence,thenumericalcoefficientofperfectlyinelasticdemandiszero.ED=0
Y
10.00
Price
ED=00
2.00
0
D 10 Quantity
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Y D Price
3%
ED>1 /3% 9%
9%
= 3
D X
Demand
4. Relatively Inelastic Demand In this case,a large change inprice, say8 %fallprice, leads to less than proportionate change in demand, say4 % rise in demand. One can notice here that change in demand is less than that of change in price. This can be represented by a steeper demandcurve.Hence,elasticityislessthanone.
D Price
8% ED<1
4% / 8%=0.5
4% D X
Demand
Inalleconomicdiscussion,relativelyelasticdemandisgenerallycalledaselasticdemandormore elasticdemandwhilerelativelyinelasticdemandispopularlyknownasinelasticdemandorless elasticdemand. 5. Unitaryelasticdemand:Inthiscase,proportionatechangeinpriceleadstoequalproportionate changeindemand.Fore.g.,5%fallinpriceleadstoexactly5%increaseindemand.Hence, elasticityisequaltounity.Itispossibletocomeacrossunitaryelasticdemandbutitisarare phenomenon.
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Y D
Price
ED=1 5% D X
5%/5%=1
5%
Demand
Outoffivedifferentdegrees,thefirsttwoaretheoreticalandthelastoneisararepossibility.Hence, in all our general discussion, we make reference only to two termsrelatively elastic demand and relativelyinelasticdemand.
2.3.3. DeterminantsOfPriceElasticityOfDemand
The elasticity of demand depends on several factors of which the following are some of the importantones. 1. NatureoftheCommodity Commoditiescomingunderthecategoryofnecessariesandessentialstendtobeinelasticbecause peoplebuythemwhatevermaybetheprice.Forexample,rice,wheat,sugar,milk,vegetablesetc. ontheotherhand,forcomfortsandluxuries,demandtendstobeelastice.g.,TVsets,refrigerators etc. 2. ExistenceofSubstitutes Substitute goods are those that are considered to be economically interchangeable by buyers. If a commodity has no substitutes in the market, demand tends to be inelastic because people have to pay higher price for such articles. For example. salt, onions, garlic, ginger etc. In caseofcommoditieshavingdifferentsubstitutes,demandtendstobeelastic.Forexample,blades, toothpastes,soapsetc. 3. Numberofusesforthecommodity Singleusegoodsarethoseitemswhichcanbeusedforonlyonepurposeandmultipleuse goodscanbeusedforavarietyofpurposes.Ifacommodityhasonlyoneuse(singeuseproduct) theninthatcase,demandtendstobeinelasticbecausepeoplehavetopaymorepricesiftheyhave
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tousethatproductforonlyoneuse.Forexample,allkindsof.eatables,seeds,fertilizers,pesticides etc.Onthecontrary,commoditieshavingseveraluses,[multipleuseproducts]demandtendstobe elastic.Forexample,coal,electricity,steeletc. 4.Durabilityandreparabilityofacommodity Durable goods are those which can be used for a long period of time. Demand tends to be elastic in case of durable and repairable goods because people do not buy them frequently. For example, table, chair, vessels etc. On the other hand, for perishable and non repairable goods, demandtendstobeinelastice.g.,milk,vegetables,electronicwatchesetc. 5.Possibilityofpostponingtheuseofacommodity Incasethereisnopossibilitytopostponetheuseofacommoditytofuture,thedemandtendstobe inelastic becausepeople have tobuy them irrespective of their prices. For example, medicines. If thereispossibilitytopostponetheuseofacommodity,demandtendstobeelastice.g.,buyingaTV set,motorcycle,washingmachineoracaretc. 6.LevelofIncomeofthepeople Generallyspeaking,demandwillberelativelyinelasticincaseofrichpeoplebecauseanychangein market price will not alter and affect their purchase plans. On the contrary, demand tends to be elasticincaseofpoor. 7.RangeofPrices Therearecertaingoodsorproductslikeimportedcars,computers,refrigerators,TVetc,whichare costly in nature. Similarly, a few other goods like nails needles etc. are low priced goods. In all these case, a small fall or rise in prices will have insignificant effect on their demand. Hence, demand for them is inelastic in nature. However, commodities having normal prices are elastic in nature. 8.Proportionoftheexpenditureonacommodity When the amount of money spent on buying a product is either too small or too big, in that case demandtendstobeinelastic.Forexample,salt,newspaperorasiteorhouse.Ontheotherhand, the amount of money spent is moderate demand in that case tends to be elastic. For example, vegetablesandfruits,cloths,provisionitemsetc.
