ELASTICITY OF DEMAND

ELASTICITY OF DEMAND 

Elasticity is the proportional (or percent) change in one variable due to the proportional change in another variable. The formula for elasticity is:

  E = percentage change in X / percentage change in Y Elasticity can either be a positive or a negative value. When the proportional change in one variable is equal to the

proportional change in the other variable, then it is called Unit Elasticity. It can be represented as E = 1.

Elasticity can be relatively elastic (E >1), when the proportional change in x is greater than the proportional change in y.

Elasticity can be perfectly inelastic (E = 0), when any change in y will have no effect on x.

Elasticity can be infinity (E = infinity) or perfectly elastic when a change in y will have infinite effect on x.

Elasticity can be less than one (E < 1) i.e., relatively inelastic when the proportional change in x is less than the proportional change in y.

price elasticity of demand The price elasticity of demand measures

the responsiveness of the quantity demanded of a good or services to a change in the price of the good or service. The price elasticity of demand is defined as the magnitude (absolute value) of the percentage change in the quantity demanded divided by the percentage change in the price.

E.D = %∆Q / %∆P

Elasticity and Revenue

Whether a change in the price of the good raises, does not change, or lowers the sellers' total revenue depends on the elasticity of demand.

If the demand for the good is elastic, a rise in its price lowers total revenue.

If the demand for the good is unit elastic, a rise in its price does not change total revenue.

If the demand for the good is inelastic, a rise in its price raises total revenue.

The total revenue test uses the relationships between the price elasticity of demand and the change in total revenue to determine whether demand is elastic, inelastic, or unit elastic by examining how total revenue changes in response to a change in the price of the good.

What determines the size of Elasticity of Demand?

The magnitude of the elasticity of demand for a good depends on four factors:

Closeness of substitutes. The more readily other goods can be substituted for the product under study, the larger is the product’s elasticity of demand. Necessities generally have fewer substitutes and have an inelastic demand; luxuries often have many substitutes, so their demand frequently is elastic.

The proportion of income spent on the good. The greater the proportion of income spent on a good, the larger is its elasticity of demand.

The significance of price in total cost to the consumer. The time elapsed since a price change. In general, the more time that

has elapsed since a price change, the larger is the elasticity of demand. Distinguishing between two time frames, the short-run demand and the long-run demand, is useful.

The short-run demand shows the initial response of buyers to a change in price and is often inelastic.

The long-run demand describes the response of buyers to a price change after all adjustments have been made and generally is more elastic than the short-run demand.

Application of price elasticity of demand

Pricing decisions of business organizations: Before taking any decision regarding pricing of a product, a business organization has to consider the price elasticity of demand for that product. The reason to consider price elasticity is because the change in the price of product would change the quantity demanded of that product depending on its coefficient of price elasticity.Pricing regulation by governments: In many countries, the government fixes the price of some products. Prominent among such products are agricultural products, demand for which is highly inelastic in nature. By restricting the supply of agricultural products, governments can raise these product prices. Demand for these products being inelastic, even after a rise in the price consumers will not reduce consumption. Hence, the expenditure of consumers on agricultural products will increase, and this in turn will increase the income of agriculturists. 

‘Paradox’ of plenty: In agricultural sector, the theory of price elasticity explains the ‘paradox’ of plenty. An increase in the supply of crops as a result of good harvest season leads to a fall in their prices. As a result, the income of farmers falls and sometimes they are unable to meet their expenditures on crop production. Hence, to ensure that farmers do not lose during the time of overproduction of crops, the government declares the minimum price for crops. Minimum price is the price at which the government is prepared to buy the crops from the farmers. 

Use in international trade: Price elasticity of demand plays an important role in international trade. In case a country faces a poor balance of payments position due to rising imports and stagnant exports, the government of that country has to decide whether to devalue its currency or not. Here, the price elasticity of demand should be taken into consideration before devaluing the currency.

Fiscal policy: If the government wants to raise its income through fiscal policies, price elasticity plays a major role. The government mainly raises its income through imposing taxes. Taxes are of two types – direct and indirect. Usually the government tries to raise income through indirect taxes such as excise duty or sales tax, which raises the price of the product being sold in the market. Here, the analysis of price elasticity plays a crucial role. For example, if the government is increasing the tax on an elastic good, its price will increase. The rise in price reduces the demand for that commodity, which in turn will not help the government to increase its revenue. The government can increase its revenue through increasing indirect taxes only when they impose taxes on those products whose demand is inelastic. 

income elasticity of demand The income elasticity of demand measures how the demand for a

good responds to a change in income. The income elasticity of demand is defined as the percentage change in the quantity demanded divided by the percentage change in income,.

