Elasticity of Demand - Essay Example

Elasti of Demand Introduction It is an important concept in micro economics/managerial economics. It has much practical utility in the real life business situations ranging from vegetables to crude oil. Everyday we purchase various products at varied price in different quantities. The consideration which we pay for a product at a certain quantity is called the price of the product. When we talk of product price, we mean market price. That is the price at which the product is sold to all buyers in the market. The quantity of a product that we purchase at a certain price is called the demand of the product. Price of a product and its quantity demanded are closely related in the sense that each of these has a bearing on another. When one of these two changes, the other also tends to change. This tendency is very well described by what is popularly known as Law of Demand. The law of Demand is a general law which need not be applicable in all situations. In certain situations this law seems to be unrealistic. The Law of Demand states that when the price increases, the quantity demanded decreases and vice versa, other things remaining the same. The phrase 'other things remain the same' is an important one that it portrays the exceptions of Law of Demand. The Law of Demand, therefore postulates the direction of change in one variable (price or quantity) due to the change in other variable. The law is silent about the magnitude of change. That means, it does not talk anything about the degree by which demand changes as a result of a change in price. Here lies the importance of Elasticity of Demand. This concept tells us the extent to which demand increases or decreases owing to a decrease or increase in price. Therefore, Law of Demand is a qualitative measurement whereas Elasticity of Demand is a quantitative measurement. Elasticity of Demand As stated earlier, elasticity is a measure of responsiveness of quantity demanded for a change in price. It measures the degree to which the demand of a product responds to a change in price. Elasticity varies among products because some product may be more essential to the consumer. Products that are necessities are more responsive to price change because consumers would purchase more at low prices and less at more prices. Mathematically, it may be computed as: (Moffatt Mike: Elasticity of Demand) To calculate percentage change in quantity and percentage change in price, the following formulae can be sued: % change in quantity = Quantity (new) - Quantity (old) / Quantity (old) (Moffatt Mike: Elasticity of Demand) % change in Price = Price (new) - Price (old) / Price (old) (Moffatt Mike: Elasticity of Demand) Price Elasticity of Demand The Price Elasticity of Demand is the measure of responsiveness of quantity demand of a product as a result of change in its own price. This is also known as Own Price Elasticity of Demand. This theory measures the rate of response of quantity demanded due to change in price. Price Elasticity is a common phenomenon because price and demand are the two closely related variables. In other words, price is the most important determinant of demand. Price of a product and its demand are negatively correlated, which means when price increases, demand decreases and vice versa. Mathematically, price elasticity of demand can be expressed as below: Price Elasticity of Demand = (% Change in quantity demanded)/ (% change in price) (Moffatt Mike: Price Elasticity of Demand) % Change in quantity demanded = Quantity (new) - Quantity (old) / Quantity (old) (Moffatt Mike: Price Elasticity of Demand) % change in price = Price (new) - Price (old) / Price (old) (Moffatt Mike: Price Elasticity of Demand) Significance of Price Elasticity The calculation of price elasticity alone is not sufficient to an economist for decision making. It is a means to an end. Thus, interpretation is more important than computation. The purpose of calculating elasticity is for analyzing how sensitive is the demand for the product due to a price change. The higher the price elasticity, the more sensitive the consumers are to price change. The following benchmark can be useful for interpreting the result of calculations. If Price Elasticity is more than 1, then Demand is Price Elastic If Price Elasticity is equal to 1, then Demand is Unit Elastic Price Elasticity is less than 1, then Demand is Price Inelastic (Moffatt Mike: Price Elasticity of Demand) The first case suggests that demand is highly sensitive to price change. Thus, higher the price elasticity, more sensitive is the demand to price change. In such a situation, when the price of a product goes up, the consumers will buy less of the product, and when its price comes down, more consumers will run after the product. The negative situation (when elasticity is less than 1) indicates that there is no change in demand as a result of change in price. It may also happen in the real life situation. For example, the demand for necessaries of life will not be affected much by the change in price. The unit elasticity is about the uniform change in quantity demanded as a result of change in price. Than means the percentage change in demand is exactly equal to the percentage change in price. Cross Price Elasticity of Demand The demand of a product is determined not only by its own price, but numerous other factors including the price of substitute and complementary products as well. When the quantity demanded of a product 'X' is affected by a change in the price of other products, product 'X' can be said to have cross elasticity. Cross- price elasticity of demand measures the rate of response