demand elasticity

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INTRODUCTION Demand is desire backed by willingness to pay and ability to pay i.e. a wish to have a commodity does not become demand. A person wishing to have a commodity should be willing to pay for it and should have ability to pay for it. Thus a desire becomes demand if it is backed by willingness to pay and ability to pay. Demand is meaningless unless it is stated with reference to a price. Decisions regarding what to produce, how to produce and for whom to produce are taken on the basis of price signals coming from the market. The law of demand explains inverse relationship between price and quantity demanded. When price falls quantity demanded of that commodity will increase. The deficiency of law of demand is removed by the concept of elasticity of demand.

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  • INTRODUCTION

    Demand is desire backed by willingness to pay and ability to

    pay i.e. a wish to have a commodity does not become demand. A

    person wishing to have a commodity should be willing to pay for it

    and should have ability to pay for it. Thus a desire becomes demand

    if it is backed by willingness to pay and ability to pay. Demand is

    meaningless unless it is stated with reference to a price.

    Decisions regarding what to produce, how to produce and for

    whom to produce are taken on the basis of price signals coming from

    the market. The law of demand explains inverse relationship

    between price and quantity demanded. When price falls quantity

    demanded of that commodity will increase. The deficiency of law of

    demand is removed by the concept of elasticity of demand.

  • MEANING AND DEFINITION

    OF

    ELASTICITY OF DEMAND

    The term elasticity was developed by Alfred Marshall, and is

    used to measure the relationship between price and quantity

    demanded. The law states that the price of a commodity falls, the

    quantity demanded of that commodity will increase, i.e. it explains

    only the direction of change in demand and not the extent of change.

    This deficiency is removed by the concept of elasticity of demand.

    Elasticity means responsiveness. Elasticity of demand refers

    to the responsiveness of quantity demanded of a commodity to

    change in its price.

    According to E.K. Estham, elasticity of demand is a measure of the

    responsiveness of quantity demanded to a change in price.

  • IMPORTANCE

    OF

    THE CONCEPT ELASTICITY

    The concept f elasticity of demand plays a crucial role in business-

    decisions regarding fixing of price with a view to make larger profit. For

    instance, cost of production is increasing the firm would want to pass the rising

    cost on to the consumer by raising the price. Firms may decide to change the

    price even without any change in the cost of production. But whether raising

    price following the rise in cost or otherwise proves beneficial depends on:

    a) The price elasticity of demand for the product, i.e. how high or low is the

    proportionate change in its demand in response to a certain percentage change in its

    price.

    b) Price elasticity of demand for its substitutes, because when the price of a

    product increases the demand for its substitutes increases automatically even if their

    prices remain unchanged.

    Raising the price will be beneficial only if:a) Demand for a product is less elasticb) Demand for its substitutes is much less elastic.

    Elasticity of demand establishes the quantitative relationship between

    quantity demanded and price or other demand determinants.

  • TYPES OF ELASTICITY

    These are three types of elasticity:-

    1. Price elasticity

    2. Income elasticitya. Zero income elasticity

    b. Negative income elasticity

    c. Positive income elasticity

    3. Cross elasticity

    1. Price Elasticity

    Price elasticity of demand may be defined as the degree of

    responsiveness of quantity demanded of a commodity in response to change in

    its price i.e. it measures how much a change in price of a good affects demand

    for that good, all other factors remaining constant. It is calculated by dividing the

    proportionate change in quantity demanded by the proportionate change in

    price.

    EP= Proportionate change in quantity demandedProportionate change in price

    2. Income elasticity

    Income elasticity of demand measures how much a change in income affects

    demand for that commodity if the price and other factors remains constant.

    EY= Proportionate change in quantity demandedProportionate change in income

  • A product with an income elasticity of more than one will experience a

    growth in demand that is higher than growth in consumers income. Luxury

    goods tend to have relatively high income elasticity. Low quality goods have

    negative income elasticities, as people stop buying them when they can afford

    to.

    There are three types of income elasticity

    Zero income elasticity Here a change in income will have no effect of quantity demanded. For example: - salt, matches, cigarettes.

    Negative income elasticity Here an increase in income leads to a decrease in quantity demanded. This happens in inferior goods.

    Positive income elasticity In this an increase in income will leads to an increase in quantity demanded. For most goods income elasticity is positive.

    3. Cross elasticity

    This measures the change in demand for a commodity due to change in

    price of another commodity.

    ED= Percentage change in quantity demanded of commodity APercentage change in price of commodity B

    If the goods having substitutes the cross elasticity is positive i.e. an

    increase in the price of X will result in an increase in sales of Y. If the goods are

    complementary and increase in the price of one commodity will depress the

    demand for the other. So cross elasticity will be negative. If the goods are

    unrelated cross elasticity will be zero. Because however much the price of one

    commodity increased demand for the other will not be affected by that increase.

