Download Measurement of elasticity of demand It is necessary to measure

Measurement of elasticity of demand
It is necessary to measure elasticity. There are four methods of measuring elasticity of
demand.
1. Point Elasticity method:
It is a commonly adopted method to measure elasticity when a change in price is too small. It
is computed at a single point on the demand curve as the price change is considered insignificant
and the points in the demand curve are so close so that they can take as one point.
D
Y
A
P1
R
Price p
S
D
B
Q1 Q
X
Quantity
In the figure, OP is the original price and OQ is the quantity demanded when DD is the
demand curve. When price changes to OP1 the new quantity demanded is OQ1. But when we
draw a tangent to demand curve DD, the slopes in the demand curve DD are the same at the
point R & S. Therefore these two points R & S are considered as one point.
This method is suggested by Prof.Marshall. The formula used to measure elasticity under this
method is:
Ep = Proportional Change in demand
Proportional change in price
Ie,
Ep =
Change in quantity
Original quantity
Q
Q
÷
P
P
÷
Change in price
Original Price
Illustration:
Price and quantity demanded of product A in 2 successive periods are given below:
Price (Rs.)
Period I
Quantity demanded
30
Period II
2000
27
3000
Determine elasticity of demand.
Solution:
Change in price
Proportional change in price =
Original price
=
27 – 30 =
30
-3
30
Change in demand
Proportional change in demand
=
Original demand
=
3000 – 2000
2000
Ep =
=
1000
2000
Proportional Change in demand
Proportional change in price
=
1000
2000
-3
30
=
1000
2000
X 30
-3
=
-5
2. Arc Elasticity
This method also known as average elasticity method is used to measure elasticity when
there is considerable change in price. For example, say 20% or more. This change in price may
result in a substantial change in demand, and so the change in demand will be represented by two
different points on the demand curve as shown in the diagram. The portion between the two
points in the demand curve is known as arc.
Y
D
P1
R
P2
S
Price
D
O
Q1 Q2
Quantity demanded
X
In the above diagram, arc is the portion between R & S in the demand curve DD. The formula
for measuring price elasticity under this method is
EP
= Q2 - Q1
P2 – P1
X
P2 + P1
Q2+ Q1
Q1
= Original quantity demanded
Q2
= New quantity demanded
P1
= Original Price
P2
= New Price
Illustration:
I.T.C Ltd. sells 10000 liters of refined oil at Rs.60/- per ltr. The demand goes up to 15000 ltrs.
when the price is reduced to Rs.45/- per ltr. What is the price elasticity of demand?
Q1
= 10000
Q2
= 15000
P1
= 60/-
P2
= 45/-
EP
= Q2 - Q1 X P2 + P1
P2 – P1
Q2+ Q1
= 10000 – 15000
x
45 + 60
60 - 45
15000 + 10000
= 1.4
3. Total Outlay Method:
Outlay method measures elasticity by taking total expenditure of the consumer on the
commodity. Total expenditure of a commodity is the product of price and quantity demanded at
that price. As per the law of demand, when price is reduced the quantity demanded increases and
vice –versa. This change in demand may be proportionate to change in price/more than
proportionate or less than proportionate. Accordingly the price elasticity may be equal to one or
more than one or less than one. This can be ascertained by comparing the total outlay before and
after the change in price as illustrated:
Price
5
4
5
4
5
4
Units demanded
1000
1250
1000
1200
1000
1300
Total Outlay
5000
5000
5000
4800
5000
5200
Price elasticity
EP = 1
EP = < 1
EP = > 1
4. Geometric Method:
This method also known as graphic method, determining elasticity with the help of demand
curve drawn on a graph paper on the basis of demand schedule.
Y R
Q2 = ∞
Q1 = > 1
Price
Q=1
Q3 = < 1
Q4 = 0
O
P
X
EP = Lower segment of demand curve
Upper segment of demand curve.
