Managerial Economics Project-Check

A study on ELASTICITY DEMAND AND SUPPLY
Submitted in partial fulfillment of the requirements for the award of MASTER OF BUSINESS ADMINISTRATION IN MANAGERIAL ECONOMICS Submitted by Sunil B to
Affiliated to
ACKNOWLEDGEMENT First and foremost, I thank the Almighty God,my parents,teachers and friends.
This project bears imprint of all those who have directly or indirectly helped and extended their kind support in completing this project. At the time of making this project I express my sincere gratitude to all of them. I express my profound gratitude to my project guide
Prof.LAKSHMI KANNAN, my College Dean Mr.NEHERUJI for their constant guidance and encouragement and very kind support and valuable guidance in completing my project. At this moment I also thank almighty, my Parents and God for the blessings showed upon me and also my Friends for their valuable suggestions. I express my sincere thanks to the concerned people for granting permission to conduct my project work in his esteemed concern and for helping and providing various information and data.
Production & Operation Management
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STUDENTS DECLARATION
I, Mr.Sunil B hereby declare that the Project Work titled ELASTICITY OF DEMAND AND SUPPLY is the original work of mine and submitted to the South Asian University in partial fulfillment of requirements for the award of Master of Business Administration in MANAGERIAL ECONOMICS. Date
Signature of student
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ELASTICITY OF DEMAND AND SUPPLY
A) Definition Elasticity is the ratio of relative change of a dependent variable to changes in independent variables. Elasticity can be analyzed in terms of demand and supply. Elasticity of supply refers to the measure of the extent to which quantity supplied of a commodity responds to changes in price of the commodity, prices of certain other goods, or any other factor influencing supply.
Elasticity of Demand Elasticity of demand refers to the measure of the extent to which quantity demanded of a commodity responds to changes in any one of the influencing factors. That is, price of the commodity, consumers income, prices of other related goods, advertising or any other factors influencing demand
There are 3 types of elasticity of demand: 1) Price elasticity of demand 2) Income elasticity of demand
Production & Operation Management Page 4
3) Cross elasticity of demand.
1) Price Elasticity of Demand This is defined as the measure of the degree of responsiveness of quantity demanded to a change in the price of a commodity (Ceteris Paribus) it is calculated using the following general formula.
Price Elasticity of Demand = PED = ED = Proportionate change in quantity demanded Proportionate change in price
If a proportionate change in price causes a more than proportionate change in quantity demanded, demand is said to be price elastic e.g. 100% change in price resulting in a 150% change in quantity demanded. The value of ED in this case will be greater than one i.e. ED > 1
If a proportionate change in price causes a less than proportionate change in quantity demanded, demand is said to be price inelastic
e.g. 100% change in price resulting in a 50% change in quantity demanded. The value of ED in this case will be less than one i.e. ED < 1.
To illustrate price elastic and inelastic demand, consider the table below showing the demand schedules for commodity X and Y.
Commod ity X Shs. Per unit. Quantity demanded per week. 10 5 100 250
Commodity Y
Shs. Per unit
Quantity demanded per week.
10 5
100 120
For commodity X
ED= proportionate change in quantity demanded Proportionate change in price.

Proportionate change in quantity demanded = 150 * 100 =150% 100
Proportionate change in price = - 5 10 ED= 150 = -3 -50 IEDI = 3
* 100 =-50%
In absolute terms, a proportionate change in price causes a more than proportionate change in quantity demanded of X IEDI = 3 therefore IEDI > 1
Thus the demand for the commodity is said to be price elastic.
For commodity Y ED = Proportionate change in quantity demanded
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Proportionate change in price
Proportionate change in Quantity demanded = 20 *100 = 100% 100 Proportionate change in price = -5 *100 =-50% 10 ED = 20 = -0.4 -50 IEDI= 0.4 In absolute terms, a proportionate change in price of commodity Y causes a less the commodity, i.e.IEDI<1 Thus the demand for commodity Y is price inelastic. N.B. ED has a negative value because of the inverse relationship between the price of the commodity and the quantity demanded of the same. The absolute value is considered as the interest in the extent of the change and not the direction of the change. than proportionate change quantity demanded of
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If a proportionate change in price causes a proportionate change in quantity demanded, demand is said to be unit price elastic.
Measurement of price elasticity of demand Price elasticity of demand can be measured in two ways:
i) ii)
Point elasticity of demand Arc elasticity of demand
i)
Point Elasticity of Demand This is the measure of price elasticity of demand at a particular price or a particular point on the demand curve. It is valid for very small changes in price. For a straight-line demand curve, point elasticity of demand can be found by using the following formula
Point ED = Q/Q = P/P
Q*P P Q
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Where P is the price at the point and Q is the quantity at the point of measurement. "(Q/P)" is the derivative of the demand function with respect to P. "Q" means 'Quantity' and "P" means 'Price'. To illustrate this consider the diagram below: To illustrate point price elasticity with a straight line demand curve
Point ED = Q * P = Q * P = Q * P2 (at point B) P Q P Q P Q2
For a non linear demand curve, Q will refer to the slope at the point of
tangency to the curve at the point of Measurement. This is illustrated below To illustrate point price elasticity with a non-linear demand curve.
Point ED (at point A) = Q * P P Q
= Q *P1 P
Q1
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Q=1 P Slope
Hence the slope is equal to P / Q Where the slope refers to the slope of the tangent TT
Example 1 Demand curve: Q = 1,000 - 0.6P a.) Given this demand curve determine the point price elasticity of demand at P = 80 and P = 40 as follows.
i.) obtain the derivative of the demand function when it's expressed Q as a function of P. Q = -0.6 P ii.) next apply the above equation to the sought ordered pairs: (40, 976), (80, 952) PED = Q * P P Q
e = -0.6(40/976) = -0.02 e = -0.6(80/952) = -0.05

