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Elasticity of Demand, Demand Estimation and Forecasting

Elasticity of Demand

Demand extends or contracts respectively with a fall or rise in price. This quality of demand by virtue of which it changes (increases or decreases) when price changes (decreases or increases) is called Elasticity of Demand.

“The elasticity (or responsiveness) of demand in a market is great or small according as the amount demanded increases much or little for a given fall in price, and diminishes much or little for a given rise in price”. – Dr. Marshall.

Elasticity means sensitiveness or responsiveness of demand to the change in price.

This change, sensitiveness or responsiveness, may be small or great. Take the case of salt. Even a big fall in its price may not induce an appreciable ex appreciable extension in its demand. On the other hand, a slight fall in the price of oranges may cause a considerable extension in their demand. That is why we say that the demand in the former case is ‘inelastic’ and in the latter case it is ‘elastic’.

The demand is elastic when with a small change in price there is a great change in demand; it is inelastic or less elastic when even a big change in price induces only a slight change in demand. In the words of Dr. Marshall, “The elasticity (or responsiveness) of demand in a market is great or small according as the amount demanded increases much or little for a given fall in price, and diminishes much or little for a given rise in price.”But the demand cannot be perfectly ‘elastic’ or ‘inelastic’.

Completely elastic demand will mean that a slight fall (or rise) in the price of the commodity concerned induces an infinite extension (or contraction) in its demand. Completely inelastic demand will mean that any amount of fall (or rise) in the price of the commodity would not induce any extension (or contraction) in its demand. Both these conditions are unrealistic. That is why we say that elasticity of demand may be ‘more or less’, but it is seldom perfectly elastic or absolutely inelastic.

Types of Elasticity:

Distinction may be made between Price Elasticity, Income Elasticity and Cross Elasticity. Price Elasticity is the responsiveness of demand to change in price; income elasticity means a change in demand in response to a change in the consumer’s income; and cross elasticity means a change in the demand for a commodity owing to change in the price of another commodity.

Degrees of Elasticity of Demand:

We have seen above that some commodities have very elastic demand, while others have less elastic demand. Let us now try to understand the different degrees of elasticity of demand with the help of curves.

 (a) Infinite or Perfect Elasticity of Demand:

Let as first take one extreme case of elasticity of demand, viz., when it is infinite or perfect. Elasticity of demand is infinity when even a negligible fall in the price of the commodity leads to an infinite extension in the demand for it. In Fig. 10.1 the horizontal straight line DD’ shows infinite elasticity of demand. Even when the price remains the same, the demand goes on changing.

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(b) Perfectly Inelastic Demand:

The other extreme limit is when demand is perfectly inelastic. It means that howsoever great the rise or fall in the price of the commodity in question, its demand remains absolutely unchanged. In Fig. 10.2, the vertical line DD’ shows a perfectly inelastic demand. In other words, in this case elasticity of demand is zero. No amount of change in price induces a change in demand.

In the real world, there is no commodity the demand for which may be absolutely inelastic, i.e., changes in its price will fail to bring about any change at all in the demand for it. Some extension/contraction is bound to occur that is why economists say that elasticity of demand is a matter of degree only. In the same manner, there are few commodities in whose case the demand is perfectly elastic. Thus, in real life, the elasticity of demand of most goods and services lies between the two limits given above, viz., infinity and zero. Some have highly elastic demand while others have less elastic demand.

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(c) Very Elastic Demand:

Demand is said to be very elastic when even a small change in the price of a commodity leads to a considerable extension/contraction of the amount demanded of it. In Fig. 10.3, DD’ curve illustrates such a demand. As a result of change of T in the price, the quantity demanded extends/contracts by MM’, which clearly is comparatively a large change in demand.

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(d) Less Elastic Demand:

When even a substantial change in price brings only a small extension/contraction in demand, it is said to be less elastic. In Fig. 10.4, DD’ shows less elastic demand. A fall of NN’ in price extends demand by MM’ only, which is very small.

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The ‘Law Of Demand’ states that, all other factors being equal, as the price of a good or service increases, consumer demand for the good or service will decrease, and vice versa.

Demand elasticity is a measure of how much the quantity demanded will change if another factor changes.

Changes in Demand

Change in demand is a term used in economics to describe that there has been a change, or shift in, a market’s total demand. This is represented graphically in a price vs. quantity plane, and is a result of more/less entrants into the market, and the changing of consumer preferences. The shift can either be parallel or nonparallel.

