Download a) Price Elasticity of Demand

Chapter # 05
Elasticity of Demand
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Detailed Questions and Answers
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Short Questions and Answer
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Multiple Choice Question (MCQ’s)
Detailed Questions and Answer
Q-1
Ans.
Define Elasticity of Demand and explain the various kinds of elasticity of demand?
Elasticity of Demand
The law of demand is straight forward. It tells us when the price of a good rises, its quantity
demanded will fall, all other things held constant. The law dose not indicate as to how much the
quantity demanded will fall with the rise in price or how much responsive demand is to a rise
price. The economists here use and measure the quantity demanded to a change in price by the
concept of elasticity of demand.
b)
Types of Elasticity of Demand:
The quantity of a commodity demanded per unit of time depends upon various factors
such as the price of a commodity, the money income of the prices of related goods, the
tastes of the people, etc., etc.
Whenever there is a change in any of the variables stated above, it brings about a change in the
quantity of the commodity purchased over a specified period of time. The elasticity of demand
measures the responsiveness of quantity demanded to a change in any one of the above factors by
keeping other factors constant. When the relative responsiveness or sensitiveness of the quantity
demanded is measured to changes, in its price, the elasticity is said be price elasticity of demand.
When the change in demand is the result of the given change in income, it is named as income
elasticity of demand. Sometimes, a change in the price of one good causes a change in the demand
for the other. The elasticity here is called cross electricity of demand. The three main types of
elasticity of demand are now discussed in brief.
a)
Price Elasticity of Demand:
The concept of price elasticity of demand is commonly used in economic literature. Price elasticity
of demand is the degree of responsiveness of quantity demanded of a good to a change in its price.
Precisely, it is defined as:
"The ratio of proportionate change in the quantity demanded of a good caused by a given
proportionate change in price".
Formula:
The formula for measuring price elasticity of demand is:
Ed = X
a)
Types:
The concept of price elasticity of demand can be used to divide the goods in to three groups.
(i)
Elastic. When the percent change in quantity of a good is greater than the percent change in its
price, the demand is said to be elastic. When elasticity of demand is greater than one, a fall in price
increases the total revenue (expenditure) and a rise in price lowers the total revenue (expenditure).
(ii)
Unitary Elasticity. When the percentage change in the quantity of a good demanded equals
percentage in its price, the price elasticity of demand is said to have unitary elasticity. When
elasticity of demand is equal to one or unitary, a rise or fall in price leaves total revenue
unchanged.
(iii)
Inelastic. When the percent change in quantity of a good demanded is less than the percentage
change in its price, the demand is called inelastic. When elasticity of demand is inelastic or less
than one, a fall in price decreases total revenue and a rise in its price increases total revenue.
b)
Income Elasticity of Demand:
Income is an important variable affecting the demand for a good. When there is a change in the
level of income of a consumer, there is a change in the quantity demanded of a good, other factors
remaining the same. The degree of change or responsiveness of quantity demanded of a good to a
change in the income of a consumer is called income elasticity of demand. Income elasticity of
demand can be defined as:
"The ratio of percentage change in the quantity of a good purchased, per unit of time to a
percentage change in the income of a consumer".
Formula:
The formula for measuring the income elasticity of demand is the percentage change in demand
for a good divided by the percentage change in income. Putting this in symbol gives.
a)
(3)
Ed = X
Types:
When the income of a person increases, his demand for goods also changes depending upon
whether the good is a normal good or an inferior good. For normal goods, the value of elasticity is
greater than zero but less than one. Goods with an income elasticity of less than 1 are called
inferior goods. For example, people buy more food as their income rises but the % increase in its
demand is less than the % increase in income.
Cross Elasticity of Demand:
The concept of cross elasticity of demand is used for measuring the responsiveness of quantity
demanded of a good to changes in the price of related goods. Cross elasticity of demand is defined
as:
"The percentage change in the demand of one good as a result of the percentage change in the
price of another good".
Formula:
The formula for measuring, cross, elasticity of demand is:
Eab = X
The numerical value of cross elasticity depends on whether the two goods in question are
substitutes, complements or unrelated.
a)
Types and Example:
Various types and kinds are given as below: -
(i)
Substitute Goods. When two goods are substitute of each other, such as coke and Pepsi, an
increase in the price of one good will lead to an increase in demand for the other good. The
numerical value of goods is positive.