Example 2 Consider the following DD schedule, compute the price elasticity of demand and when price =6 when Price = 4
Price per unit of X 8 7 6 5 4 3 2 1
Quantity demanded per week. 0 5 10 15 20 25 30 35
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a. PED when P=6 Point ED= Q * P P Q
At P= 6, Q=10, therefore, Point ED = Q * 6 P Q =1 P Slope 10
Slope = -1 = -0.2 5
Point PED (at price 6)= Q * P = 1 * 6 P Q 0.2 10
Point ED= -3
Point IEDI = 3 Thus demand is price elastic at P = 6
b. When P=4 Point ED = Q * P = Q * 4 P = Q = 1 P slope Slope = - 0.2 Point PED = Q * P (at P=4) P Q =-1 * 4 0.2 20 Point ED =-4 = -1 4 Point IEDI= 1 Thus demand is unit price elastic at P= 4
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Example 3 Given the following demand function, determine the point elasticicity of demand at the given prices. Qd=10-2P2 Find PED at P=1, P=2 and P=3 When P=1 Q=10-(2*1*1) Q=8 Slope= P Q 1 = Q=-4P= (-4*1) Slope P Point PED= 1 *P Slope Q =-4*(1) 8 = -0.5
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IPEDI= 0.5 Demand is price inelastic at P=1
When P=2 Q=10-(2*2*2) Q=2 Slope= P Q 1 = Q = -4P=(-4*2)=-8 Slope P Point PED=1 * P Slope Q =-8* 2 2 =-8 IPEDI=8 Demand is price elastic at P=2
When P=3,PED=4.5 and demand is price elastic. (Students work this out) 2 Example 4 ii. P=10-Q2 Find price elasticity of demand when Q=3 PED= Q* P= P Q Q= -1 P 2Q
P=10-(3*3) P=1
Q*P =-1 * 1 P Q 2Q 3
= -1
(6*3) = -1 18 IPEDI= 1 18 Demand is price in elastic when Q = 3
When Q=1(students to work out this)
ii)
Arc Elasticity of Demand This refers to the measurement of price elasticity between two points on a demand curve (between two prices). It is calculated both for linear and non-linear demand curves using the following formula:
Arc ED= Q *(P1+P2)/2 P (Q1+Q2) = Q * p1+p2
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q1+q2
In the formula above, P1 and Q1 represent the initial price and quantity respectively. Thus (P1 + P2)/2 is a measure of the average price between the two points along the demand curve and (Q1 + Q2)/2 is the average quantity in that range. Graphically, Arc elasticity can be illustrated as follows: To illustrate Arc elasticity of demand
For linear demand curves curves.
For
non-linear
demand
Arc ED (at point A and B)= Q * p1+p2
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P q1+q2 Pt.Cand D) Q * p3+p4 P q3+q4
Arc ED(at.
Given the following data, calculate the price elasticity of demand in the price range of 5-6 and 1-2. The data is as follows
Price\unit 8 7 6 5 4 3 2 1 For the price range of 5-6
Quantity demanded\week 0 5 10 15 20 25 30 35
Arc elasticity of demand = Q * p1+p2

