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ELASTICITY OF DEMAND

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LAW OF DEMANDLaw of demand states that if the price of commodity increases then in that case the quantity demanded will fall and if the price of commodity falls the quantity demanded for it increases.

Law of demand indicates only direction of change in quantity demanded in response to change in price but Elasticity of demand states with how much or to what extent the quantity demanded will change in response to the change in price.

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CONCEPTS OF ELASTICITY OF DEMAND

•  

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TYPES OF ELASTICITY OF DEMAND1. Price Elasticity Of Demand 2. Income Elasticity Of Demand 3. Cross Price Elasticity Of Demand 4. Advertising/ Promotional Elasticity Of Demand

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1. PRICE ELASTICITY OF DEMAND• Price Elasticity Of Demand MEANS

The extent of response of demand for a commodity to the changes in its price, other determinants of demand remaining constant is called price elasticity of demand.

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KINDS OF PRICE ELASTICITY OF DEMAND

1) Perfectly elastic demand 2) Relatively elastic demand 3) Elasticity of demand equal to utility 4) Relatively inelastic demand 5) Perfectly inelastic demand

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Perfectly Elastic Demand

P

R

I

C

E

y

0

Perfectly elastic demand curve

D D

When the demand for a product changes –increases or decreases even when there is no change in price, it is known as perfect elastic

x demand.

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Relatively Elastic Demand

Relatively elastic demand curve

P

R

I

C

E

demand0 x

y

D

D

When the proportionate change in demand is more than the proportionate changes in price, it is known as relatively elastic demand.

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Elasticity Of Demand Equal To Utility

Elasticity of demand equal to utility curve

y

x0 demand

P

R

I

C

E

D

D

When the proportionate change indemand is equal to proportionate changes in price, it is known as unitary elastic demand

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Relatively Inelastic Demand

Relatively inelastic demand curve

XO

Y

demand

D

D

P

R

I

C

E

When the proportionate change in demand is less than the proportionate changes in price, it is known as relatively inelastic demand

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Perfectly Inelastic Demand

demandD

Perfectly inelastic demand curve

0

Y D

X

P

R

I

C

E

When a change in price, howsover large, change no changes in quality demand, it is known as perfectly inelastic demand

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ALL KINDS OF DEMAND CAN BE SHOWN IN ONE DIAGRAM AS FOLLOW

D

D2D3

D4

Y

X0 D5

DEMAND

PR

I

C

E

WHERE D1) Perfectly elasticdeman

dD1 D2)Relatively elastic demandD3)Elasticity of demand equal to utility

D4)Relatively inelastic

demand D5)Perfectly

inelastic demand

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MEASUREMENT OF PRICE ELASTICITY OF DEMAND

There are 4 main methods: 1. Percentage method or proportionate method 2. Total outlay method or total revenue method 3. Geometric method or point method 4. Arc elasticity of demand

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FACTORS AFFECTING PRICE ELASTICITY OF DEMAND

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Factors Affecting Price Elasticity Of Demand

• Nature of the Commodity • Availability of Substitutes • Variety of uses of commodity • Postponement • Influence of habits • Proportion of Income spent on a commodity • Range of prices

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Practical Importance of the Concept of Price Elasticity Of

Demand

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PRACTICAL IMPORTANCE OF THE CONCEPT OF PRICE ELASTICITY OF DEMAND

• The concept is helpful in taking Business Decisions • Importance of the concept in formatting Tax Policy of

the government • For determining the rewards of the Factors of Production • To determine the Terms of Trades Between the Two

Countries • Determination of Rates of Foreign Exchange • For Nationalization of Certain Industries • In economic Analysis ,the concept of price elasticity of

demand helps in explaining the irony of poverty in the midst of plenty.

