Measurement of price elasticity of demand.

ep = (ΔQ/ΔP) × (P/Q)

It is also known as ratio method, when we measure the ratio as: ep = %ΔQ/%ΔP

Where, %ΔQ = percentage change in demand

%ΔP = percentage change in price

2. Total Outlay Method

Marshall suggested that the simplest way to decide whether demand is elastic or inelastic is to examine the change in total outlay of the consumer or total revenue of the firm.

Total Revenue = (Price × Quantity Sold)

TR = (P × Q)

Marshall has laid down the following propositions:

(a) Elastic Demand: If ep > 1, the percentage rise in quantity demanded is greater than the percentage fall in price. Revenue increases because the increase in quantity demanded more than offsets the decrease in price. Price and revenue move in opposite directions.

(b) Inelastic Demand: If ep < 1, the percentage rise in quantity demanded is less than the percentage fall in price. Revenue falls because the decline in price is not offset by the relatively small rise in quantity. Price and revenue move in the same direction.

(c) Unitary Elastic Demand: If ep = 1, the percentage rise in quantity demanded equals the percentage fall in price. Revenue is unchanged because the decline in price is just offset by the rise in quantity.

3. Point or Geometrical Elasticity Method

Under the total outlay method, the terms ‘elastic’ and ‘inelastic’ have been applied to the whole demand for a commodity. This is accurate enough for some purposes, but not for others, because the demand for a commodity can be elastic in one price range and inelastic in another.

When the demand curve is a straight line, it is said to be linear. Graphically, the point elasticity of a linear demand curve is shown by the ratio of the segments of the line to the right and to the left of the particular point.

When a point is taken on the demand curve (like midpoint P in figure 2), it divides the curve into two parts.

Point Elasticity = Lower segment of the demand curve below the given point / Upper segment of the demand curve above the given point or ep = L/U, where ‘ep’ stands for point elasticity, ‘L’ stands for the lower segment and ‘U’ for the upper segment.

Therefore, it is obvious that at the mid-point of the linear demand curve, ep = 1. At any point to the right of P, the point elasticity is less than unity (ep < 1); at any point to the left of P, ep > 1; At point R, ep = α while at M, the ep = 0.

4. Arc Method

The concept of point elasticity is relevant where a change in price and the resulting change in quantity is infinitesimally small. But where the change in price and the consequent change in demand are substantial, the concept of arc elasticity is a more relevant concept.

An arc is a portion or a segment of a demand curve. The question now is to get at the appropriate formula for arc elasticity. The percentage formula, (ΔQ/ΔP) × (P/Q).

Gives different results depending on whether the price is raised or lowered. Now, let us look at the market demand schedule and the market demand curve.

From A to C: ep = (ΔQ/ΔP) × (P/Q) = (20/2) × (4/10) = 4

From C to A: ep = (ΔQ/ΔP) × (P/Q) = (20/2) × (4/30) = 0.66

We thus get different values for ep one when the price falls and another, when the price rises.

The way out of this difficulty is to take an average of prices and quantities and then to measure elasticity at the mid-point of the arc. The formula becomes:

(ΔQ/ (1/2) (Q1 + Q2)) / (ΔP/ (1/2) (P1 + P2))

Applying this modified formula to find ep for a movement from A to C or for a movement from C to A, we get: ep = (20/ (1/2) (10 + 30)) / (2/ (1/2) (4 + 2)) = (20/20) × (3/2) = 1.5

This is equivalent to the elasticity at the midpoint, i.e., at point B.

Date: 2016-01-03; view: 922