q1+q2
p1=5 q1=15 p2=6 q2=20 Q=-5 P=1 Arc ED= -5 * (5+6) 1 (15+10)
Arc PED= -2.2 Arc IPEDI= 2.2 Thus demand is price elastic between p=5 and p=6 For the price range, 1-2, demand is price inelastic and Arc ED is 0.23 (Students should work this out) Qd=10-P2 Find PED on the price range P=1 and P=2 When P=1,Q=8 When P=2, Q=6 Arc ED= Q * p1+p2
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Q1+Q2
Q=-3 P=1 = -3 *(1+2) 1 = -0.6 (6+9)
Arc IEdI=0.6 Thus demand is price inelastic between P=1 and P=2 Example ( check) If Demand changed from 8 units to 12 units, the midpoint percent change would be (12-8)/((12+8)/2))=40%. Normal percentage change would equal (12-8)/8= 50%. The midpoint formula has the benefit that a movement from A to B is the exact negative of a movement from B to A. In our example, the midpoint percentage would be -40%, whereas our normal percentage change would be -33.3%. In the above example, assume the change from 8 to 12 units demanded was caused by a change in price from $3 to $1. The midpoint percentage change of price would be -100%. Therefore, the price elasticity of demand would be: (40%/-100%) or -40%. Often when speaking of price
elasticities, it is common to write it as the negative or absolute value of the elasticity, such that price elasticity becomes a positive number.
Price Elasticity of Demand and the Demand Curve On any demand curve PED would be different at different prices. To illustrate this consider the diagram below:
To illustrate the relationship between PED and the demand curve Check bk
When price changes from 50-40 quantity demanded increases from 4-6 units, in this case PED = 2.5 and demand is price elastic.
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When price changes from 40-30, quantity demanded increases from 6-8 units, in this case PED = 1.33 and demand is price elastic.
When price changes from 30-20, quantity demanded increases from 8-10 units, in this case PED = 0.75 and demand is price inelastic. Price elasticity of demand along a straight line demand curve is thus not the same at all prices. There are 3 exceptional cases, where price elasticity of demand is the same at all prices i.e. throughout the demand curve. These are illustrated below:
To illustrate the exceptional cases
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Perfectly price elastic price elastic
perfectly price inelastic
Unit
In the case of perfectly price inelastic demand curve, quantity demanded does not change with changes in price i.e. quantity demanded is the same at all price levels. In this case, demand is described as being perfectly price inelastic. An example of a commodity with this kind of demand is insulin, which is consumed, in fixed amounts. Insulin is described as a being an absolute necessity.
In the case of perfectly price elastic demand curve, price is the same at all levels of demand. In this case demand is described as being perfectly price elastic. An example of this is the demand curve facing a perfectly competitive market i.e. one with many buyers and sellers for a commodity and the sellers are producing a homogenous commodity.
In the case of unit price elastic demand curve, quantity demanded changes at the same proportion as the change in price at all price levels. Demand in this case is described as being unit price elastic. Determinants of Price Elasticity of Demand
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1.
Availability of Substitutes: The greater the number of substitutes for a commodity over a relevant price range, the greater will be its elasticity of demand. This is because
consumers can respond to an increase in price of the commodity by switching expenditure away from it and buying instead the substitute. If perfect substitute of a
commodity are available demand is likely to be highly elastic. Conversely if no substitutes are available demand would be price inelastic. For example, if the price of a cup of coffee went up by $0.25, consumers could replace their morning caffeine with a cup of tea. This means that coffee is an elastic good because a raise in price will cause a large decrease in demand as consumers start buying more tea instead of coffee. A contrasting inelastic good would be water which is arguably insubsitutable so a local community faced with rising water costs will be left with little choice but to pay the increased costs forming an price inelastic good
2.
Proportion of Income Spent on a Commodity: The greater the proportion of income which the price of a commodity represents the greater would be its price elasticity of demand
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e.g. a 50% increase in a price of a match box will not have the same effect on quantity demanded as a 50% increase in the price of cars.
3.
Time: Following a change in price, of demand would be greater in the long run than in the short run e.g. an increase in the price of meat will not change peoples eating habits overnight only, if this prices remain high people are eventually going to look for substitutes. For example, in the short run, the price elasticity of demand for fuel may be low because people have few options. But over a longer period, the price elasticity of demand for fuel may be much greater than in the short run as people replace their high fuel consuming vehicles with fuel efficient, compact vehicles, switch to car pools and to public transportation, and take other steps to reduce fuel consumption.
4.
Durability: The greater the durability of a product the greater its elasticity of demand and vice versa e.g. if the price of salt increases it is not possible to use the salt twice. However, if
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the price of furniture rises it can be made to last a little longer.
5.
Width of the Market: The wider the definition of a market for a commodity the more inelastic its demand is e.g. the demand for a particular brand of cigarette will tend to be elastic because of other brands which are close substitutes, while the total demand for cigarettes will be price inelastic.
6.
Nature of the Commodity:
In general, the demand for
luxuries will tend to be price elastic while that of necessities price inelastic. However, if no obvious substitutes exist for luxurious commodities its demand will be price inelastic. Also if, there are substitutes for a necessity, its demand will be price elastic.
7.
Level of Price: Since price elasticity is different at different prices then the initial price is an important determinant of elasticity of demand.
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8. Number of Uses: The greater the number of uses to which a commodity can be put, the greater its elasticity of demand e.g. electricity has many uses i.e. heating, lighting, cooking etc. A rise in price of electricity will therefore cause people not only to save on usage but also to find substitutes.
