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Economics for MBA

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INTRODUCTION Recall the law of demand, which shows the inverse relation between price of commodity and its quantity demanded. You know that when price of commodity increases (or decreases), its quantity demanded will fall (or rise). But this knowledge cannot answer a simple question that if price increases by one unit, by what proportion will quantity demanded decreases. This is to say that the law of demanded gives only the direction of change of quantity demanded in response to a given change in the price of a commodity, but not the magnitude of such a change ELASTICITY OF DEMAND Elasticity of demand measures the degree of responsiveness of the quantity demanded of a commodity to a given change in any of the determinants of demand. Types of Elasticity of Demand 1. Price Elasticity of demand. 2. Income Elasticity of demand. 3. Cross Elasticity of demand. 1. Price Elasticity of Demand The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price.

ED =

Commonly said that the flatter the demand curve, the lesser is the elasticity. The following are the different degrees of elasticity:Perfectly Elastic Demand One extreme of the elasticity range, when elasticity is equal to infinity, i.e., E = . In this case, unlimited quantities of the commodity can be demanded at the prevailing price and even a negligible, increase in price would result in zero quantity demanded The demand curve is horizontal, any change in price can and will cause consumers to change their consumption. Perfectly Elastic Demand Curve

Highly Elastic Demand When proportion change in quantity demanded is more than given in price, the commodity is regarded to have elastic demand>1.

Unitary Elastic Demand When a given proportionate change in price brings about an equal proportionate change in quantity demand then demand for that commodity is regarded as unitary elastic=1. Relatively Inelastic Demand When change in quantity demanded is found to be so offset by change in its price then the commodity has a relatively inelastic demand (E<1) Perfectly Inelastic Demand Other extreme of the elasticity range in which elasticity ia equal to zero(E=0). In this case the quantity demanded of a commodity remains the same, irrespective of any change in the price. The demand curve is vertical, the quantity demanded is totally unresponsive to the price. Changes in price have no effect on consumer demand. Perfectly Inelastic Demand Curve

Arc Elasticity Method Arc elasticity is used as a measure in case the availale figures on price and quantity are discrete, and it is possible to isolate and calculate the incremental changes. Arc elasticity is used to find the elasticity at the midpoint of an arc between any two points on a demand curve, by taking the average of the prices and quantities.

(Q2 - Q1)

Elasticity =

Income Elasticity of Demand

Q2 Q1 P1 + P2

(P2 - P1)

Income elasticity of demand measures the degrees of responsiveness of demand for a commodity to a given change in consumers income. Degrees of Income Elasticity Income elasticity of demand when the proportionate change in demand is more than that in income, demand is highly elastic; when the proportionate change in demand is less than that of income, demand is highly inelastic. Positive Income Elasticity A good that has positive income elasticity is regarded as a normal good. A normal good is one which a consumer buys in more quantities when his/her income increases. Examples are clothes, fruits, jewellery, etc. Zero income Elasticity

There is no change in the demand for a commodity when there is a change in income is known as neutral goods. For example:-can be match box, salt, postcard, needles,etc. Negative Income Elasticity Demand for a commodity decreases as the income of the consumer rises. A good that has negative income elasticity of demand is regarded as an inferior good,i.e.,inferior quality of cereals. CROSS ELASTICTY OF DEMAND Cross elasticity of demand of a commodity X measures the degree of responsiveness of its demand to a given change in the price of another commodity Y. Demand for one good to the changes in price of another related good (ceteris paribus).

If X and Y are related and an increase in price of Y results in a fall in quantity demanded of X, it means X and Y are complements; on the other hand, if increases in price of Y increases the demand for X,the two goods are substitutes. Cross elasticity can be understood under following subheads:Positive Cross Elasticity Positive cross elasticity implies that between two goods X and Y, quantity demanded of X moves in the same direction as the price of Y. Negative Cross Elasticity Negative E implies that between any two commodities X and Y the quantity demanded of one would move in the opposite direction as the price of the other. .For substitutes quantity demanded of one good moves in the same direction as the price of the other. .For complements, quantity demanded of one good moves in the opposite direction as the price of the other.

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