ηy= % of ∆ demand / % of ∆ income

If the income elasticity exceeds 1, an increase in income increases demand more than proportionally. Luxuries often have income elasticities of demand that exceed 1.

If the income elasticity is positive but less than 1, an increase in income increases demand but by a smaller proportion. Necessities frequently have positive income elasticities of demand that is less than 1.

If the income elasticity is negative, an increase in income decreases the demand for the good.

 

income elasticity of demand The income elasticity of demand is positive for

normal goods. For a normal good, as income increases, the quantity demanded increases. The income elasticity of demand is negative for inferior goods. For an inferior good, as income increases, the quantity demanded decreases.

The level of income influences the magnitude of the income elasticity of demand because what is a necessity and what is a luxury depend on the level of income. When people have very low incomes, food can be a luxury, but for people with high incomes, food is a necessity. As income increases, the income elasticity of demand for food decreases

Application of income elasticity of demand 

In developing countries like India, having scarce resources, income elasticity of demand helps firms to decide what to produce. Normally, developing economies face frequent fluctuations in business cycle. The demand for luxury products fluctuates very much during different phases of business cycles. During boom period, demand for luxury products increases significantly and declines sharply during recessionary period. Taking into account the income elasticity of a product, managers of a firm can decide what to produce. The firms producing products, which have a high income elasticity, have great potential for growth in a growing economy. For example, if a firm’s product income elasticity of demand is greater than one, it means that it will gain more than proportionately to the increase in national income. Hence, firms producing products having high-income elasticity are more interested in forecasting the level of national income. The concept of income elasticity of demand also helps a firm to decide its location and to develop its marketing strategies. For example, the firms producing products having high-income elasticity of demand will try to locate its retail outlets where the incomes of consumers are increasing rapidly. Moreover, these firms will direct their advertisement to those segments of people having high incomes.  

cross elasticity of demand The cross elasticity of demand

shows how the demand for a good responds to a change in the price of another product. The cross elasticity of demand equals the percentage change in the quantity demanded of the good divided by the percentage change in the price of the other good.ηx= % of ∆ demand of A / % of ∆

price of B

When the cross elasticity of demand is positive, the goods are substitutes. The increase in the price of a good increases the demand for its substitutes. When the cross elasticity of demand is negative, the goods are complements. The increase in the price of a good decreases the demand for its complements.

Application of cross elasticity of demand

The knowledge of cross elasticity of demand is very important in managerial decision making for developing an appropriate price strategy. Firms selling multiple products use cross elasticity of demand to analyze the effect of change in the price of one product to the demand of others. For example, Hindustan Lever Limited (HLL), the leading fast-moving consumer goods manufacturer offers several soaps for the middle income segment – Hamam, Lux, Breeze, Liril, Lifebuoy Gold, etc. These soaps are good substitutes for each other and therefore cross elasticity of demand between them is high. If HLL increases the price of Lux significantly, the demand for Lux goes down while the demand for other soaps like Breeze or Liril will increase. So considering the cross elasticity of demand, HLL will be fixing appropriate prices for all its soaps. Thus, cross elasticity of demand helps an organization to price its products in such a way that any increase or decrease in the price of a product should have positive influence on the organization's profits.

Firms producing similar kinds of product and services i.e., operating in same industry having a positive cross elasticity of demand. For example, P&G and HLL are having a positive cross elasticity of demand between each other in fabric and home care products. Hence, if HLL plans to increase the price of Surf, a washing detergent, the demand for P&G’s similar products like Ariel and Tide will increase.

Advertising or Promotional Elasticity of Demand

Advertising includes visual and oral promotional activities with an objective to create new and increase existing demand for a product or service. Advertising plays an important role in the competitive market economy. Advertising elasticity of demand measures the extent of change in the quantity demanded of a product to change in expenditure on advertisements and other promotional activities. The demand for certain products is more responsive to advertising e.g. cosmetics. The advertising elasticity can be measured by two methods – Point method and Arc method. The point formula for advertising elasticity of demand is:

E = ∆Q /A * ∆A /Q