CHAPTER -2

THEORY OF DEMAND AND SUPPLY

UNIT -1: LAW OF DEMAND AND ELASTICITY OF DEMAND

Unit
1
www.kalyaninstitute.org
enquirykalyan247@gmail.com
Page 2 .1
9463862929
 MEANING OF DEMAND
The term ‘demand’ refers to the quantity of a good or service that buyers are
willing and able to purchase at various prices during a given period of time. It is to
be noted that demand, in Economics, is something more than the desire to
purchase, though desire is one element of it. For example, people may desire much
bigger houses, luxurious cars etc. But there are also constraints that they face such as
prices of products and limited means to pay. Thus, wants or desires together with the real
world constraints determine what they buy. The effective demand for a thing depends on
(i) desire (ii) means to purchase and (iii) willingness to use those means for that
purchase. Unless desire is backed by purchasing power or ability to pay and willingness
to pay, it does not constitute demand. Effective demand alone would figure in economic
analysis and business decisions.

So Effective Demand = Desire + Means to Purchase + Wiilingness to use those

means for that Purpose.

Two things are to be noted about the quantity demanded.

(i) The quantity demanded is always expressed at a given price. At different prices
different quantities of a commodity are generally demanded.
(ii) The quantity demanded is a flow Concept. We are concerned not with a single
isolated purchase, but with a continuous flow of purchases and we must therefore
express demand as ‘so much per period of time’ i.e., one thousand dozens of oranges
per day, seven thousand dozens of oranges per week and so on
WHAT DETERMINES DEMAND?
1.) Price of the commodity: Obviously, the good’s own price is a key determinant of its
demand. Ceteris paribus i.e. other things being equal, the demand for a commodity is
inversely related to its price. It implies that a rise in the price of a commodity brings about
a fall in the quantity purchased and vice-versa. This happens because of income and
substitution effects.
2.) Price of related commodities: Related commodities are of two types:
(i) complementary goods and (ii) competing goods or substitutes.
Complementary goods and services are those that are bought or consumed
together or simultaneously. Examples are: tea and sugar, automobile and petrol and
pen and ink. The increase in the demand for one causes an increase in the demand for
the other. When two commodities are complements, a fall in the price of one (other
things being equal) will cause the demand for the other to rise. For example, a fall in
the price of petrol-driven cars would lead to a rise in the demand for petrol. Similarly,
computers and computer software are complementary goods. A fall in the price of
computers will cause a rise in the demand for software. The reverse will be the case
when the price of a complement rises. An increase in the price of a complementary good
reduces the demand for the good in question. Thus, we find that, there is an inverse
relation between the demand for a good and the price of its complement.

Unit
1
www.kalyaninstitute.org
enquirykalyan247@gmail.com
Page 2.2
9463862929
Two commodities are called competing goods or substitutes when they satisfy the
same want and can be used with ease in place of one another. For example, tea and
coffee, ink pen and ball pen, different brands of toothpaste etc. are substitutes for each
other and can be used in place of one another easily. When goods are substitutes, if the
price of a product being purchased goes up, buyers may switch to a cheaper substitute.
This decreases the demand for the product at a given price, but increases the demand
for the substitute. Similarly, a fall in the price of a product (ceteris paribus) leads to
a fall in the quantity demanded of its substitutes. For example, if the price of tea falls,
people will try to substitute it for coffee and demand more of it and less of coffee i.e. the
demand for tea will rise and that of coffee will fall. Therefore, there is direct or positive
relation between the demand for a product and the price of its substitutes.
3.) Disposable Income of the consumer:-
The purchasing power of a buyer is determined by the level of his disposable
income. Other things being equal, the demand for a commodity depends upon the
disposable income of the potential purchasers. In general, increase in disposable income
tends to increase the demand for particular types of goods and services at any given
price. A decrease in disposable income generally lowers the quantity demanded at all
possible prices. The nature of relationship between disposable income and quantity
demanded depends upon the nature of goods. A basic description of the nature of goods
is useful in describing the effect of income on demand. Normal goods are those that are
demanded in increasing quantities as consumers’ income increases. Most goods
and services fall under the category of normal goods. Household furniture, clothing,
automobiles, consumer durables and semi durables etc. fall in this category. When
income is reduced (for example due to recession), demand for normal goods falls.
Demand of normal goods Increases or Decreases according to Income Level of the
consumer, but Proportion of Increase in Income is always More than Increase in
Demand of Goods. Normal Goods also includes Durable Goods Like TV,AC,
Refrigerator etc.

Unit
1
www.kalyaninstitute.org Page 2.3
enquirykalyan247@gmail.com 9463862929
There are some commodities for which the quantity demanded rises only up to a
certain level of income and decreases with an increase in money income beyond
this level. These goods are called inferior goods. Essential consumer goods such as
food grains, fuel, cooking oil, necessary clothing etc. satisfy the basic necessities of life
and are consumed by all individuals in a society. A change in consumers’ income,
although will cause an increase in demand for these necessities, but this increase will be
less than proportionate to the increase in income. This is because as people become
richer, there is a relative decline in the importance of food and other non durable goods
in the overall consumption basket and a rise in the importance of durable goods such as
a TV, car, house etc. Demand for luxury goods and prestige goods arise beyond a
certain level of consumers’ income and keep rising as income increases. Business
managers should be fully aware of the nature of goods which they produce (or the nature
of need which their products satisfy) and the nature of relationship of quantities
demanded with changes in buyers’ incomes. For assessing the current as well as future
demand for their products, they should also recognize the movements in the macro
economic variables that affect buyers’ incomes.
4.) Tastes and preferences of buyers:-
The demand for a commodity also depends upon the tastes and preferences of
buyers and changes in them over a period of time. Goods which are modern or more
in fashion command higher demand than goods which are of old design or are out of
fashion. Consumers may perceive a product as obsolete and discard it before it is fully
utilized and then prefer another good which is currently in fashion. For example, there is
greater demand for the latest digital devices and trendy clothing and we find that more
and more people are discarding these goods currently in use even though they could
have used it for some more years. External effects on utility such as' demonstration
effect',' bandwagon effect’, Veblen effect and ‘snob effect’ do play important roles in
determining the demand for a product. Demonstration effect(Dekha-Dekhi), a term
coined by James Duesenberg, refers to the desire of people to emulate the
consumption behavior of others. In other words, people buy or have things because
they see that other people are able to have them. For example, an individual’s demand
for cell phone may be affected by his seeing a new model of cell phone in his neighbor's
or friend’s house, either because he likes what he sees or because he figures out that if
his neighbor or friend can have it, he too can. Bandwagon effect(Bhed Chaal) refers to
the extent to which the demand for a commodity is increased due to the fact that
others are also consuming the same commodity. It represents the desire of people to
purchase a commodity in order to be fashionable or stylish or to conform to the people
they wish to be associated with

