Total Outlay Method of calculating price elasticity:
The total expenditure or outlay made on it and the price elasticity of demand for that commodity are significantly related to each other. We can say that the price elasticity and total revenue received are closely related to one another because the total expenditure (price of the commodity multiplied by the quantity of that commodity purchased) made on a commodity equals the total revenue received by the seller (price of the commodity multiplied by the quantity of that commodity sold). By analyzing the changes in total expenditure (or total revenue) in response to a change in the price of the commodity, we can determine the price elasticity of demand for it.
The price elasticity of demand equals one, or unity: The price elasticity of a good is equal to unity when, as a result of a change in price, the total expenditure on the good or the total revenue received from that good remains the same. This is because the total expenditure made on the good can remain the same only if the proportional change in quantity demanded is equal to the proportional change in price. Thus, if there is a given percentage increase (or decrease) in the price of a good and if the price elasticity is unitary, the total expenditure of the buyer on the good or the total revenue received from it will remain unchanged.
Price elasticity of demand is greater than unity: We say that the price elasticity of demand is greater than unity when, as a result of an increase in price, the total expenditure made on the good or the total revenue received from that good falls, or when, as a result of a decrease in price, the total expenditure made on the good or the total revenue received from that good increases. The total revenue from headphones in our case increases from Rs 50,000 (500 x 100) to Rs 60,000 (400 x 150) as a result of the headphones’ price falling from Rs 500 to Rs 400, indicating elastic demand for headphones. Similarly, had the price of headphones increased from Rs 400 to Rs 500, the demand would have fallen from 150 to 100, indicating a fall in the total revenue received from Rs 60,000 to Rs 50,000, showing elastic demand for headphones.
Price elasticity of demand is less than unity: We say that the price elasticity of demand is less than unity when, as a result of an increase in a good’s price, the total expenditure made on the good or the total revenue received from that good increases or when, as a result of a decrease in its price, the total expenditure made on the good or the total revenue received from that good falls. The total revenue from wheat in the aforementioned example drops from Rs 10,000 (20 x 500) to Rs 9360 (18 x 520) as the price of wheat decreases from Rs 20 per kg to Rs 18 per kg, indicating inelastic demand for wheat. Similarly, the total revenue from wheat increased from Rs 9360 to Rs 10,000 as a result of the increase in price from Rs 18 to Rs 20 per kg, indicating an inelastic demand for wheat. The main drawback of this method is that by using it we can only say whether the demand for a good is elastic or inelastic; we cannot find out the exact coefficient of price elasticity.
The responsiveness of a good’s demand to changes in the firm’s advertising spending is known as “advertising elasticity of sales” or “promotional elasticity of demand.” The advertising elasticity of demand measures the percentage change in demand that occurs given a one percent change in advertising expenditure. Advertising elasticity measures the effectiveness of an advertisement campaign in bringing about new sales. The advertising elasticity of demand is typically positive. The greater the value of advertising elasticity, the greater the responsiveness of demand to change in advertisement. Advertisement elasticity varies between zero and infinity. It is measured by using the formula;
E a= %change in quantity demanded
%change in spending on advertising
The following table will give a better understanding:
|Ea = 0
|Demand does not respond at all to an increase in advertisement expenditure.
|Ea >0 but < 1
|The increase in demand is less than proportionate to the increase in advertisement expenditure.
|Ea = 1
|Demand increases in the same proportion in which advertisement expenditure increases.
|Demand increases at a higher rate than the increase in advertising expenditure.
As far as a business firm is concerned, the measure of advertisement elasticity is useful in understanding the effectiveness of advertising and in determining the optimum level of advertisement expenditure.
Cross price Elasticity of demand:
First, let us understand the price of related goods and services:
The price of related goods and demand:
The demand for a particular commodity may change due to changes in the prices of related goods. These related goods may be either complementary goods or substitute goods. This type of relationship is studied under the term “Cross Demand.” Cross demand refers to the quantities of a commodity or service which will be purchased with reference to changes in price, not of that particular commodity but of other inter-related commodities, other things remaining the same. It can be defined as the quantities of a commodity that consumers buy per unit of time at different prices for a “related article,” all other things remaining the same. The assumption of “other things remaining the same” implies that both the consumer’s income and the cost of the questioned commodity will remain constant. Before understanding cross price elasticity, let us understand substitute products and complementary products with the help of the following diagram:
- Substitute products and demand: Consider the below diagram
Explanation: In the case of substitute commodities, the cross demand curve slopes upwards (i.e., positively), showing that more quantities of a commodity will be demanded whenever there is a rise in the price of a substitute commodity. In the above figure, the quantity demanded of tea is given on the X axis. The Y axis represents the price of coffee, which is a substitute for tea. When the price of coffee increases, due to the operation of the law of demand, the demand for coffee falls. Consumers will substitute tea in the place of coffee. The price of tea is assumed to be constant. Therefore, whenever there is an increase in the price of one commodity, the demand for the substitute commodity will also increase.
- Complementary goods: Consider the below diagram:
Explanation: In the case of complementary goods, as shown in the above figure, a change in the price of one good will have an opposite reaction on the demand for the other good that is closely related or complementary. For instance, an increase in demand for solar panels will necessarily increase the demand for batteries. The same is the case with complementary goods such as bread and butter, cars and petrol, electricity and electrical gadgets, etc. Whenever there is a fall in the demand for solar panels due to a rise in their prices, the demand for batteries will fall, not because the price of batteries has gone up, but because the price of solar panels has gone up. So, we find that there is an inverse relationship between the price of a commodity and the demand for its complementary goods (other things remaining the same).
Having understood this, let us now consider cross-price elasticity:
The cross-price elasticity of demand between two goods measures the effect of the change in one good’s price on the quantity demanded of the other good. Here, we consider the effect of changes in relative prices within a market on the pattern of demand. A change in the demand for one good in response to a change in the price of another good represents the cross elasticity of demand of the former good for the latter good. It is equal to the percentage change in the quantity demanded of one good divided by the percentage change in the other good’s price.
EC= % change in quantity demanded for goods x
% change in price of good y
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