  • There exist another two types elasticity viz.

    Elasticity of price expectation and

    Advertisement elasticity

    4. Advertisement elasticity or Promotional elasticity

    The expenditure n advertisement and other sales promotion activities

    does help in promoting sales, but not in the same degree at all levels of the total

    sales. The concept of advertisement elasticity is useful in determining the

    optimum level of advertisement expenditure. It may be defined as, the

    responsiveness of demand t to changes in advertising or other promotional

    expenses.

    Proportionate change in salesProportionate change in advertising and other promotional expenditure

    5. Elasticity of price expectations

    The price expectation elasticity refers to the expected change in future

    price as a result of change in current price of a product.

    pf / pf pf pc

    pc/pc pc pf

    Where Pc and Pf are current and future price. The coefficient ex gives

    the measure of expected percentage change in future price as a result of 1

    percent change in present price. If ex > 1 it indicates the future change in price

    will be greater than the present change in price. If ex=1, it indicates that the

    future change in price will be equal to the change in current price. In ex > 1, the

    sellers will sell more in the future at higher prices.

    EA =

    ex = == x

  • FACTORS INFLUENCING

    PRICE ELASTICITY OF DEMAND

    1. Nature of commodity

    Elasticity depends on whether the commodity is a necessity, comfort or

    luxury. Necessities of life have inelastic demand and comforts and luxuries

    have elastic demand.

    2. Availability of substitutes

    Goods with substitutes have elastic demand and goods without

    substitutes have inelastic demand. For example: coffee and tea are substitutes.

    If price of tea increases, people may switch over to coffee. If price of coffee

    raises people may shift to tea. The demand of salt is inelastic.

    3. Uses of the commodity

    Certain goods can be put to many uses. Example electricity. Such

    goods have elastic demand because as the price decreases, they will be put to

    more uses.

    4. Proportion of income spent on commodity

    For some goods, consumers spend only a small part of their income. The

    demand will be inelastic. For eg: - salt and matches

  • 5. Price of goods

    Generally cheap goods have inelastic demand and expensive goods

    have elastic demand.

    6. Income of consumers

    Very rich people have inelastic demand for goods and poor people have

    elastic demand. Because rich people will buy the commodity at all levels of

    prices where poor people there is a change in quantity of consumption

    according to change in price.

    7. Time period

    Elasticity would be more in the long run than in the short run. Because in

    the long run consumers can adjust their demand by switching over to cheaper

    substitutes. Production of cheaper substitutes is possible only in the long run.

    8. Distribution of income and wealth in the society

    If there is unequal distribution of income, the demand of commodities will

    be relatively inelastic. If the distribution of income and wealth in the society is

    equal there will be elastic demand for commodities.

  • DEGREES OF ELASTICITY

    Since the responsiveness of quantity demanded varies from commodity

    to commodity and from market to market, it is important to study the degrees of

    price elasticity. We can identify five degrees of elasticity. They are: -

    1. Perfectly elastic demand

    2. Perfectly inelastic demand

    3. Unitary elastic demand

    4. Relatively elastic demand

    5. Relatively inelastic demand

    1. Perfectly elastic demand

    Perfectly elastic demand is the situation where a small change in price

    causes a substantial change in quantity demanded i.e. a slight decline in price

    causes an infinite increase in quantity demanded and a slight increase in price

    leads to demand contracting to zero. The demand is hypersensitive and the

    elasticity of demand is infinite. Demand curve becomes a horizontal straight line

    parallel to x-axis.

  • Qty demanded

    2. Perfectly inelastic demand

    It is the situation where changes in price cause no change in quantity

    demanded. Quantity demanded is non-responsive or inelastic. Demand curve is

    a vertical line parallel to Y-axis and the elasticity of demand is zero.

    Quantity demanded

    It is clear that the price is OP or OP1 or OP2. The quantity demanded remains unchanged at OM.

    P2

    P1

    P

    M

    Y

    0

    Pric

    eD

    X

    ep = 2Pr

    ice

    ep = 0

  • 3. Unitary elastic demand

    It refers to that situation where a given proportionate change in price is

    accompanied by an equally proportionate change in quantity demanded. For

    example, if price changes by 10%, quantity demanded also changes by 10%.

    ep= 10/10 = 1

    ie; elasticity will be equal to one. The demand curve is a rectangular hyperbola.

    Quantity demanded

    N1N

    Y

    X0

    D

    D

    P

    P1Pric

    e

    ep =1

  • 4. Relatively elastic demand

    Demand is said to be relatively elastic when a given proportionate

    change in Price causes a more than proportionate change in quantity

    demanded.