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(2) Income Elasticity Of Demand

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DEFINITION OF INCOME ELASTICITY•  

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TYPES OF INCOME ELASTICITY OF DEMAND

• Positive Income elasticity of demand • Negative Income elasticity of demand • Zero Income elasticity of demand

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Positive Income elasticity of demandY

D

P A

D

O XB S

Quantity Demanded

Inco

me

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Positive Income elasticity of demand

• Income Elasticity Equal to Unity or One • Income Elasticity Greater Than Unity Or One • Income Elasticity Less Than Unity or One

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Negative Income elasticity of demand

Pric

e

P

A

Total Revenue

B S

Quantity Demanded (000s)

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Zero Income elasticity of demandY

XO D

D

Quantity Demanded

Inco

me

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All Income Graphs Representation

O

Y

Inco

me

B A

C D

EF

XQuantity Demanded

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Measurement Of Income Elasticity Of Demand

Proportionate change in Demand

Income Elasticity Of Demand = Proportionate change in Income

i.e. Income Elasticity Of Demand = Q

Y

∆q ∆ y +

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Measurement Of Income Elasticity Of Demand

• Here , ∆q = Change in the quantity demanded. • Q= Original quantity demanded. • ∆y = Change in income. • Y= Original income.

• For e.g. ,when Income of the consumer = 2,500/- , he purchases 20 units of X, when income = 3,000/- he purchases 25 units of X

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Measurement Of Income Elasticity Of Demand• Thus

Income Elasticity of Demand

=

= (5/20) + (500/2500)

= 1.5

Therefore here the IED is 1.5 which is more than one.

Q Y

∆q ∆ y +

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Factors Affecting Income Of Demand

• Income Itself Only. • Price Of the Commodity

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IMPORTANCE OF THE CONCEPT OF INCOME ELASTICITY OF DEMAND

• In production planning and management • In forecasting demand when change in consumers income is

expected • In classifying goods as normal and inferior • In expansion and contraction of the firm by the figure of income

elasticity of demand • Markets situations could be studied with the help of IED

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Relationship Between Price Elasticity, Income Elasticity and

Substitution Elasticity• As Price is depended on income and

substitution effect similarly Price Elasticity is depended on Income Elasticity an Substitution Elasticity .

• These relationship can be represented by • Ep = Kx E1 + ( 1 – Kx ) es

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3. Cross Elasticity of Demand

• Cross elasticity of demand express a relationship between the change in the demand for a given product in response to a change in the price of some other product.

• E.g. if the X tea demand reduces tremendously than it effect could be seen in demand of sugar and milk.

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TYPES OF CROSS ELASTICITY OF DEMAND

• Cross Elasticity of Demand Equal to Unity or One • Cross Elasticity of Demand Greater than Unity or one • Cross Elasticity of demand less than unity or one

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Measurement Cross Elasticity of Demand

Proportionate change in Price of product Y

i.e.

∆qxQx

Py

∆p y+

Proportionate change in Demand

for product X Cross Elasticity of

Demand =

Cross Elasticity of Demand =

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Pric

e of

Y

Demand for Y

O

Y

X

Cross Elasticity of Demand For Substitutes

D

D

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Pric

e of

Y

O

Y

XD

Cross Elasticity of Demand For Complementary Products

D

Demand for Y

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Cross Elasticity of Demand For Neutral

Pric

e of

Y

O

Y

X

Products

D

Demand for Y

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IMPORTANCE OF CROSS ELASTICITY OF DEMAND

• The concept is of very great importance in changing the price of the products having substitutes and complementary goods .

• In demand forecasting • Helps in measuring interdependence of

price of commodity . • Multiproduct firms use these concept to

measure the effect of change in price of one product on the demand of their other product

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Starbucks Price Increase – A Case Study In Analysis

• Starbucks tries to raise its drink prices by as much as 8% (5 cents to 30 cents), They are doing this just when  customers are cutting back on their Starbucks trips and switching to cheaper alternatives from McDonalds and Dunkin Donuts.

• The conventional “wisdom”  on pricing is, when recession pushes customers to cut  back on expenses and switch from your products to cheaper alternatives,  you cut your prices to keep the customers. While this is a usually accepted and followed practice, it is neither wisdom nor based on analysis.

• To be successful, businesses cannot make decisions based on hunch, gut feel, latest management fad, or so called conventional wisdom. Decisions need to be based on data and analysis which is easier said than done.