Relationship between Price Elasticity of Demand and Revenue
This relationship can be summarized as follows:
1)
If demand is price elastic (a proportionate change in price causes a more than proportionate change in quantity demanded) then an increase in price will reduce total revenue while a fall in price will increase total revenue.
2)
If demand is price inelastic (a proportionate change in price results in a less than proportionate change in quantity demanded) then an increase in price will increase total revenue while a decrease in price will reduce total revenue.
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3)
If demand is unit price elastic (a proportional change in price causes a proportionate change in quantity demanded) then changes in price will not produce any change in total revenue. To illustrate this consider the diagrams below:
To illustrate the relationship between PED and Revenue: Check book Price elastic demand Price- inelastic demand.
Curves D1 and D2 represent price elastic and inelastic demand curves respectively.
An increase in price from p1 to p2 in both cases will cause a fall in quantity demanded from q1 to q2.
The revenue lost by the producer as a result of the fall in quantity demanded is represented by area Y while the gain in revenue as a result of the increase in price is represented by areas X. The case of price elastic demand, X < Y thus a fall in total revenue while in the case of price inelastic demand, X > Y thus an increase in total revenue.
A fall in price will have the opposite effect for both cases.
2.
Income Elasticity of Demand (Ey)
This refers to the measure of the degree of responsiveness of quantity demanded of a commodity to changes in consumers income or the degree to which an increase in income will cause an increase in demand is called income elasticity of demand, which can be expressed in the following equation:
It is calculated using the following general formula.
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Income elasticity of demand = Ey = a proportionate change in quantity demanded a proportionate change in income
If Ey > 1, demand is said to be income elastic e.g. 100% change in income resulting in 120% change in quantity demanded.
If Ey < 1, demand is said to be income inelastic e.g. 50% change in income resulting in a 20% change in quantity demanded.
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If Ey = 1 demand is said to be unit income elastic e.g. a 10% change in income resulting in a 10% change in quantity demanded.
In general the income elasticity of luxuries is greater than 1 while that of necessities is less than 1. The value of income elasticity of demand for normal goods is positive because of the direct relationship between income and quantity demanded. If Ey has a negative value, the commodity in question is an inferior good.
If EDy is greater than one, demand for the item is considered to have a high income elasticity. If however EDy is less than one, demand is considered to be income inelastic. Luxury items usually have higher income elasticity because when people have a higher income, they don't have to forfeit as much to buy these luxury items. Let's look at an example of a luxury good: air travel.
Bob has just received a $10,000 increase in his salary, giving him a total of $80,000 per annum. With this higher purchasing power, he decides that he can now afford air travel twice a year instead
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of his previous once a year. With the following equation we can calculate income demand elasticity:
Income elasticity of demand for Bob's air travel is seven - highly elastic.
With some goods and services, we may actually notice a decrease in demand as income increases. These are considered goods and services of inferior quality that will be dropped by a consumer who receives a salary increase. An example may be the increase in the demand of DVDs as opposed to video cassettes, which are generally considered to be of lower quality. Products for which the demand decreases as income increases have an income elasticity of less than zero. Products that witness no change in demand despite a change in income usually have an income elasticity of zero - these goods and services are considered necessities.
Determinants of Income Elasticity of Demand
a.
Nature
of
the
commodity:
Is
it
an
inferior
b.
Level of income: e.g. a TV set is a luxury in an underdeveloped country while in a developed country with high per capital income it is a necessity.
c.
Time Period: Consumption patterns adjust with a time lag to changes in income. Demand will therefore tend to be income elastic in the long run than in the short run.
3.
Cross Elasticity of Demand (Ex) This refers to the degree of responsiveness of quantity demanded of a given product to changes in the price of a closely related commodity. following general formula It is measured using the
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Ex = Proportionate change in quantity demanded of A Proportionate change in price of B
B can either be a substitute or a compliment.
Cross elasticity of demand measures the degree of substitutability and products. complimentarity between different
Substitutes have a positive cross elasticity of
demand and the higher the positive value of Ex the higher the degree of substitutability. Compliments have a negative
cross elasticity of demand and the higher the negative value of the co-efficient of Ex the higher the degree of complimentarity between the two commodities.
The main determinant of cross elasticity of demand is the nature of the two commodities relative to their uses e.g. if two commodities can satisfy equally well the same need, the cross elasticity between them will be high and vice versa.
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Importance/Applications of Elasticity of Demand
1. Price Elasticity of Demand i) Sales Revenue: the concept of price elasticity of demand is important for a businessman in predicting the effect of changes in price on his sales revenue. ii) Consumption Patterns: if the government wants to discourage the consumption of a particular commodity through taxation, this policy will only be effective if the price elasticity of demand of the commodity is high. iii) Tax Shifting: refers to the transfer of the money burden of taxation by a producer on whom the tax is imposed to the consumer in the form of increased product prices. The extent to which this burden can be transferred depends on the price elasticity of the commodity in question. illustrate this consider the diagrams below. To
To illustrate tax shifting: (Chek bk)

