Concept of Elasticity of demand & price elasticity of demand

Concept:

The law of demand has an inverse relationship with its price, i.e., as the price rises, the quantity demanded decreases and vice versa. However, it is very important to understand the extent of the relationship or the degree of responsiveness of demand to change in its determinants. I.e., how sensitive is demand to its price? If the price increases by 5%, the quantity demanded will change, but by what percentage? 5% , 10%? We often  want to know how sensitive the demand for a product is to its price; for instance, how much will the quantities demanded vary if the price increases by 5%? How big of a shift in demand can we expect if the average income increases by 5%? What impact will marketing initiatives have on sales? In order to solve this problem, economists use a number of different types of elasticities to answer questions like these, so as to make demand predictions and recommend changes in strategies. In order to understand this, let us consider the following examples:

1. The quantity demanded rises from 100 headphones to 150 headphones as a result of a decrease in the price of headphones from Rs 500 to Rs 400.
2. The quantity demanded rises from 500 kilograms to 520 kilograms as a result of the decrease in wheat’s price from Rs 20 per kilogram to Rs 18 per kilogram.
3.  The quantity demanded rises from 1000 kilograms to 1005 kilograms as a result of the decrease in salt’s price from Rs 9 per kilogram to Rs 7.50.

As you can observe, in all three situations, the quantity demanded is rising as a result of the fall in price, but the percentage is different in all three situations. The differences in the responsiveness of demand can be found by comparing the percentage changes in prices and quantities demanded. Herein lies the concept of elasticity of demand. 

What is the elasticity of demand? The amount of a commodity purchased is a function of many variables, including the commodity’s price, the prices of related commodities, the customers’ income, and other factors on which demand depends. The dependent variable, namely, the amount purchased per unit of time, will change if one of these independent variables changes. The elasticity of demand measures the relative responsiveness of the amount purchased per unit of time to a change in any one of these independent variables while keeping others constant. In general, the coefficient of elasticity is defined as the proportionate change in the dependent variable divided by the proportionate change in the independent variable.

Definition : 

The elasticity of demand is defined as the responsiveness of the quantity demanded of a good to changes in one of the variables on which the demand depends. Precisely, the elasticity of demand is the percentage change in quantity demanded divided by the percentage change in one of the variables on which the demand depends. Different elasticities of demand can be computed or measured like 

• Price elasticity
• Cross elasticity
• Income elasticity
• Advertisement elasticity

However, an important point to be noted is that, unless and until otherwise mentioned, we talk about the price elasticity of demand. In other words, it is the price elasticity of demand, which is usually referred to as the elasticity of demand.

Price Elasticity of Demand: The price elasticity of demand, which measures the sensitivity of quantity demanded to its “own price,” or the price of the good itself, is probably the most important measure for calculating the elasticity of demand. For a firm, the concept of price elasticity of demand is important for two reasons.

1. Knowledge of the nature and degree of price elasticity allows firms to predict the impact of price changes on their sales.
2. The firm’s profit-maximizing pricing decisions are guided by price elasticity.

Given the consumer’s income, preferences, and the prices of all other commodities, the price elasticity of demand describes how sensitive the quantity of a good is to a change in its price; i.e., it expresses the responsiveness of the quantity demanded of a good to a change in its price. In other words, it is determined by dividing, everything else being equal, the percentage change in quantity demanded by the percentage change in price. The price elasticity of demand (also referred to as PED) tells us the percentage change in quantity demanded for each one percent (1%) change in price. That is,

Price Elasticity (EP) = % change in quantity demanded

                                    _____________________________

                                    % change in price

The percentage change in a variable is just the absolute change in the variable divided by the original level of the variable. Therefore, 

EP=change in quantity

        ________________x 100

        Original quantity

        ___________________

        Change in price

      _________________ x100

      Original price

  OR

EP= Change in quantity    Original price

         _______________ x   ______________

        Original quantity       Change in price

In symbolic terms

Where, 

“Ep” stands for “price elasticity.”

“P” stands for original price.

Q stands for original quantity.

Δ  stands for change.

The law of demand is illustrated by a negative sign on the elasticity of demand: as the price rises, fewer quantities are demanded. You’ll see that the quantity changed only because the price changed. Income and the price of the competitors, which could also have an impact on sales, remained constant. The more elasticity there is, the more price-sensitive the quantity demanded is to its price. The value of price elasticity, strictly speaking, ranges from minus infinity to close to zero. This is because Δq

                                                             ___

                                                             Δp   has negative signs.

In other words, price elasticity is negative because, with a few exceptions,price and quantity are inversely connected.

