Kinds of Elasticity of Demand - Essay Example

Kinds of Elasti of Demand 0 Introduction Demand is a multivariate function implying that the demand is determined by many factors simultaneously. Some of the most important determinants of the market demand for a particular product are its own price, consumers’ income, prices of other commodities, consumers’ tastes, income distribution, total population, consumers’ wealth, credit availability, government policy, past levels of demand and past levels of income. The traditional theory of demand has concentrated on four of the above determinants, the price of the commodity, other prices, income, and tastes. Some of the other factors as determinants of demand have been introduced in the theory of demand recently. The traditional theory of demand starts with the examination of the behaviour of the consumer since the market demand is assumed to be the summation of the demands of the individual consumers. Thus, the demand for a given commodity is the horizontal summation of the demands of the individual consumers. In other words the quantity demanded in the market at each price is the sum of the individual demands of all consumers at that price. The responsiveness of the demand in relation to the price or income of the consumer is referred as the elasticity of demand. There are as many elasticities of demand as its determinants. The most important of these elasticities are (a) the price Elasticity, (b) the income elasticity, and (c) the cross elasticity. The concept of elasticity of demand is important in that it s being used by the economists to explain the consumer behaviour in different market conditions. With this background this paper illustrates the importance of different kinds of elasticities of demand and the ways in which they are helpful to the economists to report on the consumer behaivour... 2.0 Price Elasticity of Demand The laws of demand and supply are an important part of in the study of economics. They help the economists to measure the relative changes in the demand due to changes in prices with the concept of elasticity of demand. (Pink Monkey) The price elasticity is a measure of the responsiveness of demand to changes in the commodity’s own price. Depending on the magnitude of the changes in demand it can be termed as either point elasticity or arc elasticity of demand. If the changes in the prices are very small, the point elasticity of demand is used as the measure of responsiveness of demand. If the changes in the prices are large then arc elasticity of demand is used as the relevant measure of responsiveness. The laws of demand and supply form the basic part of economics. However since both demand and supply laws are applicable to all kinds of goods, the relations between demand and supply do serve only to a limited extent in the sphere of economics. It must be noted that the rise or fall in the quantity demanded caused by a small variation in the price may differ significantly for different goods such as in the case of food, automobiles, clothing, machinery items, and hardware materials. Even the changes in the price of land may affect its demand considerably. Hence it becomes important that the exact extent to which the level of demand is affected with respect to a given change in the price level is to be ascertained for individual goods. In fact this is the precise purpose of measuring the price elasticity of demand. Price elasticity of demand can be measured by percentage, proportion, outlay, and geometric or point elasticity methods. Of these the point elasticity is the most popular method of measuring price elasticity of demand. 2.1 Expression for Price Elasticity of Demand Thus elasticity of demand can be regarded as the degree of responsiveness, the quantity demanded exhibits in relation to a given change in the price level of any particular commodity. In other words the price elasticity can be expressed as a ratio of proportional change in the quantity demanded to the proportionate change in the price level. Proportional change in the quantity can be identified by the expression: q1 – q2 where q1 is the initial demanded quantity and q2 is the changed quantity o demand q1 Similarly Proportional Change in the Price is denoted by: P1 – P2 where P1 is the previous price and P2 is the changed price P1 Ratio of Price Elasticity of Demand (ed) is therefore given by In the ratio of price elasticity of demand, while the numerical values represent the degree or extent of the change in the demand, the sign of the ratio (plus or minus) explains the direction of change in the demand. It is due to the fact that law of demand is based on the inverse relation between the factors of demand and price, the elasticity of demand is usually stated with a negative sign. Price elasticity can further subdivided in to two major groups; (1) highly elastic, unitary elastic and the highly inelastic type and (2) the perfectly elastic and perfectly inelastic which are considered as extreme cases of elasticity. 2.2 Highly elastic, Unitary elastic and Highly inelastic: The numerical value of the elasticity of demand can be just one, greater than one or less than one depending on the degree of responsiveness of the demand. In case where the numerical value of elasticity is equal to one, it implies that the changes in the price and quantity demanded take place in the same proportion. In this case the demand is described as unitary elastic. When the numerical value of the elasticity of demand is greater than one, in that situation the percentage of proportional change in the demand for quantities is more than the proportional change in the price levels. Here the elasticity of demand is said to be highly elastic implying that the demand has greater degree of responsiveness to the price changes. The converse is the case with highly inelastic demand situation. In this case the numerical value of elasticity of demand is leas than one which implies that the proportionate changes in the quantity demanded are much less than the changes in the price levels. In highly inelastic situation, the degree of responsiveness in the demand is very less for any change in the price levels. This means the demand is not responding much to changes in prices. 