Answer the Following Question
1. What is ‘elasticity of demand’? Explain the factors determining elasticity of demand.
Ans: –Elasticity of Demand: Elasticity of demand means responsiveness of demand due to change in the price of the commodity, income of the consumer and price of the related goods.
Factors Determining Elasticity of Demand:-
Meaning:- There are several factors that influence the price elasticity of demand. The factors make the demand for a commodity either elastic or inelastic.
Factors are as follows:-
1) Nature of the commodity:- Demand tends to be relatively elastic for luxuries and comforts such as “Air Conditioners”. And demand is inelastic for necessary items such as Salt.
2) Availability of substitutes:- the greater the number of substitutes available for a commodity, the greater would be the elasticity of demand for that commodity. In other words, the demand for a product that has close substitutes is relatively elastic. However, salt has no substitute and therefore, its demand is always inelastic.
3) Composite Commodities:- Commodity having several uses tends to be more elastic in demand. For example; electricity can be used for several uses such as lighting, cooking, heating, etc however, a dingle use commodity has inelastic demand.
4) Urgency:- If wants are more urgent, demand becomes relatively inelastic. If wants can be postponed, demand becomes relatively elastic.
5) Habits:- Habits make a demand for certain goods inelastic, for examples; cigarettes, drugs, liquor.
6) Income:- Demand for goods is usually inelastic if the consumer has high income.
7) Postponement of Consumption:- The demand is elastic if we could postpone the purchase of goods and services such as in the case of electronic goods. But purchase of essential items like food grains, salt, etc., cannot be postponed, and therefore, the demand for such goods is inelastic.
8) Complementary Goods:- When a good is linked with the use of other goods, demand may be inelastic or elastic depending on the demand for complementary goods. For example, the demand for petrol or diesel depends on the use of automobiles, agricultural equipment like water pumps, etc.
9) Durability: The demand for durable goods is relatively elastic. For example, furniture, washing machine, etc. Demand for perishable goods is inelastic. For example, milk, vegetables, etc.
2. Explain the total outlay method of measuring elasticity of demand?
Ans: The total outlay method is also known as “Total expenditure method”. This method was developed by Prof. Marshall. In this method, the total amount of expenditure before and after the price change is compared.
Here the total expenditure refers to the product of price and quantity demanded.
Total expenditure = Price × Quantity demanded
In this connection, Marshall has given the following propositions:
1) Relatively elastic demand (Ed >1): When with a given change in the price of a commodity total outlay increases, the elasticity of demand is greater than one.
2) Unitary elastic demand (Ed = 1): When the price falls or rises, the total outlay does not change or remains constant, the elasticity of demand is equal to one.
3) Relatively inelastic demand (Ed <1): When with a given change in the price of a commodity total outlay decreases, the elasticity of demand is less than one.
This can be explained with the help of the following example.
Total outlay method
Price in ₹ (P)
Quantity demanded in units (Q)
Total outlay (P × Q)
Elasticity of demand
Ed > 1
Ed = 1
Ed < 1
In the above table example ‘A’ original price is ₹ 10 per unit and the quantity demanded is 6 units. Therefore, total expenditure incurred is ₹ 60. When the price rises to ₹ 20 quantity demanded fall to 5 units, the total expenditure incurred is ₹ 100. In this case, total outlay is greater than the original expenditure. Hence, in this example elasticity of demand is greater than one. (Ed >1) that is relatively elastic demand.
In example ‘B’, original price is ₹ 30 per unit and the quantity demanded is 4 units. Therefore total expenditure is ₹ 120. When price rises to ₹ 40 quantity demanded fall to ‘3’ units. Total expenditure incurred is ₹ 120. In this case total outlay is the same (equal) to original expenditure. Hence, in this example, elasticity of demand is equal to one (Ed = 1) which is unitary elastic demand.
In example ‘C’, original price is ₹ per unit and the quantity demanded is 2 units. Therefore total expenditure is ₹ 100. When price rises to ₹ 60, quantity demand falls to 1 unit and total expenditure incurred is ₹ 60. In this case total outlay is less than original expenditure. Hence, elasticity of demand is less than one (Ed <1) that is relatively inelastic demand
3. Explain the importance of elasticity of demand.
Ans: The term elasticity indicates the responsiveness of one variable to a change in the other variable. The elasticity of demand refers to the degree of responsiveness of quantity demanded to a change in its price or any other factor.
The concept of elasticity of demand is of great importance to producers, farmers, workers, and the Government. Lord Keynes considered this concept to be the most important contribution of Alfred Marshall. Significance of the concept becomes clear from the following applications:
1) Importance to a Producer: Every producer has to decide the price of his product at which he has to sell it. For this purpose, the elasticity of demand becomes important. If the demand for a product is relatively inelastic, he will fix up a higher price and vice-versa. The concept of elasticity of demand is also useful to a monopolist to practice price discrimination.
2) Importance to Government: The taxation policy of the Government is based on the concept of elasticity of demand. Those commodities whose demand is relatively inelastic will be taxed more because it will not affect their demand much and vice-versa.
3) Important in Factor Pricing: The concept of elasticity of demand is useful in the determination of factor prices. The factor of production for which demand is relatively inelastic can command a higher price as compared to those having elastic demand. For example, workers can ask for higher wages, if the demand for the product produced by them is relatively inelastic.
4) Importance in Foreign Trade: The concept of elasticity of demand is useful to determine terms and conditions in foreign trade. The countries exporting commodities for which demand is relatively inelastic can raise their prices. For example, the Organization of Petroleum Exporting Countries (OPEC) has increased the price of oil several times. The concept is also useful in formulating export and import policy of a country.
5) Public Utilities: In the case of public utilities like railways which have inelastic demand, the Government can either subsidize or nationalize them to avoid consumer’s exploitation.
6) Proportion of expenditure: If the proportion of expenditure in a person’s income is small, then demand for the product is relatively inelastic. For example, newspapers. If the proportion of expenditure is large, then demand for the product is relatively elastic.