Price elastic demand demand
Price
inelastic
DD and D1D1 represent elastic and inelastic demand curves respectively. The equilibrium price is OP1 and the quantity OQ1. SS is the initial supply curve.
Suppose there is an imposition of a unit tax on the producer of this commodity the effect would be a fall in supply reflected by the shifting of the supply curve to the left from SS to S1S1. A new equilibrium price would be established at Opt.
The vertical distance between the two supply curves at any point represents the unit tax. Thus AC in the diagrams above represents the unit tax. Out of this the consumer pays AB in the form of increased product prices and the producer BC which represents un-shifted tax burden.
In the case of elastic demand, AB is less than BC while in the case of inelastic demand AB is greater than BC. Thus it is when the price
elasticity of demand is slow the firm can transfer most of the burden of taxation to the consumer.
iv)
Devaluation: price elasticity of demand is relevant if a country is considering devaluation as a means of rectifying balance of payment problems. Devaluation generally refers to the cheapening of the value of a countrys currency in terms of other foreign currencies. This will reduce export and increase import prices. Whether or not this will
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improve the balance of payment situation depends on the relevant price elasticities of demand i.e. the higher the price elasticity of demand for imports and exports the greater the improvement on the balance of payment.
v)
Fluctuations in agricultural prices: the more inelastic the demand for agricultural products are, the more widely prices will fluctuate with changes in output from period to period. To illustrate this consider the diagram below.
To illustrate relationship between PED and price instability in agriculture.
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DD and D1D1 represent inelastic and elastic demand curves respectively. SS is the initial supply curve and OPe and Oqe is equilibrium price and quantity respectively. Suppose there is a fall in supply of this agricultural commodity because of a poor harvest, this would be represented by the shifting of the supply curve to the left as shown in the diagram above. The equilibrium price established would depend on the price elasticity of demand i.e. under conditions of inelastic demand as represented by DD prices will fluctuate from Pe to P2 while under conditions of the elastic demand as represented by D1D1 prices will fluctuate less sharply from Pe to P1. N.B.: The demand for agricultural commodities tend to be price inelastic because they constitute a small proportion of the manufacturers demand and also most of the agricultural commodities consist of foodstuffs.
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2. Income Elasticity of Demand Resource Allocation: the concept of income elasticity of demand has wide implications on resource allocation e.g. as a country experiences economic growth the proportion of income spent on luxury will be increasing while that spent on necessities will be falling. This information would be useful if the government is making policy decisions and for private firms in making decisions on production and employment.
3. Cross Elasticity of Demand i) Protection Policy: the concept of cross elasticity of demand is useful to the government in predicting the effects of its protection policy e.g. if the government imposes a tariff on an imported commodity with the intention of protecting a local industry, then the local and imported product must be close substitutes for the government to achieve its objective. If the imported commodity is of a relatively higher quality then the imposition of the
tariff will not achieve its end as people will still buy the imported product. ii) Competition and Prices: if a firm is in competitive industry, there would be a high cross elasticity between its products and those of other firms. For such a firm it may not be in its interest to increase price rather it will try to attract consumers from other firms by lowering its price.
ADVERTISEMENT OR PROMOTONAL ELASTICITY OF SALES The expenditure on advertisement and on other sales-promotion activities do help in promoting sales, but not in the same degree at all levels of the total sales. The concept of advertisement elasticity is useful in determining the optimum level of advertisement expenditure. Point advertisement elasticity (EA) of sales may be defined as
EA
% Q Q / Q % A A / A Q A . A Q
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The value of Q/A is computed by taking the derivative of Q x with respect to A, which equals a6. Therefore, the formula for the point advertisement elasticity of demand or sales can be rewritten as
E A a6 A QX
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Interpretation
of
advertisement-elasticity:
The
advertisement
elasticity of sales varies between EA = 0 and EA = .
Elasticities EA = 0
Interpretation Sales do not respond to the advertisement
expenditure. 0 < EA < 1 Increase in total sales is less than proportionate to the increase in advertisement expenditure. EA > 1 Sales increase at higher rate than the rate of increase of advertisement expenditure.
Determinants of Advertisement Elasticity
The following factors determine the advertisement elasticity. a. Level of the total sales. In the initial stages of sales of a product, particularly of one which is newly introduced in the market, the advertisement elasticity is greater than unity. As sales increase, the elasticity decreases.
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b. Advertisement by rival firm. In a highly competitive market, the effectiveness of advertisement is determined also by the relative effectiveness of advertisement by the competing firms.
c. Cumulative effect of past advertisement. In case expenditure incurred on advertisement in the initial stages is not adequate enough to be effective, elasticity may be very low. But over time, additional doses of advertisement expenditure may have
cumulative effect on the promotion of sales and advertising elasticity may increase considerably.
d. Advertising elasticity is also affected by other factors affecting demand for product, e.g., change in products price, consumers income, growth of substitute and their prices.
Elasticity of Supply This is defined as a measure of the extent to which quantity supplied of a product responds to changes in the influencing factors.
Price Elasticity of Supply (Es)

