5 elasticity of demand_and_supply

In This Lecture…

Types -Price Elasticity of Demand, Income Elasticity of Demand, Cross Elasticity of Demand

Determinants of Elasticity of Demand

Measurement of Elasticity of Demand

In This Lecture…

Types - Elasticity of Supply

Determinants of Elasticity of Supply

Measurement of Elasticity of Supply

Elasticity of Demand

Elasticity of Demand measures the responsiveness of the quantity demanded of a good, to change in its price, price of other goods and changes in consumer’s income.

Types of Elasticity of Demand

• Price Elasticity of Demand• Cross Elasticity of Demand• Income Elasticity of Demand

Price Elasticity of Demand

A measure of the responsiveness of quantity demanded to changes in price.

%Δ P → %Δ Q

Factors Determining Price Elasticity of Demand

- Availability of close substitute- Consumer’s loyalty- Necessities versus luxuries - Proportion of income spent on

the product- Postponement of the Use- Time

Elastic vs Inelastic

Elastic – when change in price has greater effect on demand

Inelastic – when change in price has lesser effect on demand

Availability of Close Substitutes

The demand for a good is price elastic which have substitutes like tea and coffee, orange juice and lime juice. It is because when the price of a commodity falls in relation to its substitutes, the consumers will go on for it and demand increases. Goods having no substitutes like Cigarettes, liquor etc. have inelastic demand.

Consumer’s Loyalty

The demand for a good is price inelastic if consumers are habituated in buying that good and are unwilling to use substitutes – eg. Cigarettes, tobacco, coffee, liquor etc. - and vice versa if the good is price elastic

Necessities versus luxuries

Generally, the more that a good is considered a luxury (a good that we can do without) rather than a necessity (a good that we can’t do without), the higher the price elasticity of demand.

Proportion of Income spent on the product

The demand for a good is price inelastic if the good takes only small proportion of income and the consumers will not react significantly – eg. Boot-polish, needles, newspapers etc. - and vice versa if the good is price elastic.

Postponement of the Use

The demand for a good is price inelastic if the goods whose demand cannot be postponed – eg. Education, health services - and vice versa (constructing a house).

Time

The longer the time period the more elastic is the demand and vice versa. It is because in the long run a consumer can change his habits more conveniently than in short period.

Measurement of Price Elasticity of Demand

Percentage / Proportionate Method

Total Expenditure MethodPoint MethodArc Method

Percentage / Proportionate Method

Percentage / Proportionate Method : It refers to the price elasticity as the ratio of percentage change in quantity demanded to the percentage change in price.

Percentage / Proportionate Method

Symbolically,eD = - Percentage Change in quantity demanded

Percentage in price

Δ Q P eD = - ---------- X ----------

ΔP QThe absolute value of the coefficient of elasticity of demand ranges from zero to infinity ( 0≤ eD ≤ ∞)

“-” sign in the formula for ed

Since there is inverse relationship between price and quantity demanded, elasticity of demand is ought to be negative like -1, -2, -3 etc. However, mathematically, -3 is lesser than -2 but in the context of elasticity of demand -3 shows higher elasticity than -2 . Therefore, in order to avoid this complexity – sign is prefixed in the formula for elasticity of demand.

Five Coefficient of Price Elasticity of Demand

- Perfectly Inelastic Demand (eD = 0)

- Inelastic / Less than Unit Elastic Demand (eD < 1)

- Unitary Elastic Demand (eD = 1)

- Elastic / More than Unit Elastic Demand (eD > 1)

- Perfectly Elastic Demand (eD = ∞)

Graphical Representation of Perfectly Price Inelastic

Demand (eD = 0)

Quantity demanded does not changeas price changes.

Graphical Representation of Price Inelastic / Less than Unit Demand

(eD < 1)The percentage change in quantity demanded is less than the percentage change in price. Quantity demanded changes proportionately less than price changes.Applicable in necessary goods like salt, kerosene.

Graphical Representation of Price Unitary Elastic Demand

(eD = 1)

The percentage change in quantity demanded is equal to the percentage change in price.

Quantity demanded changes proportionately to price changes.

Graphical Representation of Price Elastic/More than unit

Elastic Demand (eD > 1)

The percentage change in quantity demanded is greater than the %age change in price.Quantity demanded changes proportionately more than price changes.

Applicable in luxuries like AC, costly furniture etc

Graphical Representation of Perfectly Elastic Demand (eD

= ∞)

A small percentage change in price causes an extremely large percentage (infinite) change in quantity demanded (from buying all to buying nothing).

