Elasticity of Demand measures the responsiveness or sensitivity of the quantity demanded of a commodity to a change in one of its determinants, such as price, income, or the price of related goods. While the Law of Demand indicates the direction of change (inverse), Elasticity of Demand quantifies the magnitude of that change.
Types of Elasticity of Demand
Economists primarily categorize elasticity based on the variable causing the change in demand:
- Price Elasticity of Demand (PED): Responsiveness of demand to a change in the price of the commodity itself.
- Income Elasticity of Demand (YED): Responsiveness of demand to a change in the consumer’s income.
- Cross Elasticity of Demand (XED): Responsiveness of demand for Good A to a change in the price of Good B (Substitutes or Complements).
Price Elasticity of Demand (PED)
Price Elasticity is calculated as the percentage change in quantity demanded divided by the percentage change in price.
Degrees of Price Elasticity
| Degree of Elasticity | Numerical Value | Description | Example |
|---|---|---|---|
| Perfectly Inelastic | Ep=0 | Demand remains constant regardless of price changes. | Life-saving drugs, salt. |
| Inelastic | 0<Ep<1 | % change in demand is less than % change in price. | Essential fuels (Petrol/Diesel), electricity. |
| Unitary Elastic | Ep=1 | % change in demand equals % change in price. | Mid-range electronics or clothing. |
| Elastic | 1<Ep<∞ | % change in demand is greater than % change in price. | Luxury cars, international air travel. |
| Perfectly Elastic | Ep=∞ | Infinite change in demand at a specific price; demand becomes zero if price rises slightly. | Theoretical concept in Perfect Competition. |
Methods of Measuring Price Elasticity
For UPSC Prelims, understanding the logic behind these measurement techniques is essential:
- Total Expenditure (Outlay) Method: Developed by Alfred Marshall. If total expenditure moves in the opposite direction of price, demand is elastic (E>1). If it moves in the same direction, demand is inelastic (E<1). If expenditure remains unchanged, it is unitary (E=1).
- Percentage / Flux Method: Compares the ratio of the percentage change in quantity demanded to the percentage change in price.
- Point Elasticity Method: Used to measure elasticity at a specific point on a linear demand curve using the formula: Lower segment/Upper segment.
- Arc Elasticity Method: Measures elasticity over a range or “arc” of the demand curve rather than at a single point.
Income Elasticity of Demand (YED)
Income elasticity identifies the nature of the good based on how consumption reacts to changes in consumer earnings.
- Positive Income Elasticity: Demand increases as income increases. This applies to Normal Goods.
- High Elasticity (Ey>1): Luxury goods (High-end smartphones).
- Low Elasticity (0<Ey<1): Essential goods (Food grains).
- Negative Income Elasticity (Ey<0): Demand decreases as income increases. This applies to Inferior Goods (e.g., coarse cereals, public transport), as consumers switch to superior substitutes.
- Zero Income Elasticity (Ey=0): Demand remains unaffected by income (e.g., common salt).
Cross Elasticity of Demand (XED)
This measures the effect of a price change in one product on the demand for another.
- Positive Cross Elasticity: Found in Substitute Goods. If the price of Coffee rises, the demand for Tea increases.
- Negative Cross Elasticity: Found in Complementary Goods. If the price of Petrol rises, the demand for Cars decreases.
- Zero Cross Elasticity: Found in Unrelated Goods. A change in the price of shoes has no effect on the demand for bread.
Factors Influencing Elasticity of Demand
- Availability of Substitutes: Goods with close substitutes (Coke vs. Pepsi) have high elasticity. Goods with no substitutes have low elasticity.
- Nature of the Commodity: Necessities (Medicine) are inelastic; luxuries (Jewelry) are elastic.
- Proportion of Income Spent: Goods that take up a tiny fraction of budget (Matchboxes, newspapers) are inelastic. Large ticket items (Appliances) are elastic.
- Time Period: Demand is generally more elastic in the long run as consumers find it easier to adjust their habits or find substitutes.
- Number of Uses: Commodities with multiple uses (Electricity, Milk) have higher elasticity because a price rise leads to consumers restricting its use to only the most essential tasks.
Economic Significance and UPSC Trivia
- Taxation Policy: Governments impose higher taxes on commodities with Inelastic Demand (e.g., cigarettes, alcohol) because the tax burden does not significantly reduce consumption or revenue.
- Paradox of Plenty: In agriculture, a bumper harvest can lead to a sharp fall in prices. Since the demand for food grains is relatively inelastic, farmers’ total revenue may actually fall despite higher output.
- Pricing Power: Monopolists often practice price discrimination by charging higher prices in markets where demand is inelastic and lower prices where it is elastic.
- The Engel’s Law: As income rises, the proportion of income spent on food decreases, even if absolute expenditure on food rises. This implies that the income elasticity of demand for food is less than one.