• In the case of Starbucks, how did they arrive at price increase, going against the flow? The simplest calculation here is, when price conscious customers moved out all they are left with are price insensitive customers who prefer their products. Hence it makes sense to charge more for them as long as the loss in profit from further drop in customer is less than increase in profit from higher price. (Here is an attempt at formal proof onwhy increasing prices yields better profits).

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Starbucks has a gross margin of 22%. This is however the average. On their high priced premium drinks we can assume that their margins are at least twice as much. So let us say it is 44% gross margin. Their premium drinks retail for $3.75 or higher, so the new price is $4.05 and at 44% margin, their profit per cup is$1.78 . (Please note that gross margin numbers from GAAP income statements are not based on just marginal costs and include fixed cost allocations.)

• Let us say they sell ‘N’ premium drinks in a year at the current price. The increase in profit from 30 cent price increase (if the number of drinks sold remains ‘N’) is  0.3N. You will see the value of N is not important to the analysis.

• However, there is bound to be fall in sales. But how far should the sales fall to negate the benefits of price increase?

• Let us say the sales falls from  by ΔN cups, then lost profit from this lost sales is   1.78ΔN

• Their price increase will result in net loss only if 1.78ΔN  > 0.3N, that is sales has to fall by 17% from its current levels.  One in six people has to stop buying the premium drink.  (Note: We assumed a 44% margin, if it is lower  that that then the sales have to drop much more than 17% to make the price increase option unattractive)

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• Another way to look at this is from price elasticity of demand – % change in volume for one % change in price. For the price increase to be unprofitable, price elasticity of demand must be just over 2 (every % increase in price should result in  drop in volume of 2%).

• The New York Times asks, “Will the hard-core customers pay more”? How likely is a 17% sales drop? Not very given that most price sensitive customers have moved out and what they are left with are those who prefer Starbucks over other brands. So their price sensitivity is most likely to be lower than it would have been before the recession.

• Hence a 17% drop in sales is  highly unlikely. In terms of elasticity, premium drinks moved to inelastic part of the demand curve. As long as the sales drop stays below the 17%  mark, the price increase is a profitable and a smart move for Starbucks.

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You can see how  Starbucks would have made this counter-intuitive decision – because it is based on evidence and analysis. Unfortunately this does not come naturally to most marketers, because no one wants to go against the flow or stand-up to authority. Worse, most marketers accept conventional wisdom without a challenge  because they lack inclination and wherewithal to seek the right data and do the right analysis.

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4. ADVERTISING ELASTICITY OF DEMAND

• Advertising elasticity of demand is the measure of the rate of change in demand due to change in advertising expenditure

• The amount of change in demand of goods due to advertisement is known as Advertisement Elasticity of Demand .

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Advertising Elasticity of Demand

Proportionate change in Advertising expenditure

i.e.

∆qxQ A

∆a÷

Proportionate change in Demand

for product Advertising Elasticity of

Demand =

Advertising Elasticity of Demand =

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FACTORS AFFECTING ADVERTISING ELASTICITY OF DEMAND

• The stage of the Product’s Market Development . • Reaction of market Rival Firms. • Cumulative Effect of Past Advertisement. • Influence of Other Factors.

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Practical application of the elasticity concept?

• Demand for any product will expand if the price is lowered and contract if the price is raised.

• Demand for some products are more elastic than others. For example, brain tumor surgery has an upper limit and demand will never expand beyond that limit no matter how low the price. Raising the price dramatically, might limit people from having surgery, and so there is still downward elasticity.

• Hamburger demand, on the other hand, is highly elastic. Raise the price too much and people will chose a different meal. Lower the price enough, and you can build thousands of stores and take over the world.

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Practical Application # 1. Effects of Changes in Price Upon Demand:

• The concept is very useful to study the reactions of the demand for a commodity to the changes in its price. If the demand is elastic, a small change in the price brings about a considerable change in the quantity demanded, but in the case of inelastic demand this consequential change in demand is relatively small. So, the concept is relevant to the decisions relating to business pricing and profits.