For example there are two goods. Coke and Pepsi which are close substitutes. If there is increase
in the price of Pepsi called good y by 10% and it increases the demand for Coke called good X by
5%, the cross elasticity of demand would be:
(ii)
Complementary Goods. However, in case of complementary goods such as car and petrol, cricket
bat and ball, a rise in the price of one good say cricket bat by 7% will bring a fall in the demand for
the balls (say by 6%). The cross elasticity of demand which are complementary to each other is,
therefore, 6% / 7% = 0.85 (negative).
(iii)
Unrelated Goods. The two goods which are unrelated to each other, say apples and pens, if the
price of apple rises in the market, it is unlikely to result in a change in quantity demanded of pens.
The elasticity is zero of unrelated goods.
Q-2
What are the various degrees of Elasticity of Demand?
Ans.
Degrees of Elasticity of Demand:
We have stated demand for a product is sensitive or responsive to price change. The
variation in demand is, however, not uniform with a change in price. In case of some
products, a small change in price leads to a relatively larger change in quantity demanded.
a)
Elastic and Inelastic Demand:
For example, a decline of 1% in price leads to 8% increase in the quantity demanded of a
commodity. In such a case, the demand is said to elastic. There are other products where the
quantity demanded is relatively unresponsive to price changes. A decline of 8% in price, for
example, gives rise to 1% increase in quantity demanded. Demand here is said to be inelastic.
The terms elastic and inelastic demand do not indicate the degree of responsiveness and
unresponsiveness of the quantity demanded to a change in price. The economists therefore, group
various degrees of elasticity of demand into five categories.
i)
Perfectly Elastic Demand:
A demand is perfectly elastic when a small increase in the price of a good its quantity to zero.
Perfect elasticity implies that individual producers can sell all they want at a ruling price but
cannot charge a higher price. If any producer tries to charge even one penny more, no one would
buy his product. People would prefer to buy from another producer who sells the good at the
prevailing market price of $4 per unit. A perfect elastic demand curve is illustrated in fig.
Below diagram shows that the demand curve DD/ is a horizontal line which indicates that the
quantity demanded is extremely (infinitely) response to price. Even a slight rise in price (say
$4.02), drops the quantity demanded of a good to zero. The curve DD/ is infinitely elastic. This
elasticity of demand as such is equal to infinity.
Diagram:
ii)
Perfectly Inelastic Demand:
When the quantity demanded of a good dose not change at all to whatever change in price, the
demand is said to be perfectly inelastic or the elasticity of demand is zero.
For example, a 30% rise or fall in price leads to no change in the quantity demanded of a good.
In figure a rise in price from OA to OC or fall in price from OC to OA causes no change (zero
responsiveness) in the amount demanded.
iii)
Unitary Elasticity of Demand:
When the quantity demanded of a good changes by exactly the same percentage as price, the
demand is said to has a unitary elasticity.
For example, a 30% change in price leads to 30% change quantity demand =
30% / 30% = 1.
One or a one percent change in price causes a response of exactly a one percent change in the
quantity demand.
In this figure DD/ demand curve with unitary elasticity shows that as the price falls from OA to
OC, the quantity demanded increases from OB to OD. On DD/ demand curve, the percentage
change in price brings about an exactly equal percentage in quantity at all points a, b. The demand
curve of elasticity is, therefore, a rectangular hyperbola.
iv)
Elastic Demand:
If a one percent change in price causes greater than a one percent change in quantity demanded of
a good, the demand is said to be elastic.
Alternatively, we can say that the elasticity of demand is greater than. For example, if price of a
good change by 10% and it brings a 20% change in demand, the price elasticity is greater than one.
In figure DD/ curve is relatively elastic along its entire length. As the price falls from OA to OC,
the demand of the good extends from OB to ON i.e., the increase in quantity demanded is more
than proportionate to the fall in price.
v)
Inelastic Demand:
When a change in price causes a less than a proportionate change in quantity demand, demand is
said to be inelastic.
