The Law of Demand states that there exists an inverse relationship between quantity demanded of a good or service and

its price; that is, a fall in the price of a product will cause its demand to rise and vice-versa. This is intuitively obvious but is also explained by the Theory of Consumer Choice and the Law of Diminishing Marginal Utility. Quantity demanded is also affected by Conditions of Demand such as changes in tastes, changes in the price of substitute or complement goods or income increases or decreases. However, knowing by how much the quantity demanded will respond to such changes would be particularly helpful for reasons we shall explore later on. Economic theory provides a measure of the responsiveness of demand due to changes in the following 3 forms: Price Elasticity of Demand Cross Price Elasticity of Demand Income Elasticity of Demand

1. Price Elasticity of Demand The responsiveness of demand due t I changes in its own price is called Price Elasticity of Demand (PED). In other words, it is percentage change in quantity demanded by the percentage change in price of the same commodity

Formula for PED: Example:

PED =

where QD = Quantity Demanded and P = Price of the product

The quantity demanded of Good X at a price of $5 is 100 units. Following a price fall to $4, demand for Good X increases to 130 units.

%QD =

x 100 = = 100
=

x 100
100 = 30%

%P =

x 100 = = 100
=

x 100
100 = -20%

PED =

What would be the PED if the quantity of good X demanded remained 100 units? What would be the PED if the quantity of good X demanded changed to 50 units?

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Interpretation: PED always has a negative value to reflect the inverse relationship between quantity demanded and price; for example, a fall in price (-) induces an increase in demand (+), ceteris paribus. price. The response of demand to the change is price is more than proportionate. Demand is qualified as being fairly elastic. VALUE OF PED PED = = 0 PED = < 1 PED = =1 PED = > 1 PED = = DEGREE OF ELASTICITY Perfectly Inelastic Fairly Inelastic Unitary Elastic Fairly Elastic Perfectly Elastic MEANING P , %QD = 0 %QD < %P %QD = %P %QD > %P P = 0 , QD SHAPE OF DEMAND CURVE Parallel to the price axis Steep Demand curve Flat demand curve Parallel to the quantity axis

Since 1.5 > 1, it implies that the change in demand is proportionately bigger than the change in

Slope of the Demand Curves with different degree of elasticity. The slope of a demand curve measures the responsiveness of quantity demanded to a change in price, but it is not a units-free measure of this responsiveness and cannot be used to compare the demand curves of different goods.

Which demand curve corresponds to which degree of elasticity?

Determinants of PED: Number and closeness of substitutes The higher the availably of close substitutes, the greater the ease of switching from the consumption of a good which following a price rise, costs more than its substitutes. Why will the PED for Indian Oil Petrol be higher than the demand for petrol (the product, irrespective of brands)? The proportion of income spent on the good or service. If a product takes a very small proportion of the total income, it is likely that a rise in its price will not change the quantity demanded of that product. (E.g. Matches) It can be argued that goods that account for a large proportion of disposable income tend to be elastic. This is due to consumers being more aware of small changes in price of expensive goods compared to small changes in the price of inexpensive goods. The time period People take time to adjust to changes in prices and therefore in the short run, demand will remain unaffected. Other determinants: Is the Demand for cigarettes price elastic or inelastic? Why? Does water have a high or low PED? [Hint: a Necessity and multipurpose of water]

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Price Elasticity of Demand and Consumer Expenditure: One of the most important applications of PED concerns its relationship with the total consumer expenditure (TE), which is also equal to the total revenue (TR), received by the producing firm: TE = TR = P x Q Elastic Demand Check the maths!

Quantity demanded changes proportionately more than price: Price rises; Q falls more than proportionately, thus TE falls. Price falls; Q rises more than proportionately, thus TE rises. Inelastic Demand

Check the maths!

Quantity demanded changes proportionately less than price: Price rises; Q falls less than proportionately, thus TE rises. Price falls; Q rises less than proportionately, thus TE falls. Special Cases Work out the effect of changes in prices on 1. Perfectly Inelastic Demand 2. Perfectly Elastic Demand 3. Unitary Elastic Demand

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Cross Elasticity of Demand The cross elasticity of demand is a measure of the extent to which the demand for a good changes when the price of a substitute or complement changes, other things remaining the same.

1. The formula used to calculate the cross elasticity of demand is:

Cross elasticity

of demand

Percentage

change in quantity demanded of a good . Percentage change in price of one s or complement s

of its substitute
2. The cross elasticity of demand for a substitute is positive. 3. The cross elasticity of demand for a complement is negative.

Can you figure out why? Hint:

The relationship between prices of such goods and demand.

Which are likely to have the highest cross elasticity of demand: Two brands of coffee, or coffee and tea?

Income Elasticity of Demand The income elasticity of demand is a measure of the extent to which the demand for a good changes when income changes, other things remaining the same.

1. The formula used to calculate the income elasticity of demand is:

Income elasticity of demand = Percentage change in quantity demanded Percentage change in income .

2. For a normal good, the income elasticity of demand is positive. 3. When the income elasticity of demand is greater than 1, demand is income elastic. 4. When the income elasticity of demand is between zero and 1, demand is income inelastic. 5. For an inferior good, the income elasticity of demand is negative. Why would YED<0 for inferior? Hint: People consumed less canned vegetables and more fresh ones as their income rises. What is a Giffen Good?

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