Notes on Demand and Elasticity
Introduction
- Willing to Purchase at Various Prices during Period of Time
- Able to Purchase at Various Prices during Period of Time
Definitions of Demand
• Demand refers to the Quantities of Commodity that the Consumers are Able to Buy at each possible Price during a given Period of Time, other things being equal. By : Ferguson
• Demand is the Ability and Willingness to buy Specific Quantity of a Good at Alternative Prices in a given Time Period, Ceteris Paribus. By : B. R. Schiller
Determinants of Demand
- Price of the Commodity
- Price of Related Commodities
- Level of Income of the Household
- Taste & Preferences of Consumers
- Other Factors
• Price of the Commodity
Ceteris paribus i.e. Other Things Being Equal,
D ∝ 1/P
This Happens Because of Income & Substitution Effects
• Price of Related Commodities
Complementary Goods e.g. Pen & Ink
Price of one Good Decrease
Demand of Other Good Decrease
Substituting Goods e.g. Tea & Coffee
Price of one Good Increase
Demand of Other Good Increase
• Level of Income of the Household
Average Money Income Increase
Quantity Demanded of a Good Increase
Exception: Inferior Goods
Average Money Income Increase
Quantity Demanded of a Good Decrease
• Taste & Preferences of Consumers
• Other Factors
- –Size of the Population
- –Composition of Population
Law of Demand
Law of demand states that People will Buy more at Lower Prices and Buy less at Higher Prices, Ceteris paribus, or other things Remaining the Same. By : Samuelson
The Law of Demand states that Quantity Demanded Increases with a Fall in Price and Diminishes when Price Increases, other things being equal. By : Marshall
Assumption to Law of Demand
• Law of demand holds Good when “Other Things Remain the Same” meaning thereby, the factors affecting demand ,other then price, are assumed to be constant.
• Demand Function: Dx= f(PX, Pr, Y, T, E)
where,
Dx = Demand for Commodity
Px = Price of Commodity X
Pr = Price of Other Goods
Y = Income of the Consumer
T = Tastes
E = ExpGeenceratl Eacotnoimoics:nLawof Dfemtanhd aend Consumer
Explanation
• According to Law of Demand, Ceteris Paribus
Quantity Demanded ∝ 1 / Price
However, this Relation is not Proportional, meaning thereby that it is not necessary that when
Price Falls by ½, Demand for Goods will be Doubled.
This simply indicates the Direction of Change in Demand as change in Price.
Demand Schedule
• Demand Schedule is a Series of Quantities which Consumer would like to Buy per unit of Time at Different Prices.
• Two Aspects of Demand Schedule
– Individual Demand Schedule
– Market Demand Schedule
Individual Demand Schedule
• It is defined as a Table which shows Quantities of Given Commodity
which an Individual Consumer will buy at all Possible Prices at a given Time.
Market Demand Schedule
• It is defined as the Quantities of a Given Commodity which all Consumers will buy at all Possible Prices at a given Moment of Time. In Market there are many Consumers of a Single Commodity. The Schedule is based on the Assumption that there are in all, 2 Consumers ‘A’ & ‘B’ of Commodity ‘X’. By aggregating their Individual Demand, the Market Demand Schedule is constructed.
Demand Curve
• A Demand Curve is a Locus of Points showing various Alternative Price- Quantity Combinations.
• It shows the Inverse Relationship between Price & Quantity Demanded.
• It Slopes Downwards to the Right.
Individual Demand Curve
X Axis – Price (Rs.)
Y Axis – Quantity
DD – Demand Curve
The Demand Curve Slopes Downwards from Left to Right, meaning thereby that when Price is High Demand is Low and vice versa.
Market Demand Curve
Why does Demand Curve Slope Downward?
• Income Effect :
It is the Effect that a Change in a Person’s Real Income caused by Change in the Price of a Commodity has on the Quantity of that Commodity. In other words, the Increase in Demand on Account of Increase in Real Income is known as Income Effect.
• Substitution Effect :
It is the Effect that a Change in Relative Prices of Substitute Goods has on the Quantity Demanded. Substitutes are Goods that can be used in place of each other.
• Different Uses:
Demand for Commodities with Alternative Uses tends to Extend Consequent upon the fall in their prices.
