Elasticities of Demand and supply

Price Elasticity of Demand

when supply increases. the equilibrium price falls.

The price elasticity of demand is a unit-free measure of the responsiveness of the quantity demanded of a good to a change in its price, when all other influences on buyer’s plan remain the same.

Calculating Price Elasticity of Demand

Price elasticity of demand = percentage change in quantity demanded / percentage change in price

Fig 1.1 depicts the calculation of price elasticity of demand. This calculation measures the elasticity at an average price of $3 a smoothie and an average quantity of 10 smoothies an hour.

Average Price and Quantity

This gives the most precise measurement of elasticity-midway between the original and the new point. The elasticity price remains the same regardless of whether the price falls from $3.10 to $2.90 or vice versa.

A unit-free measure

Elasticity is unit free because the percentage change in each variable is independent of the units in which the variable is measured.

Minus Sign and Elasticity

When the price of a good rises, the quantity demanded decreases along the demand curve. Because a positive change in price brings a negative change in quantity demanded, the price elasticity of demand is a negative number. But it is the magnitude or absolute value of the price elasticity that depicts how elastic the demand is. so while comparing elasticities. we ignore the minus sign and use only the magnitude.

Inelastic and elastic demand

Fig 2.1, 2.2 and 2.3 respectively illustrates the 3 demand curves that cover the entire range of possible elasticities of demand. In fig 2.1 , the quantity demanded is constant regardless of price. if the quantity demanded remains constant when the price changes then the price elasticity of demand is zero and the good is said to have a perfectly inelastic demand. One good that has a very low price elasticity demand is insulin since its price don’t change the quantity bought. if the percentage change in the quantity demanded equals the percentage change in price, then the price elasticity equals 1 and that is given in Fig 2.2 i.e good is said to have unit elastic demand.  if the percentage change in the quantity demanded is less than the percentage change in price. in this case, the price elasticity of demand is between 0 and 1 and the good is said to have an inelastic demand. e.g food and housing. if the quantity demanded changes by an infinitely large percentage to a tiny price change, then the price elasticity of demand is infinity and the good is said to have a perfectly elastic demand as depicted in Fig 2.3. e.g a sanwich. similary if percentage change in qty demanded is greater than that in price, the price elasticity is >1 hence good is said to have an elastic demand. e.g cars, furniture.

Elasticity along a Linear Demand Curve

Fig 3.1

A demand curve has a constant slope. Fig 3.1 explains how elasticity changes along a straight-line demand curve. At the midpoint of the curve, the demand is unit elastic. At prices above mid point, demand is elastic. And at prices below the midpoint, demand is inelastic.

Total Revenue and Elasticity

The total revenue from the sale of a good equals the price of the good multiplied by qty sold. When price changes the effect is on revenue.

The change in total revenue depends on the elasticity of demand in following way:

1. if demand is elastic, a 1% price cut increases the qty sold by more than 1% and total revenue increases.

2. if demand is inelastic, a 1% price cut increases the qty sold by less than 1% and total revenue decreases.

3.  if demand is unit elastic, a 1% price cut increases the qty sold by 1% and so total revenue does not change.

Fig 4.1 and 4.2 illustrates that a price cut in the elastic range increases the total revenue by increasing the percentage in qty demanded greater than percentage decrease in price. and in an inelastic range the percentage increase in qty demanded is less than percentage decrease in price. at unit elasticity total revenue is at maximum.

Your expenditure and your elasticity

when a price changes, the change in your expenditure on the good depends on your elasticity of demand.  if your demand is elastic, a 1% price cut increases the qty you buy by more than 1 % and your expenditure on the item increases. if your demand is inelastic, a similar price cut increases the qty you buy by less than 1% and your expenditure on item decreases.

if you spend more on an item when its price falls, your demand for that item is elastic; but if you spend the same amount, your amount is unit elastic; and if you spend less your demand is inelastic.

Factors that influence the elasticity of demand

what makes the demand for some goods elastic and others inelastic?

the magnitude of elasticity depends on

1. closeness of substitutes: the closer the substitutes available, the more elastic is the demand for it.

2. proportion of income spent on the good: other things remaining the same, the greater the proportion of income spent on a good, the more elastic the demand for it. e.g toothpaste, housing etc.

3. time elapsed since a price change: The longer the time that has elapsed since a price change, the more elastic is demand.

* A necessity is a good which has a poor substitute, hence it is an inelastic demand e.g housing, holidays etc.

* A luxury is  a good that usually has many substitutes, one of which is not buying it. so it has an elastic demand. e.g furniture, vehicles etc

Fig 5.1 illustrates the price elasticities in 10 countries.

