Elasticity of Demand and Its Measurement

Elasticity of demand measures how much the quantity demanded of a commodity changes in response to changes in one of its determinants, such as price, income or the price of related goods.

The formula varies depending on the type of elasticity being measured, but the general idea is to quantify how responsive demand is to external changes.

Types of Elasticity of Demand

1. Price Elasticity of Demand (PED):

   • Measures the responsiveness of quantity demanded to changes in the price of the good.
   • Formula: $$\text{PED} = \frac{\%\text{Change in Quantity Demanded}}{\%\text{Change in Price}}$$

2. Income Elasticity of Demand (YED):

   • Measures the responsiveness of demand to changes in consumer income.
   • Formula: $$\text{YED} = \frac{\%\text{Change in Quantity Demanded}}{\%\text{Change in Income}}$$

3. Cross-Price Elasticity of Demand (XED):

   • Measures the responsiveness of demand for one good when the price of a related good changes.
   • Formula: $$\text{XED} = \frac{\%\text{Change in Quantity Demanded of Good A}}{\%\text{Change in Price of Good B}}$$

Price Elasticity of Demand (PED)

Let’s break this down further because PED is the most commonly tested type in exams.

Types of Price Elasticity

1. Perfectly Elastic Demand (PED = ∞):

   • Even a tiny price increase causes demand to drop to zero.
   • Horizontal Demand Curve
   • Example: Products in highly competitive markets, like perfectly substitutable goods.

2. Elastic Demand (PED > 1):

   • A percentage change in price leads to a greater percentage change in quantity demanded.
   • Flat Demand Curve
   • Example: Luxury goods, such as designer handbags.

3. Unitary Elastic Demand (PED = 1):

   • The percentage change in price equals the percentage change in quantity demanded.
   • Rectangular Hyperbola

4. Inelastic Demand (PED < 1):

   • A percentage change in price leads to a smaller percentage change in quantity demanded.
   • Steeper Demand Curve
   • Example: Necessities like salt or rice.

5. Perfectly Inelastic Demand (PED = 0):

• Demand remains constant, regardless of price changes.
• Vertical Demand Curve
• Example: Life-saving medicines.

Factors Affecting Price Elasticity of Demand

Several factors determine whether demand is elastic or inelastic:

1. Nature of the Good: Necessities have inelastic demand; luxuries have elastic demand.
2. Availability of Substitutes: More substitutes make demand elastic.
3. Proportion of Income Spent: Expensive goods tend to have elastic demand.
4. Time Period: Demand becomes more elastic in the long run as consumers adjust their behavior.
5. Addictive Goods: These often exhibit inelastic demand.

Measurement of Price Elasticity of Demand

1. Percentage Method:

   $$\text{PED} = \frac{\%\text{Change in Quantity Demanded}}{\%\text{Change in Price}}$$

   Example:

   • Price decreases from ₹50 to ₹40 (20% decrease).
   • Quantity demanded increases from 100 units to 150 units (50% increase).
   • $$\text{PED} = \frac{50\%}{20\%} = 2.5 \ (\text{Elastic Demand})$$
     

2. Total Expenditure Method:

   • If total expenditure (Price × Quantity) increases as price decreases, demand is elastic.
   • If it remains constant, demand is unitary elastic.
   • If it decreases, demand is inelastic.

3. Point Elasticity Method:

   • Used to measure elasticity at a specific point on the demand curve.
   • Formula: $$\text{PED} = \frac{\text{Change in Quantity}}{\text{Change in Price}} \times \frac{\text{Initial Price}}{\text{Initial Quantity}}$$

4. Arc Elasticity Method:

   • Measures elasticity over a range of prices.
   • Formula: $$\text{PED} = \frac{\text{Change in Quantity}}{\text{Change in Price}} \times \frac{\text{Average Price}}{\text{Average Quantity}}$$

Income Elasticity of Demand (YED)

What Is Income Elasticity of Demand?

Income elasticity of demand (YED) measures how the quantity demanded of a good responds to changes in consumer income. It helps us understand whether a product is a necessity, a luxury, or an inferior good.

Formula:

$$\text{YED}=\frac{\mathrm{\%}\text{Change in Quantity Demanded}}{\mathrm{\%}\text{Change in Income}}$$

Types of Income Elasticity of Demand

1. Positive Income Elasticity (YED > 0):

   • Demand increases as income rises.
   • Example: Normal goods like smartphones or clothing.