Extension of Demand

Other things remaining constant, when more quantity is demanded at a lower price, it is called extension of demand.

Px Dx  
15 100 Original
8 150 Extension

Contraction of Demand

Other things remaining constant, when less quantity is demanded at a higher price, it is called contraction of demand.

Px Dx  
10 100 Original
12 50 Contraction

Concept of Elasticity

Law of demand explains the inverse relationship between price and demand of a commodity but it does not explain to the extent to which demand of a commodity changes due to change in price.

A measure of a variable’s sensitivity to a change in another variable is elasticity. In economics, elasticity refers the degree to which individuals change their demand in response to price or income changes.

It is calculated as −

Elasticity = 

% Change in quantity / % Change in price

Elasticity of Demand

Elasticity of Demand is the degree of responsiveness of change in demand of a commodity due to change in its prices.

Importance of Elasticity of Demand

  • Importance to producer− A producer has to consider elasticity of demand before fixing the price of a commodity.
  • Importance to government− If elasticity of demand of a product is low then government will impose heavy taxes on the production of that commodity and vice – versa.
  • Importance in foreign market− If elasticity of demand of a produce is low in the international market then exporter can charge higher price and earn more profit.

Methods to Calculate Elasticity of Demand

Price Elasticity of demand

The price elasticity of demand is the percentage change in the quantity demanded of a good or a service, given a percentage change in its price.

Total Expenditure Method

In this, the elasticity of demand is measured with the help of total expenditure incurred by customer on purchase of a commodity.

Total Expenditure = Price per unit × Quantity Demanded

Proportionate Method or % Method

This method is an improvement over the total expenditure method in which simply the directions of elasticity could be known, i.e. more than 1, less than 1 and equal to 1. The two formulas used are −

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Geometric Method

In this method, elasticity of demand can be calculated with the help of straight line curve joining both axis – x & y.

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Factors Affecting Price Elasticity of Demand

The key factors which determine the price elasticity of demand are discussed below −

Substitutability

Number of substitutes available for a product or service to a consumer is an important factor in determining the price elasticity of demand. The larger the numbers of substitutes available, the greater is the price elasticity of demand at any given price.

Proportion of Income

Another important factor effecting price elasticity is the proportion of income of consumers. It is argued that larger the proportion of an individual’s income, the greater is the elasticity of demand for that good at a given price.

Time

Time is also a significant factor affecting the price elasticity of demand. Generally consumers take time to adjust to the changed circumstances. The longer it takes them to adjust to a change in the price of a commodity, the lesser price elastic would be to the demand for a good or service.

Income Elasticity

Income elasticity is a measure of the relationship between a change in the quantity demanded for a commodity and a change in real income. Formula for calculating income elasticity is as follows −

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Following are the Features of Income Elasticity −

  • If the proportion of income spent on goods remains the same as income increases, then income elasticity for the goods is equal to one.
  • If the proportion of income spent on goods increases as income increases, then income elasticity for the goods is greater than one.
  • If the proportion of income spent on goods decreases as income increases, then income elasticity for the goods is less by one.

Cross Elasticity of Demand

An economic concept that measures the responsiveness in the quantity demanded of one commodity when a change in price takes place in another good. The measure is calculated by taking the percentage change in the quantity demanded of one good, divided by the percentage change in price of the substitute good −

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  • If two goods are perfect substitutes for each other, cross elasticity is infinite.
  • If two goods are totally unrelated, cross elasticity between them is zero.
  • If two goods are substitutes like tea and coffee, the cross elasticity is positive.
  • When two goods are complementary like tea and sugar to each other, the cross elasticity between them is negative.

Total Revenue (TR) and Marginal Revenue

Total revenue is the total amount of money that a firm receives from the sale of its goods. If the firm practices single pricing rather than price discrimination, then TR = total expenditure of the consumer = P × Q

Marginal revenue is the revenue generated from selling one extra unit of a good or service. It can be determined by finding the change in TR following an increase in output of one unit. MR can be both positive and negative. A revenue schedule shows the amount of revenue generated by a firm at different prices −

Price Quantity Demanded Total Revenue Marginal Revenue
10 1 10  
9 2 18 8
8 3 24 6
7 4 28 4
6 5 30 2
5 6 30 0
4 7 28 -2
3 8 24 -4
2 9 18 -6
1 10 10 -8

Initially, as output increases total revenue also increases, but at a decreasing rate. It eventually reaches a maximum and then decreases with further output. Whereas when marginal revenue is 0, total revenue is the maximum. Increase in output beyond the point where MR = 0 will lead to a negative MR.

