Demand Elasticity

Need to understand It is a known fact that there is an inverse relation between demand and price or a positive relationship between demand and income, but one should also know to what extent demand changes as a result of change in its determinants. This is demand elasticity or elasticity of demand

DEFINITION The demand elasticity is simply a measure of relative responsiveness of quantity demanded to changes in one of the determinants, other determinants assumed as unchanged. In other words, elasticity of demand (ed) is defined as the ratio of the percentage change in quantity demanded to the percentage change in the demand determinant under consideration.

DEFINITION ed= Percentage change in quantity demanded of good X Percentage change in determinant Z Where the parameter Z may be one of the following: Current price of the commodity (Px) Current price of the related good (Pn) Current income (Y) The expected price of the commodity (EPx) Advertising expenditure (A)

TYPES OF ELASTICITY OF DEMAND Price elasticity of demand Income elasticity of demand Cross elasticity of demand Promotional elasticity of demand Expectations elasticity of demand

Price elasticity of demand It measures the degree of change in demand as a result of the change in price

PRICE ELASTICITY OF DEMAND Price elasticity of demand (ep) = Proportionate change in quantity demanded of good X Proportionate change in price of good X = (Q2-Q1)/Q1 (P2-P1)/P1 Where Q1 and P1 are original quantity and price respectively, and Q2 and P2 are the new quantity and price respectively.

TYPES OF PRICE ELASTICITY Perfectly elastic demand: There is very high change in demand for the slightest change in the price ep = ∞ infinite Absolutely or Perfectly inelastic demand: ep = 0 There is no change in demand for any change in price. The demand curve in this case will be vertical. Ex. Salt

Unit elasticity of demand: there is identical change in demand and price, therefore ep = 1 and the demand curve in a rectangular hyperbola Relatively elastic demand: there is more than proportionate change in demand than price, i.e. the percentage change in demand is more than percentage change in price. The demand curve is a flat, downward sloping curve ep > 1 Relatively inelastic demand: there is some change in demand but the percentage change in demand is less than the percentage change in price. The demand curve is a steep, downward sloping curve hence ep <1

Determinants of Price Elasticity of Demand Demand for a commodity will be more elastic if: It has many close substitutes The share of the commodities in buyers’ budget is high Nature of the commodities, luxuries More time is available to adjust to a price change

Determinants of Price Elasticity of Demand Demand for a commodity will be less elastic if: It has few substitutes The share of the commodities in buyers’ budget is low Nature of the commodities, Essentials Less time is available to adjust to a price change

INCOME ELASTICITY OF DEMAND Income elasticity of demand for a commodity shows the extent to which a consumer’s demand for the commodity changes as a result of a change in the income. Ey = Percentage change in the quantity demanded of good X Percentage change in income of the consumer = qx  Y qx Y = qx . Y Y qx Where qx is the quantity demanded of X and Y is the income level of the consumer

TYPES OF INCOME ELASTICITY High income elasticity: Ey >1 this implies that when there is a increase or decrease in the income of the household there is more than increase or decrease in the quantity demanded by the consumer. Unitary income elasticity: Ey =1 it indicates that the percentage change in the quantity demanded is equal to the percentage change in money.

Low income elasticity: Ey <1 it indicates that a relative change in quantity demanded is less than the relative change in money income Zero income elasticity: Ey = 0. A change in income will have no effect on the quantity demanded Negative income elasticity: Ey <0 It indicates that less is bought at higher incomes and more is bought at lower incomes.

High income elasticity: jewellery, ornaments, precious stones, luxuries items Low income elasticity: sugar, salt, safety matches. The commodities which require a very small proportion of consumer income to be spent on them. Or necessities have a low income elasticity of demand. Negative income elasticity: inferior goods

CROSS ELASTICITY OF DEMAND Cross elasticity of demand is defined as the ratio of the percentage change in demand for one good to the percentage change in the price of some other related good. For commodities X and Y which are related, the expression is : exy= qx  py qx py = qx . py py qx

Types of Commodities and Cross Elasticities Cross elasticity (exy) will have positive sign if two goods are substitutes Ex. Coca cola and Pepsi Cross elasticity (exy) will have negative sign if two goods are complementary Ex. Sugar and Tea Cross elasticity (exy) will zero if two goods are unrelated i.e. they are neither complementary nor substitutes

PROMOTIONAL ELASTICITY OF DEMAND The advertising elasticity of demand can be defined as the ratio of proportionate change in sales to proportionate change in advertisement expenditure Q2–Q1 Q2+Q1 A2-A1 A2+A1 Where Q and A refer to sales and advertisement expense respectively EA =

SIGNIFICANCE OF THE CONCEPT OF ELASTICITY OF DEMAND Level of output and price Fixation of rewards for factors of production Government policies Demand forecasting