Interpretation of elasticity of demand: Brief Overview in all Aspects

Based on values of price elasticity, economists have found it useful to categorize distinct types of demand behavior. Since we draw demand curves with quantity on the horizontal axis and price on the vertical axis,∆Q/∆P = (1/slope of curve). As a result, demand is less elastic for any given price and quantity combination, the steeper the slope of the curve. The numerical value of the elasticity of demand can assume any value between zero and infinity. Let us consider the different situations and try to understand them with the help of the diagram.

Situation 1: Elasticity is zero.

Interpretation:  

If the amount demanded does not respond at all to a price change, or if there is absolutely no change in the quantity demanded when the price changes, in other words, regardless of price, buyers will continue to purchase a fixed quantity of a good regardless of price. Perfectly inelastic demand is an extreme case of price insensitivity, merely a theoretical category with less practical significance. The vertical demand curve in the below figure represents perfectly or completely inelastic demand.

 A diagrammatic presentation of the demand curve with zero elasticity:

Situation 2 : Elasticity is one or unitary elasticity:

Interpretation:  

if the percentage change in price and the percentage change in quantity demanded are both equal. In a special situation of unit-elastic demand, the below figure of the demand curve takes the shape of a rectangular hyperbola.

 A diagrammatic presentation of the demand curve for unitary elasticity:

Situation 3 : Elasticity is greater than one.

Interpretation:

 when the percentage change in quantity demanded is greater than the percentage change in price, In such a case, demand is said to be elastic. In other words, the quantity demanded is relatively sensitive to price changes. When drawn, the elastic demand line is fairly flat, as shown in the figure given below. 

A diagrammatic presentation of the demand curve for elasticity greater than 1.

Situation 4 : Elasticity is less than one.

Interpretation: 

 Demand is said to be inelastic when the percentage change in quantity demanded is less than the percentage change in price. In this situation, when the price falls, the buyers are unable or unwilling to significantly contract demand. In other words, the quantity demanded is relatively insensitive to price changes. When drawn, the inelastic demand line is fairly steep, as shown in the below figure.

A diagrammatic presentation of the demand curve for elasticity less than 1.

Situation 4 : Elasticity is infinite.

Interpretation: 

When demand increases from zero to infinite as a result of a “small price reduction.” At this price, the demand curve is horizontal (where the demand curve touches the vertical axis). Any quantity might be demanded as long as the price remains at a particular level. Moving back and forth along this line, we discover that while the price remains constant, the quantity demanded changes. They wouldn’t purchase anything from the particular seller if there was even a tiny price increase. In other words, the quantity demanded would decrease to zero at the slightest price increase. In general, the result of dividing a number by zero is infinity, denoted by the symbol∞. Therefore, a horizontal demand curve implies an infinite price elasticity of demand .  In a market with perfect competition, this kind of demand curve is found. The horizontal demand curve in the below figure represents perfectly or infinitely elastic demand.

A diagrammatic presentation of the demand curve for infinite elasticity

Interpretation of various elasticities of demand in a table:

Why should a business firm be concerned about the elasticity of demand ? The reason is that the degree of demand elasticity predicts how changes in a good’s price will affect the total revenue earned by the producers from the sale of that good. Total revenue is defined as the total value of sales of a good or service. It is equal to the price multiplied by the quantity sold.

Total revenue : Total revenue (TR) = Price × Quantity sold

When a seller raises the price of a good, there are two effects that affect revenue in opposite directions, with the rare exception of a good whose demand is completely elastic or perfectly inelastic.

Price effect: After a price increase (or decrease), each unit sold sells at a higher (or lower) price, which tends to raise (or lower) the revenue.

Quantity  effect:  After a price increase (decrease), fewer (more) units are sold, which tends to lower (increase) the revenue. What will be the net effect on total revenue? It depends on whose effect is stronger. If the price effect, which tends to raise total revenue, is the stronger of the two effects, then total revenue goes up. If the quantity effect, which tends to reduce total revenue, is stronger, then total revenue goes down. The price elasticity of demand tells us what happens to the total revenue when price changes; its size determines which effect, the price effect or the quantity effect, is stronger. A price increase or decrease has no effect on the total revenue if demand for a good is unit-elastic (the price elasticity of demand is equal to one, as shown in the figure below). The quantity effect and the price effect precisely balance one another in this situation. A gain in revenue (Area A) equals a loss in revenue (Area B) when price increases from P to P1.