• Size of Consumer Group:
When the Price of a Commodity falls, then many Consumers, who are unable to buy that Commodity at its Previous Price, Come
Exceptions to Law of Demand
• Article of Distinction or Veblen Goods: Goods like Jewellery, Diamonds & Gems are considered as Articles of Distinction. These
Goods command More Demand when their Prices are High.
• Ignorance: Many a time, Consumers out of sheer Ignorance or Poor Judgment consider a Commodity to be of Low Quality if its Price is Low and of High Quality if its Price is High.
• Giffen Goods : Giffen Goods are those Inferior Goods whose Demand falls even when their Prices Falls. For example, ‘Bajra’. Only those Inferior Goods are called Giffen Goods where Law of Demand Fails.
• Expectation of Rise or Fall in Price in Future: If Prices are likely to Rise More in the Future then even at the Existing Higher Price people may Demand more Units of the Commodity in the Present and vice versa.
Expansion & Contraction in Demand
Expansion
• Price ↓ (decrease), QD ↑ (increase)
• Downward Movement Along the Demand Curve
Contraction
• Price ↑(increase), QD ↓ (Decrease)
• Upward Movement Along the Demand Curve
Increase & Decrease in Demand
Increase
• Price Same, QD ↑ due to Change in Other Factors
• Rightward Shift
Decrease
• Price Same, QD ↓ due to Change in Other Factors
• Leftward Shift
Distinction between Extension & Increase in Demand
• Extension in Demand means Rise in Demand in Response to fall in the Price of a Commodity, Other things being equal.
• It is expressed by the Movement from a Higher Point to a Lower Point along the same Demand Curve.
• Increase in Demand refers to the Rise in Demand in Response to the Change in the Determinants of Demand other then Price.
• It is expressed by the Upward Shift of the Entire Demand Curve.
Distinction between Contraction & Decrease in Demand
• Contraction in Demand means Fall in Demand in Response to a Rise in the Price of a Commodity, Other things being Equal.
• It is expressed by the Movement from a Lower Point to a Higher Point on the Same Demand Curve.
• Decrease in Demand means Fall in Demand in Response to Change in Determinants of Demand, Other then the Price.
• It is expressed by a Downward Shift of the Entire Demand Curve.
Elasticity of Demand
• It answers the Question “BY HOW MUCH?”
• Elasticity of Demand is defined as the Responsiveness of the Quantity Demanded of a Good to Change on one of the Variables on which Demand Depends.
E = ( % Change in Q.D. )/
% Change in one of the Variables on which Demand depends
Types of Elasticity of Demand
- Price Elasticity
- Income Elasticity
- Cross Elasticity
Price Elasticity of Demand
It is Measured as a Percentage Change in Quantity Demanded Divided by the Percentage Change in Price, Other things Remaining Same.
Ep = % Change in Q.D./
% Change in Price
Ep = Change in Quantity × Original Price
Change in Price x Original Quantity
Ep = ∆Q × P
∆P Q
Where, Ep Price Elasticity
∆ Very Small Change
P Price
Q Quantity Demanded
Note: Ep is (-)ve due to Inverse Relationship Between Price & Quantity Demanded.
Degrees of Price Elasticity of Demand
- Perfectly Elastic: E = ∞
- Perfectly Inelastic: E = 0
- Unit Elastic: E = 1
- More than Unit Elastic (Elastic): E > 1
- Less than Unit Elastic (Inelastic): E < 1
Perfectly Elastic Demand
• A Perfectly Elastic Demand is one in which a Little Change in Price will Cause an Infinite Change in Demand.
• A very little Rise in Price causes the Demand to Fall to Zero and a very little Fall in Price causes Demand to Extend to Infinity.
• Under Perfect Competition, Demand Curve of a Firm is Percfectly Elastic.
Perfectly Inelastic Demand
• Perfectly Inelastic Demand is one in which a Change in Price Produces No Change in the Quantity Demanded.
• In this case, Elasticity of Demand is Zero.
Unitary Elastic Demand
Unitary Elastic Demand is one which a % Change in Price Produces an Equal % Change in Demand.
• This type of Demand Curve is called Rectangular Hyperbola.
Greater than Unitary Elastic
• Greater than Unitary Elastic Demand is one in which a Given %Change in Price Produces Relatively more %Change in Demand.