More elasticities of Demand

Cross Elasticity of Demand

it is a measure of the responsiveness of the demand for a good to a change in the price of a substitute or complement, other things remaining the same.

Cross elasticity of demand = percentage change in quantity demanded/ percentage change in price of a substitute of complement

The cross elasticity od demand is positive for a substitute and negative for a complement.

Substitutes

Fig 5.1 discusses an example of substitute

if two items are very close substitutes, such as 2 brands of spring water, the cross elasticity is large. if 2 items are close complements such as fish and chips, the cross elasticity is also large. if 2 items are somewhat unrelated the cross elasticity is small perhaps even zero. e.g newspaper and smoothie.

Income elasticity of Demand

it is a measure of the responsiveness of the demand for a good or service to change in income, other things remaining the same.

income elasticity of demand = percentage change in qty demanded/percentage change in income

income elasticities of demand can be positive or negative and fall in to 3 interesting ranges:

1. >1 (normal good, income elastic)

2.+ve and <1(normal good, income inelastic)

3. negative (inferior good)

Income elastic demand: as income increases the qty demanded increases faster than income.

Income inelastic demand: if percentage increase in qty demanded < percentage increase in income, the income elasticity of demand is positive and <1.

in this case the qty demanded increases as income increases, but income increases faster than the qty demanded. The demand for the good is income inelastic. e.g food, clothing, etc.

Inferior Goods: if the qty demanded of a good decreases when income increases, the income elasticity of the good is negative. e.g potatoes, rice etc. low income consumers buy most of these goods.

Real World income elasticities

Income elasticity varies with income.

ELASTICITY OF SUPPLY

when demand increases, the equilibrium price rises and the eq qty increases.

The elasticity of supply measures the responsiveness of the qty supplied to a change in the price of a good when all other influences on selling plans remain the same. it is given by

elasticity of supply = percentage change in qty supplied/percentage change in price

Fig 6.1, 6.2 and 6.3 discusses the range of elasticities of supply

if the qty supplied is fixed regardless of the price, the supply curve is vertical and the elasticity of supply is zero. supply is perfectly inelastic.

if percentage change in price = percentage change in qty , supply is unit elastic (fig 6.2 no matter how steep the supply curve is if it is linear and pases through the origin it is unit elastic)

if there is a price at which sellers are willing to offer any qty for sale, the supply curve is horizontal and elasticity of supply is infinite i.e it is perfectly elastic. fig 6.3

Factors that influence the elasticity of supply

1. resource substitution possibilities.

2.time frame for the supply decision

The supply of most goods and services lies between these 2 extremes. the qty produced can be increased by only by incurring a higher cost. if a higher price is offered, the qty supplied increases. such goods and services have an elasticity of supply between zero and infinity.

Time frame for supply decisions

1. momentary supply curve is vertical because, on a given day no matter what price is the qty is fixed.

2. long-run supply curve shows the response of the qty supplied to a change in price after all the technologically possible ways of adjusting supply have been exploited.

3.short-run supply curve shows how the qty supplied responds to a price change when only some of the technologically possible asjustments to production have been made.  it slopes upward when a quick action is taken to change the qty supplied by producers.

How markets work?

The market is an amazing instrument. it enables people who have never met and who know nothing about each other to interact and do business. Everything and anything that can be exchanged is traded in markets. Here we discuss the laws of demand and supply that governs the market.

Demand and Supply

How are prices determined by demand and supply?

The demand and supply model is the main tool of economics.

Markets and Prices

A market has two sides: buyers and sellers.

Money Price : The price of an object in number of dollars that must be given up in exchange of the object.

Opportunity Cost of an action is the highest valued alternative forgone. e.g if when you buy a coffee, the highest valued thing you forgo is some chewing gum, then the opportunity cost of the coffee is the quantity of gum forgone. We can calculate the quantity of gum forgone from the money prices of the coffee and gum. e.g if money price of coffee is $1 a cup and for gum is 50cents a packet, the opportunity cost of one cup is 2 packets of gum. (divide price of a cup of coffee by price of a packet of gum and find the ratio this is relative price.) A relative price is an opportunity cost.

The theory of demand and supply determines relative prices, and the word ‘price’ means relative price. When we predict that a price will fall, we mean that its relative price will fall. that is its price will fall relative to the average price of other goods and services.

Demand

Quantity demanded: is the measure as an amount per unit of time.

Law of Demand: Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded; and the lower the price of a good, the greater is the quantity demanded.

Why does a higher price reduce the quantity demanded ?

For 2 reasons:

1. Substitution Effect

2. Income Effect

Substitution effect: When the price of a good rises, other things remaining the same, its relative price- its opportunity cost -  rises. Although each good is unique, it has substitutes – other goods that can be used in its place. People buy less of a good as its opportunity cost rises and more of its substitutes.

