Measuring Price Elasticity of Demand- Total Expenditure Method

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LearningContents:                                                            

·    Total Expenditure Method- Price Elasticity of Demand

Introduction

Total Expenditure Method/ Total Outlay Method

Prof. Alfred Marshall has propounded the total expenditure method for measuring the price elasticity of demand. In this method, the relationship between Price and Total Expenditure becomes the basis to measure the price elasticity of demand. As we know that Price and Quantity demand are inversely related to each other. Therefore, the effect of change in price is not only on quantity demanded by the consumers but also on total expenditure. Hence, the total expenditure method measures the price elasticity of demand based on the change in expenditure as a result of a change in the price of the commodity. The formula for calculating the total expenditure is:

Total Expenditure = Price × Quantity Demand

 

Three Cases of Price Elasticity of Demand

Total Expenditure method measures the degree of price elasticity of demand in three following cases:

1.      When Elasticity of demand is equal to 1 – Unitary Elastic Demand (Ed=1)

2.      When Elasticity of demand is more than 1- More than Unitary Elastic Demand(Ed>1)

3.      When Elasticity of less than 1- Less than Unitary Elastic Demand(Ed<1)


1. When Elasticity of demand is equal to 1 – Unitary Elastic Demand (Ed=1)

If rise or fall in price of the commodity produces no change in total expenditure, then it is a case of unitary elastic demand. In other words,  It is when total expenditure on the commodity remains constant, no matter whether the price of the commodity increases or decreases.

Unitary Demand Example

Table 1: Unitary Elastic Demand




In this case, we see that when the price of a good is ₹4, the total expenditure is ₹ 12. Further, if the price decreases to ₹ 3, then also total expenditure is ₹ 12. Therefore,  it shows total expenditure is independent of the price change or remains constant whether price increases or decreases. Therefore, it is a case of unitary elastic demand.

2. When Elasticity of demand is more than 1 – More than Unitary Elastic Demand (Ed>1)

When total expenditure on the commodity increases as a result of fall in price and decreases as a result of rise in price, then it is a situation of more than unitary elastic demand. Here, Price and total expenditure move in the opposite direction.

More than Unitary Elastic Demand Example

 

Table 2: More than Unitary Elastic Demand

 









In this case, we see that when the price of a good is ₹6, the total expenditure is ₹ 6. Further, if the price decreases to ₹ 5, then the total expenditure is ₹ 10. It shows that if price falls, total expenditure increases, and if price rises, total expenditure decreases. Here, Price and Total expenditure move in the opposite direction. Therefore, it is a case of more than unitary elastic demand.

3. When Elasticity of demand is less than 1 – Less than Unitary Elastic Demand (Ed<1)

When total expenditure on the commodity increases as a result of rise in price and decreases as a result of a fall in price, then it will be a case of less than unitary elastic demand. Here, Price and total expenditure move in the same direction.

Less than Unitary Elastic Demand Example











In this case, we see that when the price of a good is ₹ 2, the total expenditure is ₹ 10. Further, if the price decreases to ₹ 1, the total expenditure is ₹ 6. Therefore, if price falls, total expenditure also falls and price rises, total expenditure also rises. Here, Price and Total expenditure move in the same direction. Therefore, it is a case of less than unitary elastic demand.

Diagrammatic Illustration

Diagram 1: Relationship between Price Elasticity of Demand and Total Expenditure



















The relationship between different degrees of price elasticity and total expenditure could be understood with the help of Diagram 1. Here, the price is shown on Y-Axis and Total Expenditure is shown on X-Axis. PU is the Total Expenditure Curve. The movement from point Q to point R shows more than unitary elastic demand or elastic demand as total expenditure increases with fall in price and increases with rise in price.


The movement from point R to point S shows unitary elastic demand as total expenditure remains constant or same whether price increases or decreases. In other words, Price change has no effect on Total expenditure.

Similarly, the movement from point S to point T shows less than unitary elastic or inelastic demand as total expenditure increases with rise in price and decreases with fall in price. Hence, we can measure the different degrees of price elasticity of demand with the help of Total Expenditure Method.

Let’s try some questions

Choose the Correct Answer

1. A fall in price of a commodity reduces total expenditure and a rise in price increases it, what will be the price elasticity of demand?

a. Unitary Elastic Demand

b. More than Unitary Elastic Demand

c. Less than Unitary Elastic Demand

d. All of Above.

2. A rise in price of a commodity reduces total expenditure and a fall in price increases it, what will be the price elasticity of demand?

a. Unitary Elastic Demand

b. More than Unitary Elastic Demand

c. Less than Unitary Elastic Demand

d. All of Above.

3. When a rise or fall in price of a commodity has no effect on  total expenditure then, price elasticity of demand will be?

a. Unitary Elastic Demand

b. More than Unitary Elastic Demand

c. Less than Unitary Elastic Demand

d. All of Above.

4. What will be the elasticity of demand if price is ₹10, the quantity demand is 40 units and if price is ₹40, the quantity demand is 20 units.

a. More than unitary elastic demand  

b. Less than unitary elastic demand

c. Unitary elastic demand

d. Perfect elastic demand

 

5. When 10% decrease in price of the commodity causes 5% fall in the total expenditure of the commodity. What will be the elasticity of demand?

a. More than unitary elastic demand  

b. Less than unitary elastic demand

c. Unitary elastic demand

d. Perfect elastic demand


Answer Key

1.c

2.b

3.a

4.b

5.b

 

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