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LAW OF DEMAND

ELASTICITY OF DEMAND

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LAW OF DEMAND
When price of a good goes up, people buy less of it and when price goes down, people
buy more it, other things being unchanged.

Law of demand tells us that quantity demanded of any good is ni versely related to its
price. An inverse relationship is one in which one variable moves up in value, whereas
other variable moves down. The law states that a change in price causes a change in
quantity demanded in the opposite direction hence there is a negative or inverse
relationship between price and demand. In case of increase (expansion) or decrease
(contraction) in quantity demanded, the demand points move from one place to another
place on same curve. From point B to C is expansion in demand and from point B to A is
contraction in demand.

Due to increase in income, price remaining same a consumer purchases more of the same
good, then the demand curve shifts outward--and this is called ‘A change in demand’--but
due to fall in price a consumer purchases more items of same good, and he remains on
same demand curve, this situation is called—A change in the quantity demanded.

Combination Price per disc Quantity demanded


A Rs.5 10 units
B Rs.4 20 units
C Rs.3 30 units

Contraction
Y
A
5

4 B Expansion
Price

3 C
2

0 X
Change in quantity demanded
10 20 30

CONDITIONS OF LAW
The law will hold provided the following factors remain unchanged.
1----Consumer’s habits and tastes.
2----Consumer’s income.
3--- Fashion.
4----Price of substitute or related goods .
5----Population.

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EXCEPTIONS TO THE LAW
1----The law is not applicable in case of inferior goods. When price of inferior bread goes
down people will purchase less of it than before. This is because their real income
(purchasing power) will increase as a result of fall in price of that good and with
increased real income people can buy more expensive and superior bread, hence they will
reduce demand of inferior quality bread.

2----It is not applicable in case of conspicuous goods such as diamonds and pearls, which
are very expensive and costly and demanded for pomp and show by rich people of
society. With increase in their prices, their value will increase; therefore rich people will
increase demand of such goods .

3---It is not applicable in case of future expectations of prices. If people expect that price
of a particular good will rise further, they, instead of decreasing demand will increase
their demand now, so that that they may not suffer if prices actually rise at a future date .

SHIFTS IN DEMAND CURVE


Generally a change in price of a good changes its demand but when there is no change in
price and even then there is an increase in demand from 6 million to 8 million discs, then
this situation is called a Rise in demand and demand curve shifts outward to the right. In
graph, demand curve shifts from d-1 to d-2. When there is no change in price and even
then there is a decrease in demand from 6 million to 4 million discs, it is called Fall in
demand and demand curve shifts inward to the left. In graph, demand curve shifts from d-
1 to d-3.
Price per Demand Rise in Demand Fall in Demand
Discs In millions In millions In millions
Rs.3 6 8 4

D1
Y

3
Price

2
D3 D2

0 X
4 6 8
A change in demand

A change in price leads to “a change in quantity demanded”. This is a movement


on the curve. A change in other determinants of demand leads to a change in demand
This leads to a movement of the curve.

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CAUSES OF CHANGE IN DEMAND OTHER THAN THE CHANGE IN PRICE

1---INCOME OF CONSUMER
For most goods an increase in income of consumers will lead to an increase in their
demand and a decrease in income will lead to a decrease in their demand.

2---TASTES AND PREFERENCES OF CONSUMER


A change in consumer’s tastes in favor of a good increases demand of that product and a
taste against a good decreases its demand. If a particular good becomes part and parcel of
fashion its demand increases and if a good goes out of fashion its demand decreases.

3---SUBSTITUTES
Butter and margarine are substitutes. If price of butter remains the same and price of
margarine decreases, people will buy more margarine and less butter, and demand of
butter will decrease.

4---COMPLIMENTS
Two goods are compliments if both are used together at a time for example coffee and
cream. With a fall in price of coffee more coffee will be demanded but at the same time
more cream will also be demanded, though price of cream do not change. Since coffee
cannot be used without cream hence curve of cream will shift outward to the right.

5 ---CHANGE IN EXPECTATIONS
If consumers expectations are that goods will not be available at any price in near future,
they will demand more goods to stock now, and if they expect that in near future there
will be more supply of goods and prices will fall, the consumers for the time being will
decrease their demand now.

6 ---POPULATION GROWTH
If number of consumers is greater, demand for goods and services will increase and if
number of consumers is less in number, demand will decrease. The number of consumers
depends upon population growth. Higher growth rate increases consumers demand and
lower growth rate reduces consumers demand.