The elasticity of a good is here less than I or less than unity. For example, a 30% change in price
leads to 10% change in quantity demanded of a good, then:
In figure, DD/ demand curve is relatively inelastic. As
price fall from OA to OC, the quantity demanded of
good increases from OB to ON units. The increase in
quantity demanded is here less than proportionate to the
in price.
the
the
the
fall
Note: It may here note that the slope of a demand curve is
not a reliable indicator of elasticity. A flat slope of a demand
curve must not mean elastic demand. Similarly, a steep slope
on demand curve must not necessarily mean inelastic
demand.
The reason is that the slope is expressed in terms of units of the problem. If we change the units of
problem, we can get a different slope of the demand curve. The elasticity, on the other hand, is the
percentage change in quantity demanded to the corresponding percentage change in price.
Q-3
Ans.
How elasticity of Demand is measured?
Elasticity of demand is measured with the help of following approaches:i)
ii)
iii)
i)
Measurement of Price Elasticity of Demand
Measurement of Income Elasticity of Demand
Measurement of Cross Elasticity of Demand
Measurement of Price Elasticity of Demand:
There are three methods of measuring price elasticity of demand:
1.
2.
3.
4.
5.
Total Expenditure Method.
Proportional or Percentage Methods
Geometrical Method or
Point Elasticity Method.
Arc Method.
These three methods are now discussed in brief:
a)
Total Expenditure Method/Total Revenue Method/Total Outlay Method:
The price elasticity can be measured by noting the changes in total expenditure brought about by
changes in price and quantity demanded.
i)
When with a percentage fall in price, the quantity demanded increases so, much that it results in
the increase in total expenditure, the demand is said to be elastic (Ed > 1).
For Example:
Price Per Unit ($)
20
10
Quantity Demanded
10 Pens
30 Pens
Total Expenditure / Total Outlay
200.0
300.0
The figure shows that at price of $20 per pen, the quantity demanded is ten pens, the total
expenditure OABC ($200). When the price falls down to $10, the quantity demanded of pens is
thirty. The total expenditure is OEFG ($300).
Since OEFG is greater than OABC, it implies that change in quantity demanded is proportionately
more than the change in price. Hence the demand is elastic (more than one) Ed > 1.
ii)
When a percentage fall in price raises the quantity demanded so much as to leave the total
expenditure unchanged, the elasticity of demand is said to be unitary (Ed = 1).
For Example:
Price Per Pen ($)
10
5
Quantity Demanded
30
60
Total Expenditure/Total Outlay
300
300
The figure shows that at price of $10 per pen, the total expenditure is OABC ($300). At a lower
price of $5, the total expenditure is OEFG ($300).
Since OABC = OEFG, it implies that the change in quantity demanded is proportionately equal to
change in price. So the price elasticity of demand is equal to one, i.e., Ed = 1.
iii)
When a percentage fall in price raises the quantity demanded of a good so as to cause the total
expenditure to decrease, the demand is said to be inelastic or less than one, i.e., Ed < 1.
For Example:
Price Per Pen ($)
5
2
Quantity Demanded
60
100
In the fig at a price of $5 per pen the quantity
demanded is 50 pens. The total expenditure is OABC
($300). At a lower price of $2, the quantity demanded
is 100 pens.
The total expenditure is OEFG ($200). Since OEFG is
smaller than OABC, this implies that the change in
quantity demanded is proportionately less than the
change in price. Hence price elasticity of demand is
less than one or inelastic.
Total Expenditure /Total Outlay
300
200
Note:
As the demand curve slopes downward, therefore, the coefficient of price elasticity of demand is
always negative. The economists for convenience sake, omit the negative sign and express the
price elasticity of demand by positive number.
b)
Proportional or Percentage Method: Proportional or Percentage method explains the elasticity of demand in terms of numeric values
and it can be calculated with the help of this formula: Ed = X
c)
Geometric Method/Point Elasticity Method:
"The measurement of elasticity at a point of the demand curve is called point elasticity". The
point elasticity of demand method is used as a measure of the change in the quantity demanded in
response to a very small changes in price. The point elasticity of demand is defined as:
"The proportionate change in the quantity demanded resulting from a very small proportionate
change in price".
