User:Meenakshi narayanaswamy/Temp/Topic Elasticity of demand.doc

TOPIC: ELASTICITY OF DEMAND

INTRODUCTION

The Law of Demand states that “Other things remaining the same the demand for a commodity increases when its price falls and it decreases when its price increases.”Thus according to the law of demand there is an inverse relationship between price and quantity demanded, other things remaining the same. These other things which are assumed to be constant are taste or preference of the consumer, income of the consumer, prices of related goods etc .If these factors undergo a change, then the inverse relationship may not hold good. However we also observe that for commodities like salt or rice we do not notice much of a change in demand whereas in case of goods like Air conditioners, Cars etc even with a small change there is substantial increase in demand. The Law of demand while stating the relationship between demand and price mentions only the direction of change in demand but does not mention anything about the magnitude of the change which is very essential in decision making process for the producer and Government.

For example:

"If I lower the price of my product, will the sale increase?"

"If I raise the price, will it affect my profit?"

“If sales tax rate is increased will it have an effect on the revenue collection?"are questions that

need to be answered.

The information as to how much or to what extent the quantity demanded of a commodity

will change as a result of a change in its price is provided by the concept of elasticity of demand.

Concept Of Elasticity of demand

Alfred Marshall introduced the concept of elasticity in 1890 to measure the magnitude of the quantity demanded of a commodity to a certain percentage change in its price or the income of the buyer or in the prices of related goods.

Definition : Price Elasticity of demand is the degree of responsiveness of demand to a change in its price.In technical terms it is the ratio of the percentage change in demand to the percentage change in price.

Thus

Ep = Pecentage change in quantity demanded

Percentage change in price

From the definition it follows that when percentage change in quantity demanded is greater than

the percentage change in price then price elasticity will be greater than one and in this case demand is said to be elastic. when percentage change in quantity demanded is less than

the percentage change in price then price elasticity will be less than one and in this case demand is said to be inelastic. when percentage change in quantity demanded is equal to

the percentage change in price then price elasticity will be equal to one and in this case demand is said to be unit elastic.

Diagrammatic representation of elastic and inelastic demand curves

Numerical example to calculate price elasticity of demand

Price of tea has increased from Rs.7 to Rs 8and as a result of this demand for tea has declined from 50 cups to 48 cups. The price elasticity in this case can be calculated as follows:

Percentage change in demand = ( New demand – Old demand)/Old demand

= (48-50)/50

=-0.04

Percentage change in price = (New price –Old Price)/ Old price

= ( 8- 7)/ 7

= o.14

Price elasticity of demand = (percentage change in demand)/(Percentage change in Price)

= - 0.04 /0.14

= -0.28

Demand is inelastic. In other words we can say that for a 14% increase in price ,demand has declined only by 4%. The negative sign indicates the inverse relationship between demand and price.

Determinants of Price elasticity of demand

There are number of factors which determine the price elasticity of demand. Let us consider some of these factors'''. Firstly''' if close substitutes are available then there is a tendency to shift from one product to another when the price increases and demand is said to be elastic. For example, demand for two brands of tea. If the price of one brand A increases then the demand for the other brand B increases. In other words greater the possibility of substitution greater the elasticity. Secondly how much of the income is spent on a commodity by the consumer. Greater the proportion of income spent on the commodity greater will be the elasticity. Thirdly the uses to which the commodity can be put is important factor determining elasticity. If the commodity can be put to many uses then the elasticity will be greater'''. Fourthly''' if two commodities are consumed jointly then increase in the price of one will reduce the demand for both. Finally time element has an important role to play in determining the elasticity of demand. Demand is more elastic if time involved is long. In the short run, it is difficult to substitute one commodity for another.