Chapter-18

THE ELASTICITY OF DEMANDb

INTRODUCTION

taudies in detail the concepts of elasticity of demand.

demand which is often called own price elasticityGenerally, elasticity of demand refers
This chapter
b p r c ee l a s t i o of demand, though the notion of
lates to income, croSs and substitution elasticities of
also relates
osticity of
demand

elasticity.
demand. We discuss in detail
demand
of
ch tpe
PRICE ELASTICITY OF DEMAND,
2 PR

Meaning

Theelasticity of demand IS the degree of responsiveness of demand to

change in price. In the words of
plasticity of demand may be
Prof.Lipsey: "Elast defined as the ratio of the percentage
change in demand to the
percentage
Irs. Robinson's definition
change in price." Mrs. is more clear: "The
elasticity of demand at any price..
nroDortional change ot amount purchased in response to a small change in price, divided by the
ional change of price." Thus, price elasticity of demand is the ratio of percentage change in amount
proport
emanded to a percentage change in price. It may be written as

Percentage change in anmount demanded

Percentage change in price

If we use A (delta) for a change, q for amount demanded and p for price, the algebraic equation is

A P=-
AD Ap
P
E, the coeficient of price elasticity of demand is always negative because when price changes demand
moves in the opposite direction. It is, however, customary todisregard the negative sign. If the percentages for
guantity and prices are known, the value of the coefficient E, can be calculated.
Price elasticity of demand may be unity, greater than únity, less than unity, zero or infinite. These five
Cases are explained in Figure 1.
In the diagrams of Figure 1, Ap represents change in price, Aq change in demand, and DD the demand
Curve.
,Frice elasticity of demand is unity when the change in demand is exactly proportionate to the change in
For example, a 20% change in price causes 20% change in demand, E-20%/20% = 1. Price elasticity on
tne first demand curve in Panel (A) is unity, for Ag/Ap=
When the change in demand is more than proportionate to the change in price, price elasticity of demand
de er than unity or relatively elastic. If the change in demand is 40% when price changes by 20% then E=
o20-2, in Panel (B), i.e. AqlAp>P1
, nowever, the change in demand is less than proportionate to the change in price, price elasticity of
fthenh lesS than unity or relatively inelastic. When a 20% change in price causes 10% change in demand,
10%/20% =1/2 =<1, in Panel (C), i.e.,AqlAps1.
O elasticity of demand is one when whatever the change in price, there is absolutely no change in
uemand. rice elasticity of demand is perfectly inelastic in this case. A 20% rise or fall in price leads to no
152: Microeconomic Theory

(A) (B) (C)

D
D E = 1 1
a a
E,>1 Ap
AP Ap

A D
O
AD
b b b, b
Quantity Demanded

(D) (E)
D

E = 0 E = o
Ap
-D
Ag
O
Quantity Demanded
Fig. 1

change in the amount demanded, E,-0/20%=0,in Panel (D), i. e. 0l A p=0.

Lastly, price elasticity of demand is infinity when an infinitesimal small change in price leadsto
infinitely large change in the amount demanded. Visibly, no change in price causes an infinite change i
demand, E, = 0 /0= C0 , in Panel (E), at OD price, the quantity demanded continues to increase from O, to 0

. It is perfectly elastic demand

METHODS OF MEASURING PRICE ELASTICITY OF DEMAND

There are four methods of measuring elasticity of demand. They are the percentage method,po
method, arc method and expenditure method.
(1) The Percentage Method
The price elasticity of demand is measured by its coefficient (E). This coefficient (E,) measures
percentage change in the quantity of a commodity demanded resulting from a given percentage changen
price. Thus

%change ing Aq/g- A , P

% change in p Ap/p Ap 4
Where q refersto quantity demanded, p to price and A to change. If E, >1, demand is elastic. 1
demand is inelastic, and if E,=1, demand is unity elastic.
le
With this formula, we can compute price elasticities of demand on the basis of a demand scheduic

Table 18. l : Demand Schedule

Combination Price (Rs.) Ouantity

Per Kg. of X Kgs. ofX
A 6 0
10
20
30
E
40
50
60
 The Elasticity of Demand: 153
take combinations B and D.
Let us first
lheDrice of
the price commodity
X falls from Rs. 5 per kg. to Rs. 3
(1) Suppose Then per kg, and its
increases
firom 10 Kgs. to 30 kgs. quantity demanded
(30-10) 20 S
6p - 3 )2.
T0 or> 1

This shows elastie demand or elasticitylikeofthis:

demand greater than unity
Note: The formula can
be understood
Note d. where q, is the new quantity (30 kgs.)
A p , wherep, is the new price (Rs. 3) and p, and q, the original quantity (10 kgs.).
the original
price (Rs. 5).
A mula, p refers to the original price (P,)) and q to original quantity
n tnosite is the case in example (11) below, where Rs. 3 becomes the (g).
original price and 30 kgs. as the
ariginal qua easure elasticity by moving in the reverse direction.
Suppose the Thenof X rises rom Rs. 3 per
e to Rs. 5 per kg. and the quanny demanded decreases from 30 kgs. to 10 kgs.price

E-y 0-30)
(5-3) 300
This shows unity elasticity of demand.
Natice that the value of E, in example (1i) differs from that in example (i) depending on the direction in
ove. This difference in the elasticities is due to the use
of a different base in computing percentage
in each case.
changes
Now consider combinations D and F
(il) Suppose the price of commodity X falls from Rs. 3 per kg. to Re. 1 per kg. and its quantity demanded
increases from 30 kgs. to 50 kgs. Then

E-Ag50-30),320x-
4p9 -3 30*30-
This is again unity elasticity.
(iv) Take the reverse order when the price rises from Re. 1 per
demanded decreases from 50 kgs. to 30 kgs. Then
kg. to Rs. 3 per kg. and the quantity

This shows inelastic demand or less than unitary.