(i)
Measurement of Elasticity on a Linear Demand Curve:
The price elasticity of demand can also be measured at any point on the demand curve. If the
demand curve is linear (straight line), it has a unitary elasticity at the mid point. The total revenue
is maximum at this point.
Any point above the midpoint has an elasticity greater than 1, (Ed > 1). Here, price reduction leads
to an increase in the total revenue (expenditure). Below the midpoint elasticity is less than 1. (E d <
1). Price reduction leads to reduction in the total revenue of the firm.
Graph/Diagram:
The elasticity at each point on the demand curve can be
traced with the help of point method as:
Ed = Lower Segment / Upper Segment
In the figure AG is the linear demand curve (1).
Elasticity of demand at its mid point D is equal to
unity. At any point to the right of D, the elasticity is
less than unity (Ed < 1) and to the left of D, the
elasticity is greater than unity (Ed > 1).
a)
Elasticity of demand at point is equal to 1
b)
Elasticity of demand at point E is <1.
c)
Elasticity of Demand at point C is >1.
d)
Elasticity of Demand at point C is infinity.
e)
At point G, the elasticity of demand is zero.
(Unity).
d)
Arc Elasticity of Demand (Non Linear Demand Curve):
If the demand curve is non linear, then elasticity at a point can be measured by drawing a tangent
at the particular point. It is called Arc Elasticity of Demand. This is explained with the help of a
figure given below:
Normally the elasticity varies along the length of the
demand curve. If we are to measure elasticity
between any two points on the demand curve which
has an ARC SHAPE is called ARC Elasticity of
Demand, then the Arc Elasticity Method, is used.
Arc elasticity is a measure of average elasticity
between any two points on the demand curve. It is
defined as:
"The average elasticity of a range of points on a
demand curve".
Formula:
Arc elasticity is calculated by using the following
formula: Ed = X
e)
Point Elasticity of Demand: When we calculate elasticity of demand in case when there are very small changes in price and
quantity demand, such type of elasticity of demand is called Point Elasticity of Demand and it can
be measure with the help of this formula: -
Ep = X
b)
Income Elasticity of Demand:
"The ratio of percentage change in the quantity of a good purchased, per unit of time to a
percentage change in the income of a consumer".
The formula for measuring the income elasticity of demand is the percentage change in demand
for a good divided by the percentage change in income. Putting this in symbol gives.
(3)
Ey = X
Cross Elasticity of Demand:
The concept of cross elasticity of demand is used for measuring the responsiveness of quantity
demanded of a good to changes in the price of related goods. Cross elasticity of demand is defined
as:
"The percentage change in the demand of one good as a result of the percentage change in the
price of another good".
Formula:
The formula for measuring, cross, elasticity of demand is:
Eab = X
The numerical value of cross elasticity depends on whether the two goods in question are
substitutes, complements or unrelated.
a)
Types and Example:
Various types and kinds are given as below: -
(i)
Substitute Goods. When two goods are substitute of each other, such as coke and Pepsi, an
increase in the price of one good will lead to an increase in demand for the other good. The
numerical value of goods is positive.
For example there are two goods. Coke and Pepsi which are close substitutes. If there is increase
in the price of Pepsi called good y by 10% and it increases the demand for Coke called good X by
5%, the cross elasticity of demand would be:
(ii)
Complementary Goods. However, in case of complementary goods such as car and petrol, cricket
bat and ball, a rise in the price of one good say cricket bat by 7% will bring a fall in the demand for
the balls (say by 6%). The cross elasticity of demand which are complementary to each other is,
therefore, 6% / 7% = 0.85 (negative).
Q-4
Ans.
Explain the factors that determine the Elasticity of Demand?
Factors Determining Elasticity of Demand:
The price elasticity of demand is not the same for all commodities. It may be or low
depending upon number of factor. These factors which influence price elasticity of
demand, in brief, are as under:
(i)
Nature of Commodities. In developing countries of the world, the per capital income of the
people is generally low. They spend a greater amount of their income on the purchase of
necessaries of life such as wheat, milk, course cloth etc. They have to purchase these commodities
whatever be their price. The demand for goods of necessities is, therefore, less elastic or inelastic.