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9Habits Whenpeoplearehabituatedfortheuseofacommodity,theydonotcareforpricechangesovera certainrange.Forexample,incaseofsmoking,drinking,useoftobaccoetc.Inthatcase,demand tendstobeinelastic.Ifpeoplearenothabituatedfortheuseofanyproducts,thendemandgenerally tendstobeelastic. 10.Periodoftime Priceelasticityofdemandvarieswiththelengthofthetimeperiod.Generallyspeaking,intheshort period,demandisinelasticbecauseconsumptionhabitsofthepeople,customsandtraditionsetc.do notchange.Onthecontrary,demandtendstobeelasticinthelongperiodwherethereispossibility ofallkindsofchanges. 11.LevelofKnowledge Demandincaseofenlightenedcustomerwouldbeelasticandincaseofignorantcustomers,itwould beinelastic. 12.Existenceofcomplementarygoods Goodsorserviceswhosedemandsareinterrelatedsothatanincreaseinthepriceofoneof theproductsresultsinafallinthedemandfortheother.Goodswhicharejointlydemandedare inelasticinnature.Forexample,penandink,vehiclesandpetrol,shoesandcocksetchaveinelastic demandforthisreason.Ifaproductdoesnothavecomplements,inthatcasedemandtendstobe elastic.Forexample,biscuits,chocolates,ice0creamsetc.Inthiscasetheuseofaproductisnot linkedtoanyotherproducts. 13. Purchasefrequencyofaproduct Ifthefrequencyofpurchaseisveryhigh,thedemandtendstobeinelastic.Fore.g.,coffee,tea,milk, matchboxetc.ontheotherhand,ifpeoplebuyaproductoccasionally,inthatcasedemandtendsto beelasticforexample,durablegoodslikeradio,taperecorders,refrigeratorsetc. Thus,thedemandforaproductiselasticorinelasticwilldependonanumberoffactors.
2.3.4 Measurementofpriceelasticityofdemand
Therearedifferentmethodstomeasurethepriceelasticityofdemandandamongthemthefollowing twomethodsaremostimportantones. 1. Totalexpendituremethod. 2. Pointmethod.
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3. Arcmethod. 1. TotalExpenditureMethod Underthismethod,thepriceelasticityismeasuredbycomparingthetotalexpenditureofthe consumers(ortotalrevenuei.e.,totalsalesvaluesfromthepointofviewoftheseller)before and after variations in price. We measure price elasticity by examining the change in total expenditureasaresultofchangeinthepriceandquantitydemandedforacommodity. Totalexpenditure=PriceperunitxTotalquantitypurchased Pricein (Rs.) ICase 5.00 4.00 2.00 IICase 5.00 4.00 2.00 IIICase 5.00 4.00 2.00 Note: 1.Whennewoutlayisgreaterthantheoriginaloutlay,thenED>1. 2.WhennewoutlayisequaltotheoriginaloutlaythenED=1. 3.WhennewoutlayislessthantheoriginaloutlaythenED<1. Qty Demanded 2000 3000 7000 2000 2500 5000 2000 2200 4200 Total Nature
expenditure ofPED 10000 >1 12000 14000 10000 =1 10000 10000 10000 <1 8000 8400
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Price
ABCDistotalexpenditurecurve E=1
C D 0 E<1 X
TotalExpenditure
Fromthediagramitisclearthat 1.FromAtoBpriceelasticityisgreaterthanone. 2.FromBtoCpriceelasticityisequalthanone. 3.FromCtoDpriceelasticityislesserthanone. Note: Itistobenotedthatwhentotalexpenditureincreaseswiththefallinpriceanddecreaseswitha riseinprice,thenthePEDisgreaterthatone. Whenthetotalexpenditureremainsthesameeitherduetoariseorfallinprice,thePEDisequal toone. Whentotalexpenditure,decreasewithafallinpriceandincreasewithariseinprice,PEDissaid tobelessthanone. 2.PointMethod: Prof.Marshalladvocatedthismethod.Thepointmethodmeasurespriceelasticityofdemand.at different points on a demand curve. Hence, in this case attempt is made to measure small changes in both price and demand. It can be explained either with the help of mathematical calculationorwiththehelpofadiagramorgraphic representation.
