Elasticity
of Demand
The
quantitative relationship between the demand for a product and its determinants
for taking managerial decisions is known as elasticity of demand. Elasticity of
demand si mainly of three types:
1.
Price Elasticity of Demand
2.
Income Elasticity of Demand
3.
Cross Elasticity of Demand
A.
Price Elasticity of Demand - Measures how responsive
quantity demanded is to a price change
Formula: Ep = Change in
quantity demanded = Q2 - Q1 X P1
Change in Price P2 - P1 Q1
Importance:
— Guides
a firm whether its sales proceeds decrease or remain variable under conditions
of price variations
— Helps
the firm to estimate the likely demand for its product at different prices
Cases of Elasticity of Demand:
1. Perfectly
elastic demand: (Ed=∞) – When a very insignificant
change in price leads to an infinite change in quantity demanded. The demand
curve in such a situation is parallel to X-axis.
2. Perfectly
inelastic demand: (Ed=0) - When a change in price
produces no change in the quantity demanded of a commodity. The demand curve is
parallel to Y-axis.
3. Relatively
elastic demand: (Ed >1) - When a small change in
price causes a greater change in quantity demanded. The demand curve is
relatively flatter.
4. Relatively
inelastic demand: (Ed <1) - Where a greater change
in price leads to smaller change in quantity demanded. The demand curve is
relatively steeper.
5. Unitary
elastic demand: (Ed=1) – When a change in price
results in exactly the same percentage change in the quantity demanded of a
commodity. The demand curve takes the shape of rectangular hyperbola.
B. Income Elasticity of
Demand: Measures the responsiveness of a consumer’s purchase of a
particular commodity to a change in his income.
Formula: Ey = Percentage Change in
Quantity Demanded of Good X
Percentage Change in Real Income of Consumer
Importance:
— To
estimate the likely changes in demand for product as a result of change in
income
— To know
whether a commodity is a superior, inferior or normal good
Cases
of Income Elasticity of Demand:
1.
Normal Goods: Between 0 and 1 - positive income elasticity of demand
2.
Inferior Goods: Less than 1 - negative income elasticity of
demand
3.
Luxury Goods: Greater than 1 - positive income elasticity of demand
C.
Cross Price Elasticity of Demand: Quantity demanded of a
commodity in response to a change in the price of related good, which may be
substitutes or complements.
Formula: Ec
= Change in Quantity Demanded of Good X
Change in Price of Good Y
Importance:
— Measures
the interdependence of demand for a commodity and the price of its related
commodities
— Estimate
the likely effect of sales of pricing decisions, competitors and sellers
Cases
of Cross Price Elasticity of Demand:
1.
Infinite – Slightest change in
the price of good Y causes a substantial change in the quantity demanded of
good X – Perfect Substitutes
2.
Positive- Change in the price of
good Y causes a change in the quantity demanded of good X in same direction – Substitutes
3.
Negative – Change in the price of
good Y causes a change in the quantity demanded of good X in opposite direction – Complements
4.
Zero – Change in the price of
good Y does not affect the quantity demanded of good X - No relationship
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