• In this case Elasticity of Demand is Greater than Unitary.
Less than Unitary Elastic Demand
• Less than Unitary Elastic Demand is one in which a given % Change in Price Produces Relatively Less % Change in Demand
• In this case, Elasticity of Demand is Less then Unitary.
Point Elasticity of Demand
• Refers to Measuring the Elasticity at a Particular Point on Demand Curve.
• Makes Use of Derivative Changes Rather than Finite Changes in Price & Quantity.
• Defined As: dq/dp × p/q
Where, dp/dq
is the derivative of Quantity w.r.t. Price at a point on Demand Curve.
Point Elasticity =( Upper Segment)/(Lower Segment) = PM/PN
• As we Move from N to M, Elasticity Goes on Increasing. At Mid Point, Ep = 1, at N Ep = 0 & at M Ep = ∞
Arc Elasticity of Demand
• When Elasticity is to be found between 2 Points, we use Arc Elasticity.
Elasticity = (q1 − q 2) /(q1 + q2) × (p1 + p2 )/(p1 − p2)
Where,
p1 = Original Price
q1 = Original Quantity
p2 = New Price
q2 = New Quantity
Total Expenditure (Outlay) Method
• This Method was evolved by Dr. Alfred Marshall.
• According to this Method, To Measure the Elasticity of Demand it is Essential to Know How Much & In What Direction the Total Expenditure has Changed as a Result of Change in the Price of a Good.
| Elasticity of Demand | Price | Total Expenditure |
| Greater than Unity Ep>1 | Increase Decrease |
Decrease Increase |
| Unity Ep=1 | Same Same |
Unchanged |
| Less than Unity Ep<1 | Increase Decrease |
Increase Decrease |
Determinants of Price Elasticity of Demand
- • Availability of Substitutes
- • Position of Commodity in Consumer’s Budget
- • Nature of Need that a Commodity Satisfies
- • Number of Uses to which a Commodity is Put
- • Period
- • Consumer Habits
Income Elasticity of Demand
• Income Elasticity of Demand is the Degree of Responsiveness of Quantity Demanded of a Good to a Small Change in the Income of Consumer.
Ey = % Change in Quantity Demanded
% Change in Income
Degrees of Income Elasticity of Demand
- Positive Income Elasticity of Demand
- Unitary Income Elasticity of Demand
- Less than Unitary Income Elasticity of Demand
- More than Unitary Income Elasticity of Demand
- Negative Income Elasticity of Demand
- Zero Income Elasticity of Demand
Positive Income Elasticity of Demand
• Income Elasticity of Demand for a Good is Positive, When with an Increase in
the Income of a Consumer, his Demand for the Good Increases and Vice Versa.
• It is Positive in case of Normal Goods.
Negative Income Elasticity of Demand
• Income Elasticity of Demand is Negative when Increase in the Income of the Consumer is Accompanied by Fall in Demand of a
Good
• It is Negative in case of Inferior Goods which are known as Giffen Goods.
Zero Income Elasticity of Demand
• Income Elasticity of Demand is Zero, When Change in the Income of Consumer evokes No Change in his Demand.
• Demand for Necessaries like oil, salt, etc., have Zero Income Elasticity of Demand
Cross Elasticity of Demand
• Cross Elasticity of Demand is a Change in the Demand of One Good in Response to a Change in the Price of Another Good.
Ec = (∆Q x / ∆Py ) × (Py / Qx)
Where, Ec = Cross Elasticity
Qx = Original Q.D. of X
∆Qx = Change in Q.D. of X
Py = Original Price of Y
∆Py = Change in Price of Y
Positive Cross Elasticity of Demand
• It is positive in case of Substitute Goods.
• For example, Rise in the Price of Coffee will lead to Increase in Demand for Tea.
• The Curve slopes Upward from Left to Right.
Negative Cross Elasticity of Demand
• It is Negative in Case of Complementary Goods.
• For example, Rise in Price of Bread will bring Down the Demand for Butter.
• The Curve slopes Downwards from Left to Right.
Zero Cross Elasticity of Demand
• Cross Elasticity of Demand is Zero when Two Goods are Not Related to each other.
• For example, Rise in the Price of Wheat will have No Effect on the Demand for Shoes.
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