ELASTICITY OF DEMAND AND SUPPLY

by modi Sun Oct 27, 2013 12:58 pm

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.