The value of
E, again differs in this example than that given in example (iii) for the reason stated above.
(2) The Point Method
Prof. Marshall devised a geometrical method for measuring
ICIty at a point on the demand curve. Let RS be a straight line
and curve in Figure 2. If the price falls from PB(=0A) to
,the quantity demanded increases from OB to OD.
at
y point P on the RS demand curve
according to the
ormula is:is. -
Oomula E,ap, 2 A
ere Ag represents Ap M
in change in quantity demanded, Ap
els. price level while p and q are initial price and quantity
From Figure 2 A
Ag=BD
Ap PQ QM
PB
OB BD
stituting these values in the Quantity
elasticity formula: Fig. 2
154: Microeconomic Theory

PB
OM
E, PO OB

Moreover, OM
PO PR
BS IZ POM=2 PBS being right angles and POM and PBS are similar A s

BS PB BS
PB OB OB

Since, A PBS and A ROS are similar, D L-Ep =

BS OA PS Lower Segmen
E at point P=
OB AR PR Upper Segment M-Ep>1
With the help of the point method, it is easy to point out
elasticity at any point along a demand curve. Suppose that the
straight line demand curve DC in Figure 3 is 6 centimetres. Five N< Ep =1
points L,M, N, P and Q are taken on this demand curve. The a
elasticity of demand at each point can be known with the help
of the above method. Let point N be in the middle of the demand P-Ep <1
curve. So elasticity of demand at point.

CN(Lower Segment)_3
ND(Upper Segment) 3=l (Unity) Quantity C
Elasticity of demand at point Fig. 3

M-
MD =5 or> 1. (Greater than Unity)
Elasticity of demand at point

LTho
L (nfinity).
Elasticity of demand at Point

P=
P=
pD5 or<1
(Less thanUnity).
Elasticity of demand at point
CO
0D=0 (Zero)
We arrive at the conclusion that at the
Moving up the demand curve from the mid-point, mid-point on the demand curve, the elasticity of unilty
elasticity becomes demand
the Y-axis, elasticity is infinity. Ipso greater. When the demand curve
jacto,
demand. Elasticity becomes Zero when theany
point below the mid-point towards
the X-axis will show innelastv
demand curve touches
the X axis.
(3) The Arc Method
We have studied the measurement of D
elasticity at a point on a demand
curve.But when elasticity 1S measured between two D
points on the same
demand curve, it is known as arc elasticity. In the words of Prof.
Baumol, P
Arc elasticity is a measure of the
average responsiveness
to price change
exhibited by a demand curve over some finite stretch of the
curve."
Any two points on a demand curve make an arc. The area
between P AP
and M the DD curve in Figure
on 4 1s an are which measures
elasticity over
a certain range of price and quantities. On any two points of a
demand Pa
curve, the elasticity coefficients are likely to be different depending upon A
the method of computation. Consider the price-quantity combinations P
O 92
and M as given in Table 2.
Quantity
Fig.4
 The Elasticity of Demand: 155

Table 2: Demand Schedule

Price (Rs)
Point Quantity(Kg)
8 10
6 12

from P to M, the elasticity of demand is

If we move

E
E - 2 - 1 0 ) ,

(6-8)To -
in the reverse direction from M to P, then
If we move

(10-20)
Thus the point method of measuring elasticity at two points on a demand curve gives different elasticity
Eients because we used a different base in computingthe percentage change in each case
c0e elasticity for the are P in Figure 4 is calculated by taking the average of the
To avoid this discrepancy,

tuo prices (P +P2)!/2and the average two quantities

(q +q2)!/2. The formula for price elasticity of
ofthe
C in the arc PM on the demand curve is
demand at the mid-point
Ag
(91 +92)//2 Ag (P+P2)/2 AqP+ P2
Ap (a +92)1/2 Ap Ap 9/ +942
(P +P2)!/2
of demand when there is a movement either
On the basis of this formula, we can measure arc elasticity
frompoint P to M or from M to P.
From P to Mat point P, p,= 8, q,= 10, and at point M, p,
=

6, 9, =
12.
Applying these values, we get

PI+P22-10) 8+0)
Ap 9+42 (6-8)
From M to P at point M, p, = 6, q, = 12 and at point P, P2= 8,9,= 10.

Now we have (10-12)6+8)10)

E-8-0(12+ 2
14

the formula for arc elasticity

us wnether we from MM to P or P to M on the arc PM of the DD curve,
move
two points P and M are, the more accurate is the
meac ra8vEs the same numerical value. The closer the the arc on the demand curve are
50clac aStiCity on the basis of this formula. If the two points which form the numerical value
f Doint ney almost merge into each other, the numerical value of arc elasticity equals
OTpoint elasticity.
4) The Total Outlay Method
elasticity. of
total expenditure method as a
measure
the total
Ved
mparino g the total outlay, or total r e v e u e or
the change in price, it can be known
before and after
Ninether his den expenditditure of a purchaser bothelastic. Total outlay is price multiplied by the quantity of
SOd purchac is
r a good elastic, unity or less demand
d: Total Outlay Pricex Quanantity Demanded. This is explained with the help of the
SChedule in Table 3.
he )inIn thn. Demand is elastic, when with the fall in price the total expenditure increases and with
rise p
price falls from Rs. 9 to Rs. 8, the
Penditure indexpenditure decreases. Table 3 shows that when the price
Rs. 280increases from Rs. 180 to Rs. 240 and when price rises from Rs. 7 to Rs. 8, the total expenditure
to Rs. 240.
Demand is elastic (E, 1) in this case.
156: Microeconomic Theory

Table 3: Total Outlay Method

TE in Rs.
Price Rs. per Kg. Quantity in Kgs
(1) (2) (1x2)=3
4
9 20 180
8 30 240
40 280
S0 300
60 300
75 300
80 240
90 0
<1
100 100

(i) Unity Elastic Demand. When with the fall or rise in price, the total expenditure remains unchano
the elasticity of demand is unity. This is shown in the
table when with the fall in price from Rs. 6 to Rs. S orwi
the rise in price from Rs. 4 to Rs. 5, the total expenditure remains
unchanged at Rs. 300, i.e., E, = 1.
(ii) Less Elastic Demand. Demand is less elastic if with the fall in price, the total
with the rise in price the total expenditure rises. In Table 3 when the expenditure falls
price falls from Rs. 3 to Rs. 2, to
expenditure falls from Rs. 240 to Rs 180, and when the price rises from Re. I to Rs. 2. the total
rises from Rs. 100 to Rs. 180. This is the case of inelastic or less elastic expenditure asm
demand, E, < 1.