Unit
1
Page 2.4
By ‘Snob effect’ we refer to the extent to which the demand for a consumers'
good is decreased owing to the fact that others are also consuming the same
commodity. This represents the desire of people to be exclusive; to be different; to
dissociate themselves from the "common herd." For example, when a product becomes
common among all, some people decrease or altogether stop its consumption.
By Veblen Effect, this was given by Thorstein Veblen. in which highly Priced
Goods are Consumed by status seeking rich people to satisfy their needs for
Conspicous Consumption.

Difference between Demonstration/Bandwagon Effect and Snob Effect

Demonstration/Bandwagon Effect Snob Effect

It is understood as the desire to possess a

It is a psychological effect in which people
unique commodity having a prestige value.
do the same what others are doing. They do
It is quite opposite to the bandwagon or
not have their own belief and thinking.
demonstration effect.

It leads to increase in demand of a It leads to decrease in demand of a

particular commodity. particular commodity

Example: If Miss. X and Miss. Y are rich

Example: When some people start rivals of each other and if in any party
investing money in share market then many Miss. X wears an expensive dress and on
people start following the same without seeing it Miss. Y who also having the same
considering its advantages and dress decided to reject the use of the same
disadvantages. dress further. Rather Miss. Y will try to use
even more expensive one.

15.)Consumers’ Expectations:-
Consumers’ expectations regarding future prices, income, supply conditions etc.
influence current demand. If the consumers expect increase in future prices, increase in
income and shortages in supply, more quantities will be demanded. If they expect a fall in
price or fall in income they will postpone their purchases of nonessential commodities and
therefore, the current demand for them will fall. Levels of consumer and business
confidence about their future economic situations also affect spending and demand.

Unit
1
www.kalyaninstitute.org Page 2.5
enquirykalyan247@gmail.com 9463862929
 Other factors:
1.) Size of population: Generally, larger the size of population of a country or a
region, larger would be the number of buyers and the quantity demanded in the
market would be higher at every price. The opposite is the case when population is less.
2.) Age Distribution of population: If a larger proportion of people belong to older
age groups relative to younger age groups, there will be increased demand for
geriatric care services, spectacles, walking sticks, etc. and less demand for children’s
books. Similarly, if the population consists of more of children, demand for toys, baby
foods, toffees, etc. will be more. Likewise, if there is migration from rural areas to
urban areas, there will be decrease in demand for goods and services in rural
areas.
3.) The level of National Income and its Distribution: The level of national
income(Income of All the Persons living in the Country) is a crucial determinant of market
demand. Higher the national income, higher will be the demand for all normal
goods and services. The wealth of a country may be unevenly distributed so that
there are a few very rich people while the majority is very poor. Under such conditions,
the propensity to consume(that part of Income which is Spent by the Person) of the
country will be relatively less, because the propensity to consume of the rich people is
less than that of the poor people. Consequently, the demand for consumer goods will be
comparatively less. If the distribution of income is more equal, then the propensity to
consume of the country as a whole will be relatively high indicating higher demand for
goods.
4.) Consumer-credit facility and interest rates: Availability of credit facilities
induces people to purchase more than what their current incomes permit them. Credit
facilities mostly determine the demand for investment and for durable goods which are
expensive and require bulk payments at the time of purchase. Low rates of interest
encourage people to borrow and therefore demand will be more
5.) Government policies and regulations:
The governments influence demand through its taxation, purchases, expenditure, and
subsidy policies. While taxes increase prices and decrease the quantity demanded,
subsidies decrease the prices and increase the quantity demanded. For example taxes on
luxurious goods and subsidies for solar panels. Similarly total bans, restrictions and higher
taxes may be used by government to restrict the demand for socially undesirable goods
and services. Government’s policy on international trade also will affect the domestic demand
for goods and services. Apart from above, factors such as weather conditions, business
conditions, stage of business cycle, wealth, levels of education, marital status, socioeconomic
class, group membership, habits of the consumer, social customs and conventions,
salesmanship and advertisements also play important roles in influencing demand.

Unit
1
www.kalyaninstitute.org Page 2.6
enquirykalyan247@gmail.com 9463862929
 THE DEMAND FUNCTION:--

THE LAW OF DEMAND:--

“The greater the amount to be sold, the smaller must be the price at which it is
offered in order that it may find purchasers or in other words the amount
demanded increases with a fall in price and diminishes with a rise in price”.

The law of demand states that other things being equal, when the price of a good rises
, the quantity demanded of the good will fall. Thus, there is an inverse relationship
between price and quantity demanded, ceteris paribus. The ‘other things’ which are
assumed to be equal or constant are the prices of related commodities, income of
consumers, tastes and preferences of consumers, and all factors other than price which
influence demand.If these factors which determine demand also undergo a change, then
the inverse price-demand relationship may not hold good. For example, if incomes of
consumers increase, then an increase in the price of a commodity, may not result in a
decrease in the quantity demanded of it. Thus, the constancy of these ‘other factors’
is an important assumption of the law of demand.