2.3 Perfectly Price Elastic and Perfectly Price Inelastic Demand Apart from the unitary, highly elastic, and highly inelastic demand there are two other extreme values of elasticity; perfectly price elasticity and perfectly price inelastic Perfectly Price Elastic Demand In this case the quantity demanded enlarges to an infinitely large level for a small downward change in the price. Therefore in the case of perfectly price elastic position the consumers demand as much as they can even when there is a small reduction in the price. Here the responsiveness of the demand is said to be perfectly price elastic and the price elasticity is denoted by ‘e’ signifying ‘infinity’. The demand curve takes the form of horizontal line in this case. Perfectly Price Inelastic Demand In this extreme case there may not be any changes in the quantity demanded for any change in the prices. The consumers do not react by demanding more to any price level changes. Hence the demand can be said to be highly unresponsive to any price change. In this case the price elasticity of demand takes the value of ‘0’ (Zero) as the demand is said to be perfectly price inelastic. The graph for the perfectly price inelastic demand takes the form of a vertical line. 2.4 Determinants of Price Elasticity of Demand The basic determinants of the elasticity of demand of a commodity with respect to its own price are: (1) The availability of substitutes; the demand for a commodity is more elastic if there are close substitutes for it. (2) The nature of the need that the commodity satisfies; in general luxury goods are price elastic while necessities are price inelastic (3) The time period; demand is more elastic in the long run (4) The various uses to which a commodity can be put; the more the possible uses of a commodity the greater its price elasticity will be (5) The proportion of income spent on the particular commodity. The following table shows the examples and the approximate demand elastic factors: Table: Estimated Elasticities of Demand Goods Estimated Elasticity of Demand Inelastic Salt 0.1 Matches 0.1 Toothpicks 0.1 Airline travel, short-run 0.1 Gasoline, short-run 0.2 Gasoline, long-run 0.7 Residential natural gas, short-run 0.1 Residential natural gas, long-run 0.5 Coffee 0.25 Fish (cod) consumed at home 0.5 Tobacco products, short-run 0.45 Legal services, short-run 0.4 Physician services 0.6 Approximately Unitary Elasticity Movies 0.9 Housing, owner occupied, long-run 1.2 Shellfish, consumed at home 0.9 Oysters, consumed at home 1.1 Private education 1.1 Tires, short-run 0.9 Tires, long-run 1.2 Radio and television receivers 1.2 Elastic Restaurant meals 2.3 Foreign travel, long-run 4.0 Airline travel, long-run 2.4 Fresh green peas 2.8 Automobiles, short-run 1.2 - 1.5 Chevrolet automobiles 4.0 Fresh tomatoes 4.6 Source: Economics: Private and Public Choice, James D. Gwartney and Richard L. Stroup, eighth edition 1997, seventh edition 1995 3.0 Income Elasticity of Demand The income elasticity of demand is defined as the proportionate change in the quantity demanded resulting from a proportionate change in income. The income elasticity of demand can be symbolically represented by: The income elasticity is positive for normal goods. The income elasticity has been used by some economists to differentiate goods between ‘luxuries’ and ‘necessities. A commodity is considered as ‘luxury’ if its income elasticity is greater than one. A commodity is termed as ‘necessity’ in case the income elasticity of the commodity is small; usually less than one. 3.1 Determinants of Income Elasticity of Demand The main determinants of income elasticity of demand are: (1) The nature of the need the commodity covers; the percentage of income spent on food declines as income increase. (2) The initial level of income of a country; for example a Television set may be considered as ‘luxury’ in a country with poor per capita income. Whereas, the same television set may be considered as a ‘necessity’ in a rich country with higher per capita income (3) The time period – usually the consumption pattern gets itself adjusted over the period with the level of income and hence time factor becomes a determinant in the income elasticity of demand. 4.0 Cross Elasticity of Demand Under normal circumstances the price elasticity of demand for any particular product with respect to changes in its own price. However there may be instances where the changes in prices of similar goods which hold a mutual relationship may with the changes in their prices bring changes in the quantities demanded. Thus the degree of responsiveness in the demand for the quantity of a product A with respect to the change in the price of a commodity B is described by ‘cross elasticity of demand’. Thus the cross elasticity of demand can be defined as the proportionate change in the quantity demanded of product A resulting from a proportionate change in the price of product B. The relationship between commodity A and B may be either a substitute or they may be complementary to each other Substitute Products In the case of substitute products like tea and coffee or different brands of toothpaste