Ep>1
TE is maximum

A Ep 1
B

Ep< 1

10 20 30 40 50 60 70 80 90 100
Quantity Demanded
Fig.5
Figure 5
illustrates the relation between
curve. The rectangles show total elasticity of demand and total expenditure on the DD, dem
expenditure
point of the demand curve, total expenditure is Pricexquantity demanded. The figure shows that athe m
with quantities 50 kgs. and 60 kgs. Total the maximum in the range of unity elasticity, i.e. RS. 0and
expenditure
9, Rs. 8 and Rs. 7 with quantities 20 kgs., 30 Kgs. rises
40
as price
falls, in the elastic range of demann d.
and Kgs. Total expenditure
falls as price falls i s
in
range, i.e. Rs.3, Rs. 2 and Re. 1 with quantities 80 90
in the AB range of DD, curve, elastic in the range AD
Kgs., Kgs. and 100
kgs. Thus elasticity of demao
B. The conclusion is that price above point A and less elastic in the
BD, range
elasticity of demand refers to a movement along a specific demana
 The Elasticity of Demand: 157

Alternate Method

summarises these relationships

Table 4
Table. 4 Total Outlay Method

7E
Price

Rises
Palls Falls
Rises
Unchanged
Falls Unchanged
Rises Falls
Falls Rises
Rises
Total Outlay Method can also be explained with the help of Figure 18.5(A).

Total Exponditure
Curve

P E
Ep> 1

Ep = 1

Ep<<1
A

O
Total Expenditure

Fig. 5A
n the f
e Jurst stage, when price falls from OP, to OP, and OP,, total expenditure rises from P.E to P,D and
and
EThas pertion
lherhand, of total expenditureOP, OP, OP, expenditure falls from
when price rises from to and total P,D
Curve Of shows elastic demand (E,> 1). In the second stage
P,C to
wher s rom OP, to OP, or rises from OP, to OP, , total expenditure, P, C= P, B which shows unity
elusticity demand
oPA.On the
(E, ).n the third stage, when price falls from OP, to OP total expenditure falls from P,B
eis other side, ses from OP to OP, total expenditure rises from PA to P,B. This shows
when price rises
elastic demand (E, 1). <
,

Elast icity and Slope

of the Demand Curve
I5
essential and
that theimportant
n nt to distinguish between the slope of the demand curve and its price elasticity.
C thought
ArVThat price
ice elasticity of demand can be known by simply looking at the slope of a demand
emkind. But thisa flatter
S,
demand curve has greater price elasticity and a steeper curve has lower price elasticity of
cur
enand. In corder to is a
wrong notion because the slope of a demand curve is different from its price elasticity of
Aemand understand the difference between the two, let us analyse the formula for price elasticity of
Table is 1Or
understanding this method. There is no need to give it in the examination.
158: Microeconomic Theory

where its first part, Ag Ap. is the reciprocal of the slope of the demand curve, and the seoo
q is the ratio of the price to quantity.
The slope of a demand curve, whether it is flat or steep, is based on absolute changes in pi
rice o
quantity, that is,

Slope of demand curve =

Aq/Ap
On the other hand, the price elasticity of demand is concerned with relative changes in price
quantity, that is,
Aq
EAp/P
Thus the slope of the demand curve and its price elasticity are different because
1 Ag/q
Aq/Ap Ap/p
Further, as is clear from Figure 3, the slope of the linear demand curve DC is constant througho
length, whereas the price elasticity of demand varies between co and
O on its different points.* Thus it is clear that the slope of the demand
Curve is different from its price elasticity. This fact can also be verified
by measuring price elasticities on two demand curves of the same or N
different slopes.
(a) Two straight line demand curves originating
from the same
point. There are two straight line demand curves NM and NS in
6. At a
glance, the curve NS is flatter than NM. Therefore, it
Figure
that its price elasticity is higher appears
than the other curve. But this is not a
reality. If we draw line PV passing
a
through these curves and touching
the vertical axis at
point P,
the elasticity at
point T on the NAM curve
according to the point formula is:
Quantity
MT OP
TN PN
Fig.6

Similarly, elasticity at point V on the NS curve is SV OP

DAT Therefore,
MT SV OP
TN VN PN
Thus elasticity is equal on both the
curves. We may
points T and V of the two
conclude that if two
lineardemand curves
the vertical axis at the same
point, such as N, originate from R
elasticities at every single price. they have
exactly equal
(b) Two straight line demand curves originating N
points which are neither parallel nor intersecting. from different
Figure
demand curves NM and RS. Of these, the curve RS is 7 shows two
P

looks more price elastic, But this is wrong. To flatter and so it

prove it, draw a line from
point P of the vertical axis which passes through these curves
at points
A and B respectively. Thus price
elasticity at pointA on the NM curve is
M
Quantity
MA OP and at point B on the ko Curve is OP OP
RR Fig.7
AN PN PR Snce
pN PR
Students should draw Fig. 3 here.
 The Elasticity of Denmand: 159

