Explain the total outlay method of measuring elasticity of demand?
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Explanation:
There is another method to measure price elasticity of demand. This is known as outlay method. The price elasticity of demand for a goods and the total outlay (expenditure) made on the goods are greatly related to each other.
From the changes in the total expenditure made on a good as a result of changes in its price, we can know the price elasticity of demand for the good. But it should be remembered that with the total outlay method we can know only whether elasticity is equal to one, greater than one or less than one. With this method we cannot find out the exact and precise coefficient of elasticity.
When as a result of the change in price of the quantity demanded of a good the total expenditure remains the same, the elasticity of demand for goods will be equal to unity. This is because total expenditure made on the goods can remain the same only if the proportional change in quantity demanded is equal to the proportional change in price.
When due to the fall in price the quantity demanded of the good rises so much that the total expenditure made on the goods increases, the price elasticity of demand will be greater than unity. This is so because with a fall in price the total expenditure can increase only if the proportional increase in the quantity demanded is greater than the proportional change in price.
It should be carefully noted that when due to the rise in price, the total expenditure on the goods declines, elasticity of demand will be greater than one because increase in total expenditure as a result of fall in price and decrease in total expenditure as a result of rise in price are the same things.
If as a result of fall in the price of the goods, the total expenditure decreases, the price elasticity of demand will be less than unity. This is because with the fall in price the total expenditure can decrease only if the proportional increase in the quantity demanded is less than the proportional fall in the price. Thus, when due to the rise in price the total expenditure made on the goods increases, the price elasticity of demand will be less than one.
Let us illustrate how we judge the elasticity of demand as to whether it is greater than one, equal to one or less than one. Consider Table 1, which gives quantity demanded of pens at various prices. It will be seen from Table 1 that quantity demanded increases from 30 pens at price Rs. 5 per pen to 87 pens at price Rs. 3.25.
We have calculated the total outlay by multiplying the quantity demanded with the corresponding price of the pen. It will be observed from the table that when price of pen falls from Rs. 5 to Rs. 4.75, from Rs. 4.75 to Rs. 4.50, from 4.50 up to Rs. 4.25 and from Rs. 4.25 to Rs. 4, the quantity demanded increases so much that the total outlay on pen increases indicating thereby that elasticity of demand is greater than one at these prices.
When the price falls from Rs. 4.00 to Rs. 3.75, the quantity demanded increases from 75 pens to 80 pens so that total outlay remains the same at Rs. 300. This shows that price elasticity of demand is unity. When the price of pen further falls from Rs. 3.75 to Rs. 3.50 and then to Rs. 3.25, the total outlay spent on pen decreases. Thus, the elasticity of demand for pen at these prices is less than unity.
This relationship between the price elasticity of demand and total outlay can also be graphically illustrated with the aid of the demand curve.
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