This refers to a measure of the degree of responsiveness of quantity supplied of a product to changes in the price of the commodity. It is calculated using the following general formula:
Price Elasticity of Supply = Es = Proportionate Change in Quantity Supplied Proportionate Change in Price
For point elasticity of supply
Qs * P P Q
For arc elasticity of supply
Qs * P1+P2 P Q1+Q2
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N.B.: Es will have a positive value because of the direct relationship between quantity supplied and price. If Es > 1 supply is said to be price elastic. If Es < 1 supply is said to be price inelastic. If Es = 1 supply is said to be unit price elastic.
Relationship between Price Elasticity of Supply and the Supply Curve
To illustrate this relationship consider the diagram below:
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Thus as the slope of the curve increases, price elasticity of supply is reducing and vice versa. Therefore, there is an inverse
relationship between price elasticity of supply and the slope of the supply curve. N.B.: Steeply sloping supply curves will be associated with inelastic supply while gently sloping supply curves will be associated with elastic supply.
Types of Price Elasticities of Supply
1.
Perfectly inelastic supply: supply is said to be perfectly inelastic if quantity supplied is constant at all prices thus Es in this case = 0 and the curve would be a vertical straight line. This is illustrated below. To illustrate perfectly inelastic supply
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This is the case of a very short run situation where increases in price do not cause an increase in quantity supplied e.g. goods brought to the market in the morning cannot be immediately increased as prices increase.
2.
Inelastic supply: supply is said to be price inelastic if a proportionate change in price causes a less than proportionate change in quantity supplied. In this case the value of Es < 1 and the supply curve touches the X axis this is illustrated in the diagram below.
To illustrate price inelastic supply
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This is the case of a commodity with limited stock or one, which takes a long time to produce. Thus when price is increased quantity supplied cannot be increased drastically. Also it is the case of a highly perishable product, which if price falls quantity supplied cannot be reduced substantially through storage e.g. milk.
3.
Unit price elastic supply: supply is said to be unit price elastic if changes in price bring about changes in quantity supplied in equal proportions. The value of Es in this case = 1 and the supply curve is a straight line passing through the origin. This is illustrated below.
To illustrate unit price elastic supply
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This is the case of a commodity with adequate stock or one, which can be produced, in a fairly short period of time. Thus when price increases supply can easily be expanded or it is the case of a product, which is relatively non-perishable and cannot be stored. Thus when price falls supply can easily be contracted.
4.
Price elastic supply: supply is said to be price elastic if a change brings about a change in quantity supplied in a greater proportion. The value of Es in this case > 1 and the supply curve touches the Y-axis. This is illustrated below.
To illustrate price elastic supply
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This is the case of a commodity with plenty of stock or one which can be produced in a very short period of time. Thus if price increases quantity supplied can be expanded very easily. It is also the case of a manufactured commodity
which can be easily stored instead of being sold at a loss or at a reduced profit margin.
5. Perfectly price elastic supply: supply is said to be perfectly or infinitely price elastic if price is fixed at all levels of supply. The value of Es = and the supply curve is a straight horizontal line.
6. This is illustrated below.
To illustrate perfectly price elastic supply
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This is the case of price controls.
Factors Determining Price Elasticity of Supply
1.
Level of employment: with a situation of full or near full employment of resources, the supply of most commodities will tend to be price inelastic. This is because with an
increase in demand which results to an increase in prices, production cannot be expanded. To increase production at full
employment will call for an improvement in technology or discovery of new economic resources. This too may not be possible in the short run.
2.
Mobility of factors of production: the higher the degree of factor mobility the more responsive quantity supplied of a commodity will be to changes in price. If the factors of production are relatively mobile supply will tend to be price elastic.
3.
Production time: if it takes a long time to produce a commodity, its supply will tend to be price inelastic e.g. production of wine. Supply will however be price elastic if the production time is relatively shorter.
4.
Level of stock: if the level of stock of a particular product is high supply would be price elastic. This is because with increases in price more supplies would be retrieved from the store.
5.
Nature of the commodity: price elasticity of supply will depend on the nature of commodities i.e. the supply of perishable products will not respond to a fall in price as they cannot be stored. On the other hand the supply of manufactured products will
decrease with a fall in price of the items.