MA SB It means that price elasticity of demand is less

therefore AN BR
B on the demand curve RS and greater than I at point A
than 1
at point
curve.
NM
onthe demand
c) Tiwo parallel straight line curves. Two parallel

etraicht line demand curves appear to have the same slope and hence
This View is
wrong. prove, To and RS let NM
dhe same price elasticity. demand curves. Draw a line PT which passes
line
wa Darallel straiglht
through these straight tolines
at
point L and 7 respectively, as shown in
ioire 8. According the point formula, elasticity point L on the
at
M
MNOP Similarly, elasticity at point T on the RS curve Quantity
NMcurve 1s N PN
Fig. 8
OP OP ML ST
STOP SInce
DR PN PR
rCiOre
LN TR I t means greater
1STR PR
i at noint L on the line NM than at point T on the line RS. In other words, the curve which is nearer to
rioin has greater elasticity than which is farther from the origin. Thus even two parallel straíght line
each and every point.
different elasticities at
deand curves have
on a Let us take points A
curved demand curve.
(ad) Tiro poinis
and B on a curved
demand curved D in Figure Elasticity at point B is
9.
is SAlAR. Since SAIAR is greater than MB/BN,
MB BN, and at point A
at A IS greater than unity and at point B, it is less than
point
elasticity
unity.
The above cases prove that the price elasticity of
demand cannot N
at the slope of a demand curve.
be ascertained by simply looking
Exceptions
However, there are three exceptional cases when price elasticity
S M
can be known from the slope of the demand curve.
be said by
) When price ard quantity a r e identical, it can Quantity
demand curves which Fig.9
looking at the slopes of the two intersecting
in Figure 10 where the
one 1s more or less elastic. This is explained that of the NM curve
stope ofit the RS curve shows that it is flatter and
Snows to be steeper. Both intersect at point K so that they have identical price OP and identical quantity OQ

SK OP
Price elasticity on the RS curve at point K is KR RSimilarly, elasticity
PR

at point Kon the NM curve is MKOP.But OP

PR
OP
PN
Therefore,
KN PN R
T h u s the flatter curve RS has greater elasticity than the steeper p
KR KN
Curve NM at poinc K
demand curve is vertical, its price elasticity 1s zero, as
the
OWh in Figure 1 (D). (Draw this curve here).
M
5) If the demand curve is horizontal, its price elasticity 1S iniinite, O
Shown in Figure 1 (E) (Draw this curve here). Quantity
Fig. 10
3. CROSS ELASTICITY OF DEMAND
change in the quantity demanded of a
to th5 elasticity of demand is the relation between percentage
words of J.S. Sloman, "Cross elasticity of
In the
ge change in the price of a for onegood.
related
land referc the price of another." The crossS
good to a change in
Ohe responsiveness of demand
Odemand between good A and B is
 160: Microeconomic Theory

Percentagechange in the quantity of B

Eba Percentage change in price of A

Agb/qh Aqb paAqb, Pa

Apa pa Apa Apa gb
It can also be measured with the formula of arc elasticity with the difference that here price and quanti
refer to different goods.

Eba = dit. in qb
sum of qb
Sumofpa
dif. in pa
Let us suppose that when the price of tea is Rs 8 per kg, 100 kg, of coffee is
bought but when the price rises to Rs. 10, the demand for coffee increases to 120 kg. According to this

(00-120,
tormula, the coefficient of cross elasticity, Eba = (100+120) ( 8 - 1 0 ) 220 <lor less
than unity
There are two types of related goods: substitutes and complementaries

Cross Elasticity of Substitutes

In the case of substitnutes, the cross elasticity is positive and large. The higher the coeficient Eba te
better substitutes the goods are. Ifthe price of butter rises, it will lead to increase in the demand for jan
Similarly, a fall in the price of butter will cause a decrease in the demand for jam.
Ifa change in the price of good A leads to more than proportionate change in the demand for good , t
cross elasticity is high (Eba> 1) In Figure 11 Panel (A), the price of good A is taken on Y-axis and the quan
of good B on X-axis. The change in the amount demanded of good B, A qb is more than proportionate tot
change in the price of A, A pa. The cross elasticity is high. Such goods are close substitutes.

(A) (B) (C) D

D
Eba>1 Eba = 1 Eba< 1

Apa Apa
a Apa
D
|Agb
D
O b b O b b
Quantity of B
(D) (E
D
Eba=0
Apa Apa
a

O b b
Quantity ofB
Fig. 11
 The Elasticty of Demand: 161

Theross elasticity of demand is unity (Eba - 1) when a change in the price of good A causes the same
ale change in the quantity of good B, This is shown in Panel (B) where A qb (the change in the
p r o p o r t i o n a t e

of B) and A pa (the change in price of A) are cqual,

qunily
wes clasticity is less than unity, (ba ) when the quantity demanded of good B changes less
the
response toth change in the
price of good A, as in Panel (C), It means that goods A and
nately in
proportiona

thon substitules tor cach other

Rare
he poorn the change in the price of good A has no eflect whatsoever on the demand for good B, the cross
of demand is zero. anel (D) shows that with the change in the príce of A, from a to a, the demand for
Pan
elasticilty
emains unchanged as OD (Eba 0), Such goods are unrelated to cach other, like butter and mango
case the two goods are perfectsubstintes, the cross elasticity of demand will be infnilte, Cba -0, A
de nrice of butter may reduce the demand for jam to nothing. The demand curve for good B (jam) will
with the Y-axis.
coincide
Thonoh the cross elasticity of demand for substitutes varies between zero and infinity, it may also be
euative. If the price of A falls, the demand for A being inclastic, then less ofA will be purchased because it is
negnt and more of B will be bought. In Panel (), a fall in the price of good A froma, to a leads to a rise in
cheoper,
hedemand for B from b, to b, The slope of the DD curve shows negative cross elasticity.

Cross Elasticity of Complementary Goods

If two goods are complementary (jointly demanded), a rise in the price of one leads to a fall in the demand
fbor the other. Rise in the prices of cars will bring a fall in their demand together with the demand for petrol.
Similarly, a fall in the prices of cars will raise the demand for petrol. Since price and demand vary in the opposite
direction, the cross elasticity of demand is negative.
If the changein quantity demanded B is exactly in the same proportion as the change in the price of A,
the cross elasticity is unity (Eba= 1), as in Figure 2 Panel (A), Aqb/Apa = 1.

