Demand In Economics - Law Of Demand - Elasticity of Demand

Demand Schedule or Demand Table

These are the two devices to present the law. The demand schedule is a schedule or a table which contains various possible prices of a commodity and different quantities demanded at them. It can be an individual demand schedule representing the demand of an individual consumer or can be the market demand schedule showing the total demand of all the consumers taken together, this is indicated in the following table.

It can be observed that with a fall in price every individual consumer buys a larger quantity than before as a result of which the total market demand also rises. In case of an increase in price the situation will be reserved. Thus the demand schedule reveals the inverse price-demand relationship, i.e. the Law of Demand.

Demand Curve DD

It is a geometrical device to express the inverse price-demand relationship, i.e. the law of demand. A demand curve can be obtained by plotting a demand schedule on a graph and joining the points so obtained, like the demand schedule we can derive an individual demand curve as well as a market demand curve. The former shows the demand curve of an individual buyer while the latter shows the sum total of all the individual curves i.e. a market or a total demand curve. The following diagram shows the two types of demand curves.

 

In the above diagram, figure (A) shows an individual demand curve of any individual consumer while figure (B) indicates the total market demand. It can be noticed that both the curves are negatively sloping or downwards sloping from left to right. Such a curve shows the inverse relationship between the two variables. In this case the two variable are price on Y axis and the quantity demanded on X axis. It may be noted that at a higher price OP the quantity demanded is OM while at a lower price say OP1, the quantity demanded rises to OM1 thus a demand curve diagrammatically explains the law of demand.

Assumptions of the 'Law of Demand'

The law of demand in order to establish the price-demand relationship makes a number of assumptions as follows:

1. Income of the consumer is given and constant.
2. No change in tastes, preference, habits etc.
3. Constancy of the price of other goods.
4. No change in the size and composition of population.

These Assumptions are expressed in the phrase “other things remaining equal”.

Exceptions of the 'Law of Demand'

In case of major bulk of the commodities the validity of the law is experienced. However there are certain situations and commodities which do not follow the law. These are termed as the exceptions to the law; these can be expressed as follows:

1. Continuous changes in the price lead to the exceptional behavior. If the price shows a rising trend a buyer is likely to buy more at a high price for protecting himself against a further rise. As against it when the price starts falling continuously, a consumer buys less at a low price and awaits a further in price.
2. Giffens’s Paradox describes a peculiar experience in case of inferior goods. When the price of an inferior commodity declines, the consumer, instead of purchasing more, buys less of that commodity and switches on to a superior commodity. Hence the exception.
3. Conspicuous Consumption refers to the consumption of those commodities which are bought as a matter of prestige. Naturally with a fall in the price of such goods, there is no distinction in buying the same. As a result the demand declines with a fall in the price of such prestige goods.
4. Ignorance Effect implies a situation in which a consumer buys more of a commodity at a higher price only due to ignorance.

In the exceptional situations quoted above, the demand curve becomes an upwards rising one as shown in the alongside diagram. In the alongside figure, the demand curve is positively sloping one due to which more is demanded at a high price and less at a low price.

Determinants (Factors Affecting) of Demand

The law of demand, while explaining the price-demand relationship assumes other factors to be constant. In reality however, these factors such as income, population, tastes, habits, preferences etc., do not remain constant and keep on affecting the demand. As a result the demand changes i.e. rises or falls, without any change in price.