ELASTICITY OF DEMAND
Elasticity is a measure of price responsiveness of a good demanded. It is the rate at which
quantity demanded varies with a change in price. In elasticity we want to know as to how
much change in the price of a good will cause how much change in its demand. Price
elasticity means the degree of responsiveness of quantity demanded of a good in response
to a relative change in its price. Law of demand states that quantity demanded and prices
are inversely related; therefore price elasticity of demand is always negative.

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CASES, DEGREES OF ELASTICITY
1. Perfectly inelastic demand or zero elasticity.
2. Perfectly elastic demand or Infinite elasticity.
3. Elasticity equal to unity or Unit elasticity.
4. Elasticity more than unity or elastic.
5. Elasticity less than unity or inelastic

TYPES OF ELASTICITY
1. Price Elasticity.
2. Income Elasticity.
3. Cross Elasticity.
4. Arc Elasticity.
5. Point Elasticity

1-----PERFECTLY ELASTIC DEMAND


It is also called Infinite elasticity of demand and is extreme one in price elasticities of
demand. It represents total responsiveness of quantity demanded to price changes. At
price Rs.2 consumers will demand an unlimited quantity of a good. In this demand curve
becomes a horizontal straight line parallel to OX axis.

Price Demand
Rs.2 4 items
Rs.2 6 items

A B
Price

Y 1
O 4 6 X Quantity demanded

Formula: - Proportionate change in quantity demanded


Proportionate change in price
?Q x P= 6-4 x 2 = 2 x 2 = 4 = Infinite elasticity
?P q 2-2 4 0 4 0

2----PERFECTLY INELASTIC DEMAND


It is also called Zero elasticity of demand. It represents total un-responsiveness of
quantity demanded to price changes. It exhibits zero responsiveness; no matter whatever
price is, quantity remains the same. It may be applicable to people who are hard-drug
addicted and have no financial problems to purchase those drugs. If even a big change in
price followed only by a small change in demand, it is therefore inela stic demand. If price

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of salt varies too much, people continue to buy same quantity of salt; hence demand
elasticity for salt is inelastic. Demand curve becomes a straight line parallel to OY axis.

Price Demand
Rs.2 4 items
Rs.3 4 items

Y
3 B
Price

2
A
1
0 X
1 2 3 4
Quantity demanded

Formula : - Proportionate change in quantity demanded


Proportionate change in price
?Q x P = 4- 4 x 2 = 0 x 2 = 0 = Zero Elasticity
?P Q 2- 3 4 1 4 4

3-----ELASTICITY EQUAL TO UNITY


In equal to unity demand elasticity the proportionate change in demand is same as that of
change in price. Generally goods of comforts of life have ela sticity equal to unity. In it
there is 1% change in price and same 1% change in demand. It is also called Price Unit-
elastic demand.
Price Demand Total expenditure
Rs.10 6 units Rs.60
Rs.6 10 units Rs.60

10
A

8 B
6
Price

4 C
2
0
2 4 6 8 10
Quantity demanded

P Q ?P ?Q (P1 + P2) / 2 (q1 + q2 ) / 2


Rs.10 6
Rs.6 10 4 4 (10+6)/2=8 (6+10)/2=8

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?q / ?p 4 / 4 = 4 x 8 = 32 = 1
(q1 + q2)/2 / ( p1 + p2)/2 = 8 8 8 4 32 Equal to unity

4-----ELASTICITY LESS THAN UNITY


In less than unity demand elasticity or price ine lastic demand, the proportionate change in
demand is less than that of change in price. The best price policy of a seller for any good
is to increase its prices when demand for that good is less elastic or inelastic; in that case,
revenue and profits would be greater. Goods of necessities of life have elasticity less than
unity. In it there is 1% change in price but less than 1% change in demand.

Price Demand Total expenditure


Rs.10 8 units Rs.80
Rs.6 10 units Rs.60

10 A
Price

6 C B

4
0 2 4 6 8

Quantity demanded

P Q ?P ?Q (P1 + P2) / 2 (q1 + q2 ) / 2


Rs.10 8
Rs.6 10 4 2 (10 + 6)/2 =8 (8 + 10 ) 2 == 9

?q ?P 2 / 4 = 2 x 8 = 16 = 0. 4
(q1 + q2)/2 / ( p1 + p2)/2 = 9 8 9 4 36 Less than unity

Formula No.2 Proportionate change in quantity demanded


Proportionate change in price
? Q x P = 10 - 8 x 10 = 2 x 10 = 20 = 0.6 Less than unity
?P Q 6 - 10 8 4 8 32

5-----ELASTICITY MORE THAN UNITY


Pr

In more than unity demand elasticity or price elastic demand proportionate change in
demand is more than change in price. Goods of luxuries of life have elasticity more than
unity. In it there is 1% change in price but more than 1% change in demand or 1%
increase in price but 5% decrease in demand. (1%increase in price and more than 1 %
decrease in demand is elasticity more than unity).

