Elasticity

Topic 4

Elasticity of Demand and Supply• In order to turn supply and demand into a truly useful tool, we need to know how

much supply and demand respond to changes in prices.

• Some purchases like those for vacation travel are very sensitive to price changes. Others like food or electricity are necessities for which consumer purchases respond very little to price changes.

• The quantitative relationship between price and quantity purchased is analyzed during the crucial concept of elasticity.

Price Elasticity of Demand• The price elasticity of demand (sometimes simply called price elasticity) measures

how much the quantity demanded of a good changes when its price changes.

• The precise definition of price elasticity is the percentage change in quantity demanded divided by the percentage change in price.

• Goods vary enormously in their price elasticity. When the price elasticity of a good is high, we say that the good has elastic demand, which means its quantity demanded responds greatly to price changes.

• When the price elasticity of a good is low, it is “inelastic” and its quantity demanded responds little to price changes.

• For necessities like food, fuel, shoes and prescription drugs demand tends to be inelastic.

Price Elasticity of Demand• By contrast, you can easily substitute other goods when luxuries like European

holiday or Italian designer clothing rise in price.

• Goods that have ready substitute tend to have more elastic demand than those that have no substitutes.

Calculating Elasticities:

• If we can observe how much quantity demanded changes when price changes, we can calculate the elasticity.

• Price elasticity of Demand = Ed = % change in quantity demanded/ % change in price.

Price Elasticity of Demand• E.g. If a 1 percent increase in price yields a 5 percent decrease in quantity

demanded, the commodity has a highly price-elastic demand.

• When a 1 increase in price yields only 0.2 percent decrease in demand, the commodity has price inelastic demand.

• One important special case is unit elastic demand, which occurs when the percentage change in quantity is exactly the same as the percentage change in price.

Price Elasticity of Supply• Of course, consumption is not the only thing that changes when prices go up or

down. Businesses also respond to price in their decisions about how much to produce.

• Price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price.

• As with demand Elasticities, there are polar extremes of high and low Elasticities of supply.

• Suppose that amount supplied is completely fixed, as in the case of perishable fish brought to market to be sold at whatever price they will fetch.

• This is a completely inelastic supply which is a vertical supply curve.03008288833

Price Elasticity of Supply• At the other extreme, say that a tiny cut in price will cause the amount supplied to

fall to zero, while the slightest rise in price will coax out an indefinitely large supply.

• Here the ratio of the percentage in quantity supplied to percentage change in price is extremely large and gives rise to a horizontal supply curve.

• Between these extremes, we call supply elastic or inelastic depending on whether the change in quantity is larger or smaller than the percentage change in price.

• The definitions of price Elasticities of supply are exactly the same as those for price Elasticities of demand. Except that for supply the quantity response to price is positive, while for demand the response is negative.

Price Elasticity of Supply• The major factor influencing supply elasticity is the ease with which production in

the industry can be increased.

• If all inputs can be readily found at going market prices, as in the case of textile industry, then output can be greatly increased with little increase in price.

• This would indicate that supply elasticity is relatively large.

• On the other hand, if production capacity is severely limited, as in the case for the mining of South African gold, then even sharp increases in the price of gold will call forth but a small response in production.

• This would be inelastic supply.

Price Elasticity of Supply• Another important factor in supply elasticities is the time period under

consideration.

• A given change in price tends to have a larger effect on amount supplied as the time for suppliers to respond increases.

• For very brief period after a price increase, firms may be unable to increase their inputs of labour, materials and capital so supply may be very price inelastic.

• However, as time passes and businesses can hire more labour, build new factories and expand capacity, supply elasticities will become larger.

Income Elasticity of Demand• In economics, the income elasticity of demand measures the

responsiveness of the demand of a good to the change in the income of the people demanding the good.

• It is calculated as the ratio of the percent change in demand to the percent change in income.

• For example, if, in response to a 10% increase in income, the demand of a good increased by 20%, the income elasticity of demand would be 20%/10% = 2.

• A negative income elasticity of demand is associated with inferior goods; an increase in income will lead to a fall in the demand and may lead to changes to more luxurious substitutes.

Income Elasticity of Demand• A positive income elasticity of demand is associated with normal goods; an

increase in income will lead to a rise in demand.

• If income elasticity of demand of a commodity is less than 1, it is a necessity good. If the elasticity of demand is greater than 1, it is a luxury good or a superior good.

• A zero income elasticity (or inelastic) demand occurs when an increase in income is not associated with a change in the demand of a good. These would be sticky goods.

Cross Price Elasticity• Economics, the cross elasticity of demand and cross price elasticity of

demand measures the responsiveness of the demand of a good to a change in the price of another good.

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

• For example, if, in response to a 10% increase in the price of fuel, the demand of new cars that are fuel inefficient decreased by 20%, the cross elasticity of demand would be −20%/10% = −2.

• In the example above, the two goods, fuel and cars(consists of fuel consumption), are complements; that is, one is used with the other.

Cross Price Elasticity• In these cases the cross elasticity of demand will be negative, as shown by the

decrease in demand for cars when the price of fuel increased.

• In the case of perfect complements, the cross elasticity of demand is negative infinity.

• Where the two goods are substitutes the cross elasticity of demand will be positive, so that as the price of one goes up the demand of the other will increase.

• For example, in response to an increase in the price of carbonated soft drinks, the demand for non-carbonated soft drinks will rise. In the case of perfect substitutes, the cross elasticity of demand is equal to infinity.

Cross Price Elasticity• Where the two goods are independent, the cross elasticity of demand will be zero:

as the price of one good changes, there will be no change in demand for the other good.

• When goods are substitutable, the diversion ratio—which quantifies how much of the displaced demand for product j switches to product i—is measured by the ratio of the cross-elasticity to the own-elasticity multiplied by the ratio of product i's demand to product j's demand.