or television sets, the sign of cross elasticity of demand will be positive. In this case when the price of commodity A increases the demand for commodity A will fall but on the other hand the demand for commodity B will rise. Therefore the relation between the price of A and quantity of B is direct. This leads to the positive sign in the cross elasticity for substitute goods. Complementary Products A vehicle (Product A) and gasoline (Product B) are complementary to each other. In this case with an increase in the price of product A the demand for product A will fall. But the quantity demanded of product B will also fall. The sign of the cross elasticity in the case of complementary goods will be negative. (A. Koutsoyannis) It may be noted that the higher the value of the cross elasticity the stronger will be the degree of substitutability or complementarity of products A and B. The main determinant of the cross elasticity is the nature of the commodities relative to their uses. If two commodities can satisfy equally well the same need, the cross elasticity is high and vice versa. 5.0 Importance of Elasticity of Demand The concept of elasticity of demand through the numerical values attached to the demand for several economic goods helps the important purpose of classifying the goods as elastic or inelastic in demand. This becomes handy in various practical economic applications, including taxation, foreign trade, monopoly, and price determination. One of the important implications of price elasticity of demand concerns the effect of imposing a tax on any particular commodity will have on the equilibrium price and quantity demanded. Federal State and local governments based on the analysis of elasticity of demand of various commodities decide on the goods and services that may be taxed. The examples in this connection are the taxes on items like liquor, cigarettes, or beer. Once tax is levied on various commodities the seller tries to pass on the tax to the consumer. However the question of how much tax is finally passed on to the customer and how much he pays depends on the price elasticity of demand. The income elasticity of demand sometimes functions as a measure of welfare in the development stage of an economy. 6.0 Application of Elasticity of Demand and Consumer Behaviour “To predict consumer behavior, economists use well-defined techniques evaluating the sensitivity of consumers to changes in price.” (Patrick L. Anderson et al) The economists have used the concept of price elasticity of demand as a model of consumer behaviour in developing further theories there of. Demand attempts to locate and distinguish the factors that have a bearing on the choices the consumer makes. In neoclassical economic theory demand is construed as a factor subject to which the customer tries to maximize the utility. “An individual’s demand function can be thought of as a series of equilibrium or optimal conditions that result as the price of a good changes.” (Larry Reynolds) For explaining the individual demand function as the base the economists have raised two approaches namely utility analysis and indifference analysis. The relationship between the elasticity, changes in price levels, and changes in total revenue highlights that the impact of a change in price in the total revenue depends largely on the price elasticity of demand for the particular commodity. This relationship is being used to maximize the profits of a firm by understanding the impact of consumer behaviour and sensitivity through measuring the elasticities of demand. (Chapter 5) “In the study of economics, the elasticity of demand model has given us the tools to know that decreasing a product’s price under specific circumstances is a means to increase revenue.”( Bill Mokrzycki) Thus the impact of consumer behaviour on the consumer demand assessed both on individual and collective basis, and combined with the theory of supply put together show how market prices are determined. Hence the price determination on the basis of consumer behaviour using the elasticities of demand and supply becomes the main utility of elasticities for the economists. (Steven Adams and Paul Penton, 2006) 7.0 Conclusion Thus elasticity of demand can be regarded as a convenient tool to examine and report on how the consumers respond to given changes in relevant variables. Price elasticity measures the responsiveness of the consumers to changes in the price of the goods. It measures a movement along a demand function. The price elasticity describes the quantum changes in the quantity demanded due to shift in price levels. Income elasticity is a measure of changes in the demand function in relation to changes in the income level of the consumers. On the other hand the cross elasticity of demand is used to measure the changes in the demand of related goods due to changes in the price of one of the goods. The elasticity of demand is mainly useful in identifying the demand elastic and demand inelastic goods for the purposes of taxation in an economy. The concept of elasticities of demand is used by the economist to explain the consumer behavior. References: A.Koutsoyannis ‘Modern Micoreconomics’ Edition 2 Macmillan Press Limited Hampshire Bill Mokrzycki ‘Elasticity of Demand, Accessing the Risks and the Opportunities’ Chapter 5 ‘The Elasticity of Demand’ Larry Reynolds ‘Demand and Consumer Behaviour’ Patrick L. Anderson, Richard D. Mclellan, Joseph P. Overton and Dr. Gray L. Wolfram ‘The Universal Tuition Tax Credit: A Proposal to Advance Parental Choice in Education’ PinkMonkey ‘Elasticity of Demand and Supply’ Steven Adams and Paul Periton (2006) ‘Fundamentals of Business Economics’ Elsevier Read More