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What is Elasticity?
Is a measure of how much buyers and sellers respond to the changes in market
conditions.
The concept of elasticity of demand plays a crucial role in the pricing decisions of
the business firms and the Government when it regulates prices. The concept of
price elasticity is also important in judging the effect of devaluation or depreciation
of a currency on its export earnings.
It has also a great use in fiscal policy because the Finance Minister has to keep in
view the price elasticity of demand when it considers to impose taxes on various
commodities. We shall explain below the various uses, applications and
importance of the elasticity of demand.
The business firms take into account the price elasticity of demand when they take
decisions regarding pricing of the goods. This is because change in the price of a
product will bring about a change in the quantity demanded depending upon the
coefficient of price elasticity.
This change in quantity demanded as a result of, say a rise in price by a firm, will
affect the total consumer’s expenditure and will therefore, affect the revenue of the
firm. If the demand for a product of the firm happens to be elastic, then any
attempt on the part of the firm to raise the price of its product will bring about a
fall in its total revenue.
Thus, instead of gaining from the increase in price, it will lose if the demand for its
product happens to be elastic. On the other hand, if the demand for the product of a
firm happens to be inelastic, then the increase in price by it will raise its total
revenue. Therefore, for fixing a profit-maximizing price, the firm cannot ignore the
price elasticity of demand for its product.
1. What will be the effect on sales if a firm decides to raise the price of its product,
say by 5 percent.
It has been found by some empirical studies that business firms often fail to take
elasticity into account while taking decisions regarding prices, or they give
insufficient attention to the coefficient of price elasticity. No doubt, the main
reason for this is that they don’t have the means to calculate price elasticity for
their product, since sufficient data regarding past prices and quantity demanded at
those prices are not available.
Even if such data are available, there are difficulties of interpretation of it because
it is not clear whether the changes in quantity demanded were the result of changes
in price alone or changes in some other factors determining the demand.
Income elasticity of demand refers to the sensitivity of the quantity demanded for a
certain good to a change in real income of consumers who buy this good, keeping
all other things constant.
The formula for calculating income elasticity of demand is the percent change in
quantity demanded divided by the percent change in income. With income
elasticity of demand, you can tell if a particular good represents a necessity or a
luxury.
Solution
High: A rise in income comes with bigger increases in the quantity demanded.
Depending on the values of the income elasticity of demand, goods can be broadly
categorized as inferior goods and normal goods. Normal goods have a positive
income elasticity of demand; as incomes rise, more goods are demanded at each
price level.
Normal goods whose income elasticity of demand is between zero and one are
typically referred to as necessity goods, which are products and services that
consumers will buy regardless of changes in their income levels. Examples of
necessity goods and services include tobacco products, haircuts, water, and
electricity.
As income rises, the proportion of total consumer expenditures on necessity goods
typically declines. Inferior goods have a negative income elasticity of demand; as
consumers' income rises, they buy fewer inferior goods. A typical example of such
type of product is margarine, which is much cheaper than butter.
•SUBSTITUTES:
Substitute is products in competitive demand.
With substitutes, an increase in the price of one good (Ceterisparibus) will lead
to an increase in the demand for arrival product.
•COMPLEMENTS:
Compliments are product in joint demand.
A fall in the price of one product causes an increase in demand for the
complementary product.
The value of XED for two complements is always negative.
Weak Substitutes:
A large rise in price of S lead to small increase in demand for T.
Cross Price Elasticity of Demand-Complements
Close complements:
As small fall in price of A causes a large rise in demand for B.
Weak Complements:
A large drop in price of E causes only small rise in demand for F.
The change in the quantity supplied of a product due to a change in its price is known as
Price elasticity of supply.
When the supply for a product change – increases or decreases even when there is
no change in price, it is known as perfect elastic supply.
P s s
R
I
C
E
2) Relatively elastic supply
When the proportionate change in supply is more than the proportionate changes in
price, it is known as relatively elastic supply
When the proportionate change in supply is less than the proportionate changes in
price, it is known as relatively inelastic supply
5) Perfectly inelastic supply
When there is no change in the quantity supplied with the change in its price, it is
perfectly inelastic supply
EXAMPLE
Q=100 P= 15
Q1=50 P1=10
• Es= P/Q*∆Q/∆P = 15/100*50/5 = 1.5
• Es> 1, it is a case of elastic sup