6.
Time interval: supply will tend to be price elastic in the long run than in the short run.
7.
Risk taking: the more willing entrepreneurs are to take risks the more supply will be responsive to changes in price
Applications of Price Elasticity of Supply
1.
If supply of a commodity is price elastic, an increase in demand will benefit both the producer and the consumer. This is because the producer will be in a position to supply relatively more of his commodity and the consumer to pay a relatively lower price. To illustrate this, consider the diagram below.
To illustrate effect of a change in demand under conditions of elastic and inelastic supply
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The diagram above combines two conditions of supply i.e. when supply is price elastic as represented by S1 and when it is price inelastic as represented by S. The original demand curve is DD which intersects with the supply curve to establish an equilibrium price of OPe and quantity OQe. If demand increases the demand curve will shift to the right from DD to D1D1. Two possible new equilibrium positions would be established depending on the elasticity of supply.
If supply is relatively price inelastic as represented by SS an increase in demand will establish a new equilibrium price of OP2 and quantity OQ2. If however, supply is relatively price
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elastic the new equilibrium price will be relatively lower at OP1 and quantity relatively higher at OQ1.
2.
If supply is price inelastic businessmen risk losing revenue when there is a fall in price. This is because they would be forced to sell their product at a loss or at a reduce profit margin. If however, supply is price elastic businessmen can store their products when prices fall thus contracting supply.
3.
The possibility of shifting part or whole of the money burden of tax by a producer to a consumer will also be determined by the price elasticity of supply. The more inelastic the supply of a commodity is the more difficult it is for the producer to shift the money burden of tax to the consumer.
Reasons why agricultural prices fluctuate One of the main problems facing the agricultural industries is the instability of prices of agricultural products which fluctuate more widely than the prices of industrial products. The reasons for these fluctuations derive from the elasticity of demand and supply of
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agricultural products and their supply conditions. these reasons include: i)
Specifically
The supply of agricultural products is more directly affected by natural forces such as weather, diseases and pests than the supply of industrial products. In most cases these natural forces tend to be unpredictable and beyond the control of the farmers. Thus in agriculture there is always a divergence between planned and actual output while in industry output is relatively predictable. The effect of divergence is a shift of the short run supply curve whose position will depend on whether the harvest is good or bad.
ii)
Fluctuation in prices resulting from natural forces are intensified by the inelasticity of supply. The short run supply curve tends to be price inelastic because of the following reasons: a) Once a given amount of crop has been planted, it is difficult to increase or decrease the resulting output. b) It is relatively difficult to store agricultural products as most of them tend to be perishables. To illustrate how inelasticity of supply worsens price fluctuations resulting to natural forces consider the diagram below:
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DD is the initial demand curve and Ls is the long run supply curve indicating the amount that producers would plan to supply at each and every price. Thus OPo and OQo would be the equilibrium price and quantity respectively if actual production was to equal planned production.
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If however, as a result of natural forces, the production of agricultural products was to be below planned production say, at OQ1, and were fixed at this amount the short run supply curve would become S1 establishing an equilibrium price of OP1.
On the other hand, if actual production was to exceed planned production say, at OQ2 and was fixed at this amount the short run supply curve would become S2 establishing an equilibrium price of OP2.
Thus fluctuation in the amount produced and supplied can produce wide fluctuations in prices of agricultural commodities. If the short run supply curve had not been perfectly price inelastic say, S3 instead of S1, the rise in price in the first instance would only have been to OP3 instead of OP1.
If the short run supply curve had been more elastic as represented by S4 the rise in price would have been still less to OP4.
Thus the more inelastic the short run supply curve, the more fluctuations in price produced in a change in supply.
iii)
The effect of fluctuation in the amounts supplied is aggravated in the case of agricultural products by the inelasticity of supply. . The demand for agricultural
products tend to be price inelastic because of the following 2 reasons: a) Agricultural products consists mainly of food stuffs whose demand tends to be inelastic especially in the case of staple foods. b) Most agricultural commodities are only inputs used in the production of other products and form a very small proportion of the total cost of that product. To illustrate how inelasticity of demand aggravates price instability consider the diagram below:
To illustrate how inelasticity of demand increases price instability
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The initial equilibrium is at price OPo and at quantity OQo. Ls is the planned output. Suppose there is a divergence between planned output and actual output, the short run supply curve will shift to the left if the actual supply was less than the planned supply i.e. S1.
The new equilibrium price established will depend on the elasticity of demand. If demand is relatively price elastic as represented by D1, the rise in price would be a sharp one to OP1. On the other hand, demand is
relatively price elastic as represented by D2, the rise in price would be a more moderate one to OP2. Thus, the more inelastic the demand for a product is the more sharply prices will fluctuate as a result of a change in supply.
iv)
Nature of commodity: price fluctuation of agricultural commodities will also depend on the degree to which it is possible to store the product i.e. a sharp increase in price could be prevented during a shortage in output by sale from stock. A fall in price during a glut could be prevented by adding the excess output to the stock. The extent to which this is possible depends on how easily a product can be stored. Most agricultural products are often perishables e.g. fruits, flowers, etc. Industrial products on the other hand tend to be less perishable thus easy to store. This difference is reflected by the wide seasonal variations in prices exhibited by many agricultural products.
v)
Cobweb theorem:
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Equilibrium prices are also difficult to attain because of the lagged response by farmers to price . To illustrate this,
suppose that supply which is a function of price is written as follows:
St = f (Pt) where t is the time period.
In agriculture however, it is the price of the previous period that determines the supply in the current period i.e. farmers will look at this years price in determining how much of the crop to plant for the next year i.e.
St = f (Pt 1)
The effect of this lagged response of the farmers on market equilibrium is explained by the cobweb theorem whose diagram is illustrated below.
To illustrate the Cobweb Theorem
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Suppose both the diagrams above show the demand and supply curves for corn.
In year 1 for some reason, the price is at OP1. At this price farmers would wish to supply a quantity of OQ1 and are thus encouraged to do so for year 2. In year 2, the output is OQ1 and is fixed at that quantity in the short run. However, an output of OQ1 can only be sold at a price of OP2 thus price falls to this level.
This low price discourages farmers from planting corn and so they only produce an amount of OQ2 in the following year. However, this is sold at a higher price of OP3. The price of OP3 encourages farmers to produce more and so on.
From the diagram above, tracing a line through the relevant points on the demand and supply curve, a cobweb is obtained hence the name of the theorem.
There are a number of means available to the government to stabilize prices and also incomes to the farmers. They include the following:
i)
Operation of a buffer stock: in this case the government buys part of the supply when output is excessive, stores the surplus and resells it to the consumer in times of shortage or reduced supply. This will have the effect of stabilizing prices of agricultural commodities.
ii)
Operation of a fund: instead of actually dealing with the commodity, the government could choose only stabilize only the farmers income. This is done through a fund, which the government could make direct payments to growers by purchasing products at a given price and selling it to consumers at market price. The price is set in such a way as to ensure a stable income to farmers
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despite fluctuations in output. The operation of the fund is done through a marketing board. iii) Price control: through the use of a minimum price, the government can ensure adequate income to farmers and also stabilize prices of agricultural products.
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Managerial Economics Project-Check