The Demand Schedule - Tabular Presentation of Law of Demand

A demand schedule is a table showing the quantities of a good that buyers would
choose to purchase at different prices, per unit of time, with all other variables held
constant

Unit
1
www.kalyaninstitute.org Page 2.7
enquirykalyan247@gmail.com 9463862929
 The Demand Curve:-
A demand curve is a graphical presentation of the demand schedule. By convention,
the vertical axis of the graph measures the price per unit of the good. The horizontal axis
measures the quantity of the good, which is usually expressed in some physical measure
per time period. By plotting each pair of values as a point on a graph and joining the
resulting points, we get the individual’s demand curve for a commodity.

Market Demand
The market demand for a commodity gives the alternative amounts of the commodity
demanded per time period, at various alternative prices, by all the buyers in the
market.

The market demand for a commodity thus depends on all the factors that determine
the individual’s demand and, in addition, on the number of buyers of the
commodity in the market.

The Market Demand Curve

The market demand curve for good X represents the quantities of good X
demanded by all buyers in the market for good X. The market demand curve is
obtained by horizontal Summation of all individual demand curves.

Unit
1
www.kalyaninstitute.org Page 2.8
enquirykalyan247@gmail.com 9463862929
 Rationale of the Law of Demand
the basic or underlying reason or explanation for it
1.) Price Effect of a fall in price: The price effect which indicates the way the consume
r's purchases of good X change, when its price changes, is the sum of its two
components namely: substitution effect and income effect.
Substitution effect: Hicks and Allen have explained the law in terms of substitution
effect and income effect. The Substitution effect describes the change in demand
for a product when its relative price changes. When the price of a commodity falls,
the price ratio between items change and it becomes relatively cheaper than other
commodities. Assuming that the prices of all other commodities remain constant, it
induces consumers to substitute the commodity whose price has fallen for other
commodities which have now become relatively expensive. The result is that the total
demand for the commodity whose price has fallen increases. This is called substitution
effect. When the price falls, the substitution effect is always positive; i.e it will
always cause more to be demanded. The substitution effect will be stronger when:

(a) the goods are closer substitutes

(b) there is lower cost of switching to the substitute good
(c) there is lower inconvenience while switching to the substitute good.

2.)Income effect: The increase in demand on account of an increase in real

income is known as income effect. When the price of a commodity falls, the
consumer can buy the same quantity of the commodity with lesser money or he can buy
more of the same commodity with the same amount of money. In other words, as a
result of fall in the price of the commodity, consumer’s real income or purchasing
power increases. A part or whole of the resulting increase in real income can now be
used to buy more of the commodity in question, given that the good is normal.
Therefore, the demand for that commodity (whose price has fallen) increases. However,
there is one exception. In the case of inferior goods, the income effect works in
the opposite direction to the substitution effect. In the case of inferior goods, the
expansion in demand due to a price fall will take place only if the substitution effect
outweighs the income effect

Unit
1
www.kalyaninstitute.org Page 2.9
enquirykalyan247@gmail.com 9463862929
2.) Utility maximising behaviour of Consumers: A consumer is in equilibrium (i.e.
maximises his satisfaction) when the marginal utility of the commodity and its
price equalize. According to Marshall, the consumer has diminishing utility for each
additional unit of a commodity and therefore, he will be willing to pay only less for each
additional unit. A rational consumer will not pay more for lesser satisfaction. He is
induced to buy additional units only when the prices are lower. The operation of
diminishing marginal utility and the act of the consumer to equalize the utility of the
commodity with its price result in a downward sloping demand curve.
Units Marginal Utility Price
1 ₹50/- ₹28/-
2 ₹40/- ₹28/-
Consumer
3 ₹28/- ₹28/- Equilibrium
4 ₹10/- ₹28/-
3.) Arrival of new consumers: When the price of a commodity falls, more
consumers start buying it because some of those who could not afford to buy it earlier
may now be able to buy it. This raises the number of consumers of a commodity at a
lower price and hence the demand for the commodity in question increases. For example:
At the time of Launch Iphone 7 Price was ₹1,00,000/- but now at this time Iphone 7 is of
₹25,000 to 30,000/-, Now at this time More consumer will be able to buy it.
4.) Different uses: Many commodities have multiple uses. When the price of such
commodities are high (or rises) they will be put to limited uses only. If the prices of
such commodities fall, they will be put to more number of uses and therefore their
demand will increase. Thus, the increase in the number of uses consequent to a fall in
price make the buyer demand more of such commodities making the demand curve slope
downwards. For example : Milk
Exceptions to the Law of Demand - Law of demand is Universal - No there are
Some Exception of Law of Demand
1.) Conspicuous goods: Articles of prestige value or snob appeal or articles of conspicuous
consumption are used by the rich people as status symbol for enhancing their social
prestige or /and for displaying wealth. These articles will not conform to the usual law of demand
as they become more attractive only if their prices are high or keep going up. This was found out by
Veblen in his doctrine of “Conspicuous Consumption” and hence this effect is called Veblen effect or
prestige goods effect. Veblen effect takes place as some consumers measure the utility of a
commodity y its price i.e., if the commodity is expensive they think that it has got more utility. As
such, they buy less of this commodity at low price and more of it at high price. Diamonds are often
given as an example of this case. Higher the price of diamonds, higher is the prestige value
attached to them and hence higher is the demand. These are also called Veblen Goods or Snob
Goods or Prestige goods
2.) Giffen goods: Sir Robert Giffen, a Scottish economist and statistician, was surprised to find
out that as the price of bread increased, the British workers purchased more bread and not
less of it. This was something against the law of demand.Unit
1
www.kalyaninstitute.org Page 2.10
enquirykalyan247@gmail.com 9463862929
 Why did this happen? The reason given for this is that, when the price of bread went up,
it caused such a large decline in the purchasing power of the poor people that they were
forced to cut down the consumption of meat and other more expensive foods. Since
bread, even when its price was higher than before, was still the cheapest food article,
people consumed more of it and not less when its price went up.
Such goods which exhibit direct price-demand relationship are called ‘Giffen
goods’. Generally those goods which are inferior, with no close substitutes
available and which occupy a substantial place in consumers’ budget are called
‘Giffen goods’. All Giffen goods are inferior goods; but all inferior goods are not Giffen
goods. Examples of Giffen goods are coarse grains like bajra, low quality rice and wheat
etc. Demand Curve for giffen goods is always upward sloping beacuse there is
direct relation between X- axis and y- axis.All Giffen Goods are Inferior Goods but
all Inferior Goods are not giffen goods.