The demand for luxury goods, on the other hand is greatly elastic.
For example, if the price of burger falls, its demand in the cities will go up.
(ii)
Availability of Substitutes. If a good has greater number of close substitutes available in the
market, the demand for the good will be greatly elastic.
For examples, if the price of Coca Cola rises in the market, people will switch over to the
consumption of Pepsi Cola, which is its close substitute. So the demand for Coca Cola is elastic.
(iii)
Proportion of the Income Spent on the Good. If the proportion of income spent on the purchase
of a good is very small, the demand for such a good will be inelastic.
For example, if the price of a box of matches or salt rises by 50%, it will not affect the consumers
demand for these goods. The demand for salt, maker box therefore will be inelastic. On the other
hand, if the price of a car rises from $6 lakh to $9 lakh and it takes a greater portion of the income
of the consumers, its demand would fall. The demand for car is, therefore, elastic.
(iv)
Time. The period of time plays an important role in shaping the demand curve. In the short run,
when the consumption of a good cannot be postponed, its demand will be less elastic. In the long
run if the rise price persists, people will find out methods to reduce the consumption of goods. So
the demand for a good in the, long run is elastic, other things remaining constant.
For example if the price of electricity goes up, it is very difficult to cut back its consumption in the
short run. However, if the rise in price persists, people will plan substitution gas heater, fluorescent
bulbs etc. so that they use less^electricity. So the electricity of demand will be greater (E d = > 1) in
the long run than in the short run.
v)
Number of Uses of a Good. If a good can be put to a number of uses, its demand is greater elastic
(Ed > 1).
For example, if the price of coal falls, its quantity demanded will rise considerably because
demand will be coming from households, industries railways etc.
vi)
Addition. If a product is habit forming say for example, cigarette, the rise in its price would not
induce much change in demand. The demand for habit forming good is, therefore, less elastic.
vii)
Joint Demand. If two goods are Jointly demand, then the elasticity of demand depends upon the
elasticity of demand of the other Jointly demanded good.
For example, with the rise in price of cars, its demand is slightly affected, then the demand for
petrol will also be less elastic.
Q-5
Ans.
Explain the Importance of Elasticity of Demand:
Importance of Elasticity of Demand:-
a)
Theoretical Importance:
The concept of elasticity of demand is very useful as it has got both theoretical and
practical advantages. As regards its importance in the academic interest, the concept, is
very helpful in the theory of value. In the words of Keynes:
"The concept of elasticity is so important that in the provision of terminology and apparatus to aid
thought, I do not think, Marshall did any greater service than by the explicit introduction of the
idea of the elasticity".
b)
Practical Importance:
Practical important can be explained as: -
i)
Importance in taxation policy. As regards its practical advantages, the concept has immense
importance in the sphere of government finance. When a finance minister levies a tax on a certain
commodity, he has to see whether the demand for that commodity is elastic or inelastic.
If the demand is inelastic, he can increase the tax and thus can collect larger revenue. But if the
demand of a commodity is elastic, he is not in a position to increase the rate of a tax. If he does so,
the demand for that commodity will be, calculated and the total revenue reduced.
ii)
Price discrimination by monopolist. If the monopolist finds that the demand for his commodities
is inelastic, he will at once fix the price at a higher level in order to maximize his net profit. In case
of elastic demand, he will lower the price in order to increase, his sale and derive the maximum net
profit. Thus we find that the monopolists also get practical advantages from the concept of
elasticity.
iii)
Price discrimination in cases of joint supply. The concept of elasticity is of great practical
advantage where the separate, costs of Joint products cannot be measured. Here again the prices
are fixed on the principle. "What the traffic will bear" as is being done in the railway rates and
fares.
iv)
Importance to businessmen. The concept of elasticity is of great importance to businessmen.
When the demand of a good is elastic, they increases sale by towering its price. In case the
demand' is inelastic, they are then in a position to charge higher price for a commodity.
v)
Help to trade unions. The trade unions can raise the wages of the labor in an industry where the
demand of the product is relatively inelastic. On the other hand, if the demand, for product is
relatively elastic, the trade unions cannot press for higher wages.
vi)
Use in international trade. The term of trade between two countries are based on the elasticity of
demand of the traded goods.
vii)
Determination of rate of foreign exchange. The rate of foreign exchange is also considered on
the elasticity of imports and exports of a country.
