Understand Personal Finance

Learn personal financial management, budgeting, and investing.

# The Elasticity of Demand – A Quick Overview

We all know that the changes in the price of the product, income of the households, prices of related goods, tastes and expectations, advertisement expenses, etc affect the quantity demanded of a product or service. This indicates only the directional impact of the changes in the factors influencing demand.

This only indicates the directional impact of the changes in the factor influencing demand. Since the change in any demand determinant does not affect the demand for every good to some extent, the knowledge about the direction of any change in demand is therefore insufficient for any management to plan changes in the production or sales plan.

The manager needs to know more. It must have information regarding the magnitude of the impact of each of these factors on the quantity demanded as changes in them don’t affect demand for each product to the same extent.

And this is where the elasticity of demand set its foot. Fortunately, the economist has a tool to measure the effect of changes in any one of the determinants in the demand function like price, income, expectations, advertising, expenditure, etc. This tool is named the elasticity of demand which helps us in providing a qualitative value for the responsiveness of the quantity demanded to change in each of the determinants in the demand function.

## What is the elasticity of demand?

The elasticity of demand can be termed as the percentage change in quantity demanded caused by a one percent change in the demand determinant under consideration, while other determinants are held constant.

The general equation for the measurement of elasticity of demand or elasticity of demand can be measured through

Percentage in quantity demanded of good X / Percentage change in determinant Z

The larger the absolute value of this elasticity, the more responsive the quantity demanded changes the determinant under consideration. If we look at the demand function, we can notice that certain determinants of demand are completely beyond the control of the firm.

The firm can’t possibly make any significant difference to the average annual income of the consumer, the number of consumers, or the prices of related goods. Yet the managers are certainly interested in knowing how changes in these variables affect the demand for the product.

## Types of elasticity of demand

While it is conceptually possible to measure the elasticity of demand concerning each of the demand determinants, there are certain insurmountable problems in quantifying certain variables. Therefore, we will consider the following elasticity of demand:

### Price elasticity of demand

The measure of relative responsiveness of quantity demanded to price along a given demand curve is known as the price elasticity of demand.

Mathematically it can be written as the

Proportionate change in quantity demanded of good X / Proportionate change in the price of goods X

The Law of demand states that the quantity demanded and price of goods are inversely related. But decision-makers are frequently interested in the effect that the changes in price and quantity demanded to tend to have the offsetting effect. The change in total revenue will therefore depend upon which offsetting effect dominates- the increase in price or the decrease in quantity demanded.

Thus, it can be seen that the effect of a price change depends upon the relative responsiveness of quantity demanded to price along the demand curve.

The price elasticity of demand will always have a negative sign and a downward-sloping demand curve.

### Income elasticity of demand

The income elasticity of demand for a commodity shows the extent to which a consumer’s demand for the commodity changes as a result of a change in his income. Like the price elasticity of demand, the income elasticity of demand may be referred to as a ratio of the percentage change in the quantity demanded of a good to the percentage change in income of the consumer

Mathematically it can be written as

Percentage change in the demanded quantity of goods X / Percentage change in income of the consumer

The income elasticity of demand is positive for all normal goods because the demand of the consumer for a good changes in the direction of the change in his income. In the case of inferior goods, the demand for the goods varies inversely with income. As a result, the income elasticity of demand for inferior goods is stated to be negative.

### Cross elasticity of demand

In the demand function, it was mentioned that the demand for a commodity is not only a function of its price but also a function of the prices of old related goods. Hence, the concepts of elasticity can also be applied here in a situation where two commodities are related to each other. The elasticity in this case is named the cross elasticity of demand.

So it can be properly referred to as the ratio of the percentage change in the demand for one good to the percentage change in the price of some related goods. The concept of cross elasticity of demand is useful in handling inter-commodity demand relations.

This change of demand for one good due to a change in the price of some other good comes about because the two goods either may substitute or complement each other. In the case of a perfectly substituted product, the cross elasticity is very highly positive whereas for the perfectly complementing goods the cross elasticity will be highly negative.

### Promotional elasticity of demand

Advertising or promotions occupies an important place in a competitive or partially competitive market economy. It consists of visual and oral activities to create or expand demand for the product or service.

To what extent the demand for a product or service will be influenced by advertisement and other promotional activities may be measured by advertising elasticity of demand. Advertising elasticity of demand measures the response of quantity demand change to change in expenditure on advertising and other sales promotion activities.

It is highly influenced by the stage of the product market, the effect of advertising in terms of time, and the influence of advertising on rivals.

### Demand elasticity of substitution

The elasticity of substitution between two goods is a measure of the ease with which one good can be substituted for another good.

So substitution elasticity may be defined as the degree to which one good can be substituted for another as a consequence of a given change in their price ratio if the consumer is to enjoy the same satisfaction. The demand elasticity of substitution is the relative measure of the substitution effect.

Mathematically demand elasticity of substitution can be written as the

Proportionate change in the quantity ratios of goods X and Y / Proportionate change in the price ratios of goods X and Y

## Significance of the concept of elasticity of demand

The understanding of the concept of elasticity of demand is highly useful both from theoretical and practical points of view. Some of its important uses may be the following

### Level of price and output

If production is to be profitable, the volume of goods and services produced must be by the demand for the commodity. If the price elasticity of the demand for the product is inelastic, the producer can charge high charges for it. Thus it is an important consideration.

### Fixation of rewards for factors of production

The concept of elasticity of demand is also quite important in determining the rewards of various factors of production in the country. For example, if the demand for workers is inelastic, the efforts of trade unions to raise the wages of the workers will meet with success, otherwise not the same holds good for other factors of production as well.

### Demand forecasting

While price and cross elasticity is useful for pricing policy, income elasticity can be used for forecasting demand for the product in the future. Thus, production planning and management, in the long run, depend significantly upon the knowledge of income elasticity, as the businessman can then find out the impact of changing income levels on the demand for his commodity.

We thus find that the concept of elasticity of demand is perceived in different facets of economic decision-making.

### Government policies

In pursuing its physical control policy the government can take a lot of help from the knowledge of the elasticity of demand. The government must take into account the elasticity of demand for a commodity before imposing statutory price control on it.

The decision about the industries to be declared as public utilities to be owned and operated by the government depends significantly on the knowledge of the elasticity of demand. Besides, it is also of great help to the government in its taxation policy.

Apart from that, when fixing a proper rate of exchange for its currency the government can take considerable help from the concept of elasticity of demand.

## Conclusion

As we discussed above, you might clear all your queries with all the important concepts of elasticity.  In general, we covered elasticity and its several forms.

We hope that you are now clear about the concept of elasticity of demand. So let us know how it is going.