1. Income: The relationship between income and the demand is a direct one. It means the demand changes in the same direction as the income. An increase in income leads to rise in demand and vice versa.
2. Population: The size of population also affects the demand. The relationship is a direct one. The higher the size of population, the higher is the demand and vice versa.
3. Tastes and Habits: The tastes, habits, likes, dislikes, prejudices and preference etc. of the consumer have a profound effect on the demand for a commodity. If a consumers dislikes a commodity, he will not buy it despite a fall in price. On the other hand a very high price also may not stop him from buying a good if he likes it very much.
4. Other Prices: This is another important determinant of demand for a commodity. The effects depends upon the relationship between the commodities in question. If the price of a complimentary commodity rises, the demand for the commodity in reference falls. E.g. the demand for petrol will decline due to rise in the price of cars and the consequent decline in their demand. Opposite effect will be experienced incase of substitutes.
5. Advertisement: This factor has gained tremendous importance in the modern days. When a product is aggressively advertised through all the possible media, the consumers buy the advertised commodity even at a high price and many times even if they don’t need it.
6. Fashions: Hardly anyone has the courage and the desire to go against the prevailing fashions as well as social customs and the traditions. This factor has a great impact on the demand.
7. Imitation: This tendency is commonly experienced everywhere. This is known as the demonstration effects, due to which the low income groups imitate the consumption patterns of the rich ones. This operates even at international levels when the poor countries try to copy the consumption patterns of rich countries.

Variation & Changes In Demand

The law of demand explains the effect of only-one factor viz., price, on the demand for a commodity, under the assumption of constancy of other determinants. In practice, other factors such as, income, population etc. cause the rise or fall in demand without any change in the price. These effects are different from the law of demand. They are termed as changes in demand in contrast to variations in demand which occur due to changes in the price of a commodity. In economic theory a distinction is made between (a) Variations i.e. extension and contraction in demand due to price and (b) Changes i.e. increase and decrease in demand due to other factors.

(a) Variations in demand refer to those which occur due to changes in the price of a commodity.

These are two types.

1. Extension of Demand: This refers to rise in demand due to a fall in price of the commodity. It is shown by a downwards movement on a given demand curve.
2. Contraction of Demand: This means fall in demand due to increase in price and can be shown by an upwards movement on a given demand curve.

(b) Changes in demand imply the rise and fall due to factors other than price.

It means they occur without any change in price. They are of two types.

1. Increase in Demand: This refers to higher demand at the same price and results from rise in income, population etc., this is shown on a new demand curve lying above the original one.
2. Decrease in demand: It means less quantity demanded at the same price. This is the result of factors like fall in income, population etc. this is shown on a new demand lying below the original one.

 

 

Fig (A) Extension/Contraction of Demand

Fig (B) Increase/Decrease in Demand

In figure A, the original price is OP and the Quantity demanded is OQ. With a rise in price from OP to OP1 the demand contracts from OQ to OQ1 and as a result of fall in price from OP to OP2, the demand extends from OQ to OQ2.

In figure, B an increase in demand is shown by a new demand curve, D1 while the decrease in demand is expressed by the new demand curve D2, lying above and below the original demand curve D respectively. On D1 more is demand (OQ1) at the same price while on D2 less is demanded (OQ2) at the same price OP.

Elasticity of Demand

The law of demand explains the functional relationship between price and demand. In fact, the demand for a commodity depends not only on the price of a commodity but also on other factors such as income, population, tastes and preferences of the consumer. The law of demand assumes these factors to be constant and states the inverse price-demand relationship. Barring certain exceptions, the inverse price- demand relationship holds good in case of the goods that are bought and sold in the market.

The law of demand explains the direction of a change as it states that with a rise in price the demand contracts and with a fall in price it expands. However, it fails to explain the extent or magnitude of a change in demand with a given change in price. In other words, the law of demand merely shows the direction in which the demand changes as a result of a change in price, but does not throw any light on the amount by which the demand will change in response to a given change in price. Thus, the law of demand explains the qualitative but not the quantitative aspect of price- demand relationship.

Although it is true that demand responds to change in price of a commodity, such response varies from commodity to commodity. Some commodities are more responsive or sensitive to change in price while some others are less. The concept of the elasticity of demand has great significance as it explains the degree of responsiveness of demand to a change in price. It thus elaborates the price-demand relationship. The elasticity of demand thus means the sensitiveness or responsiveness of demand to a change in price.

According to Marshall, “the elasticity (or responsiveness) of demand in a market is great or small accordingly as the demand changes (rises or falls) much or little for a given change (rise or fall) in price.”