    Quantity demanded

    N1N

    Y

    X0

    D

    D

    P

    P1Pric

    e

    ep >1

  • 5. Relatively Inelastic demand

    Demand is relatively inelastic when a given proportionate change in

    price causes a less than proportionate change in quantity demanded. Demand

    curve will be a very steep curve. Elasticity is less than 1. For example, If price

    changes by 20% quantity demanded changes by 10%

    Then ep = 10/20 = .5 ie; ep

  • MEASUREMENT OF

    ELASTICITY OF DEMAND

    Important methods to measure the elasticity of demand are: -

    1. Proportional or percentage method

    2. Expenditure or Outlay method

    3. Geometric or point method

    These are the commonly used methods.

    1. Proportional method or Percentage method

    Under this method the elasticity of demand is measured by the ratio

    between the proportionate or percentage change in the quantity demanded and

    proportionate or percentage change in price. It is also known as formula

    method.

    Ep= Proportionate change in quantity demanded

    Proportionate change in price

    q p q p

    p q q p

    =

    =

    X

  • ep is the price elasticity

    q is the change in quantity demanded

    p is the change in price

    q is the initial quantity

    p is the initial price

    For example:Price of A Quantity demanded of A 5 10

    4 15

    When price of A is Rs.5 quantity demanded is 10. When price falls to Rs.4

    quantity demanded rises to 15.

    Here p = 1, q= 5

    Initial price = 5, Initial quantity = 10

    ep = p q

    q p

    = 5 X 5

    10 1

    = 2.5

    Elasticity is greater than one (relatively elastic) if price elasticity is equal

    to one, it is unitary elastic demand. If elasticity is less than one, it is relatively

    inelastic demand. If elasticity is more than one, it is relatively elastic demand. If

    elasticity is zero, it is perfectly inelastic demand. If elasticity is infinity, it is

    perfectly elastic demand.

    2. Expenditure or Outlay method

    By this method elasticity is measured by estimating the change in price

    that leads to a change in quantity demanded causes changes in total

    X

  • expenditure incurred on commodity. According to sellers total expenditure

    means total revenue. So this method is also known as total revenue method.

    By looking at variation in total expenditure, price elasticity can be calculated.

    Price (PQuantity

    Demanded (Q)

    Total Expenditure

    (P x Q)18

    15

    12

    9

    3

    4

    5

    6

    54

    60

    60

    54

    In this table a fall in price leads to a more than proportionate increase in

    quantity demanded increase in total expenditure. Conversely, a fall in price

    leads to a less than proportionate increase in quantity demanded results in

    decrease in total expenditure. A fall in price leads to a proportionate increase in

    quantity demanded result in total expenditure remaining constant.

    e > 1

    e=1

    e 1

    e = 1

    e

  • Total Expenditure

  • In this figure price is on the vertical axis and total expenditure on horizontal

    line. As the price falls and total outlay increases, elasticity is greater than 1. We

    find elasticity greater than 1 in the CB portion of the total outlay curve. In BA,

    total expenditure remains the same while price is falling. Therefore elasticity is

    equal to 1. In AL the price is falling and total expenditure is also falling. From A

    to L the curve is bending towards the origin. So elasticity is less than one

    If total expenditure increases, elasticity >1

    If total expenditure decreases, elasticity

  • Then the point at which elasticity is to be known has to be marked on

    demand curve dividing it into upper segment and lower segment.

    ep = lower segmentupper segment

    Qty demanded

    4. Arc method

    Arc method is not so important that it is applicable only when there are very

    small change in price and demand.

    ep=0

    ep1

    ep=2

    e

    a

    X0

    Y

    PRIC

    E

  • Using of Elasticity Concept in Business

    We are the company which produce a commodity x. We earn maximum

    profit by selling 80% of commodities at the rate of Rs.20/-.

    STAGE I At the time of commencement

    Qty

    Suddenly we have to face a decline in demand. Demand falls by 10% and

    the current demand deceases from 80% to 70%..

    STAGE II Decrease in demand

    Qty

    At this time we have to reduce the price by Rs. 18/- instead of Rs. 20/- to

    increase the demand and demand increases from 70% to 75%.

    70

    80

    20

    0 X

    D

    DPR

    ICE

    80

    20

    0 X

    D

    D

    PRIC

    E

  • STAGE III Current position of our company

    Qty

    Reasons for decline in demand

    There are certain reasons for the sudden decline of demand for our

    commodity.

    1. Availability of cheap substitutes

    The main reason is the availability of cheap substitutes in the market i.e.

    more substitutes is available in the market at low price. So that people buy

    more of that commodity and because the demand for our commodity falls.

    Substitution effect means change in demand due to substituting one commodity

    for another.

    70D1

    75 80

    20

    0 X

    D

    D

    PRIC

    E

    D1

  • When price of a commodity falls the cheaper commodities will be substituted

    in the place of dearer commodities. Thus price of the commodity falls more of it

    will be demanded and the consumer uses it as a substitute for high priced

    commodities.