(A) (B) (A)

Eba = 1
Eba> 1 D Eba <1
D
Apa a
Apa Apa
a

|Aqb D

O b O b b
b b b

Quantity of B

(D) (E)
Eba = 0 Eba =o

Apa D

Quantity of B
Fig. 12
162 Microeconomic Theory

In
the demand for B of
the case complementary goods, eross elasticity is grealer than umity (Eba >
the
good (Aqb) is more than proportionate to the change in the price of good 4, (Annge
I, Whas
A, as good (Apa),
inPanel (B) i.e. Aqb/Apa 1 show
The cross elasticity is less than unity (Eba< 1),
when the change in the quantity of B is leet
less in response
in Panel (C),Aqb /Apa 1. <

to a change in the price of A, as shown

when the change in the price of Aca
The cross clasticity of demand is zero (Eba0),
In Panel (D), a fall in the price of good A from a to a
whatsoever in the purchases of B, Aqb/Apa 0.
is in the of unrelated goods like tea and car.
demand OD of good B unchanged. This
case
It is infinity (Eba 00) when an infinitesimal change in the price of A causes an infinitely laroe al..

of B, Aqb/Apa =00. The price of A remains almost the same (OD) and the demand for Binem
in the purchase increass
from b to b, as in Panel (E).
Some Conclusions
We may draw certain inferences from this analysis of cross elasticity of demand.
(a) The cross elasticity between two goods, whether substitutes or complementaries, is only a one-wa
traflic. The cross elasticity between butter and jam may not be the same as the cross elasticity of jam to buter
A 10% fall in the price of butter may cause a fall in the demand for jam by 5%. But a 10% fall in the prce ofja
may lower the demand for butter by 2%. It shows that in the first case the coefficient is O.5 and in the se
case 0.2. The superior the substitute whose price changes, the higher is the cross elasticity of demand.
This rule also applies in the case of complementary goods. If the price of car falls by 5%, the demand
petrol may go up by 15%, giving a high coefficient of 3. But a fall in the price of petrol by 5% may leadtoans
in the demand for cars by 1%, giving a low coefficient of 0.2.
(b) Cross elasticities for both substitutes and complementaries vary between zero and infinity. Generuly
is
cross
clasticity for substitutes in exceptional circumstances it may also be
positive, but
(c) Commodities which are lose substitutes have high eross elasticity and commodities with lov
negative.
elasticities are poor substitutes for each other. This distinction helps to define an industry. If some goods ta
high cross elasticity, it means that they are close substitutes. Firmms producing them can be
industry. A good having a low eross elasticity in relation to other goods may be regarded a regarurodi
and its manufacturing firm becomes an industry by determining the boundary of an industry. mono ro
elasticities are simply guidelines.
4. INCOME ELASTICITY OF
DEMAND
The concept of incomeelasticity of
demand (E) expresses the deman
(or expenditure consumption
or
) for any good to the responsiveness of a consuhe ratio
change in
percentage change in the quantity demanded of a commodity to the his income. It may be detineu Won
of Lipsey, "The responsiveness of demand for percentage change 1nco
in
elasticity
demand." Thus
a
product to changes in income is ternmed inco

Percentage changeinthe quantity demanded

Percentage change in income

AQ/AQYAQY o
AY/Y AY AY
where A is change, O quantity demanded and Y is
The coefficient E, may be
income.
positive,negative
increase in income leads to an increased
or zero
depending upon the nature of a connt modity.

demand for a
commodity, the income elasticity coe
positive. A commodity whose incone elasticity Is positive is a normal
good
chast
the consumer's income reases. On the other hand, if an increase in because more of it is P
a commodity, its income elasticity coefficient (E,1s negative. Such a
income leads to a fall in tneiof
because less of it is purchased as ome increases. If the quantity of a commodity is called nchl
commodity
regardless of the change in incom the income elasticity of demand is zero (E =purchased remal ike
It is a necess
Normal goods are of three types : necessaries, luxuries and comforts. 0).
In the case of
coefficient of income elasticity is positive but high, E,>1. Income
elasticity
demand for a commodity rises more than proporttonate to the inerease in income. Assuming
of demand prices
is hisoofallon

goods as constant, if the income of the consumer inereases by 5% and as a result his purchases
 The
106then E, Elasticity of Demand: 163
10% 5% 20
demand Q,Takng
noditynerea

horizontal axis, the increase i in income on the vertical axis and

0, is more
n
A m n d e do

Pgure13Pan Panel (A). The curve Dy shows a positive and than the
elastic
the
rise in income quantity
income demand Y, Y,, as shown
(A)
(B)
(C)
,Dy
Dy

(D)
Quantity
(E) Dy
Dy

Quantity
Fig. 13
In the case of necessities, the
coetficient of income
of demand is low when the demand for a elasticity is positive but low, E< 1.
proportion income spent on a
of commodity rises less than Income elasticity
25 (<1). Panel (B) shows a commodity increases by 2% when the proportionate
to the rise in
the income. If the
consumer's
.is less than proportionate topositive
but inelastic income
the rise in income demand curve Dy becauseincome goes up by 5%, E
the increase in
In the case of Y, Y,. demand O
comforts, the coefficient of
income
COmmodity rises in the same elasticity is unity (E, 1) when the demand
SY% rise in demand, E 5/5proportion
=
as the increase in
income. For for a
= =
1. The curve example,a 5% increase in income
Increase in
quantity demanded Q, Q, exactly Dy the in Panel (C) shows
unity income elasticity of demand. leads to
The coefificient of equals
income elasticity of demand in the increase in income
Y, Y,
The
nterior goods, the consumer will reduce his case of inferior goods is negative. In the case of an
nis income increases. If a 5% increase in purchases of it, when
n demand, E=-2/5 (<0). Panel income leads to 2% reduction
eOr good which bends upwards (D) shows the D, curve for an
from A to B when the
emanded decreases by 0,0, with the
IT with rise in income by
quantity
increase in YY
the coefficient income,
the quantity demanded
nged, of income
remains
Crease income, there is no change in the
in elasticity, E 0. If, say,
=

with
0/5 0. Panel (E)=

with zero elasticity.

quantity demanded,
shows a vertical income demand curve
D

Q
Quantity
Fig. 14
164: Microeconomic Theory

ELASTICITY OF DEMAND
5. MEASURING INCOME own as an Eny

income-quantity relationship
levels ofincoel Cur
expresses the buy at Engel
would
Incom In
Each D eurve
which a f consumer curves.

which shows the quantities of a commodity In generstic

we have explained income

with the nei
elasticity of demand measured with the point
formula.
general, the p
5, curves can
be
14, 15 and
T
emand of non-linear Engel
in temms in Figures
and E. as shown
ces fook ike the curves &. E.