3.) Conspicuous necessities: The demand for certain goods is affected by the
demonstration effect of the consumption pattern of a social group to which an
individual belongs. These goods, due to their constant usage, become necessities of
life. For example, in spite of the fact that the prices of television sets, refrigerators, air-
conditioners etc. have been continuously rising, their demand does not show any
tendency to fall.

4.) Future expectations about prices: It has been observed that when the prices are
rising, households, expecting that the prices in the future will be even higher, tend
to buy larger quantities of such commodities. For example, when there is wide-spread
drought, people expect that prices of food grains would rise in future. They demand
greater quantities of food grains even as their price rises. On the contrary, if prices are
falling and people anticipate further fall, rather than buying more, they postpone their
purchases. However, it is to be noted that here it is not the law of demand which is
invalidated. There is a change in one of the factors which was held constant while
deriving the law of demand, namely change in the price expectations of the people.

5.) Incomplete information and irrational behaviour: The law has been derived
assuming consumers to be rational and knowledgeable about market-conditions.
However, at times, consumers have incomplete information and therefore make
inconsistent decisions regarding purchases. Similarly, in practice, a household may
demand larger quantity of a commodity even at a higher price because it may be ignorant
of the ruling price of the commodity. Under such circumstances, the law will not remain
valid.
Unit
1
www.kalyaninstitute.org Page 2.11
enquirykalyan247@gmail.com 9463862929
Sometimes, consumers tend to be irrational and make impulsive purchases without
any rational calculations about the price and usefulness of the product and in such
contexts the law of demand fails.
Demand for necessaries: The law of demand does not apply much in the case of
necessaries of life. Irrespective of price changes, people have to consume the minimum
quantities of necessary commodities.

6.)Demand for necessaries: The law of demand does not apply much in the case of
necessaries of life. Irrespective of price changes, people have to consume the minimum
quantities of necessary commodities.

7.)Speculative goods: In the speculative market, particularly in the market for

stocks and shares, more will be demanded when the prices are rising and less will
be demanded when prices decline.

Demand Quantity Demanded

QD is units Demanded at Particular Price.It is

Demand Shows entire relationship between Price and QD
specific to a price

EXPANSION AND CONTRACTION OF DEMAND- occurs due to change in price

The demand schedule, demand curve and the law of demand all show that when the
price of a commodity falls, its quantity demanded increases, other things being
equal. When, as a result of decrease in price, the quantity demanded increases, in
Economics, we say that there is an expansion of demand and when, as a result of
increase in price, the quantity demanded decreases, we say that there is a contraction of
demand. For example, suppose the price of apples is ₹ 100/ per kilogram and a consumer
buys one kilogram at that price. Now, if other things such as income, prices of other goods
and tastes of the consumers remain the same but the price of apples falls to ₹ 80 per
kilogram and the consumer now buys two kilograms of apples, we say that there is a
change in quantity demanded or there is an expansion of demand. On the contrary, if the
price of apples rises to ₹ 150 per kilogram and the consumer then buys only half a
kilogram, we say that there is a contraction of demand.

Unit
1
www.kalyaninstitute.org
Page 2.12
enquirykalyan247@gmail.com 9463862929
 Increase and Decrease in Demand :-
Till now we have assumed that the other determinants of demand remain constant when
we are analysing the demand for a commodity. It should be noted that expansion and
contraction of demand take place as a result of changes in the price while all other
determinants of price viz. income, tastes, propensity to consume and price of
related goods remain constant. The ‘other factors remaining constant’ means that the
position of the demand curve remains the same and the consumer moves downwards or
upwards on it.

There are factors other than price (non-price factors) or conditions of demand
which might cause either an increase or decrease in the quantity of a particular
good or service that buyers are prepared to demand at a given price. What happens
if there is a change in consumers’ tastes and preferences, income, the prices of the
related goods or other factors on which demand depends? As an example, let us
consider what happens to the demand for commodity X if the consumer’s income
increases:

Unit
1
www.kalyaninstitute.org
Page 2.13
enquirykalyan247@gmail.com 9463862929
The table below summarises the effect of non - price determinants on demand

Changes in determinants other than Changes in determinants other than price

price that cause increase in demand that cause Decrease in Demand (Leftward
(Rightward shift of demand curve when shift of demand curve when less is
more is demanded at each price) demanded at each price)

A fall in income in case of normal Decrease in wealth in case of normal

goods, and a rise in income in case of goods, and an increase in wealth in case
inferior goods of inferior goods

Rise in the price of a substitute good Fall in the price of a substitute good

Fall in the price of a complement Rise in the price of a complement

An increase in the number of buyers A decrease in the number of buyers

A change in tastes in favour of the

A change in tastes against the commodity
commodity

A redistribution of income to groups of Redistribution of income away from groups

people who favour the commodity of people who favour the commodity.

