## Elasticity of Demand.

Elasticity of Demand

Law of demand explains the directions of changes in demand. A fall in price leads to an increase in quantity demanded and vice versa. But it does not tell us the rate at which demand changes to change in price. The concept of elasticity of demand was introduced by Marshall. This concept explains the relationship between a change in price and consequent change in quantity demanded. Nutshell, it shows the rate at which changes in demand take place.

Elasticity of demand can be defined as “the degree of responsiveness in quantity demanded to a change in price”. Thus it represents the rate of change in quantity demanded due to a change in price.

### There are mainly three types of elasticity of demand:

1. Price Elasticity of Demand.

2. Income Elasticity of Demand. and

3. Cross Elasticity of Demand. Definitions of Price Elasticity of Demand

The concept of price elasticity of demand has been defined by different economists as under :

According to Alfred Marshall: “Elasticity of demand may be defined as the percentage change in quantity demanded to the percentage change in price.”

According to A.K. Cairncross : “The elasticity of demand for a commodity is the rate at which quantity bought changes as the price changes.”

According to J.M. Keynes : “The elasticity of demand is a measure of the relative change in quantity to a relative change in price.”

According to Kenneth Boulding : “Elasticity of demand measures the responsiveness of demand to changes in price.”

Price Elasticity of Demand

Price Elasticity of demand measures the change in quantity demanded to a change in price. It is the ratio of percentage change in quantity demanded to a percentage change in price. This can be measured by the following formula.

Price Elasticity = Proportionate change in quantity demanded/Proportionate change in price

OR

Ep =       Change in Quantity demanded / Quantity demanded

———————————————————————–

Change in Price/price

OR

Ep =       (Q2-Q1)/Q1

——————-

(P2-P1) /P1

Where: Q1 = Quantity demanded before price change

Q2 = Quantity demanded after price change

P1 = Price charged before price change

P2 = Price charge after price change.

There are five types of price elasticity of demand. (Degree of elasticity of demand) Such as perfectly elastic demand, perfectly inelastic demand, relatively elastic demand, relatively inelastic demand and unitary elastic demand.

1) Perfectly elastic demand (infinitely elastic)

When a small change in price leads to infinite change in quantity demanded, it is called perfectly elastic demand. In this case the demand curve is a horizontal straight line as given below. (Here ep= ) 2) Perfectly inelastic demand

In this case, even a large change in price fails to bring about a change in quantity demanded. I.e. the change in price will not affect the quantity demanded and quantity remains the same whatever the change in price. Here demand curve will be vertical line as follows and ep= 0 3) Relatively elastic demand

Here a small change in price leads to very big change in quantity demanded. In this case demand curve will be fatter one and ep=>1 4) Relatively inelastic demand

Here quantity demanded changes less than proportionate to changes in price. A large change in price leads to small change in demand. In this case demand curve will be steeper and ep=<1 5) Unit elasticity of demand ( unitary elastic)

Here the change in demand is exactly equal to the change in price. When both are equal, ep= 1, the elasticity is said to be unitary. The above five types of elasticity can be summarized as follows

 SL No type Numerical expression description Shape of curve 1 Perfectly elastic α infinity Horizontal 2 Perfectly inelastic 0 Zero Vertical 3 Unitary elastic 1 One Rectangular hyperbola 4 Relatively elastic >1 More than one Flat 5 Relatively inelastic <1 Less than one Steep

IMPORTANCE OF ELASTICITY OF DEMAND

The concept of elasticity of demand is of great importance in practical life. Its main points are given as under:

It enables the business in general and the monopolists in particular to fix the price. Studying the nature of demand the monopolist fixes higher prices for those goods which have inelastic demand and lower prices for goods which have elastic demand. In this way, this helps him to maximise his profit.

2. Fixation of Prices:

It is very useful to fix the price of jointly supplied goods. In the case of joint products like paddy and straw, the cost of production of each is not known. The price of each is then fixed by its elastic and inelastic demand.

It helps the Finance Minister to levy tax on goods. After levying taxes more and more on goods which have inelastic demand, the Government collects more revenue from the people without causing them inconvenience. Moreover, it is also useful for the planning.

4. Fixation of Wages:

It guides the producers to fix wages for labourers. They fix high or low wages according to the elastic or inelastic demand for the labour.

5. In the Sphere of International Trade:

It is of greater significance in the sphere of international trade. It helps to calculate the terms of trade and the consequent gain from foreign trade. If the demand for home product is inelastic, the terms of trade will be profitable to the home country.

It explains the paradox of poverty in the midst of plenty. A bumper crop instead of bringing prosperity may result in disaster, if the demand for it is inelastic. This is specially so, if the products are perishable and not storable.

7. Significant for Government Economic Policies.

The knowledge of elasticity of demand is very important for the government in such matters as controlling of business cycles, removing inflationary and deflationary gaps in the economy. Similarly, for price stabilization and the purchase and sale of stocks, information about elasticity of demand is most useful.

8. Determination of Price of Public Utilities.

This concept is significant in the determination of the prices of public utility services. Economic welfare of the society largely depends upon the cheap availability

References

http://en.wikipedia.org/wiki/Price_elasticity_of_demand

http://www.investopedia.com/terms/p/priceelasticity.asp

http://www.investopedia.com/terms/d/demand-elasticity.asp

http://www.extension.iastate.edu/agdm/wholefarm/pdf/c5-207.pdf

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