G
Q Quantity
Fig. 16
Quantity
Fig. 15
curve
E, at point
ficient ndof
A. The coefficient incon
to the Engel
LA is tangent
Consider Figure
14 where
(1) 4 is
demand at point
elasticity of

its range. When

the Engel Curve s
over much
of
income elastic
showS that theE, is
curve
good. coefficient of inom
This the case ofa luxury at point B. The incone
sloped and E>I, it is to the Engel
curve
B,
positively is tangent
Take Figure
15 where NB
2)
elasticity at point B is
E- , larger than zero butsmale
is
much of its range
of E, curve
over
and is incom
This shows that
the income elasticity the commodity is a necessity
curve
sloped and
is positively E,<1,
than 1. When the Engel
the backward-slopingrm
inelastic.
is backward-sloping after point B. In
the Engel curve E, point C is
3) In Figure 16, coefficient of income elasticity at
at point C. The
draw a tangent GC

curve E, is negatively
sloped. E, IS neg
from B upward, the Engel tne
This shows that over the range
bends backward, the Engel curve E, illustrates a
But before it
and the commodity is an inferior good.
over much of its range.
a necessary having
good income inelasticity
dema
Its Determinants
the income elasticity
There are certain factors which determine
1. Nature of Commodity comforts and luxuries. We
have seen abovc
Commodities are generally grouped
into necessities,
case of comforts, E= 1, and in
the case of luxuries, E, A cars
case
of necessities, E, <1, in the of commodities depends upon the income level of a couny
2. Income Level. But this grouping
in a poor low-income country. long-run, the consun
be a necessity in a high-income country and a luxury
demand depends on the time period. Over the long-run, eo
3. Time Period. Income elasticity of
D e C o

in income with the result that a luxury today

patterns of the people may change with changes
necessity after the lapse of a few years.
 The Elasticity of Demand: 165

demonstratio effect also plays an important role in

Effect. The
changing the tastes,
D e m o n s t r a t i o n

hoices
and choi
people and hence the income elasticity of demand for different
of the
ences Tncrease in ncome It is the frequency of increase types of goods.
5 Prequ ency of
in income which determines
income
p r e l e

demand for goods.

If thee frequency is greater, income
to buy comforts and luxuries.
elasticity will be high because there will be
elasticity

tendency
to
general
a FACTORS AFFECTING PRICE ELASTICITY OF DEMAND
6. F
Elasticity of demand for any commodity is determined oriinfluenced
by a number of factors which are discussed
der
a su n d e r

af the Commodity.
The elasticity of
demand for any commodity depends upon the category
(1) N s ie. whether it is a necessity, comfort, or
to which it luxury. The demand for necessaries of life or
eossaries is generally less elastic. For example, the demand for necessaries like food, salt,
convenio does not change much with the rise or fall in their prices. Similar is the case with commodities which
matches, e
of marriage, death ceremonies, etc.
at the time
are requi I and for necessaries of eficiency (such as milk, eggs, butter,
etc.), and for comforts is moderately
c ewith the rise or fall in their prices, the demand for them decreases or increases moderately. On
elasn hand, the demand for luxuries is more elastic because with a small change in their prices there is a
in their demand.
large change
Dt fhe demand for prestige goods, like jewels, rare coins, rare stamps, paintings by Tagore or Picasso,
etc.is inelastic because they possess unique utility for the buyers who are prepared to buy them at all costs.
2) Substitutes. Commodities having substitutes have more elastic demand because with the change in
the price of one commodity, the demand for its substitute is immediately affected. For example, if the price of
rices the demand for coffee will decrease and that for tea will increase, and vice versa. But the demand
no good substitutes is inelastic.
for commodities having
8) Variety of Uses. The demand for a commodity having composite demand or variety of uses is more
elastic. Such commodities are coal, milk, steel, electricity, etc. For example, coal is used for cooking and heating,
for power generation, in factories, in locomotives, etc. If there is a slight fall in the price of coal, its demand will
increase from all quarters. On the other hand, a rise in its price will bring a considerable decrease in demand in
less important uses (domestic), and in more important uses efforts will also be made to economise its use, as in
railways and factories. Thus the overall effect will be a reduction in demand. A commodity which cannot be put
to more than one use, has less elastic demand.
(4) Joint Demand. There are certain commodities which are jointly demanded, such as car and petrol, pen
and ink, bread and jam, ete. The elasticity of demand of the second commodity depends upon the elasticity of
demand of the major commodity. If the demand for cars is less elastic, the demand for petrol will also be less
elastic. On the other hand, if the demand for, say, bread is elastic, the demand for jam will also be elastic.
(5) Deferred Consumption. Commodities whose consumption can be deferred (postponed) have an
elastic demand. This is the case with durable consumer goods, like cloth, bicycle, fan, etc. If the price of any
oT these articles rises, people will postpone their consumption. As a result, their demand will decrease, and vice
versa.
(0 Habits. People who are habituated to the consumption of a particular commodity, like coffee, tea or
arette of a particular brand, the demand for it will be inelastic. We find that the prices of coffee, tea and
e s increase almost every year but there has been little effect on their demand because people are in the
habit of
consuming them.
Income Groups. The elasticity of demand also depends on the income group to which a person
i ersons who belong to the higher income group, their demand for commodities is less elastic. It 1s
c a l to a rich man whether the price of a commodity has fallen or risen, and hence his demand for the
dlat will be unaffected. On the other hand, the demand of persons in lower income groups is generally
nof Se or fall in the prices of commodities will reduce or increase the demand on their part. But this does
not a
O the case of necessities, the demand for which on the part of the poor is less elastic.
atatinroportion of Income Spent. If the consumer spends a small proportion of his income on a commodity
Such comuand for that commodity is less elastic because he does not bother much about small expenditure.
Proportio e s are shoe polish, pen, pencil, thread, needle, etc. But commodities which entail a large
income of the
OT the the demand for them is elastic, such as bicycle, watch, etc.
consumer,
166: Microeconomic Theory demand for comme
elasticity of es,
the ela level is low, the
e
influences
Level of Prices. The
level of prices also
elastic, and
o m m o d i t i e s is elastnc, a
commodities
when the price
hioh price and great or at least
nand is
nand for
c
the price level is high, the demand the fall goes so fast 4d
of demand gt Cades away if
is