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A study on ELASTICITY DEMAND AND SUPPLY

Production & Operation Management

Production & Operation Management

ELASTICITY OF DEMAND AND SUPPLY

3) Cross elasticity of demand.

Shs. Per unit

Quantity demanded per week.

ED= proportionate change in quantity demanded Proportionate change in price.

Proportionate change in quantity demanded = 150 * 100 =150% 100

Proportionate change in price = - 5 10 ED= 150 = -3 -50 IEDI = 3

Thus the demand for the commodity is said to be price elastic.

For commodity Y ED = Proportionate change in quantity demanded

Production & Operation Management

Proportionate change in price

Production & Operation Management

Point elasticity of demand Arc elasticity of demand

Point ED = Q/Q = P/P

Production & Operation Management

Point ED = Q * P = Q * P = Q * P2 (at point B) P Q P Q P Q2

Point ED (at point A) = Q * P P Q

e = -0.6(40/976) = -0.02 e = -0.6(80/952) = -0.05

Price per unit of X 8 7 6 5 4 3 2 1

Quantity demanded per week. 0 5 10 15 20 25 30 35

Production & Operation Management

a. PED when P=6 Point ED= Q * P P Q

At P= 6, Q=10, therefore, Point ED = Q * 6 P Q =1 P Slope 10

Point PED (at price 6)= Q * P = 1 * 6 P Q 0.2 10

Point IEDI = 3 Thus demand is price elastic at P = 6

Production & Operation Management

IPEDI= 0.5 Demand is price inelastic at P=1

(6*3) = -1 18 IPEDI= 1 18 Demand is price in elastic when Q = 3

When Q=1(students to work out this)

Arc ED= Q *(P1+P2)/2 P (Q1+Q2) = Q * p1+p2

Production & Operation Management

For linear demand curves curves.

Arc ED (at point A and B)= Q * p1+p2

Production & Operation Management

P q1+q2 Pt.Cand D) Q * p3+p4 P q3+q4

Price\unit 8 7 6 5 4 3 2 1 For the price range of 5-6

Arc elasticity of demand = Q * p1+p2

Production & Operation Management

Q=-3 P=1 = -3 *(1+2) 1 = -0.6 (6+9)

Production & Operation Management

To illustrate the exceptional cases

Production & Operation Management

Perfectly price elastic price elastic

perfectly price inelastic

Production & Operation Management

Production & Operation Management

Production & Operation Management

the price of furniture rises it can be made to last a little longer.

Nature of the Commodity:

In general, the demand for

Production & Operation Management

Relationship between Price Elasticity of Demand and Revenue

This relationship can be summarized as follows:

Production & Operation Management

Income Elasticity of Demand (Ey)

It is calculated using the following general formula.

Production & Operation Management

Production & Operation Management

Production & Operation Management

Determinants of Income Elasticity of Demand

Arc ED= Q (P1+P2)/2 P (Q1+Q2) = Q p1+p2