From the above discussion, it will be clear that thought different commodities react to a change in price in the same direction; the degree of their response differs. Demand for some commodities is more sensitive or responsive to a change in price, while it is less responsive for some others. Elasticity of demand is a measure of relative changes in the amount demanded in response to a small change in price. Certain goods are said to have an elastic demand while others have an inelastic demand. The demand is said to be elastic when a small change in price brings about considerable change in demand. On the other hand, the demand for a good is said to be inelastic when a change in price fails to bring about significant change in demand.

The concept of elasticity can be expressed in the form of an equation as:

Ep = [Percentage change in quantity demanded / Percentage change in the price]

Types of Price Elasticity

The concept of price elasticity reveals that the degree of responsiveness of demand to the change in price differs from commodity to commodity. Demand for some commodities is more elastic while that for certain others is less elastic. Using the formula of elasticity, it possible to mention following different types of price elasticity:

1. Perfectly inelastic demand (ep = 0)
2. Inelastic (less elastic) demand (e < 1)
3. Unitary elasticity (e = 1)
4. Elastic (more elastic) demand (e > 1)
5. Perfectly elastic demand (e = ∞)

1. Perfectly inelastic demand (ep = 0)

   This describes a situation in which demand shows no response to a change in price. In other words, whatever be the price the quantity demanded remains the same. It can be depicted by means of the alongside diagram.

   The vertical straight line demand curve as shown alongside reveals that with a change in price (from OP to Op1) the demand remains same at OQ. Thus, demand does not at all respond to a change in price. Thus ep = O. Hence, perfectly inelastic demand. Fig a

2. Inelastic (less elastic) demand (e < 1)

   In this case the proportionate change in demand is smaller than in price. The alongside figure shows this type.

   In the alongside figure percentage change in demand is smaller than that in price. It means the demand is relatively c less responsive to the change in price. This is referred to as an inelastic demand. Fig e

3. Unitary elasticity demand (e = 1)

   When the percentage change in price produces equivalent percentage change in demand, we have a case of unit elasticity. The rectangular hyperbola as shown in the figure demonstrates this type of elasticity. In this case percentage change in demand is equal to percentage change in price, hence e = 1. Fig c

4. Elastic (more elastic) demand (e > 1)

   In case of certain commodities the demand is relatively more responsive to the change in price. It means a small change in price induces a significant change in, demand. This can be understood by means of the alongside figure.

   It can be noticed that in the above example the percentage change in demand is greater than that in price. Hence, the elastic demand (e>1) Fig d

5. Perfectly elastic demand (e = ∞)

   This is experienced when the demand is extremely sensitive to the changes in price. In this case an insignificant change in price produces tremendous change in demand. The demand curve showing perfectly elastic demand is a horizontal straight line. Fig b

   It can be noticed that at a given price an infinite quantity is demanded. A small change in price produces infinite change in demand. A perfectly competitive firm faces this type of demand.

From the above analysis it can be concluded that theoretically five different types of price elasticity can be mentioned. In practice, however two extreme cases i.e. perfectly elastic and perfectly inelastic demand, are rarely experienced. What we really have is more elastic (e > 1) or less elastic (e < 1 ) demand. The unitary elasticity is a dividing line between these two cases.

Determinants of Elasticity

1. Nature of the Commodity: Humans wants, i.e. the commodities satisfying them can be classified broadly into necessaries on the one hand and comforts and luxuries on the other hand. The nature of demand for a commodity depends upon this classification. The demand for necessities is inelastic and for comforts and luxuries it is elastic.
2. Number of Substitutes Available: The availability of substitutes is a major determinant of the elasticity of demand. The large the number of substitutes, the higher is the elastic. It means if a commodity has many substitutes, the demand will be elastic. As against this in the absence of substitutes, the demand becomes relatively inelastic because the consumers have no other alternative but to buy the same product irrespective of whether the price rises or falls.
3. Number Of Uses: If a commodity can be put to a variety of uses, the demand will be more elastic. When the price of such commodity rises, its consumption will be restricted only to more important uses and when the price falls the consumption may be extended to less urgent uses, e.g. coal electricity, water etc.
4. Possibility of Postponement of Consumption: This factor also greatly influences the nature of demand for a commodity. If the consumption of a commodity can be postponed, the demand will be elastic.
5. Range of prices: The demand for very low-priced as well as very high-price commodity is generally inelastic. When the price is very high, the commodity is consumed only by the rich people. A rise or fall in the price will not have significant effect in the demand. Similarly, when the price is so low that the commodity can be brought by all those who wish to buy, a change, i.e., a rise or fall in the price, will hardly have any effect on the demand.
6. Proportion of Income Spent: Income of the consumer significantly influences the nature of demand. If only a small fraction of income is being spent on a particular commodity, say newspaper, the demand will tend to be inelastic.
7. According to Taussig, unequal distribution of income and wealth makes the demand in general, elastic.
8. In addition, it is observed that demand for durable goods, is usually elastic.
9. The nature of demand for a commodity is also influenced by the complementarities of goods.

