Lesson 6, Topic 1
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Determination of Elasticity of Demand

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Ed = $$\frac {Percentage \; change \; (\Delta) \;in\; Demand}{Percentage \; change\; (\Delta)\; in\; Price}$$

Income Elasticity of Demand

This refers to the degree of responsiveness of demand to a little change in consumer income. Income elasticity of demand is negative for inferior goods since an increase in income will lead to a decrease in demand for them.

Ey = $$\frac{\%change \; in \; quantity \; demanded}{\%change \; in \; income} \\ = \frac{\% \; change \; (\Delta) \;in\; Qdd}{\% \; change \; (\Delta) \;in\; Y}$$

If ∑Y = Positive normal/ luxurious goods is a type of income elasticity of demand in which an increase in income of consumers will equally lead to an increase in the quantity of a commodity demanded. This also called normal goods.

If ∑Y = Negative inferior commodity is a type of income elasticity of demand in which an increase in income of consumers will lead to a decrease in the quantity of a commodity demanded. This is called inferior goods.

Cross Elasticity of Demand

This is the degree of responsiveness of demand for a commodity to a little change in the price of another commodity. It is the proportionate change in the quantity of goods (X) demanded over the proportionate change in the price of another good(Y) demanded. It measures the relationship between changes in price and quantity demanded of complementary and (substitute goods) competitive goods. Cross elasticity of demand is negative for complementary goods but positive for close substitutes.

It is given as

∑XY = $$\frac{\% change \; in \; quantity \; demanded \; of \; commodity X}{\% change \; in \; Price \; of \; commodity X}$$

If ∑XY = Negative – complementary

∑XY   = Positive – Substitute

Determination of Elasticity of Demand

1. Close substitute of a commodity: A slight increase in the price of a commodity with close substitutes will make people switch over to the substitutes and vice versa.

2. Degree of necessity: If a commodity is necessary the demand for it is inelastic but for luxury and normal goods, demand is elastic.

3. Consumer’s Income: The higher the consumer income the more inelastic would be his demand for commodities.

4. The proportion of consumer’s budget represented by the expenditure on the commodity: If the commodity being bought is a larger item in the consumer’s budget, the demand tends to be elastic. Thus a slight increase in the price of automobiles or a TV is usually met by a large drop in demand.

5. Habit: From the common wisdom that habits die-hard, one may expect the demand to be inelastic for those commodities that are consumed out of habit. Example: An alcoholic addict does not usually reduce his daily intake because the price of beer has slightly increased, therefore demand for beer will be inelastic.

6. The extent of various uses: If a particular good can be put into many uses the demand for it will be elastic.  If the price of the commodity falls, people would buy more quantities of it in order to use it progressively less important purposes e.g.  Demand for sachet water is elastic.

7. Durability: Demand for durable goods and those that are capable of being repaired tend to be elastic.

8. Nature of the commodity

Application of Elasticity of Demand

The knowledge of elasticity of demand is of crucial importance to the producers or businessmen and to the government. The total amount of money spent on a commodity by the consumers determines the amount of revenue received.

Importance of Elasticity of Demand to the Government

It helps the government in determining the imposition of taxes on goods and services. The government raises revenue by imposing taxes on produced goods. Since the aim is to collect as much revenue as possible, the government would impose taxes on goods that have fairly low elasticity. This is because if prices go up people will still buy much and the total revenue will rise. In the case of imported goods, the aim is to discourage consumption. The government usually imposes taxes on highly elastic goods because if prices rise, consumption falls. This makes imports to decrease, which saves foreign exchange and creates a market for homemade substitutes.

Importance Elasticity of Demand to the Producers

1. It helps to determine the maximum output to produce in order to ensure a high turnover.

2. Increase in revenue: Since total returns or revenue to the producer depends on the expenditure on that good by the consumers and since expenditure depends on the elasticity of demand, it, therefore, follows that revenue is determined by the elasticity of demand whether expenditure rises or falls. If demand is elastic, total expenditure and total revenue will rise while price falls. If there is an increase in price, total revenue will fall along with total expenditure. But for an inelastic demand, an increase in price will bring about a rise in both total expenditure and total revenue and vice versa.

3. It helps the producer to determine which goods to produce more in substitute goods

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