Income Effect: When the price of a good rises and other influences on buying plans remain unchanged, the price rises relative to incomes. Faced with a higher price and unchanged income, people can’t afford to buy what they previously brought. They must decrease the quantities demanded of at least something and usually, the good whose price has increased is one of the goods that people buy less of.

Demand Curve and Demand Schedule

The term demand refers to the entire relationship between the price of the good and the quantity demanded of the good. Demand is illustrated by the demand curve and the demand schedule. The term quantity demanded referes to a point on a demand curve.

Fig 1.1 and 1.2

Fig 1.1 depicts the demand curve and Fig 1.2 depicts the demand schedule.

Change in Demand

When any factor that influences buying plans other than the price of the good changes, there is a change in demand. When demand increases, the demand curve shifts rightward and the quantity demanded is greater at each and every price.

Expected future income, Population, preferences etc affect change in demand.

If price increases, qty demanded decreases and movement up demand curve..whereas if price decreases and qty demanded increases there is movement down  the demand curve.

The law of supply states that other things remaining the same, the higher the price of a good, the greater is the quantity supplied; and the lower the price of a good, the smaller is the quantity supplied.

Fig 2.1 and 2.2 discusses the Supply curve and supply schedule respectively.

Minimum Supply price: the supply curve, like the demand curve, has 2 interpretations. it is the minimum supply price curve. it gives us the lowest price at which some one is willing to sell another unit. if a small quantity is produced, the lowest price at which some one is willing to sell one more unit is low. but if a large quantity is produced, the lowest price at which some one is willing to sell one more unit is high.

A change in supply

When any factor that influences selling plans other than the price of the good changes, there is a change in supply. 5 main factors that bring about changes in supply are:

changes in

1. the prices of factors of production : if this price increases, the lowest price a producer is willing to accept rises so supply decreases. e.g a rise in the wages of the disc producers decreases the supply of CD-Rs.

2. the prices of related goods produced: e.g if price of lamb meat rises, the supply of lambskins increases. since both are completments in production i.e goods that must be produced together.

3. expected future prices: if the price of a good is expected to rise, the return from selling the good in future is higher than it is today. so supply decreases today and increases in the future.

4. the number of suppliers: the larger the number of firms that produce a good, the greater is the supply of the good. And as the firms enter an industry. the supply in that industry increases. As firms leave an industry, the supply reduces.

5. technology: depends on +ve change and -ve change.

WHEN SUPPLY INCREASES, THE SUPPLY CURVE SHIFTS RIGHTWARD AND THE QTY SUPPLIED IS LARGER AT EACH AND EVERY PRICE.

Market Equilibrium

we are now going to study how prices coordinate the plans of buyers and sellers and achieve equilibrium. An equilibrium is a situation in which opposing forces balance each other. Equilibrium in a market occurs when the price balances the plans of buyers and sellers. The equilibrium price is the price at which the quantity demanded equals the quantity supplied. The equilibrium quantity is the quantity bought and sold at equilibrium price. A market moves towards equilibrium because: 1. price regulates buying and selling plans. 2. price adjusts when plans dont match.

Price as a regulator

The price of a good regulates the quantities demanded and supplied. if the price is too high, the quantity supplied exceeds the quantity demanded. if the price is too low, the quantity demanded exceeds the quantity supplied. there is one price at which the quantity demanded equals the quantity supplied.

This figure 3.1 depicts the market equilibrium

if the price is below the equilibrium there is a shortage and that if the price is above equilibrium there is a surplus. We can count a price change that eliminates a shortage or surplus.  A shortage forces the price up where as a surplus forces the price down.

Predicting changes in price and quantity

The demand and supply theory that we have studied provides us with a powerful way of analysing influences on prices and the quantities bought and sold.

Change in Demand

When demand increases, both the price and quantity increases.

when demand decreases, both the price and quantity decreases.

Change in Supply

when supply increases, the quantity increases and price falls.

when supply decreases, the quantity decreases and price rises.

A change in both demand and supply

What happens if both demand and supply change together?

Demand and supply change in same direction

An increase in demand raises the price and increases the quantity bought and sold; and an increase in supply lowers the price and increases the quantity bought and sold.  when both demand and supply increase, the quantity increases and the price might increase, decrease or remain the same. when both demand and supply decreases, the quantity decreases and the price might increase, decrease or remain the same.

The above Fig 4.1 depicts that change in supply and demand may or maynot have an effect on the price.

Fig 5.1 illustrates when the demand and supply is both change in opposite directions.

When demand decreases and supply increases the price falls and the quantity might increase, decrease or remain the same.

when demand increases and supply decreases the price rises and the quantity might increase, decrease or remain the same.