From the above analysis of the determinants of elasticity of demand, it is clear that no precise conclusion about the nature of demand for any specific commodity can be drawn. It depends upon the range of price, and the psychology of the consumers. The conclusion regarding the nature of demand should, therefore be restricted to small changes in prices during short period. By doing so, the influence of changes in habits, tastes, likes customs etc., can be ignored.

Measurement of Elasticity

For practical purposes, it is essential to measure the exact elasticity of demand. By measuring the elasticity we can know the extent to which the demand is elastic or inelastic. Different methods are used for measuring the elasticity of demand.

1. Percentage Method: In this method, the percentage change in demand and percentage change in price are compared.

   ep = [Percentage change in demand / Percentage change in price]

   In this method, three values of ‘ep’ can be obtained. Viz., ep = 1, ep > 1, ep > 1.

   • If 5% change in price leads to exactly 5% change in demand, i.e. percentage change in demand is equal to percentage change in price , e = 1, it is a case of unit elasticity.
   • If percentage change in demand is greater than percentage change in price, e > 1, it means the demand is elastic.
   • If percentage change in demand is less than that in price, e > 1, meaning thereby the demand is inelastic.

2. Total Outlay Method: The elasticity of demand can be measured by considering the changes in price and the consequent changes in demand causing changes in the total amount spent on the goods. The change in price changes the demand for a commodity which in turn changes the total expenditure of the consumer or total revenue of the seller.

   • If a given change in price fails to bring about any change in the total outlay, it is the case of unit elasticity. It means if the total revenue (price x Quantity bought) remains the same in spite of a change in price, ‘ep’ is said to be equal to 1
   • If price and total revenue are inversely related, i.e., if total revenue falls with rise in price or rises with fall in price, demand is said to be elastic or e > 1.
   • When price and total revenue are directly related, i.e. if total revenue rises with a rise in price and falls with a fall in price, the demand is said to be inelastic pr e < 1.

3. Another suggested by Marshall is to measure elasticity at a point on a straight line is called Point Method

Income Elasticity of Demand

The discussion of price elasticity of demand reveals that extent of change in demand as a result of change in price. However, as already explained, price is not the only determinant of demand. Demand for a commodity changes in response to a change in income of the consumer. In fact, income effect is a constituent of the price effect. The income effect suggests the effect of change in income on demand. The income elasticity of demand explains the extent of change in demand as a result of change in income. In other words, income elasticity of demand means the responsiveness of demand to changes in income. Thus, income elasticity of demand can be expressed as:

EY = [Percentage change in demand / Percentage change in income]

The following types of income elasticity can be observed:

1. Income Elasticity of Demand Greater than One: When the percentage change in demand is greater than the percentage change in income, a greater portion of income is being spent on a commodity with an increase in income- income elasticity is said to be greater than one.
2. Income Elasticity is unitary: When the proportion of income spent on a commodity remains the same or when the percentage change in income is equal to the percentage change in demand, EY = 1 or the income elasticity is unitary.
3. Income Elasticity Less Than One (EY< 1): This occurs when the percentage change in demand is less than the percentage change in income.
4. Zero Income Elasticity of Demand (EY=o): This is the case when change in income of the consumer does not bring about any change in the demand for a commodity.
5. Negative Income Elasticity of Demand (EY< o): It is well known that income effect for most of the commodities is positive. But in case of inferior goods, the income effect beyond a certain level of income becomes negative. This implies that as the income increases the consumer, instead of buying more of a commodity, buys less and switches on to a superior commodity. The income elasticity of demand in such cases will be negative.