Price Ceiling and Price Flooring

Price ceilings and price flooring are basically price controls.

Price Ceilings

Price ceilings are set by the regulatory authorities when they believe certain commodities are sold too high of a price. Price ceilings become a problem when they are set below the market equilibrium price.

There is excess demand or a supply shortage, when the price ceilings are set below the market price. Producers don’t produce as much at the lower price, while consumers demand more because the goods are cheaper. Demand outstrips supply, so there is a lot of people who want to buy at this lower price but can’t.

Price Flooring

Price flooring are the prices set by the regulatory bodies for certain commodities when they believe that they are sold in an unfair market with too low prices.

Price floors are only an issue when they are set above the equilibrium price, since they have no effect if they are set below the market clearing price.

When they are set above the market price, then there is a possibility that there will be an excess supply or a surplus. If this happens, producers who can’t foresee trouble ahead will produce larger quantities.

Demand Estimation and Forecasting

Demand Estimation

Business enterprise needs to know the demand for its product. An existing unit must know current demand for its product in order to avoid underproduction or over production. The current demand should be known for determining pricing and promotion policies so that it is able to secure optimum sales or maximum profit. Such information about the current demand for the firm‟s product is known as demand estimation.

Demand Estimation is the process of finding current values of demand for various values of prices and other determining variables.

Steps in Demand Estimation

  1. Identification of independent variables such as price, price of substitutes, population, percapita income, advertisement expenditure etc.,
  2. collection of data on the variables from past records, publications of various agencies etc.,
  3. Development a mathematical model or equation that indicates the relationship between independent and dependant variables.
  4. Estimation of the parameters of the model. I.e., to estimate the unknown values of the parameters of the model.
  5. Development of estimates based on the model.

Tools and techniques for demand estimation includes

  1. Consumer surveys.
  2. Consumer clinics and focus groups
  3. Market Experiment.
  4. Statistical techniques.

Demand Forecasting

Accurate demand forecasting is essential for a firm to enable it to produce the required quantities at the right time and to arrange well in advance for the various factors of production. Forecasting helps the firm to assess the probable demand for its products and plan its production accordingly.

Demand Forecasting refers to an estimate of future demand for the product. It is an “objective assessment of the future course of demand”. It is essential to distinguish between forecast of demand and forecast of sales. Sales forecast is important for estimating revenue, cash requirements and expenses. Demand forecast relate to production inventory control, timing, reliability of forecast etc…

Levels of Demand forecasting

Demand forecasting may be undertaken at three different levels;

  1. Macro level – Micro level demand forecasting is related to the business conditions prevailing in the economy as a whole.
  1. Industry Level – it is prepared by different trade association in order to estimate the demand for particular industries products. Industry includes number of firms. It is useful for inter-industry comparison.
  1. Firm level – it is more important from managerial view point as it helps the management in decision making with regard to the firms demand and production.

 

Types of Demand Forecasting

Based on the time span and planning requirements of business firms, demand forecasting can be classified into short term demand forecasting and long term demand forecasting.

Short term Demand forecasting: Short term Demand forecasting is limited to short periods, usually for one year. Important purposes of Short term Demand forecasting are given below

  1. Making a suitable production policy to avoid over production or underproduction.
  2. Helping the firm to reduce the cost of purchasing raw materials and to control inventory.
  3. Deciding suitable price policy so as to avoid an increase when the demand is low.
  4. Setting correct sales target on the basis of future demand and establishment control. A high target may discourage salesmen.
  5. Forecasting short term financial requirements for planned production.
  6. Evolving a suitable advertising and promotion programme.

Long term Demand Forecasting:  this forecasting is meant for long period. The important purpose of long term forecasting is given below;

  1. Planning of a new unit or expansion of existing on them basis of analysis of long term potential of the product demand.
  2. Planning long term financial requirements on the basis of long term sales forecasting.
  3. Planning of manpower requirements can be made on the basis of long term sales forecast.
  4. To forecast future problems of material supply and energy crisis.

Demand forecasting is a vital tool for marketing management. It is also helpful in decision making and forward planning. It enables the firm to produce right quantities at right time and arrange well in advance for the factors of production.

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