A diagrammatic presentation of total revenue when elasticity is equal to one.

A higher price increases total revenue if a good’s demand is inelastic (the price elasticity of demand is less than one). The price effect is stronger in this instance than the quantity effect. On the other hand, when demand is inelastic , a fall in price reduces total revenue because the price effect outweighs the quantity effect.

Diagramatic presentation when total revenue is less than one:

If a good’s demand is elastic (its price elasticity of demand is greater than one), a price rise reduces overall revenue, whereas a fall in price increases total revenue. In this case, the quantity effect is stronger than the price effect. which is shown in the below figure.

diagrammatic presentation when total revenue is greater than one:

The relationship between price elasticity and total revenue:

When demand is elastic, price increases, total revenue decreases, and when price decreases, total revenue increases.

When demand is unitary elastic, regardless of whether price increases or decreases, the total revenue remains the same.

When demand is inelastic, as the price increases , total revenue increases, and as the price decreases, total revenue decreases.

income elasticity of demand.

The income elasticity of demand is a measure of how much the demand for a good is affected by changes in consumers’ incomes. Businesses can use estimates of income elasticity of demand to forecast possible growth in sales as average consumer incomes grow over time. time. Income elasticity of demand is the degree of responsiveness of the quantity demanded of a good to changes in the income of consumers.

E= percentage change in demand

  I _________________

      percentage change in income.

This can be given mathematically as: 

E  i  = change in quantity 

          ______________  x   change in income

          Quantity                      _____________

                                              income

=Change in quantity

    ______________ x income

     Quantity                 _________

                                  Change in income

= change in quantity

   ________________ x  income

 Change in income         ________

                                       Quantity

The income elasticity of a good and the proportion of income spent on it have a useful relationship. The relationship between the two is described in the following three propositions:

1. The income elasticity of a good is equal to one if the proportion of income spent on that good is equal as income increases.
2. A good’s income elasticity is greater than one if the proportion of income spent on it increases as income increases. Demand for these products rises more quickly than income does.
3.  The income elasticity of a good is positive but less than one if the proportion of income spent on the good decreases as income increases. The demand for income-inelastic goods rises, but substantially slowly compared to the rate of increase in income. 

The income elasticity of goods reveals a few very important features of demand for the goods in question.

The demand for goods is very unresponsive to changes in income if the income elasticity is zero. An increase in income results in an increase in demand for goods when income elasticity is greater than zero or positive. The majority of goods experience this, and these goods are referred to as “normal goods.” Income elasticity is positive for all normal goods. But depending upon the nature of commodities, the degree of elasticity varies. A good is inferior when the income elasticity of demand is negative. In this instance, as income increases, the quantity demanded at any given price decreases. The explanation is that consumers prefer to consume superior substitutes as income increases. Another significant value of income elasticity is that of unity. When income elasticity of demand is equal to one, the proportion of income spent on goods remains the same as the consumer’s income increases. This represents a useful dividing line. If the income elasticity for a good is greater than one, it means that the good bulks larger in the consumer’s expenditure as he becomes richer. Such goods are called “luxury goods.” On the other hand, if the income elasticity is less than one, it shows that the good is either relatively less important in the consumer’s eye or, it is a good that is a necessity. The fact that income elasticities differ in the short and long runs, which is a key feature of income elasticity. The income elasticity of demand is larger in the long term than in the short term for almost all goods and services. Knowledge of income elasticity of demand is very useful for a business firm in estimating the future demand for its products. The knowledge of income elasticity of demand helps firms measure the sensitivity of sales for a given product to incomes in the economy and predict the outcome of a business cycle on its market demand. For instance, if
EY= 1, sales move exactly in step with changes in income. If EY >1, sales are highly cyclical, that is, sales are sensitive to changes in income. For an inferior good, sales are countercyclical, that is, sales move in the opposite direction of income and EY < 0. This knowledge enables the firm to carry out appropriate production planning and management.

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