of quantity demanded of one good due to a price change of another good. Cross elasticity occurs when a product has substitutes and complementary. Two goods are said to be substitutes when the change in price of one good results in change in demand of another good. Consumers prefer to purchase that product whose price is low when two identical products are available. Two products are complements when the use of one product is accompanied by another product. In other words, two products are said to be complements when the change in quantity demanded of a product is affected by a change in the price of another product in the same direction. For example, car and petrol are complements. The price increase in petrol will result in decrease in the demand not only petrol but also that of car. Thus, substitutes have inverse correlation whereas complements have positive correlation. Mathematically, cross elasticity can be expressed as below: Cross Elasticity of Demand = (% change in quantity demand for Good 'X') / (% change in price for Good 'Y') (Moffatt Mike: Cross Elasticity of Demand) % change in quantity demand for Good 'X' = Quantity of Good 'X' (new) - Quantity of Good 'X' (old) / Quantity of Good 'X' (old) (Moffatt Mike: Cross Elasticity of Demand) % change in Price for Good 'Y' = Price of Good 'Y' (new) - Price of Good 'Y' (old) / Price of Good 'Y' (old) (Moffatt Mike: Cross Elasticity of Demand) Significance of Cross-Price Elasticity of Demand Cross-Price Elasticity is a measure of how responsive is the demand for a good is to a price change of another good. The manager or economist is required to interpret the result of calculation of cross-price elasticity with utmost care. Because, interpretation makes the things happen in managerial decisions. For the purpose of correct interpretation, the following benchmark can be used. When Cross-Price Elasticity of Demand is greater than ZERO, the two goods are substitutes When Cross-Price Elasticity of Demand is equal to ZERO, the two goods are independent When Cross-Price Elasticity of Demand is lesser than ZERO, the two goods are complements (Moffatt Mike: Cross Elasticity of Demand) Thus, a positive Cross-Price Elasticity of Demand implies that if the price of one good goes up, the demand for another good also goes up and such goods are called substitutes. A negative relationship means an increase in the price of one good result in decrease in the demand of another good and vice versa. When the price change of one good is in no way affect the demand for another good, such goods are purely independent goods. Income Elasticity of Demand This is another important measure of elasticity of demand. This measure tells us the rate of change in the demand for a good as a result of a change in the income of consumers. It is a common phenomenon that when the consumers' income changes, the demand for certain goods responds to such change. This change is measured through what is known as Income Elasticity of Demand. It may be defined as the degree of responsiveness of demand of a product due to a change in the income of consumers. It may be expressed quantitatively as below: Income Elasticity of Demand = % change in Quantity Demanded / % change in Consumers' Income (Moffatt Mike: Income Elasticity of Demand) % change in Quantity Demanded = Quantity Demanded (new) - Quantity Demanded (old)/ Quantity Demanded (old) (Moffatt Mike: Income Elasticity of Demand) % change in Consumers' Income = Consumers' Income (new) - Consumers' Income (old) / Consumers' Income (old) (Moffatt Mike: Income Elasticity of Demand) Significance of Income Elasticity of Demand It is quite common that consumers' income has a important bearing on the demand for certain products. The demand for most of the product changes as a result of consumers' income change. Because, the income is the basic determinant of purchase decision. Unless there are desires backed by capacity to purchase (income), the desires remain as desires and never become demand. Income Elasticity is used to measure how sensitive is the demand for a product is to a change in income. The following criteria are useful for interpreting the result of Income Elasticity of Demand. When Income Elasticity of Demand is greater than ONE, the good is Income Elastic and it is a Luxury good When Income Elasticity of Demand is less than ZERO, the good is Negative Income Elastic and it is an Inferior good. When Income Elasticity of Demand is in between ONE and ZERO, the good is Income Inelastic and it is a Normal Good. (Moffatt Mike: Income Elasticity of Demand) References Cross Price Elasticity of Demand. (n.d.). Spotlight on the theory. Viewed 25 November, 2008, Economics Basics: Elasticity (n.d.). Investopedia. Viewed 25 November, 2008, Income Elasticity of Demand. (n.d.). Tutor2u. Viewed 25 November, 2008, Moffatt Mike (n.d.). A Primer on the Cross-Price Elasticity of Demand- Cross-Price Elasticity of Demand. Viewed 25 November, 2008, Moffatt Mike (n.d.). A Primer on the Price Elasticity of Demand. Price Elasticity of Demand Viewed 25 November, 2008 http://economics.about.com/cs/micfrohelp/a/priceelasticity.htm Moffatt Mike (n.d.). A Primer on the Income Elasticity of Demand. Income Elasticity of Demand Viewed 25 November, 2008 http://economics.about.com/cs/micfrohelp/a/income_elast.htm Moffatt Mike (n.d.). A Primer on the Elasticity of Demand. Elasticity of Demand Viewed 25 November, 2008http://economics.about.com/cs/micfrohelp/a/priceelasticity.htm Rakshit R. (2007). Price Elasticity of Demand. Viewed 24. November, 2008. Riley Geoff (2006). Market and Market System- Cross-price Elasticity of Demand. Viewed 25 November, 2008. Read More