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PED=
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Demand Itisclearthatonanystraightlinedemandcurve,priceelasticitywillbedifferentatdifferentpoints sincethedemandcurverepresentsthedemandscheduleandthedemandschedulehasdifferent elasticitysatvariousalternativesprices. Graphicalrepresentation The simplest way of explaining the point method is to consider a linear or straight line demand curve.LetthestraightlinedemandcurvebeextendedtomeetthetwoaxisXandYwhenapoint is plotted on the demand curve, it divides the curve into two segments. The point elasticity is measuredbytherationoflowersegmentofthedemandcurvebelow,thegivenpointtotheupper segmentofthecurveabovethepoint.Hence. Lowersegmentofthedemandcurvebelowthepoint Pointelasticity= Uppersegmentofthedemandcurveabovethepoint Inshort,e=L/UwhereestandsforPointelasticity,LforlowersegmentandUforuppersegment. InthediagramABisthestraightlinedemandcurveandPisisagivenpoint.PBisthelower segmentandPAistheuppersegment.
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Y A UpperSegment P
Lower Segment
Y D A
Price
Price
P D B Demand X
B Demand
Inthediagram,ABisthestraightlinedemandcurveandPisagivepointPBisthelower segmentandPAistheuppersegment. E=L/U=PB/PA Ifaftertheactualmeasurementofthetwopartsofthedemandcurve,wefindthat PB=3CMsandPA=2CMsthenelasticityatPointPis3/2=1.5 Ifthedemandcurveisnonlinearthenwehavetodrawatangentatthegivenpointextendingitto intersectbothaxes.Pointelasticityismeasurebytheratioofthelowerpartofthetangentbelowthat given point to the upper part of the tangent above the point. Then, elasticity at point P can be measuredasPB/PA. Incaseofpointmethod,thedemandfunctioniscontinuousandhence,onlymarginalchangescan be measured. In short, Ep is measured only when changes in price and quantity demanded are small. 3. ArcMethod Thismethodissuggestedtomeasurelargechangesinbothpriceanddemand.Whenelasticityis measured over an interval of a demand curve, the elasticity is called as an interval or Arc elasticity.Itistheaverageelasticityoverasegmentorrangeofthedemandcurve.Hence,itis alsocalledasaverageelasticityofdemand. ThefollowingformulaisusedtomeasureArcelasticity. Q2Q1 P2+P1 Arcelasticity=X Q2+Q1 P2P1 Illustration
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P1=originalprice1000.
Q1=originalquantity=200units By
Price
P1 DP P2
M
DD N D
X Q1 Q2 Demand Inthediagram,inordertomeasurearcelasticitybetweentwopointsM&Nonthedemandcurve, onehastotaketheaverageofpricesOP1andOP2andalsotheaveragequantitiesofQ1&Q2. Practicalapplicationofpriceelasticityofdemand 1. Productionplanning It helps a producer to decide about the volume of production. If the demand for his products is inelastic, specific quantities can be produced while he has to produce different quantities, if the demandiselastic. 2. Helpsinfixingthepricesofdifferentgoods Ithelpsaproducertofixthepriceofhisproduct.Ifthedemandforhisproductisinelastic,hecanfix a higher price and if the demand is elastic, he has to charge a lower price. Thus, priceincrease policy is to be followed if the demand is inelastic in the market and pricedecrease policy is to be followedifthedemandiselastic. Similarly,ithelpsamonopolisttopracticepricediscriminationonthebasisofelasticityofdemand. 2. Helpsinfixingtherewardsforfactorinputs Factorrewardsreferstothepricepaidfortheirservicesintheproductionprocess.Ithelpsthe producer to determine the rewards for factors of production. If the demand for any factor unit is inelastic,theproducerhastopayhigherrewardforitandviceversa. 3. Helpsindeterminingtheforeignexchangerates
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DemandAnalysis