An expectation that price will rise in the An expectation that price will fall in the
future future

Government policies encouraging Government regulations discouraging

consumptionof the good Eg. Grant of consumption e.g. ban on cigarette smoking
consumer subsidies / ban on consumption.

Unit
1
www.kalyaninstitute.org
Page 2.14
enquirykalyan247@gmail.com 9463862929
 Movements along the Demand Curve vs. Shift of Demand Curve

It is important for the business decision-makers to understand the distinction between a

movement along a demand curve and a shift of the whole demand curve.
A movement along the demand curve indicates changes in the quantity demanded
because of price changes, other factors remaining constant. A shift of the demand
curve indicates that there is a change in demand at each possible price because
one or more other factors, such as incomes, tastes or the price of some other
goods, have changed.
Thus, when an economist speaks of an increase or a decrease in demand, he refers to
a shift of the whole curve because one or more of the factors which were assumed to
remain constant earlier have changed. When the economists speak of change in
quantity demanded he means movement along the same curve (i.e., expansion or
contraction of demand) which has happened due to fall or rise in price of the commodity.
In short ‘change in demand’ represents shift of the demand curve to right or left resulting
from changes in factors such as income, tastes, prices of other goods etc. and ‘change in
quantity demanded’ represents movement upwards or downwards on the same demand
curve resulting from a change in the price of the commodity. When demand increases due
to factors other than price, firms can sell more at the existing prices resulting in increased
revenue. The objective of advertisements and all other sales promotion activities by any
firm is to shift the demand curve to the right and to reduce the elasticity of demand. (The
latter will be discussed in the next section). However, the additional demand is not free of
cost as firms have to incur expenditure on advertisement and sales promotion devices.

ELASTICITY OF DEMAND
Elasticity of demand is defined as the degree of responsiveness of the quantity
demanded of a good to changes in one of the variables on which demand depends.
More precisely, elasticity of demand is the percentage change in quantity demanded
divided by the percentage change in one of the variables on which demand depends.

Price Price Elasticity

Income Income Elasticity

Demand

Related Goods Cross Elasticity

Advertisement Advertisement Elasticity

Unit
1
www.kalyaninstitute.org
Page 2.15
enquirykalyan247@gmail.com 9463862929
 Price Elasticity of Demand
Price elasticity of demand which measures the sensitivity of quantity demanded to
‘own price’ or the price of the good itself.
The concept of price elasticity of demand is important for a firm for two reasons.
Knowledge of the nature and degree of price elasticity allows firms to predict the
impact of price changes on its sales.
Price elasticity guides the firm’s profit-maximizing pricing decisions.
Price elasticity of demand expresses the degree of responsiveness of quantity
demanded of a good to a change in its price, given the consumer’s income, his tastes
and prices of all other goods.

This tells Only Direction of Demand, Price

Price Demand
Elasticity tells by hoe Much Amount Price
Elasicity of Demand Changes

Elasticity of Demand(Ep) = -Percentage Change in QD

Percentage Change in Price
Beacuse QD Responds only in Opposite Direction Price Elasticity is Negative
Point Elasticity
The point elasticity of demand is the price elasticity of demand at a particular point on the
demand curve. The concept of point elasticity is used for measuring price elasticity
where the change in price is infinitesimal. Price elasticity is a key element in applying
marginal analysis to determine optimal prices. Since marginal analysis works by
evaluating “small” changes taken with respect to an initial decision, it is useful to
measure elasticity with respect to an infinitesimally small change in price.

Point elasticity makes use of derivative rather than finite changes in price and
quantity. It may be defined as:

Unit
1
www.kalyaninstitute.org
Page 2.16
enquirykalyan247@gmail.com 9463862929
 Measurement of Elasticity on a Linear Demand Curve – Geometric Method
By definition, the price elasticity of demand is the change in quantity associated
with a change in price (∆Q/∆P) times the ratio of price to quantity (P/Q) Therefore,
the price elasticity of demand depends not only on the slope of the demand curve but
also on the price and quantity. The elasticity, therefore, varies along the curve as price
and quantity change. The slope of a linear demand curve is constant. However, the
elasticity at different points on a linear demand curve would be different. When price is
high price is high and quantity is small, the elasticity is high. The elasticity becomes
smaller as we move down the curve.

Arc-Elasticity
Often we may be required to calculate price elasticity over some portion of the
demand curve rather than at a single point. In other words, the elasticity may be
calculated over a range of prices. When price and quantity changes are discrete
and large we have to measure elasticity over an arc of the demand curve.

Interpretation of the Numerical Values of Elasticity of Demand

Economists have found it useful to divide the demand behaviour into different
categories, based on values of price elasticity. Since we draw demand curves
with price on the vertical axis and quantity on the horizontal axis, ∆Q/∆P =
(1/slope of curve). As a result, for any price and quantity combination, the
steeper the slope of the curve, the less elastic is demand.

Unit
1
www.kalyaninstitute.org
Page 2.17
enquirykalyan247@gmail.com 9463862929
 Numerical measure of
Verbal description Terminology
elasticity

Quantity demanded does not Perfectly (or completely)

Zero
change as price changes inelastic

Quantity demanded changes

Greater than zero, but less
by a smaller percentage than Inelastic
than one
does price

Quantity demanded changes

One by exactly the same Unit elasticity
percentage as does price

Quantity demanded changes

Greater than one, but less
by a larger percentage than Elastic
than infinity
does price
Unit
1
www.kalyaninstitute.org
Page 2.18
enquirykalyan247@gmail.com 9463862929
 Numerical measure of
Verbal description Terminology
elasticity

Purchasers are
prepared to buy all they
can obtain at some Perfectly (or infinitely)
Infinity
price and none at all at elastic
an even slightly higher
price

Now that we are able to classify goods according to their price elasticity, let us see whether the goods
mentioned below are price elastic or inelastic.