Price Elasticity of DemandSummary

Price Elasticity and Total Revenue

Total revenue (TR) of a seller equals the price of a good times the quantity of the good sold (P x Q).

Total Expenditure / Revenue Method

• This is also known as Total Outlay Method propounded by Alfred Marshall

• How much and in what direction total expenditure/ revenue changes determines the Price Elasticity of Demand of a commodity.

Total Expenditure Method (contd.)

Situa-tion

Price$

Quantitylb

TotalExpenditu

re

Effect on Total

Expenditure

Elasticity of Demand

A 21

48

88

Same TotalExpenditure

Unitary ElasticEd = 1

B 21

410

810

Total ExpenditureIncreases

Greater than UnitaryEd > 1

C 21

34

64

Total ExpenditureDecreases

Less than UnitaryEd < 1

Elastic Demand and Total Revenue I

If demand is elastic, the percentage change in quantity demanded is greater than the percentage change in price.

Elastic (Ed >1)%ΔQ > %ΔP; P↑→TR↓P↓→ TR↑

Elastic Demand and Total Revenue (Contd.)

Demand is elastic between points A and B.

A fall in price, from P1 to P2, will increase the size of the total revenue rectangle from 0P1AQ1 to 0P2BQ2.

A rise in price, from P2 to P1, will decrease the size of the total revenue rectangle from 0P2BQ2 to 0P1AQ1.

In other words, when demand is elastic, price and total revenue are inversely related

Inelastic Demand and Total Revenue (Contd.)

If demand is inelastic, the percentage change in quantity demanded is less than the percentage change in price.

Inelastic (Ed < 1)%ΔQ < %ΔP; P↓→TR↓P↑→ TR↑

Inelastic Demand and Total Revenue (Contd.)

Demand is inelastic between points A and B.

A fall in price, from P1 to P2, will decrease the size of the total revenue rectangle from 0P1AQ1 to 0P2BQ 2.

A rise in price, from P2 to P1, will increase the size of the total revenue rectangle from 0P2BQ2 to 0P1AQ1.

In other words, when demand is inelastic, price and total revenue are directly related.

Unit Elastic Demand and Total Revenue

___

Unit Elastic (Ed =1)%ΔQ = %ΔP; P↑→TRP↓→TR

If demand is unit elastic, the percentage change in quantity demanded is equal to the percentage change in price.

Unit elastic Demand and Total Revenue

Demand is unit elastic between points A and B.A fall in price, from P1 to P2, will not change the size of the total revenue rectangle from 0P1AQ1 to 0P2BQ 2.

A rise in price, from P2 to P1, will not change the size of the total revenue rectangle from 0P2BQ2 to 0P1AQ1. In other words, when demand is unit elastic, price and total revenue are equal.

Elasticity, Price Changes, and Total Revenue

Point/ Geometric Method

It measures elasticity of demand at different points on demand curve.

Ed (at a point on = lower segment

demand curve ) upper segment

Point Method (Contd.)

Ed = ∞

Ed > 1

Ed = 1

Ed < 1

Ed = 0

Arc Elasticity

It measures the elasticity of demand over a ranges of prices. Rather than using initial or the final price, we use average of the two, P; for the quantity demanded Q.

Ed =Δ Q x P

ΔP QP = Average PriceQ = Average Quantity

Arc Elasticity (Contd.)

So, the formula for measuring arc price elasticity is,

ED= ΔQ x (P1 + P2 ) /2 ΔP ( Q1 + Q 2) /

2

(Q2 – Q1) (P1+ P2) = ----------------------------- x ---------------------------

(P2- P1) (Q1 + Q2 )

Arc Elasticity (Contd.)

For example, When the price of a good falls from Rs.15 to Rs.10 per unit, the quantity demanded increases from 100 units to 200 units. The arc elasticity will be,

(Q2 – Q1) (P1+ P2) Ed = ----------------------------- x ---------------------------

(P2- P1) (Q1 + Q2 ) = - 100/5 x 25/300 = - 20 x 1/12 = 5 / 3 = 1.66

Calculating Price Elasticity of Demand – Arc Method

We identify two points on a demand curve. At point A, price is $12 and quantity demanded is 50 units. At point B, price is $10 and quantity demanded is 100 units.

Calculating Price Elasticity of Demand - Arc Method (Contd.)

When calculating price elasticity of demand, we use the average of the two prices and the average of the two quantities demanded. The formula for price elasticity of demand is:

Calculating Price Elasticity of Demand - Arc Method (Contd.)

For example, the calculation is:

Cross Elasticity of Demand

Measures the responsiveness in quantity demanded of one good to changes in the price of another good.

