Measurement of Price Elasticity of Demand by Total Outlay Method
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Elasticity of Demand
The elasticity of demand is a measure of degree of responsiveness of quantity demanded for a product to the change in its determinants.
The law of demand helps to understand the direction in which price and quantity demanded change.
It is limited to the statement as:
If price increases, quantity demanded will decline or if income rises demand will increase.
But it cannot answer by how much?
In business or economic analysis, it is essential to address ‘by how much’ question.
It is necessary to find out the exact value of the change in quantity demanded in response to the change in price or income.
Elasticity of demand helps to find out the exact values in such cases.
The elasticity of demand is a measure of degree of responsiveness of demand for a product to the change in its determinants.
Elasticity of demand (Ep) = Percentage change in quantity demand for a good ÷ Percentage change in its price
Demand is determined by various factors such as price, income, price of other goods, taste, preferences etc.
There are various types of elasticity of demand as its determinants.
However, we discuss only price, income and cross elasticity of demand as they are the main determinants of demand whose change is visible and measurable.
Types of Elasticity of Demand
There are three types of elasticity of demand. They are
Measurement of Price Elasticity of Demand by Total Outlay Method
The total outlay method is the simple method of measuring price elasticity of demand.
It helps to establish the relationship between change in price of a good and change in total expenditure of a consumer on that good.
The change in total spending caused by the change in price is directly related to the elasticity of demand.
In this method, we observe direction of change in total expenditure of a buyer on a good in response to the change in the price of the good to calculate the price elasticity of demand.
When, price of a good changes, it brings change in the total expenditure of the consumer on that good.
Based on the direction of the change in the total expenditure, the elasticity of demand may be;
1. Elasticity of demand greater than unity or relatively elastic demand,
2. Elasticity of demand less than unity or relatively inelastic demand, and
3. Elasticity of demand equal to unity or unitary elastic demand.
Elasticity of demand greater than unity [relatively elastic demand]
If the total expenditure of the consumer increases with fall in price; and total expenditure decreases due to rise in price, elasticity of demand is called greater than unity.
In other words, if there is an inverse relationship between the change in price of a good and the corresponding change in total expenditure of a buyer on that good, then the demand is known as relatively elastic demand.
Here, the value of elastic remains greater than unity (one).
Here, an increase in price leads to a decline in total expenditure and vice versa.
Here, Amount = Rs = $ = £ = € = ₹ = Af = ৳ = Nu = Rf = රු = Currency of your country
|
Per unit price (P) |
Units of quantity demanded (Q) |
Total expenditure (in ₹/Rs) (P × Q) |
|
60 |
1 |
60 |
|
50 |
2 |
100 |
The table shows that a price Rs 60, total expenditure is Rs 60.
When price decreased from Rs 60 to 50, then total expenditure increased from Rs 60 to 100.
The price and total expenditure are moving in opposite directions because the percentage decline in price is less than the percentage increase in quantity demanded.
Therefore, the total expenditure curve is downward sloping against the price.
And this type of elasticity is found in case of luxurious goods.
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Elasticity of demand equal to unity [unitary elastic demand]
If total expenditure on a good of a buyer is totally irresponsive to the change in price of the good, then the demand is known as unitary elastic demand.
At that time, whatever is the price of the good, total expenditure of a buyer on it remains constant.
Here, Amount = Rs = $ = £ = € = ₹ = Af = ৳ = Nu = Rf = රු = Currency of your country
|
Per unit price (P) |
Units of quantity demanded (Q) |
Total expenditure (in ₹/Rs) (P × Q) |
|
40 |
3 |
120 |
|
30 |
4 |
120 |
The table shows that at price Rs 40, total expenditure is Rs 120.
Even the price decreased from Rs 40 to 30, total expenditure is remained constant at Rs 120.
There is no relationship between price and total expenditure because price and quantity demanded are changing in the same percentage.
Therefore, the total expenditure curve is a vertical straight line on a certain level of total expenditure or there is no change in total expenditure.
This type of elasticity can be found basically in normal goods.
Elasticity of demand less than unity [relatively inelastic demand]
If total expenditure falls with decrease in price and vice-versa, the elasticity of demand is said to be less than unity.
In other words, if there is a positive relationship between price of a good and total expenditures of a buyer on that good, then the demand is known as relatively inelastic demand and the value of elasticity remains less than unity.
In that case, an increase in price leads an increase in total expenditure and vice versa.
Here, Amount = Rs = $ = £ = € = ₹ = Af = ৳ = Nu = Rf = රු = Currency of your country
|
Per unit price (P) |
Units of quantity demanded (Q) |
Total expenditure (in ₹/Rs) (P × Q) |
|
20 |
5 |
100 |
|
10 |
6 |
60 |
The table shows that at price Rs 20, total expenditure is Rs 100.
When price decreased from Rs 20 to 10 then total expenditure also declined from Rs 100 to 60.
The price and total expenditure are moving in the same direction because the percentage decline in price is greater than the percentage increase in quantity demanded.
This type of elasticity can be found in inferior goods and basic necessary goods.
All three types of elasticity of demand with response the change in total expenditure are shown in figure:
In above figure, total expenditure of the consumer is shown on X-axis and Price on Y-axis.
The curve denoted by TE is the total expenditure curve of the buyer.
When the price of the goods is P1 in the market, the corresponding total expenditure is denoted by TE1.
As there is fall in price from P1 to P2, the total expenditure of the buyer has increased from TE1 to TE2.
The further fall in price increases expenditure to TE3.
So, the TA segment of the curve represents price elasticity of demand greater than unity.
Likewise, when price further falls from P3 to P4, there is no any change in total expenditure i.e. it remains fixed at TE3.
So, by definition, when there is no change in total expenditure due to any fall or rise in price, it represents unitary elastic demand.
Thus, the AB segment of the curve shows that price elasticity of demand equal to unity.
On the other hand, the ‘BE’ segment of the curve shows that price elasticity of demand is less than unity.
As price falls from P4 to P5 and P6, the total expenditure has decreased from TE3 to TE2 and further TE1.
So, by definition when total expenditure falls with fall in price, it is called less elastic demand i.e. price elasticity of demand is less than unity.
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