Interpretation of the coefficient of price elasticity:We only take into account the coefficient of price elasticity’s magnitude, or its absolute size, when interpreting the coefficient of price elasticity.  For example, if Ep =-1.22, we say that the elasticity is 1.22 in magnitude. That is, we ignore the negative sign and consider only the numerical value of the elasticity. Therefore, if a change in price of 1 percent results in a 2 percent change in the quantity demanded of good A and a 4 percent change in the quantity demanded of good B, the elasticity of A and B is then calculated as 2 and 4, respectively, indicating that demand for B is more responsive to price changes than demand for A. If minus signs had been taken into account, we would have come to the incorrect conclusion that the demand for A is more elastic than the demand for B. Hence, by convention, we take the absolute value of price elasticity and draw conclusions.

Determinants of price elasticity of demand: Now we know what price elasticity is and how to measure it. Now an important question is: what are the factors that determine whether the demand for a good is elastic or inelastic? Let us understand the determinants of prime elasticity.

Determinants of price elasticity: 

The following are the determinants of price elasticity:

• Availability of substitutes: The degree of substitutability and availability of substitutes is one of the most important determinants of elasticity. There are close substitutes for some goods, like butter, cabbage, cars, soft drinks, etc. These are, in that order, margarine, other types of green vegetables, other makes of cars, and other types of cold beverages. A change in the price of these commodities, with the prices of the substitutes remaining constant, can be expected to cause quite substantial substitution—a fall in price leading consumers to buy more of the commodity in question and a rise in price leading consumers to buy more of the substitutes. It is expected that a change in these commodity prices, with the prices of the substitutes remaining constant, will result in quite significant substitution, with a fall in price prompting consumers to purchase more of the target commodity and an increase in price prompting them to purchase more of the substitutes. Additionally, the more substitutes that are readily available, the greater the elasticity will be. For instance, there are many different kinds of toothpaste, toilet soap, and other products, and each brand is a close substitute for the other. It should be noted that while, as a group, a good or service may have inelastic demand, when we consider its various brands, we say that a particular brand has elastic demand. Thus, while the demand for a generic good like petrol is inelastic, the demand for Indian Oil’s petrol is elastic. Similarly, while there are no general substitutes for health care, there are substitutes for certain doctors or hospitals. Likewise, the demand for common salt and sugar is inelastic because good substitutes are not available for these.
• position of a commodity in a consumer’s budget: The greater the proportion of income spent on a commodity, generally speaking, the greater will be its elasticity of demand and vice-versa. Because a household spends only a fraction of its income on each of these items, the demand for items like common salt, matches, buttons, etc. tends to be very inelastic. On the other hand, since households typically spend a good part of their income on them, demand for items like apparel and rental properties tends to be elastic. When goods absorb a significant share of consumers’ income, it is worth their time and effort to find a way to reduce their demand when the price goes up.
• The nature of the need that a commodity satisfies: Luxury products typically have price elasticity since one can easily live without luxury. replaceable. Contrarily, necessities are price inelastic. As a result, while demand for a home theater is somewhat elastic, demand for housing and food is generally inelastic. A good will have elastic demand if it is possible to postpone the consumption of that good. Because the consumption of necessary goods cannot be postponed, their demand is inelastic.
• The number of uses to which a commodity can be put to use: The more the possible uses of a commodity, the greater will be its price elasticity and vice versa. When the price of a commodity that has multiple uses decreases, people tend to extend their consumption to its other uses. The more the possible uses of a commodity, the greater will be its price elasticity and vice versa. When the price of a commodity that has multiple uses decreases, people tend to extend their consumption to its other uses.
• Time period: The longer the time period one has, the more completely one can adjust. Time gives buyers the opportunity to find alternatives or substitutes, or change their habits. A simple example of the effect can be seen in motoring habits. In response to a higher petrol price, one can, in the short run, make fewer trips by car. In the longer run, not only can one make fewer trips, but he can also purchase a car with a smaller engine capacity when the time comes to replace the existing one. Hence, one’s demand for petrol falls by more when one has made long-term adjustments to higher prices.
• Consumer habits: The demand for a commodity will be inelastic if a person uses it regularly, regardless of how much the price changes. If buyers have rigid preferences, demand will be less price elastic.
• Tied demand: In contrast to products whose demand is autonomous in nature, the desire for things that are related to others is typically inelastic. Consider printers and ink cartridges as examples.
• Price range: Demand is inelastic for goods with extremely high or extremely low prices, while it is elastic for those in the middle range.
• Minor complementary items: Demand for inexpensive, complementary goods that are combined with more expensive goods has a tendency to be inelastic.