In the above diagram RP is the straight line demand curve. Suppose the length of this is 8
cm. Q is the central point in the demand curve. RQ = QP. At the point Q 4 cm ÷ 4 cm = 1. ie,
here elasticity of demand is equal to unity. At Q1 elasticity of demand is Q1 P ÷ R Q1 = 6÷ 2 =3
here elasticity is greater than one. At the point Q3 elasticity of demand is less than one.
Importance of Price elasticity
The concept of elasticity of demand is an important tool in economic analysis. It has practical
utility and theoretical importance:
 Determining price policy:
The concept of elasticity of demand helps the producers and business man. They must
determine the prices according to the elasticity of demand for commodities. They must charge a
lesser price for elastic goods and at a higher price for inelastic goods and thus obtain a higher
profit.
 Importance for the Govt.:
While imposing taxes on commodities, the Finance Minister should consider the
elasticity of demand. It is not profitable to impose taxes on commodities for which the demand is
elastic. The demand for such goods will fall when the price rises due to taxation. The Govt. will
not get much revenue. On the other hand it is profitable to impose taxes on commodities for
which the demand is inelastic.
 Importance in the determination of factor pricing:
The share of each factor of production in national product is determined by its demand. A
factor with an inelastic demand can always command a higher price as compared to a factor with
relatively elastic demand.
 Importance in International trade:
The concept of elasticity of demand plays a very important role in international trade.
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An idea of the concept of elasticity of demand enables the Govt. to fix a proper rate of
exchange for its currency in relation to other currencies.
The terms of trade agreed upon by the Govt. of two nations are closely associated with
this concept. If the demand is inelastic, terms would be infavour of the seller.
Rates of tariff levied depend on elasticity of demand for the products. Tariffs will be
higher if demand is inelastic and lower if it is elastic.
Income Elasticity
Income is a major factor influencing demand. The rate of change in demand due to
change in the income of the consumer is known as income elasticity. Watson define income
elasticity as “income elasticity of demand means the ratio of the percentage change in quantity
demanded to the percentage change in income”. When the income of a consumer increases, he
demands more of a good, and so the relationship between demand and income is positive. But
this is not applicable in inferior goods. The income elasticity of inferior goods may be negative
because an increase in consumer’s income may induce them to go for superior goods and so the
demand for inferior goods may decrease when income increases.
The income elasticity of normal goods can be illustrated as under:
Y
D
I2
Income
I1
I
D
O
Q
Q1Q2
X
In the above diagram OX axis represents quantity demanded and OY axis the income of
consumers. As shown in the diagram, when the income increases from OI to OI1, the quantity
demanded increases from OQ to OQ1. After some level, the demand curve becomes vertical
indicating that after a level the increase in income may not have any effect on demand. That
means after a level, the increase in income will not increase the demand (OQ3). The income
elasticity can be measured using 2 methods:
1. Point elasticity method:
This method is used when the change in income is small, usually less than 20%. Under this
method elasticity is measured as:
EY =
Proportional Change in demand
Proportional change in Income
Ie,
Change in quantity
Original quantity
÷
Change in Income
Original Income
Illustration:
A consumer purchases 5 packets of biscuits when his income was Rs.5000/- per month. Now his
income is Rs.5500/- and he purchases 6 packets of biscuits. What is the income elasticity.
Original demand (Q)
= 5 Packets.
Change in demand
= 1 (6-5)
Original Income
= 5000/-
Change in income
= 500 (5500 -5000)
Ey
= 1/500 x 5000/5
=2
2. Arc Elasticity method:
Arc elasticity method is used when the change in income is more than 20%. The elasticity is
measured using the following formula:
EY
= Q2 - Q1
Y2 – Y1
X
Y2 + Y1
Q2+ Q1
Illustration:
Simpson Electronics sold 60 television sets per month in the city shop when the percapita
income in Tvm. district was Rs. 5000/- per month. When the income increased to 7000 per
month number of sets sold increased to 90. Find the income elasticity.