What do we note in the above hypothetical example? We note that the demand for headphones
is quite elastic, while demand for wheat is quite inelastic and the demand for salt is almost the
same even after a reduction in price. The price elasticity of demand for the vast majority of goods
is somewhere between the two extreme cases of zero and infinity. Generally, in real world
situations also, we find that the demand for goods like refrigerators, TVs, laptops, fans, etc. is
elastic; the demand for goods like wheat and rice is inelastic; and the demand for salt is highly
inelastic or perfectly inelastic. Why do we find such a difference in the behavior of consumers in
respect of different commodities? We shall explain later at length those factors which are
responsible for the differences in elasticity of demand for various goods. Before that, we will
consider another method of calculating price-elasticity which is called total outlay method.

Total Outlay Method of Calculating Price Elasticity

The price elasticity of demand for a commodity and the total expenditure or outlay made on it are
significantly related to each other. As the total expenditure (price of the commodity multiplied by
the quantity of that commodity purchased) made on a commodity is the total revenue received by
the seller (price of the commodity multiplied by quantity of that
Unit
1
www.kalyaninstitute.org
Page 2.19
enquirykalyan247@gmail.com 9463862929
commodity sold of that commodity), we can say that the price elasticity and total revenue received are closely
related to each other. By analyzing the changes in total expenditure (or total revenue) in response to a change in
the price of the commodity, we can know the price elasticity of demand for it.

Price Elasticity of demand equals one or Unity: When, as a result of the change in price of a good, the total
expenditure on the good or the total revenue received from that good remains the same, the price elasticity for the
good is equal to unity. This is because the total expenditure made on the good can remain the same only if the
proportional change in quantity demanded is equal to the proportional change in price. Thus, if there is a given
percentage increase (or decrease) in the price of a good and if the price elasticity is unitary, total expenditure of
the buyer on the good or the total revenue received from it will remain unchanged.

Price elasticity of demand is greater than unity: When, as a result of increase in the price of a good, the total
expenditure made on the good or the total revenue received from that good falls or when as a result of decrease
in price, the total expenditure made on the good or total revenue received from that good increases, we say that
price elasticity of demand is greater than unity. In our example of headphones, as a result of fall in price of
headphones from ₹ 500 to ₹ 400, the total revenue received from headphones increases from ₹ 50,000 (500x100)
to ₹ 60,000 (400 x 150), indicating elastic demand for headphones. Similarly, had the price of headphones
increased from ₹ 400 to ₹ 500, the demand would have fallen from 150 to 100 indicating a fall in the total revenue
received from ₹ 60,000 to ₹ 50,000 showing elastic demand for headphones.

Price elasticity of demand is less than unity: When, as a result of increase in the price of a good, the total
expenditure made on the good or the total revenue received from that good increases or when as a result of
decrease in its price, the total expenditure made on the good or the total revenue received from that good falls, we
say that the price elasticity of demand is less than unity. In the example of wheat above, as a result of fall in the
price of wheat from ₹ 20 per kg. to ₹ 18 per kg. the total revenue received from wheat falls from ₹ 10,000 (20 x
500) to ₹ 9360 (18 x 520) indicating inelastic demand for wheat. Similarly, we can show that as a result of
increase in the price of wheat from ₹ 18 to ₹ 20 per kg, the total revenue received from wheat increase from ₹
9360 to ₹ 10,000 indicating inelastic demand for wheat.

The main drawback of this method is that by using this we can only say whether the demand for a good is elastic
or inelastic; we cannot find out the exact coefficient of price elasticity. Why should a business firm be concerned
about elasticity of demand? The reason is that the degree of elasticity of demand predicts how changes in the
price of a good will affect the total revenue earned by the producers from the sale of that good. The total revenue
is defined as the total value of sales of a good or service. It is equal to the price multiplied by the quantity sold.

Total Revenue
Total revenue (TR) = Price × Quantity sold
Except in the rare case of a good with perfectly elastic or perfectly inelastic demand, when a seller raises the price
of a good, there are two effects which act in opposite directions on revenue.

Price Unit Elastic Elastuc Demand Inelastic Demand

Increase TR - Same TR Decrease TR Increase

Decrease TR - Same TR - Increase TR Decrease

Inverse relation between TR & Price Direct relation between Price & TR

Unit
1
www.kalyaninstitute.org
enquirykalyan247@gmail.com
Page 2.20
9463862929
 Price effect: After a price increase (decrease), each unit sold sells at a higher
(lower) price, which tends to raise (lower) the revenue.
Quantity effect: After a price increase (decrease), fewer (more) units are sold,
which tends to lower (increase) the revenue.

When Price Increase

Price Effect Qty Effect

10 Units * Rs. 50 = Rs. 500 10 Units * Rs.50 = Rs. 500

10 Units * Rs. 80 = Rs. 800 5 Units * Rs. 80= Rs. 400
Due to Price effect TR Due to Qty Effect TR
Increase Decrease

Price Effect > Qty Effect - TR Increases - this will be the case of Inelastic Demand
Price Effect < Qty Effect - TR Decreases - this will be the case of Elastic Demand
Price Effect = Qty Demand - TR same - Unit Elastic Demand

Determinants of Price Elasticity of Demand

In the above section we have explained what price elasticity is and how it is measured. Now an
important question is: What are the factors which determine whether the demand for a good is
elastic or inelastic? We will consider the following important determinants of price elasticity.