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Exchange rate refers to the rate at which currency of one country is converted in to the currency of another country. It helps in the determination of the rate of exchange between the currenciesoftwodifferentnations.Fore.g.ifthedemandforUSdollartoanIndianrupeeisinelastic, inthatcase,anIndianhastopaymoreIndiancurrencytogetoneunitofUSdollarandviceversa. 4. Helpsindeterminingthetermsoftrade Itisthebasisfordecidingthetermsoftradebetweentwonations.Thetermsoftradeimpliesthe rateat which the domestic goods are exchanged to foreign goods. For e.g. ifthedemandfor JapansproductsinIndiaisinelastic,inthatcase,wehavetopaymoreintermsofourcommodities togetoneunitofacommodityfromJapanandviceversa. 5.Helpsinfixingtherateoftaxes Taxes refer to the compulsory payment made by a citizen to the government periodically withoutexpectinganydirectreturnbenfitfromit.Ithelpsthefinanceministertoformulatesound taxationpolicyofthecountry.Hecanimposemoretaxesonthosegoodsforwhichthedemandis inelasticandfewertaxesifthedemandiselasticinthemarket. 6. HelpsinDeclarationofPublicUtilities Public utilities are those institutions which provide certain essential goods to the general publicateconomicalprices.TheGovernmentmaydeclareaparticularindustryaspublicutilityor nationalizeit,ifthedemandforitsproductsisinelastic. 7.PovertyintheMidstofPlenty: Theconceptexplainstheparadoxofpovertyinthemidstofplenty.Abumpercropof riceorwheatinsteadofbringingprosperitytofarmersmayactuallybringpovertytothem becausethedemandforriceandwheatisinelastic. Thus,theconceptofpriceelasticityofdemandhasgreatpracticalapplicationineconomictheory.
2.2.5
INCOMEELASTICITYOFDEMAND
Income elasticity of demand may be defined as the ratio or proportionate change in the quantitydemandedofacommoditytoagivenproportionatechangeintheincome. Inshort,it indicatestheextenttowhichdemandchangeswithavariationinconsumersincome.Thefollowing formulahelpstomeasureEy.
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DemandAnalysis
Unit2
Symbolically
D Y EyX Y D
Originaldemand=400unitsOriginalIncome=400000 Newdemand=700unitsNewIncome=600000 Generallyspeaking,Eyispositive.Thisisbecausethereisadirectrelationshipbetweenincomeand demand, i.e. higher the income higher would be the demand and viceversa. On the basis of the numericalvalueofthecoefficient,Eyisclassifiedasgreaterthanone,lessthanone,equaltoone, equal to zero, and negative. The concept of Ey helps us in classifying commodities into different categories. 1.WhenEyispositive,thecommodityisnormal[usedindaytodaylife] 2.WhenEyisnegative,thecommodityisinferior..ForexampleJowar,beedietc. 3.WhenEyispositiveandgreaterthanone,thecommodityisluxury. 4.WhenEyispositive,butlessthanone,thecommodityisessential. 5.WhenEyiszero,thecommodityisneutrale.g.salt,matchboxetc. Practicalapplicationofincomeelasticityofdemand 1. Helpsindeterminingtherateofgrowthofthefirm. Ifthegrowthrateoftheeconomyandincomegrowthofthepeopleisreasonablyforecasted,inthat caseitispossibletopredictexpectedincreaseinthesalesofafirmandviceversa. 2. Helpsinthedemandforecastingofafirm. ItcanbeusedinestimatingfuturedemandprovidedtherateofincreaseinincomeandEyforthe productsareknown.Thus,ithelpsindemandforecastingactivitiesofafirm. 3. Helpsinproductionplanningandmarketing The knowledge of Ey is essential for productionplanning,formulating marketing strategy, deciding advertisingexpenditureandnatureofdistributionchanneletcinthelongrun.
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DemandAnalysis
Unit2
2.3.6. CrossElasticityOfDemand
It may be defined as the proportionate change in the quantity demanded of a particular commodityinresponsetoachangeinthepriceofanotherrelatedcommodity.Inthewordsof Prof. Watson cross elasticity of demand is the percentage change in quantity associated with a percentagechangeinthepriceofrelatedgoods.Generallyspeaking,itarisesincaseofsubstitutes andcomplements.Theformulaforcalculatingcrosselasticityofdemandisasfollows. Ec=PercentagechangeinquantitydemandedcommodityX PercentagechangeinthepriceofY Dx Py SymbolicallyEc= X Py Dx 40 4 X =1.6 250
PriceofTearisesfromRs.400to600percup Demandforcoffeerisesfrom50cupsto80cups. Crosselasticityofcoffeeinthiscaseis1.6. Itistobenotedthat 1.Crosselasticityofdemandispositiveincaseofgoodsubstitutese.g.coffeeandtea. 2.Highcrosselasticityofdemandexistsforthosecommoditieswhichareclosesubstitutes.Inother words,ifcommoditiesareperfectsubstitutesForexampleBataorCoronaShoes,closeupor pepsodenttoothpaste,Beansandladiesfinger,Pepsiandcocacolaetc. 3.Thecrosselasticityiszerowhencommoditiesareindependentofeachother.Forexample, stainlesssteel,aluminumvesselsetc.