elastic. As elabroated by Marshall, "Elasticity falls, and graduany

declines as the price
O medium prices, but it the elasticity
fluencing
ofddemand forc
ofhoi
level is reached." role in in the elasticityCoMand
be
important the
lesser
wi and
(10) Time Factor. Time factor pla
an
commodity, buying a
buys a consumer takes in
The shorter the time in which the which the possible redity
consumer

the other hand,

the longer the
time
Stigler mentions three reasons
run, the consumer ha or
that product. On the for that
product. Prot. In the long
demand elasticity. his consumeab
higher will be the elasticity of
higher thantime
the
short-period

his budget,
and might change
umption paten
long-period elasticity being takes
to readjust
knowledge of tthe price changes,
changes.
due to possible technological
ELASTICITY

PRICE
CONCEPT
OF
and undee
IMPORTANCE OF THE in the
formulation
ng d,
7. importance
practical
is of great
of elasticity the price for his
The concept problems.
policies and
Price. A monopolist while fixing he will profit moo
of economic elastic,
Monopoly for his product is
number
ofdemand. the demand price. Similarly, a nDre
Determination

In the If highter
(1)
its elasticity of
in position to fix a
his product Tf n
elastic, he is
a
d e m a n d in pricing
into
consideration
demand is less
of elasticity
of cue demany
In c a s e the the degree attract s o m e additional customer
a low price. has to study he can
competition
relation to the
other producers,
demand will not induce hic
monopolistic
is m o r e
elastic in
a relatively
inelastic Customen
for his product On the other hand,
of his product. discriminati
lowering the price the price of his product. Monopoly.
Under monopoly
e
on the elasticity of denm
if he raises Discriminating
to leave him D e t e r m i n a t i o n of Price
under
also depends demand i
monopolist five saa low
markets
(2) In the s a m e commodity
in two different the discriminating
of pricing the for his commodity,
problem elastic demand
the market with he charges a high
price.
each market. In in fixinggnprias
market with less elastic demand,
Elasticity of demand further helps
in the Uilities.
a high price is chard
price and Prices of Public
D e t e r m i n a t i o n of services is inelastic,
demand for
(3) In the utilities. Where the domestic demand for electric
rendered by public instance, the
for the services demand a low price
is charged. For that convenient substitutes
elastic know
while in the case of rates. The latter
Boards charge high lower rates beca
the State Electricity c o n c e r n s are charged
being less elastic, available. But factories and other manufacturing
electricity are not like coal, oil or diesel power.
of good substitutes of
the authorities are
aware of the presence
Products. The concept of
the elasticity of demand is mud
Determination of Prices of Joint and straw, cotton and
cotton seeds, etc. h
(4) In the wool and mutton, wheat
use in the pricing of joint
products, like the price of each is fixet
of each commodity is not known. Therefore,
of production an inelak
such cases separate cost wheat and cotton having
of demand. That is why products like wool, seeds which hat
on the basis of its elasticity straw and cotton
compared to their by- products like mutton,
demand are priced very high as

an elastic demand. is
The concept of elasticity of demand
5) In the Determination of Wages. of labour. If the demand for labo0ur m
of wages of a particular type
important in the determination avail in raising wages. If, howev
industry is elastic, stríkes and other trade union tactics will not be of any
the threat of a strike by the union will induce the employers to radlse
demand for labour is inelastic, even

wages of workers in an industry. thal prom

Promotional BElasticity It is the knowledge of the concept of elasticity
(6) The Basis of
producers to spend large sums of money on advertising
their products. For they know that adverb
makes the demand for the product less elastic, so that raising the price will not reduce its sales. This Tcau
concept of promotional elasticity which measures the responsiveness of sales to changes in advelu
other promotional expenses. The formula for this is:
Changes in sales Sum ofpromotional expenses
Promotional Elasticity Sum ofsales Change in promotional expenses
 The Elasticity of Demand:167

iomce in Government Policies. We may now discuss the application of the concept of elasticity
t h e formulation of government policies in various fields.
mand ranting protection. The government considers the elasticity of demand of the products of
of) hich apply for the
grant of a subsidy or protection. Subsidy or protection is
given tounless
only
those
ndustruhose products have an elastic demand. They
ndustries
are unable to face foreign competition
those i
ugh subsid
wered through subsidy or by raising the prices of imported goods by imposing heavy duties
t h e i rp r i c e s

publie
lic utilities. Similarly, the
)While deciding about the elasticity government decision
them.

to declare certain industries

denends upon of demand for their
products.
It is in public interest that
only
as pub
should be taken Over and run as public utilities by the state, the demand for whose products
t h o s e i n d u s t r i e s