.
viii)
Guideline to the producers. The concept of elasticity provides a guideline to the producers for the
amount to be spent on advertisement. If the demand for a commodity is elastic, the producers shall
have to spend large sums of money on advertisements for increasing the sales.
ix)
Use in factor pricing. The factors of production which have inelastic demand can obtain a higher
price in the market then those which have elastic demand. This concept explains the reason of
variation in factor pricing.
Short Questions and Answer
Q-1
Ans.
What is meant by Elasticity of Demand?
Elasticity of Demand explains the relationship between the quantity and price and it shows a
proportional or percentage change in demand due to percentage or proportional change in price of
good. However it may be defined as
“Elasticity of demand is a proportional or percentage change in demand due to proportional or
percentage change in price of good”
Q-2
Ans.
List the determinants of elasticity of demand?
Elasticity of demand depends upon the following determinant or factors: ●
●
●
●
●
●
●
Q-3
Ans.
Nature of Commodities.
Availability of Substitutes.
Proportion of the Income Spent on the Good.
Time.
Number of Uses of a Good.
Addition.
Joint Demand
Name the methods of measurement of Elasticity of Demand?
Elasticity of demand can be measured with the help of following methods which are listed below:
a.
b.
c.
d.
e.
Outlay / Total Expenditure Method
Percentage / Proportional Method
Geometric Methods
Point Elasticity of Demand Method
Arc Elasticity of Demand Method
Multiple Choice Questions & Answer
Select the Correct Answer from given choices
1.
It the change in demand and price are in the same ration, the elasticity of demand will
be____________________
a)
Relative Elastic
b)
Elastic (√)
c)
In-Elastic
d)
Highly Elastic
2-
The elasticity of demand for luxuries is __________________________ than unity?
a)
Inelastic (√)
b)
Very Elastic
c)
Perfectly Elastic
d)
Elastic
3-
If the demand curve is parallel to x-axis then demand will be ________________?
a)
Perfectly Inelastic
b)
Perfectly Elastic (√)
c)
Elastic
d)
In-Elastic
4-
A change in ______________ cause expansion or contraction of demand?
a)
Price (√)
b)
Value
c)
Nature
d)
Shape
5-
The Elasticity of demand for necessities is always_____________ than unity?
a)
More
b)
Less (√)
c)
Constant
d)
Equal
6-
The numerical measurement of elasticity of demand ___________________?
a)
More than 1
b)
Less than 1
c)
Equal to Unity (√)
c)
None of them
7-
A vertical straight line demand curves implies ___________ degree of elasticity?
a)
Elastic
b)
Inelastic
c)
Perfectly Elastic
d)
Perfectly In Elastic (√)
8-
The measurement of elasticity of demand on arc shape demand curve is______?
9-
a)
Zero Elasticity
c)
Point Elasticity
12-
d)
More than Unity
Constant
A commodity which requires a large portion of consumer’s income tends to have ____
demand?
a)
Less than Unit
b)
More than Unity (√)
c)
11-
Point Elastic
Arc Elasticity of Demand (√)
Percentage Elasticity
Necessaries have a _________________ Demand?
a)
Less then Unity (√)
b)
c)
10-
b)
d)
Equal to Unity
d)
Constant
The perfectly elastic demand curve is _____________
a)
Vertical
b)
Horizontal (√)
c)
Favorable
d)
Flatter
Demand for cigarettes is highly ________________?
a)
Elastic
b)
In Elastic (√)
c)
Regular
d)
Favorable
13-
Resultant Elasticity of demand for substitutes is always ___________?
a)
Positive (√)
b)
Zero
c)
Negative
d)
None of them
14-
Resultant Elasticity of demand for compliment goods is __________?
a)
Positive
b)
Negative (√)
c)
15-
Zero
d)
All the above
Resultant Income Elasticity of demand is _____________
a)
Positive (√)
b)
Zero
c)
Negative
d)
None of them