Elasticity of Demand

The law of demand indicates only the direction of change in quantity demanded in response to change in prices. However, this does not tell us by how much the or to what extent the quantity demanded of a good will change due to the change in its price. This information as to how much or to what extent the quantity demanded of a good will change as a result of a change in its price is provided by the concept of ELASTICITY OF DEMAND. It is price elasticity of demand which is usually referred to as elasticity of demand.
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 But, since we have seen in earlier discussions, demand for a good is determined by its price, incomes and price of related goods etc. The concept of elasticity of demand therefore, refers to the degree of responsiveness of quantity demanded of a good to a change in its price, income and prices of related goods. Accordingly, there are three kinds of demand elasticity: o Price Elasticity o Income Elasticity o Cross Elasticity
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Price Elasticity of Demand:

The price elasticity of demand refers to the responsiveness of quantity demanded of goods to the change in its price only. In other words, price elasticity of demand is a measure of the relative change in quantity purchased of a good in response to the relative change in its price. So, According to Robinson, the Price elasticity of demand can be precisely defined as the proportionate change in quantity demanded in response to small change in price divided by the proportionate change in price, thus:
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 Price elasticity =
Proportionate Change in Quantity Demanded --------------------------------------------------------------Proportionate Change in Price

That means,
Change in quantity demanded/quantity demanded -------------------------------------------------------------------------Change in price/original price In symbolical terms: eP = (q/q)/(p/p) = (q/q) x (p/ p) = (q/ p) x (p/q) Where, eP stands for price elasticity q stands for quantity p stands for price stands for change

 Mathematically speaking, price elasticity of demand (eP) is negative, since the change in quantity demanded is in opposite direction to the change in price. That is based on the law that when price falls quantity demanded rises and vise versa. But for the sake of convenience in understanding the magnitude of response of quantity demanded to the change in price we ignore the minus sign and take into account only the numerical value of the elasticity. Broadly there are two types of Elasticity of demand such as: Elastic Demand and Inelastic Demand. This can shown in the following diagrams: 5

Elastic Demand:
Price

P P1

Q1

Quantity

Inelastic Demand:
Price

P1

Q1

Quantit y
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Income Elasticity of Demand:

Income is a major determinants of demand for a number of goods. The income demand function can be defined as

D = f(M)

This suggests that the demand may change due to a change in the consumers income, other factors remaining constant. The income elasticity of demand measures the degree of responsiveness of demand for a good to change in the consumers income. So, the Income elasticity is defined as proportional change in the quantity demanded to the proportional change in income.
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 The income elasticity is therefore calculated as: Percentage change in quantity demanded Ei = ------------------------------------------------------------Percentage change in income Symbolically, Ei = (%Q/% I)

Where, % Q stands for percentage change in demand, and % I stands for percentage change in income. It can be expressed as: Ei = (Q/Q) x (I/ I) Or, (Q/ I) x (I/Q)
Where, Q = Change in quantity demanded Q = Initial quantity I = Initial Income I = Change in income

Cross Elasticity of Demand:

In the cross elasticity of demand, we take into account the change in the price of commodity y and its effect on the demand for commodity x. The concept of cross elasticity of demand is important in the case of commodities which are substitutes and complementary to each other. For example: Tea and coffee are substitutes, Pen and Ink, car and petrol are complementary to each other. Therefore, the cross elasticity of demand refers to the degree of responsiveness of demand for a commodity to a given change in the price of some 10 related goods.

 In particular, the cross elasticity of demand between any two goods x and y is measured by dividing the proportionate change in the quantity demanded of x by the proportionate change in the price of y, thus:
Percentage change on demand for x Cross Elasticity = -------------------------------------------------Percentage Change in price of y Symbolically,

EC or EXY = (Qx/Qx)/ (Py/Py) Or, (Qx/ Py) x (Py/Qx)

Where, EC or EXY = Cross elasticity of demand Qx = Change in quantity demanded for commodity x Qx = Initial demand for x Py = Initial price of commodity y Py = Change in price of commodity y

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 The cross elasticity of demand measures the extent to which products are substitute or complementary. A positive cross elasticity of demand indicates that the two products in consideration are substitutes, since and increase/decrease in price one product (y) causes increase/decrease in the quantity demanded of other products (x). A negative cross elasticity of demand shows that the two products in consideration are complementary to each other, since an increase/decrease in the price of one product (y) leads to decrease/increase in the quantity demanded for other products (x).
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Hypothetical Numerical Example of Cross Elasticity of Demand: To illustrate the use of the formula, let us take a hypothetical example as:
Commodity Original Change

Price (Rs.)
Tea Coffee Bread Butter (50gm) 3 4 2 7

Quantity (Units)
50 30 80 30

Price (Rs.)
3 5 2 6

Quantity (Units)
60 20 90 40

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 From the above table, we may take the data for tea and coffee and measure the coefficient of price cross-elasticity of demand as: Let X = Tea, and Y = Coffee Qx = 50, Qx = 60 50 = 10 Py = 4, Py = 5 4 = 1 Exy = (Qx x Py)/(Py x Qx) = (10 x 4)/(1 x 50) = 4/5 = 0.8 Let X = Bread, Y = Butter Qx = 80, Qx = 90 80 = 10 Py = 7, Py = 6 7 = -1 Exy = (Qx x Py)/(Py x Qx) = (10 x 7)/(-1 x 80) = -7/8 = -0.88
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 Thus, the numerical coefficient of cross elasticity of demand may be either positive or negative. Substitute goods (Tea and Coffee) have positive price elasticity of demand. On the other hand, jointly demanded or complementary goods (bread and butter) have negative cross price elasticity of demand. A higher coefficient of cross elasticity obviously means a higher degree of substitutability or complementarity between two goods x and y. On the contrary, two unrelated goods have zero cross elasticity . The demand curves of these cross price elasticities are shown in the following diagrams as:
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1. Substitutes Goods of X and Y

Price of Y

D1

Quantity of X

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2. Complementary Goods of X and Y:

Price of Y

D2

Quantity of X

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3. Unrelated Goods of X and Y:

D3

Price of Y

Quantity of X

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 The nature of the goods relative to their uses mainly determines the cross elasticity of demand. The cross elasticity tends to be high when two goods satisfy the same wants equally well. In common sense we know that cross price elasticities should not be worked out in case of totally unrelated goods, for example, change in the price of razor blade and the demand for petrol.

Practical Application to the Business man:

In decision making, the concept of elasticity of demand is utmost use, for while taking decision for pricing policy, the business man has to know the likely effect of price change on the demand for his 19 product in the market.

 In particular, he has to consider, for instance, whether a lowering of price will cause in the expansion of demand for his product, If so, to what extent, and thus to what extent his total revenue would rise fetching what amount of profit. This he can know easily if he has the idea about the demand elasticity of his product. Most business man consciously or unconsciously know by intuition something about the elasticity of demand for their product while making price decision. Several, however, do not pay attention to the price elasticity of demand and make the wrong decision, 20 so suffer heavy losses.

 By knowing the type of elasticity of demand it is easy to know whether a price cut is better or a price rise for increasing the sales, total revenue and the profit. When demand for the product is found to be unitary elastic, price change is ineffective in bringing more of total revenue. In case of demand elasticity being more than unity, a price cut would lead to an increase in sales more than proportionately, so the total revenue will rise and in such cases the price policy would be beneficial. On the other hand if the product has inelastic demand, by rising the price no significant decrease in sales will be effected, so the total revenue and the profit will rise. In short, for elastic demand a business man would be better off by charging a low price and in case of inelastic demand, by putting a high price for the commodity, the business would be profitable.
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