EY
= Q2 - Q1
Y2 – Y1
X
Y2 + Y1
Q2+ Q1
= 90-60/ 7000 -5000 x 7000 + 5000/90 +60
= 30/2000 x 12000/150 = 1.2
Types of Income elasticity
1. Zero Income Elasticity:
It means that there is no change in demand due to change in income. The demand for salt,
safety matches etc. are examples of zero income elasticity.
2. Negative Income elasticity:
If the demand for a commodity decreases due to increase in income, the income elasticity is
said to be negative. This is always applicable to the case of inferior goods. When consumer’s
income increases, they shift to superior goods and so the demand for inferior goods decreases.
3. Positive Income elasticity:
The income elasticity of superior goods and normal goods is usually positive, as the
customer’s buy more when their income increases.
According to the responsiveness of demand income elasticity can be classified as:
a. Unit Income elasticity:
The change in quantity demanded is in proportion to change in income ie, one percent
increase in income leads to one percent increase in demand.
b. Income Elasticity more than Unity:
The proportional change in demand is more than proportional change in income ie, a one
percent change in income leads to a more than one percent change in demand.
c. Income elasticity less than unity:
The proportional change in demand is less than the proportional change in income ie, a one
percent change in income leads to a less than one percent change in demand.
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If the income consumption curve has a negative slope, income elasticity is negative.
If it is a vertical straight line, income elasticity is zero.
If the income consumption curve is relatively steep, income elasticity is less than unity.
If the curve has the angle of 45 degree to the origin, income elasticity is equal to unity.
If the curve is relatively flat, income elasticity is greater than unity.
Y -ve 0
<1
Income
1
>1
Amount demanded
X
Advertisement Elasticity
Advertisement elasticity otherwise known as promotional elasticity. It is the degree of
responsiveness of demand to change in advertisement expenditure. Advertisement expenses
increases the sale of products. That is they increase the demand for a firm’s product. Expansion
of demand through advertisement can be measured by advertising elasticity or promotional
elasticity. It is measured under point elasticity method as:
Ea
=
Proportional Change in demand
Proportional change in advertisement expenditure
Ie, Change in demand
Original demand
÷
Change in advertisement expenditure
Original advertisement expenditure
Since the increase in advertisement expenditure causes increase in sales, the
advertisement elasticity is always positive.
Under Arc elasticity method it is measured as:
Ea
= Q2 - Q1
A2 – A1
X
A2 + A1
Q2+ Q1
Factors influencing advertisement elasticity:
The following factors influencing the advertisement elasticity:
1. Stage in the life cycle of the product:
If the product is in the early stage of introduction in the market, the advertisement elasticity
will be very high. That means the change in demand will be more when advertisement is made if
the product is just introduced in the market, on the condition that other things remains the same.
On the other hand if the product is an already established one, its advertisement elasticity will be
much less.
2. Reaction of competitors:
The main aim of advertisement is to shift the consumers from competitor’s product. When
competitors are also spending huge amount on advertisement the shifting of consumers from
their product becomes difficult. Under such situations advertisement elasticity will be lower.
3. Past advertisement:
Most of the present sales are the result of past advertisement and so the present advertisement
expenditures influence on sales can be estimated only from future sales. The present elasticity of
demand is mainly due to the past advertisement expenditure.
4. Quality and mode of advertisement:
The types of advertisement media of advertisement etc. are influencing factors of
advertisement elasticity. Again other demand determinants like income, price, tastes, preferences
etc. are also cause change in the advertisement elasticity.
Cross elasticity:
Cross elasticity refers to the proportional change in the quantity demanded of a product in
response to a proportional change in the price of another product, which may be either substitute
or complementary. Cross elasticity of substitute goods is positive as the increase in the price of
one substitute goods is positive (Eg: tea) causes an increase in demand for the other (Eg: coffee).
But in the case of complimentary goods, the cross elasticity is negative. If the price of one
complementary goods increases (Eg; car) the demand for another complementary goods
decreases (Eg; tyres). In short there is an inverse relationship between car and tyres (Pen and
Ink).
