Elasticity Of Demand (Theory of Consumer Behaviour) Class 12 Economics

Concept of Elasticity of Demand

Understanding Responsiveness of Demand

If the prices for both goods decrease to PX₂ and PY₂, the quantity demanded for good X increases to OX₂ and for good Y to OY₂. If the increase in quantity demanded for good X is greater than that for good Y, it indicates that good X is more responsive to price changes than good Y. This responsiveness is what we refer to as the elasticity of demand.

Price Elasticity of Demand
Price elasticity of demand specifically measures how much the quantity demanded of a commodity responds to changes in its own price, while keeping income and the prices of related goods constant.
Mathematically, price elasticity of demand is defined as:$Price\; Elasticity\; of\; Demand$Alternatively, it can also be expressed as the absolute value of the ratio of the percentage change in quantity to the percentage change in price. Thus, elasticity of demand is inherently a relative concept, allowing for comparisons of how different goods react to price changes.

Formula for Calculating Elasticity of Demand

The price elasticity of demand (E_P) can be calculated using the following formula:

This can be expressed mathematically as:

EP =

Where:

• $\backslash Delta\; Q$ΔQ = Change in quantity demanded
• $\mathrm{<br\; style="word-break:\; break-word;\; line-height:\; 1.8;\; font-family:\; Lato,\; sans-serif;\; font-size:\; 20px;\; letter-spacing:\; inherit;\; color:\; black;">}Delta\; P$ΔP = Change in price
• $\mathrm{<span\; style="word-break:\; break-word;\; line-height:\; 1.8;\; font-family:\; Lato,\; sans-serif;\; font-size:\; 20px;\; letter-spacing:\; inherit;\; color:\; black;">Q\; =\; Original\; quantity\; demanded</span>}$
• $\mathrm{<span\; style="word-break:\; break-word;\; line-height:\; 1.8;\; font-family:\; Lato,\; sans-serif;\; font-size:\; 20px;\; letter-spacing:\; inherit;\; color:\; black;">P\; =\; Original\; price</span>}$

The vertical lines indicate that we take the absolute value of the ratio. Since price and quantity move in opposite directions, the elasticity (E_P) will typically yield a negative value. To simplify, we drop the negative sign and use the absolute value.

For example, if we calculate:

$EP\; =\; \backslash left|\; -\backslash frac\{5\backslash \%\}\{2\backslash \%\}\; \backslash right|\; =\; 2.5$EP =

This result shows that the price elasticity is a unitless number, making it independent of the units used for measurement (e.g., kilograms, liters). Thus, the percentage change in demand remains consistent regardless of how quantity is measured.

Types of Own (Price) Elasticity of Demand

1. Elastic Demand (E_P > 1):

   • Definition: Demand is elastic if the percentage change in quantity demanded is greater than the percentage change in price.
   • Example: For luxury goods, a 10% decrease in price may result in a more than 10% increase in quantity demanded.
   • Illustration: If the price of gold decreases from Rs. 160 to Rs. 140 and demand rises from 1,000 kg to 2,000 kg:
     $EP\; =\; \backslash frac\{1,000\}\{1,000\}\; \backslash div\; \backslash frac\{20\}\{160\}\; =\; \backslash frac\{1,000\}\{20\}\; \backslash cdot\; \backslash frac\{160\}\{1,000\}\; =\; 8$E_P = 1,000/1,000 ÷ 20/160 = 1,000/20 .160/1,000 = 8
   • Since E_P > 1, gold is considered a luxury item.

2. Inelastic Demand (E_P < 1):

   • Definition: Demand is inelastic if the percentage change in quantity demanded is less than the percentage change in price.
   • Example: For necessary goods, a 10% decrease in price might lead to a 1% increase in quantity demanded.
   • Illustration: If the price of wheat drops from 40 paisa to 20 paisa, and demand rises from 1,600 kg to 2,000 kg:$EP\; =\; \backslash frac\{400\}\{160\}\; \backslash div\; \backslash frac\{20\}\{40\}\; =\; \backslash frac\{400\}\{20\}\; \backslash cdot\; \backslash frac\{40\}\{1,600\}\; =\; 0.5$E_P = 400/160 ÷ 20/40 = 400/20. 40/1,600 = 0.5
   • Since EP < 1, wheat is categorized as a necessary good.

