According to the law of demand a negative relationship exists between the price and the quantity demanded.  Price elasticity provides an indication of how sensitive or responsive the quantity demanded is for a change in the price.  If the quantity demanded by consumers responds strongly to a change in the price, the demand is said to be "elastic", while the concept "inelastic" is used when the quantity demanded is not very responsive to a change in the price.

Price elasticity (ep) of demand is measured as follows:

(more)

It provides a relative measure of elasticity. The elasticity coefficient is a number and a distinction is made between ep <1 (more); ep =1; ep >1 (more); and the theoretical cases of ep = 0 and ep = infinite. 

Price elasticity is important for firms since it has an important impact on the total revenue firms receive from the sales of their products.(more)

Price elasticity is influenced by factors such as the availability of substitutes, degree of complementarity of the product, degree of necessity or luxury, the time period under consideration and proportion of income spend on the product.

Elasticity  is a measure of the sensitivity or responsiveness between two variables that are related. This indicates that a cause and effect reaction exists between the two variables.  A change in X causes a change in  Y and elasticity provides a measurement of how strong this effect is.  Examples of elasticity in economics are price elasticity of demand and supply, income elasticity of demand, cross elasticity and interest elasticity of investment.

TYPES OF ELASTICITIES

ELASTICITIESGRADE 11 CONTENT

MICRO ECONOMICS

TOPIC: DYNAMICS OF MARKETS - PRICE ELASTICITY

SECTION (1)

What is elasticity?

Meaning: Dictionary

A measure of a variable's sensitivity to a change in another variable.It also relates to flexibility or adaptability.Something is elastic when it can change its shape easily.

Meaning in Economics

Elasticity is the measure of the sensitivity or responsiveness between two related variables.In other words, it is the sensitivity of quantity demanded or supplied to changes in prices.

Types of elasticities in Economics

(1) Price elasticity of demand(2) Price elasticity of supply(3) Cross elasticity of demand(4) Income elasticity of demand

Kinds of elasticities

(1) Perfectly elastic (2) Perfectly inelastic(3) Relative elastic(4) Relative inelastic(5) Unitary elasticity

There are two ways to determine price elasticity, graphically and/or mathematically:

PRICE ELASTICITY OF DEMAND

Definition/Description

Price elasticity of demand is the responsiveness or sensitivity of demand to a change in price.

What happens to consumer demand for a good when prices change?

We generally accept that as the price for a product: increase consumers demand a lower quantity (consuming less or substituting other goods) decrease consumers demand a higher quantity

The question is “by how much”? In other words, quantity demanded is sensitive to price changes.

Formula 1

Price elasticity of demand=Percentage change∈Quantity DemandedPercentagechange∈Price

Formula 2

Price elasticity of demand=Change∈Quantity DemandedChange∈Price x Original PriceOriginalQuanity

There are five elasticity forms:Elasticity form Value (meaning)Perfectly elastic demand x = Relatively elastic demand 1 < x < Elasticity of 1 (unitary elasticity) x = 1Relatively inelastic demand 0 < x < 1Perfectly inelastic x = 0

(A) Perfectly elastic demand curve

When the price elasticity of demand for a good is perfectly elastic, any increase in the price, no matter how small, will cause demand for the good to drop to zero.

Hence, when the price is raised, the total revenue of producers falls to zero. The demand curve is a horizontal straight line.

Graph: Perfectly elastic demand curve

(B) Perfectly inelastic demand curve

When the price elasticity of demand for a good is perfectly inelastic (Ed = 0), changes in the price do not affect the quantity demanded for the good. The demand curve is a vertical straight line.

Graph: Perfectly inelastic demand curve

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(C) Relatively elastic demand curve (elasticity greater than 1)

When the price elasticity of demand for a good is elastic (|Ed > 1), the percentage change in quantity is greater than that in price.

Features

A small change in price will lead to a greater proportionate change in quantity demanded The percentage change in quantity demanded is greater than the percentage change in price This relates to luxury goods and services that have close substitutes The curve will be relatively flatter

Graph: Relatively elastic demand curve

(D) Relatively inelastic demand (elasticity less than 1)

When the price elasticity of demand for a good is inelastic (|Ed< 1), the percentage change in quantity is smaller than that in price. The demand curve will be very steep.

Graph: Relatively inelastic demand curve

(E) Unitary elastic demand (elasticity of 1)

When the price elasticity of demand for a good is unit elastic (or unitary elastic) (Ed = 1), the percentage change in quantity is equal to that in price.

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Features

The percentage change in price leads to an equal proportional change in quantity demanded

Graph: Unitary elastic demand curve

FACTORS THAT INFLUENCE THE ELASTICITY OF DEMAND

1. SubstitutionThe demand for goods and services is very elastic if substitutes are available within the same price range.The demand for goods and services tend to be inelastic if no substitutes are available.

2. Income and wealthThe demand for articles which are too expensive for people with a limited income tend to be elastic.The demand for the lower income group will be more elastic than that of the upper income groups, because the lower income groups are more price sensitive than the higher income groups.

3. Nature of the productThe demand for essential goods tends to be inelastic.The demand for luxuries is elastic because consumers can manage without them.

4. Durability of the productA longer durability tends to be inelastic. The longer the article last, the greater is the possibility that it will not be replaced soon, e.g. cars.A shorter durability tends to be elastic. Perishable goods, like fresh fruit and vegetable must be bought although price might double.

5. Relative importance of an article in the total expenditureThe demand for goods which consumers devote a small percentage of their income tend to be inelastic, e.g. salt, newspapers.

