Elasticity of Demand: Meaning Types and Significance
Elasticity of Demand: Meaning, Types and Significance: With a decrease or increase in price, demand expands or contracts. Elasticity of Demand refers to the quality of demand that fluctuates (raises or lowers) in response to price changes (decreases or increases).
“The quantity demanded rises considerably or little for a given reduction in price, and reduces much or little for a given rise in price, depending on the elasticity (or responsiveness) of demand in a market.” — Marshall, Dr.
Elasticity refers to how sensitive or responsive demand is to price changes.
This shift in sensitivity or responsiveness might be subtle or dramatic. Take, for example, the instance of salt. Even a significant decrease in its price may not result in a significant increase in demand. A minor decrease in the price of oranges, on the other hand, might result in a significant increase in demand. That is why, in the first scenario, demand is ‘inelastic,’ whereas in the second example, demand is ‘elastic.’
When a little change in price causes a large change in demand, the demand is elastic; when even a large change in price causes only a minor change in demand, the demand is inelastic or less elastic. “The elasticity (or responsiveness) of demand in a market is high or little according to how much or little the quantity wanted rises for a given reduction in price, and reduces considerably or little for a given rise in price,” says Dr. Marshall. The demand, on the other hand, cannot be absolutely ‘elastic’ or ‘inelastic.’
When demand is completely elastic, a little decrease (or increase) in the price of the commodity causes an infinite expansion (or contraction) in demand. If demand is completely inelastic, any drop (or increase) in the price of the commodity will not result in any expansion (or contraction) in demand. Both of these scenarios are implausible. That’s why we say demand elasticity may be’more or less’ elastic, but it’s seldom totally elastic or completely inelastic.
Elasticity of Demand: Meaning, Types and Significance
Price Elasticity, Income Elasticity, and Cross Elasticity may all be distinguished. Price elasticity refers to how sensitive demand is to changes in price; income elasticity refers to how responsive demand is to changes in the consumer’s income; and cross elasticity refers to how responsive demand is to changes in the price of another commodity.
(a) Demand Elasticity that is infinite or perfect
Let’s start with the most extreme example of demand elasticity, namely when it is unlimited or perfect. Elasticity of demand is unlimited when even a little decrease in the price of a commodity causes the demand for it to expand infinitely. The horizontal straight line DD’ depicts infinite demand elasticity. Even when the price is constant, the demand fluctuates.
(b) Demand that is perfectly inelastic
When demand is fully inelastic, the opposite extreme is reached. It indicates that no matter how much the price of the item rises or falls, the demand for it stays constant. The vertical line DD’ in Fig. 2 depicts a fully inelastic demand. In other words, demand elasticity is zero in this scenario. A change in price does not cause a change in demand.
In the actual world, there is no item whose demand is completely inelastic, meaning that changes in its price have no effect on its demand. Because some expansion or contraction is unavoidable, economists maintain that demand elasticity is just a question of degree. Similarly, there are few goods whose demand is completely elastic. As a result, in real life, the elasticity of demand for most commodities and services is somewhere between infinity and zero. Some demand is extremely elastic, while others is less elastic
(c) High Demand Elasticity
When even a minor change in the price of a commodity results in a significant expansion or contraction of the quantity sought of it, it is said to be extremely elastic. The DD’ curve in Figure 3 depicts such a demand. The amount wanted extends/contracts by MM’ as a consequence of a price shift of T, which is obviously a big change in demand.
(d) Demand Is Less Elastic
It is considered to be less elastic when even a significant change in price only causes a slight expansion or contraction in demand. Figure 4 indicates that demand is less elastic in DD’. A price drop of NN’ only expands demand by MM’, which is a very modest amount.
The Importance of Demand Elasticity
- Determining the Level of Output
It is critical that the amount of products and services produced corresponds to the demand for that product in order for manufacturing to be profitable. Because price changes cause changes in demand, knowing the elasticity of demand is crucial for predicting the production level.
- Price Determination
The foundation for determining a product’s price is its demand elasticity. The elasticity of demand may be used to calculate the ratio in which demand for a product decreases as its price rises and vice versa.
If a product’s demand is inelastic, the producer may charge a high price, but if the demand is elastic, the manufacturer can charge a low price. As a result, understanding demand elasticity is critical for management in order to maximise profit.
- Monopolist Price Discrimination
The challenge of pricing the same item in two separate markets under monopolistic discrimination is also influenced by the elasticity of demand in each market. The discriminating monopolist sets a low price for his product in markets with elastic demand, and a high price in markets with less elastic demand.
- Price Determination of Production Factors
The idea of demand elasticity is critical for establishing the pricing of different components of production. Factors of production are compensated based on their demand elasticity. To put it another way, if a factor’s demand is inelastic, its price will be high, and if it is elastic, its price would be low.
- Forecasting Demand
Demand elasticity is the foundation of demand forecasting. The ability to estimate future demand for producible commodities requires an understanding of income elasticity. The income elasticity has a greater impact on long-term production planning and management because management can see the impact of shifting income levels on demand for his product.
- Dumping
To fight overseas competition, a company enters foreign markets with the intention of dumping its goods on the basis of demand elasticity.
- Determination of Joint Product Prices
The idea of demand elasticity is very useful in pricing joint items such as wool and mutton, wheat and straw, cotton and cotton seeds, and so on. In such circumstances, the cost of each product’s manufacture is unknown.
As a result, each item’s price is determined by its demand elasticity. That is why inelastic demand goods like wool, wheat, and cotton are so expensive when contrasted to elastic demand byproducts like mutton, straw, and cotton seeds.
- Policy Making by the Government
The government may use information about demand elasticity to assist them make policy decisions. The government must examine the elasticity of demand for a commodity before putting statutory price controls on it.
The government’s decision to designate public utilities industries whose goods have inelastic demand and are at risk of becoming monopolised is based on the elasticity of demand for their products.
- Aided in the Adoption of a Protection Policy
The government takes into account the demand elasticity of the goods of those industries that request for a subsidy or protection. Only industries whose goods have an elastic demand get subsidies or protection. As a result, they are unable to compete with international producers unless their prices are subsidised or imported items’ costs are raised by imposing high tariffs.
- Gains from International Trade Calculation
The benefits of international commerce are dependent on a variety of factors, including demand elasticity. If a country sells items with low demand elasticity and imports commodities with high demand elasticity, it will benefit from international commerce.
It will be able to demand a high price for its products in the first scenario, and it will pay less for items purchased from the other nation in the second situation. As a result, it will benefit in both directions and will be able to grow the amount of its exports and imports.