Cross Elasticity of Demand

While discussing the determinants of demand for a commodity, we have observed that demand for a commodity depends not only on the price of that commodity but also on the prices of other related goods. Thus, the demand for a commodity X depends not only on the price of X but also on the prices of other commodities Y, Z….N etc. The concept of cross elasticity explains the degree of change in demand for X as, a result of change in price of Y. This can be expressed as:

EC = [Percentage Change in demand for X / Percentage change in price of Y]

The relationship between any two goods is of two types. The goods X and Y can be complementary goods (such as pen and ink) or substitutes (such as pen and ball pen). In case of complementary commodities, the cross elasticity will be negative. This means that fall in price of X (pen) leads to rise in its demand so also rise in t) demand for Y (ink) On the other hand, the cross elasticity for substitutes is positive which means a fall in price of X (pen) results in rise in demand for X and fall in demand for Y (ball pen). If two commodities, say X and Y, are unrelated there will be no change i. Demand for X as a result of change in price of Y. Cross elasticity in cad of such unrelated goods will then be zero.

In short, cross elasticity will be of three types:

1. Negative cross elasticity – Complementary commodities.
2. Positive cross elasticity – Substitutes.
3. Zero cross elasticity – Unrelated goods.

Importance of Elasticity

The concept of elasticity is of great importance both in economic theory and in practice.

1. Theoretically, its importance lies in the fact that it deeply analyses the price-demand relationship. The law of demand merely explains the qualitative relationship while the concept of elasticity of demand analyses the quantitative price-demand relationship.
2. The Pricing policy of the producer is greatly influenced by the nature of demand for his product. If the demand is inelastic, he will be benefited by charging a high price. If on the other hand, the demand is elastic, low price will be advantageous to the producer. The concept of elasticity helps the monopolist while practicing the price discrimination.
3. The price of joint products can be fixed on the basis of elasticity of demand. In case of such joint products, such as wool and mutton, cotton and cotton seeds, separate costs of production are not known. High price is charged for a product having inelastic demand (say cotton) and low price for its joint product having elastic demand (say cotton seeds).
4. The concept of elasticity of demand is helpful to the Government in fixing the prices of public utilities.
5. The Elasticity of demand is important not only in pricing the commodities but also in fixing the price of labour viz., wages.
6. The concept of elasticity of demand is useful to Government in formulation of economic policy in various fields such as taxation, international trade etc. (a) The concept of elasticity of demand guides the finance minister in imposing the commodity taxes. He should tax such commodities which have inelastic demand so that the Government can raise handsome revenue.(b) The concept of elasticity of demand helps the Government in formulating commercial policy. Protection and subsidy is granted to the industries which face an elastic demand.
7. The concept of elasticity of demand is very important in the field international trade. It helps in solving some of the problems of international trade such as gains from trade, balance of payments etc. policy of tariff also depends upon the nature of demand for a commodity.

In nutshell, it can be concluded that the concept of elasticity of demand has great significance in economic analysis. Its usefulness in branches of economic such as production, distribution, public finance, international trade etc., has been widely accepted.

Question Bank - Concept of Demand In Economics

1. Write a short note on 'Law of demand'
2. Explain briefly how the demand for a commodity is affected by changes in price. In come, price of substitute, advertisement ad population.
3. Define price elasticity of demand ad distinguish between its various types. Discuss the role of price elasticity of demand in business decision
4. Define elasticity of demand. Explain with diagrams the cases where the absolutely value of elasticity is (i) zero (ii) infinity (iii) one (iv) less than one (v) more than one

Source: Economics Lecture 2, Study Notes For Academic Year 2009-2010.