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Price Demand Total expenditure
Rs.10 8 units Rs.80
Rs.6 20 units Rs.120

10 A

8
C B
6
Price

0 X
2 Quantity
4 demanded
6 8 10 12

P Q ?P ?Q (P1 + P2) / 2 (q1 + q2 ) / 2


Rs.10 8
Rs.6 20 4 12 (10+6)/2=8 (8+20)/2+14

?Q ?P 12 / 4 12 x 8 = 96 = 1.7
(q1 + q2)/2 / ( p1 + p2)/2 = 14 8 14 4 56 More than unity

Formula 2: - Proportionate change in quantity demanded


Proportionate change in price
?Q x P = 20 - 8 x 10 = 12 x 10 =120 = 3.7 More than unity
?P Q 6 - 10 8 4 8 32

FORMULA OF EXPENDITURE METHOD

Price Demand Total expenditure


Rs.6 3 Rs.18 With fall in price if total expenditure is
Rs.5 4 Rs.20 more, than elasticity is more than unity

Rs.5 4 Rs.20 With fall in price if total expenditure is


Rs.4 5 Rs.20 equal, than elasticity is equal to unity

Rs.4 5 Rs.20 With fall in price if total expenditure is


Rs.3 6 Rs.18 less, than elasticity is less than unity

DETERMINANTS OF ELASTICITY OF DEMAND


It is not possible to mention any hard and fast rule as to which good has elastic demand
and which one has inelastic demand. It all depends on the circumstances of the case.
However, following factors determine ela sticity of demand.

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1 ---EXISTENCE OF SUBSTITUTES
The closer are the substitutes for a particular good and more are of them, the greater will
be its price elasticity of demand, for example, demand for Coca-cola may be highly
elastic because consumers can change their demand to Pepsi-cola .

2 ---SHARE OF BUDGET EXPENDITURE


Greater the percentage of a total budget spent on a good, the greater will the price
elasticity of demand for that good. In the same way smaller the percentage of a total
budget spent on a good, smaller will be consumers price elasticity of demand for that
good, for example, demand for salt is thought to be very inelastic merely because
individuals spend little money on it as compared to their total budget. In contrast demand
for things such as transport & housing is thought to be far more ela stic because these
items occupy a large part of peoples budget, and change in their prices cannot be ignored
easily without sacrificing of other alternative goods that could be purchased.

3 ---TIME FOR ADJUSTMENT


When price of a good changes and that price change continues, then more people will
learn more about it. Consumers will be able to revise their consumption patterns in long
period of time. Suppose price of electricity goes up, then people will in long run can
devise methods to reduce electric consumption and instead of using electric heaters they
will change their home and office installations from electric to gas heaters and stoves,
hence in long run demand will become elastic, however in short period of time the
demand will be less elastic.

4 ---HABITS OF CONSUMER
If a consumer is habitual of smoking, then increase in price of cigarettes will not decrease
his demand for cigarettes. Consumer smokes out of habit, which cannot be changed
therefore, increase in price will not result in the decrease in demand of cigarettes and
hence demand will remain inelastic .

5 ---NUMBER OF USES OF A GOOD


If price of a good having many uses is very high, its demand will be less and it will be put
to the most important use. If price of such a good falls it will be put to less important uses
also and its quantity demanded will rise. If price of milk falls, it would be demanded for
preparation of curd, cream ghee and sweets. Hence demand for milk tends to be elastic.

6 -- NECESSITIES VERSUS LUXURIES


Necessities tend to be in inelastic demand, luxuries in elastic demand. Salt is often cited
as a commodity with a very inelastic demand because it is a necessity. The demand for
luxurious goods can be postponed with increase in their prices.

IMPORTANCE OF ELASTICITY OF DEMAND


Practical importance of elasticity of demand can be judged from the following: -

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1----FIXATION OF PRICES
While fixing prices of products business firms keep into consider price elasticity of
demand. If demand of a good is elastic, then increase in price will result in the decrease
in demand hence total revenue of firms will reduce. Thus instead of gaining by raising
price, firms will be losing and vice versa.