2. Negative Income Elasticity (YED < 0):

   • Demand decreases as income rises.
   • Example: Inferior goods like low-cost instant noodles or second-hand products.

3. Income-Inelastic Demand (0 < YED < 1):

   • Percentage change in demand is less than the percentage change in income.
   • Example: Necessities like rice, vegetables, or milk.

4. Income-Elastic Demand (YED > 1):

   • Percentage change in demand is greater than the percentage change in income.
   • Example: Luxuries like designer clothes, international vacations.

5. Zero Income Elasticity (YED = 0):

   • Demand remains unchanged regardless of income levels.
   • Example: Goods like salt or water.

Factors Affecting Income Elasticity of Demand

1. Nature of the Good:

   • Necessities tend to have low income elasticity, while luxuries have high elasticity.

2. Consumer Preferences:

   • Cultural or regional differences influence income elasticity.

3. Income Levels:

   • At very high incomes, even luxury goods may show lower elasticity.

4. Availability of Substitutes:

   • Goods with no substitutes (e.g., life-saving drugs) have low income elasticity.

5. Economic Conditions:

   • During economic downturns, inferior goods may show high negative income elasticity.

Measurement Methods of Income Elasticity

1. Percentage Method:

   • The formula is straightforward: $$\text{YED}=\frac{\mathrm{\%}\text{Change in Quantity Demanded}}{\mathrm{\%}\text{Change in Income}}$$

2. Point Income Elasticity Method:

   • Used to calculate elasticity at a specific income level: $$\text{YED}=\frac{\text{Change in Quantity}}{\text{Change in Income}}\times \frac{\text{Initial Income}}{\text{Initial Quantity}}$$

3. Arc Income Elasticity Method:

   • Used for a range of income levels: $$\text{YED}=\frac{\text{Change in Quantity}}{\text{Change in Income}}\times \frac{\text{Average Income}}{\text{Average Quantity}}$$

Cross-Price Elasticity of Demand (XED)

Cross-price elasticity of demand (XED) measures how the quantity demanded of one good (Good A) changes when the price of another related good (Good B) changes. It highlights the relationship between substitute and complementary goods.

Formula:

$$\text{XED}=\frac{\mathrm{\%}\text{Change in Quantity Demanded of Good A}}{\mathrm{\%}\text{Change in Price of Good B}}$$

Types of Cross-Price Elasticity of Demand

1. Positive Cross-Price Elasticity (XED > 0):

   • Indicates substitute goods.
   • Example: If the price of tea increases, the demand for coffee rises.

2. Negative Cross-Price Elasticity (XED < 0):

   • Indicates complementary goods.
   • Example: If the price of petrol rises, the demand for cars decreases.

3. Zero Cross-Price Elasticity (XED = 0):

   • No relationship between the two goods.
   • Example: Price changes in apples have no effect on the demand for bicycles.

Factors Affecting Cross-Price Elasticity of Demand

1. Nature of Relationship Between Goods:

   • Substitutes have positive XED; complements have negative XED.

2. Closeness of Substitutes or Complements:

   • The closer the substitutes or complements, the higher the magnitude of XED.

3. Proportion of Budget Spent:

   • Goods that occupy a significant portion of the consumer’s budget exhibit higher XED.

4. Consumer Behavior:

   • Brand loyalty or habitual buying can lower the XED.

Measurement of Cross-Price Elasticity

1. Percentage Method:

   • Simple calculation using percentage changes: $$\text{XED}=\frac{\mathrm{\%}\text{Change in Quantity Demanded of Good A}}{\mathrm{\%}\text{Change in Price of Good B}}$$

2. Point Cross-Elasticity Method:

   • Used for precise measurement: $$\text{XED}=\frac{\text{Change in Quantity of Good A}}{\text{Change in Price of Good B}}\times \frac{\text{Initial Price of Good B}}{\text{Initial Quantity of Good A}}$$

3. Arc Cross-Elasticity Method:

   • Applies to ranges of prices: $$\text{XED}=\frac{\text{Change in Quantity of Good A}}{\text{Change in Price of Good B}}\times \frac{\text{Average Price of Good B}}{\text{Average Quantity of Good A}}$$