1.) Availability of substitutes: One of the most important determinants of elasticity is the
degree of substitutability and the extent of availability of substitutes. Some commodities like
butter, cabbage, car, soft drink etc. have close substitutes. These are margarine, other green
vegetables, other brands of cars, other brands of cold drinks respectively. A change in the price
of these commodities, the prices of the substitutes remaining constant, can be expected to
cause quite substantial substitution – a fall in price leading consumers to buy more of the
commodity in question and a rise in price leading consumers to buy more of the substitutes.
Commodities such as salt, housing, and all vegetables taken together, have few, if any,
satisfactory substitutes and a rise in their prices may cause a smaller fall in their quantity
demanded. Thus, we can say that goods which typically have close or perfect substitutes have
highly elastic demand curves. Moreover, wider the range of substitutes available, the greater
will be the elasticity. For example, toilet soaps, toothpastes etc have wide variety of brands and
each brand is a close substitute for the other

Available Elastic Demand

If Substitutes
Not Available Inelastic Demand

Unit
1
www.kalyaninstitute.org
Page 2.21
enquirykalyan247@gmail.com 9463862929
It should be noted that while as a group, a good or service may have inelastic demand, but
when we consider its various brands, we say that a particular brand has elastic demand.
Thus, while the demand for a generic good like petrol is inelastic, the demand for Indian
Oil’s petrol is elastic. Similarly, while there are no general substitutes for health care, there
are substitutes for one doctor or hospital. Likewise, the demand for common salt and sugar
is inelastic because good substitutes are not available for these.

2.) Position of a commodity in the consumer’s budget: The greater the proportion of
income spent on a commodity; generally the greater will be its elasticity of demand and
vice- versa. The demand for goods like common salt, matches, buttons, etc. tend to be
highly inelastic because a household spends only a fraction of their income on each of
them. On the other hand, demand for goods like rental apartments and clothing tends to be
elastic since households generally spend a good part of their income on them. When the
good absorbs a significant share of consumers’ income, it is worth their time and effort to
find a way to reduce their demand when the price goes up.
Proportion of Income Spent

Major Proportion of Income Spent Major Proportion of Income Spent

Inelastic Demand E.g Newspaper elastic Demand E.g Clothes

3.) Nature of the need that a commodity satisfies: In general, luxury goods are price
elastic because one can easily live without a luxury. In contrast, necessities are price
inelastic. Thus, while the demand for a home theatre is relatively elastic, the demand for
food and housing, in general, is inelastic. If it is possible to postpone the consumption of a
particular good, such good will have elastic demand. Consumption of necessary goods
cannot be postponed and therefore, their demand is inelastic.
Nature of Goods

Elastic Demand Inelastic Demand

Consumption of Goods can be Consumption of Goods can not be

postponed when Price is higher Postponed
4.) Number of uses to which a commodity can be put: The more the possible uses of a commodity, the greater
will be its price elasticity and vice versa. When the price of a commodity which has multiple uses decreases, people
tend to extend their consumption to its other uses. To illustrate, milk has several uses. If its price falls, it can be
used for a variety of purposes like preparation of curd, cream, ghee and sweets. But, if its price increases, its use
will be restricted only to essential purposes like feeding the children and sick persons.
Unit
1
www.kalyaninstitute.org
enquirykalyan247@gmail.com
Page 2.22
9463862929
5.) Time period: The longer the time-period one has, the more completely one can
adjust. Time gives buyers the opportunity to find alternatives or substitutes, or change
their habits. A simple example of the effect can be seen in motoring habits. In response
to a higher petrol price, one can, in the short run, make fewer trips by car. In the longer
run, not only can one make fewer trips, but he can purchase a car with a smaller engine
capacity when the time comes for replacing the existing one. Hence one’s demand for
petrol falls by more when one has made long term adjustments to higher prices.
6.)Consumer habits: If a person is a habitual consumer of a commodity, no matter how
much its price change, the demand for the commodity will be inelastic. If buyers have
rigid preferences demand will be less price elastic.
7.)Tied demand: The demand for those goods which are tied to others is normally
inelastic as against those whose demand is of autonomous nature. For example printers
and ink cartridges.
8.) Price range: Goods which are in very high price range or in very low price range
have inelastic demand, but those in the middle range have elastic demand.
9.) Minor complementary items: The demand for cheap, complementary items to be
used together with a costlier product will tend to have an inelastic demand. Knowledge of
the price elasticity of demand and the factors that may change it is of key importance to
business managers because it helps them recognise the effect of a price change on their
total sales and revenues. Firms aim to maximise their profits and their pricing strategy is
highly decisive in attaining their goals. Knowledge of the price elasticity of demand for
the goods they sell helps them in arriving at an optimal pricing strategy. If the demand for
a firm’s product is relatively elastic, the managers need to recognize that lowering the
price would expand the volume of sales and result in an increase in total revenue. On
the contrary, when the demand is elastic, they have to be very cautious about increasing
prices because a price increase will lead to a decline in total revenue as fall in sales
would be more than proportionate. If the firm finds that the demand for their product is
relatively inelastic, the firm may safely increase the price and thereby increase its total
revenue as they can be assured of the fact that the fall in sales on account of a price rise
would be less than proportionate.
Knowledge of price elasticity of demand is important for governments while determining
the prices of goods and services provided by them, such as, transport and
telecommunication. Further, it also helps the governments to understand the nature of
responsiveness of demand to increase in prices on account of additional taxes and the
implications of such responses on the tax revenues.

Unit
www.kalyaninstitute.org 1

enquirykalyan247@gmail.com Page 2.23

Elasticity of demand explains why the governments are inclined to raise the indirect
taxes on those goods that have a relatively inelastic demand, such as alcohol and
tobacco products.