Importance of having knowledge of price elasticity of demand to business managers and government:

The importance of having knowledge of the price elasticity of demand to business managers:

For business managers, knowing the price elasticity of demand and the factors that may change  it is crucial because it enables them to recognise the effect of a price change on their overall sales and revenues. Firms want to maximize their profits as much as possible, and their pricing strategy is highly decisive in attaining their goals. Knowledge of the price elasticity of demand for the goods they sell helps them arrive at an optimal pricing strategy. The managers of a company must understand that lowering the price would expand the sales volume and increase total revenue if the demand for the product is relatively elastic. Instead, companies must be very careful when demand is elastic since increased prices will result in a decline in total revenue because a fall in sales would be more than proportionate. The firm may safely increase the price and hence increase overall revenue if it determines that the demand for its product is relatively inelastic since it can be assured that the fall in sales on account of a price rise would be less than proportionate.

The importance of having knowledge of the price elasticity of demand to the government:

Governments must consider the price elasticity of demand while determining the price of the goods and services they supply, such as transportation and telecommunication. Additionally, it aids governments in understanding the nature of the responsiveness of demand to increases in prices brought on by additional taxes and the implications of such responses on tax revenues. Demand elasticity explains why governments are inclined to raise indirect taxes on products with relatively inelastic demand, including alcohol and tobacco.

Point Elasticity

The price elasticity of demand at a particular point on the demand curve is known as the point elasticity of demand. The concept of point elasticity is used for measuring price elasticity where the change in price is infinitesimal. Price elasticity is a key element in applying marginal analytics to determine the optimal prices. It is useful to measure elasticity with respect to an infinitesimally small change in price, since marginal analysis works by evaluating small changes with respect to an initial decision. Point elasticity makes use of derivatives rather than finite changes in price and quantity. It may be defined as:

EP=-dq

         ___xp

         Dp   _

               Q

Where, dq

             __

       Dp is the derivative of quantity with respect to price at a point on the demand curve, and p and q are the price and quantity at that point. Economists generally use the word “elasticity” to refer to point elasticity.

Point elasticity is, therefore, the product of the price quantity ratio at a particular point on the demand curve and the reciprocal of the slope of the demand line.

Measurement of elasticity on a linear demand curve: Geometric Method:

By definition, the price elasticity of demand is the change in quantity associated with a change in price (∆Q/∆P) times the ratio of price to quantity (P/Q). As a result, in addition to the slope of the demand curve, the price elasticity of demand also depends on quantity and price. As a result, as the price and quantity change, the elasticity varies along the curve. A linear demand curve has a constant slope. However, the elasticity at different points on a linear demand curve would be different. When the price is high and the quantity is small, the elasticity is high. The elasticity becomes smaller as we move down the curve. Given a straight line demand curve tT,in the above figure of point elasticity, point elasticity at any point, say R, can be found by using the formula:

RT= lower segment

________________

Rt     upper segment     

Using the above formula, we can get elasticity at various points on the demand curve.

A diagram showing elasticity at different points on the demand curve:

Thus, we see that as we move from T towards t, elasticity goes on increasing. At the midpoint, it is equal to one; at point t, it is infinity; and at T, it is zero.

Arc Elasticity:

It is frequently necessary to determine price elasticity over some portion of the demand curve as opposed to at a single point. In other words, it is possible to compute the elasticity over a range of prices. When price and quantity changes are discrete and large, we have to measure elasticity over an arc of the demand curve.

The Arc elasticity diagram

The question of which price and quantity to use as the base  arises when price elasticity is to be found between two prices (or two points on the demand curve, say A and B, as shown in the above figure). This is due to the fact that elasticities computed using new price and quantity figures will differ from those found using original price and quantity figures as a base. As a As a As a result, the midpoint method is used to avoid confusion rather than selecting the initial or the final. price and quantity, in which case the averages of the two prices and quantities are used as the base (i.e., original and new). The midpoint formula has the advantage of consistent elasticity values when price moves in either direction, even though it is an approximation to the actual percentage change in a variable. The arc elasticity can be found by using the formula: We drop the minus sign and use the absolute value.

EP= Q2- Q1

         ______

        Q2+ Q1/2

        _______

        P2–P1

       P2+P1/2

EP = Q2-Q1

        ______X  P2+P1

        Q2+ Q1    _____

                         P2–P1

Where, Where P1, Q1are the original price and quantity and P2, Q2are the new ones.

Thanks for Reading, Stay tuned for more updates.