    2. Lack of Advertisement

    Lack of Advertisement is also a reason for the declining demand for goods.

    In a highly competitive market advertisement is very important and it also affect

    the change in demand. The main objective of advertisement is to create

    additional demand by attracting more consumers to our product. So we must

    advertise well to increase our demand of our product.

    3. Technological progress

    Technological progress also affect demand for a commodity. Inventions and

    discoveries bring new things in the market. So people will not demand older

    things. So we must use more technological devices to improve the demand for

    our product.

  • 4. Lack of demonstration

    Lack of demonstration also brings out our commodity to a fall in demand i.e.

    people get motivated or they were attracted by the demos given by us and they

    will buy that product not because of their increase in income or it becomes a

    cheaper product but their neighbour or relatives bought it. Tendency of the

    consumer to imitate others will help us to increase the demand for our

    commodity.

    5. Free goods

    More Free goods are given by other producer to attract consumers and that

    will affect the demand of our product. So we also gave more free goods than

    the other companies.

    Because of these reasons we must forced to reduce the price of our

    commodity to increase our commodities demand. For this we must know the

    different market conditions and the factors affecting demand for a commodity.

  • DETERMINANTS OF DEMAND

    1. Price of a commodity

    Price of the commodity is the most important factor that determine demand.

    An increase in price of a commodity leads to a reduction in demand and a

    decrease in price leads to an increase in demand.

    2. Price of related goods

    Demand for a commodity depends on Price of related goods also. Related

    goods include both substitutes and complementary goods.

    Substitutes are those goods which can be used one another or the goods

    with same use are substitutes. e.g.:- tea and coffee.

    When price of tea falls demand for coffee also falls. Because when price of

    tea falls people buy more tea and less coffee.

    Complementary goods are those goods which can be used only jointly. e.g.:

    - car, petrol or pen, ink. When price of a commodity raises demand for its

    complementary goods falls. If x and y are complementary goods we cannot use

    x without y. When price of x raises demand for x falls and y cannot be used

    without x and demand for y also falls.

  • 3. Income of the consumer

    Income of the consumer and demand for a commodity are positively related.

    For normal goods when income increases demand also increases and vice

    versa. But for inferior goods there is a negative relationship between income

    and demand. So when income increases, demand decreases.

    Taste and Preferences of consumers

    Taste and Preferences of consumers also brings out changes in demand for

    a commodity. Tendency to imitate other fashions, advertisements etc affect

    demand for a commodity. It change from person to person, place to place and

    time to time.

    4. Rate of Interest

    Higher will be demanded at lower rates of interest and lower will be

    demanded at higher rate of interest.

    5. Money supply

    Demand is positively related to money supply. If the supply of money

    increases people will have more purchasing power and hence the demand will

    increase and vice versa.

    6. Business condition

    Trade cycles or business cycles also demand for a commodity. Demand will

    be high during boom period and low during depression.

  • 7. Distribution of income

    Distribution income in the society also affects the demand of commodity. If

    there is equal distribution of income demand for necessary goods and comforts

    will be greater. If there is an unequal distribution of income demand of comforts

    and luxuries will be greater.

    8. Government policy

    Government policy also affects the demand of commodities. For example, if

    heavy taxes are imposed on certain goods, the demand will decrease. On the

    other hand, if government announces tax concessions for certain commodities,

    their demand will increase.

    9. Consumers expectations

    Consumers expectation about a further rise or fall in future price will affect

    the demand of a commodity. If consumers expect a rise in the price of a

    commodity in the near future, they may purchase large quantity even though

    there is some rise in the price. When the price of a commodity decreases,

    people expect a further fall in price and postpone their purchase. Similarly, if

    consumers believe that their incomes will rise in the near future they are more

    inclined to buy more expensive items today. So these expectations changes the

    demand for goods.

  • CONCLUSION

    In the project regarding the elasticity of demand, we discuss different

    degrees, types and measurement of elasticity. Applying the theory of elasticity

    we have to increase our demand of our commodity. But this increase in demand

    will not lead to an increase in cost of production. When cost of production

    increases automatically we must sacrifice the rate of profit that we earn. So we

    must take some strategic decisions to improve our quality of our commodity and

    thereby increase profit, increase in demand and also we have to reduce the

    cost of production.

    Although most businessmen are very much aware of the elasticity of

    demand of the goods they make, the use of precise estimates of elasticity of

    demand will add precision to their business decision i.e. the theory of elasticity

    of demand is very useful at the time of taking tactical decisions by the top

    management. So this project is much useful to us to know how elasticity

    influences the working of business and even in our day to day life.

    INTRODUCTIONMEANING AND DEFINITION OF

    ELASTICITY OF DEMAND1. Price Elasticity2. Income elasticity3. Cross elasticity

    Reasons for decline in demand