Cross elasticity s measured as:
Ec
=
Proportional Change in demand of X
Proportional change in price of Y
=
QX
PY
X
PY
QX
Where,
QX
= Change in demand of product X
PY
= Change in price of product Y
PY
= Original price of product Y
QX
= Original demand of product X
Uses of demand elasticity in business decisions:
 Measurement of demand elasticity is very useful in taking business decisions like price
fixation, price discrimination, market selection, product modification etc.
 Price elasticity of demand is very useful in the field of production and distribution.
Pricing decisions are always based on elasticity of demand. A product with less elasticity
can be priced higher than the product with high elasticity.
 Income elasticity concept is very useful for sales forecast or it shows the relationship
between the income and demand. It helps the companies to determine the market share of
its products when a change in the national income is anticipated.
 Advertisement elasticity is becoming a major factor influencing demand and a majority
of firms spend huge amount on advertisement. It helps the firm in making decisions on
the expenditure on advertisement and the effect of advertisement in different medias.
 Cross elasticity concept is of immense helps to ascertain the nature of market enjoyed by
the firm. This helps the management to ward off the influence of price changes of related
goods on the demand for the product as the market for the product can be classified on
the following lines:

If the cross elasticity of a product is zero, it has a pure monopoly market.

If the cross elasticity is very high, the product experiences monopolistic competition.

If the cross elasticity is infinite, the product has perfectly competitive market because a
small reduction in the price by rival producers causes an unlimited reduction in the
demand of the product.
Revenue Concepts
For the purpose of demand analysis, it is useful to differentiate three types of revenue –
average, marginal and total revenue.
Total revenue
Total revenue is calculated by multiplying the price per unit of the commodity by the
units sold. It is the total proceeds from sales during the period.
Thus TR = PQ
Average revenue
It means per unit revenue. It is obtained by dividing the total revenue by the number of
units sold. It is nothing but price.
Thus AR = TR ÷ Q
Marginal revenue
It is the additional revenue obtained by selling one more unit of the product or service. It
is the selling price of the last unit.
MR = Addition to TR ÷ Addition to total Quantity
= R2 –R1 ÷ Q2 –Q1
Incremental revenue
It is the additional revenue resulting from the sale of some additional units. It is the
difference between new and existing total revenue (total sales). The formula for measuring
incremental revenue is:
IR = R2 –R1
R2 = New total revenue
R1 = Original total revenue.
Revenue Schedule
Quantity
demanded
0
1
2
3
4
5
6
7
8
9
10
Average
Revenue
12
10
9
8
7
6
5
4
3
2
1
Total
revenue
0
10
18
24
28
30
30
28
24
18
10
Marginal
revenue
10
8
6
4
2
0
-2
-4
-6
-8
From the table we can see that:
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While average revenue is decreasing marginal revenue will be less than average revenue.
Marginal revenue falls more quickly than average revenue.
Total revenue goes on increasing till marginal revenue is positive.
When marginal revenue is negative, total revenue falls.
Total revenue is at its maximum when marginal revenue is zero.
Relationship Between revenue and price elasticity of demand
Price elasticity of demand is AR ÷ Q. We can show the relationship through the
following three general statements:
 When price elasticity of demand is greater than one, marginal revenue is positive and
total revenue rises as price falls.
 When price elasticity of demand is unity marginal revenue is zero and a change in price
will not change total revenue.
 When price elasticity of demand is less than one, marginal revenue is negative and total
revenue falls as price falls.
According to Mrs. Joan Robinson the following formula shows the relationship among
marginal revenue, AR and price elasticity of demand:
1. Average Revenue = MR x e/e-1
2. Marginal Revenue = AR x e-1/e
Here ‘e’ is point elasticity of demand on the average revenue curve, A is AR and M is MR.
3. Price elasticity = Average revenue / Average revenue – Marginal revenue.
ie, Ep = A/ A-M