= % ΔQD of A = PB X ΔQDA

% ΔP of B QDA ΔPB

Cross Elasticity of Demand

Ec > 1 → Goods are substitutesEc < 1 → Goods are complementsEc = 1 → Goods are independent

Cross Elasticity of Demand

Cross Elastic - The percentage change in quantity demanded of a good is greater than the percentage change in price of other good.Cross Inelastic - The percentage change in quantity demanded of a good is less than the percentage change in price of other good.Cross Unit Elastic - The percentage change in quantity demanded of a good is equal to the percentage change in price of other good

Cross Elasticity of Demand

Substitutes

Complements

Independent

Income Elasticity of Demand

Measures the responsiveness in quantity demanded to changes in income

= % ΔQD = Y X ΔQD

% ΔY QD ΔY

Ey > 1 Superior Good Ey > 1 Normal Good Ey < 1 Inferior Good

Income Elasticity of Demand (Contd.)

Income Elastic - The percentage change in quantity demanded of a good is greater than the percentage change in income.Income Inelastic - The percentage change in quantity demanded of a good is less than the percentage change in income.Income Unit Elastic - The percentage change in quantity demanded of a good is equal to the percentage change in income

Income Elasticity of Demand (Contd.)

QD

YED = 1

YED > 1 YED < 1

Income (Y)

Normal Good Inferior Good

An Engel Curve shows the amount of a good demanded at different levels of income.

Price Elasticity of Supply

Measures the responsiveness of quantity supplied to changes in price.

Factors Determining Elasticity of Supply

- Nature of Inputs Used- Natural Constraints- Risk Taking - Nature of Commodity- Technique of Production- Time

Nature of Inputs Used

If specialized FOP are used then the supply will be inelastic.

If common FOP are used then the supply will be elastic.

Natural Constraints

If more teak wood is to be produced, it will take years of plantation before it becomes usable. Supply of teak will be less elastic.

Risk Taking

Higher the risk taking element among the entrepreneurs the supply will be more elastic and vice versa.

Nature of Commodity

Perishable goods are less elastic in supply while durables are more elastic as its easier to store.

Technique of Production

If complicated technique of production is used that needs large stock of capital then the supply of that commodity will be less elastic and vice versa.

Time

The longer the time period more is the time available to adjust the supply and more elastic will be the supply curve.

Very Short Period : perfectly inelasticShort Period : elasticLong Period : more elastic

Measurement of Elasticity of Supply

Percentage / Proportionate Method

Point Method

Percentage / Proportionate Method

Percentage / Proportionate Method : It refers to the price elasticity as the ratio of percentage change in quantity supplied to the percentage change in price.

Percentage / Proportionate Method

Symbolically,eD = Percentage Change in quantity supplied

Percentage in price

Δ Q P eD = ---------- X ----------

ΔP QThe absolute value of the coefficient of elasticity of supply ranges from zero to infinity ( 0≤ eD ≤ ∞)

Five Coefficient of Price Elasticity of Supply

- Perfectly Inelastic Supply (eS = 0)

- Inelastic / Less than Unit Elastic Supply (eS < 1)

- Unitary Elastic Supply (eS= 1)

- Elastic / More than Unit Elastic Supply (eS > 1)

- Perfectly Elastic Supply (eS = ∞)

Graphical Representation of Elastic Supply

The percentage change in quantity supplied is greater than the percentage change in price: Es > 1 and supply is elastic.

Graphical Representation of Inelastic Supply

The percentage change in quantity supplied is less than the percentage change in price: Es 1 and supply is inelastic. .

Graphical Representation of Unit Elastic Supply

The percentage change in quantity supplied is equal to the percentage change in price: Es = 1 and supply is unit elastic.

Graphical Representation of Perfectly Elastic Supply

A small change in price changes quantity supplied by an infinite amount: Es =

∞ and supply is perfectly elastic.

Price Elastic Graphical Representation of Supply

A change in price does not change quantity supplied: Es = 0 and supply is perfectly inelastic.

Point/ Geometric Method

It measures elasticity of supply depending on the origin of supply curve.

There are three possible situations of elasticity of supply according to this method:

Situation 1 : Es =1

Situation 2 : Es > 1

Situation 3 : Es < 1

Point/ Geometric Method

Situation 1 : Es = 1 is when supply curve starts from the origin.

Price Es = 1

Es = 1

Es = 1

O Quantity

Point/ Geometric Method

Situation 2 : Es > 1 is when supply curve starts from Y axis.

Price

Es > 1

O Quantity

Point/ Geometric Method

Situation 3 : Es < 1 is when supply curve starts from X axis.

Price

Es < 1

O Quantity

Summary of the Four ElasticityConcepts