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DemandAnalysis
Unit2
4.Crosselasticitybetweentwogoodsisnegativewhentheyarecomplementaries.Inthesecases, riseinthepriceofonewillleadtofallinthequantitydemandedofanothercommodityFor example,carandpetrol,penandink.etc. Practicalapplicationofcrosselasticityofdemand 1. Helpsatthefirmlevel Knowledgeofcrosselasticityofdemandisessentialtostudytheimpactofchangeinthepriceofa commodity which possesses either substitutes or complementaries. If accurate measures of cross elasticities are available, a firm can forecast the demand for its product and can adopt necessary safe guard against fluctuating prices of substitutes and complements. The pricing and marketing strategy of a firm would depend on the extent of cross elasticities between different alternative goods. 2. Helpsattheindustrylevel Knowledge of cross elasticity would help the industry to know whether an industry has any substitutesorcomplementariesinthemarket.Thishelpsinformulatingvariousalternativebusiness strategiestopromotedifferentitemsinthemarket.
2.3.7. AdvertisingOrPromotionalElasticityOfDemand.
Most of the firms, in the present marketing conditions spend considerable amounts of money on advertisement and other such sales promotional activities with the object of promoting its sales. Advertisingelasticityreferstotheresponsivenessdemandorsalestochangeinadvertising orotherpromotionalexpenses.Theformulatocalculatetheadvertisingelasticityisasfollows. Percentagechangeindemandorsales Ea= PercentagechangeinAdvertisementexpenditure DorSales A 40,000 800 SymbolicallyEa= X X =2.67 A Demandorsales 120010,000 Originalsales=10,000units Newsales=50,000units originaladvertisementexpenditure=80000 newadvertisementexpenditure =200000
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DemandAnalysis
Unit2
Intheaboveexample,advertisingelasticityofdemandis1.67.itimpliesthatforeveryonetime increaseinadvertisingexpenditure,thesaleswouldgoup1.67timesThus,Eaismorethanone. Practicalapplicationofadvertisingelasticityofdemand The studyof advertising elasticity ofdemand is of paramount importance to afirm in recent years becauseoffiercecompetition. 1.Helpsindeterminingthelevelofprices The levelofpricesfixed by onefirmfor its product would depend onthe amountofadvertisement expenditureincurredbyitinthemarket. 2.Helpsinformulatingappropriatesalespromotionalstrategy The volume of advertisement expenditure also throws light on the sales promotional strategies adoptedbyafirmtopushoffitstotalsalesinthemarket.Thus,ithelpsafirmtostimulateitstotal salesinthemarket. 3.Helpsinmanipulatingthesales Itisusefulindeterminingtheoptimumlevelofsalesinthemarket.Thisisbecausethesalesmade byonefirmwouldalsodependonthetotalamountofmoneyspentonsalespromotionofotherfirms inthemarket.
2.3.8.SubstitutionElasticityOfDemand.
Itmeasurestheeffectsofthesubstitutionofonecommodityforanother.Itmaybedefinedasthe proportionate change in the demand ratios of two substitute goods X and y to the proportionatechangeinthepriceratiooftwogoodsXandY Thefollowingformulasisusedto measuresubstitutionelasticityofdemand. Percentagechangeintheratioof2goodsxandy Es= Percentagechangeinthepriceratioof2goodsxandy
[Px/Py] Px/Py
WhereDx/DyisratioofquantitydemandedoftwogoodsX&Y.
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DemandAnalysis
Unit2
The coefficient of substitution elasticity is equal to one when the percentage change in demand ratiosoftwogoodsxandyareexactlyequaltothepercentagechangeinpriceratiosoftwogoodsx and y. It is greater than one when the changes in the demand ratios of x and y is more than proportionatetochangeintheirpriceratios.
