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.