2 ---TAX REVENUE
Concept of elasticity of demand is very important for Finance Minister. Tax is imposed
by him on that good, demand of which is inelastic and with increase in price of that good,
demand do not decrease, thus Govt. gets a lot of revenue .

3 ---MONOPOLY PRICE
If demand of a monopolist’s product is inelastic, he can increase price and thus makes a
lot of profit and if demand is elastic then increase in price reduces the consumption of
monopolist’s product, thus his total revenue and profit declines. Thus before fixing any
price monopolist always undertakes research about demand elasticity of his product.

4 ---FOREIGN TRADE
If demand of exports is inelastic, a decrease in prices of exportable goods will not
improve country’s foreign exchange earnings. Fall in price will not increase exports and
country may suffer on account of overall reduction in total export earnings.

5 ---DISCOURAGING USE OF HARMFUL GOODS


Govts. often levy taxes on tobacco products and alcohol. In such cases objective of tax is
to discourage consumption of these goods, which are considered harmful for health.
Generally sellers of a taxed good will attempt to pass on some or all the tax on to
consumers if he can. The degree to which taxes are shifted onto buyers and sellers
depends on the relative elasticity of demand and supply. If demand of tobacco and
alcohol is elastic to some consumers, then with increase in their prices, demand will
decrease and people will avoid consuming of such items.

6 ----JOINT PRODUCTS
In case of joint products separate costs are not ascertainable. Prices in such cases are
fixed as per the saying ‘The transport authorities fix their rates according to the principle
when we say that they charge what the traffic will bear.’

7---OUTPUT
Elasticity of demand affects industrial output for which elasticity of demand for
individual as well as that of whole market should be taken into consideration.

8 -----WAGES
If demand for a particular type of labor is relatively inelastic, then wage rate of that
particular labor increases.

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INCOME ELASTICITY OF DEMAND
Income elasticity of demand tells us as to what percentage quantity demanded will
change for a particular percentage change in income of a consumer.

1-----ZERO INCOME ELASTICITY


It means that a given increase in income does not at all lead to an increase in quantity
demanded nor a decrease in income reduces its consumption. The good in question is
quite unresponsive to changes in income of a consumer; therefore, we say that change in
elasticity is zero.

Income Demand for salt


Rs.100 2 kg
Rs.110 2 kg

Formula: - Percentage change in quantity demanded = ?Q x Y


Percentage change in income ?Y Q
2 – 2 x 100 = 0 x 100 = 0 = 0 Zero income elasticity for salt
110-100 2 10 2 20

2.-----POSITIVE INCOME ELASTICITY


It means that a given increase in income results in increase in quantity of a good, which a
consumer already uses. These types of goods are called Normal goods, whose demand
increases with increase in income of a consumer.

Income Demand for rice


Rs.100 5 kg
Rs.110 6 kg

Formula: - Percentage change in quantity demanded = ?Q x Y


Percentage change in income ?Y Q
6– 5 x 100 = 1 x 100 = 100 = + 2
110-100 5 10 5 50
Positive income elasticity for normal good (rice

3----NEGATIVE INCOME ELASTICITY


It means that a given increase in income results in decrease in qua ntity of a good,
which a consumer already has. These types of goods are called Inferior goods, whose
demand decreases with increase in income of a consumer. Since consumer becomes well
off with increase of his income he now moves from an inferior good to a superior good. If
income elasticity is less than Zero it is negative and good is said to be an Inferior good.

Income Demand for rice


Rs.100 3 kg
Rs.110 2 kg

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Formula: - Percentage change in quantity demanded = ?Q x Y
Percentage change in income ?Y Q
2–3 x 100 = -1 x 100 = - 100 = - 3.3
110-100 3 10 3 30
Negative, income elasticity for an inferior good.

CROSS ELASTICITY OF DEMAND


In Cross elasticity of demand price of one good (Y) changes, whereas demand of another
good X changes, even though price of X remains unchanged.

1---CROSS ELASTICITY OF SUBSTITUTES


Substitute goods are considered to be economically inter-changeable by buyers, for
example, if an increase in price of coffee causes buyers to switch away from it and buy
more quantities of tea, then these goods can be regarded as substitutes for one another. If
there is an increase in price of beef but no change in price of chicken, consumer will buy
less beef and will demand more chicken, which is a close substitute of beef. The demand
of chicken will go up though its price has not gone down. Cross ela sticity for substitutes
is positive.
Price of beef (B) Demand for chicken (A)
Rs.10 per kg 50 Kg
Rs.12 per kg. 70 Kg

Cross elasticity between beef and chicken.