2.3.9PracticalApplicationOfSubstitutionElasticityOfDemand
Theconceptofsubstitutionelasticityisofgreatimportancetoafirminthecontextofavailabilityof various kinds of substitutes for one factor inputs to another. For example, let us assume one computercandothejobof10laborersandifthecostofcomputerbecomescheaperthanemploying workers,inthatcase,afirmwouldcertainlygoforsubstitutingworkersforcomputers..Anemployer would always compare the cost of different alternative inputs and employ those inputs which are much cheaper than others to cut down his cost of operations. Thus, the concept of elasticity of demandhasgreattheoreticalaswellaspracticalapplicationineconomictheory. SelfAssessmentQuestion2 1. Lawofdemandexplainthe______________changeindemandandelasticityofdemandexplain ______changeindemand. 2. AccordingtoMarshall,_________isthedegreeofresponsivenessofdemandtothechangein priceofthatcommodity. 3. Therelativelyelasticdemandcurveis______ 4. When the quantity demanded increases with the increase in income, we say that income elasticityofdemandwillbe____.Whenquantitydemandeddecreaseswithincreaseinincome, wesaythattheincomeelasticityofdemandis____. 5. _______helpsthemanagertodecidetheadvertisementexpense. 6. Pointmethodhelpstomeasure_________quantityofchangeindemandandarcmethodshelps tomeasure____changesindemand.
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DemandAnalysis
Unit2
2.4 Summary Demandiscreatedbyconsumers.Consumerscancreatedemandonlywhentheyhaveadequate purchasingpowerandwillingnesstobuydifferentgoodsandservices.Thereisadirectrelationship between utility and demand. Law of demand tells us that there is an inverse relationship between priceanddemandingeneral.Sometimescustomersbuymoreinspiteofriseinthepricesofsome commodities. Thus, the law of demand has certain exceptions. Demand for a product not only dependsonpricebutalsoonanumberofotherfactors.Inordertoknowthequantitativechangesin bothpriceanddemand,onehastostudyelasticityofdemand.Priceelasticityofdemandindicates the percentage changes in demand as a consequence of changes in prices. The response from demandtopricechangesisdifferent.Hence,wehaveelasticandinelasticdemand.Onecanexactly measuretheextentofpriceelasticityofdemandwiththehelpofdifferentmethodslikepointandArc methods.Incomeelasticitymeasuresthequantumofchangesindemandandchangesinincomeof the customers. Cross elasticity tells us the extent of change in the price of one commodity and corresponding changes in the demand for another related commodity. Substitution elasticity measurestheamountofchangesindemandratiooftwosubstitutegoodstochangesinpriceratioof two substitutegoods in the market. The concept of elasticityof demand hasgreat theoretical and practicalapplicationinallaspectsofbusinesslife. TerminalQuestions 1. Stateandexplainthelawofdemand. 2. Discussthevariousexceptionstolawofdemand. 3. Explaintheconceptsofshiftsindemand 4. Explainthevariousdeterminantsofdemand 5. What is elasticity of demand ? explain the different degree of price elasticity with suitable diagrams 6. Discussthedeterminantsofpriceelasticityofdemand. 7. Discussanyonemethodofmeasuringpriceelasticityofdemand. 8. Explainthecross,income,advertisingandsubstitutionelasticityofdemand. 9. Discussthepracticalimportanceofvarioustrendsofelasticityofdemand.
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DemandAnalysis
Unit2
AnswerforSelfAssessmentQuestions SelfAssessmentQuestions 1 1. Inversely 2. Same/upward 3. Expansion,contraction 4. Qualitative 5. Comprehensive/wider 6. Fall. SelfAssessmentQuestions2 1. Directionpercentage 2. PriceElasticityofDemand 3. Flatter 4. Positivenegative. 5. AdvertisementElasticityofDemand. 6. Small,large AnswerstoTerminalQuestions 1. Refertounits2.2 2. Refertounits2.3 3. Refertounits2.4 4. Refertounits2.5 5. Refertounits2.2.1and2.2.2 6. Refertounits2.2.3 7. Refertounits2.2.4 8. Refertounits2.2.5,2.2.6,2.2.7to2.2.8 9. Refertounits2.2.4,2.2.5,2.2.6,2.2.7and2.2.8
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