6. Possible usesThe more uses for an article, the more elastic the demand for it. One-purpose articles tend to be more inelastic.

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7. Habit-forming articlesThe demand for habit-forming article like tobacco and alcoholic drinks tends to be relative inelastic.

8. TimeOver a short term, the demand for goods and services tends to be inelastic.Habits of consumers do not change at once.

THE BENEFITS OF HAVING KNOWLEDGE ON ELASTICIITY OF DEMAND

Producers A manufacturer who knows the elasticity of the demand of a product can calculate how a

change in price will affect total revenue. Faced with an inelastic demand the producer can increase profits by raising prices and selling

less. This will increase total revenue and reduce total cost of production. A producer thinking about expansion must estimate the level in which the price must be reduced

in order to sell the extra quantity of goods. If the elasticity of demand for the product is greater than 1 (relative elastic), a small reduction in

price might increase sales considerably. If the elasticity of demand is less than 1 (relative inelastic), the producer will sell a larger of

quantity of goods in return for a smaller total sales revenue. The importance of a knowledge of elasticity of demand will enable a producer to: (a) adjust

prices; (b) adjust the scale of production (c) attract more customers.

Government A knowledge of the elasticity of demand plays an important part in policy decisions as taxation is

concerned. An increase in VAT will cause prices to increase. If the demand for goods is elastic, there could be a reduction in the demand for products,

causing tax revenues to decline. If the demand for goods is inelastic, some greater tax revenues can be expected, e.g. products

like tobacco, basic food etc. are normally targeting in the form of indirect taxes. The use of elasticity of demand for the government is: (a) to raise government revenue; (b) to

discourage the use of demerit goods, like cigarettes, etc.

PRICE ELASTICITY OF SUPPLY

Definition

Price elasticity of supply is defined as the responsiveness of the quantity supplied of a product to a change in price of a product.

Formula 1

Price elasticity of supply= Percentagechange∈Quantity SuppliedPercentagechange∈Price

It is measured as the percentage change in supply that occurs in response to a percentage change in price.

Formula 2

Price elasticity of supply=Change∈Quantity SuppliedChange∈Price x

Original PriceOriginalQuanity

There are five elasticity forms:Elasticity form Value (meaning)Perfectly elastic supply x = Relatively elastic supply 1 < x < Elasticity of 1 (unitary elasticity) x = 1Relatively inelastic supply 0 < x < 1Perfectly inelastic supply x = 0

If supply is elastic (i.e. PES > 1), then producers can increase output without a rise in cost or a time delay.

If supply is inelastic (i.e. PES < 1), then firms find it hard to change production in a given period.

What factors affect the elasticity of supply?

1. Spare production capacity: If there is plenty of spare capacity then a business can increase output without a rise in costs and supply will be elastic in response to a change in demand. The supply of goods and services is most elastic during a recession, when there is plenty of spare labour and capital resources.

2. Stocks of finished products and components: If stocks of raw materials and finished products are at a high level then a firm is able to respond to a change in demand - supply will be elastic. Conversely when stocks are low, dwindling supplies force prices higher because of scarcity.

3. The ease and cost of factor substitution/mobility: If both capital and labour are occupationally mobile then the elasticity of supply for a product is higher than if capital and labour cannot easily be switched. E.g. a printing press which can switch easily between printing magazines and greetings cards. Or falling prices of cocoa encourage farmers to switch into rubber production

4. Time period and production speed: Supply is more price elastic the longer the time period that a firm is allowed to adjust its production levels. In some agricultural markets the momentary supply is fixed and is determined mainly by planting decisions made months before, and also climatic conditions, which affect the production yield. In contrast the supply of milk is price elastic because of a short time span from cows producing milk and products reaching the market place.

INCOME ELASTICITY OF DEMAND

DefinitionIncome elasticity of demand measures the responsiveness of the quantity demanded of a good to the change in the income of the people demanding the good.

Formula:

Incomeelasticity=Percentage change∈Quantity DemandedPercentagechange∈income

It is measured as the percentage change in demand that occurs in response to a percentage change in income.

Example - If income increases by 10% and the quantity of a good demanded increased by 20%, the income elasticity of demand would be 20%/10% = 2.

A positive income of elasticity of demand is associated with normal goods. An increase in income will lead to a rise in the quantity demanded. A high positive income elasticity is associated with luxury goods.

A zero-income elasticity of demand is an increase in income without a change in quantity demanded.

Many necessities have an income elasticity of demand between 0 and 1. For example, bread. The demand for bread for lower income people will increase to a

certain level, but as income increases further, the demand will drop. Expenditure on these goods may increase with income, but not as fast as income does, so

the proportion of expenditure on these goods falls as income rises. A negative income elasticity of demand is associated with inferior goods.

An increase in income will lead to a fall in the quantity demanded and may lead to changes to more luxurious substitutes.

CROSS ELASTICITY OF DEMAND

Definition

Cross elasticity of demand and cross price elasticity of demand measures the responsiveness of the quantity demand of a good to a change in the price of another good.

It is measured as the percentage change in quantity demanded for the first good that occurs in response to a percentage change in price of the second good.

Example

A 10% increase in the price of petrol, the quantity of new cars that are fuel inefficient demands will decrease by 20%, the cross elasticity of demand would be -20%/10% = -2.

Where two goods are complements the cross elasticity of demand will be negative. In other words, if the price of petrol increases, the demand for fuel inefficient cars will

decrease.

When the two goods are substitutes, the gross elasticity of demand will be positive. In other words, if the price of petrol increases, the demand for fuel efficient cars will

increase.