3. Unit Elasticity of Demand (E_P = 1):

   • Definition: Demand has unit elasticity when the percentage change in quantity demanded equals the percentage change in price.
   • Example: A 10% decrease in price results in a 10% increase in quantity demanded.
   • Illustration: If the price of a commodity falls from Rs. 200 to Rs. 100, and demand rises from 400 kg to 800 kg:
     E_P = 400/400 ÷ 100/100 = 400/100. 100/400 = 1

4. Perfectly Elastic Demand (E_P = ∞):

   • Definition: Demand is perfectly elastic if a slight change in price leads to an infinitely large change in quantity demanded.
   • Illustration: The demand curve is horizontal, indicating that consumers will only buy at one price. This situation is typical in perfectly competitive markets for individual firms.
     

5. Perfectly Inelastic Demand (E_P = 0):

   • Definition: Demand is perfectly inelastic if quantity demanded does not change regardless of price changes.
   • Illustration: The demand curve is vertical, indicating that quantity demanded remains constant at any price. This can apply to essential medications or other non-substitutable goods.
     

Measurement of Elasticity of Demand

1. Total Outlay (Revenue) Method:

   • Concept: Proposed by Alfred Marshall, this method uses the relationship between total revenue (TR) and price changes to assess elasticity.
   • Definition: Total revenue (or total outlay) is calculated as: T_R = P × Q
   • Analysis:
     • Elastic Demand (E_P > 1): If the price decreases and total revenue increases, demand is elastic. Conversely, if the price increases and total revenue decreases, demand remains elastic.
     • Inelastic Demand (E_P < 1): If the price decreases and total revenue decreases, demand is inelastic. If the price increases and total revenue increases, demand is still inelastic.
     • Unit Elasticity (E_P = 1): A change in price does not affect total revenue, indicating unit elasticity.

2. Point Elasticity Method:

   • Concept: This method calculates elasticity at a specific point on the demand curve.
   • Formula: E_P =
   • Explanation: Here, dQ/dP represents the derivative of quantity with respect to price, showing how quantity demanded changes at a particular price level. This method is particularly useful for calculating elasticity when dealing with small changes in price and quantity.

3. Arc Elasticity Method:

   • Concept: This method measures elasticity over a range of prices, providing an average elasticity between two points on the demand curve.
   • Formula: $EP\; =\; \backslash frac\{\backslash Delta\; Q\; /\; Q\_\{avg\}\}\{\backslash Delta\; P\; /\; P\_\{avg\}\}\; =\; \backslash frac\{\backslash Delta\; Q\}\{\backslash Delta\; P\}\; \backslash cdot\; \backslash frac\{P\_\{avg\}\}\{Q\_\{avg\}\}$
   • Explanation:
     • $\backslash Delta\; Q$ΔQ is the change in quantity demanded.
     • ΔP is the change in price.
     • $Q\_\{avg\}$Q_avg and $P\_\{avg\}$P_avg are the average quantity and price, respectively, over the range considered.
   • Usefulness: This method is effective for measuring elasticity in cases where there are larger changes in price and quantity.

Summary

Each method of measuring elasticity has its applications, advantages, and limitations. The total outlay method provides insights based on revenue changes, while the point and arc methods offer more precise measurements of elasticity in different scenarios. Understanding these methods helps in making informed decisions regarding pricing strategies and understanding consumer behavior.

Factors Determining Elasticity of Demand

1. Nature of the Commodity:

   • Essential Goods: Generally have inelastic demand because price changes do not significantly affect the quantity demanded. Examples include basic necessities like food and medicine.
   • Luxury Goods: Tend to have elastic demand. Consumers can reduce their consumption when prices rise and increase it when prices fall. For instance, a TV may be considered a luxury for low-income individuals but a necessity for higher-income individuals.