INCOME ELASTICITY OF DEMAND

The income elasticity of demand is a measure of how much the demand for a good
is affected by changes in consumers’ incomes. Estimates of income elasticity of
demand are useful for businesses to predict the possible growth in sales as the average
incomes of consumers grow over time. Income elasticity of demand is the degree of
responsiveness of the quantity demanded of a good to changes in the income of
consumers.
Proportionate Method
There is a useful relationship between income elasticity for a good and the
proportion of income spent on it. The relationship between the two is described in the
following three propositions:
1. If the proportion of income spent on a good remains the same as income increases,
then income elasticity for that good is equal to one.
2. If the proportion of income spent on a good increase as income increases, then the
income elasticity for that good is greater than one. The demand for such goods
increase faster than the rate of increase in income.
3. If the proportion of income spent on a good decrease as income rises, then income
elasticity for the good is positive but less than one. The demand for income-inelastic
goods rises, but substantially slowly compared to the rate of increase in income.
Necessities such as food and medicines tend to be income- inelastic.

CROSS - PRICE ELASTICITY OF DEMAND

Price of Related Goods and Demand
The demand for a particular commodity may change due to changes in the prices of
related goods. These related goods may be either complementary goods or substitute
goods. This type of relationship is studied under ‘Cross Demand’. Cross demand refers
to the quantities of a commodity or service which will be purchased with ref.6erence to
changes in price, not of that particular commodity, but of other inter-related commodities,
other things remaining the same. It may be defined as the quantities of a commodity that
consumers buy per unit of time, at different prices of a ‘related article’, ‘other things
remaining the same’. The assumption ‘other things remaining the same’ means that the
income of the consumer and also the price of the commodity in question will remain
constant.

Unit
1
www.kalyaninstitute.org
enquirykalyan247@gmail.com
Page 2.24
9463862929
(a) Substitute Products and Demand
In the case of substitute commodities, the cross-demand curve slopes upwards
(i.e. positively), showing that more quantities of a commodity, will be demanded
whenever there is a rise in the price of a substitute commodity. In figure, the
quantity demanded of tea is given on the X axis. Y axis represents the price of
coffee which is a substitute for tea. When the price of coffee increases, due to the
operation of the law of demand, the demand for coffee falls. The consumers will
substitute tea in the place of coffee. The price of tea is assumed to be constant.
Therefore, whenever there is an increase in the price of one commodity, the
demand for the substitute commodity will increase

(b) Complementary Goods:-

In the case of complementary goods, as shown in the figure 11 below, a change
in the price of a good will have an opposite reaction on the demand for the other
commodity which is closely related or complementary. For instance, an increase
in demand for solar panels will necessarily increase the demand for batteries. The
same is the case with complementary goods such as bread and butter; car and
petrol, electricity and electrical gadgets etc. Whenever there is a fall in the
demand for solar panels due to a rise in their prices, the demand for batteries will
fall, not because the price of batteries has gone up, but because the price of solar
panels has gone up. So, we find that there is an inverse relationship between
price of a commodity and the demand for its complementary good (other things
remaining the same)

Unit
1
www.kalyaninstitute.org
enquirykalyan247@gmail.com
Page 2.25
9463862929
 We shall now look into the cross - price elasticity of demand.

The cross-price elasticity of demand between two goods measures the effect of
the change in one good’s price on the quantity demanded of the other good.
Here, we consider the effect of changes in relative prices within a market on the
pattern of demand. A change in the demand for one good in response to a
change in the price of another good represents cross elasticity of demand of the
former good for the latter good. It is equal to the percentage change in the
quantity demanded of one good divided by the percentage change in the other
good’s price.

In the case of the cross-price elasticity of demand, the sign (plus or minus) is very
important: it tells us whether the two goods are complements or substitutes.
When two goods X and Y are substitutes, the cross-price elasticity of demand is
positive: a rise in the price of Y increases the demand for X and causes a
rightward shift of the demand curve. When the cross-price elasticity of demand is
positive, its size is a measure of how closely substitutable the two goods are.
Greater the cross elasticity, the closer is the substitute. Higher the value of cross
elasticity, greater will be the substitutability.

 If two goods are perfect substitutes for each other, the cross elasticity between
them is infinite.
 If two goods are close substitutes, the cross-price elasticity will be positive and
large.
 If two goods are not close substitutes, the cross-price elasticity will be positive
and small.
 If two goods are totally unrelated, the cross-price elasticity between them is
zero.

When two goods are complementary (tea and sugar) to each other, the cross
elasticity between them is negative so that a rise in the price of one leads to a fall
in the quantity demanded of the other causing a leftward shift of the demand
curve. The size of the crossprice elasticity of demand between two complements
tells us how strongly complementary they are: if the cross-price elasticity is only
slightly below zero, they are weak complements; if it is negative and very high,
they are strong complements

Unit
1
www.kalyaninstitute.org
enquirykalyan247@gmail.com
Page 2.26
9463862929
However, one need not base the classification of goods on the basis of the above
definitions. While the goods between which cross elasticity is positive can be
called substitutes, the goods between which cross elasticity is negative are not
always complementary. This is because negative cross elasticity is also found
when the income effect of the price change is very strong. The concept of cross
elasticity of demand is useful for a manager while making decisions regarding
changing the prices of his products which have substitutes and complements. If
cross elasticity to change in the price of substitutes is greater than one, the firm
may lose by increasing the prices and gain by reducing the prices of his products.
With proper knowledge of cross elasticity, the firm can plan policies to safeguard
against fluctuating prices of substitutes and complements.

ADVERTISEMENT ELASTICITY
Advertisement elasticity of sales or promotional elasticity of demand is the
responsiveness of a good’s demand to changes in the firm’s spending on
advertising. The advertising elasticity of demand measures the percentage
change in demand that occurs given a one percent change in advertising
expenditure. Advertising elasticity measures the effectiveness of an
advertisement campaign in bringing about new sales.

Advertising elasticity of demand is typically positive. Higher the value of

advertising elasticity greater will be the responsiveness of demand to change in
advertisement.

Unit
1
www.kalyaninstitute.org
enquirykalyan247@gmail.com
Page 2.27
9463862929