ELASTICITY OF DEMAND AND SUPPLY
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ELASTICITY OF DEMAND AND SUPPLY
THEORY OF MARKETS (continued)
ELASTICITY OF DEMAND AND SUPPLY
ELASTICITY
We have previously looked at supply and demand curves from the standpoint of movement
along a curve, a shift of the curve and the slope of a curve. There is another way to look at
supply and demand curves known as elasticity which relates to the shape (steepness and
flatness) of the curves. Although elasticity is a similar concept to slope, don’t confuse it with
slope because they are not the same. Elasticity uses “percentage changes in variables”, slope
does not. It is not difficult to understand the concept of elasticity, if one keeps in mind that it
refers to: the “stretching or contraction of quantity (Q)” demanded or supplied in response to a
change in the 1). price of a product. In addition, the stretching or contraction of quantity
demanded can occur in response to a change in the 2). income of buyer(s) or the 3). price of
related products. In other words elasticity is a measure of the magnitude of a change in Q due
to a change in one of the three aforementioned variables.
Price Elasticity of Demand
The formula for the price elasticity of demand is :
% change in Qdx = Ed
% change in Pdx
where Qdx is the quantity demanded of product x and Pdx is the price of product x.
The result of the above formula calculation is the coefficient of price elasticity of demand
(Ed). The Ed measures the degree of elasticity in a change in the quantity of product x
resulting from a change in the price of product x.
1). If Ed is > 1, then the response of Q demanded is said to be elastic.
If Ed is < 1, then the response of Q demanded is said to be inelastic.
If Ed is = 1, then the response of Q demanded is said to be unitary elastic.
If Ed is = 0, then the response of Q demanded is perfectly inelastic.
If Ed is = infinity then the response of Q demanded is perfectly elastic.
2). Eyeballing the elasticity of demand curves on a graph.
The graph of a perfectly inelastic demand curve is a vertical line.
The graph of a perfectly elastic demand curve is a horizontal line.
The graph of a relatively elastic demand curve is flat.
The graph of a relatively inelastic demand curve is steep.
3). Elasticity is “not constant” and changes along a given demand curve.
The elasticity along a given demand curve decreases with movement down the
demand curve. This is why demand curves are said the be “relatively elastic” or
“relatively inelastic”. For any given demand curve there is an elastic range, a
point on the curve of unitary elasticity and an inelastic range.
4). Midpoints are used to calculate elasticity.
In calculating the % change in Q and the % change in price midpoint values are
used.
Determinants of Price Elasticity of Demand
Certain variables called determinants affect the elasticity of a Demand curve. These
determinants are:
1). Whether a product is a luxury or a necessity.
Demand for a luxury product is always more elastic than demand for a product
that is a necessity.
2). Availability of substitute products.
A product that has more substitutes will always have a more elastic demand.
3). Relative price of a product compared to the price of other products.
Higher priced products that take a bigger portion of income have a more elastic
demand than those that cost less and take a lower % of income.
4). Time (to purchase).
The more time an individual has to purchase a product, the more elastic the
individual’s demand for that product is.
EFFECT OF PRICE ELASTICITY OF DEMAND ON TOTAL REVENUE
A very important and practical consequence of the elasticity of demand is the effect that it
has on a firm’s total revenue as the price of the firm’s product changes. This effect is
summarized below.
If demand is elastic (Ed >1):
 a price decrease will increase a firm’s total revenue
 a price increase will decrease a firm’s total revenue
If demand is inelastic (Ed<1):
 a price decrease will reduce a firm’s total revenue
 a price increase will increase a firm’s total revenue
If demand is unitary elastic (Ed=1):
 a price decrease or a price increase will not change a firm’s total revenue.
The importance to a firm of knowing the elasticity of its demand curve is that it will know
what will happen to its total revenue with changes in the price of its product. For example
a firm that has price elastic demand should not raise its price because lower total
revenues will result.
Price Elasticity of Supply
The price elasticity of supply is a measure of the “stretching or contraction of the quantity
supplied” of a product in response to a change in the price of the product. It is very similar to
the price elasticity of demand discussed above, except that it applies to supply.
The formula for the price elasticity of supply is:
% change in Qsx = Es
% change in Psx
where Qsx is the quantity supplied of product x and Psx is the price of product x.
The result of the above formula calculation is the coefficient of price elasticity of supply
(Es). The Es measures the degree of elasticity in a change in the quantity of product x
resulting from a change in the price of product x.
If Es is > 1, then the response of Q supplied is said to be elastic.
If Es is < 1, then the response of Q supplied is said to be inelastic.
If Es is = 1, then the response of Q supplied is said to be unitary elastic.
Determinant of Price Elasticity of Supply
The primary determinant of price elasticity of supply is “time”. As time increases, the price
elasticity of supply increases because producers have more time to adjust production in
response to price changes.
Market Time Period
Period of time in which producers don’t have enough time to adjust production
levels in response to a price change of the product they produce. As a result in the
market period, the supply curve is perfectly inelastic.
Short Run Time Period
Period of time in which capital resources (plant and equipment) can not be changed,
but the labor resource can be modified. As a result in the short run period, the
supply curve is more elastic.
Long Run Time Period
In the long run firms can change the amount of all resources used in production and
can make larger changes in the level of output in response to price changes.
Therefore, in the long run the supply curve is even more elastic.
Conclusion: As the period of time increases, the price elasticity of supply (Es)
increases.
Other Elasticities
So far we have discussed above two types of elasticities (stretching/contraction of Q).
They are the price elasticity of demand and the price elasticity of supply. Both of these
elasticities measured changes in Q due to a change in price of the product under
consideration. Two other elasticities are also important. They are income elasticity of
demand and cross elasticity of demand.
“Income elasticity of demand” measure the changes in Q demanded in
response to a change in buyer’s income. The more Q demanded changes in response to
a change in buyer incomes, the more income elastic the demand for a given product is.
“Cross price elasticity of demand” measures the changes in Q demanded in response
to a change in the price of a related product (substitute or complementary product). The
more Q demand in response to the change in a related products price, the higher the
cross elasticity of demand.
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