2. Availability of Substitutes:

   • Close Substitutes: Commodities with many substitutes exhibit elastic demand. For example, if the price of Horlicks rises, consumers may switch to Complan or other similar products.
   • Few Substitutes: Commodities with fewer or no substitutes tend to have inelastic demand. Price changes have less impact on quantity demanded.

3. Extent of Uses:

   • Multiple Uses: Commodities used for various purposes, like electricity, usually have elastic demand. A decrease in electricity prices can lead to reduced use of alternatives (e.g., coal or gas).
   • Single Use: Commodities with limited uses are less sensitive to price changes, resulting in inelastic demand.

4. Habitual Consumption:

   • Habitual Goods: Items consumed out of habit or convention (e.g., cigarettes) often exhibit inelastic demand. Even if prices rise, habitual users are less likely to reduce consumption.

5. Time Dimension:

   • Short Run vs. Long Run: Demand tends to be more inelastic in the short run because consumers may not have immediate alternatives. In the long run, as substitutes become available or consumers adjust, demand may become more elastic.

6. The Importance of Being Unimportant:

   • Small Budget Share: If a product constitutes a small part of a consumer's budget, they are less sensitive to price changes. For example, a slight increase in train fare for infrequent travelers may not significantly affect their travel decisions.

7. Durability:

   • Durable Goods: These typically have elastic demand. For instance, if refrigerator prices rise, consumers may postpone their purchase. Conversely, non-durable goods, which are consumed quickly, often exhibit inelastic demand.

The elasticity of demand is shaped by the nature of the commodity, the availability of substitutes, the extent of its uses, habitual consumption patterns, the time frame for adjustments, the relative importance of price changes in the consumer's budget, and the durability of the goods. Understanding these factors helps businesses and policymakers predict consumer behavior in response to price changes.

Importance of the Concept of Elasticity of Demand

1. Price Determination

• Market Conditions: Elasticity of demand is vital for determining prices under different market structures. In perfect competition, if demand falls while supply remains fixed, prices will drop, and vice versa. A stable price environment is influenced by the elasticity of both demand and supply.
• Agricultural Economics: For agricultural products, inelastic demand can lead to economic hardship for farmers if they increase production without a corresponding rise in demand. Policymakers can use this understanding to implement measures to stabilize farmers' income.
• Monopoly Pricing: A monopolist must understand the elasticity of demand for their product. They will focus on producing in the elastic range of the demand curve to maximize revenue.

2. Wage Determination

• Collective Bargaining: Elasticity informs wage negotiations. Trade unions can successfully push for higher wages if labor demand is inelastic since firms have fewer options for substituting labor with machines.
• Impact on Employment: The elasticity of demand for the product affects how changes in wages impact employment levels. For elastic demand, a rise in wages may lead to a larger contraction in employment compared to inelastic demand, which is more resistant to changes in labor costs.

3. Policy Determination

• Taxation: For effective tax policy, the elasticity of demand for the taxed goods is crucial. Taxes are typically levied on goods with inelastic demand to ensure stable revenue generation. Understanding elasticity helps in predicting the burden of taxes on consumers.
• Incidence of Tax: The ability to shift tax burdens depends on demand elasticity. With inelastic demand, producers can pass on the tax burden to consumers more easily.

4. Exchange Rate Determination

• International Trade: Elasticity of demand is essential for understanding currency devaluation's effects on a country's balance of payments. A successful devaluation hinges on the elasticities of demand for exports and imports.
• Terms of Trade: The elasticity of demand influences the terms of trade between countries, affecting how goods are exchanged internationally.

Summary: The concept of elasticity of demand is fundamental to economic analysis and decision-making. It aids in price setting, wage negotiations, policy formulation, and international trade strategies. A thorough understanding of elasticity enables businesses and policymakers to make informed decisions that consider the responsiveness of consumers to price changes, ultimately enhancing economic stability and efficiency.