1s in this way able to provide essential goods and services to the

The state people at reasonable
exploitation.
eliminating monopolistic
thus
alcs
s:l Eyplains the paradox of poverty in the midst of plenty
One of
great contradictions in private enterprise economies is
he

adox of poverty in the midst potential plenty. A rich harvest

of
thep a r a d o x
growers might ruin them, if the
bringing prosperity to
instead of
Since the demand for, say, wheat
inelasti
the product is
P
mand for a large fall in its price. In such a
a bumper crop Will bring
isinelast will be the losers, because the total revenue
Situatton,
the farmers
from the is
mper crop less than that from a small
obtained by them P
illustrated in Figure 17
This is
crop. curve and S is the supply curve of an ordinary
D is the demand
at E establishes OP price at which Oo
uheat crop. Their equilibrium
nantity is bought and sold. The bumper crop increases the supply
hS which lowers the price to OP and increases the supply to O0
Initially, the total revenue was OPEQ and after the bumper crop it is
OP EO. The difference between the rectangles P,PER and ORE,O.
Wheat
is the reduction in total revenue following the increase in the supply Fig. 17
of wheat.
(iv) In fixing minimunm prices for farm products. Government
policies of guaranteeing minimum prices for farm products, price
S
Support programmes and creating buffer stocks are meant to stabilise a
agricultural prices, to nullify the efftect of bumper crops and to P
encourage farmers to produce more. How guaranteed minimum prices
help the farmers in selling their farm products without incurring a
loss in total income is illustrated in Figure 18. Suppose in the previous
yearthe equilibrium price of wheat was OP at which OQ quantity P
was bought and sold. In anticipation of a bumper wheat harvest,
the government fixes OP, as the minimum price of wheat for the
curent year. But at this price, the quantity supplied will be O0, and
the quantity demanded 00,. In order to make its price policy
etfective,the government will have to purchase 0,2, (=ds) amount
0T Whieat from the market at OP, price and creating buffer stocks at
the same time.
(mportance to the finance minister. The concept or
Rsicity of demand is of paramount importance to the finance Wheat
Fig. 18
ST, The finance minister has to find out how he can bring more
revenue
he tne exchequer. For this, he must know the elasticity of demand of the product on which the tax is to
inelaets Let us ilustrate with the help of Figure 19 whether a tax on a product with elastic demand or
4sC demand would bring larger revenue to the exchequer.
n n a l demand curve is D and the supply curve is S. They set a price PQ at which OQ quantity is
Xchangen e supply curve for the product after the imposition of the excise duty is S, So drawn because an
ndirect a s the impact of reducing the quantity demanded as the price of the product rises. As a result, the
168: Microeconomic Theory

$ame quantity O0 will be sold by the producer at P, price (a

PP, higher price equal to the tax). In this situation, no consumer
Would buy the product at all. However, they are prepared to u
s
Since D
d
reduced quantity O0, at a slightly higher price P,2, revenue
an elastic curve, the
government obtains 7,R,PS, total
on the sale of O0, quantity of the product But
when the demand
total revenue. D 5
Tor product is less elastic, it gains more inthe price P,, wIn
ess elastic demand curve which sets
As the deman
the excise duty.
Suppiy curve S, after the levy of much. It is O0,
The
stac D
1S
elastic, demand is not reduced
less
is greater tha
is T.R.PS, which
revenue from the excise duty is
obvious conclusion
w h e n the demand is
elastic. The
revenue by levying indireet
h a t the government would get larger the gooas Quantity
demand than from 19
with less elastic
taxes on goods
Trade,O0A 0 HPig.
with elastic demand.
in the
Problems of International
importance in
analySing some of the comnla.
porlance has great practical the terms of trade,
the gains fro
of elasticity of demand trade, te
ne concept
the volume of exports and imports,
international trade, such as
Or balance of payments. at which a country exchanges
her ev
effects of tariffs, and the refer to the rate
The terms of trade take place, will be determina
() In terms of trade.
will
The exact rate at
which exchanges by the
imports from the
other country.
countries for each other's products.
demand of the two on the elasticity of demand
relative elasticities of
The gains from trade depend,
among others, We
irade. demand and import those goods fo
(ii) In gains from with less elasticity of
trade if we export goods for our products anddiin the
gain from international the first case, we will be in a position to charge a high price
our demand is
elastic. In
obtained from the other country.
Thus, we gain both wae ways and
will be paying less for the goods
latter case we
and imports.
volume of our exports
shall be able to increase the
of domestic goods. The extent internal prices
to which nri
policy Tariffs tend to raise the prices goode
(iil) In tarif If the demand for the protected ods is
the elasticity of demand of the protected goods.
rise depends on
Conversely, if the demand is less elastic, people wil
reduced with the rise in prices.
elastic, their sales will be as a result of the tariff policy.
have to bear the burden of higher prices
devaluation. The consideration of elasticity of demand for imports and exports
(iv) In the policy of of correcting its adverse balance of payments by devaluation
important for a country, which is thinking dearer of the country adopting it. Suppose we resortt
Devaluation makes exports cheaper and imports
effect will be that the prices of our imports will rise and we will be
devaluation, as we did in June 1966. Its first
of demand for imports. On the other hand, te
induced to reduce our imports. But this depends upon elasticity
fall in the foreign price of our exports will induce us to export more, but it depends upon the elasticity of demand
to reduce the gap betwean
of the foreigners for our products. Thus the extent to which we are in a position
receipts and expenditure of foreign exchange depends upon the elasticities of demand for exports and impors

EXERCISES
1Explain the concept of price elasticity of demand and examine the various methods of its measurement
2. The concept of elasticity is a versatile tool of economic analysis." Discuss the validity of this statemen
appropriate instances.
3. What is income elasticity of demand? How do we measure it? slopeot
4. Define price elasticity of demand. Show with the help of a diagram the difference between elasticity an

a demand curve on a given point ofthe demand curve.

i for(
5. Define cross elasticity of demand. How do we measure it? Show the nature of cross elasticity of demanu
substitutes, (ii) complementary goods, and (11) independent goods.
6. Differentiate between the 'point' and 'arc' methods of measuring price elasticity of demand.