Formula: - Percentage change in quantity of A demanded = ? Q (a) x P (b)
Percentage change in price of B ? P (b) Q (a)
70-50 x 10 = 20 x 10 = 200 = 2 Positive more than unity
12-10 50 2 50 100

2----CROSS ELASTICITY OF COMPLIMENTARY GOODS


Complimentary goods or compliments demand is inter-related (a joint demand) so that an
increase in price of one good results in a fall in demand for another good for example, if
price of motor cars increases, this will not only decrease demand of motor cars but it will
also decrease in demand of petrol, as less cars will require less petrol than before, as both
items are used together. If price of tennis rackets goes down this will not only increase
demand of tennis rackets but will also increase demand of tennis ba lls, though price of
tennis balls has not decreased. Cross elasticity for compliments is negative.

Price of rackets (B) Demand for balls (A)


Rs.50 per racket 10 balls
Rs.40 per racket 15 balls

Cross elasticity between tennis rackets and tennis balls .


Formula: - Percentage change in quantity of A demanded = ? Q (a) x P (b)
Percentage change in price of B ? P (b) Q (a)

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15-10 x 50 = 5 x 50 = 250 = - 2.5
40-50 10 - 10 10 - 100 Elasticity is negative

POINT ELASTICITY
When elasticity of demand at a given point on a demand curve is measured, it is called
point elasticity. In point elasticity changes in price and demand are very small, and a
fraction or a segment represents it.
Formula: - Lower segment
Upper segment

Point
Price

a Lower seg = 1 / 1 = 1 x 2 = 2 = 1, elasticity equal to unity


Upper seg 2 2 2 1 2

Demand

Lower seg = 1 / 3 = 1 x 4 = 4 = .3 elasticity less than unity


Upper seg 4 4 4 3 12
Price

b Point

Demand

Point
Lower seg = 3 / 1 = 3 x 4 = 12 = 3 elasticity more than unity
c Upper seg 4 4 4 1 4
Price

Demand

ARC ELASTICITY
Arc elasticity is a rough measure of the responsiveness of demand to changes in price. In
the case of price elasticity of demand it is the ratio of the percentage change in quantity
demanded to the percentage change in price over a price range such as P1P2. Arc
elasticity of demand is expressed as under: -
Q1 – Q2 x P1 + P2
P1 – P2 Q1 + Q2

Where P 1 is original price, P2 is new price, Q1 is original quantity, Q2 is new quantity.


Because arc elasticity measures the elasticity of demand over a price range or arc of the
demand curve it is only an approximation of demand elasticity at a particular price.

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Price Quantity demanded
P1 Rs.3 Q1 6
P2 Rs.2 Q2 8

6-8 x 3+2 = -2 x 5 = -10 = -0.7 Less than unity


3-2 6+8 1 14 14

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ARC ELASTICITY OF DEMAND
Any two points on a demand curve make an arc. Arc elasticity measures the
elasticity of demand over a price change on arc of demand curve and it is a rough
measure of the responsiveness of demand to changes in price.

10 A
8
Price C B
6
4
2

0 2 4 6 8 10
Quantity demanded

Price Demand
Rs.3 p-1 6 q-1
Rs.2 p-2 8 q-2

Formula: - q1 – q2 / p1 -- p2
q1 + q2 p1 + p2
6—8 / 3 – 2 = -2 / 1 = -2 x 5 = - 10 = -. 71 Less than unity
6+8 3+2 14 5 14 1 14

POINT ELASTICITY OF DEMAND


When the elasticity of demand at a given point on a demand curve is measured, it
is called Point elasticity. In it changes in price and demand are very small. It is
represented by fraction or segment.
Formula: - Lower segment
Upper segment

d-2
Lower seg = 1 / 1 = 1 x 2 = 2 = 1 = Unity (1)
Upper seg 2 2 2 1 2
Point
Lower seg = 1 / 3 = 1 x 4 = 4 = .3 less than unity
Upper seg 4 4 4 3 12 (2)
d-1
Lower seg = 3 / 1 = 3 x 4 = 12 = 3 more than unity
Upper seg 4 4 4 1 4 (3)
d-2
d-2
Point
Point

50
d-1
d-1
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