• Thus, the fixing of price of a commodity is crucially based on the elasticity of demand of the commodity. As Bates and Parkinson put it: “When costs are rising, it is tempting to pass on the cost increases by increasing price to the consumer, and if demand for the product is relatively inelastic, this measure may well succeed; and when, as for example in the case of rail transport, there are many substitutes and the demand is relatively elastic, increasing prices may well lead to a reduction of total revenue rather than an increase.”

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Practical Application # 2. Effects of Changes in Price on Revenue:

• The concept enables us to determine the condition of equilibrium of a firm. And a profit-maximising firm reaches equilibrium when revenue = marginal cost.

MR = P (1 – 1/Ep) where Ep is coefficient of price elasticity. • Thus, we could easily assert from this relationship that • (i) When Ep = 1 (unit elasticity of demand), • MR = AR x (1 -1) = 0. It means that a change in price will not affect total revenue. • (ii) When Ep → α (perfectly elastic demand), MR = AR x (1 – 0) = AR, as under perfect competition. So, a firm may raise the price of its product(s) if demand is inelastic, in which case sales and profits would not be affected. In case of a commodity with elastic demand, a reduction in price alone can raise the sales volume and, consequently, profit.

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Practical Application # 3. Monopoly Pricing:

• The concept is useful in monopoly price- decisions. The monopolist, being the sole supplier of a particular commodity, can raise price but cannot affect demand pattern of consumers. So, in fixing the price the monopolist will have, of necessity, to take note of the elasticity of demand for his product. He will fix the price at a low level when the demand is elastic and at a high level when it is inelastic.

• Moreover, a profit-maximising monopolist will always operate on the elastic part of his demand curve or his average revenue curve. Neither too high nor too low a price may enable him to realise his objective: profit maximisation. What will be the profit- maximising price will be dictated by elasticity of demand; and it will enable the monopolist to know exactly at what price sales proceeds or total revenue will be the highest.

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Practical Application # 4. Price Discrimination:

• In perfect competition, the same price is charged from all the buyers. But, the downward slope of the demand curve of the monopolist gives scope for price discrimination. Price discrimination refers to the practice of charging different prices for the same product from different buyers at the same time. It can be profitably practised only when price elasticity of demand differs from market to market or from one segment of the market to another.

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Practical Application # 5. Importance in Taxation:

• Furthermore, the concept is a useful tool in taxation. A finance minister is to consider the elasticity of demand of the different commodities for the purpose of taxation. If he pushes commodity tax (excise duty) rates up too much the consequent increase in price may make the total tax yield even lower than before. On the other hand, a small tax reduction may result in an increase in the tax yield.

• Firstly, the total expenditure by the consumers will determine the size of the tax yield. And, the total expenditure is the measure of elasticity of demand. If, however, the government simply wishes to discourage the consumption of a commodity which happens to have a highly inelastic demand—e.g., in case of cigarettes — the imposition of a tax may have very little effect on demand and tax collections may rise.

• So, before imposing a tax or raising the existing rate of a tax, the government will have to consider the elasticity of demand of the commodity concerned. It can get more revenue from the taxes imposed on commodities with inelastic demand (like sugar, clothes, kerosene oil, etc.) than what is possible from the taxation of those with elastic demand (like refrigerators, motor cars, steel furniture’s, etc.). It so happens because in the former case taxes may raise their prices but their demand and sales will not fall very much; but, in the latter case taxes, by raising the prices, reduce the demand and sales considerably.

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Practical Application # 6. Economic Policy:

• The knowledge of elasticity is also valuable in the formation of economic policies, too. This point may now be illustrated. A country suffering from balance of payments problems may try to tackle the imbalance by devaluing its currency.

• But, whether devaluation will be successful or not crucially depends upon other countries, i.e., the rest of the world’s demand for the devaluing country’s products. If the demand for its products is inelastic there will be no increase in volume sold after devaluation, and consequently export earnings will fail due to lower unit price of its product (sales remaining constant).

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THANK YOU